With Charity for All

June 7, 2013

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Ken Stern. With Charity for All: Why Charities Are Failing and a Better Way to Give. New York: Doubleday, 2013.

After I saw the statistics in this book on the size of the charitable sector of the economy, I wondered why I had never studied it before. That, of course, is part of the problem: Many of us just assume that organizations created to do good things…well…do good things. We don’t hold them to the same standards as businesses that are expected to make money producing useful products, or governments that are expected to spend our tax dollars for the public good.

“Charitable activity accounts for 10 percent of the economic life of this country,” which is very high by international comparison. That includes over a million charities employing about 13 million people and using another 61 million volunteers. They take in over $1.5 trillion in revenue, with an estimated third of that coming from government spending. Taxpayers also support charities indirectly by exempting them from taxation. “American charities dominate critical sectors of public life. They control segments of the education and health-care fields…and hold substantial positions in the environmental sectors, social services, arts, and media and digital services.”

Until the late nineteenth century, Americans generally preferred individual acts of giving and discouraged organized charities. The heightened awareness of social problems during the Progressive Era and the Great Depression began to change that. Government made two major contributions to the expansion: “a change in federal tax policies that encouraged widespread giving and, most important, the invention of the welfare state and a new federal practice of outsourcing much of its activity to the social sector.” Only in 1954 did the federal government subsidize giving with income tax and estate tax deductions for charitable contributions. The number of nonprofit organizations has increased by a factor of 116 since 1940, from only 12,000 then to 1.4 million now.

Evaluating so many organizations and identifying those worth supporting is a daunting task. Evaluating for-profit organizations is in many ways easier, since “there are…only some fifteen thousand publicly traded companies in the United States, and by law each company is required to divulge detailed financial and risk information to the investing public.” (I have to qualify this by saying that some investors want to do more than identify profitable companies; they want to get market-beating increases in share prices, and that too is a daunting task.) While we can reasonably assume that some charities are more effective than others, no one is requiring charities to provide enough evidence of their effectiveness. That’s why Stern can indict the charitable sector in general for setting very low standards of performance.

In those cases in which well-known charities have been subjected to close scrutiny, they often fail to show results commensurate with the amounts of money poured into them. Chapter 1 contains several examples:

  • Donors have contributed hundreds of millions of dollars to provide clean water in developing countries; yet “the water charity community, in the aggregate, has been singularly ineffective in relieving the problems of waterborne diseases.” That seems to be because the charities do the easy work of drilling wells, but not the harder, longer-term work of maintaining systems or bringing water to the home so that people can wash more often.
  • The biggest drug prevention program, D.A.R.E., has had great success in expanding and maintaining its funding despite the fact that “virtually every piece of quantitative evidence demonstrates that the D.A.R.E. program doesn’t actually work.”
  • The Bush administration expanded the Department of Education’s 21st Century Community Learning Centers program into a billion-dollar program for after-school activities. It continues to be funded despite the fact that the Department’s own evaluation showed it to be ineffective. “Most outcomes measured yielded no discernible differences between the study group and the control group, and negative effects were found in many categories.” The negative findings actually “dovetailed closely with a long history of social science findings that show negative effects when at-risk children are brought together in poorly structured groups.”

Stern questions whether some kinds of organizations should qualify as charities at all:

  • In most respects, nonprofit and for-profit hospitals are indistinguishable. On the average, they each spend about 4 or 5 percent of their operating expenses on uncompensated care. The cost to the government in lost tax revenue from the nonprofit exemption far exceeds the amount that the so-called charities actually spend on charity care. “Charitable hospitals have become some of the most aggressive debt collectors in the country.”
  • Beginning with the Rose Bowl and its association with the nonprofit Tournament of Roses, college bowls have been organized as charities. “The principal beneficiaries of these charities are not the public in any meaningful way but a small club of bowl employees, committee members, and the athletic directors and conference commissioners who have been the loudest and proudest defenders of the current bowl system.”
  • Operas such as the Metropolitan fall into “that odd class of charities where the principal beneficiaries of the service are defined primarily by their wealth,” since few others can afford to attend the pricey performances.

