Why we (still) need Cramdown

Recently, I ran into Phillip Swagel's account of his time in the Treasury during the worst days of 2007-2008. While I think many people glazed over the lengthy section on homeowner assistance, I think this portion unwittingly provides an excellent overview of why some sort of cramdown legislation (ie, allowing bankruptcy courts to write down principal due on a mortgage) makes a lot of sense, and why past attempts to resolve the housing crisis through servicer-started modifications haven't been enough. I say "unwittingly" because Swagel was, in fact, opposed to cramdown.

Some background: as Michael Konczal, Yves Smith, and others have emphasized: every foreclosure represents a missed opportunity to renegotiate debt with a borrower. I think this is a bit overstated -- some people really are in the wrong house, not the wrong mortgage. Some foreclosures are inevitable, and the historical record on this issue is difficult to interpret. But certainly the number of forced sales represents a huge market failure. Banks and borrowers alike would be both better off if more housing principal was written down though some sort of modification.

Not Enough Mods

The first problem is that servicers aren't doing enough modifications, which involve both what I'll call "informational" problems as well as other "institutional" problems. The informational problems center around the difficulties in identifying troubled borrowers and extending them modifications. One way to solve this problem would be to extend an automatic modification to all borrowers who are behind on their payments. As we (may) have found out in response to Countrywide's announced modification strategy (which limited eligibility to such delinquent borrowers), this could be a recipe to encourage others to miss payments as well to qualify. There are some people who recover from delinquency to making payments on their own, and a mass-modification approach would write down their mortgages too.

So servicers, in general, adopt their own screening processes for dealing with modification requests. The problem here is that the scale of the problem has overwhelmed every existing servicer. In the past few years, servicers have grown rapidly on the assumption that the business is prone to economies of scale -- that larger companies are more profitable. This is true if every borrower makes their payment, in which case the servicer does little other than forward payments. But in bad times, servicing transforms into a business that requires a great deal of case-by-case dealing with individual borrowers (Amar Bhide style). It's simply difficult to scale up operations to deal with the scale of housing problems and hire the necessary loan officers. So you end up with a world in which the vast majority of delinquent borrowers fail to receive a modification after several months-- something like 90% by one estimate.

Aside from the various difficulties that individual servicers and banks have with sorting and dealing with delinquent borrowers; there is broader "social fairness" point. The issue is to what degree public money ought to be directed towards indignent borrowers who fail to make payments on enormous McMansions. Remember that the infamous rant on the trading desks that started the whole Tea Party idea was primarily about venting against such borrowers receiving too much assistance. These concerns seem to have played a large role, according to Swagel, in limiting government involvement.

Then; there are the institutional problems, as Swagel lists in exhaustive detail. Second-liens attached to properties have the power to hold up a modification on the first mortgage; as they view the resulting higher cash flows as going primarily to the holder of the first mortgage. Securitized mortgages in general face institutional problems in providing for sufficient modifications, as the servicers on loans that were packaged and sliced are rarely properly compensated for bothering to modify a loan. Even among "portfolio" loans held by banks; banks are reluctant to realize capital losses on mortgages by writing down the principal. Finally -- there are broader social external consequences of foreclosure that banks don't take into account -- like the effects on nearby housing prices, and municipal revenues -- that mean we probably need more modifications than banks would prefer. It appears that Treasury has known much of this for quite some time.

Mods of the Wrong Type

Aside from extending too few modifications, servicers and banks are also extending modifications of the wrong type. Driven by the pressure to meet the demands of bondholders (in the case of securitized mortgages), or avoid realizing capital losses (in the case of portfolio loans and those held by Fannie/Freddie); private modification efforts have often worked by lowering the interest rate faced by the borrower; while in many cases extending the length of the loan. The principal on the loan then frequently does not change; this means that the economic value of the mortgage remains the same. If that property was underwater -- the mortgage worth less than value of the property -- this doesn't help at all.

Modifications, too often, only targeted the "front-end" debt-to-income ratio. That is, mortgages were only restructured so as to allow homeowners to pay at most about a third of their income on their mortgage. However, this ignores the various other debt commitments borrowers face -- like credit card and auto debt -- which are frequently binding constraints. While computing modifications on a front-end basis is a lot easier, it also leaves many homeowners with more debt commitments than cash flow.

