Relax, Said the Night Man

Recently, Bloomberg published a Barry Eichengreen column headlined "Don't Sell the Euro Short.  It's Here to Stay".  He writes:

Two forms of glue hold the euro together. First, the economic costs of break-up would be great. The minute investors heard that Greece was seriously contemplating reintroducing the drachma with the purpose of depreciating it against the euro, or against a “new Deutsche mark,” they would wire all their money to Frankfurt. Greece would experience the mother of all banking crises. The “new Deutsche mark” would then shoot through the roof, destroying Germany’s export industry.

More generally, those predicting, or advocating, the euro’s demise tend to underestimate the technical difficulties of reintroducing national currencies. 

In the conclusion, he says "I argued that it is the roach motel of currencies. Like the Hotel California of the song: you can check in, but you can’t check out."   To be precise, that's true of the Roach Motel (see here, if you don't know what that's all about), but, according to the Eagles, you can actually check out of the Hotel California, though you can never leave (hmm... sounds kind of like "Brexit"...).

In any case, the fact it hangs together because eurozone members feel trapped by the costs of exit is hardly an affirmative case for the single currency.  In Greece's case, its hard to believe that the costs of exit really would have been higher than the costs of staying; this FT Alphablog post by Matthew Klein pointed out this figure from the IMF's Article IV report:

The IMF also released a self-evaluation of its Greece program, which Charles Wyplosz analyses in a VoxEU column.  See also: this Martin Sandbu column and this article by Landon Thomas.  Matt O'Brien's write-up of research by House, Tesar and Proebsting of the impact of austerity in Europe is also relevant.

The fact that the eurozone rolls on with no sign that a depression in one of its smaller constituent economies is enough to bring about a fundamental change is disturbing.  It wouldn't be able to ignore an election of Marine LePen as President of France - Gavyn Davies considers the consequences of that.

Update: Cecchetti and Schoenholtz also had a good post on the implications of a LePen win.

Time for a Sterling Crisis?

The UK pound plunged again earlier this month:

two dates are marked with vertical lines: the the Brexit vote (red line) and the Prime Minister's speech signalling that the most likely outcome was a "hard Brexit" (green line) where the UK leaves the European single market (i.e., that it won't become part of the European Economic Area, like Finland* Norway, or negotiate an arrangement like Switzerland's).

Departure from the EU and the single market make the UK a less attractive location for foreign investment (see, e.g., comments from Nissan's CEO about its Sunderland plant).  A decrease in demand for UK assets implies a drop in the pound.  The UK is also a less attractive location for domestic investment now as well, and the situation is probably not a good one for consumer confidence - a reduction in demand due to lower desired consumption and investment would imply lower interest rates, which also would cause the pound to fall.

Is this yet another "sterling crisis"?  Not in the usual sense - as Gavyn Davies notes, there is no fixed exchange rate to defend this time, and most of the UK's external debt is denominated in pounds.

As Paul Krugman explains, a fall in the pound is a part of the adjustment process.  He writes:

But it’s important to be aware that not everyone in Britain is equally affected. Pre-Brexit, Britain was obviously experiencing a version of the so-called Dutch disease. In its traditional form, this referred to the way natural resource exports crowd out manufacturing by keeping the currency strong. In the UK case, the City’s financial exports play the same role. So their weakening helps British manufacturing – and, maybe, the incomes of people who live far from the City and still depend directly or indirectly on manufacturing for their incomes.

However, a rebalancing of the UK economy in favor of manufacturing exports will not come quickly, according to Barry Eichengreen (Robert Skidelsky goes further and argues for helping the process along through "import substitution" policies).

One likely consequence is inflation, as Ambrose Evans-Pritchard writes.  Prices of imported goods will rise significantly (though the process of "exchange rate pass-through" generally occurs with a lag - the "marmite row" may have been a harbinger of things to come).  The inflation will hit lower-income families especially hard, according to Evans-Pritchard's column, because the government has frozen some benefit payments, so inflation will cause their real value to fall.

Rising costs for imports don't only impact consumers - they also affect producers.  On the one hand, domestic producers benefit from increases in the relative prices of imported substitutes.  On the other - and this is becoming more and more relevant in an age of global supply chains - prices of imported inputs (intermediate goods) will rise, increasing production costs.

With the rise in cost of intermediate inputs and the greater costs of selling to its main trading partners, the impact of Brexit looks like a negative supply shock.  Supply shocks create a nasty dilemma for monetary policy.  Policy can "accommodate" the shock by allowing inflation to rise - doing so minimizes the increase in unemployment and helps keep output near its (diminished) potential.  Or the Bank of England could tighten policy to keep inflation in check, with negative consequences for output and employment.

The risk with accommodation is not just inflation itself, but a potential increase in inflation expectations and loss of the central bank's credibility. Part of the standard interpretation of 1970's stagflation is that the Fed was too accommodating after the 1973 oil shock, and which contributed to inflation expectations getting out of control.

The Bank of England has a formal 2% inflation target; right now inflation is running below target, but that will change.

I personally think its to Bank of England's credit that it's allowed inflation go above target at a couple of points during the turmoil of recent years.  If their policy is credible, an occasional miss doesn't cause inflation expectations to rise.  But the point of inflation targeting is to achieve credibility by meeting a stated target, so the BofE may be putting that at risk if it's always seen to be accommodating shocks.

*corrected 10/26

Lies, Damned Lies and Ireland's GDP

Being an academic economist can be humbling - while it involves learning lots of esoteric stuff, it also makes one much more aware of how much one doesn't know.  But I know this much is true: the total amount of goods and services produced in Ireland did not increase by 26.3% in 2015.

But that's what Ireland's Central Statistics Office has reported.  It's not entirely clear how they came to such a (literally) incredible figure for real GDP growth.   The expenditure approach to calculating GDP adds up purchases of new final goods and services in four categories - consumption (C), investment (I), government purchases (G) and net exports (NX).  I took the data from table 6 of their release and normalized each component to 100 in 2010 to illustrate how the change is driven by large jumps in I and NX.

News reports have focused on activities of multinational corporations, particularly on "inversions" which involve transferring their legal headquarters to Ireland in order to take advantage of its low corporate tax rates.

That may be correct, but its not an entirely satisfying explanation.  GDP is supposed to measure the value of goods and services produced in a country.  The legal domicile of the corporations producing it is irrelevant.  Ownership of capital - both physical machinery, equipment and structures and also intangible forms (intellectual property, etc.) - also is irrelevant, so the fact that multinational corporations like to hold IP in Ireland for tax reasons shouldn't matter in principle.

