The short-run: what is at stake?
Presumably, the reason why we have seen so much intervention in the banking sector is to avoid some catastrophy of macroeconomic significance. To me, the puzzling question is: what sort of catastrophy? We do not learn much about catastrophies in our economics classes and I wonder what the basis for such a fear is.
In the models that we are taught in graduate schools, there is something called the “financial accelerator”. It says that when there is more wealth around, borrowers have more collateral and get better terms. As a result there is more investment and thus more economic activity.
Under certain conditions, this wealth includes something like a housing bubble and therefore when it evaporates there is indeed less wealth and less collateral – banks ask for a higher interest rate, investment falls, and there is a recession. But a recession is not a catastrophy especially if we believe that the growth rates of the last decade were too high, because of the artificial financial accelerator generated by the bubble. If US GDP falls by say 3 % (and we have seen none of that), then it will be at the same level as if it had grown by 0.3 points less each year in the past ten years – still a magnificent growth performance for an advanced economy.
It is written nowhere that a recession must be avoided at all cost. Just because the recession originates in the financial accelerator does not mean we should stimulate the economy more than, say, if it originated in an equivalent fall in consumer confidence. Furthermore, the bubble has to burst. It does not make sense to issue an equivalent amount of public debt every time a bubble bursts, just because there is a financial accelerator.
In exchange for the associated pains, a recession would
-bring back US private consumption to sustainable levels, thus restoring the much damaged external accounts.
-depreciate the real value of the dollar to support the needed reallocation of activity toward the export sector
-bring back the ridiculously high house prices to levels that truly reflect fundamentals
-bring back the stock market to sound fundamental values (although this may happen quickly)
In short, the US economy would exit a period of misallocation of resources that was due to wrong prices – wrong interest rates, wrong asset values, wrong exchange rates. So if the socialization of the financial sector that we are witnessing is just there to avoid a recession, I say it is a pretty poor idea.
Furthemore, the real economy has deteriorated only very recently. According to the Bureau of Economic Analysis (and to my astonishment), the annual rate of GDP growth was a strong 3.3 % in the second quarter, following a weaker 0.9 %. This hardly looks like the Great Depression, and not even like a recession as conventionally defined – granted, the third quarter is going to be worse. Also, the weakening dollar is working its way into a healthier structure of demand: imports are falling and exports are raising, thus contributing to correct the abysmal trade deficit. Private consumption is probably still too high though, partly due to the administration fiscal stimulus package.
An entirely different story is that the “payment system” may collapse. This would happen if there is a run on deposits and accordingly if businesses become unable to finance their short term liabilities. Then the consequences would be a massive disruption of economic activity. The payment system is a public good which is produced by private banks jointly with the allocation of savings to investment, which is a private activity. As the recent take-over by the Fed of the commercial paper market shows, the payment system is now in danger. The preferred policy is to save the payment system by saving the banks, and to save the banks by bailing out cynical lenders and imprudent borrowers with the money of the tax payer, while not conceptually separating the payment system from the banking system. But let us ask the following question: why is it that right now perfectly sound firm A, in need of cash, cannot finance itself by borrowing from firm B, which has too much cash? I do not know the answer to this mystery but I speculate that this is because the money lent to A will first of all be deposited…in a bank! If instead it were deposited in some public agency in charge of the payment system, firm B will not hesitate to lend to firm A. And the Fed would not have to take over the CP market to save the payment system. Nor would the Treasury have to spend the public’s money to bail out banks, it could instead let them fail without touching the payment system. In some sense I am advocating the Hayekian proposal of 100 % reserve money (M3=H). Hayek was hysterical about the role of the total money stock, and thought that 100 % reserve was the only way to maintain it fixed. Modern economists think that the money stock is not that important, what matter are the relevant associated prices (interest rates, inflation rate, asset prices…). However, the Hayekian proposal allows to separate the payment system – a public good – from the banking activity – a private good. By doing so, it reduces public incentives to bail out the banks in case of trouble, thus enforcing sound loans and individual responsibility.
