One problem with blogging is that at any given time many of your readers don’t know about ground you’ve already covered. I’ve tried to remedy that in part with my list of macroeconomics posts over to the right — before commenting on my macro analysis, you might want to read them. Still, it sometimes helps to repost an earlier argument.

So, about why the euro needs inflation to work, here’s what I wrote some time ago:

Jean-Claude Trichet is sounding hawkish about inflation again — and this is very bad news for the European periphery. Let me offer a stylized example to explain why.

So, imagine a eurozone that contains only two countries, Germany and Spain. And let’s make two assumptions: first, Germany’s economy is three times the size of Spain’s, so that German inflation is 3/4 of the overall index, Spain’s inflation 1/4; second, past events have left Spanish wages and prices 20 percent logarithmic too high relative to Germany. (Why logarithmic? So I can just add percentage changes, without having to worry about compounding.)

Now suppose that you want to get relative prices and wages back in line over the course of 5 years. How can this happen? Well, one way or another we need to have German inflation 4 points higher than Spanish inflation over that period.

So consider two scenarios: in scenario A, we have 2 percent German inflation and 2 percent Spanish deflation. This implies an overall eurozone inflation rate of 1 percent. In scenario B, we have 4 percent German inflation and zero Spanish inflation, implying eurozone inflation of 3 percent.

In a frictionless world, it wouldn’t matter which scenario gets chosen. But in reality, scenario A, the low-inflation scenario, is vastly worse for Spain — for two reasons. First, it’s much, much harder to get actual deflation than simply to have stable prices, so scenario A means much higher unemployment. Second, because Spanish debt is in euros, scenario A implies a significantly worse debt burden.

So what we’re seeing is an ECB catering to German desires for low inflation, very much at the expense of making the problems of peripheral economies much less tractable.

This is going to be ugly.

I’d add that the ECB and European leaders have been in complete denial on this point, willing neither to acknowledge the deflation their policies require nor to accept the need for higher overall inflation if deflation is to be avoided.

Dean Baker raises an important point here: it’s really awfully late in the game to be saying that the important inequality issue is college graduates versus non-graduates. It’s not clear that this was ever true, and it certainly hasn’t been true for a while.

I wrote about this years ago, using Ben Bernanke’s maiden testimony as Fed chair as an entry point. As I said then, Bernanke — like many others — had made

a fundamental misreading of what’s happening to American society. What we’re seeing isn’t the rise of a fairly broad class of knowledge workers. Instead, we’re seeing the rise of a narrow oligarchy: income and wealth are becoming increasingly concentrated in the hands of a small, privileged elite.

I think of Mr. Bernanke’s position, which one hears all the time, as the 80-20 fallacy. It’s the notion that the winners in our increasingly unequal society are a fairly large group — that the 20 percent or so of American workers who have the skills to take advantage of new technology and globalization are pulling away from the 80 percent who don’t have these skills.

…

Why would someone as smart and well informed as Mr. Bernanke get the nature of growing inequality wrong? Because the fallacy he fell into tends to dominate polite discussion about income trends, not because it’s true, but because it’s comforting. The notion that it’s all about returns to education suggests that nobody is to blame for rising inequality, that it’s just a case of supply and demand at work. And it also suggests that the way to mitigate inequality is to improve our educational system — and better education is a value to which just about every politician in America pays at least lip service.

The idea that we have a rising oligarchy is much more disturbing. It suggests that the growth of inequality may have as much to do with power relations as it does with market forces. Unfortunately, that’s the real story.

Let me illustrate this point with some CBO data. First, from the new report, here are the income shares of the top 1 percent and the rest of the top quintile:

There has been no rise in the share of the 81-99 group! It’s all about the top 1 percent.

Second, even within the top 1 percent the gains are going mainly to a small minority. An earlier CBO report, using slightly different methods, looked inside the top 1 percent up through 2005. Here’s some of that data:

The big gains have gone to the top 0.1 percent.

So income inequality in America really is about oligarchs versus everyone else. When the Occupy Wall Street people talk about the 99 percent, they’re actually aiming too low.

One last point: I see that David Brooks is arguing that the oligarchy issue, if it matters at all, is a coastal phenomenon, not the issue in the heartland. Let me point out, then, that we have one country, with a tightly integrated economy. High finance is concentrated in New York, but it makes money from the United States as a whole. And even when oligarchs clearly get their income from heartland, red-state sources, where do they live? OK, one of the Koch brothers still lives in Wichita; but the other lives in New York.

Put it this way: having much of the wealth your state creates go to people who are in effect absentee landlords, whose income therefore shows up in another state’s statistics, doesn’t mean that you have an equal distribution of income. Out of state shouldn’t mean out of mind.

Look, I understand that some people find the notion that we’ve become an oligarchy — with all that implies about class relations — disturbing. But that’s the way it is.

