Who would have expected extreme thinking from central bankers? That is the theme of some coverage in the financial press over the past few weeks. For example, the Financial Times takes note that “a growing chorus of economists is saying central banks should take more radical steps, including buying assets other than government bonds.”

Some, if not all, of these steps are not so radical from a broad historical perspective. Following the recent bankers’ brainstorming session in Jackson Hole, Wyoming, Fed Chairman Ben Bernanke was said to be pondering various possibilities including (1) QE (quantitative easing) 3, (2) a lowering of the interest rate paid on banks’ reserve accounts at the Fed, (3) an extension until 2015 of the Fed’s low-interest-rate precommitment, and perhaps in the longer term, (4) adopting nominal GDP targeting, as endorsed, for example, by George Soros in a recent opinion piece on the eurozone and Germany in particular.

Today, the Fed announced that it would adopt options (1) and (3), purchasing $40 billion in mortgage-backed debt each month for an indefinite period and predicting that the federal funds rate would remain near zero through mid-2015 (see news article for more details).

Most of the measures being contemplated are portrayed as more radical than they actually are, in my view. For example, most of the actions being pondered by the Fed could not match the impact of the approximately $500 billion “fiscal cliff” due in January, or even the “fiscal clifflet,” the Economist’s phrase for the portion of the cliff that actually winds up going into effect, once the current Congress gets its last chance to pass legislation.  As a blog at that publication’s site puts it,

Even if the Bush tax cuts are extended and the sequester delayed, a huge amount of fiscal drag remains in place. They include the expiration of the payroll tax cut, the expiration of extended unemployment insurance benefits, imposition of a new 3.8% Medicare investment tax on the wealthy, and the bite to discretionary spending embedded in the Budget Control Act and prior continuing resolutions.

One novel and potentially effective Fed approach would be the monetary “helicopter drop” recently discussed in the full-page FT article and a recent column in the same newspaper. The idea would be for the central bank (the Fed in the US case) to send money to individuals, through direct deposits in Americans’ bank accounts or by distributing currency via the banking system. continue reading…

Whatever the outcome of efforts to resolve severe economic difficulties in Europe and elsewhere, it is becoming increasingly clear that the next big economic crisis may not hinge on interest rates at all. One reason is that the world’s central banks, many of them following something like a Robinsonian “cheap money policy,” have managed to keep interest rates reasonably low in many countries. For example, it seems clear that yields on Spanish and Italian bonds are under control for now, after statements last month by Mario Draghi, the president of the ECB, that he was “ready to do whatever it takes,” to keep interest rates down. As made clear in this interesting and enlightening 2003 book edited by Bell and Nell (Stephanie Bell Kelton and Edward Nell), the theoretical argument for the Eurozone was badly flawed from the beginning.  (Indeed, many in the world of heterodox economics saw these  flaws from the beginning.) But, returning in this post to a key theme in Joan Robinson’s writings on the interest rate, I will offer some of the thoughts of John Maynard Keynes himself, who wrote in 1945 that:

The monetary authorities can have any rate of interest they like.… They can make both the short and long-term [rate] whatever they like, or rather whatever they feel to be right. … Historically the authorities have always determined the rate at their own sweet will and have been influenced almost entirely by balance of trade reasons [Collected Writings*, xxvii, 390–92, quoted from L.–P. Rochon, Credit, Money and Production, page 163 (publisher book link)].

Here in the United States, the Fed has shown its ability as a liquidity provider to keep interest rates on relatively safe investments very low across the maturity spectrum, despite spending much more than it received in tax payments in calendar years 2009–2011, and presumably the current year.  Keynes’s statement, much like the quote from Robinson mentioned above and the one in this earlier post, foretells this outcome.

Hence, recent US experience supports the view that calls for cuts in government spending and/or tax increases cannot be justified by fears that high deficits cause high interest rates at the national or global level.

* Note: The complete set of Keynes’s  works is out of print in hardback and will be reissued as a 30-volume set of paperbacks later this fall, according the Cambridge University Press website. – G.H., September 3

Over at The Nation, Dimitri Papadimitriou writes about the accelerating eurozone bank runs, in which euros have been flowing out of Spanish and Greek banks and into Germany at an eye-popping rate, and lays out scenarios for how this whole things ends:

The migration of money into Germany is quickening. And under TARGET 2, the trillions of euros that the ECB has loaned out to finance this race will be uncollectable.

How to counteract a disaster of these proportions? Unlimited deposit insurance for all euros in EMU banks, backed by the creation of a strong European federal treasury, would end the bank runs, just as deposit insurance in the United States has prevented them here ever since the Great Depression. The insurance liability would be on Europe’s central bank, which would become insolvent if Spain or Italy abandoned the euro. Since, unlike the United States, the ECB doesn’t have a unified European treasury to backstop it, Germany would presumably get the bill for a default.