The medium run: Two scenarios
In the medium run, assuming we survive past doomsday, i.e. that the payment system survives, what are the macroeconomic consequences of the crisis? Authorities are presumably aiming at 2.5 % growth, constant employment, and are accordingly “fine-tuning” the economy by stimulating both aggregate demand (low interest rates, fiscal injections) and aggregate supply (injecting money in banks).
But there are two other scenarios, which, despite contradicting each other are real possibilities:
A. Deflation, aka the Japanese syndrome. We already observe that reduction in interest rates and injections of liquidity do not work well because people prefer to hoard money. Inflationary expectations as measured by yields on inflation-indexed bonds have also fallen. If the fall in aggregate demand triggered by stumbling consumer confidence, falling house prices and defaults on mortgages is strong enough, the economy may enter a deflationary spiral. Interest rates would fall to zero but people would still hoard liquidity, as they would get good return on that thanks to falling prices. Monetary policy would be ineffective. The government would likely counter that with public spending and fiscal deficits. The Japanese experience, where public debt increased from say 70 % of GDP to 160 % during the crisis, to no effect, suggests that this may be quite problematic. Past a certain level, people react to public debt in a perverse way by anticipating highly distortionary taxes in the future: they react to increases in public debt by saving more and fiscal policy becomes as impotent as monetary policy. Of course, the government may tax more and use the proceeds to dig holes in the ground (a procedure known as the Haavelmo theorem)…
B. Inflation. This would not be a result of the crisis itself but of the public handling of the crisis. We observe that Fed is swapping dollar bills and treasury bills in exchange for toxic mortgage-based assets and more recently, commercial paper. Isn’t that a “monetization of debt”, and a “deterioration of the Fed’s balance sheet”, likely to lead to inflation? In principle, the answer is no. The reason is that the Fed is not a bank. The Fed’s commitment is to issue fiat money which is used as a medium of exchange. Money as a medium of exchange is not backed by the assets of the Fed. It is backed by its commitment to low inflation. In principle, the swaps that have been used do not alter that commitment, as long as the Fed is expected to target the same inflation levels in the medium run. In other words, there is no difference between the Fed swapping T- bills for CDOs vs; the Treasury doing so. In both cases what we have is a public bail out of bad loans. Similarly, when the Fed is providing liquidity by lending to banks as the interbank market shuts down, it is transforming M3 money (money created by banks when they lend out of their deposits) into high-powered money. This leaves the total money stock unaffected. So in principle that should be non-inflationary too: we are actually moving toward the Hayekian ideal of 100% reserve money. However, there are two caveats:
First, an explosion in M3 as lending resumes should the economy exit the crisis; this would boost spending and fuel inflation. This should be offset by open-market operations to withdraw the High powered money that was issued during the crisis. But to engineer such an open market operation the Fed needs to sell assets, which makes it problematic if all it has in its balance sheet is worthless MBS…Alternatively, one may want to simply increase the currency reserve requirements of the banks, moving us again in the Hayekian direction. In all cases, there will be a delicate transition.
Second, there must be a reason why central banks only accept good collateral when supplying liquidity to the private sector: If they accept any junk the private sector will then happily generate such junk in order to fund bad loans and Ponzi schemes. This could lead to another misallocated “boom” of the housing bubble kind.
Another potential source of (hyper) inflation, rather than monetary policy, is the use of fiscalpolicy during the crisis. There is the hint that public authorities are willing to go to any length to preserve the system. The cost of the bail out may be a blip in public debt by say 10-20 % of GDP (it is of the order of magnitude of the housing bubble itself), to which should be added fiscal stimulus measures and foregone earnings due to the recession. As public debt rises, part of its financing may well be through the inflation tax (it is in fact optimal from a tax perspective to increase inflation a little bit when the burden of debt is higher). Such an expectation will lead to a move out of dollar-denominated assets, eventually forcing the fed to increase interest rates. This reinforced by the incentives for the US to engineer partial implicit default on its dollar-denominated debt by depreciating its own currency.
