AD shocks make structural problems MUCH worse

Tyler Cowen has a post criticizing the widespread view that Germany is the key to solving the euro crisis.  He’s right that moral hazard is a much bigger problem than most bloggers seem to think, and he’s right that Germany can’t be expected to bail out the PIIGS.  But I’m not so sure about this:

Furthermore, there is no “half hearted recovery” in the offing, not even with better AD policy.  A lot of institutional arrangements were set up in an unstable fashion and now they are unwinding, as indeed they had to do, with economic carnage along the way.  The periphery countries all thought they were wealthier than they in fact are, and behaved as such, but now is the painful unwinding, including the collapse of a lot of ultimately unworkable EU governance structures.  Markets now see this, and the ECB cannot so easily reverse it.

In other posts I’ve argued that even if your “real problem” is pneumonia, it’s very much in your interest to avoid being stabbed by a mugger.  And even if your real problem is structural (and I agree with Tyler that this is the big problem in the Mediterranean economies) you very much want to avoid a sharp fall in NGDP growth.

Let’s suppose Tyler is right that “no half hearted recovery” is likely if the ECB pumps up NGDP by 5% over the next 12 months.  Even in that case I’d argue that demand stimulus is of crucial importance.  Why?  Because if 5% NGDP growth will produce a recession, then negative 5% NGDP growth will produce a depression.  And that could happen if the ECB remains completely passive.  I’m not sure that Tyler disagrees with that, but I think most people reading the excerpt I provided would assume that he disagrees.

Trotsky once said “You may not be interested in war, but war is interested in you.”

I’d say the same about AD shocks.

As far as what the markets can see, I’d say the wild gyrations on Wall Street suggest the markets don’t know what’s going to happen.  The Europeans are playing a game of chicken, with one side asking for austerity and the other side asking for bailouts (via ECB bond purchases.)  As with the NBA strike I expect a deal before the worst case develops, but in any game of chicken the worst case is a possibility.  Tyler Cowen pointed out in a previous post that if the worst case was not a possible outcome, then the negotiators would have no leverage.  You must be willing to unleash Armageddon.

Wasn’t the European Union set up to prevent exactly this sort of dangerous brinkmanship?

PS.  And don’t forget that the difference between positive 5% and negative 5% NGDP growth in the eurozone is the difference between a Greek default and a dramatically larger Greece/Italy/Portugal and perhaps Spanish default.

Update: Paul Krugman discusses some interesting evidence put together by Rebecca Wilder:

You can see the big divergence as the euro crisis has exploded. But I think it’s interesting that Finland and Sweden started to diverge back in April. What happened then?

Ah, yes “” the ECB started raising rates. And as Rebecca Wilder points out, that’s precisely when euro bond spreads began their upward march, culminating in the current crisis.

By itself, that rate hike “” although it was obviously, obviously a big mistake “” should not have mattered that much. But maybe it acted as a signal of the ECB’s bloody-mindedness, and that’s what set off the panic.

If that’s what happened, then the ECB’s hard-money madness may have destroyed the euro.

A signal indeed.  We keep seeing over and over again that expectations of future monetary policy drive current asset prices.  And wasn’t April the last time we saw a decent jobs number in the US?  It’s also roughly the time that the Fed sent out strong signals that QE2 would be shutdown.



36 Responses to “AD shocks make structural problems MUCH worse”

  1. Gravatar of pct pct
    27. November 2011 at 14:24

    I claim that the greatest favor Germany could do the EU right now would be to, right now, Sunday evening, get a bunch of big black rubber stamps that read “D-MARK.” overstamp all their Euro notes, pull their representatives from the ECB, and announce they had left the Euro. No need for intergovernmental cooperation. No need for treaty changes. No need for German debt guarantees or for a transfer union. The Euro would start trading Monday at around US$0.95. The periphery would be happy because their currencies had finally depreciated. Germany would be happy because it got its D-Mark back and doesn’t have to support the deadbeats. Scott Sumner would be happy because Euro-denominated NGDP would skyrocket. Win-win-win.

  2. Gravatar of Steve Steve
    27. November 2011 at 14:49


    Tyler is completely wrong (and I thought that even before I saw he was quoting from Morgan Warstler).