Gross National Product (GNP) adds up the total value of goods and services produced with resources owned by a country's citizens.  Since many multinational corporations operate in Ireland, it has higher GDP than GNP because some of its GDP is produced using foreign-owned capital - the same data release showed a shocking increase of 18.7% in Ireland's GNP last year.

The information released by the CSO is not very detailed.  The FT Alphaville's Matthew Klein, Bloomberg Columnist Leonid Bershidsky, and Seamus Coffey at the Irish Economy blog have made useful attempts at sorting things out.

Clearly, the way the CSO is calculating GDP is failing to correspond to the concept.  Statistical agencies need to provide estimates calculated in a consistent fashion, so it wouldn't have been appropriate for them to suddenly decide to calculate it differently because they got a strange number.  But the methods for estimating GDP are not etched in stone.  If legal and accounting maneuvers of multinationals are distorting some of their source data, they need to find a way of correcting for it.  Standards for national accounts are coordinated internationally and it is not clear whether the problems in this report are due to something the CSO is doing or a more general methodological issue which happens to be most apparent because of Ireland's unique circumstances.

Statistical agencies update their methods and revise their estimates regularly - e.g., in 2013, the US BEA did a "comprehensive revision" that began the treatment of development of intellectual property as a component of investment (see this earlier blog post).  I hope the CSO will release more information to help everyone better understand what's gone wrong with their figures.  That will be a first step towards correcting the method used to estimate GDP and producing a revised set of figures - one which will not show a 26% increase in real GDP in 2015.

Update: Procedures mandated by Eurostat are mostly to blame, writes Colm McCarthy.

Greek Tragedy, European Farce

It looks as though Greece is staying in the euro, after all (for now at least...).  The terms of the deal - pending approval by the Greek parliament - are not very favorable to Greece.  Essentially it means more of the same - additional financing from the EU in exchange for more austerity, "structural reforms" (in some cases absurdly detailed) and a EU supervised privatization of state-owned assets.  There is a vague promise to consider debt restructuring, but nothing concrete.

The reports from the negotiations over the weekend reinforced the impression that Germany, along with some of the other smaller countries, really wanted to push Greece out, but the French and Italians worked to prevent this outcome.

From the viewpoint of Germany, the issue is making sure that euro membership entails following associated rules and obligations: a more forgiving treatment of Greece would create a "moral hazard" problem, inviting more deviations in the future.  However, the rules they are enforcing do not make economic sense: they force procyclical fiscal policies and fail to confront an unsustainable debt burden.  (Some sympathy for the Germans, though: as this VoxEU piece by Kang and Mody illustrates, they were reluctant about the euro from the beginning).

The response to the deal has been highly critical: see Barry Eichengreen, Martin Sandbu, Wolfgang Munchau, Christian Odendahl and John Springford, Paul Krugman, Ambrose Evans-Pritchard, John Cassidy, Eric Beinhocker, Neil Irwin.  This interview with former finance minister Varoufakis is also interesting.  Simon Wren-Lewis has a nice post on "trust," a word which has been thrown around alot lately.

The FT's Gideon Rachman has a somewhat different take, emphasizing that Germany backed off its evident desire to force a "Grexit".

One condition of the deal was continued IMF involvement.  While Greece objected to this, it may ultimately prove to be in their favor - the IMF has the capacity to act as a voice of sanity, and they have said that Greece's debt is unsustainable (much of the criticism of the IMF is that they haven't pushed strongly enough for a debt writedown, as they ordinarily would).  IMF chief economist Olivier Blanchard discussed Greece in a blog post (and Ashoka Mody offered a critical response).

Although some of us think Greece might be better off outside the euro, their willingness to sign on to an agreement of the sort the Syriza govermnment came in to power promising to end (and essentially what they voted "no" on in the referendum a week ago) demonstrates how badly they want to stay in.  As long as Greece is saddled with an unsustainable debt, the prospect of a rerun of this drama will remain.  But the removal of the immediate threat of a euro exit hopefully will give a short-run boost (Daniel Davies gives some reasons for short-term optimism).

As for the euro, the last several years have laid bare the institutional shortcomings - some of which are discussed in this Simon Tilford column - underscoring the reasons many economists were skeptical of the project from the outset.  Although political solidarity and continued moves towards integration might have overcome these flaws, the last several weeks have demonstrated that, as a political matter, the sense of commonality needed to make the euro work does not exist.

Update: IMF to the rescue (?!):

The International Monetary Fund threatened to withdraw support for Greece’s bailout on Tuesday unless European leaders agree to substantial debt relief, an immediate challenge to the region’s plan to rescue the country.

On this, see also Ambrose Evans-Pritchard and Josh Barro.  A few hours ago I said they had the "capacity to act as the voice of sanity" but I didn't expect them to use it so soon...  This made me laugh:

Object to IMF involvement so spite-crazed Germans will insist on it. Then reveal that the IMF agreed with you! pic.twitter.com/IO4DTpdPJC

— Matt! (@mattyglesias) July 15, 2015

Hmm... at this point, hard to say if this will lead to a better deal, or just blow it up, as Gideon Rachman suggests:

IMF may not realise it, but they are effectively calling for the break-up of the euro. No way creditor parliaments will buy this

— Gideon Rachman (@gideonrachman) July 14, 2015

Europe's Final Countdown to "Grexit"?

The "no" vote in its referendum last Sunday seems to have accelerated the momentum towards a Greek exit for the euro.  While there is plenty of room to second-guess the negotiating strategy, I think the Syriza government and Greek voters were right to reject continuing on the same policy path.  If they are forced out of the euro (which looks likely), it will be traumatic and disruptive, but the experience of Argentina in 2002 suggests a fairly quick rebound (from a very low starting point) is possible. 

Ultimately, this may be worse for the rest of Europe - not only does it open up the possibility of future crises by demonstrating the reversibility of the euro, it also demonstrates a fundamental lack of solidarity: the "ever closer union" isn't really that close (see Dani Rodrik and Peter Eavis).

Some of Europe's leaders seem recognize this; the main stumbling block in the last-ditch negotiations appears to be on whether some of Greece's debts will be written off (i.e., "restructuring" or "haircut").  The IMF has publicly said that Greece's debt are not sustainable (debt writedowns are part of standard IMF interventions), and the US is urging a writedown.

Politically, it is easy to see why this is a nonstarter in many of the creditor countries.  Some "leadership" is badly needed, particularly in Germany, and doesn't appear to be forthcoming: in the Times, Bruce Ackerman calls out Germany's "failure of vision."  Clive Crook argues that the Greeks are being deliberately pushed out.  Eduardo Porter notes that Germany seems to be forgetting that it has been a beneficiary of debt relief (see also Thomas Piketty).  The German stubbornness may be more than just politics - Simon Wren-Lewis argues part of the problem is that they (naturally) do not want to acknowledge the failure of their economic ideology.

