The sick man label – attributed originally to Russian Czar Nicholas I in his description of the Ottoman Empire in the mid-19th century – has more recently been applied at different times over the past decade and a half to Germany, Italy, Portugal, Greece and France. But this fascination with the crisis country of the moment has masked a broader phenomenon: the erosion of Europeans’ faith in the animating principles that have driven so much of what they have accomplished internally.

The prolonged economic crisis has created centrifugal forces that are pulling European public opinion apart, separating the French from the Germans and the Germans from everyone else. The southern nations of Spain, Italy and Greece are becoming ever more estranged as evidenced by their frustration with Brussels, Berlin and the perceived unfairness of the economic system.

The way things are moving it seems that politicians still do not understand the causes of the economic crisis, still blaming too much government debt instead of macroeconomic imbalances caused by private sector investments that drove some real estate markets first into bubbles and then into busts. The austerity policies would be ridiculous, if it weren’t for the disastrous effects.

The political elites have been ingenious in preserving their power, which shifts back and forth from left to right with no change of policy. The price of continuing this policy is high. The rise of populist politicians that are able to win discussions because these are not dominated anymore by facts, theories and divergence of opinions but by frustration and anger. In this climate, Europe’s future is unpredictable. Whatever financial markets think about the situation (and stock markets break record after record), Europeans have lost confidence in their ability to solve problems. That is sad.

• reduce (government) debt
• increase number of children
• family is nucleus of society
• introduce direct democracy like in Switzerland
• less Europe through more competition and responsibility (following David Cameron)

This programme recently prompted Jens Berger in the taz to describe the party as paleoliberal, which is to the right of normal liberal parties like the FDP in Germany. A quick check of Wikipedia reveals the following definition for the US (which is a quote):

Paleolibertarianism holds with Lord Acton that liberty is the highest political end of man, and that all forms of government intervention – economic, cultural, social, international – amount to an attack on prosperity, morals, and bourgeois civilization itself, and thus must be opposed at all levels and without compromise. It is ‘paleo’ because of its genesis in the work of Murray N. Rothbard and his predecessors, including Ludwig von Mises, Albert Jay Nock, Garet Garrett, and the entire interwar Old Right that opposed the New Deal and favored the Old Republic of property rights, freedom of association, and radical political decentralization.

In Germany, it would be a bit different from the historical perspective, but it seems fair to describe Alternative für Deutschland as a Teutonic Tea Party with ivory tower loftiness (many academics and educated bourgeoise, no astro turf) rather than another left-wing party, of which 3.5 already exist: Socialdemocrats, Greens, Die Linke and the Piraten (anybody ever heard of conservative pirates?).

That leaves external adjustment. According to the IMF, France will be the only large eurozone member country to run a current account deficit this year. It forecasts that, by 2018, every current eurozone member, except Finland, will be a net capital exporter. The eurozone as a whole is forecast to run a current account surplus of 2.5 per cent of GDP. Such reliance on balancing via external demand is what one would expect of a Germanic eurozone.

Yesterday I had shown the situation in crisis countries applying my own IS/MY model. So, this is where we are (red lines):

Investment has fallen, debt is being repaid (IV), demand is weak and supply is down (III) with expectations of more of the same (I). Monetary policy is useless since we are in the liquidity trap (I). How do we get out?

My suggestion was to use government spending to increase demand towards levels that bring us closer to full employment. However, the political leadership does not allow it. Instead, the plan is to increase exports in all euro zone countries which would bring the whole euro zone into a net exporting position, as described by Martin Wolf above. Here is what the result would look like (green lines):

So, becoming more competitive means that prices are falling relative to prices elsewhere, which I show as a change in the level of inflation in the south-east quadrant. This pushes domestic incomes down and will lead to lower domestic consumption. This causes imports to fall since these are now relatively more expensive. What is produced and not absorbed by domestic sources is exported, which means that exports will be rising. Total demand is back where it was before, since the fall in domestic demand has been compensated by a rise in foreign demand.

Foreign demand, however, can only increase if foreign incomes are increasing, which partly consist of foreign lending. So, if euro zone countries lend abroad, then this kind of economic adjustment will work in the short run. Of course, it will create foreign debt with the trade partners. These, however, are not part of the euro zone and in part of default after the next real estate bubble can default on their debt obligations and devalue their exchange rate.