Things are falling apart in Europe; the center is not holding. Papandreou is going to hold a referendum; the vote will be no. Italian 10-years at 6.29 at pixel time; that’s a level at which the cost of rolling over the existing debt will force a default, even though Italy has a primary surplus. And with everyone simultaneously pushing for fiscal austerity, a recession seems almost certain, aggravating all of the continent’s problems.

I’ve been charting this trainwreck for a couple of years, and am feeling too weary to trace through it again right now. Let’s just say that the euro was an inherently flawed idea that can work only given a strong European economy and a significant degree of inflation, plus open-ended credit to sovereigns facing speculative attack. Yet European elites embraced the notion of economics as morality play, imposing across-the-board austerity, tightening money despite low underlying inflation, and have been too concerned with punishing sinners to notice that everything was going to blow apart without an effective lender of last resort.

The question I’m trying to answer right now is how the final act will be played. At this point I’d guess soaring rates on Italian debt leading to a gigantic bank run, both because of solvency fears about Italian banks given a default and because of fear that Italy will end up leaving the euro. This then leads to emergency bank closing, and once that happens, a decision to drop the euro and install the new lira. Next stop, France.

It all sounds apocalyptic and unreal. But how is this situation supposed to resolve itself? The only route I see to avoid something like this involves the ECB totally changing its spots, fast.

Aside from that, Mr. Draghi, are you enjoying your new job?

An earlier version of this post misspelled the surname of the Greek prime minister. It is spelled Papandreou, not Panadreou.

Just read the whole thing — it’s short. Brad gives us an important history lesson, showing that the lender of last resort function has always been an essential part of a central bank’s job, and that the Bank of England played that role when necessary even though it lacked proper legal authority.

So the ECB, by insisting that price stability is its sole responsibility, may sound conservative but is actually taking a radical stance that has never worked in the past. Of course, this is true of a lot of economic policy these days: the dirty hippies want us to take Econ 101 seriously, while the Very Serious People want us to believe in confidence fairies and invisible vigilantes.

Anyway, read Brad — and hope that Mario Draghi is reading him too.

From Business Insider:

Steve Pearlstein has a very nice piece about the Economic Policy Institute, which is indeed the small think tank that could, playing a disproportionate role in policy discussion. I still consider Obama’s failure to appoint someone from EPI to a senior position one of his biggest mistakes; he really needed someone who would speak up for workers and a view of economics not tinged by financial-sector connections.

At this point EPI is the single best source for analysis of labor issues, one of the best sources of macroeconomic analysis, and in general a bastion of humane clarity. The institute’s success demonstrates just how powerful it is when you combine intellectual integrity with commitment, when you make a point of doing the math right, but also never forget that you stand for something.

Oh, by the way: Since Pearlstein makes a point of mentioning some ancient disputes I had with EPI, I guess I should say something about where all that stands. The main thing, I think, is that trade policy — where I still have some differences with EPI — is much more peripheral an issue than it seemed to be in the early 1990s. I once had a conversation with Bob Kuttner in which we agreed that while we were arguing about NAFTA, Sauron was gathering his forces in Mordor. Our common ground — a shared concern with the fate of workers and the dangers of rising inequality, combined with a healthy skepticism of what Very Serious People say — is far more important than any differences, especially given just how excellent EPI’s work has become.

Put it this way: I’ve had a number of meetings with senior officials along with other progressive economists, and I always feel that of the group, Larry Mishel is talking the most sense — and, whaddya know, agreeing with me.

We’re going to have a little celebration tomorrow evening; let’s hope that EPI’s influence will continue to grow.

Bob Hall has posted his original 1976 paper making the distinction between fresh water and salt water economists (pdf):

The fresh water view holds that fluctuations are largely attributable to supply shifts and that the government is essentially incapable of affecting the level of economic activity. The salt water view holds shifts in demand responsible for fluctuations and thinks government policies (at least monetary policy) is capable of affecting demand.

What I find interesting is that even in 1976 the fundamental weakness of the fresh water position was obvious: the effects of monetary policy were far too persistent to make sense in terms of the “Lucas supply curve” in which confusion about the price level caused real effects, and stories that relied on a constantly shifting equilibrium unemployment rate failed to offer any plausible explanation of why that should be happening.

Hall concludes by noting that there had not been a major defense of Keynesian ideas against the fresh water onslaught, which was true in 1976. Over the next 15 years however, that gap would be filled. The trouble was that by that time the fresh water types had stopped listening. In the late 1970s, despite the obvious problems with their world-view — obvious to Bob Hall in 1976! — fresh water schools declared themselves triumphant and Keynes dead, stopped teaching any kind of demand-side economics, and created a hermetic intellectual world that was totally unprepared for the very Keynesian crisis we’re now living through.

