Thursday, August 12, 2010

The States Grow Restless as an Empire Wanes

There is a long tradition in the United States of dissent among the States toward the Federal Government. The battle between State and Federal power has been constant since the birth of the nation. In the decades since World War II, however, it is quite clear that the balance of power has shifted decisively toward the Federal Government.

Lately, I've theorized that the nation as a whole would do a lot better if each state had greater autonomy. Bigger states, smaller Federal Government. An immediate rebuttal is the "economy of scales" argument which would state that things could be done more efficiently at the Federal level and that, by empowering the Federal government, we could have a smaller governmental presence in the aggregate. The flip side to the efficiency argument is that empowering each State to a larger degree would create a very robust political structure that would be nearly impossible to sink by an outside influence. Assassinating the president is easy. Assassinating 50 governors who are widely distributed is nearly impossible.

To a large degree, redundancy is already present in our political structure. After all, we already have 50 governors. But the states themselves do not have as much power as the founding fathers intended. Instead, States find themselves beholden to the Federal Government for funds for schools and infrastructure. The reason behind this is the discrepancy in the tax base. In 2007, the Federal Government collected $2.674 Trillion in taxes while the states collected a comparatively paltry $800 Billion. The result? States find themselves gutted. The power may as well not even be there.

Why have distributed power? Simply put, we are a diverse nation with diverse problems and solutions to the same problem may not be the same across the country. In California there is a large consensus to legalize marijuana. In Utah... things are quite different to be polite. Standardized Federal Income tax brackets are a perfect example of "one size does not fit all." If you make $250,000 a year and live in Orlando your a wealthy person. If you make $250,000 a year and live in New York City you're middle class at best and you'd be lucky to have a Manhattan address. I could write for days about how an all powerful Federal Government is actually very inefficient.

The point of this post (as indicated in the title) is that the states aren't taking this lying down. In fact, there's a steadily growing list of them that, starting in 1994, are telling the Feds to piss off. The kicker is that they're justified in doing this under the tenth amendment to the constitution: 

"The powers not delegated to the United States by the Constitution, nor prohibited by it to the States, are reserved to the States respectively, or to the people."

Here's a list of the States invoking the 10th Amendment with links to their resolutions embedded:
-New Hampshire

(Edit: I'll fix those links in a couple of hours)

Thursday, June 24, 2010

European Debt Crisis: A Comprehensive Analysis


I have to confess that when I first heard of the European debt crisis I was overcome with joy. This was for three reasons. First, I demonstrated that the European Monetary Union was, collectively, in a much more precarious fiscal condition than the United States in a class I had at Rollins in the spring of 2009 where the teacher openly mocked me for suggesting that the EMU member states might experience a sovereign debt crisis. Second, the emergence of said crises was proof that the world was running out of things that could go wrong. Third, the European debt crisis was a perfect economics problem.

The European debt crisis is multifaceted. In order to understand it, one must take into consideration the structure of the monetary system, how money interacts with the real economy, and, of course, the political economy. We will begin with an overview of monetary theory, as I see it, an assessment of the “real” value of the Euro, and an overview of Central Bank models. This last point, it should be noted, is of critical importance to one trying to understand the European Debt Crisis. From there we will look at how money interacts with the real economy, the effects of fiscal policy, and the effects of inflation. We will then briefly cover Game Theory, as it is relevant to this study, and then perform an exhaustive overview of the political economy.

Money and the Economy

Fairness and the Balance Between Debtors and Creditors
There has been a great deal of economic research in recent years dedicated to the concept of “fairness” in economics. This research has taken on many forms, most notably focusing on the distribution of wealth and income. The broad consensus of this body of work is that inefficiency and other frictions often result out of a lack of fairness. These frictions manifest themselves as fraud or some other criminal activity. Why fairness is important to monetary policy is not immediately clear to most so I offer the following example.