An alternative path which might be complementary is a real estate bubble in Germany. The first signs are already visible, and the authorities do not seem willing to reign in the free market. If this is the European strategy, it is creating unsustainable debt bubbles elsewhere while keeping adjustment in Germany at zero. It will be interesting to see whether the trade partners of the euro zone are willing to turn into net importers. If not, there might be a beggar-thy-neighbor policy race, these days called “currency war” by a press which is happy for every war (war on drugs, war on terror, and so on). Basically, declaring a war lets you free ride as in an actual war in the sense that critical voices will be blended out and dissent shouted down. The Iraq war sets the precedent.

So, where does it leave the world? Will perhaps China be turning into a net importer vis-a-vis the euro zone? Will it be Eastern Europe? The US quite certainly won’t have it, since they just had a real estate bubble. Politically, we are back in mercantilist times where nations compete for markets and international cooperation takes a back seat. In order to become competitive, you could either increase productivity or cut wages. Obviously, since government spending is cut, the euro zone opts for the second alternative. This means that purchasing power of households who depend on income from wages (and not interest from invested capital) will fall. Instead, a bigger part of production will be exported in exchange for foreign assets that might be defaulted upon by those that emitted them (think of Iceland). In how far that is to promote peace and prosperity in the European Union or elsewhere I have no idea.

“Two Cheers for Anarchism” conducts a brief and digressive seminar in political philosophy, starting from the perspective of a disillusioned leftist. “Virtually every major successful revolution ended by creating a state more powerful than the one it overthrew,” Scott writes. Traditionally, this has been an argument against revolutions, but Scott wonders whether it might be an argument against states. He stops short of calling for the abolition of government, which explains the missing cheer. Instead, he highlights everyday acts of petty resistance: “foot-dragging, poaching, pilfering, dissimulation, sabotage, desertion, absenteeism, squatting, and flight.” Most of all, he urges citizens to be wary of their governments, which is good advice, but rather deflating—Scott can make anarchism sound like little more than a colorful word for critical thinking.

This reminds me of a short story by Portuguese poet Fernando Pessoa named “The Anarchist Banker”. In it, the story-teller asks his friend, the banker, whether he really was an anarchist:

Given some expectations about the real economy (I), the banking sector expands credit by accommodating loan demand (II). This determines demand (including debt-financed investment), which determine income (III). At the equilibrium that I have constructed the private sector debt is stable, private savings equal investment (IV).

Now let us assume that nevertheless a bubble bursts and the private sector wants to increase net savings. This is the new situation:

There has been a shift in behavior of the economy, since now the deleveraging activities in the private sector drive the economy and not profit-led activities (IV). Hence, loans are repaid, the monetary aggregate falls (II). Less investment is financed, which means that demand has fallen (III). Expectations about the real economy have changed to the worse and loan demand is now in a situation which we call the liquidity trap. That is why the loan demand curve has shifted in the south-west diagram. Loan demand is not interest rate elastic at the new equilibrium, hence a lower interest rate will not induce more debt-financed investment. This means that aggregate demand is weak and will not increase.

Government spending can save the day by shifting the C+I+G+NX curve in the north-east upwards. This will have no feedback on the south-west corner, since the short-term interest rate is set by the central bank and will not increase even if the government borrows and spends huge amounts of money. Inflation will only arise when aggregate demand goes above potential output (however that is defined) and/or the exchange rate weakens. However, the central bank could instantly react by pulling the interest rate up which should a) decrease aggregate demand (via investment) and b) attract foreign capital inflows, which will move lead to appreciation.

One interesting fact in my model is that the liquidity trap is not “fixed” as in the IS/LM model. The loan demand curve depends in conditions of balance sheets and expectations and shifts around over time. This could be called a “dynamic liquidity trap” versus a traditional “static liquidity trap”. Hence, the zero lower bound is not the big issue but instead the balance sheet conditions and the way the public perceives them (expectations in the widest sense). The public can pile up debt in an irrational manner, it might even be human to do this, until the Wile E Coyote moment arrives and the public moves into a position where it frantically increases net savings. Hence, the same conditions prevail as before but the shift of the dynamic liquidity trap is what puts the economy into a position where monetary policy is without effect and government spending is needed to bring aggregate demand back up.

