Arnold Kling  

Today on the Eurozone Crisis

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1. James Hamilton reviews the emergency lending of the Fed from 2008-2011.


Phase 4, then, could turn out to be a return to emergency lending as the Fed tries to contain collateral damage from the unfolding European drama.

2. Olivier Blanchard writes,

What has become clearer this year is that liquidity problems, and associated runs, can also affect governments. Like banks, government liabilities are much more liquid than their assets--largely future tax receipts. If investors believe they are solvent, they can borrow at a riskless rate; if investors start having doubts, and require a higher rate, the high rate may well lead to default. The higher the level of debt, the smaller the distance between solvency and default, and the smaller the distance between the interest rate associated with solvency and the interest rate associated with default.

Blanchard appears to have become fully assimilated into the bankers' view of the economy. The problem is one of liquidity and managing perceptions. The reality of fiscal and monetary policy, which once dominated macroeconomic textbooks, has slipped into the background.

I long for a Sumnerian rant that says, "You can let banks fail! You can cut government spending! Just make sure that the monetary authorities maintain aggregate demand!"

It's like Bernanke and Blanchard have two versions of macroeconomics. One version goes into their courses and textbooks, and it is what Scott Sumner keeps expecting from them. But once in power, these economists act on a completely different version of macroeconomics, in which confidence in banks becomes the centerpiece.

Maybe this is what happens when you become a policy maker. I have this "Invasion of the Body Snatchers" nightmare in which Sumner is appointed to a top position at the Fed or the IMF and soon thereafter starts defending "special lending facilities" instead of aggregate demand.

3. John Cochrane writes,


Europeans leaders think their job is to stop "contagion," to "calm markets." They blame "speculation" for their troubles. They keep looking for the Big Announcement that will soothe markets into rolling over another few hundred billion euros of debt. Alas, the problem is reality, not psychology, and governments are poor psychologists. You just can't fill a trillion-euro hole with psychology.

Read the whole thing. Other paragraphs are equally bracing.

The two-drunks model is still looking apt. The banks are dependent on the governments for their solvency. And the governments are dependent on the banks for their liquidity. The longer these two drunks lean on one another to try to hold each other up, the worse it will be if (when) they fall down.

At this point, it looks to me as though the European banks are about as private as Freddie Mac and Fannie Mae. And in Europe, the non-bank financial sector is much smaller than in the U.S.

I think where this leads in ten years is a sort of Third World situation, with small business operating in the underground economy and the legal economy consisting of government-sponsored enterprises. For small business, operating legally only has an advantage if you have access to capital markets, but that access is going to be crowded out by government and government-sponsored enterprises. Meanwhile, the tax cost of operating legally is going to rise.


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CATEGORIES: Eurozone crisis



COMMENTS (4 to date)
Jeff writes:
I think where this leads in ten years is a sort of Third World situation, with small business operating in the underground economy and the legal economy consisting of government-sponsored enterprises. For small business, operating legally only has an advantage if you have access to capital markets, but that access is going to be crowded out by government and government-sponsored enterprises. Meanwhile, the tax cost of operating legally is going to rise.

That is...grim. In that scenario, what's to stop capital markets from sliding into the underground economy also, though?

Mike Rulle writes:

I always try to understand these crises in their most general and basic form. But its hard to do. What is some times useful, is to look at a nation's household balance sheet. The Fed produces one for the US. (106 B.100 Balance Sheet of Households and Non-Profits)

What is interesting about these balance sheets is what is not on them. What is not on them are the liabilities owed to treasury bond holders----What is also not on them is what is owed to muni-bond holders. The assets are there in funds or directly held, but not the liabilities. These are actual liabilities outstanding and ultimately owed by US citizens. But because no single individual owes anything, they are ignored in our Household Net Worth balance sheet.

The same logic holds true when we try to create an economic balance sheet, but this is much harder to calculate. Assumptions need to be made about future productivity growth, growth in general etc.. But we do know that payments made into retirement and healthcare systems have already largely been used for other things and are not part of savings---hence their ponzi scheme similarity.

The sum of these unrecorded debts reduce our actual net worth versus our perceived or recorded net worth. This can only be made up through strong economic growth with more savings and less consumption. This is an old story by now.

I do not know what Europe's real household balance sheet, nominal or economic, looks like, but it has to be considerably worse than ours, particularly after factoring in sovereign debt and transfer payments.

At least our population grows. I really cannot see how Europe gets out of this. They first have to accept they are much more poor than they think they are. That is really hard to do. Their only choice is to save their way out of this through more work and less consumption/leisure. But who is ready for that? It seems impossible for there not to be major social conflict and rebellion at some point in some places. The historical irony of Germany being the payer of last resort is so bizarre, it is hard to believe.

Japan at least has a singular culture---which is why their apparent even worse debt situation has not yet completely destroyed them. They will work harder and consume even less for as long as they can. This buys them a lot of time.

We have the longest time to change our ways and the most options---but who knows. I do not believe we will make any significant changes in the forseeable future.

mark writes:

"Europeans leaders think their job is to stop "contagion,'"

Having inculcated the ethos of "solidarity" as a fundamental aspect of modern European societies, it is extremely hard to hope to stop "contagion", as they are really the same thing.

Methinks writes:

Reading Blanchard's paragraph, my first thought was that this is how most confidence games work - only so long as everyone believes. As long as we are conned into believing everything is alright, it will appear to be.

Also, while there has been much grumbling about the "shadow banking system" (which, I take it, means any financial institution or activity outside the traditional oh-so-well regulated banking system) in the United States, it seems that the lack of such a system will harm smaller businesses in Europe by not providing alternative access to capital markets.

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