    There are plenty of middle grounds that don’t involve unleashing Armageddon. The mutually assured destruction doctrine of the cold war didn’t mean you would launch the missiles every time you didn’t get your way, it meant you would unleash Armageddon if the other side did so first. There was plenty of room to negotiate and fight proxy wars. Berlin blockade, Cuba Missile, Bay of Pigs, Vietnam, Afghanistan, etc.

    The problem now is that Merkel is unilaterally unleashing Armageddon rather than drawing up a realistic proposal to compromise. She’s the one pushing the red button.

    Plenty of proposals have been submitted, including the EC’s Red Bond/Blue Bond proposal which which create joint liability for the first 60% debt/GDP of each country’s sovereign bonds, or Munchau’s proposal to allow the ECB to cap the credit spreads for each country (depending on their fiscal situation). Both proposals would allow the ECB to engage in practically unlimited QE without completely unwriting moral hazard. It’s the Bundesbank power play that is blocking this, because the Germans don’t want anyone else to have a say in European monetary policy.

  3. Gravatar of John Thacker John Thacker
    27. November 2011 at 15:04

    The euro has had these sort of structural problems for years. Enough so that American economists kept predicting that there would be a crisis, or that the euro would fail at the first major crisis. This caused some crowing in 2010 by European economists with the Econ Journal Watch article “It Can’t Happen, It’s a Bad Idea, It Won’t Last: U.S. Economists on the European monetary union and the euro, 1989-2002.” Of course, for those who believe that pride goeth before a fall, that was amazingly poor hubris.

    My belief is that the euro had structural problems and everybody knew that further integration, culturally and in every other way, was needed. The euro was intended to speed up that integration faster than just having free movement and tariffs abolished. However, it made everything more brittle and vulnerable to a crisis.

    Yes, that doesn’t mean that it caused the crisis. Had the crisis been avoided, it may have all worked out once the EU got past the danger point and a real EUropean identity was established. But the euro was still the opposite of insurance; it worked more like excessive leverage, or vacuuming up quarters in front of a steamroller. Slightly hastening integration was not worth massively worsening the events of any crisis.

    The exact assigning of blame is a philosophical one, though, between the proximate cause and the structural one.

  4. Gravatar of Doc Merlin Doc Merlin
    27. November 2011 at 16:18

    …or maybe its that fake stimulated AD hides real problem, so the crash ends up being bigger.

  5. Gravatar of Morgan Warstler Morgan Warstler
    27. November 2011 at 16:18

    DeKrugan doesn’t see the innate beauty of this, so he doesn’t really count:

    I’ll say it again and again, this is not about past debts, this is about the welfare state getting less by law, and being believable about it…

    Every time DeKrugman talks about Sweden and Finland, he misses the OBVIOUS response that as soon as the Greeks learn to:

    1. establish a high trust society – become Sweden / Finland


    2. pay their public employees less, and raise pension ages etc.

    Then his Nordic point is valid. And since not #1, then #2, DeKrugman is wrong.

    Europe will muddle through, it isn’t past debts, so it isn’t current rates… if they leave, no one will loan to them… so leaving has no upside.

  6. Gravatar of Doc Merlin Doc Merlin
    27. November 2011 at 16:20

    …or maybe its that fake stimulated AD hides real problem, so the crash ends up being bigger later?

  7. Gravatar of Claudia Sahm Claudia Sahm
    27. November 2011 at 16:37

    If you have pneumonia isn’t it tough to out run your mugger? But I agree…there’s no reason to expect passivity in a crisis.

  8. Gravatar of StatsGuy StatsGuy
    27. November 2011 at 16:50

    The monetary authorities are treating the fiscal situation as a forcing function – they don’t want to loosen the screws, lest they lose the opportunity to get the fiscal policies they want.

    It’s like a doctor who refuses diabetes medication until the patient demonstrates that s/he is holding to a healthy diet and exercise.

  9. Gravatar of Contemplationist Contemplationist
    27. November 2011 at 17:26


    So you subscribe to Morgan’s model now?

  10. Gravatar of Morgan Warstler Morgan Warstler
    27. November 2011 at 17:59


    Frankly, I don’t know why you think enabling economic diabetes is some how a moral good.