Last minute negotiations are ongoing... when Syriza first came to power, the idea of GDP-linked debt was raised.  This seems to have fallen off the table, but it might provide a "face saving" way out: the IMF's knack for optimistic projections could be helpful in making the value to the creditors appear initially large.  Since they would have some equity-like characteristics, replacing the debt with GDP-linked bonds would have some passing similarity to what normally occurs in a corporate bankruptcy, where creditors receive equity stakes (and perhaps this would help make a "fairness" argument).  And it actually might work: if the chances of future austerity and/or a euro exit were substantially reduced, Greece should have a chance at some rapid "bounce back" growth.  I don't know anything about Greek politics, but I would think that, in the long-run, a government led by an "outsider" party like Syriza might have a better shot at implementing structural reforms like better tax collection.

See also: a good "tick-toc" on the negotiations from the Times' Landon Thomas on the breakdown of negotiations last week; Ambrose Evans-Pritchard; Ashoka Mody is very harsh on the creditors and the IMF, Daniel Gros is a bit more sympathetic.

More Greek Notes

perhaps Greece should be printing some notes this weekend...

Recently, Christian Odendahl had a sensible take on what should be done in Greece, but reasonable advice from economists is being overtaken by politics and events.  Catherine Rampell:

Greeks are hoarding cash and sending their savings abroad; by a conservative estimate, Greek bank deposits have fallen by about 45 percent since their peak in 2009. Recent talk of capital controls and bank closures has only accelerated this bank run (or, as some have dubbed it, a “bank jog”), making the banking sector weaker, and, by the day, even more in need of European assistance. Last week alone, Greeks withdrew an estimated 4 billion euros. For those keeping track, that’s two-and-a-half times what the country owes the IMF at the end of the month. 

Karl Whelan discusses the connection between a Greek government default, the ECB and a euro exit -- in theory, the ECB could help Greece stay in the euro even if the government defaults, but it doesn't appear inclined to.  Ultimately, if the euro is to avoid similar crises in the future, it needs to be robust to a sovereign default.

Reports over the deal terms being discussed are hardly encouraging.  Wonkblog's Matt O'Brien writes:

Europe is making life so difficult for Greece with such specific demands for austerity that it almost seems like Europe is trying to get Greece to leave the euro now. Before this latest showdown, Greece had actually cut so much that it had a budget surplus before interest payments...

But Europe isn't interested in that. It's interested in making Greece run bigger and bigger budget surpluses, without much regard for the economic consequences. Not only that, but Greece has to run surpluses the way Europe wants them to. Never mind that Greece has already cut its spending a lot, already cut its pensions a lot, and already reformed its labor markets a lot. There are always new cuts and new reforms that Europe says will make Greece grow at some point in the future.

If this is how it's going to be, why should Greece stay in the euro? It sure seems like Europe is trying to force Syriza to do what Syriza said it wouldn't just to prove a point: don't underestimate the power of the ECB. It's a not-so-subtle message to the anti-austerity parties in Spain and Portugal that they have nothing to gain and everything to lose from challenging the budget-cutting status quo.

Although its the EU that deserves most of the blame, the IMF's role has been controversial, too: see this Politico article and this Ambrose Evans-Pritchard column.  At the IMF's blog chief economist Olivier Blanchard explains what the IMF believes a "credible deal" requires.

See also: James Galbraith on "reform", and Branko Milanovic on what this means for Europe.

Update (6/29): The Greek government has called a referendum and imposed capital controls.  See Eichengreen, Krugman and Stiglitz (and Tony Yates for a take somewhat more critical of the Greek government) Charles Wyplosz on the ECB,  Francisco Saraceno and Matt Yglesias on the politics, and Hugo Dixon on how the referendum may play out.

Greek Notes

A key point about "bailouts" - we say that a borrower got rescued, but the real beneficiary is usually the original creditors.  In the case of Greece, Ashoka Mody reminds us, Europe and the IMF got German and French banks off the hook:

Greece's onerous obligations to the IMF, the European Central Bank and European governments can be traced back to April 2010, when they made a fateful mistake. Instead of allowing Greece to default on its insurmountable debts to private creditors, they chose to lend it the money to pay in full.

At the time, many called for immediately restructuring privately held debt, thus imposing losses on the banks and investors who had lent money to Greece. Among them were several members of the IMF’s board and Karl Otto Pohl, a former president of the Bundesbank and a key architect of the euro. The IMF and European authorities responded that restructuring would cause global financial mayhem. As Pohl candidly noted, that was merely a cover for bailing out German and French banks, which had been among the largest enablers of Greek profligacy.

Ultimately, the authorities' approach merely replaced one problem with another: IMF and official European loans were used to repay private creditors. Thus, despite a belated restructuring in 2012, Greece's obligations remain unbearable -- only now they are owed almost entirely to official creditors.

This complicates the politics: the citizenry of Europe feels that Greece has already gotten a rescue at their expense, and now any restructuring is a hit to government finances (including to those of the US, as the largest shareholder of the IMF).  But since the debt has been transferred from the private to the official sector, it is tempting to believe that a Greek default - and an exit from the euro - are less likely to spark a financial crisis (though I wouldn't be so sure about this; people thought markets were "prepared" for Lehman's bankruptcy after all...).

The Greek government's handling of the situation has been less than smooth - I'm not sure what to make of the complaints about their negotiating style, but raising old war reparations claims and playing footsie with Putin do not seem like constructive steps.  Still, the fundamental position articulated by Greek finance minister Varoufakis in this Project Syndicate piece seems very reasonable (much more so than that of the EU finance ministers sniping at him).

As Paul Krugman wrote last week:

[E]xiting the euro would be extremely costly and disruptive in Greece, and would pose huge political and financial risks for the rest of Europe. It’s therefore something to be avoided if there’s a halfway decent alternative. And there is, or should be....

The shape of a deal is therefore clear: basically, a standstill on further austerity, with Greece agreeing to make significant but not ever-growing payments to its creditors. Such a deal would set the stage for economic recovery, perhaps slow at the start, but finally offering some hope.

But right now that deal doesn’t seem to be coming together...

And as Antonio Fatas points out:

What the European partners want is much less clear. They would love to get paid back on all the current Greek government debt that they hold but that's unlikely to happen. Some would love to see Greece outside of the Euro area so that they do not have to deal with this again. There is a sense that whatever agreement is found now will not be the last one. The lack of trust has reached levels that has made it clear to some that Grexit is the best long-term outcome. But they are afraid of the consequences, both in the short run and in the long run in terms of credibility of the membership that would be left after Greece was gone. 

