The Road to Economic Crisis Is Paved With Euros - NYTimes.com

The Road to Economic Crisis Is Paved With Euros - NYTimes.com

Can Europe Be Saved?

By PAUL KRUGMAN

THERE’S SOMETHING peculiarly apt about the fact that the current European crisis began in Greece. For Europe’s woes have all the aspects of a classical Greek tragedy, in which a man of noble character is undone by the fatal flaw of hubris.

Not long ago Europeans could, with considerable justification, say that the current economic crisis was actually demonstrating the advantages of their economic and social model. Like the United States, Europe suffered a severe slump in the wake of the global financial meltdown; but the human costs of that slump seemed far less in Europe than in America. In much of Europe, rules governing worker firing helped limit job loss, while strong social-welfare programs ensured that even the jobless retained their health care and received a basic income. Europe’s gross domestic product might have fallen as much as ours, but the Europeans weren’t suffering anything like the same amount of misery. And the truth is that they still aren’t.

heart of glass

Employment, Interest, and Money: In Case of Emergency Break Glass

I’ve always contended that M. Bastiat was wrong. Based on my own introspection, what would happen if someone broke one of my windows? Would I reduce my spending on something else in order to pay for the broken window? Not at all: I would “save” less, in the sense that, at the end of the month, the increase in my bank balance would be less than it otherwise would have been, but I would not feel a need to reduce my standard of living temporarily in order to pay for the glass. Moreover, when I was younger and didn’t make enough money to have savings left over at the end of the month, I would merely have let my credit card balance run up a little to pay for the glass. (If such losses proved frequent, I would – and in fact did, back in my poorer days – take out a home equity loan to pay off the credit card balances.) I imagine (perhaps wrongly) that most people, or at least many people, are like me in this respect.

This is old news, and M. Bastiat’s defenders have several counterarguments, none of which I find convincing. First they argue that, even if I don’t reduce my current consumption of other products to pay for the glass, I will have to reduce my future consumption because I will have less savings. This logic seems to presume that I intend to go to my grave with a net worth of zero, or with some net worth that I will decide beforehand independent of the window-breaking incident. That presumption is wrong. I intend to go to my grave with a positive net worth, because I am uncertain about when I will die, and I am averse to the possibility of running out of wealth before I die if I underestimate my lifespan. Nor is my intended net worth at my expected time of death a fixed number. As long as I expect that number to be positive enough to leave minimal risk of outliving my wealth, I will consume what I consume and not worry about the exact number. So no, I won’t reduce my future consumption.

Perhaps so, they may argue, but surely your heirs will then have to reduce their consumption. The problem there is that I expect my heirs to have a predisposition similar to mine, and to continue their lifestyle indifferently to a one-time bequest. The Bastiatites may then take the argument one step further and talk about the heirs of my heirs. And we can keep this argument going all day as I apply the same logic to each successive generation. At the end of time, perhaps, some distant heir will have to reduce their consumption – but perhaps not, because the usual rules of trade don’t apply when people believe that the end of the world is imminent. And if it comes as a surprise, it will obviously not reduce the heir’s consumption.

All of which is a red herring, because the real argument is that, even if I don’t reduce my consumption, someone else will have to reduce their consumption. If I don’t reduce my consumption, I will (as I acknowledged) have to reduce my bank balance by the end of the month, and there will be less for the bank to lend to others, who will thus have to reduce their consumption (or investment). Not really, though. If the bank has a disposition similar to mine, it will merely reduce its excess reserves in the same way that I reduce my saving. Or the Fed, which has a policy of targeting the interest rate at which banks borrow, will replenish the bank’s reserves in order to prevent that interest rate from rising.

But, the Bastiatites may contend, eventually, if enough windows get broken and enough people reduce their savings, the Fed will have to raise interest rates to reduce the additional demand (as the demand for glass increases while the demand for other things initially remains constant), lest it stress the economy’s resources and produce inflation. My window could, as likely as any other, be the straw that breaks the camel’s back. (I’m trying to imagine a window made of straw.) The general principle is, Fed or no Fed, and no matter how profligate I may be personally, the economy has limited resources, and if some of those resources are diverted to produce more glass, fewer resources will be available to produce everything else.