It's easy to say "this is all obvious now"; but I think you could have said the same even before the crisis. Without really changing the structure of a mortgage by writing down its principal, you don't change the economic decision available to consumers.

Crucially, according to Swagel's account, all of these bad characteristics (which were initially the product of constraints faced by private subprime servicers) became written into government policy through the IndyMac modification effort (overseen by the FDIC) and HAMP.

Cramdown

Cramdown actually solves all of these problems. Rather than requiring banks to sort through millions of modification requests, bankruptcy puts the onus on borrowers and bankruptcy trustees. The homeowner actually needs to go ahead and file, which -- given the massive stigma and damage to credit that results -- represents a huge deterrent to casual filers. Upon filing for a Chapter 13 plan; borrowers' mortgage debt (along with all of their other debt) is instantly written down to a perhaps sustainable level, with little fuss. Bankruptcy can't do many things; but it is very good at filtering between types of borrowers. All the reasons why we have wimpy and too few modifications immediately vanish. Plus -- by granting homeowners a powerful stick -- servicers may be more aggressive in modifying on their own.

It also solves the "indigent borrower" issue. While many people are upset about government-sponsored HAMP efforts, many people at least see bankruptcy as characteristic of America's failure-tolerant culture. The costs of bankruptcy are principally borne by the borrower; not by taxpayers.

After outlining the various reasons that existing modification policy failed; Swagel provides an entirely unconvincing argument for why Treasury fought hard to avoid cramdown legislation (which did in fact pass the House): it would have drained "private capital" from the housing market.

The fairest way to interpret this statement is that Treasury at the time was concerned about maintaining supply and demand in the housing market. While cramdown would have reduced the flow of distressed properties hitting the market (by putting those borrowers in bankruptcy, and allowing them to meet smaller monthly payments); it may have also reduced the capital available for new borrowers. The net effect, in a given moment, is hard to figure out; but clearly Treasury was worried that it may force prices to go down even further.

But this is a very short-term assessment, a trend that seems to be inevitable during the course of a crisis. Sure, we have have temporarily lowered the flow of new buyers. But the long-term impact of fewer distressed properties hitting the market would have been massive. At what point should Treasury deal with the short-term pain to secure a huge long-term benefit? Also, as has been the case for quite some time, there is virtually no private money in the mortgage market. Virtually all mortgage originations are financed by the government, through Fannie/Freddie/FHA. Having less private capital flow into the mortgage market would be basically costless right now.

This other problem with this argument is that it completely fails to evaluate the costs and benefits of more private capital, instead seeing that as some sort of ultimate good (much like "liquidity" is often treated). Personally, I think higher capital costs for high-risk borrowers (resulting in smaller houses and more renting) would be phenomenal. We could even design cramdown to avoid impacts on future crises -- for instance, by making it retroactive only. Swagel might complain that this still signals to lenders that our approach to contracts has gotten more flexible. This may be the case, but that really seems a second-order consideration for (hypothetical) future private lenders.

Also, what's the alternative? Instead of cramdown, we got a horrible 50 billion dollar modification plan (HAMP) that has perpetuated all of the bad practices of previous subprime modification efforts. Suppose we think of cramdown as some sort of "tax" on all people with bad credit to benefit some homeowners who file for bankruptcy, paid for out of the higher cost of privately provided credit. By what logic is that better than an actual, massive, tax that redistributes income from renters to homeowners in a massively inefficient manner? Swagel might argue that he didn't institute HAMP. But as he argues elsewhere, there is a natural continuity between the Bush and Obama Administrations on housing policy. And the Bush Treasury's failure to properly put in modifications led directly to the Obama's Administration's push on this issue.