This will be a test of the wisdom and statesmanship of Europe's leaders; Roger Cohen reminds us why - despite how lousy it looks at the moment - the European project is worth saving.  Things look set down to go down to the wire: the Greek government is scrounging all the euros out of its couch cushions but at some point it will miss a payment, which will force some difficult decisions.  Here's hoping Angela Merkel, Mario Draghi et al. rise to the occasion.

Update (5/5): The FT's Gideon Rachman makes a case for Grexit.

Mark Blyth to the Social Democrats

Jacobin magazine has Mark Blyth's thought-provoking speech to the German Social Democrats, in which he encourages them to act like social democrats:

When you ask for the content of what structural reform means, it seems to be a checklist of lower taxes, deregulate everything in sight, privatize anything not nailed down, and hope for the best. But are these policies not disturbingly American, if not Thatcherite? Indeed, isn’t this everything that the SPD is supposed to be against, and much of which the German public would never put up with?

Interesting...

"Structural reform" means lots of different things - some good and some bad - and whether "austerity" is appropriate depends on the circumstance, so I'm wary of blanket statements about either of those concepts, but I think he is broadly correct in the context of what is going on in Europe right now. The existence of the Euro, in conjunction with ECB policy, prevents necessary monetary and exchange rate adjustments that from taking place, and misguided moralism about debt may make a political settlement impossible.  It is this last point which is his target.

Just the Varoufakis, Ma'am

An interesting BBC interview with Yanis Varoufakis, the finance minister of the new Greek government (interview begins at about 3:30):

If the eurozone breaks apart - and it seems we're back to worrying about that yet again - I don't think it will be because the Greeks are being unreasonable (or uncool). 

Varoufakis also spoke with Ambrose Evans-Pritchard:

Mr Varoufakis is braced for an arid meeting on Thursday with his German counterpart and long-time nemesis Wolfgang Schäuble, a man he once accused – borrowing from Tacitus - of reducing Europe to a desert and calling it peace.

“I will try to be as charming as I can in Berlin. I will tell Mr Schäuble that we may be a Left-wing riff-raff but he can count on our Syriza movement to clear away Greece’s cartels and oligarchies, and push through the deep reforms of the Greek state that governments before us refused to do,” he said.

“But I will also tell him that we are going to end the debt-deflation spiral and do what should have been done five years ago. That is not negotiable. We have a democratic mandate to challenge the whole philosophy of austerity,” he said.

In a recent blog post, Paul Krugman clarified how we should think if the conflict between Greece and the EU-ECB-IMF "troika" -

[A]t this point Greek debt, measured as a stock, is not a very meaningful number. After all, the great bulk of the debt is now officially held, the interest rate bears little relationship to market prices, and the interest payments come in part out of funds lent by the creditors. In a sense the debt is an accounting fiction; it’s whatever the governments trying to dictate terms to Greece decide to say it is.

OK, I know it’s not quite that simple — debt as a number has political and psychological importance. But I think it helps clear things up to put all of that aside for a bit and focus on the aspect of the situation that isn’t a matter of definitions: Greece’s primary surplus, the difference between what it takes in via taxes and what it spends on things other than interest. This surplus — which is a flow, not a stock — represents the amount Greece is actually paying, in the form of real resources, to its creditors, as opposed to borrowing funds to pay interest.

Greece has been running a primary surplus since 2013, and according to its agreements with the troika it’s supposed to run a surplus of 4.5 percent of GDP for many years to come. What would it mean to relax that target?

It would not mean demanding that creditors throw good money after bad; everyone has already implicitly acknowledged that the debt will never be fully paid at market rates, but Greece is making a transfer to its creditors by running a primary surplus, and we’re just arguing now about how big that transfer will be.

At Project Syndicate, Joe Stiglitz writes:

So it is not debt restructuring, but its absence, that is “immoral.” There is nothing particularly special about the dilemmas that Greece faces today; many countries have been in the same position. What makes Greece’s problems more difficult to address is the structure of the eurozone: monetary union implies that member states cannot devalue their way out of trouble, yet the modicum of European solidarity that must accompany this loss of policy flexibility simply is not there....

When companies go bankrupt, a debt-equity swap is a fair and efficient solution. The analogous approach for Greece is to convert its current bonds into GDP-linked bonds. If Greece does well, its creditors will receive more of their money; if it does not, they will get less. Both sides would then have a powerful incentive to pursue pro-growth policies.

This short paper by Marcel Fratzscher, Christoph Steffen and Malte Rieth of DIW Berlin lays out how GDP-linked debt might work.

The Greek government's proposals are along the same lines, according to Ambrose Evans-Pritchard's article:

The proposals offer a bond swap to ease the debt burden – 177pc of GDP - without demanding an explicit writedown of Greece’s foreign loans. This allows both sides to save face. The aim is to slash Greece’s primary budget surplus from the troika target of 4.5pc of GDP to around 1.5pc to pay for welfare pledges and boost investment. “This gives us a reasonable buffer. The old target is ludicrous,” Mr Varoufakis said.

Loans from the EU bailout machinery would be replaced by GDP-linked bonds, akin to Keynes’s "Bisque Bonds" in the 1930s. Money owed to the ECB would convert into “perpetual bonds”.

The Times' Eduardo Porter reminds us that economists foresaw that the euro might not work out so well:

The euro had been enshrined in a treaty but not yet come to life in the autumn of 1997, when Martin Feldstein, the influential president of the National Bureau of Economic Research, published an essay arguing that European leaders’ hopes that a monetary union would foster greater harmony and peace in a Continent repeatedly ravaged by wars were misplaced.

It “would be more likely to lead to increased conflicts,” wrote Mr. Feldstein, a former chief economic adviser to President Ronald Reagan.

War within Europe, “would be abhorrent but not impossible,” he added. “The conflicts over economic policies and interference with national sovereignty could reinforce longstanding animosities based on history, nationality and religion.”

The real difficulty is politics, not economics; as Porter writes:

Fixing this is not impossible. The most direct way would be for the creditors in Europe’s north to relax the tight conditions on debtor countries, provide them with debt relief and allow them to spend more to kick-start growth. Alternatively, they might just invest more themselves, which would lead to higher wages and prices at home, encouraging more output in their poorer neighbors.

This path presents some political complications, however. Voters in Germany and other rich northern countries have no appetite for transfering resources to the vulnerable neighbors around Europe’s edge. And, comfortably insulated by their own prosperity and conditioned by memories of hyperinflation after World War I, they still fear higher inflation. Even the direst warnings of impending doom seem unlikely to shift the public mood.