As Randall Wray and I predict in a new Levy Institute policy paper, “That’s a bill Germany will not accept, hence, probably no deposit insurance.” And no future for the euro.

Update:

Papadimitriou was also interviewed on the topic for Ian Masters’ Background Briefing radio program (listen here).

Since eurozone governments don’t issue the currency in which their debts are denominated and can’t borrow euros directly from the European Central Bank, member-states essentially have to run budget surpluses—generating euros by taxing the private sector—if they’re going to reliably meet their debt servicing costs, according to Jan Kregel, and they have to run even bigger surpluses if they’re going to reach the debt limits set by the Stability and Growth Pact.  Kregel puts this in Minskyan terms:  “member-states should be engaged in ‘hedge’ finance, which means producing a fiscal surplus well in excess of debt service. If it cannot do this, it must issue additional debt to the private sector, since it cannot borrow from the ECB. In this case, the government would be engaging in what Minsky called ‘Ponzi’ finance: it would be borrowing to meet debt service.”

But in order to maintain such budget surpluses, Kregel points out, the eurozone needs higher economic growth, and this sets up a fundamental paradox:

…governments cannot produce this growth through deficit spending; it must come from either domestic or foreign demand. Lowering government expenditures or raising taxes to generate the required fiscal surplus will only reduce domestic demand. This leaves external demand as the only solution. But without the ability to improve external competitiveness through exchange rate adjustment, internal depreciation through wage reductions or productivity increases in advance of wage increases will be required. However, this is also a policy that reduces domestic demand, offsetting the benefits of higher foreign demand. And here is the paradox: all the policies proposed to increase growth of incomes and generate fiscal surpluses ultimately have a negative impact on income growth. Keynes called it the paradox of saving; here, it is the paradox of euro survival.

This is partly why, he argues in a new Policy Note, more political integration can’t solve the most fundamental problem facing the eurozone.  According to Kregel, this is one of the six lessons we ought to have learned from the crisis.

The other five lessons: continue reading…

The cliff approaches, and politicians and pundits in Washington are pondering how to deal with it. For those who have forgotten, recent nontechnical summaries of the legislative issues and amounts of money at stake can be found here , here, and in this old post. But essentially, the term “fiscal cliff” refers to a massive group of tax increases and spending cuts due to take effect on or around January 1 of next year. President Obama and some Congressional Democrats are seeking to take a stand for distributional fairness and deficit reduction at the same time by pushing for a renewal of the Bush tax cuts, but only for those with incomes less than perhaps $250,000 for a couple. On the other hand, some long-time fiscal conservatives are seeking to cushion the blow by delaying the impact of the spending cuts and tax increases and by seeking a less indiscriminate choice of program cuts. They emphasize that in any case, draconian measures must in their view be taken eventually and committed to now.

From the point of view of Keynesian macroeconomics, what the fiscal conservatives fail to understand is that the economy requires even more fiscal ease than they have been willing to contemplate so far; otherwise, like Spain and many other European nations (see the FT and the WSJ on the European austerity debate), this country will experience such weak economic performance that even the goal of reducing the deficit will be elusive—let alone feeding the hungry, keeping states and localities from going broke, maintaining an adequate defense, or funding scientific research.

The automatic spending cuts (known also as sequesters) due to take effect soon are designed to hit almost every discretionary defense and nondefense spending item—to the tune of 10- to 15-percent cuts in what the federal government spends each day on average on these items. continue reading…

Martin Essex of the Wall Street Journal flags Dimitri Papadimitriou and Randall Wray’s recent Policy Note on the eurozone, “Euroland’s Original Sin.”  The Note traces the root cause of the eurozone’s struggles, including the solvency issues and bank runs in the periphery, to a fundamental design flaw in its setup:  national governments gave up currency sovereignty by adopting the euro but retained responsibility for their own fiscal policy.

Essex chooses to focus on a footnote that quotes some early predictions by those associated with the Levy Institute, which is fine.  But it’s important to note a couple of things here.  First, the point is not that the euro project was predicted to run into trouble in general, but that in these quotations the problems were predicted to flow from a particular structural flaw:  the separation between fiscal policy and monetary sovereignty.  And this is important for reasons that go beyond a prescience contest.  The predictions serve as a useful guide for figuring out what needs to be done to save the euro project.

Getting it right isn’t about being able to say “I told you so,” but about having the credibility to say “here’s what should happen next.”  In this case, in the context of addressing the bank runs afflicting the periphery, Papadimitriou and Wray argue for the necessity of eurozone-wide deposit insurance backed by the creation of a serious EU-level Treasury.  Getting the diagnosis right also allows you to see which solutions won’t work:  using the EFSF/ESM to bail out banks, which was part of the plan emerging from the June summit, won’t solve the problem, the authors argue, since those bodies don’t have the unlimited firepower of a sovereign currency issuer.