The last argument Swagel gives is that cramdown would revive the 2005 bankruptcy legislation. Personally, I see that as a good thing; given that I view that legislation as the source of all current evils (for instance, see this Michelle White paper on how making bankruptcy harder encouraged the foreclosure crisis). But then, as with so much of Swagel's account, this debate turns into unverifiable accounts on political possibilities. Well, the reality is that the House passed cramdown legislation without broader implications. Perhaps the Senate could have as well, if Treasury and other stakeholders were as committed to the idea as they were to HAMP and other abominations.

I can't guarantee that cramdown would have "worked." But I can guarantee that it would have allowed as many people that tried to qualify for HAMP a better way to afford their mortgage, without costing taxpayers 50 billion dollars. A lot of the criticism and commentary over the Treasury has focused on their high profile decisions to bail/not bail out Lehman, AIG, etc. But I hope more people look at their approach to homeowner assistance, and their decision on cramdown in particular.

Quantitative Easing

To clear up the debate over quantitative easing, there are only three relevant questions: (1) Should the Fed ease ever? (2) Should the Fed ease now? and (3) Is 'Quantitative Easing' the right strategy? If you disagree with the Fed about QEII, you have to say no to one or more of those questions.

Should the Fed Ease Ever?

This is a surprising one. If you would have talked to me a few years ago, I would have said that there is a widespread consensus around the idea that the Fed should loosen policy to make recessions easier (and ideally tighten in good times).

Yet now there has been an outpouring of anger at this idea -- led by intellectuals of many stripes, but politically primarily by Republicans. The concern is that "printing money" is not sufficient to handle "primarily structural" problems in the economy. The underlying idea here is that purely nominal changes reflecting the money supply can't have an effect on the real economy (according to Paul Ryan, they never have).

The other critique, bizarrely, enough, is that the Fed eased too much during the boom years, generating a "bubble," and more easing now might lead to runaway inflation. Sometimes, you hear both concerns from the same people. But let me focus first on the idea that monetary policy can't do anything.

As Christina Romer (former CEA Chair) has pointed out, the entire recovery the US had from the Great Depression can be accounted for by monetary stimulus -- in particular, the decision to get off the Gold Standard (which removed a huge constraint on how much money we could print). Vockler generated a huge recovery in 1983 by loosening policy. And as recently as 2000-01, the Fed’s easing prevented what were actually quite enormous real economic losses (comparable to subprime losses) from turning into worse outcomes.

The theory of how this happens has been explained by Milton Friedman, among others. Paul Krugman has a particularly good explanation of this using a parable of the baby co-op, that I'll provide a lengthy excerpt from:

A group of people (in this case about 150 young couples with congressional connections) agrees to baby-sit for one another, obviating the need for cash payments to adolescents. It's a mutually beneficial arrangement: A couple that already has children around may find that watching another couple's kids for an evening is not that much of an additional burden, certainly compared with the benefit of receiving the same service some other evening. But there must be a system for making sure each couple does its fair share.

The Capitol Hill co-op adopted one fairly natural solution. It issued scrip--pieces of paper equivalent to one hour of baby-sitting time. Baby sitters would receive the appropriate number of coupons directly from the baby sittees. This made the system self-enforcing: Over time, each couple would automatically do as much baby-sitting as it received in return. As long as the people were reliable--and these young professionals certainly were--what could go wrong?…

Now what happened in the Sweeneys' co-op was that, for co

mplicated reasons involving the collection and use of dues (paid in scrip), the number of coupons in circulation became quite low. As a result, most couples were anxious to add to their reserves by baby-sitting, reluctant to run them down by going out. But one couple's decision to go out was another's chance to baby-sit; so it became difficult to earn coupons. Knowing this, couples became even more reluctant to use their reserves except on special occasions, reducing baby-sitting opportunities still further.

In short, the co-op had fallen into a recession.

Since most of the co-op's members were lawyers, it was difficult to con

vince them the problem was monetary. They tried to legislate recovery--passing a rule requiring each couple to go out at least twice a month. But eventually the economists prevailed. More coupons were issued, couples became more willing to go out, opportunities to baby-sit multiplied, and everyone was happy….