Let’s say we live in an economy with a fixed money supply. We’ll say that the money is in the form of gold coins and that no additional gold is ever found and therefore no additional coins are ever minted. From here, let’s imagine two scenarios, one in which prices are fixed and barter is strictly prohibited, and one in which prices float and barter is strictly prohibited, called scenarios one and two respectively[1]. Now, let’s say that I’m a wealthy individual in the community with a large stock of gold coins and that you are a lowly farmer that grows carrots. The carrot business has been slow lately. It turns out that I’m the only one in the community that likes carrots but I’m not willing to pay your prices. So, the first year you grow your crop, I don’t buy it, and the crop ends up rotting away. The second year you grow your crop, again I don’t buy it, and the crop ends up rotting away. The third year you grow your crop, I don’t buy it, and the crop, again, ends up rotting away.

If we live in a world such as scenario one, you cannot sell your carrots because prices are fixed and you’re at the consumer’s (my) mercy. After three years I still have my gold coins but you don’t have your three crops of carrots. In fact, you have nothing to show for your work.  Not very fair, eh? If we live in a world such as scenario two, you’ll sell your carrots but it will be at a lower price than you want because I have the gold coins and I know that there won’t be any other coins minted that might compete for your carrots. Again, not very fair.

The problem, here, does not lie in the nature of the capitalist system, human greed, or the distribution of wealth. It’s in a poorly designed monetary system. The problem is that your carrots rot and my coins do not and this is a very big problem indeed and it also an excellent segway to the next discussion.

Entropy, Inflation, and “Real World” Finance
In the real world things break down: buildings crumble, cars rust, vegetables rot, and a plethora of other degenerate processes manifest themselves. This concept is formally elucidated by the second law of thermodynamics which states that the universe moves from a state of order to disorder in the aggregate, an idea commonly known as entropy. Something else happens in the real world, however. Certain processes produce returns in excess of their investment: seeds from a single plant are able to produce hundreds of plants, a lathe is able to produce several copies of itself before it itself wears out, and a rail-road can move the coal and steel to build itself thousands of times over before it itself wears out. The ability to survive and, indeed, thrive as a civilization depends on our ability to carry out the later processes at a faster rate than the former processes. To elaborate on this, consider that, in order to survive, we must grow more food than we consume when we plant and harvest said food. When we drill for oil the well must produce more oil than was used to build the derrick and the pipeline if we are to continue using cars, tractors, planes, and trains. This concept is known as EROEI (Energy Returned On Energy Invested) and is beyond the scope of this paper. The point of the preceding exercises is to see economic activity for what it is: real stuff.

Now, the tricky part. We have to “finance” real world stuff.

When we think of money we think of exchange rates, interest rates, money supply, money demand, velocity, political uncertainty, and every now and again some lunatic yells from the rooftops that our money is a sham and that only gold is “real money”. What we forget is that money is a marker for goods in the real world and nothing more. It is not money that makes you healthy, it is the food, medicine, and environment you experience over your lifetime. It is not money that makes you wealthy, it is the house you live in, the food you eat, and… the car you drive? The preceding points are up for philosophical debate but the point I’m trying to make is clear: money is worthless without real world goods. In the modern world, where we are highly specialized and separated by distances that were insurmountable to commerce only a few centuries ago, the opposite is also nearly true: without money real world goods are worthless. Now we’re starting to tread on the source of the problems that besiege the European Monetary Union.

Back to finance. We’ve come full circle and are back to the dilemma whereby your carrots rot and my money does not. How can we reconcile this to make things “fair”? In an ideal world money would carry a negative interest rate. It would literally “rot” over time. People would seek savings in producing assets such as real estate, solar panels, shares of a productive company, or something else along those lines. Currency would be issued as goods were produced and would correspondingly degrade with that good thus incentivizing people to spend their currency instead of accumulate it. Use it or lose it.

I’ve been considering such a currency system for a few years now but have made little head way. The variables surrounding such self-script issuance are mind numbing. So, it’s back to the real world of finance where paper currencies are fiat or “faith” based. How do we achieve a negative interest rate if the nominal value of our money never falls? Well, if we have constant output one way to achieve this by steadily increasing the money supply. Assuming that I rely on savings alone my money will decrease in value over time. This is the phenomenon known as inflation and, as we all know, it occurs in the real world. In the real world, real output generally increases, thus inflation can only occur if the money supply grows faster than real output.