Oh, my. David Cameron has a piece in today’s FT that should put paid to any notion that he knows what he’s doing.

He opens by declaring that

I am confident that we can both resolve the crises at hand and come through them with an economy that is stronger and fundamentally fairer. My argument here at home and at the meeting of the Group of 20 leading economies in Cannes is that we can only do so if we show complete single-mindedness on three fronts …

I don’t know exactly how you show complete single-mindedness on three fronts. Is this some sort of Zen thing?

More seriously, here’s his defense of his austerity policies:

It is thanks to the credible plan this government has set out that today we have market interest rates of just 2.5 per cent – half what they are in Spain or Italy.

Indeed, nobody else has managed to achieve low interest rates despite large debt and deficits. Oh, wait:

Japanese rates are also down, although not as much because they’re so close to the zero lower bound. All signs point to falling rates because of falling, not rising, confidence: nobody expects the countries with their own currencies to default, nor did they ever, but they now expect short-term rates to stay low for a very long time thanks to a weak economy.

So this is really sad. Cameron is pointing to a decline in rates that’s happening world-wide, except among countries that have given up their currencies, and claiming that he sees the confidence fairy.

The European rescue plan is falling apart even faster than I expected.

One way to think about this is to say that if Italy were perceived as safe, with no real chance of a future default, it would be able to borrow long-term at an interest rate comparable to Germany’s. German rates are currently below 2 percent, but that’s partly because eurozone fears are depressing the outlook; still it’s a good bet that Italy’s rate would be in the 3-4 percent range.

But if the debt must be rolled over at >6%, given the size of Italy’s debt, that vastly increases the primary (non-interest) budget surplus Italy needs to stabilize its position. And that difference is quite plausibly the difference between paying its debts and defaulting.

So we’re deep into self-fulfilling pessimism territory here. Either the ECB moves in with big purchases, or the euro is crostini.

For once — and I almost never say this — I think Dean Baker is being a bit too hard here. The Draghi piece was mainly a profile, and I’m willing to cut a bit of slack on the macro analysis.

That said, Dean is completely right about the macro doom loop the Europeans have created for themselves, in which the ECB’s refusal to provide either the lender of last resort facility or the monetary expansion the eurozone needs is creating a vicious circle of self-reinforcing austerity. Dick Baldwin got at this very well last week, although he was excessively optimistic about how long the fix would last; it was two days, not six months.

And was anyone else struck by Sarkozy’s declaration last week that since French growth was going to be slower than expected, it would be necessary to tighten the budget further? France may still have a AAA rating, but at the margin it’s behaving like a debt crisis country, with fiscal policy reinforcing a downturn rather than fighting it.

I’d still like to imagine that next week Mario Draghi, newly installed as ECB president, will suddenly reveal himself as a supporter of quantitative easing and a 4 percent inflation target, not to mention open-ended lending to crisis countries. And all this would be perfectly sensible — much more so than the way the ECB is actually behaving. But it’s not going to happen.

A correspondent’s daughter will be trick-or-treating as the confidence fairy:

Dean Baker is angry at the Washington Post for spreading disinformation about Social Security. He’s right, of course — and it’s shocking that a well-known fallacy is the subject of a “news analysis” that purports to inform readers.

You see, the WaPo makes a big deal of the fact that Social Security is currently taking in less in payroll taxes than it’s paying out in benefits. Yet this means nothing, except as a favorite point used to create confusion by those who want to kill the program.

I’ve written about this repeatedly in the past, but here it is again: Social Security is a program that is part of the federal budget, but is by law supported by a dedicated source of revenue. This means that there are two ways to look at the program’s finances: in legal terms, or as part of the broader budget picture.

In legal terms, the program is funded not just by today’s payroll taxes, but by accumulated past surpluses — the trust fund. If there’s a year when payroll receipts fall short of benefits, but there are still trillions of dollars in the trust fund, what happens is, precisely, nothing — the program has the funds it needs to operate, without need for any Congressional action.

Alternatively, you can think about Social Security as just part of the federal budget. But in that case, it’s just part of the federal budget; it doesn’t have either surpluses or deficits, no more than the defense budget.

Both views are valid, depending on what questions you’re trying to answer.

What you can’t do is insist that the trust fund is meaningless, because SS is just part of the budget, then claim that some crisis arises when receipts fall short of payments, because SS is a standalone program. Yet that’s exactly what the WaPo claims.

This is what you call negative journalistic value added.

Christina Romer calls on Ben Bernanke to adopt a nominal GDP target, and suggests that he consider himself in a position comparable to that of Paul Volcker — where Volcker took drastic action to fight inflation, Bernanke should do likewise to fight unemployment.

I’m good with that. At the risk of reading the stage instructions, however, let me add that the Volcker parallel may run deeper than most people appreciate.