    But if you are going to ask society to pay for said meds (the new expensive kinds), pandora’s box is open, and guys like me are going to waltz right through making fat people miserable.

    Liberals would write much better policy if they just accepted “beggars can’t be choosers” as a fact, it cuts down on beggars, narrows their policy agenda and outcomes, and increases “trust.”

    Do you know how many of Matty’s crowd had no issue with Foodies using stamps at Whole Foods? They were as unconvincing as OWS.

    That said, I think society would be ok with covering plastic surgery for the guy who lost all that weight… incentives cut both ways…. and we should reward austerity, right?

  11. Gravatar of Bob Murphy Bob Murphy
    27. November 2011 at 18:46

    I’m taking notes for our debate, Scott. When the central bank cuts interest rates, that’s not a signal of loose money; in fact, as Milton Friedman taught us, it’s a sign of tight money.

    And when central banks raise rates, it’s a signal of tight money–in fact bloody-minded tight money.

    Got it.

  12. Gravatar of Bob Murphy Bob Murphy
    27. November 2011 at 18:50

    Oh I forgot the most important thing: If interest rate cuts, and interest rate hikes, are all signs of tight money, how do we know when the central banks are engaging in sufficiently loose money?

    A: When prosperity returns.

    (Yes I’m being saucy, but I could back up the above claims with all sorts of Sumner links if subpoenaed.)

  13. Gravatar of Morgan Warstler Morgan Warstler
    27. November 2011 at 20:16

    Bob, by definition, money was too loose anytime level targeted NDGP ran over 4% (Scott’ll say 4.5%), which occurs during most of the mid-2000 years I’d guess you’d think money was too loose…. assuming normative Fed speak.

  14. Gravatar of david david
    27. November 2011 at 20:22

    The independence of monetary policy authorities has to go both ways, or someone is going to learn painfully that the independence can be revoked.

  15. Gravatar of Contemplationist Contemplationist
    27. November 2011 at 21:01


    You are being deliberately obtuse. NGDP is nominal. Scott’s claim is nominal – that the central bank has the power (i’m sure you agree with this part) and hence should (you disagree here) to keep NOMINAL SPENDING on a stable trajectory. What happens to REAL OUTPUT and REAL GDP cannot be controlled by the central bank. Is that so hard? Can we quit the cute sniping?

  16. Gravatar of John John
    27. November 2011 at 21:05

    There really isn’t a nice pragmatic solution. The Greek workforce doesn’t have the productivity to pay the debts the government has accumulated and maintain the type of welfare government western nations think is essential. Greece has to default and doing so will force losses at banks and put pressure on the borrowing costs ofother European nations. This should be done sooner rather than later and in an orderly process. The ECB should follow the old wisdom about lending freely at a high rate of discount to member banks in order to separate the wheat from the chaff ASAP.

    The euro debt crisis is a lot like the subprime lending crisis in that guaranteeing or insuring against debts doesn’t prevent falling valuations of houses or bonds. I hope Europe works this out in a market-oriented manner. Their priorities should be an orderly and effective Greek default where both sides split the losses and the preservation of an area where capital and labor can move freely.

  17. Gravatar of John Thacker John Thacker
    27. November 2011 at 21:12


    You’re obviously being saucy, but you’re also misquoting Scott. I have a hard time believing that you don’t understand, but is it willful ignorance? You’re clearly confusing levels with changes.

    When the central bank raises rates, they are making money tighter.

    If you assume that the central bank is targeting inflation alone, then if the rate necessary to achieve inflation is very low, then that is a sign of tight money (because of, for example, low V.) (It would, of course, be better to think of the rate necessary to achieve a stable NGDP.)

    It is always tricky to reason from a price change. If the Fed raises rates, it is making money tighter. It may be doing this because money is loose, in which case it is the right decision (and the economy will show the results). It may however be making a mistake.

    Scott’s position here is that money was already tight, and yet the ECB chose to make it tighter, which was a mistake.

    Your comments, Bob, assume an infallible central bank.

  18. Gravatar of Morgan Warstler Morgan Warstler
    27. November 2011 at 21:32

    John, US southern states figured out how to compete against northern states… less regulation, lower wages, less social safety net, etc.