There are, however, a cornucopia of problems with inflation in the real world. The most obvious problem is that of menu costs. There is a real cost to firms and individuals in changing and keeping track of prices. Another problem is that of hyperinflation. Higher prices beget higher prices in an unending and, at the aggregate level, irrational spiral. Hyperinflation is best exemplified by Germany after The Great War where prices doubled every two days at one point. The largest problem with inflation, however, has to do with employment and capacity utilization.

In introductory economics we are often told that there is a tradeoff between inflation and employment and that there is an equilibrium between the two called the “natural rate” of unemployment. The mechanism whereby low inflation creates unemployment is, usually, never explained. This is what we will now investigate but before I begin I want to share an interesting morsel of information I recently came across in a company’s earnings statement: the average employee at Sandisk, a maker of flash memory devices, produces an average of $1.2 million per year in revenue for the company and nearly $396,000 in profits. Astounding! Now let’s use Sandisk in an example that demonstrates how low inflation can create high unemployment and low capacity utilization (unemployed machines).

We’re going to change Sandisk’s numbers a little for convenience and easy math. We’ll say that the company is capable of producing one billion memory chips per year at full capacity and full employment. In order to do this, however, it needs financing to pay it’s employees, pay for materials, and pay for electricity. This all has to be done in advance so, once the company agrees to financing it is locked into repaying that amount. Further, we will say that the company operates FINISH THIS EXAMPLE DAMNIT ITS HARDER THAN I THOUGHT.

Calculating Currency Values
As a diversion, and to emphasize the importance of real economic activity, we will now try to estimate what the value of a Euro should be compared to the value of a dollar. One way to do this is to compare the average number of hours worked per person in the EMU to the number of hours worked per person in the United States and then compare these figures to velocity adjusted per capita money supply. The following tables summarize the data and the results:

GDP (Bil)
GDP Euro
GDP/Hour Euro
Total Hours(mil)

European Monetary Union
United States
Total Hours of Work
Hours of Work Per Capita
Money Supply
Money Supply VA
Money Supply Per Capita
Money Per Hour Work
True Exchange Rate
1.00 Euro
True Exchange Rate
0.61 Euro

The table above reads that the Dollar/Euro exchange rate should be $1.64 per Euro (it is currently $1.23).

My goal was to have an apples to apples comparison of the Euro and the Dollar based on the premise that an hour of work by an American produces the same real output as an hour of work done by someone living in the European Monetary Union. To adjust for the difference in population I did everything on a per capita basis. I began by summing up the GDP, Population, and GDP per hour of work in each of the countries in the European Monetary Union (Table 1). The GDP and GDP per hour of work numbers provided by the OECD were in dollar terms so my next step was to convert these to euro terms by dividing by 1.4709, which is what I determined the average euro/dollar exchange rate to be for 2008. Next, I assembled GDP, population, and GDP per hour of work in dollar terms for the United States. From there I calculated the total hours of work for each country by dividing GDP by GDP per hour of work. Then, I divided total hours of work by total population in each country to find hours of work per capita. Before I could compare currencies, I needed to find money supply per capita but before I could do that I needed to adjust money supply for velocity. I divided

A Note On Velocity
The velocity of money is the number of times a dollar (or any other currency) circulates through an economy. Imagine that you and I lived in our own tiny island economy. Let’s say that we use empty bottles for currency and that we have a total of ten of them. We’ll also say that the only transaction that ever occurs is that we “buy” firewood from one another. If I give you a bottle you have to go get me a cord of wood to burn for fire. If you give me a bottle, I have to go get you a cord of wood to burn for fire. Let’s say that I start out with all of the bottles and spend them. The next month you spend all of the bottles and so on throughout the rest of the year. At the end of the year, each one of the bottles will have changed hands, or been “spent”, twelve times. Thus, our velocity for the bottle supply would be twelve. Another way to derive this is from the gross domestic product of our island economy. We produced one hundred and twenty cords of wood and we know that each cord of wood is equal to one bottle in price and that we have a total of ten bottles. Thus, we could divide one hundred and twenty by ten and arrive at our velocity of 12. This is best summarized by the quantity theory of money elucidated by Milton Friedman: MV=PY, where m is money, v is velocity, p is real output, and y is the price level.