Does that mean “some more inflation” or “much more inflation”. I suppose this would mean an inflation rate reaching 6 to 7 % in a couple of years. However, things could be nastier if there was a massive run on the dollar. Can the current increase in public debt lead to such a run? A week ago, I would have said that this possibility is unlikely. Now I am not so sure. At least one serious economist (Larry Kotlikoff) deems it inevitable.
One stabilizing factor is that there is less room for a self-fulfilling run because US government liabilities are denominated in dollars. if there is a run, a country indebted in foreign currency will have trouble fulfilling its claims because of its depreciated money and the associated deterioration in the terms of trade. On the contrary, if there is a run on the dollar, the U.S. balance sheet improves, so it will have less problems satisfying its obligations. This is stabilizing, but it remains nevertheless true that the dollar has depreciated and that those who sold their dollar assets first are better-off than the others.
What makes a run on the dollar a possibility is the following: As someone rightly pointed out on the web, the pool of foreign holders of US treasury bonds is a cartel. They keep buying (or not selling) ,them to prevent their real value from falling, which would inflict a severe capital loss to them. But in each cartel there is an incentive to deviate and sell one’s bonds before the others. When somebody deviates, the cartel collapses and the price falls brutally. And that incentive is greater if the prospect of the US inflating its debt become more real. In that respect, only a moderate increase in the expected depreciation rate of the dollar may trigger a collapse of the cartel and a sudden run on the dollar.
Which scenario is more likely? I don’t know: the markets and the authorities seem to put a fairly high probability on scenario A and a low probability on scenario B. Yet many antecedents of such crises (for example, Sweden 1992) have been associated with balance-of-payments crises and sharp falls of the currency.
The long run: the return of Socialism?
During the crisis we have witnessed: (i) a rush by public authorities to bail-out, nationalize, take control of various financial institutions, as well as to lower interest rates and to inject fiscal stimulus, and (ii) a blossoming of “I told you so” types in various circles who happily conclude that Capitalism does not work and that the government should regulate and/or manage the financial sector (which sometimes reminds me of Charles de Gaulle’s claim that the market is just good for allocating groceries).
In some sense, there is now a general sense that “the French are right”: the financial sector should be tightly controlled by the government. Worse, since “too big to fail” banks are being rescued, “too big to fail” firms in the industrial sector are rushing to beg for taxpayer’s money.
In that respect, the bail-out of Wall Street can be interpreted as a French-style policy of subsidizing declining industries to preserve jobs. We know that it is typically a bad idea to spend public money on declining industries to protect jobs there. The financial sector is no exception: many goods that it is selling (the sophisticated financial instruments that are at the core of the current crisis) are now “obsolete”, not least because they cannot be priced in the face of systemic shocks like the bursting of a bubble. Presumably one should expect a return to a more rustic way of conducting business. As a result the financial sector is too big and should contract. By pumping money into it, authorities engage in French-style state aid and French-style public management. The French experience suggests that this means poor corporate governance, decisions that disregard customer value, and therefore more future losses to be borne by the tax payer.
The recent take-over of financial institutions by public authorities may save them in the short run, but is not good news for the allocation of capital in the long run. Moral hazard problems are highly exacerbated in publicly controlled firms. In fact part of the current problems stem from excess political involvement in credit markets: Freddie and Fanny have a federal guarantee on their debt. As a result they could issue any amount of debt at a lower cost than their competitors, and no creditor would even think before purchasing it. They indulged in using that money in making poor loans to the housing sector; their public guarantee did not make them more virtuous than the rest of lot, quite the contrary indeed. Furthermore, it seems that Freedie and Fanny were not immune from political pressure to extend loans to poor families despite their likely insolvency.
This does not look too much like “capitalism”, nor do the artificially low interest rates of the early 2000s which contributed to the housing bubble.
It is true, though, that consumer credit and mortgages are less regulated in the US than in, say, France. But it is not clear that irresponsible lending would have taken place in the absence of a government ready to socialize losses and having already done so during the Savings and Loan crisis.
