Let’s have the banks and the governments shore up each other:

I am afraid that the leaders are contemplating some inappropriate steps. They are talking about recapitalising the banking system, rather than guaranteeing it.

A fair enough point, but where will the money come from to do that?

In exchange for a guarantee, the major banks would have to agree to abide by the instructions of the ECB. This is a radical step but necessary under the circumstances. Acting at the behest of the member states, the central bank has sufficient powers of persuasion. It could close its discount window to, and the governments could seize, the banks that refuse to co-operate.

The ECB would then instruct the banks to maintain their credit lines and loan portfolios while strictly monitoring the risks they take for their own account. This would remove one of the main driving forces of the current market turmoil.

The other driving force – the lack of financing for sovereign debt – could be dealt with by the ECB lowering its discount rate and encouraging countries in difficulties to issue treasury bills and prompting the banks to subscribe.

Um…if it all is a liquidity crisis, this might work, public choice problems aside.  Otherwise it is calling for possibly insolvent banks to prop up not only the real economy but the governments too, which in turn will guarantee the banks, which by the way now have to keep on making bad loans.

I’ll skip context and links and cut right to the chase.  Reinhart-Rogoff and nominal gdp perspectives and TGS views also have been predicting a slow recovery, so while IS-LM has done OK here it wins no special prizes.

What about the “no crowding out” prediction?  Since at least the early to mid 1980s, it has been well-known in macroeconomics that U.S. budget deficits do not forecast real interest rates very well and that includes under periods of full or near-full employment.  Here is a brief survey by Alan Reynolds on the topic (you can follow up on his references), and he is usually considered a villain by the Keynesians and so he is hardly a Keynesian himself.

There may be a few reasons for the general lack of a connection between deficits and real interest rates in the United States:

1. The supply of capital to the United States is fairly elastic, either domestically or internationally.

2. We don’t have good identifying restrictions on the empirics in the first place.  For one thing, controlling for monetary policy is tricky.

3. We haven’t yet seen budget deficits big enough to matter.

4. We are not measuring budget deficits correctly because what matters is the consolidated fiscal stance of the U.S. government, a’la Robert Eisner.

5. Ideas related to Barro’s Ricardian Equivalence hypothesis.

Anyone — Keynesian or otherwise — paying attention to the last thirty years of empirical macro never expected much crowding out of financial capital in the first place.  It simply has not been in the cards.

To put it more bluntly, the “no crowding out” result is not much of a predictive victory for Keynesian economics, IS-LM, the liquidity trap, and so on, even though I have read it claimed as such many times.  It is a strike against some predictors who were wrong in the first place, especially in the right-wing popular press circa 2009-2010, plus some Republicans who jumped ship on the issue, perhaps because they wanted to attack Obama.

What’s a unique prediction we might look at?  It is a common Old Keynesian claim these days, at least from Krugman, that the AD curve is upward-sloping because of a liquidity trap.  That would imply that harsh and binding minimum wage hikes, and other wage-propping mechanisms, should prove expansionary.  That claim, at least for the Great Depression, has been knocked down fairly conclusively by Scott Sumner.  If there is no comparable test on today’s data, it is because we have grown that much wiser.

To halt the fall in house prices, the government should reduce mortgage principal when it exceeds 110 percent of the home value. About 11 million of the nearly 15 million homes that are “underwater” are in this category. If everyone eligible participated, the one-time cost would be under $350 billion. Here’s how such a policy might work:

If the bank or other mortgage holder agrees, the value of the mortgage would be reduced to 110 percent of the home value, with the government absorbing half of the cost of the reduction and the bank absorbing the other half. For the millions of underwater mortgages that are held by Fannie Mae and Freddie Mac, the government would just be paying itself. And in exchange for this reduction in principal, the borrower would have to accept that the new mortgage had full recourse — in other words, the government could go after the borrower’s other assets if he defaulted on the home. This would all be voluntary.

Here is more.

I am sad that the IS-LM debate devolved into IS-LM vs. close substitutes, because I meant to raise a broader set of objections to one particular kind of technocratic curve-shifting as the foundation for macroeconomic thought.  Let me list a few alternative starting points for macroeconomics:

1. Public choice economics (still the most underrated, in today’s profession)

2. Growth theory (as distinct from the view that all business cycles are simply fluctuations in the rate of growth)

3. The New Institutional Economics of property rights and incentives

4. Financial asset pricing theory (as distinct from the view that financial markets are always efficient)

To see what this all means, let’s consider the euro crisis.  I start with #4, financial asset pricing theory, and consider whether, if “euros in Greek banks” and “euros in German banks” are fundamentally different assets, perhaps they should have different prices.  If prices cannot adjust, quantities will.