Above all, the story of the co-op tells you that economic slumps are not punishments for our sins, pains that we are fated to suffer. The Capitol Hill co-op did not get into trouble because its members were bad, inefficient baby sitters; its troubles did not reveal the fundamental flaws of "Capitol Hill values" or "crony baby-sittingism." It had a technical problem--too many people chasing too little scrip--which could be, and was, solved with a little clear thinking.

Sometimes, your problems really are just monetary. When the demand for holding money shoots up, and we don’t respond by increasing the supply (we refuse to "debase our currency"); people start to hoard cash, and we get a recession.

But even if you don't buy that logic; clearly we can't go on with the same money stock that existed, say, in 1913. We need more money from time to time, and that happens through two channels -- (1) banks can do more lending, resulting in more privately generated money, or (2) the Fed can exchange bonds held by banks for cash, in effect giving banks a "licence" to print more money. In our system, the actual process of money generation actually happens through banks, but the government has a key role through monetary operations that allow or cancel what are in effect "money printing licences."

Again -- there really shouldn't be any debate over this. We need to print money from time to time. This is especially important when there is an excess demand for money -- at which point purely nominal changes can result in actual, large-scale effects in the economy. Room for reasonable debate starts at:

Should the Fed ease Now?

We have various statistics on governing monetary aggregates and indicators. Most of them suggest that money growth is below trend:

M2 is a basic standard of "money;" the one preferred by Milton Friedman. Here, you can see that growth in M2 is below recent trends:


M3 is another measure, that incorporates broader monetary items. According to Gary Gorton, it's a better measure of money in the modern world, where financial instruments -- like repos or Treasuries -- serve as money in financial markets. That's actually declining.

Then there is inflation. The most recent data show that “core” inflation is weighing in at .6%. If you were to better impute ongoing house price declines (or hedonistic quality improvements), that would be even lower. (It would be higher if you counted some commodities. But the price growth in those items is driven primarily by strong demand from emerging countries, not from monetary expansion in the US.)

Of course, low current inflation may be a temporary sideshow. Inflation could jump up in the future, as people have argued for several years now. But instead of relying on unfalsifiable fears or concerns -- I prefer to look at the markets. What do markets think about future inflation? The Cleveland Fed has the best figures; that show inflation expectations are low and falling:


So, by every possible measure, the money supply is low and trending lower. It’s projecting to be low in the future as well. If you think that money growth should be a little counter-cyclical to meet greater money demand, it's too low by far. Even if you think that the Fed should only have an inflation target around 2% — money supply is too low.

As you have probably heard, Japan spent a lost decade (really, now 18 years) going through a deflationary period enduring all sorts of economic pain. Here’s America relative to Japan on that path:


Deflation, in general, isn't necessarily a bad thing. America went through deflationary trends in the 1860s-1870s and the 1920s but did just fine. When deflation is driven by supply-side technological improvements that reduce secular prices, the Fed does not need to deliver inflation (arguably, this was the case in the 2000s; when trade and technology may have reduced prices on their own; and Fed intervention just led to a "housing bubble."). Deflation is a bigger problem when it’s driven by shortfalls in demand; and gets you a world like the baby co-op where all members are afraid to run down babysitting script for fear that they would be unable to pick one up later.

Deflation during times of economic stagnation is nothing short of catastrophic. The Japanese have been unable to generate enduring economic growth for, again, close to two decades now. High inflation is easy enough to end with central bank that cares about the issue -- but deflation on Japanese lines is near impossible to cure. In my view, the massive costs of persisting in a Japan-like ditch are sufficiently large (and the odds that it will happen are high enough); suggesting that we should be prepared to pay a high premium for an insurance policy against such an outcome. Fortunately for us, this is really a negative premium considering the benefits that inflation closer to target would have for us today.

If anything, our experience would be worse than Japan’s. As Michael Pettis points out, Japan had the fortunate chance of dealing with economic stagnation by undergoing domestic rebalancing. Though economic growth was slow, households earned a steadily larger share of the pie. America doesn’t have that option, given how large household consumption already is. American households in a deflationary environment would likely be hit by a double-whammy — as growth stagnated, households would readjust their consumption share downwards as they started to save.