Those whose are enthusiastic for public control of the financial sector should recall the French Crédit Lyonnais scandal when politically acquainted executives spent their publicly owned bank’s capital in all sorts of worthless projects (some of them being pure looting involving organized crime). A number of these projects were located in the electoral districts of highly influential politicians – so that the CEO at that time, Jean-Yves Haberer, defended himself by arguing he was working hand in hand with the politicians to defend French jobs and boost the size of the company. The recent partial nationalizations in the UK are associated with claims by politicians that there will be more lending to fund “small businesses” and home ownership for poor households. This is clearly allocating credit on the basis of a political agenda, and is doing nothing to prevent a subprime crises in the future.
The only advantage that publicly controlled lenders could have over private lenders is that the former could refrain from joining asset bubbles and value collateral at its true fundamental level. As far as housing is concerned, experience shows us that is certainly not the case: political considerations make them even more likely to engage in poor loans.
So the current wave of bail-outs is the next stage of crony social-capitalism with the associated drain on the allocation of capital and a real risk of yet another round of reckless borrowing and another crisis.
7 Responses to “Speculative Thoughts on the Macroeconomic Aspects of the Crisis”
From an ecological perspective that includes the whole earth, it’s a poor use of capital to tear down living forests and their ecosystems which soak up CO2, just to deposit their lifeless residue in McMansions all across America. If a rich person married to an heiress with a fat bank account can afford 7 “houses,” should they be allowed to buy them from a whole earth point of view? The rich have too way too much money going into the wasteful consumption of our ecological resources, just so that capital can spin at dizzying rates degrading a beautiful planet. In addition, don’t blame this downward spiral in the market and economy on a few poor people just lookin’ for a home. I guess it’s the downtrodden masses who finally broke America? Marx would be amazed, tossing in his grave.
To Chris,Sarah Palin? Is that you???
I think it’s Al Gore…
Gilles,Excellent walk-through.Clearly the authorities have their sights on “A” (Deflationary Spiral). Ben Bernanke has made no secret of his long-held view that Deflation is the ultimate enemy.They’ll attack “A” at the risk of “B” (hyperinflation).Assuming they’re right, once this is over, all the water (Money) that is being hosed on to the fire will need to be cleaned up…
Thoughts from outside the political box.Can Sustainable Cities Save The Planet?By Walter Libbyhttp://theendpoint.blogspot.com/Can sustainable cities save the planet? This is a good question and it deserves a good answer. But a more relevant question is, can sustainable cities save the United States? Our rising unemployment rate in the global economy has finally caught up with us—we are out of bubbles and are now a nation at risk. With nine straight months of job losses and a looming financial crisis, our prospects look grim—despite the efforts being made to prop up our financial system.The problem is we are in liquidity trap. Here, despite low interest rates, the infusion of new blood, the cash that is being pumped into banks will just sit in their vaults as recession forces consumers to cut back on spending forcing firms to cut back on production, investments and workers perpetuating the cycle pushing the economy ever deeper into crisis.The question now becomes, how do we get out the trap? We can’t look to a turn around in residential construction. But we can look to a turn around in our thinking as we shift from urban sprawl to the development of new cities designed along sustainable lines. So together with their development and the investments in renewable energy they will begin to pull us out of the trap.The advent of peak oil has convinced venture capitalists to get busy in saving the planet. Now we have to sell the idea of new cities to investors, developers, and the people, and that requires a model that captures their imagination and investment dollars. So following in the footsteps of Ebenezer Howard, here’s how I see cities of tomorrow: clusters of neighborhoods (linked by elevated transportation arteries shared by electric vehicles, bikes, pedestrians and rapid transit systems) will form the city. These neighborhoods are large terraced multi-storied structures sheltering thousands. Here their terraces are reserved for greenhouses and homes and their centers for factories and fully controlled-environment farms.So, as you walk out into your neighborhood you encounter not hallways but wide walkways, allies and breezeways lined with trees and plants, schools, hospitals, libraries, theaters, businesses, shops, and restaurants—all within walking distance, or a short elevator ride. And when you go to the first floor, at ground level you find barns (for pigs, beef and dairy cows, and chickens that are harvested next door) opening onto natural habitant mixed with organic farms, orchards, parks, playgrounds, and golf courses. Here, instead of sending our table and produce straps, our unwanted leftovers, dry bread, spoiled fruit to landfills, we recycle them to neighborhood barnyards or to community organic orchards and gardens.Once there is a sufficient population, a larger central city is built. This