  19. Gravatar of Matt Waters Matt Waters
    27. November 2011 at 22:01


    It’s simply willful ignorance if you truly think Scott has said that a central bank lowering interest rates is actually tightening money.

    What he’s said is that lower interest rates can be a SIGNAL of tighter money. That means that monetary policy is having less traction if lower interest rates are still not transferring to higher NGDP growth.

    Conversely, if a bank is raising interest rates and still not having traction lowering inflation, that is, once again, a SIGNAL of looser policy. Either way, a central bank will likely think they’ve done all they can to either tighten/loosen policy, when in reality they could do much more.

    In the case of the early-80’s, that “much more” was an unprecedented 18% Fed Funds rate. Today, that “much more” is more QE, lower IOER, better communication for expectations, etc.

    And let me be saucy for a little bit myself here. Your comments suggest to me that you really were not intellectually curious about Sumner’s viewpoints and AD arguments to begin with. I’m guessing your internal logic says “this does not match my purist Austrian views and therefore I will not rationally consider the argument or the data backing the argument.”

    In my experience, most such Austrians use crazy arguments from authority and causality arguments which sound good, but ultimately have little data backing them up. Then, when confronted with other possible causality arguments for high unemployment such as downward wage rigidity, Austrians typically do not have a good response for why “misallocation of capital” causality arguments are better. That’s because no data actually supports the argument that all unemployment is merely markets realigning itself. Meanwhile, there is an avalanche of data that shows nominal shocks create unnecessary massive unemployment due to a basic market failure: downward wage rigidity.

  20. Gravatar of John Thacker John Thacker
    27. November 2011 at 22:27

    Also, one can look at the yield curve. If the long term rate is very low, that indicates tight money; conversely with loose money. Of course one has to back out any implied default rate.

    Those auction and market set rates are very different from the central bank set rates. Scott does think that the market is efficient, but not necessarily the Fed.

  21. Gravatar of John Thacker John Thacker
    27. November 2011 at 22:31


    Bob is No True Austrian, for what Austrian would support a government central bank setting prices by fiat over the calculations of the market and the interest rates obtained freely.

    Bob thinks that the government has solved the calculation problem, at least the central bank. He is clearly no Austrian.

  22. Gravatar of Matt Waters Matt Waters
    27. November 2011 at 22:40

    As far as the Euro goes, I also don’t see a neat and tidy solution.

    The only thing I see is something like Chapter 9 bankruptcy in the US for an orderly default. In the case of Chapter 9 bankruptcy, a bankrupt municipality has a way to keep funding day-to-day expenses while cutting down on its debt loads. A federal judge has authority to cut up all sorts of city contracts while imposing more taxes. In return, the city can get a haircut on creditors and can issue senior debt to keep funding day-to-day expenses.

    In the case of Greece/Italy, both Germany and them have a big incentive to not break up the Euro. The recent increase in bond yields for even Germany and Finland shows that investors are skiddish about how a Euro breakup might actually shake out. There’s too many contracts and too much debt in Euro terms for all Eurozone investors to suddenly face uncertainty about the very existence of the currency.

    On the other hand, though, we also face this prisoner’s dilemma either Greece/Italy or Germany could benefit if the other side gives in (or a game of chicken if you prefer, but they seem like the same metaphor to me). That’s why the 17 countries need to actually decide something as far as true involuntary haircuts for Greece, ironclad austerity requirements for all PIIGS and an ironclad backstop from the ECB or from Eurobonds (the same thing, really).

    In short, there needs to be a moment like when the US passed TARP. I do believe that VERY unorthodox Fed policy could have offset a run on the entire banking system, but I also believe such unorthodox policy would have never happened and we would have had another Great Depression without TARP. Everybody hates it now, but at that moment, people saw the stock market and realized that all the prognostications were true.

    IMO, eventually Germany will come to the realization that the Euro could in fact break up with devastating consequences and they will have a TARP moment. Markets are still too high even now for a Eurozone breakup. They’re just pricing in the possibility of a breakup, but in the end I think that countries will come together for some sort of fiscal union.

  23. Gravatar of Matt Waters Matt Waters
    27. November 2011 at 22:48


    I guess that’s what I get for just glancing at his blog. All the arguments seemed like regular Austrian-type stuff when I first looked at it, particularly the “misallocation of capital” angle. That is indeed pretty crazy.