In the real world, velocity is dependent on a variety of factors. For example, the introduction of automatic teller machines increased the velocity of money greatly because it made it easier for people to get money out of their bank account. The introduction of the credit card also increased the velocity of money. An important determinant of velocity is the frequency of wage payments. An individual is more likely to spend their entire paycheck if they know that the next one is just a few days away. If their paycheck is several weeks away, however, they are more likely to be frugal. Of interest in the above table is the considerably low velocity in the European Monetary Union. Notice that it is half that of the United States. One could attribute this to a larger share of the population relying on transfer payments from the government which occur only monthly instead of weekly (this is just a theory, I have no research to back this idea).

Adjusting money supply for velocity takes a little bit of insight. Does one divide or multiply money supply by velocity in order to determine total money supply? The answer is that you divide because what you are ultimately after (especially in this exercise) is the variable P or the price level. In this particular study, we are after the price, in either euro or dollar terms, of an hour of labor.

Economic Feedback Loops
If we assume that the United States monetary system is “Goldilocks” (not too inflationary, not too deflationary, just right and there is no guarantee that this is the case) then we are left with a European Monetary Union that is inherently deflationary. Let’s consider the graphic below. The two circles represent, collectively, the entire economy of the EMU. The circle on the left is the private economy and the circle on the right is the public economy. The number on the circumference of each circle is the portion of the money supply associated with that sector of the economy. The number on the diameter of each circle is real output.
Example 1: private sector output, public sector output, and money supply is in stasis.
Example 2: a dynamic currency, private sector output rises, public sector output rises, money supply increases, everything is in stasis
Example 3: a static currency, private sector output rises, public sector output rises, money supply remains constant, deflation ensues
Example 4: a static currency with taxes to expand the public sector, assume sticky prices, public sector productivity expands, public sector money supply expands through taxation, private sector output remains constant in phase 1 but money supply contracts. In phase 2 private sector output falls (from a lack of money and due to sticky prices) necessitating higher taxes to maintain the public sector which reduces the money supply in phase 3 which further reduces private sector productivity in phase 4
Example 4 alternate:  a static currency with borrowing to expand the public sector, assume sticky prices, public sector productivity expands, public sector money supply expands through borrowing, private sector production and money supply remains constant. In period 2, the need to borrow more to expand the public sector raises causes higher interest rates which necessitates taxation which shrink private sector money supply. This leads to lower private production in period 3 which leads to higher taxes in period 4 and so on ad infinitum.

Whatever the root cause (mal-investment, abusive taxation, innocent victim, whatever), European Monetary Union governments are in quite a predicament. No matter what they do the result will be lower GDP and the need for higher taxes in the next period. The end game, short of large direct investment from another county, is obviously default for all of the governments in the Union that do not have net savings (which is everyone but Germany). So what is a politician to do? This brings us to the political economy.

Political Economy and Game Theory

Before we look at politics in the EMU, first let’s look at the framework we’ll use to analyze them. From Wikipedia:

Two suspects are arrested by the police. The police have insufficient evidence for a conviction, and, having separated both prisoners, visit each of them to offer the same deal. If one testifies (defects from the other) for the prosecution against the other and the other remains silent (cooperates with the other), the betrayer goes free and the silent accomplice receives the full 10-year sentence. If both remain silent, both prisoners are sentenced to only six months in jail for a minor charge. If each betrays the other, each receives a five-year sentence. Each prisoner must choose to betray the other or to remain silent. Each one is assured that the other would not know about the betrayal before the end of the investigation. How should the prisoners act?