And that sets the political constraint on the other end of the field. “The right policies would defuse the political crisis in the peripheral countries at the expense of intensifying it in Germany,” Mr. De Grauwe said. “It would prevent communists taking over in the south but would fuel the extreme right in the north.”

As we've seen in the US, the right policies to deal with financial crises and depressions do not appeal to most people's moral intuition, and are thus very difficult politically.  If the euro - and the project of European unity - is to be saved, it will take some courage on the part of the leaders in Germany and other "northern" countries.

Update: the embedded video was taken down, but a shorter version is available at the link.

Franc Notes

Switzerland abruptly ended its ceiling on the euro-franc exchange rate last week, resulting in a 20% appreciation of the franc.

This highlights one fact of fixed exchange rates: no peg is forever.  This fact lends some drama to foreign exchange markets.  Normally pegs collapse in the other direction - a country which is trying to keep its currency over-valued spends down its reserves of foreign currency and faces speculative attacks from traders who believe it cannot sustain the policy, and the attacks make the policy even harder to sustain (e.g., Britain's 1992 ejection from the european exchange rate mechanism).  Since Switzerland's intervention involved keeping its currency under-valued relative to its market price, it was selling Swiss francs for euros.  In doing so, it accumulated reserves, so the possibility of running out which could have forced a crisis did not exist.

Normally, I'm not a fan of fixed exchange rates, but Switzerland's motivation for implementing the ceiling was understandable, as it faced huge financial inflows seeking a "safe haven" during some of the worst parts of the euro crisis.

On the graph, the exchange rate is the euro price of the franc, so an increase is a franc appreciation.  One can see the rapid appreciation in 2010-11 before the intervention, as well as the spike at the very end when the Swiss National Bank lifted the ceiling.

One of the problems of a fixed exchange rate is that it forces monetary policy to follow an external objective, rather than focusing on the state of the domestic economy.  In this case, Switzerland's policy had been forcing it to expand the supply of francs.  While this can be inflationary, in a world where deflation is the main worry, expansionary policy is appropriate (and Switzerland was not seeing any problems with inflation).  However, Switzerland does have low unemployment and a huge current account surplus.  Allowing its currency to appreciate will help its current account adjust.  It also means that the franc will not be locked into following the euro on its downward trend relative to the dollar and other currencies (the SNB's move also makes it easier for the ECB to exploit the exchange rate channel to stimulate the european economy).  Floating the franc does mean that the SNB once again faces the prospect of inflows seeking a safe haven - its trying to combat this with negative interest rates (the costs associated with holding large amounts of cash create a bit of space for negative returns on financial assets).

There has been quite a bit of commentary on this, which Brad DeLong nicely rounded up in one of his "socratic dialogues."  This guest post at The Economist's Free Exchange by Simon Cox of BNY Mellon seems to me like a sensible take.

Europe in Depression

In a post back in 2012, when things were looking pretty hairy for the euro, I said it would be "a real human disaster if the euro cracked up in a crisis."  Two years later, fear of a calamitous exit by the "peripheral" Eurozone countries have eased (as evidenced by reduced bond yields).  The euro appears to have been saved - and it has been a real human disaster nonetheless.

At wonkblog, Matt O'Brien writes:

As I've said before, the euro is the gold standard with moral authority. And that last part is the problem. Europeans don't think the euro represents civilization, but rather the defense of it. It's a paper monument to peace and prosperity that's made the latter impossible. So the eurocrats who have spent their lives building it are never going to tear it down, despite the fact that, as it's currently constructed, the euro is standing between them and recovery.

Just like the 1930s, Europe is stuck with a fixed exchange system that doesn't let them print, spend, or devalue their way out of a crisis. But, unlike then, Europe might never give it up. It's a fidelity to failure that even the gold bloc couldn't have imagined.

Unemployment rates are above 20% in Spain and Greece, and above 10% in Portugal, Italy, Ireland, France, Cyprus, Slovakia and Slovenia:

 (source: Eurostat)

Ambrose Evans-Pritchard spoke to several economics Nobel laureates:

An array of Nobel economists have launched a blistering attack on the eurozone's economic strategy, warning that contractionary policies risk years of depression and a fresh eruption of the debt crisis.

"Historians are going to tar and feather Europe's central bankers," said Professor Peter Diamond, the world's leading expert on unemployment. "Young people in Spain and Italy who hit the job market in this recession are going to be affected for decades. It is a terrible outcome, and it is surprising how little uproar there has been over policies that are so stunningly destructive," he told The Telegraph at a gathering of Nobel laureates at Lake Constance...
Professor Joseph Stiglitz said austerity policies had been a "disastrous failure" and are directly responsible for the failed recovery over the first half of this year, with Italy falling into a triple-dip recession, France registering zero growth and even Germany contracting in the second quarter.
"There is a risk of a depression lasting years, leaving even Japan's Lost Decade in the shade. The eurozone economy is 20pc below its trend growth rate," he said...
Professor Christopher Sims, a US expert on monetary policy, said EMU policy makers had not sorted out the basic design flaws in monetary union, and are driving Club Med nations into deeper trouble by imposing pro-cyclical austerity.
"If I were advising Greece, Portugal or even Spain, I would tell them to prepare contingency plans to leave the euro. There is no point being in EMU if all that happens when you are hit with a shock is that the shock gets worse," he said.
"It would be very costly to leave the euro, a form of default, but staying in the euro is also very costly for these countries. The Europeans have created a system that is worse than the Gold Standard. Countries are in the same position as Latin American states that borrowed in dollars," he said.

It may be a slightly hopeful sign that Francois Hollande is coming to a recognition of the problem, the Times' Liz Alderman reports:

After months of insisting that a recovery from Europe’s long debt crisis was at hand, President François Hollande on Wednesday delivered a far bleaker message. He indicated that the austerity policies France had been compelled to adopt to meet the eurozone’s budget deficit targets were making growth impossible.

Paris officials say that France — the eurozone’s second-largest economy after Germany — will no longer try to meet this year’s deficit-reduction targets, to avoid making economic matters worse. Even in abandoning those targets, they indicated that France was unlikely to recover soon from its long period of stagnation or quickly reduce its unemployment rate, which exceeds 10 percent.

“The diagnosis is clear,” Mr. Hollande said in an interview published Wednesday in the French daily Le Monde. “Due to the austerity policies of the last several years, there is a problem of demand throughout Europe, and a growth rate that is not reducing employment.”

To really make a difference, though, a more inflationary monetary policy is needed, and there is no sign of that on the horizon.

A euro breakup in 2010, 11 or 12 would have been disastrous for sure, but I'm beginning to wonder if it would have been worse than what we've actually seen.