But here they are wrong again. (I will skip the argument about inventories here, since I probably lose that one.) The logic of limited resources only applies when the economy is using most of those limited resources. If there are slack resources, we need merely mobilize some of the slack resources. If the economy is operating below full employment, as is often the case, then there is no need for the Fed to raise interest rates. The window-breaking incident will indeed create additional net employment, just as the naïve onlookers thought.

Here the argument becomes more subtle. M. Bastiat’s defenders will argue that there is no fixed point of full employment. Rather, one can merely say that one state of employment is, as it were, “fuller” than another. In the terminology of contemporary Keynesians, there is a “Phillips curve” or an “aggregate supply curve,” which is not flat, and which, econometricians typically assume, is roughly a straight line. Moreover, there is a certain point on that curve that corresponds to the non-accelerating inflation rate of unemployment (NAIRU). If the unemployment rate is higher than the NAIRU (which, they will argue, is what I must mean by “slack resources”), then the inflation rate will decline, and the Fed (assuming its long-run inflation target is unchanged) will then allow unemployment to fall below the NAIRU in the future, to bring us back to the original inflation rate. If my glass purchase reduces unemployment, then the initial decline in the inflation rate will be smaller. There will therefore be less room to increase the inflation rate in the future. Thus, in the future, the Fed will not allow the unemployment rate to go down as far as it would have if the glass had not been broken. The additional employment today will be offset by reduced employment in the future.

But yet again they are wrong. If the Phillips curve were actually a straight line, their argument would be valid. But the Phillips curve is not a straight line. That’s pretty obvious. The unemployment rate can’t go below zero, so either the curve has a kink at zero (where it becomes vertical), or it has some convexity as it approaches zero. The latter possibility seems infinitely more likely to me, since I cannot imagine that a decline in the unemployment rate from 10% to 9.01% has the same effect on inflation as a decline from 1% to 0.01%. When the number of available workers becomes extremely small, the difficulty in obtaining workers becomes extremely large, and even a little bit of additional demand will necessitate a huge increase in prices, if only to cover the incredibly large recruitment costs.

I contend that the Phillips curve has considerable convexity throughout. Does one really believe that reducing the unemployment rate from 20% to 19% would involve any noticeable change at all in the pattern of prices, let alone a change as large as, say, reducing the rate from 5% to 4%? Does it make any sense that the curve would be vertical on one end, almost horizontal on the other end, but a straight line on the range in between? Not to me.

In particular, I am convinced that, when the unemployment rate is below the NAIRU, the Phillips curve is steeper than when the unemployment rate is above the NAIRU. When the unemployment rate is above the NAIRU (as it surely is now, for example), a certain increase in employment (due, for example, to broken windows) will be associated with a smaller – by a certain amount – decline in the inflation rate. When it comes time to make up that decline by allowing unemployment to fall below the NAIRU, the necessary decline in the unemployment rate will also be smaller – but by a smaller amount.

Perhaps an example will make this a little clearer. Suppose that the unemployment rate is 10% and that the inflation rate falls from 5% to 2% – in accordance with a hypothetical Phillips curve – over the course of a year, and let’s say 2% is the target. Then the unemployment rate falls gradually but remains “too high” for some time, and the inflation rate continues to fall. Suppose inflation falls to zero by the time the economy gets back to equilibrium, and let’s say this corresponds to an unemployment rate of 5%. To bring inflation back up to the target, the Fed now allows unemployment to fall from 5% to 2.5% for a year, and let’s say this is just sufficient. That is our baseline case.