If the costs of low inflation are high, the costs of dealing with high inflation are manageable. As Scott Sumner has argued; the Fed has many more tools to combat inflation that in the 1970s. Futures markets indicate market expectations about future inflation, ensuring that the Fed won't be caught off guard by unexpected rises in inflation. Plus, with economic slack and underutilized labor and equipment, rises in nominal spending would presumably manifest in the form of greater utilization, rather than higher prices. This allows the Fed a greater degree of cushion in setting policy.

The Fed also has a new tool — it’s policy of paying interest rates on bank excess reserves. Banks now have the option of holding extra money at the Fed and earn interest, instead of extending loans in the real economy or buying bonds. The Fed’s decision to undertake this policy explains in part why the traditional monetarist fears about a larger monetary base generating inflation haven’t panned out. The Fed’s (brand new) policy has short-circuited the normal process of money creation. The upside is that future increases in inflation will be easily curbed by the Fed if it is willing to use this tool.

Finally, there's the fact that while higher inflation is hardly a cure-all, the costs of having unprecdentedly low inflation right now make solving nearly every other problem in the economy much harder. It’s harder to rebalance global consumption (more savings in the US, more consumption elsewhere) while the dollar is strong. It’s harder to dig out of a housing debt overhang when inflation is lower than home buyers anticipated when they drew up contracts. It’s harder to deal with government debt if the Fed isn’t purchasing that debt. All of these are “real” economic problems, but they’re impossible to manage in the presence of deflation, and difficult enough when inflation is as low as it is.

While easing may generate the "risk" of inflation, it's worth considering what that means. There's no good economic evidence that inflation has any bad consequences until it hits the double digits. India, for instance, is managing 8% economic growth just fine even as inflation nears 10%. Inflation was around 4% when Vockler declared a victory against high inflation (subsequently, he was attacked by Republican officeholders for letting inflation fall below that — how times have changed).

Why QE?

To sum up; we have a deflationary environment; the Fed has ample tools to attack inflation in the future, and it has in effect a "magic ball" that allows it to anticipate changes in inflation before they happen. On top of that, higher inflation would, if anything, be good; while the costs of extended deflation could be quite bad.

The only reason to have a debate about this at all is that the traditional tool of monetary policy — the Fed purchasing short-term Treasury debt in exchange for money — has run out. With short-term interest rates near zero, banks simply take the money from any Fed asset purchases and send it right back to the Fed to earn comparable interest rates as excess reserves. Short-term asset purchases now simply change one low-interest bearing government asset for another.

But suppose, as Rortybomb and others have suggested, that we simply find that we are mistaken about interest rates, and the Fed actually could ease a little more through the conventional route. It’s tough to imagine that anyone would actually then oppose further easing. After all, the Fed bought a great deal of government bonds (lowered interest rates) in 2007-2008; a period of time during which growth was higher than now, inflation was higher, and growth in monetary aggregates was also higher. No one complained about debasing the currency then.

The entire debate thus revolves around the fact that the Fed, in trying to ease while short-term interest rates are zero, is going to purchase government bonds of slightly longer duration (quantitative easing). That's the only difference. You can call this an "unprecedented" or "risky" strategy if you like, but really it’s virtually identical to the policy we would all like to do if short-term interest rates were a few points higher.

There is one and only one new concern that QE raises, as Greg Mankiw points out:

If future events require higher interest rates, the Fed will end up making losses on its portfolio. And even if doesn't recognize these losses (by not marking to market), it could end up paying more interest on newly expanded reserves than it is earning on its newly acquired portfolio of long bonds. Such a cash-flow deficit could potentially undermine the Fed's political independence (which is already not very popular in some circles). Yet if the Fed tries to avoid these losses by failing to raise rates when needed, inflation could indeed become a problem down the road.

The issue is that, if higher inflation hits, the Fed will be forced to deal with that. If it contracts by selling the same long-term bonds it purchases today, it may be forced to realize a nominal loss. But losses from central banks are a little odd to think about. The Fed practically has a license to print money. It’s normal activities also generally produce a sizable surplus, which typically goes to the Treasury (but a greater proportion of which could stay with the Fed to counter realized losses). Bernanke considered this issue extensively in his speech to the Bank of Japan (in which he urged the adoption of various tactics to deal with Japan’s deflation and zero-rate problem), suggesting that:

In short, one could make an economic case that the balance sheet of the central bank should be of marginal relevance at best to the determination of monetary policy.