In this game, regardless of what the opponent chooses, each player always receives a higher payoff (lesser sentence) by betraying; that is to say that betraying is the strictly dominant strategy. For instance, Prisoner A can accurately say, "No matter what Prisoner B does, I personally am better off betraying than staying silent. Therefore, for my own sake, I should betray." However, if the other player acts similarly, then they both betray and both get a lower payoff than they would get by staying silent. Rational self-interested decisions result in each prisoner being worse off than if each chose to lessen the sentence of the accomplice at the cost of staying a little longer in jail himself (hence the seeming dilemma). In game theory, this demonstrates very elegantly that in a non-zero-sum game Nash Equilibrium need not be a Pareto optimum.

Now that that’s out of the way, let’s look at and model likely political outcomes.

The majority of political power in Austria is vested in a two-house national council (the national council and the federal council) which is elected every two years. The national council is dominated by the Austrian People’s Party and the Freedom Party of Austria which collectively control 55% of the votes and have been the dominant . Both of these parties have similar goals with respect to the EU and EMU:
·      No accession of Turkey into the European Union
·      No intrusion of EU policy in Austria
·      No increase in the Austrian contribution to the EU
One could deduce that Austria would prefer monetary and economic autonomy according to voter sentiment. Also, one could deduce that it would not be in the interest of either the Austrian People’s party or the Freedom Party of Austria to bail out other EMU members. Of note is the fact that Austria has a direct democracy. A great deal of legislation is started by popular initiatives whereby a petition is signed by at least 100,000 voters. The elections are held every two years and the last election was held in 2008.

The structure of political power in Belgium is very complex but I will try to distill it as much as possible. In the case of international relations, the Senate and Chamber of Representatives have equal power. This power, however, is not absolute. Executive power is held by the council of ministers, which has veto power over both the Senate and the Chamber. Elections are held every four years. The last election was held in 2007.

Three political parties dominate Belgium politics. These are the Christian Democratic and Flemish Alliance, the Reformist Movement, and the Flemish Interest. The Christian Democratic and Flemish Alliance is the oldest of these parties and has strong ties to labor unions and to the Farmers’ League (also a union). The Reformist Movement is actually a composite of three small liberal parties that traditionally follow the ideals of liberalism and free market economics. The Vlaams Belang is a political party that advocates the independence of Flanders. They seek strict immigration and cultural controls.

The government of Cyprus is a presidential representative democratic republic. The president is both the head of state and the head of government. Legislative power is vested in the House of Representatives. Presidential elections are held every five years. The last election was in 2008. The current president, Dimitris Christofias, ran on a communist platform in 2008.

The House of Representatives is elected every five years and was last elected in 2006. This is an election year. The dominant parties in the last election were the Progressive Party of Working People and the Democratic Rally. The Progressive Party of Working People ran on a communist platform and widely proclaims itself as a communist party. It has always favored Cyprus’ entrance into the EU and EMU. As an interesting note, a communist party in neighboring Greece, KKE, strongly rejected entrance into the EU and EMU saying that it supported American and British interests. In contrast, the Democratic Rally is far more conservative and supports liberal economic policies.

Political power in Finland is vested in the President, who holds executive power, and in Parliament, which holds legislative power. The current president, Tarja Halonen, was elected in 2006 and is associated with the Social Democratic Party. Elections are every six years. The parliament is dominated by the Centre Party, the National Coalition Party, and the Social Democratic Party. The Social Democratic policy advocates, as it’s name implies, social democracy. It traditionally has strong ties to labor unions. The National Coalition Party takes a liberal conservative stance: they seek minimal government intervention in the markets, free trade agreements, and the like. They have been strong proponents of the EU and EMU agreements. The Centre Party caters primarily to rural interests and has strong ties to agriculture. Their primary goal is to transfer power back to municipalities from the central government, though it was in favor of the EU and EMU agreements.