Germany's Turn

The US Treasury:

Within the euro area, countries with large and persistent surpluses need to take action to boost domestic demand growth and shrink their surpluses. Germany has maintained a large current account surplus throughout the euro area financial crisis, and in 2012, Germany’s nominal current account surplus was larger than that of China. Germany’s anemic pace of domestic demand growth and dependence on exports have hampered rebalancing at a time when many other euro-area countries have been under severe pressure to curb demand and compress imports in order to promote adjustment. The net result has been a deflationary bias for the euro area, as well as for the world economy. 

That is from the semi-annual "Report to Congress on International Economic and Exchange Rate Policies" (pdf).

Typically the headline from such reports is about China, as the US criticizes its policy of intervening to keep the RMB undervalued to support a trade and current account surplus, but stops short of officially declaring it a "currency manipulator" which could trigger a conflict (which some, like Paul Krugman, have said the US should be willing to start).

The shift in focus to Germany is a sign the policy discussion is catching up to reality.  Although it is still intervening in the foreign exchange market, China has allowed a significant appreciation of the RMB (and even more in real terms) over the past several years and its current account surplus has narrowed.  That said, its "rebalancing" is still far from complete - consumption remains very low as a share of GDP; the decrease in the share of net exports seems to have been made up for by an increase in investment rather than consumption (with the usual caveat that the data are less than perfect..).

The biggest threat to the world economy now is a crisis in Europe, and while the ECB has managed to calm (for now at least) fears of a dramatic collapse, the Euro-area economy is still in lousy shape, which is a tragedy for the millions unemployed there, and a drag on economic activity in the rest of the world.

The Treasury is correct that Germany's current account surplus plays a role - stronger demand growth in Germany would help the suffering "periphery" of Europe (Spain, Italy, etc..) by creating more demand for their exports.  But Germany continues to be in denial, as Bloomberg reports:

Germany today reiterated its rejection of the Treasury report, saying it doesn’t merit criticism. “There are no imbalances in Germany which require a correction of our growth-friendly economic and fiscal policy,” Finance Ministry spokesman Martin Kotthaus told reporters in Berlin. 

The difficulty, in part, comes from the moralistic connotations of some of the language used to discuss international flows.  That is, Germany is running a current account "surplus" which results from a high level of "savings", and saving and having a surplus sound like the results of virtuous behavior (while having deficits and low savings connote profligacy).  So the idea that German economic policy is part of the problem is a hard sell to politicians, commentators and voters (and even some economists who should know better).  But it takes two to have an imbalance.  Or as Karl Whelan put it on Twitter:

See German politicians know that running surpluses shows they are good morally upright people. All countries should run surpluses. With Mars
— Karl Whelan (@WhelanKarl) November 1, 2013

Germany wants all countries in EZ to run surpluses. But then we also need hard money and a strong euro which makes that almost impossible.
— Karl Whelan (@WhelanKarl) November 1, 2013

One thing that is lost is that the current account surplus implies a lower standard of living for German citizens because it means they get to consume less of what they make.  In the second quarter of 2013, private consumption accounted for only 57% of Germany's GDP (via OECD), which is pretty low (in the US, which tends to be on the high side, its around 70%).  While exporting always seems to sound great to everyone, every BMW that is exported to the US is one less BMW that a German gets to drive (and the surplus implies that Germany is getting pieces of paper - not Mustangs - in return).  In the case of China, policies that led to a high share of exports could be defended as a development strategy - while this meant that the level of consumption was lower at any point in time, it may have generated a higher growth rate.  Its harder to apply such a rationale to a relatively high-income country like Germany.

However, though I don't agree with FT columnist Gideon Rachman's defense of Germany, he is correct that the Treasury's timing is poor (the report is required by law), coming on the heels of the reports that the US might have been spying on Angela Merkel, and that episodes like the debt ceiling wrangle seriously damage US economic policy credibility. 

The Economist's "Charlemagne" has a nice column this week on subject.

Update: See also Paul Krugman.

Is Euro-geddon Nigh?

 Brad DeLong writes on the value of studying economic history:

Ten years ago I thought that my curiosity about and interest in the Great Depression was an antiquarian diversion from my day job of understanding the interaction of economic institutions, economic policies, and economic outcomes. The fact that we had gone through the Great Depression, had learned lessons from it, and had incorporated those lessons into our institutions and policy processes meant that there was little practical use to going over it once again. Boy, was I wrong. History may not repeat itself, but it certainly does rhyme—and nothing made an economist better-prepared and better-positioned to understand what happened to the world economy between 2007 and 2013 than a deep and comprehensive knowledge of the history of the Great Depression.

One of the most basic lessons from the 1930's, as well as the semi-regular banking panics of the 19th century, is the importance of preventing bank runs.  This can be accomplished by providing a mechanism, such as deposit insurance, that makes depositors confident that they will always be able to get their money out - therefore they won't feel an urgent need to take it out at the first sign of trouble.

Even though its been evident for a while that Europe, or at least its "leaders", seem determined to forget (or ignore) the lessons of economic history, what they're doing with Cyprus is rather stunning.  Neil Irwin writes:

It is a bad day to have your money deposited in a bank in the Mediterranean island nation of Cyprus. And it may just mean some bad days ahead for the rest of us.

Early Saturday, the nation reached an agreement with international lenders for bailout help. Part of the agreement: Bank depositors with more than 100,000 euros ($131,000) in their accounts will take a 9.9 percent haircut. Even those with less in savings will see their accounts reduced by 6.75 percent. That’s right: Anyone with money in a Cypriot bank will have significantly less money when the banks open for business Tuesday than they did on Friday. Cypriots have reacted with this perfectly rational reaction: lining up at ATM machines to try to get as much money out in the form of cash before the money they have in their accounts is reduced.

The Economist's "Schumpeter" blog further explains some of the ways in which this move is problematic:

The bail-out appears to move Europe further away from the institutional reforms that are needed to resolve the crisis once and for all. Rather than using the European Stability Mechanism to recapitalise banks, and thereby weaken the link between banks and their governments, the euro zone continues to equate bank bail-outs with sovereign bail-outs. As for debt mutualisation, after imposing losses on local depositors, the price of support from the rest of Europe is arguably costlier now than it ever has been.

It is also hard to square this outcome with the ongoing overhaul of finance. The direction of efforts to improve banks’ liquidity position is to encourage them to hold more deposits; the aim of bail-in legislation planned to come into force by 2018 is to make senior debt absorb losses in the event of a bank failure. The logic behind both of these reform initiatives is that bank deposits have two, contradictory properties. They are both sticky, because they are insured; and they are flighty, because they can be pulled instantly. So deposits are a good source of funding provided they never run. The Cyprus bail-out makes this confidence trick harder to pull off.