is the cultural center of the whole. Here you have universities, the larger hospitals, museums, aquariums, zoos, sports stadiums, theaters for the performing arts, large central parks, plazas, street performers, and so on.New cities are going to play a significant part in our economic recovery. And they are not going to be connected by super highways but by railroads carrying passengers, cars, trucks, commodities, construction equipment and freight.New cities, as an alternative to unsustainable urban sprawl, by itself is a strong selling point. Add to that greater efficiency, lower taxes, and a mix of town and country. But its best pitch to the captains of industry is that they are necessary for our national security and confidence in general—for Wall Street and Main Street, and for those in the world who doubt that America can resolve its economic crisis, our ability to bootstrap our economy.Yet, while the development of new cities will rev up our economy structural problems still plague the global economy—it’s unbalanced and so unsustainable as witnessed by our mounting trade deficits. And given that the financial crisis was brought on by our loss of jobs to the global economy (the housing bubble was the result of the Fed lowering interest rates to rock bottom in a desperate and vain attempt to avoid recession following the collapse of the dot.com bubble), we have to ponder the question, is capitalism collapsing? And this poses challenges not only for America and democracy in general, but for communist China, Russia and Venezuela as well.China, having taken the capitalist road, has pretty much captured the means production as multinationals, in a race to the bottom, in a race to China to beat their competitors, have left in their wake socioeconomic crisis in their respective countries—notably in the U.S. In the process China has pretty much become the factory to the world. And in doing so have created a contradiction in the global economy—who are going to buy its products? This is a contradiction that threatens China.And Russia and Venezuela, as oil prices plummet with a global collapse, face economic ruin—along with the rest of the oil producing countries. We need a new global order, a new world agenda.Mikhail Gorbachev has stated such in The Search For A New Beginning: Developing A New Civilization.Essentially, Gorbachev is touting sustainable development. Yet, he says “It has been the fond hope of many that the end of the Cold War would liberate the international community to work together to avert threats and work in a spirit of cooperation in addressing the dangerous problems that affect the world as a whole. But, despite the numerous summit meetings, conferences, congresses, negotiations, and agreements, there does not appear to have been any tangible progress… Between the old order and the one lies a period of transition that we must go through—moving toward a new structure of international relations marked by cooperating, interacting, and taking advantage of new opportunities. What we are seeing today, however, looks rather like a world disorder.It is my belief that today’s policy makers lack a necessary sense of perspective and the ability to evaluate the consequences of their actions. What is absolutely necessary is a critical reassessment of the views and approaches that currently lie at the basis of political thinking and a new combination of player to envision and carry us through to the next phase of human development.”The next phase of human development is the development of new sustainable cities throughout the world. As a start we should also pursue the moral equivalent of war. The industrialized nations should form an economic coalition to assist the Palestinians, the nations of Afghanistan and Pakistan, and other nations in turmoil, in the development of new cities. Peace through prosperity.The idea of cooperation didn’t begin with Gorbachev, it began with the atom bomb—war was out and cooperation was in. So after World War II, The World Bank and the IMF (International Monetary Fund) came into existence. Their combined mission is to foster economic growth, high levels of employment, while providing temporary loans and financial assistance to relieve debt.While that mission remains the same its focus should now be on the development of sustainable cities. The world faces an energy crisis as the production of oil peaks and then declines, as well a looming water crisis exacerbated by the increasing threat of droughts. Their mission should be now to focus on the development of renewable energy to power control-environment farms. And then add on the neighborhoods.The thing is it may well beyond the scope of the World Bank and the IMF to implement. Therefore we need a summit meeting of the industrialized nations to forge a consensus along with working out just how this is to be accomplished.That said, however, the first condition of the summit should be that loans or direct investments tied to the development of natural resources in the developing countries require that their leaders will channel their revenues into the development of sustainable projects while ensuring the workers receive wages sufficient for the necessities of life along with low interest loans to purchase their new homes —this means that the enlightened nations will only support democracies and work together to convince dictators and corrupt officials to rethink their positions.There is also something that all nations should consider: that it is in their best interest that they shift to a global economy where trade is no longer a zero-sum