He also suggested a bond conversion (or interest-swap) proposal between the Bank of Japan and the Ministry of Finance (here, the Fed and the Treasury) that would protect the Bank of Japan (Fed) from any subsequent interest rate changes. This would, in effect, reduce the scary-sounding “quantitative easing” to normal monetary policy — on which there should exist broad consensus that we need to ease.

So, again, that's the only real "risk" that QE induces -- the risk that inflation will somehow jump up dramatically (even though money growth is trailing GDP, and markets don't expect it), that the Fed burns through trillions of dollars of short-term bonds in responding to that (bearing minimal losses); and that the Fed then somehow takes minor nominal losses on their long-term bond purchases. And we even have solutions to that if we can get the proper coordination between the Treasury and the Fed (bond conversion or the Fed keeping more of the money they make). When balanced against the risk of letting inflation expectations de-anchor from historical norms and lead to a deflationary spiral, I think that's a pretty fair tradeoff. Certainly I don't think this risk in any way justifies the sort of vituperative rage that has been directed against the Fed.

Plus, I don't think QE skeptics have fully thought through their position. It is entirely resonable, in my view, to suggest that the zero-rate bound should represent a real constraint on the actions of the Fed -- that the Fed should simply not purchase any long-duration assets. So if short-term interest rates are zero; tough luck.

But if you really believe that, the resulting low inflation means low (nominal) interest rates, which means that the Fed will run out of its traditional ammo and hit the zero-rate bound again and again, and be left paralyzed. This means that we really need insurance against hitting this bound, in the form of higher inflation that results in higher nominal interest rates.
Put differently -- if you want low inflation (ie, 2%); you also need to give the Fed the tools it needs to conduct monetary policy when interest rates hit zero, as they will frequently with inflation that low. Just complaining about printing money isn’t an option — everybody needs to believe in easing now (if you don’t think the zero-rate bound is a real barrier), or easing later (to generate higher long-term inflation).

The criticisms I take more seriously argue that QE will do little. I think the market responses to the anticipation and announcement of QE2 demonstrate that it can do some good; but I also think it won't do much.

But what we need to do then is pair it with policies that will do good. For instance, we can end the Fed policy of paying interest on excess reserves, and then have the Fed buy many more government bonds of all durations. That way, banks will take the money and put it somewhere in the economy. Even if they park it in other bonds, that will lower interest rates, push the seller to do something with the money, and at some point result in higher nominal spending. Or, the Fed could just eliminate this policy now, see what the current $1 trillion of parked reserves could do, and then think about future asset purchases.

Alternatively, the Fed could try to push money out by other ways. A combined Treasury-Fed operation is a commonly envisioned tactic -- this would work by having the government spend money in some way, and have the Fed foot the bill by buying the resulting additional government bond issuances. Even John Cochrane, who is skeptical of both monetary and fiscal policy, agrees that this would have some effect. So do the modern monetary theory guys. Bernanke, too, stressed this sort of monetary and fiscal cooperation in his speeches to the Japanese. Either his logic was wrong then, or it’s wrong now.

Finally, I'll say that for me, this issue is as much moral as it is purely practical. I was drawn to the bipartisan, technocrat economic management school not because of the patently unrealistic assumptions about human behavior, but because I saw it had real solutions to solve major economic problems. You don't have to suffer a Great Depression -- you just need to set your monetary policy correctly, etc.

Now, I'm worried that so many commentators have seemingly checked out of these debates. You see many people complaining about new policies, and worrying about supposed "risks" or "worries" that don't exist in data coming in statistics or financial markets. There are fewer and fewer people with tangible solutions on how to solve this mess. I think that erodes the moral legitimacy of capitalism. I think no economic system that tolerates 10% unemployment is acceptable; and something must be done. If you don't like QE; if you don't like the alternate options here; then what's your plan? What's your strategy for avoiding a Japan death trap/Mad Max world? For Krugman and Bernanke, it was frustrating to watch policymakers in Japan seemingly self-destruct in the face of difficult economic times. Turns out it's also frustrating to live in that world.