    FWIW, I admire the ideological purity of Austrians. There’s a very alluring siren call for libertarian to blame every lost problem on government, including massive cyclical unemployment. But I just don’t understand how cyclical unemployment can be anything other than a traditional market failure, like natural monopolies or tragedy of the commons.
    In an ideal world with no market imperfections, cyclical unemployment would not exist.

  24. Gravatar of Peter N Peter N
    28. November 2011 at 02:24

    An NGPD target may be a long term solution (certainly compared with a crisis time scale of a few weeks), but in the meantime, h0w big a bailout fund would you need to live to see the long term.

    Well, Bloomberg extracted some information from the Fed about the banks borrowing in the 2008 bailout. The largest total for any day was $1.2 trillion. And

    “Add up guarantees and lending limits, and the Fed had committed $7.77 trillion as of March 2009 to rescuing the financial system, more than half the value of everything produced in the U.S. that year.”

    Also see Felix Salmon, where I got the link.

    The European banks are much bigger and at least as sick, so I figure something like twice those amounts should be enough if all goes well. The ECB will have to sell its stamp collection.

  25. Gravatar of Lars Christensen Lars Christensen
    28. November 2011 at 03:09

    Matt, Government institutions are clearly to blame – central banks failed and that is why we are in this mess, but Bob think that loose monetary policy is to blame – market monetarists including myself believe that overly tight monetary policy is to blame. The odd thing is that Bob is in favour of a gold standard – I say why not feel it to the market to decide what monetary regime you would like? George Selgin & Co. are the true Free Market advocates in monetary questions – the gold bunch just want another form of government intervention in money.

  26. Gravatar of dwb dwb
    28. November 2011 at 05:18

    more like the practice of bloodletting to “balance the humours.” Sure, the patient is sick. Bloodletting only weakens the patient further and makes him/her suceptible to infections.

  27. Gravatar of Peter N Peter N
    28. November 2011 at 05:19

    I think You’re both right. The Fed went on a loosening spree in early 2002 and then tried to tighten in 2005. However they lost control, because the banks and shadow banks created money equivalents so they could keep partying.

    In 2008 the market for some of these money equivalents froze up. If you can’t trade them, money equivalents cease being equivalent and can’t substitute for money. This reduces the money supply by the value of the equivalents – trillions of dollars. People started hoarding money. Banks wouldn’t lend even to each other.

    The Fed didn’t understand the scope of the problem. You don’t usually go from fairly loose to extremely tight in a few weeks.

  28. Gravatar of Morgan Warstler Morgan Warstler
    28. November 2011 at 05:43

    Peter you hit the nail on the head.

    Which is why TBTF has to be stopped, it cannot be accounted for with insurance taxes or anything else. If there is to be FDIC then we must force banks to keep their loans on their books.

    Lately, I’ve come to s simple formula… the crushing winning argument.

    Since Big Business = Big Government, any small government proponent MUST equally demand tax policy that favors small business over big business, moral equivalence between small business and big business is not acceptable.

  29. Gravatar of Eric Morey Eric Morey
    28. November 2011 at 06:30

    “by definition, money was too loose anytime level targeted NDGP ran over 4% (Scott’ll say 4.5%)…”

    You are describing rate targeting, not level targeting. It is the reason why you don’t understand the last four years of monetary policy was a failure but you think it was a success.

  30. Gravatar of Contemplationist Contemplationist
    28. November 2011 at 07:51

    Lars Christensen

    I’m firmly in George Selgin’s camp as well – the gold and “hard money” fetish is ridiculous especially for anarcho-capitalists. Who the hell do they think is going to enforce the gold standard?

  31. Gravatar of ssumner ssumner
    28. November 2011 at 07:59

    pct, Maybe, but how do you decide which euro notes are German?

    Steve, I think you mix up two issues. The Germans are right to oppose bailouts, eurobonds, etc, but wrong to oppose monetary stimulus. A agree that something short of Armageddon is possible, and indeed likely.

    John Thacker, I agree.

    Doc, AD is the real problem.

    Morgan, You said:

    “I’ll say it again and again”

    I can’t disagree with you there.