An IS-LM approach will focus on flows and be distracted — incorrectly — by claims that Ireland, Spain, etc. were not in bad fiscal positions before the crisis hit.  That’s wrong, they were writing intolerable naked puts all along.

A macro approach should then move to public choice theory and interpret the governance of the EU and ECB and the coalitions in the various European governments.  It wasn’t (for the most part) deliberately set up so that politicians could play short-run fiscal games, but that is in fact why a lot of politicians supported the eurozone.  Cheap borrowing brought a big party, but it was a ticking time bomb from the beginning, as recognized by Milton Friedman and others.  Based on Buchanan and Tullock (Calculus of Consent), the analysis can move forward with some understanding of why its governance is unworkable in a crisis, and with an understanding of why the Germans originally insisted on such a governance scheme at all.  I also wouldn’t mind a citation to Hayek and his critique of French rationalist constructivism, you won’t find that in the IS-LM model either.

We can put all that together, combined with a theory of bank runs, and then we see there will be strong and perhaps intolerable deflationary pressures.  Maybe one could use IS-LM for this part of the modeling, but I’ll stick with the kind of ideas you find in Irving Fisher or Scott Sumner.  They are simpler and retain the core point that deflationary pressure can be very bad.  As Scott notes, the sort of interest rate issues raised by IS-LM are more of a distraction than anything, at this point for this problem.  And no, the eurozone for the most part has not been in a liquidity trap.  Nonetheless aggregate demand really does matter in this setting.

One often reads that Italy is the linchpin of the euro crisis.  To understand Italy we should look to growth theory, the new Institutional Economics, the theory of corruption, theories of political gridlock, and related ideas.  Toss in Edward Banfield.  Italy’s growth problems predate the immediate mess in the eurozone and they are not plausibly pinned on deflationary forces; the country hasn’t grown much in a decade.  IS-LM is absolutely silent here, but if Italy were growing at two percent a year probably the whole mess would be manageable.  Demographics matter too, and if this is a messier version of economics sign me up.

The idea that Ireland is seeing a partial recovery, piled on top of some deep structural problems in its domestic sectors, flows more naturally from institutions-based approaches than from IS-LM.

The all-important interplay between monetary and fiscal policy, critical for understanding this crisis, is forced out of the box by IS-LM.

For the final denouement, if indeed it arrives, there is Minsky and the theory of speculative attacks.  Keynes in his chapter 12 of the GT had a good understanding of how expectations can switch so suddenly, a key factor at several stages of the euro crisis.

There is more, but you get the point.  IS-LM should not be foundational for an analysis of this problem, IS-LM is not necessary, and arguably it is better not to invoke the model at all.  And if I had to give undergraduates only one point on one part of the blackboard, I would use the comparison between Greek and German banks.

IS-LM leads one to the mistaken attitude that macro is fundamentally simple, and that all would be well if only people and politicians understood the need to “get tough” with expansionary policy rather than austerity.  It’s a lot more complicated than that, yet we can understand these complications by building up from some fairly simple and intuitive models.  It’s a better approach to use public choice incentives to understand why the current situation is unworkable, rather than preaching about why the flows should be different than they are.  When I hear so much preaching, I tend to think the preacher is using a model with a missing variable or two.

Here is a good post from Philip Levy on why macro is hard, and how that relates to the recent Nobel Prizes.

Soon I’ll turn my attention to whether IS-LM Keynesianism has been making uniquely good predictions during this crisis.

NYTimes: “The Rason government will do our best to provide favorable conditions for investment,” said Hwang Chol-nam, the vice mayor in charge of economic development. “Please tell the world.”

A common refrain from a mayor, unremarkable, except for the fact that Rason is in North Korea.

North Korean leaders are slowly opening their isolated nation to foreign investment.

A thrust of their strategy is to develop previously created “free trade and economic zones” on the borders that have languished. Here, about 30 miles from China, the combined towns of Rajin and Sonbong, called Rason, are central to the new push.

…“The policy environment has been improving continuously,” said Zheng Zhexi, 58, the company’s vice president. “It’s moving towards a market economy.”

He pointed to the official tolerance for the bazaar, where merchants rent stalls from the government to sell goods that they buy from Chinese traders. Prices fluctuate and shoppers haggle. The bazaar has proved so successful that it is expanding to six times the current size.

An interesting experiment that one hopes will expand. Don’t expect too much, however, consider this rather amazing survey of Chinese business people and what they say North Korea needs.

The Peterson Institute for International Economics, based in Washington, recently published conclusions from a 2007 survey of 250 Chinese companies doing business in North Korea. The authors found that while nearly 90 percent were profitable, the companies “generally have a negative assessment of the business environment” for reasons like poor infrastructure and lack of rule of law.