A widespread lack of accountability leads to a proliferation of scams. On the one hand, charities can defraud donors. With thousands of charities using names with words like “‘veterans,’ ‘policemen,’ ‘firefighters,’ ‘children,’ ‘hope,’ ‘support,’ ‘beneficial,’ ‘cancer,’ ‘widows and orphans,” donors have trouble distinguishing the legitimate from the illegitimate. “The absence of clear rules and marketplace data, and terrific opportunities for brand confusion, mean that many charities live in a quasi-lawful zone, distributing some minimal amount of funds to recipients but directing a far greater share of the proceeds to management and the expenses of fundraising.” On the other hand, individuals can loot the charities they run because of lax internal oversight. While the average bank robber only gets about $4,000, the average charitable theft is estimated at $100,000. Politicians have also used charities as “convenient vehicles to launder public dollars.” One political boss of a New York county used the charity he ran to channel public money to real estate developers and other businesses, which in turn made large campaign contributions to him and his party.

Why is there so little accountability in the charity sector? First, charitable status is so easy to obtain. The IRS approves 99.5% of all applications. With over 50,000 new charities appearing every year, the IRS doesn’t have the resources to scrutinize them very closely. Once they are approved, chances are slim that the approval will ever be revoked. Only thirteen states even attempt any oversight of charities, with probably fewer than a hundred state officials working on it in all states combined. When they do try to take legal action, the courts have trouble distinguishing fraud from incompetence or ineffectiveness, since legal standards of conduct in this area are so vague.

But what about the donors? Don’t they create the marketplace within which charities must compete? Why don’t they hold charities more responsible? In Chapter 5, Stern explores the question of why people give and what they expect from their contributions. The dominant theory is that people give in order to obtain some tangible or intangible benefit, especially the “warm glow” of giving, to use economist James Andreoni’s term. Some theorists support a more altruistic, less self-interested conception of giving, although it is harder to square with the individualistic assumptions of mainstream economics. (Is it so hard to imagine that a cultural animal can actually identify with something larger than the self?) The theoretical debate is relevant because “warm-glow donors behave differently than altruistic ones.” They can get their emotional high from responding to a good story, preferably accompanied by a picture of a cute child. They don’t have to be interested in facts and figures about results. Studies have found that donors are more likely to support a campaign to help one person than to support a campaign to help many people.

In some cases, the “care and feeding of donors who make highly personal gifts can distract from core charitable purposes and matters of organizational effectiveness.” The charitable arm of a large bank gave Florida State University a $500,000 grant for economics, as long as the courses would feature the writings of libertarian Ayn Rand. The estate of one prominent donor sued the Metropolitan Opera because their staging of Wagner was allegedly less traditional than she had specified. Donors easily become part of the problem as well as part of the solution.

When donors do consider organizational effectiveness, they often assume that the percentage of revenue going to recipients is a sufficient measure of it. In recent years, the Red Cross has come under fire both for responding ineffectively to disasters such as hurricane Katrina, but also for increasing the portion of revenue used to build the infrastructure needed to improve future performance. The simplistic idea that charities need to spend only on current programs and not invest in future organizational effectiveness is one of the biggest obstacles to improvement.

Continued

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The Clash of Economic Ideas (part 3)

May 16, 2013

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Here I will bring together several parts of Lawrence White’s book that deal with monetary policy: the debate over the gold standard, the ascendancy of monetarism during the inflationary 1970s, and the recent sovereign debt crisis in several countries.

Tying a nation’s currency to gold places a limit on the money supply. Mercantilists used to worry that if a country allowed too many imports, paying for them would deplete its stock of gold. In 1752 David Hume made a classical case for free trade, describing an automatic balancing process now known as the “price-specie-flow mechanism.” The gold that flows out of a country that has a trade deficit causes deflation in that country and inflation in the surplus country. That tends to correct the trade imbalance by making the deficit country’s goods cheaper and the surplus country’s goods more expensive. Prosperity does not depend on restricting the import of goods or the outflow of gold.