    Statsguy, That sounds like Morgan.

    Bob, You said;

    “I’m taking notes for our debate, Scott. When the central bank cuts interest rates, that’s not a signal of loose money; in fact, as Milton Friedman taught us, it’s a sign of tight money.”

    You better take better notes, as that’s not what Friedman said (or what I said.) He said that low rates are a sign that money HAS BEEN tight.

    Watch the market rates. After the ECB raised it’s policy rate in April, euro market rates fell. Thus the ECB was forced to face reality and cut the policy rate more recently.

    And you also overlooked Krugman’s comment that it wasn’t so much the rate itself, it was the signal of future policy intentions. The ECB was signalling that they intend to tighten money in the future.

    You will need a much more effective strategy if you are to have any success in the debate.

    david, Policy independence is OK, as long as they have the right target (NGDP.)

    John, Let’s hope they don’t make the same mistake the Fed made in 2008–letting NGDP fall sharply below trend.

    Matt, Yes, but a euro-TARP doesn’t solve the problem of falling NGDP.

    Peter, Those estimates seem a bit high, but I’m in no position to judge.

  32. Gravatar of pct pct
    28. November 2011 at 08:12

    Scott, Tyler Cowen had a long post on how Greece could leave the Euro from which I cribbed the idea. But basically, I am responding to your earlier comment “If it was just Greece, the government could meet in secret and work out an emergency transition plan,” in which you despaired because of all the coordination required if the Euro is to fall apart from the bottom. But it can fall apart from the top a lot easier. It’s just Germany. The government could meet in secret and work out an emergency transition plan.

  33. Gravatar of Morgan Warstler Morgan Warstler
    28. November 2011 at 09:47

    Eric, no I mean level targeting.

    The point being that at 4% level, we’d never have had the mortgage crisis. The very efforts by the govt. to put sub-pars into homes would have artificially driven NGDP up and the Fed would have raised rates.

    But I was actually trying to channel Scott’s answer and did a poor job of putting it into his voice (I think I pragmatically sit between Scott and Bob)… Scott would say the Fed should raise rates anytime the level target is breached.

    So you’ll need to find another reason to imagine I’m wrong.

    Using Scott’s 4.5% I personally think for Scott to be fair we need to start with 4.5% from 2001 on…. we need to discount the false growth of the housing boom.

    Tactically, politically, I think that if we ever get level targeted NGDP formalized it will be driven by the Tea Party lead GOP, an actual change in the law instructing the Fed and it will be:

    1. 4% level ongoing.
    2. Maybe a couple of points of “catch up” to win liberal converts.

    They’ll call it the Fed Castration Act of 2013.

  34. Gravatar of John John
    28. November 2011 at 17:50

    Matt Waters,

    Read some Rothbard and see what you think. There isn’t a single shred of proof for the government needing to control things like “collective goods” and yet the state has arrogated itself the most important positions within the market economy. The government, whose sole power comes from a monopoly on force, has no ability to make economic calculations because they rely on force rather than voluntary exchange for their revenue. Because they can tax and don’t run things for profit, they get no market feedback which is the only signal of how to rationally allocate resources.

    Everything the government becomes involved in–roads, public transportation, education, healthcare, and especially money production– turns into absolute chaos. If you look around the world, that is undeniable. Even a left-liberal like Gailbraith wrote The Affluent Society about the inferiority of government provided services. But you can keep believing in the magical, unproven power of the state despite the state turning everything to shit around you like one of the old USSR true believing Communists. You’re the one living in fantasy land, not me.

    The statists like yourself simply assume that you can go blah, blah, blah public goods, blah, blah, blah, market failure and you’re making some kind of point. Your positions have been rebutted a thousand times and you remain willfully ignorant .

  35. Gravatar of ssumner ssumner
    28. November 2011 at 17:58

    pct, What makes you think Germany would be the only one leaving? How about the other relatively well off countries?

    John, There are countries with relatively good public services like roads—although I agree with the basic point that governments do far too much.

  36. Gravatar of CA CA
    28. November 2011 at 22:31

    “Everything the government becomes involved in-roads, public transportation, education, healthcare, and especially money production- turns into absolute chaos.”


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