Political power in France, as far as foreign policy and economic policy is concerned, is vested in the Prime Minister, the Senate, and the National Assembly. The current Prime Minister, Francois Fillon, was first elected in 2007 and is due for re-election again in 2011. Fillon is a member of the Union for a Popular Movement which espouses liberal trade policies. The Senate, which faces elections every four years and was last elected in 2008, is dominated by the Union for a Popular Movement and the Socialist Party. The Socialist Party takes a pro-labor stance but is not opposed to trade liberalization. The National Assembly is utterly dominated by Union for a Popular Movement.

The German government is a representative democracy with power vested in the Chancelor, the Bundestag (the equivalent of a Senate) and the Bundesrat (the equivalent of the House). The current Chancelor, Angela Merkel, was elected in 2005 and is up for re-election this year. She is associated with the Christian Democratic Union whose ideology is that of trade liberalization and European Integration. Accordingly, it is a strong proponent of the EU and EMU. The Bundestag, which faces elections every four years and was last elected in 2009, is dominated by the Christian Democratic Union and the Social Democratic Party of Germany. The primary goals of the Social Democratic Party of Germany are a social market economy, however, they are advocates of trade liberalization and European integration. The Bundesrat, which does not face elections but instead is made up of members nominated by state elections, is dominated by the Christian Democratic Union and the Free Democratic Party. The Free Democratic Party is strongly in favor of trade liberalism and European integration.

Political power in Greece is largely vested in the Prime Minister of Greece and the Hellenic Parliament. The current Prime Minister, George Papandreou, was elected in 2009 and is not up for re-election again until 2013. He is the leader of the Panhellenic Socialist Movement which has generally been a pro-labor party. This is in contrast to Kostas Karamanlis, Papandreou’s predecessor, who was the leader of the New Democracy Party, which was pro-capital and pro-trade liberalization. The Hellenic Parliament, which was elected in 2009 and face election again in 2013, is dominated by members of the Panhellenic Socialist Movement and members of the New Democracy party.

The politics of the Republic of Ireland are dominated by Guinness draft beer. Just kidding. That was just a test to see if anyone had ever read this far. The politics of Ireland are complicated to say the least but a brief summary ensues. The majority of the political power is vested in the Oireachtas (the equivalent of U.S. Congress) which faces staggered elections. Currently, the Oireachtas is dominated by the parties Fianna Fail and Fine Gael. Fianna Fail adheres to the ideas of conservative government and trade liberalization. Fine Gael follows similar economic views.

Italy is theoretically a democratic republic, but, in reality, it is more of an elected monarchy. The President of the Council, also known as the “Premier” exercises the majority of political power. The current president, Silvio Berlusconi, is also one of the wealthiest men in Italy if not in Europe. His economic policies have been largely pro-capital and he was the driving force behind Italy’s entrance into the EU and EMU.

Political power in Luxemborg is vested in the Prime Minister and the Chamber of Deputies. The Prime Minister is subject to election every five years. The current Prime Minister, Jean-Claude Juncker, faces election again in 2014. Juncker is a member of the Christian Social People’s Party which takes a strong stance of pro-European integration and pro-trade liberalization. The Chamber of Deputies, which faces elections again in 2014, is dominated by the Christian Social People’s Party and the Luxembourg Socialist Worker’s Party (LSAP). The LSAP has strong ties to labor unions and was generally against Luxembourg’s entrance into the European Union.

Political power in Malta is concentrated in the Prime Minister of Malta and Parliament. The current Prime Minister, Lawrence Gonzi, was elected in 2004 and faces election again this year. Gonzi is a member of the Nationalist Party which takes a stance of pro-European integration and pro-trade liberalization. Parliament is dominated by the Nationalist Party and the Malta Labour Party, which is pro-labor and has generally opposed European integration and trade liberalization.

Political power in the Netherlands is concentrated in the Dutch Monarchy and the Cabinet of Ministers. The Cabinet of Ministers is currently dominated by the Christian Democratic Appeal and the Labor Party. The Christian Democratic Appeal favors liberal government and has generally been in favor of European Integration and the EMU. The Labor Party, which was founded on the ideal of creating a welfare state, has generally been opposed to European Integration.