game, but a sustainable end game where everyone wins–it’s about cooperation and balancing tradeThere is a huge amount of work (enough to keep us all busy) to make the transition to would-be sustainable cities throughout the world, and that requires that nations with a trade surplus, who are shifting their economies (their workers) to the development of new cities, turn to those nations with a trade imbalance–an imbalance in employment–take their foreign reserves and invest in or directly trade for whatever is necessary to facilitate and expedite the building of their cities.Thinking that pressuring China to revaluate its currency as a solution is wrong-headed. It will only create unemployment for China and inflation for others.And for those who think that the conflict Marxism and liberal democracy as inevitable, they should think again—think about where sustainable are heading.Sustainable cities are on built on three legs: they have a source of renewable energy, produce their own food, and have the ability to manufacture their own necessary consumer goods. Today we have the technology for the first two and eventually tomorrow’s technology will replace low-wage workers with robots as the final assemblers in fully automated factories–automated factories that can be scaled to provide the necessary consumer goods on a local level—eliminating middlemen and transportation costs.When that day comes their will no be longer a struggle over the means of production and we’ll find ourselves at the end of history—the end of the historical ideological battle between liberal democracy and Marxism. And when that day comes we’ll also see the world’s population stabilizing just as in the industrial nations populations have stabilized (the U.S. the notable exception—but that works as it allows us build new cities) as they modernized and urbanized.Here, Marxism finds its final resting place in the dustbin of history. Seeing history as written in stone—seeing conflict as the final solution—is a bad idea.On other hand it is democracy, freewill, that puts forward the ideas to meet the challenges that a fast changing presents. But here too we have an ideology based on self-interest that is false and cowardly. Self-interest rightly understood is a collective-free-market-will that puts aside the issues that divides us and focuses on the ideas that insure the integrity of whole. The “invisible hand” as it guides ”the butcher, the baker, the brewer” has to be replaced with the hand of reason—hopefully enlightening those who subsist on corruption and greedHumanity was conceived ignorance. As such Gorbachev reflecting on the past tells us ”Conflicts and wars have been an organic part of history.” Another way of saying it is that “there will be trials and tribulations.”So we have choice, on both sides, continued conflict, continuing ignorance, or emerging cooperation. If conflict remains in place there’s another determinism to be considered—the historical determinism of weapons—best expressed by the dialectics of Marxism. The United States (the thesis) was followed by the rise of the Soviet Union (the antithesis) who together cannot exist without constantly revolutionizing the means destruction and exchange—nuclear weapons and ICBM’s. Eventually their numbers will reach a critical mass, and a great leap occurs, leading not to a synthesis, but the victory of matter over mind, the end of all history. This was “the backbone of perestroika.” It is why the Soviet Union was allowed to collapse. It is why Gorbachev posits a new world order. As I see it, a new world order where sustainable cities mark the beginning of a new epoch that not only saves the planet, but also saves us our from ourselves.FootnoteControlled-environment farming: In a world facing the challenges of severe droughts and extreme weather, looming worldwide water shortages, along with rising oil costs and rising food prices controlled-environment farms are being touted as the answer. While there are variations of indoor farming, they all are pretty much based on hydroponics and tout the same economic efficiencies. They all can be located within cities or neighborhoods. They all run on electricity, require no pesticides, herbicides nor fertilizers (all derived from fossil fuels). They produce crops year around, and depending on the technology, use from one-tenth to one-twentieth the water of conventional farms. They not only use less water, they can use recycled water from the surrounding communities.One up and running venture was the Phytofarm (re: Discover magazine December 1988, The Green Machine: Indoor Farming). This is a fully enclosed farm fed by artificial lighting where one acre can produce 100 times the yield of conventional farms (day or night). And while it was geared to produce leafy greens and herbs, there is practically nothing that cannot be grown indoors—albeit it would require a shift to growing some food in composted earth pots. Yet, while the project had a successful run, producing sought-after high quality crops, for a number of years, in the end it lost out due to high-energy costs and closed its doors in the early 1990s.Today, vertical farms are being touted along the same sustainable lines. Essentially these are high rises with greenhouses stacked on one another. Yet, they have not attracted any investors and so their technology remains in doubt. But phytofarms are a proven technology and they too can be stacked on one another. And they can start producing with the completion of the first floor. As such, the investment here can play its role in a sustainable economic recovery.
