Antonio Fatas debates Paul Krugman. Fatas noted that there is limited evidence that using the Euro is correlated with extreme economic distress. Krugman argued roughly that there is a strong theoretical presumption that the Euro is the work of the devil. Fatas praised Krugman’s unshrill analysis and then chose to debate his basic claim. This is not, in general, a good idea. In this case it is a terrible idea.
2. Ben Bernankepoulos.
Here is my second scenario: let’s have a Euro periphery country leave the Euro (or never join) and have monetary policy follow the policies that Ben Bernanke has followed in the US (bring interest rates down to zero, aggressive quantitative easing).
And what would happen to capital flows? It is likely that capital will flow out of the country, given that the country started with a current account deficit this would be a problem (dealing with a sudden stop is never easy). If debt is denominated in foreign currency the situation could be dramatic (as in the Asian crisis in the 90s). But even if debt is denominated in local currency there is still an issue: there is the need to finance a current account deficit and in the absence of capital inflows it would lead to a collapse of internal demand. Yes, exports might be increasing but it is hard to see that this adjustment would be fast enough to compensate for the immediate correction required given the lack of funding. Unless the rest of the world is happy holding more of our currency, in which case we can finance our expenditures via monetary expansion.
My reaction (toned down to be polite) is WTF ?!?! How the hell does this happen ? Here the idea is that a country whcih has been running a current account deficit suddenly can’t anymore so the sudden increase in netx eports causes “a collappse of internal demand” Well there is an alternative “Unless the rest of the world is happy holding more of our currency, in which case we can finance our expenditures via monetary expansion.” What ??? What does the rest of the world have to do with anything ?
Fatas asserts as plainly obvious that in a closed economy expenditures can’t be financed with monetary expansion. He gives no hint to an explanation of why this might be.
Here is a sincere attempt to try to figure out what he was thinking. German banks have been loaning money to Greece buying Treasury bonds and loaning to Greek banks which loan to other Greek entities. Then they suddenly stop. Ben Bernankepoulos has no way to replace the demand for Greek Treasury bonds or the supply of laons to Greek banks, because Central Banks don’t have discount windows and can’t conduct open market operations.
Well that didn’t work very well. OK the problem is that if Bernankepoulos creats DRachmas out of nothing to buy bonds and loan at a low discount rate, then no one will have any faith in the Drachma so it will lose value both compared to other currencies and compared to goods and services. The appraoch of making sure that a loss of international confidence doesn’t cause a recession will cause inflation. And central banks can’t allow inflation, because Bernankepolous is like Bernanke except that he doesn’t have a dual mandate.
To go on, in the real world, inflation accelerates when economies are overheated. Between recession and accelerating inflation there is a sweet spot of neither. Yes if we assume rational epectations, then the loss of confidence will worsen the inflation unemployment tradeoff (inflation need not continuously accelerate but it should jump up and stay high). I don’t believe this for a second, but will assume for the sake of argument that, given the sudden fiscal dominance (need to monetize the national debt) expected inflation will jump up and either actual inflatoin will jump too or unemployment will rise.
So ? Fatas didn’t write that with a loss of confindence a country must accept high unemployment or high inflation — he said the country must accept high unemployment.
Fatas is a very smart and, until now, always very reasonable economist. What happened ? I speculate fter the jump.