Prophecies of impending Euro-doom over the past several years have repeatedly been wrong (or premature, at least), but this doesn't look good.  How many hours until banks open in Spain?

Update: According to the FT, it was the IMF that had been pushing the idea of "depositor haircuts" - I'd thought they were a little more enlightened, but apparently not...

See also: Karl Whelan,  Felix Salmon, David Beckworth, Paul Krugman.

Dirty Mario?

From a story by the Times' Landon Thomas about ECB President Mario Draghi:

“You do not go back to the lira or the drachma or whatever,” Mr. Draghi declared at that same early-August news conference. By alluding to the former currency of his home country, Italy, and seeming to place it in the same category of woebegone Greece, Mr. Draghi — who played a crucial policy role in the euro’s creation — signaled that he was taking the bears’ skepticism personally. 

“It’s like Dirty Harry saying, ‘Make my day,”’ said Stephen Jen, a former economist at the International Monetary Fund who now manages a hedge fund based in London. “You can’t imagine Greenspan or Bernanke saying something like this,” he said, referring to the previous and current U.S. central bank chairmen, Alan Greenspan and Ben S. Bernanke. “It was very Italian and very powerful.” 

Mr. Draghi’s weapon of choice, of course, is more subtle than the Smith & Wesson .44 Magnum favored by Clint Eastwood in the “Dirty Harry” movies. But from a financial markets perspective, there is no less firepower in his suggestion that the E.C.B. might buy the bonds of countries like Spain and Italy if they commit to tough measures to reduce deficits and restructure their economies. 

Of course, what made Eastwood's Inspector Callaghan "Dirty" was his willingness to break the rules.  If he really means to save the Euro,  Mario Draghi may need to show a similar disregard for legal niceties.  I'm not an expert on the ins and outs of the Maastricht treaty, so I won't take a position on whether large-scale purchases of the bonds of distressed governments by the ECB exceeds its authority (or on the related question of whether the "European Stability Mechanism" is constitutional), but some - particularly in Germany - have been making that case (see, e.g., here and here).

Some of the relevant language from the Maastricht treaty:

Article 104 1. Overdraft facilities or any other type of credit facility with the ECB or with the central banks of the Member States (hereinafter referred to as “national central banks”) in favour of Community institutions or bodies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments...

Article 104b 1. The Community shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of any Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project. A Member State shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law or public undertakings of another Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project.

If Draghi is serious about doing whatever it takes to save the Euro, he won't let that slow him down.

Critics of intervention can make appeals - perhaps with some validity - to the "rule of law," but this is a case where following the letter of the law (at least if its interpreted strictly) would lead to a real human disaster if the Euro cracked up in a crisis.

Some people found Dirty Harry's rule-breaking objectionable (Pauline Kael called it "fascist medievalism"). But John Wayne's perspective - in the context of explaining why he turned down the role - might be instructive for Draghi:

I thought Harry was a rogue cop. Put that down to narrow-mindedness because when I saw the picture I realized that Harry was the kind of part I'd played often enough: a guy who lives within the law but breaks the rules when he really has to in order to save others.

A little rule breaking is part of the tradition of central banking - as Brad DeLong explained, modern central banking came into being when the Bank of England acted outside its legal authority by assuming the role of "lender of last resort" during the panic of 1825.

Unlike Dirty Harry, whose magnum had six bullets, there will be no question of whether or not Dirty Mario has run out of firepower.  The question that remains is the extent of his willingness to use it, even if it means risking having to turn in his badge later.

Draghi probably wouldn't like the analogy, but I'd imagine its preferable to being called "Super Mario" all the time.

Maybe America has a Greek Problem After All

I was asked recently if I was worried that the US was turning into Greece.  "I'm not worried about that at all," I said.  I gave the standard economist's explanation: the crucial difference is that the US government is borrowing in its own currency, and the primary evidence that markets aren't worried is the low yield on long-term Treasuries. 

However, reading Paul Krugman's column today about Mitt Romney's taxes, I realized that the US-Greece parallel may be valid in one unfortunate respect: both countries appear to have a serious tax-avoidance problem on the part of their elites. 

Wonkblog's Brad Plumer wrote about a study of tax evasion in Greece:

A bigger question is why Greece hasn’t been able to crack down on tax evasion. The authors note that Greek officials seem to have a very good idea of who’s avoiding taxes: In 2010, the parliament took up a bill that specifically targeted doctors, dentists, lawyers, architects, engineers and so forth. As the authors note, these are precisely the groups evading the most taxes (largely because they receive much of their income in bribes). But the crackdown bill failed — possibly because, as the authors discover, these are the professions best represented within the Greek parliament.

In the US, we have a problem of illegal tax evasion - the "tax gap" - which, while significant, may not be on the same scale as Greece's.  The bigger problem in the US is the ability - and willingness - by corporations and very high-earners to legally avoid taxes. 

Though its hard to know for sure what's going on without more information, Mitt Romney's IRA might be an example. According to Krugman:

I.R.A.’s are supposed to be a tax-advantaged vehicle for middle-class savers, with annual contributions limited to a few thousand dollars a year. Yet somehow Mr. Romney ended up with an account worth between $20 million and $101 million. 

I doubt Romney did anything illegal by the letter of the law, but the complexity of our tax system provides lots of ways for people and corporations that can muster legal and accounting firepower to minimize their taxes.  Moreover, the same people and corporations who benefit from the messiness of the tax code have disproportionate influence in Washington which may help them keep their loopholes open, and perhaps get them widened a little here and there.

The obvious policy answer is a simpler, and better-enforced tax code.  But, given the political economy, that's probably not realistic.  And focusing on the tax rules may miss the real issue, both here, and perhaps in Greece, that there is not a strong enough sense that taxes are a duty (one might even say noblesse oblige) and some attempts to avoid them - even if legal - might be wrong. 

Krugman noted that, in contrast to his son, George Romney was notably transparent about his finances:

Those returns also reveal that he paid a lot of taxes — 36 percent of his income in 1960, 37 percent over the whole period. This was in part because, as one report at the time put it, he “seldom took advantage of loopholes to escape his tax obligations.” 

There probably always have been and will be "loopholes", but what matters is the willingness to take advantage of them.  That depends, in part, on how socially acceptable it is to do so.  While the details are different (and the macroeconomics is very different), the US and Greece seem to share a significant failing in the "social norms" department.

Hans-Werner Sinn is for Hanging Separately. Is Germany?