Now, going back to the beginning of the example, suppose an epidemic of broken windows causes the unemployment rate to be 9% instead of 10%. Inflation will fall more slowly, so let’s say it falls from 5% to 2.5% over the course of a year. Subsequently, following a path roughly parallel to the baseline case, the inflation rate falls to 0.5% instead of 0.0%. Again, the Fed wants to bring inflation back to the 2% target by allowing the unemployment rate to fall below 5% for a year. How far below? Not as far as in the baseline case. Maybe to 3% this time instead of 2.5%. The broken windows originally caused an additional 1% of the labor force – about 1,500,000 people – to be employed for a year. The reversal process has caused an additional 0.5% of the labor force – about 750,000 people – to be unemployed for a year. Jacques Bonhomme’s son and his fellow vandals have created a net 750,000 jobs.

(I have left some I’s undotted and some T’s uncrossed in the example above. But you see it is already getting complicated and not so easy to follow. If I’m going to avoid writing a whole book here, you’ll have to take my word for it: qualitatively, the argument works, as long as you believe in a Philips curve that is convex in the region of the NAIRU.)

I’m not advocating that the stimulus package include funding for slingshots. The window-breaking solution does involve some net loss of production (750,000 person-years worth, in my example – without dotting the I’s). There are certainly more productive ways to stimulate the economy. Jf you can create 750,000 jobs without foregoing the additional production, that’s obviously better. That is, in fact, one sense in which the so-called Broken Windows Fallacy is indeed fallacious: While the observers may be right to conclude that the broken window will increase employment, they would clearly be wrong if they thought it would create a quantity of employment that could not be created more profitably by other means.

Under normal circumstances, anyhow. When serious deflation becomes an issue, there is a case to be made (which I did make) that the emergency might call for breaking windows as a preferred stimulus compared to something more productive. I don’t think that’s where we are right now. But I do think, when putting together an economic stimulus, there is no great need to worry about how many windows get broken in the process. If someone insists on building a bridge to nowhere, I say build it.

rebuttal to broken window fallacy

It's easy enough to dispense with this by simply mentioning public goods,
i.e. goods with high social value that, because of market failure, will not be produced without government
intervention. Producing these goods is just the opposite of "throwing towels on the floor," and the net benefits from these projects are particularly high now since input costs have fallen so much as the economy has weakened. There are other easy counterarguments as well, but rather than rehashing those, I want to play the window game.

Suppose there is an economy that is humming along at full employment. Then, all of a sudden, out of nowhere, a giant, extremely rare windstorm - it's like nothing anyone can remember - comes along
and blows out many of the windows in town's homes and businesses. The windows are broken.

This is
unfortunate. The town specializes in delicate goods that cannot be exposed to
the weather, and when the windows were broken and the weather rushed in all of the inventory, or much of
it anyway, was destroyed. In addition, since all of the town's wealth was
invested in the inventory, and then some (i.e. they had borrowed to finance some
of the inventory), the people of the town lost both their wealth and their
ability to borrow from residents of other towns.

So they are wiped out. With all of their wealth gone and no way to borrow, there
is no way to rebuild the town and go on as before. Most people are struggling
just to get by each day, they don't have time to repair the windows, let
alone the resources to finance the repairs and then restock the shelves.

Or maybe there is a way. Suppose the government steps in and hires people to
replace the broken windows, and then makes loans as needed (or makes loan guarantees, with an appropriate allowance for risk, or even outright grants in some cases)
to recapitalize the businesses and cover the cost of the repairs. That way, the business owners can purchase new inventory and go
on as before (well, not exactly as before, one condition of the government loan
is that windows of a certain strength are installed, by regulation if necessary,
so that the government financed inventory is safe from another disaster).

Thus, instead of destroying wealth, the government is essential in creating
it. After the economy-wide window disaster, the government ignores the advice to turn its back in a time of need, and instead steps in and provides the help
that is needed to get the economy up and running again. Because of the government action, the economy is revived, and
they all live happily ever after.

some perspective

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Lost Balance: Were Is The Anger? � Real-World Economics Review Blog

Lost Balance: Were Is The Anger? Real-World Economics Review Blog: "The more naked the capitalism the more unequal the income."

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