Political power in Portugal is concentrated in the Prime Minister and the Assembly of the Republic. The current Prime Minister, Jose Socrates, was elected in 2009 and does not face election again until 2013. Socrates is a member of the Socialist Party which has generally favored European integration. The Assembly of the Republic is dominated by the Socialist Party and the Social Democratic Party. The Social Democratic Party takes a conservative view on government though it has favored European integration.

Political power in Slovakia is primarily vested in Parliament and the Prime Minister. The current Prime Minister, Robert Fico, has been in office since 2006 and is up for election again this year. He is a member of the party Direction-Social Democracy which advocates a socialist state with strong government. Parliament is dominated by Direction-Social Democracy and the Slovak Democratic and Christian Union. The Slovak Democratic and Christian Union generally favors conservative government and trade liberalization.

Political power in Slovenia is concentrated in the National Assembly and the Prime Minister. The current Prime Minister, Borut Pahor, has been in office since 2008 and face election again in 2012. He is a member of the Social Democrats of Slovenia which has strong ties to labor. The National Assembly is dominated by the Slovenian Democratic Party and Liberal Democracy of Slovenia. Both of these political parties are generally in favor of economic and trade liberalism.

Spain is still a Monarchy but a large portion of power is vested in the Prime Minister who is an elected official. The current Prime Minister, Jose Luis Zapatero, is a member of the Spanish Socialist Worker’s party which strives to achieve socialism and has strong ties to labor. The SSW was generally against Spain’s entry into the European Union and is still against further trade liberalization.

In short, the majority of political parties that were in power during the creation of the European Monetary Union still are in power and thus they need to either rectify the problem or face a fall from grace. Re-trenching and backing out of the EMU, by and large, is not an option for those that are currently in power. In the short term (1-2 years) is that the EMU will remain intact. However, in the medium term, as economic conditions worsen and the election cycle comes about, new politicians may be tempted to take bold action in order to sieze power and, accordingly, withdraw their respective countries from the EMU.

Take Away
Of the many possible outcomes of the European Debt Crisis, one option I do not foresee happening is the Federalization of the European Union. Europe is the world’s cornucopia of political and cultural variety. Even within small countries there is an enormous amount of variety accompanied with constant struggle and conflict among competing interests. A counter argument to this point is that the United States was once in a similar position but there is a fundamental difference: the Federal Government in the U.S. was established a mere four years after a harrowing revolutionary war. Wars are often unifying as they allow an otherwise fragmented people to define themselves by saying “we are not them (the enemy).” The modern record demonstrates this repeatedly: warring fractions in Somalia unified their focus on the Americans and separate religious sects in Iraq unified themselves against the American occupational force.

There is a possible solution to this mess, however, a sword which the ECB could use to discipline EMU member countries: deposit insurance.

The ECB does not currently run a deposit insurance program like the FDIC in the United States. Instead, it simply has a by-law that says that EMU member countries must offer at least 20,000 Euros in deposit insurance but this is ridiculous in my opinion as such insurance depends on the solvency of the country unlike the United States, which can print its own money and therefore has no credit risk.

ECB run deposit insurance could work like this: banks that wish to apply for deposit insurance must open up their trading books, regularly, to the ECB. If a commercial bank buys the bonds of an EMU member country for its own account (not a client’s account which represents the client’s capital) that is running an unsustainable deficit (a deficit that is larger than trend growth, about 3%) then the ECB would cancel that bank’s deposit insurance. This is a significant dis-incentive for a bank as it would cause depositors to flee to a safer institution possibly causing a run on the bank, a risk no large bank would want to take. Thus, the ECB could passively force governments to spend within their means which resolves the primary criticism of the EMU: fiscal autonomy without monetary autonomy.

[1] The assumption of fixed prices is valid when modeling the macro economy because the empirical record shows that nominal prices have very little downward flexibility and a great deal of upward flexibility. The assumption of illicit barter is also valid because of the fact that it represent such a small portion of our economy and because it could not, in its current form, support a modern specialized and de-centralized economy.