This is a technical analysis and as that says nothing about what should be done. If you are fine with a GDP loss as a result of a bubble that bursts, that’s fine. If you like to stabilize GDP by increasing government spending, that’s fine, too. It should be left to the public to decide what they want: austerity and mass unemployment or increased government spending and stable GDP growth. This is what my theory says is available for nations with sovereign currencies (sorry, euro zone, you must change the rules first!). To those that pretend to offer austerity and stable GDP growth under existing circumstance (weak foreign demand, high private sector debt) and those who pretend to offer increase government spending with mass unemployment I would say that my model speaks against it.

https://moocfellowship.org/submissions/moderne-geldtheorie-eine-paische-perspektive

Im Kurs “Moderne Geldtheorie: eine €-päische Perspektive” stellen wir eine Volkswirtschaft aus Sicht der Bilanzen dar. Im Mittelpunkt steht dabei Geld: wie wird es erzeugt, wer setzt es wofür ein, was kann man dafür kaufen, und wer kontrolliert die Geldmenge? Dazu geht es immer wieder um die Krise in der Eurozone, die eine besondere Konstruktion einer Zentralbank ausmacht: Regierungen können sich bei der Europäischen Zentralbank kein Geld besorgen. Wer also verstehen möchte, wie Zentralbanken und Banken Geld schöpfen und wie Bilanzen im Rest der Wirtschaft “funktionieren” der ist bei unserem Kurs genau richtig! (Vorkenntnisse werden nicht benötigt, Englischkenntnisse sind hilfreich aber kein Muss.) Mehr Informationen gibt es auf den Seiten des Veranstalters:

https://moocfellowship.org/submissions/moderne-geldtheorie-eine-paische-perspektive

(What’s this? I teamed up with a colleague to apply for a grant of €25,000 which would allow us to design a massive open online course at the website above in the summer term 2014. The course is called “Modern Theory of Money: a European Perspective” and takes a balance sheet view. The more votes we get, the more chances we have to get the grant. The language in the course will be German, which is why this is posted in German.)

Remember, Britain has its own currency, which means that it can’t run out of cash. Furthermore, the short-term interest rate is set by the Bank of England. And the long-term rate, to a first approximation, is a weighted average of expected future short-term rates. Unless markets believe that Britain is going to default — which it isn’t, and they won’t — this is more or less an arbitrage condition that ties down the long run rate no matter what happens to confidence. Or to be a bit more precise, it’s hard to see what would drive up long rates except a belief that the BoE will raise short rates; and why would it do that unless it sees economic recovery in prospect?

And Wray also points us to what Krugman said before: “once we’re no longer in a liquidity trap, running large deficits without access to bond markets is a recipe for very high inflation, perhaps even hyperinflation”. Krugman had already pointed out that the US had the wrong debate, talking about the deficit instead of unemployment, but this new development should lead to a louder outcry against the sequester.

I don’t like to use metaphors, but the economic woes in the US and even more so in Europe are self-imposed. If you want to increase employment and GDP the government can do so. In the US the rules would allow it, even though the debt ceiling should probably be cancelled because it enables political blackmail. In the euro zone, the ECB would have to be allowed to directly finance governments. So, the US basically is one good idea away from a return to economic growth while in Europe there is the need for one good idea plus one European dream to fix the situation. The euro needs to be backed up by a fiscal component that helps countries in distress. Now it would put Germany into a position where she pays, but who knows where the next bubble develops? Enlightened self-interest should lead to a pan-European insurance scheme in which parts of demand are financed via Brussels. Why not put pension systems on a pan-European basis so that national governments cannot through budget cuts remove demand from an economy which already has a demand side problem?

Oh, by the way: I wonder when Paul Krugman will take over the idea of endogenous money.

In unscripted remarks during a question and answer session, the high-profile historian and writer said Mr Keynes was indifferent to the long run because he had no children, and that he had no children because he was gay.

But in a statement posted on his website, he said it was obvious that people who do not have children also care about future generations. The historian also insisted he was not homophobic.

[..] In 1926, Mr Keynes married Lydia Lopokova, a Russian ballerina, and Prof Ferguson also said he had forgotten that she had miscarried.

In the light of these incidents, I recall a book by George F. DeMartino named “The Economist’s Oath“. This is it (p. 3):

I do solemnly swear:

That I will be loyal to the Profession of Economics and just and generous to its members. That I will practice the art of economics in uprightness and honor.

That into whatever community I shall enter, it shall be for the good of the community to the utmost of my power, holding myself aloof from wrong, from corruption, from the tempting of others to vice.