If you think the eurozone is in trouble primarily because of the fiscal profligacy of lazy spendthrifts in the periphery, you will have a very different idea of what needs to happen next.  But if the fundamental problem in the eurozone is the divorce between fiscal and monetary sovereignty, then until this design flaw is fixed, “solvency” issues are bound to arise—even for a national government running a fiscal surplus (which is precisely what happened to Spain).

Essex cites a number of other economists who predicted trouble for the eurozone early on, and he invites his readers to come up with some other examples.  One example he doesn’t mention is featured in Papadimitriou and Wray’s Note: continue reading…

When the European Monetary Union was set up, member-states adopted what was essentially a foreign currency (the euro) but were left in charge of their own fiscal policy.  Dimitri Papadimitriou and Randall Wray explain in a new Policy Note (“Euroland’s Original Sin“) why this basic structural defect was always bound to tear the eurozone apart.  The solvency crises and the bank runs afflicting Spain, Greece, and Italy were entirely foreseeable (and as Papadimitriou and Wray point out, entirely foreseen).  Unless something is done to remedy this design flaw, the EMU will continue to crumble.

The banking crises laid bare what happens when you try to separate fiscal policy from a sovereign currency:  “banks were freed to run up massive debts that would ultimately need to be carried by governments that, because they had abandoned currency sovereignty, were in no position to bear the burden,” say Papadimitriou and Wray.  Inasmuch as they are users rather than issuers of a currency, EMU nations are essentially in the same position as US states—but the difference is that US states can rely on the currency-issuing firepower of the federal government (when Texas was hit with the S&L crisis in the 1980s, the federal government picked up the tab; a tab that was about one quarter the size of Texas’ entire GDP).  And the problem is not just the size of the debts member-states took on, but that they took them on without the benefit of controlling their own currency—which makes all the difference in the world.  The US and Japan can borrow at very low rates while countries like Spain (whose debt ratios are much, much smaller than those of Japan) are caught in a vicious cycle of rising borrowing costs.

Papadimitriou and Wray explain how all of this was compounded by the TARGET system, which made possible the massive bank runs in Spain, Greece, and Italy.  They argue that EMU-wide deposit insurance backed by the creation of a strong EU-level treasury is necessary.  There was some initial enthusiasm (as there always is, initially) when the latest “solution” emerged from the June 29 summit.  But it is becoming clear that the EMU is not moving towards a true banking union* anytime soon.

Read the whole Policy Note here.

* The term “banking union” is being thrown around a lot, but there’s a difference between giving the ECB extra supervisory powers over the banking system and moving to unlimited deposit insurance, which, as of yet, does not appear to be on the horizon.  A similar confusion can arise with the term “fiscal union”:  rather than the creation of a strong European federal treasury, the term is commonly used to refer merely to the new fiscal accord in which member-states will face stiffer penalties when they violate the Maastricht criteria limits on deficits and debt.  The only “union” that will remedy the structural error built into the EMU is one that addresses the doomed separation between fiscal policy and currency sovereignty.

As the Center on Budget and Policy Priorities (CBPP) has reported in several recent postings, cuts to SNAP—formerly known as the food stamp program—now being considered in Washington would impose severe hardship on millions of people who use SNAP benefits to buy groceries in retail stores. For example, the Center released a report a few days ago on cuts to the program contained in the farm bill recently proposed by House Agriculture Committee leaders. These three points, quoted from the report, summarize the impact of the proposed cuts:

• The bill would terminate SNAP eligibility to several million people.  By eliminating categorical eligibility, which over 40 states have adopted, the bill would cut 2 to 3 million low-income people off food assistance.
• Several hundred thousand low-income children would lose access to free school meals.  According to the Congressional Budget Office (CBO), 280,000 children in low-income families whose eligibility for free school meals is tied to their receipt of SNAP would lose free meals when their families lost SNAP benefits.
• Some working families would lose access to SNAP because they own a modest car, which they often need to commute to their jobs.  Eliminating categorical eligibility would cause some low-income working households to lose benefits simply because of the value of a modest car they own.  These families would be forced to choose between owning a reliable car and receiving food assistance to help feed their families.