You see, the early Volcker years were the period when the Fed at least claimed to have become monetarist, to be setting targets for monetary aggregates like M1 and M2 rather than interest rates. It didn’t last long; by the summer of 1982 the Fed had more or less thrown out the monetarist playbook.

Yet the monetarist interval served a purpose: it gave the Fed a usefully euphemistic way to talk about its inflation-fighting strategy. Officials didn’t have to say, “We’re going to push the economy into a deep recession, and keep it there until inflation cries uncle.” Instead, they could talk in terms of M1 growth rates and credible long-run strategies and whatever, while in fact what they were basically doing was pushing the economy into a deep recession and keeping it there until inflation cried uncle.

Nominal GDP targeting is quite a lot like that. To be sure, NGDP is a much better target than M1, which (it turns out) is subject to wide swings in velocity. And the Fed’s goals, if frankly stated, wouldn’t be nearly as politically explosive as what it was doing in 1979-82. Still, NGDP is arguably mainly a relatively palatable way to state a strategy that’s ultimately about something else.

As I see it — and as I suspect many people at the Fed see it — the basic point is that to gain traction in a liquidity trap you must either engage in huge quantitative easing, raise the expected rate of inflation, or both. Yet saying this is very hard; people treat expansion of the Fed’s balance sheet as horrible money-printing, and as for the virtues of inflation, well, wear your body armor.

But say that we need to reverse the obvious shortfall in nominal GDP, and you’ve found a more acceptable way to justify huge quantitative easing and a de facto higher inflation target.

Don’t call it a deception, call it a communications strategy. And as I said, I’m for it.

Let me follow up a bit on the sudden discovery by Republicans that cuts in government spending cost jobs and drive up the unemployment rate – as long as the spending is on destruction rather than construction. Oh, and thanks to commenters for reminding me of Barney Frank’s coinage, “weaponized Keynesianism.”

The first thing to say is that liberals shouldn’t engage in mirror-image thinking, and imagine that spending we dislike somehow lacks the job-creating virtues of spending we like. Economics, as I say often, is not a morality play. As far as creating aggregate demand is concerned, spending is spending – public spending is as good as but also no better than private spending, spending on bombs is as good as spending on public parks. As I pointed out not long ago, a perceived threat of alien invasion, by getting us to spend on anti-invasion measures, would quickly restore full employment, even though the spending would be on totally useless object.

It’s also worth noting that one of the main sources of evidence that fiscal expansion really does stimulate the economy comes from tracking the effects of changes in defense spending. That’s true of Depression-era studies like Almunia et al, and also of several of the studies described in the Romer and Romer lecture on fiscal policy. Why the focus on defense? Two reasons, actually. One is that in practice defense spending is what moves: the fact is that large-scale stimulus programs consisting of domestic spending basically don’t happen, while wars and arms races do.

The other is that domestic spending tends to be endogenous, responding to events in the economy, so that cause and effect get blurred – spending on unemployment insurance generally soars during recessions, but the causation runs from recession to spending and not the other way around.

And the evidence clearly shows that weaponized Keynesianism works – which means that Keynesianism in general works.

So why do politicians and their hired economic propagandists say differently? On reflection, I think it’s a bit more complicated than I suggested in my previous post on this topic, because there’s a strong element of cynicism as well as genuine intellectual confusion.

What kind of cynicism am I talking about? First, there’s the general fear on the part of conservatives that if you admit that the government can do anything useful other than fighting wars, you open the door to do-gooding in general; that explains why conservatives have always seen Keynesianism as a dangerous leftist doctrine even though that makes no sense in terms of the theory’s actual content. On top of that there’s the Kalecki point that admitting that the government can create jobs undermines demands that policies be framed to cater to all-important business confidence.

That said, there’s also the Keynes/coalmines point: there’s a strong tendency to take any spending that looks like a business proposition – building bridges or tunnels, supporting solar energy or mass transit – and demanding that it appear to be a sound investment in terms of its financial return. This makes most such spending look bad, since almost by definition a depressed economy is one in which businesses aren’t seeing good reasons to invest. Defense gets exempted because nobody expects bombs to be a good business proposition.

The moral here should be that spending to promote employment in a depressed economy should not be viewed as something that has to generate a good financial return; in effect, most of the resources being used are in reality free.

I wonder if we’ll ever have a political system mature enough to understand this.

Kash Mansori is unhappy with the state of the Italian bond market just days after the supposed big rescue. Indeed, the Panzerfaust has fallen far short; Italy is having to roll over its debt at levels that are unsustainable, and the unraveling of the euro is definitely still on.

It’s still looking impossible to save this system without a drastic change in both the ECB’s actions and its philosophy. If that’s impossible, as so many people claim, the euro will be a failed experiment.