Is the US More like Italy or Japan?

The great folks at e21 have a piece up arguing that repeated comparisons of the US to Japan may be inapt; and rather that Italy might be a better comparison. The lesson is that quantitative easing might not be a cure all:

Just as Italy went from one financial crisis in 1974 to another in 1976, is the U.S. poised to follow its 2008 financial crisis with another in 2011 or 2012? Maybe. Just as Italian easy monetary policy boosted domestic demand, which could not be satisfied by domestic production even as it reduced the value of the lira, the Fed’s policy has stimulated domestic consumption and reduced the trade-weighted value of the dollar without materially closing the current account since 2008.

I understand this point of view and appreciate the role that skeptics are playing here. I'm also still trying to think through these issues. At the same time, there are a number of reasons why the lessons from Italy might not apply.

First -- the 70s were a tough economic decade for many countries. High energy prices, unions and structural problems in Italy's economy drove prices higher and deficits up. This was a time of great political instability. In particular, the pressures in maintaining both a fixed exchange rate while paying more for oil imports seems to have been a huge driver in Italy's current accounts. But let's accept for a moment the monetarist idea that changes in inflation were ultimately due to monetary issues.

To the left is a graph of Italy's growth in M2, taken from an article linked to in the e21 piece (their big crisis was 1975). As the authors of that note -- the problem was not political pressure to monetize debt, but rather a general desire to pursue expansionary policies. This led to a quite substantial growth in the money supply, at least in M2 (Friedman's favorite monetary unit), which in turn seems to be associated with inflation and currency depreciation.

At the same time, there is also evidence that wages were growing steadily as well, in part due to pressure by unions. To the extent that real wage increases faster than productivity led to inflation, the lesson from Italy that "quantitative easing can be bad" might be less applicable; especially given how weak wage increases have been lately. But, again, let's take purely the monetarist point of view for the moment. How does America compare?

David Beckworth provides a graph for the US, here:

Clearly, M2 growth lately has been below both historical averages and Italy. It appears at 2-3 percent here. Meanwhile, other measures of monetary bases -- like M3 -- are actually declining. As Gary Gorton has suggested, M3 may be a better indication of what "money" means in today's economy. It includes, for instance, at least some repurchase agreements, which operate today as "money" in the market for financial assets.

Japan has had figures that looked much more like the US today than Italy. Milton Friedman observed that during Japan's "troubled times," money (which he defined as M2 + CDs) grew at just 2%. For Friedman, this was not just unacceptably low, but was causally linked to their terrible economic performance as well. Since interest rates on short-term government debt were close to zero; he recommended quantitative easing as a matter of course. He would have been shocked if you suggested to him that in fact he was recommending an unproven idea as risky as geoengineering -- for him, as well as many other Japan experts, the only plausible explanation for the Bank of Japan's failure was their complete ineptitude.

And, of course, the fact that Japan and the US suffered banking crises means that velocity in these countries (rate at which money turns over) was much lower. As Friedman has argued; central banks ought to adjust the monetary base to keep pace with movements in velocity and output. So the tepid growth in monetary bases in both the US and Japan can be really destructive.

By the way, here's a comparison of Japan and US along inflation:

It's difficult to judge what the lessons from Italy are. Monetarist skeptics like Modigliani will presumably argue that Italy only shows that union-brokered wage increases in the face of a stagnant economy and oil shocks can be inflationary. Monetarists might instead argue that double-digit growth in M2 eventually results in inflation. However, it's not clear why that result should give us pause given that money growth in the US now is an order of magnitude lower.

Finally, if the results from Italy represent the worst possible result of quantitative easing -- it doesn't look that bad. Italy, after all, recovered and grew fairly rapidly afterwards; passing the British economy by 1987. Meanwhile, the only sorpasso that Japan experienced was their being lapped by China. I think they'd happily trade their problems for the post-1975 experience in Italy, and I think in a few years we'd like to take that trade as well.