I have had several requests to comment on the euro crisis. One person suggested discussing this post by Megan McArdle:
The Great Depression was composed of two separate panics. As you can see from contemporary accounts–and I highly recommend that anyone who is interested in the Great Depression read the archives of that blog along with Benjamin Roth’s diary of the Great Depression–in 1930 people thought they’d seen the worst of things.
Unfortunately, the economic conditions created by the first panic were now eating away at the foundations of financial institutions and governments, notably the failure of Creditanstalt in Austria. The Austrian government, mired in its own problems, couldn’t forestall bankruptcy; though the bank was ultimately bought by a Norwegian bank, the contagion had already spread. To Germany. Which was one of the reasons that the Nazis came to power. It’s also, ultimately, one of the reasons that we had our second banking crisis, which pushed America to the bottom of the Great Depression, and brought FDR to power here.
Not that I think we’re going to get another Third Reich out of this, or even another Great Depression. But it means we should be wary of the infamous “double dip” that a lot of economists have been expecting. The United States is in comparatively good shape, but the euro is in crisis, and already-weak European banks seem to be massively exposed to Greece’s huge debt load. They’re even more exposed to the debt of the other PIIGS, which is far too large for it all to be bailed out. The size of the rescue package that Greece needs is already going to take a fairly substantial chunk of the IMF’s war chest.
I also found it hard to avoid comparisons to 1931. I wish I could tell you the precise lessons of 1931, but it is surprisingly difficult. The first question we need to consider is why some bad news from tiny Portugal seemed to knock 2.4% 0ff the S&P yesterday. I always look at other markets for insights, and I noticed that the fall in stock prices was accompanied by lower 5 year inflation expectations, and a stronger dollar. That looks like a contractionary monetary shock.
In 1931 it was actually fairly easy to figure out how European debt problems caused deflation in the US. It led to a scramble for liquidity, and in 1931 gold was the ultimate form of liquidity. Even central banks hoarded gold. A higher demand for gold was deflationary for countries still linked to gold (such as the US.) The analogous asset today would obviously be dollars, which are a sort of safe haven in financial crises that are occurring overseas. So the demand for dollars rose on Tuesday, which is deflationary.
But there is also an important difference; in 1931 the US could not print more gold, the only surefire way to avoid deflation was to devalue the dollar. And that was politically very difficult. In contrast, the Fed can print almost unlimited dollars, so an increased demand for dollars need not be deflationary.
On the other, other hand (by now you may share Harry Truman’s preference for one-handed economists), the markets seemed to indicate that they did not expect the Fed to fully accommodate any increase in demand for money. I base this conclusion on the various asset price movements discussed above, which suggest that on Tuesday investors slightly scaled back their forecasts of medium term US NGDP growth. And one can certainly understand why markets might be worried about the risk of slower NGDP growth, after all, the Fed failed to fully accommodate the demand for dollars associated with the 2008 banking crisis.
So as in many game theory situations almost anything is possible. Even worse, the effects may not be linear, or even monotonic. A small crisis in Europe might cause the Fed to do nothing, while a big crisis might cause such a large expansionary response by the Fed that US NGDP actually ended up higher. But the truth is probably much simpler. My hunch is that a bigger crisis in Europe would cause an even bigger fall in US stock prices and NGDP.
By now you may regret that I was asked to comment, as I haven’t come up with any definite answers. As I keep saying, the markets are the best indicator of the likely effect of shocks; it’s our job to infer the best policy responses from the information embedded in asset prices. If you want something much more interesting, from an economist who is actually comfortable with open economy macro, check out Nick Rowe’s recent post.
What should the Europeans do? I don’t see any good options. The ECB should be more expansionary, but for reasons unrelated to Greece. And even that would probably not be enough to prevent a default in Greece. It might, however, boost property markets on the Iberian peninsula enough to tip the balance in those two countries. Just to be clear, if NGDP levels in the eurozone were adequate then I would not recommend using monetary policy to bail out debtors. Even with this disclaimer I suppose many people will assume I am merely an inflationist who wants to paper over fiscal imbalances. Of course what I am really saying is that a massive financial crisis is not the best time for the ECB to downshift to a much lower NGDP growth track, especially as NGDP is the variable that determines a country’s ability to service its nominal debt. But the ECB moves in mysterious ways.
PS. I just noticed that Nick Rowe also made the case for more monetary ease in this post.
HT: Kyle Griffin
2. Romer on monetary stimulus
Several commenters (Marcus Nunes and Daniel Carpenter) asked me to discuss this puzzling argument from Christina Romer:
The other fundamental source of the lingering shortfall of aggregate demand comes from the limits of monetary policy. The recession we have just been through is different in character from almost every other postwar recession. The usual postwar recession has a fairly simple narrative. The groundwork is laid when for some reason policy is overly expansionary and so generates inflation. The recession occurs when the Federal Reserve realizes that things have gone awry. It raises interest rates, slows the economy, and so brings inflation down — at the cost of a recession.9
That type of recession is easy to end: once the Federal Reserve is satisfied with the behavior of inflation, it can slash interest rates and provide the economy with a large jolt of stimulus. The result is that the recoveries from severe recessions caused by tight monetary policy have been very strong. For example, in the year following the trough of the 1981-82 recession, real GDP grew almost 8 percent and the unemployment rate fell 2.3 percentage points.
The recent recession was obviously not caused by tight monetary policy. Interest rates were not especially high when it began, and so the Federal Reserve had only limited room to cut them. It has brought short-term rates down to virtually zero, but it cannot push them below that. The result is that we have not had the strong monetary stimulus that we would normally have in these economic circumstances. One study found that given the Federal Reserve’s usual responses to inflation and unemployment, economic conditions would lead it to cut its target for the federal funds rate by an additional 5 percentage points if it were able to do so.10 That is, despite the very low level of interest rates and all the attention to the growth of the Federal Reserve’s balance sheet, current monetary policy is in fact unusually tight given the condition of the economy.”
This is a very strange comment. Christine Romer did some very well known research on the role of gold flows in the Great Depression. She argued that fears of war led Europeans to move gold to America. This gold inflow boosted the US monetary base, and contributed to rapid economic recovery. I don’t consider the recovery to have been all that rapid, partly because much of the enlarged MB was hoarded as excess reserves. But nonetheless, that was her argument. And keep in mind that nominal interest rates were near zero throughout the late 1930s. So why is she now arguing that monetary policy can do nothing once rates hit zero? And don’t say she only means conventional monetary policy. People like Paul Krugman think that even OMOs (or QE) were ineffective during the late 1930s. In contrast, Romer clearly argued that a higher MB was expansionary, even at near zero rates. So while the conventional/unconventional distinction may work for Krugman, it doesn’t seem to explain Romer’s views at all. What have I missed?
If I’m right, then it seems to me that Obama fans lose the excuse that he doesn’t control the Fed. Rather it seems that his advisors are giving him bad advice, or perhaps they are being forced to toe the party line that only fiscal stimulus can save us now.