A more realistic criticism of a gold standard is that it limits the government’s options for financing its spending. Government spending is balanced by tax revenue, a change in debt, or a change in the stock of government-issued money held by the private sector (G = T + ΔD + ΔM). If money is backed by gold, the government can’t just print more of it without causing a run on gold. Many critics of government spending welcome that restraint, but advocates of Keynesian deficit spending do not. Printing more money is not, of course, a way of getting something for nothing, since the country may pay for it through inflated prices. But if the government spending so financed creates employment and increased production, a Keynesian can argue that the benefits outweigh the risks.

World War I set off a chain of events that led to the decline of the gold standard:

During the First World War, the governments of Britain, France, Germany, and other combatant nations of Europe each suspended the gold standard so that it could print money to finance war expenditures. With currency irredeemable in gold, no gold outflows constrained the government’s monetary expansion. Considerable
monetary expansion had the inevitable effect of considerably raising the domestic price level.

After the war, England tried to return to the gold standard by restoring the pound to its prewar price in gold, but with so many pounds now in circulation, the result was a run on gold. Other European countries had similar problems.

Large amounts of British and continental European gold flowed into the United States during and after the First World War. The leaders of the new Federal Reserve System, which first opened its doors in 1914, often chose to “sterilize” the inflows, that is, to prevent them from expanding the domestic money stock and bank credit and thereby raising the price level, although such adjustments were part of Hume’s process for stemming the flows and restoring international payments equilibrium.

Supporters of the gold standard say that it could have continued to work if central bankers hadn’t interfered with it, either by printing money not backed by gold or by trying to control prices instead of letting them respond to gold flows. In any case, European countries found it increasingly burdensome to back their currencies with gold. England went off the gold standard for good in 1931. The Bretton Woods conference of 1944 “committed the major European currencies to redeemability not for gold but only for U.S. dollars, with the U.S. dollar as the key international reserve currency that other central banks could redeem for gold….Exchange rates against the dollar were to be pegged, that is, fixed for the time being but adjustable when necessary.”

This system lasted until 1971, when the U.S. itself left the gold standard because it was experiencing its own balance-of-trade deficit and run on gold. Inflation in the United States was reducing the purchasing power of the dollar at home, but fixed exchange rates between the dollar and other currencies made imported goods a relative bargain. The foreign businesses that sold us goods exchanged the dollars for local currency through their central bank, which then had the option of redeeming the dollars for gold. When very little gold was left in the U.S., the Bretton Woods system broke down.

During the “Great Inflation” of the 1970s, the “monetarist” economists led by Milton Friedman gained influence at the expense of the Keynesians. Friedman was one of the economists who had joined the Mont Pelerin society organized by Friedrich von Hayek in 1947, with the purpose of keeping classically liberal free-market economics alive. Now he argued that the principal cause of inflation was a too-rapid increase in the money supply. (Similarly, he argued that the main reason for the severity of the Great Depression was the failure of the Federal Reserve to maintain an adequate money supply.) He recommended a consistent policy of only modest and steady monetary expansion, and he warned against the kind of activist Keynesian policy that tried to stimulate the economy with deficit spending and/or rapid monetary expansion.

I was surprised that a book about the clash of economic ideas wouldn’t have a chapter on economists’ interpretations of the housing bubble and the Great Recession of 2007-09. White does mention that the recession sparked a new interest in Keynesian economics, but he doesn’t elaborate. He does have a chapter on sovereign debt crisis in countries such as Greece, with a strong monetarist emphasis. An increasing burden of debt gives a government a strong incentive to expand the money supply, since “reducing the value of the monetary unit reduces the real burden of any existing debt denominated in that unit.” In fact, some economists argue that the growth of government debt eventually forces it to resort to inflationary finance. As a government borrows more and more, lenders can demand higher interest, until the cost of servicing the entire debt increases faster than the additional amount borrowed. Additional borrowing is then counterproductive, and expanding the money supply is the only way left to finance a increasing deficit. Eventually, that leads to a collapse of confidence in the currency.