(The Ryan budget would lead to even larger cuts, as this report shows.) As a macroeconomist, I tend to be in favor of government programs that automatically increase in size as the economy falls into a recession. Of course, such programs help to maintain spending when households and/or businesses suffer a setback due to a financial crisis or some other macroeconomic problem. Many of these programs have the added advantage that they focus on the most adversely affected individuals. They are aimed at providing people with the most basic essentials. They reduce the need for ad hoc “stimulus bills” during recessions. Finally, they are known for achieving an especially high level of “bang for the buck,” as a form of fiscal stimulus, because they go mostly to individuals who spend almost all of their small-to-modest incomes. (An employer-of-last-resort program would represent perhaps the “alpha and omega” of such automatic-stabilizer programs.)

The proposed cuts would fall on a program that has grown rapidly in recent years. continue reading…

Slate‘s Matt Yglesias nicely captures the gap between the reactions of opinion-makers to the Greek election results and the reactions of markets (Sunday’s electoral results point to a coalition government centered around New Democracy and Pasok): “Markets were supposed to be reassured. Instead they’re freaking out. European stock markets are declining, and Spanish bond yields are back into the 7 percent danger zone. What went wrong?  Perhaps the better question to ask is how it ever got to be conventional wisdom that maintaining the Greek status quo was the reassuring option?”

A Greek exit from the eurozone is still very much a live possibility.  And given that the election results represent a continuation of the status quo, you might say a Grexit is even more likely.  If you believe the status quo is unsustainable, and that only something like a Greek New Deal would bring the growth necessary to pull Greece out of its depression, then there is little room for optimism.  So what would a Greek exit actually look like?  C. J. Polychroniou tackles this question in a new policy note.

Polychroniou argues that it was a mistake not to allow Greece to proceed with an orderly default two years ago.  While Greece is in for some economic pain whether it stays on the euro or returns to the drachma, it would, he argues, be better off in the latter scenario given a well-worked-out strategy for an orderly default (which is to say, better off compared to being continuously “rescued” with what are essentially bailouts of the EU’s banks attached to austerity directives, leaving Greece with the doubtful task of substantially reducing its debt-to-GDP ratio while shrinking its economy).  Polychroniou’s assessment of the relative costs of a Greek exit is based in part on his reading of the background political conditions:

The gloom-and-doom scenario involves a disorderly default on Greek government debt and assumes that Greece will be completely cut loose. This scenario essentially removes all political considerations from the picture and is highly unlikely to happen. It is a scenario much closer to a Hobbesian “state of nature,” when a Machiavellian outcome is far more probable. Indeed, a more likely scenario is that the Grexit will be orderly (the German Ministry of Finance and virtually all major banks,
including the ECB, have already made contingency plans), and that both the EU and the IMF will become involved in damage control.

Read it here.

The intensity of the debate over whether the Baltic economies (Estonia, Latvia, and Lithuania) should serve as models for the rest of the eurozone periphery has been raised a couple notches.  Last week, Paul Krugman noted that the Estonian recovery, while positive, has not been as remarkable as austerity supporters tend to imply.  This prompted a vigorous reaction from Estonia’s head of state (unless there’s someone impersonating Toomas Hendrik Ilves on Twitter).  But let’s bracket for the moment this question of how impressive the Baltic recoveries have been.  They are growing again, and that’s at least something.  Last week, Rainer Kattel and Ringa Raudla put out a policy note that focused on a different aspect of the problem:  whatever you think of the results, to what extent is the Baltic experience replicable?  If the rest of the eurozone periphery can’t reproduce the conditions that led to Baltic growth, then this isn’t a terribly useful model.

The argument is supposed to be that austerity and internal devaluation (that’s basically trying to get your real wages to fall in order to regain competitiveness) should be credited for the recoveries in the Baltics (incomplete though they may be).  As C. J. Polychroniou has been pointing out, the latest attempts at internal devaluation don’t appear to be working terribly well in the rest of the periphery.  But perhaps if Greece and the rest of the GIPSI countries were to suck it up, bite down hard, or whatever is the tough love phrase of the day, they might come out on the other end with a Baltic-type recovery.

The problem with this argument, as Rainer Kattel and Ringa Raudla point out, is that there was very little actual “adjustment” in Estonia, Latvia, and Lithuania.  The Baltic recoveries are largely attributable to economic factors that have little to do with austerity policies.  The recoveries were largely “outsourced,” as Kattel and Raudla put it.  First, the Baltic states have been relying on advanced use of EU structural support funding (as Kattel and Raudla note, a stunning 20 percent of Estonia’s budget is made up of EU funds), and second, Baltic exporters are deeply integrated with the Scandinavian and Polish economies, both of which weathered the crisis quite well. Finally, all of the Baltic economies have very flexible labor markets, accompanied by an usual amount of emigration—which is in part why (very high) unemployment rates have started to tick down.  This is simply not a model that could be replicated periphery-wide.

Moreover, Kattel and Raudla provide reasons to believe that the “outsourced” Baltic recoveries are unsustainable.  The whole thing is worth reading.  A One-Pager version is available here.