Bring on the coolies!

The Greek crisis poses an incredible challenge to Europe and could pose a threat to the US recovery. I think Paul Krugman has it right: even if Greece defaults, the magnitude of the fiscal adjustment it will have to endure is greater than is consistent with its membership in the euro system. The problem is that reducing its deficit will be extraordinarily contractionary. Its participation in the euro system does not allow it to soften the blow with a monetary expansion or devaluation of the currency. Europe does not have the type of interstate fiscal transfers that would cushion the economy in the US.

Greg Mankiw calls Krugman's argument "thoughtful and thought-provoking." Mankiw then offers some of his own thoughts, which I can only describe as "head-scratching and mind-numbing." Referring to the fiscal transfer issue, Mankiw writes

Is that right? I am not so sure. The United States in the 19th century had a common currency, but it did not have a large, centralized fiscal authority. The federal government was much smaller than it is today. In some ways, the U.S. then looks like Europe today. Yet the common currency among the states worked out fine...

One might argue that the 19th century had a different set of labor institutions than we have today, and these facilitated the adjustment of wages. That argument, suggested by the research of Chris Hanes, may have some merit. If that is the case, then maybe that is the path forward for Greece and the rest of Europe. As Paul suggests, increasing wage flexibility won't be painless. Yet it might be easier than giving up on the Euro experiment.

The snarky response is to remind N. Greg that 19th century America's labor market institutions included slavery, coolie and child labor, and a host of other abominations. Setting the snark aside though, the problem with Mankiw's argument is that the political system in the US, not to mention Europe, would not, cannot tolerate the type of volatility, hardship and dislocation that the 19th century business cycle entailed. Current US fiscal institutions developed, by design or by chance, at precisely the moment at which US political institutions ceased to be tolerant of the unfettered 19th century business cycle and government took on a greater responsibility to ensure economic stability.

Let Greece free up its labor markets to 21st century northern European standards, by all means, but imagining that Greece could increase flexibility to anything approaching that of 19th century Europe is quite batty.

Time to go negative

All right, I'm going to start trying to post regularly again. See if anyone's still reading.

Today's NY Times reports that "Stimulus by Fed is Disappointing, Economists Say." Let me quickly point out two problems with the article. First, the title. It's not really the passive voice, but it's in the classic circumlocutory style of the news media that I find annoying. I'd go with "Fed's Stimulus Disappoints Economists." Saves on newsprint too. Second, the article is very thinly sourced. On the Keynesian end of the spectrum we have Mark Thoma, on the RBC end we have Charles Plosser, and that's pretty much it. Add to that two finance professors from Northwestern and an economist from Bank of America. Not exactly a summary of the profession's opinion. And the article leaves the crucial question unanswered: does the fact that the Fed's efforts have not been tremendously successful mean that it should do more or less in the months to come? One could write a very interesting article surveying economists on their response to that question.

Put me in the "more" camp. Another round of fiscal stimulus, this time focused on aid to states to prevent them from continuing slashing budgets, would be the best policy. That's obviously not going to fly politically in Washington (nor, it has occurred to me these last few months, in the states - it now seems clear that Republican governors have found the fiscal crisis to be a very convenient pretext for pursuing their political objectives, beginning with smashing public employee unions). The Fed should certainly not end its bond purchasing program in June as scheduled, but it will face considerable political pressure to do just that, so I don't see much hope of any further quantitative easing.

That leaves one other policy response: imposing a negative interest rate on bank reserves. A number of economists have proposed this before. The idea is to penalize banks who hold excess reserves, force them to use those reserves to make loans or buy securities (which would have the effect of lowering interest rates, exactly like quantitative easing would do). Banks would also try to pass costs onto their customers by charging interest on checking deposits, so people with money in banks would have the incentive to spend rather than accumulate bank balances. The problem with this proposal is that faced with negative interest rates on checking deposits, customers might instead simply withdraw money from the banking system and hoard it in big piles on their dressers. After all, cash pays a zero percent interest rate which would be better than you could get at the bank.

Greg Mankiw half-seriously proposed imposing a negative interest rate on cash by once a year drawing a number between 0 and 9 by lot, and all currency with a serial number ending in that digit would no longer be useable as legal tender. This would in effect impose an expected rate of return of negative ten percent on all money holdings. (Incidentally: Greg Mankiw is a wonderful guy, a gracious host, a riveting speaker. But I find it highly ironic that this co-founder of the branch of macroeconomics known as New Keynesian economics had to have Silvio Gesell's proposal for stamped money, which Keynes cites approvingly in the General Theory, brought to his attention by Alan Taylor. Apparently Mankiw has not read the General Theory!)

Any scheme of stamped money or money-extinguishing lotteries is likely to be difficult to impose in practice. But there's an alternative. Hoarding money in response to negative interest rates on checking deposits is only possible if the Fed supplies currency perfectly elastically. This happens to be the Fed's current policy: if customers go to their banks in large numbers to withdraw money in cash from their checking accounts, the banks ask the Fed for more currency, and the Fed gives them as much as they want, exchanging the banks' reserves at the Fed for currency at par. But suppose the Fed simply exchanged reserves for currency at a discount (I suppose equal to the negative interest rate charged on reserves)? Banks would pass this charge on to customers: if you wanted to withdraw $100 of cash from your checking account where it was earning -5% interest, you'd have to pay a $5 fee for the privilege. The only way to avoid the charge would be to spend the money in your checking account in some way: buy groceries, a new car, a fine Easter bonnet; or if not that, put your funds into a money market account or retirement account where it ends up being used to purchase stocks, bonds, commercial paper, and other assets, thus driving the prices of those assets up and their yields down.

This proposal has the virtue of not requiring the Fed to purchase any more assets. In essence, the Fed forces the banking system and bank customers to engage in quantitative easing on its behalf. There may of course be practical difficulties. For one thing, the Fed would have to implement this plan (at least the fee for currency purchases) by surprise, because otherwise there would be a massive withdrawal of cash from the banking system in anticipation of the new fees. But the Fed employs thousands of very clever economists, I'm sure they could find their way around these problems.

Bons mots from Greg Mankiw

First he criticizes Barack Obama for dropping the "cadillac" health plan tax and replacing the lost revenue with a tax on unearned income:

This change was probably made to attract more House Democrats. It will likely make the plan even less attractive to congressional Republicans.

So whereas zero Republicans were going to vote for the plan before...

Next he's on to the proposal to cap insurance rate hikes:

Very, very strange. You would think that all those future Nobel-prize-winning economists working for the President would explain to him the history and economics of government price controls. Imposing price controls certainly wasn't President Nixon's finest hour.

Alternatively he could have those economists turn to the chapter in Greg Mankiw's Econ 101 textbook on how to regulate prices of natural monopolies.