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“Past a certain level, people react to public debt in a perverse way by anticipating highly distortionary taxes in the future: they react to increases in public debt by saving more and fiscal policy becomes as impotent as monetary policy.”Applying the Japanese experience to the US misses the point that the US doesn’t finance itself with its own citizen’s money but abroad in its own currency (today, it is mainly with Central Banks, see Brad Setser’s site). If the Chinese/Japanese/Russian/OPEC CB decide to stop buying treasuries, you will quickly go to possibility B. I think that the first one to break the cartel will be the oil-producers (with Russia as a cheerleader as it has the highest marginal production costs). The Chinese and the Japanese will also realize that they have to stop digging further the hole they are in. Once the inflation genie will be out of the bottle, it will be very difficult to stop high inflation, together with some contraction of real output.Europe seems more similar to Japan and could have the same fate. But the mechanism requires that the most productive “surplus” regions (Germany in Europe, Tokyo/Tokai regions in Japan) accept to finance the less productive “deficit” regions (PIIGS in europe, Hokkaido and others in Japan) with no realistic expectation to see the money back. Thanks to the electoral system, but also to the strong sense of “Japaneseness” in the population, it has been possible in Japan. I am skeptical that the same level of interregional transfer is politically possible on a long term basis in the eurozone (Bernard Connelly from AIG estimates that, if made permanent, the present value of transfers from Germany is the same order of magnitude than what it had to pay for reparations after WWII, ironic isn’t it ?). Therefore, the end game in Europe will be either :1 a united eurozone where the surplus countries accept a stronger regional inflation than the deficit countries, with significant inflation on average of the eurozone (Scenario B in your terminology) : probably the most benign economically, but requires that the ECB deviate from its mandate. This has the preference of the deficit countries2 a united eurozone with strong deflation of deficit countries : This has the preference of Germany ( Scenario A in your terminology), but can lead to political turmoil in deficit countries such that we end up into..3 an explosion of the eurozone with a return to national currency : what Germany didn’t want to loose as credit losses, it looses it (and more…) as forex losses just like China/Japan with the US.My bet ? : we will end up with scenario 1 not only in Europe but worldwide : high inflation globally, but higher in surplus countries than in deficit countries, with maybe Japan staying out of the debasement game for the cultural reasons outlined above.One more remark about the ” highly distortionary taxes in the future” : when seniors are retired or put out of a job, they may be tempted to just take their assets and move to a financially better managed foreign country that has lower debt burden. After “medical tourism”, we could see “fiscal migration of pensioners”, at least from countries that have “lump sum” retirement benefit (pay-go system can be subject to withholding taxes).One can witness this phenomenon in countries like Morocco, Dominican republic, etc… This has not hit Japan again for structural reasons (Japanese usually are uncomfortable abroad, it is technically difficult to get assets out, and the expected “highly distortionary tax in the future” is a 85% inheritance tax that only happens when the individual dies)