That I will recognize and keep always in view that the community I serve is never a means for my ends, but always an end unto itself. It, and not I, is the rightful architect of its future …

If reading these lines prompts you to laugh sarcastically, hold on a minute. I know many economists who are definitely not happy with the discipline. They think that they have to play by the rules until they get tenure, and then can do whatever pleases. I don’t think so. Those colleagues that followed this strategy never made it back to the good side. Once you are in circles where loyalty counts more than economic science, there is hardly a way out. Not many economists have used the crisis to come clean and move back into the realm of science. It is still widely believed that as long as economists claim that, for instance, austerity policies create growth, then all problems will go away.

The state of economics is bad. I think it is decades of intellectual corruption that brought macroeconomics to the state of today. Nobody saw the crisis coming, many if not most deny the crisis, and if there is any problem: government is the cause. That is unworthy of a scientific discipline. If regulatory capture has led to special interests dominating academia, then the rules should be changed so that society gets the economists it deserves. In the existing system it is almost impossible for independent minds to come through. If your PhD advisor cannot put your articles into good journals, then you will never become a professor, even if with hindsight you were right.

Science must allow critical questions, pluralist views and economists which use at least 50% of their time to read instead of doing paperwork, getting publications published on which funding and salary depend, or whatnot. Medicine has the Hippocratic Oath because of what doctors can do to individual. Perhaps we do not an economists oath because of what economists can do to society?

“But the more important reason is that Republicans in Congress seem to have given up on the idea of using the debt ceiling to force additional spending cuts,” he said. “So the tail risk that the overall fiscal drag will be much larger than the 1½-2 percentage points we assume for 2013, and that this will push the economy below ‘stall speed’ and into a renewed recession, looks much lower now.”

But will the fiscal tail risks re-enter the limelight further down the road? Nope, Hatzius said. The deficit has already fallen from 10% of GDP in fiscal 2009 to 7% in 2012 and is likely to shrink to only 3% in 2015 due to lower spending, higher tax rates and a cyclical improvement in the economy.

“The longer-term budget outlook remains much more problematic, mainly because of the sharp projected increases in federal health care spending. But even in this area we have seen a bit of good news recently, as actual spending has come in well below official projections,” he said.

This is odd. In the first paragraph, the fiscal drag is to push the economy into renewed recession. In the last paragraph, actual spending coming in below official projections is good news. Huh? Is fiscal spending pushing the economy into recession or not? It appears that it is “yes” for the short run and “no” for the short run, since he talks about recent data. In how far does the longer-term budget outlook play a role in the economy? This only makes sense if you believe in too much government debt slowing down the economy, but that myth has been discarded. Alternatively, how many parallel universes are there?

Apparently, many politicians don’t understand the implications of this. German finance minister Wolfgang Schäuble during his visit in Spain has outed himself as a “loanable funder”, according to EL PAIS:

¿Pero está dispuesta Alemania, como piden muchos expertos, a fomentar un aumento de su demanda para así mejorar las exportaciones de los países del sur?, le preguntaron. El “no” fue tajante. “No compartimos la opinión de que si en Alemania impulsáramos un crecimiento más fuerte esto disminuiría los problemas de otros. Hay mucho dinero en circulación, mucho dinero del BCE, y muy poca inversión. Ese es el problema.

So, he was asked, is Germany willing to increase her domestic demand, like many experts call for? A radical “no” was the answer. “We don’t believe in the idea that more growth in Germany means less problems for other countries. There is much money in circulation, much money from the ECB and weak investment. That is the problem.”

Actually, you don’t need money in circulation for banks to give loans. Banks can create money by giving a loan. In return, they give you a deposit in a bank and that is what we call endogenous money. And some people say that the creation of money by banks has fuelled the real estate bubbles in Spain and Ireland. Here is Adair Turner (via positivemoney):

The financial crisis of 2007/08 occurred because we failed to constrain the private financial system’s creation of private credit and money. Resolving this crisis is stuck because this has not been understood by the public, the policy makers or the press. The way our monetary system is set up, money is debt. Since money buys thing, a situation where incomes are falling in some European nations and stagnating in other together with falling government spending and a private sector repaying debt instead of spending money by borrowing leads to one crucial question: if nobody has more money, than how can we expand production?

The regular policy is for the ECB to put the interest rate down, but the ECB has it at 0.75% and is out of room for maneuver. Somebody somewhere has to spend more money. Mr Guindos understands that, and maybe Mr Schäuble understands that, too. Only when the European public gets it we will see the austerity policies for what they really are: transforming society without a mandate towards a society which is more unequal and less solidary. These reforms are in no way helping those countries to grow. Just the opposite: they shrink those economies. Pride and prejudice rule, and perhaps the best quote from the movie is this: “Angry people are not always wise.”