In a NY Times op-ed attempting to explain "Why Berlin is Balking on a Bailout" Hans-Werner Sinn writes:

Even a European nation, however, should not socialize debt, a lesson demonstrated by the United States in the 19th century. 

When Secretary of the Treasury Alexander Hamilton socialized the states’ war debt after the Revolutionary War, he raised the expectation of further debt socialization in the future, which induced the states to over-borrow. This resulted in political tensions in the early 19th century that severely threatened the stability of the young nation. 

Wow.  

Every American schoolkid learns that Ben Franklin said "we must all hang together or assuredly we shall all hang separately." The point is that the we succeeded by hanging together.  Sinn somehow manages to draw the opposite lesson.  Wow.

The more widely-held (until today, I would have said "universally") view is that Hamilton's plans - which faced a great deal of opposition at the time - helped establish the creditworthiness of the United States and provided a foundation for its financial and economic development. Bob Wright and David Cowen, in Financial Founding Fathers explain:

The positive effects of funding and assumption of the debt upon not only the country's credit standing but also its commerce were felt almost immediately. Writing from Hartford in 1791, Noah Webster, the "schoolmaster of America," boasted about the era of prosperity brought on by assumption. "The establishment of funds to maintain public credit," he noted, "has an amazing effect upon the face of business and the country." "Commerce," he continued, "revives and the country is full of provision. Manufactures are increasing to a great degree, and in the large towns vast improvements are making in pavements and buildings."

Moreover, Europe's capital markets magically opened to the United States. As early as March 1791, United States securities were selling from 1 to 40 percent above par in Europe. In November 1791, European-based broker John Fry assured Hamilton that American credit overseas was secure and that European funds would stabilize securities prices. "The American Funds," Fry claimed, "had inspired no Confidence in this market 'til they had acquired a high price at home & three months ago a sale of them must have been effected here with the greatest difficulty." "The Case is now so materially alter'd," he wrote, "that one friend of mine has bought & sold near a Million of Dollars." Fry noted that Europeans at that time had more money than local investment opportunities and were looking to employ their capital in the United States. In short, Americans were able to borrow money in Europe at between 3 and 6 percent and use it to fund projects that returned 10, 15, even 20 percent per year. 

That is, Hamilton's plan for the national debt mostly worked out pretty well and is a good example of something that was controversial at the time but vindicated by history.

I really hope Sinn's view isn't representative of German opinion.  If it is, we're in way more trouble than I realized.

The Subordination of Economic Theory to Society

At Project Syndicate, Schlomo Ben-Ami writes:

Europe, however, has always found it difficult to come to terms with an over-confident, let alone arrogant, Germany. The current political turmoil in Europe shows that, regardless of how sensible Chancellor Angela Merkel’s austerity prescriptions for debt-ridden peripheral Europe might be in the abstract, they resemble a German Diktat. The concern for many is not just Europe’s historic “German problem,” but also that Germany could end up exporting to the rest of Europe the same ghosts of radical politics and violent nationalism that its economic success has transcended at home.

Once the crisis became a sad daily reality for millions of unemployed – particularly for what appears to be a lost generation of young, jobless Europeans – EU institutions also became a target of popular rage. Their inadequacies – embodied in a cumbersome system of governance, and in endless, inconclusive summitry – and their lack of democratic legitimacy are being repudiated by millions of voters throughout the continent.

Europe’s experience has shown that the subordination of society to economic theories is politically untenable. Social vulnerability and frustration at the political system’s failure to provide solutions are the grounds upon which radical movements have always emerged to offer facile solutions.

If "economic theories" is taken to mean the theories of economists, the "subordination of society to economic theories" is not the problem in Europe right now.

The euro project was driven by politicians and businessmen - not economists - from the outset.  In terms of economic theory, giving up autonomous monetary policy is highly problematic, especially in the absence of fiscal union and when labor mobility is limited. 

Moreover, according to economic theory, the "austerity prescriptions" are anything but "sensible."   Economic theory says that these policies are pro-cyclical (i.e., exacerbate the current economic slump) and that the adjustment of economic imbalances through "internal devaluation" is extremely painful.

The underlying motives for the push for austerity in Europe are largely political.  I cannot claim to have any insight about domestic politics in Germany, but the last several years in the United States have demonstrated that interventions grounded in basic economic ideas - counter-cyclical fiscal policy, expansionary monetary policy, and "lender of last resort" financial interventions - can be deeply unpopular.  Even though these policies can deliver what appears to be a (nearly) "free lunch," they are profoundly unappealing to the instinct and intuition of voters.  What the voters ("society") seem to want are economic policies that reward virtue and punish profligacy (last year, Stephen Gordon nicely observed a parallel between German attitudes and the US "Tea Party").

Economists and our theories are far from perfect, but the problem in Europe is not economic theories, or at least it isn't the economic theories of economists.  Europe would be doing much better right now if it was subordinated to economic theory (not the same thing as "technocrats").   The problem is that voters have their own economic theories, grounded in their perceptions of fairness and virtue, and these stand in the way of resolving the crisis.  That is, Ben-Ami has it exactly backward: what is underlying the European crisis is the subordination of economic theories to society.

Update:  Empirical evidence, tweeted by the Economist's Greg Ip:

Apparently many voters mistrust IS-LM. YouGov Economist poll: How stimulate econ? 47%=>gov't infrastructure spending; 46%=> reduce deficit.

And related thoughts in Paul Krugman's blog.

Central Bank Firepower

Bundesbank's Jens Weidmann (via Bloomberg):

"Monetary policy is not a panacea and central bank firepower is not unlimited, especially not in a monetary union,” he said. “We can only win back confidence if we bring down excessive deficits and boost competitiveness. And it is precisely because these things are unpopular that makes it so tempting for politicians to rely instead on monetary accommodation."

As a factual matter, Weidmann is just plain wrong (and I think he knows it - perhaps this was just a poor word choice on his part).  In a fiat money system the central bank's firepower - its ability to create money - is unlimited.  There are good reasons why central banks choose to exercise restraint, but it is a policy choice.  In the case of Europe today, the ECB could create money to buy government bonds.  A mere expression of willingness to use its "firepower" this way could significantly bring ease the pressure on bond spreads.

The objections to this are twofold: (i) it creates "moral hazard" by allowing governments to escape the consequences of their own fiscal policies (though as Krugman and others have pointed out, the standard narrative about profligate peripheral governments is not really accurate) and (ii) money creation could lead to inflation.  Some of us think a little more inflation in Europe would actually be quite helpful, but others - particularly in Germany due to the memory of hyperinflation in the 1920s - are quite averse to it, and modern central bankers worry alot about maintaining the "credibility" of low inflation expectations.

In any case, the ECB has the firepower, its just choosing not to use it.