Maybe the reason White focuses on sovereign debt crisis instead of other aspects of the recent economic crisis is that he is most comfortable telling a monetarist story that blames economic problems on government. As with the first chapter about the earlier “turn away from laissez-faire,” he seems more reluctant to acknowledge market failures, which seem rather conspicuous during the housing bubble. Also, having just read Michael Pettis’s The Great Rebalancing, I know that economists differ sharply in their interpretations of sovereign debt crisis as well. Pettis attributes it as much to over-saving in creditor countries like Germany and China as to over-borrowing in deficit countries like Greece and the United States. He specifically warns against blaming the debtors alone for the global capital flows that finance both asset bubbles and sovereign debt.

Overall, I found the book a better exposition of classical and monetarist views than of less free-market-oriented alternatives, especially in its discussions of recent economic developments.

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The Clash of Economic Ideas (part 2)

May 15, 2013

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Chapter 5 of Lawrence White’s book is devoted to “The Great Depression and Keynes’s General Theory.” I will also incorporate some ideas from later chapters that are relevant to Keynesian economics.

Keynes and Hayek disagreed fundamentally over the ability of the market economy to sustain full employment and economic growth without deliberate government stimulus. Hayek believed that the income generated by economic production would automatically stimulate further production, because the income would either support consumption or new investment. Either consumer goods or capital goods would be produced. Keynes, on the other hand, did not believe that income that people saved rather than consumed would necessarily support new investment. An increase in what he called the “propensity to save” might just reduce consumption without increasing investment, resulting in a lack of “aggregate demand” and a reduction in production and employment. Some Keynesians would say that a big reason for an excess of saving and a lack of demand is an income distribution favoring rich savers over lower-income spenders, but that argument was not essential to Keynes’s original theory. His point was simply that production didn’t necessarily create the demand needed to generate further production.

Keynes understood the Great Depression as a vicious circle of low demand and low production, with no short-run market solution. Hayek saw economic slumps as self-correcting as long as central banks properly managed the money supply. “Despite the reservations and objections of orthodox (often older) economists, Keynes’s theory quickly caught on among younger economists and completely eclipsed Hayek’s theory.” Keynesian theory dominated economic thought in Great Britain and the United States until the 1970s.

According to Keynesian economics, government spending in excess of taxes could increase aggregate demand and stimulate the economy. Only if the economy were already operating at full employment would that spending merely replace other kinds of spending with no net gain in aggregate demand and national output. At less than full employment, government spending would lead to a net gain in GDP (the size of which could be expressed by the “multiplier” ΔY/ΔG–the ratio of the change in GDP to the change in government spending). Keynesians rejected the classical economic view that running a deficit is as foolish for a nation as it is for a household. Otto Eckstein argued that a national debt is different from a household debt because “we owe it to ourselves.” In theory, we can repay it out of the larger income that deficit spending generates. This argument was more convincing before other countries began financing a large portion of our debt.

Critics of Keynesian economics such as James M. Buchanan argued that government spending had to burden either current or future taxpayers, and that the theory encouraged fiscal irresponsibility: “Keynesian economics has turned the politicians loose; it has destroyed the effective constraint on politicians’ ordinary appetites. Armed with the Keynesian messages, politicians can spend and spend without the apparent necessity to tax.”

Keynesian economist Paul Samuelson provided an additional rationale for government spending in his theory of “public goods.” As described by White, “the theory…views government as a faithful agent hired by the citizenry to provide desired goods and services having characteristics such that the market economy provides too little of them.” This elaborated on an idea already present in the writings of classical and neoclassical economists. Private entrepreneurs may not find it in their self-interest to produce something even if the public values it enough to pay for it. For example, they may not be able to make a profit financing basic research or general intellectual activity (as opposed to applied research to develop specific products), and yet the public may well wish to finance universities with their tax dollars. The problem for the entrepreneur is to “capture all of the potential gains from production and trade,” which is hard to do for ideas that spread freely. The failure to do so is a type of market failure known as a “Pareto inefficiency,” named for the Italian economic Vilfredo Pareto. Arthur Pigou related the problem to the concept of externality discussed in the previous post. Just as markets sometimes reward individuals for doing things that have negative externalities (social costs), they also fail to reward individuals for doing things that have positive externalities (social benefits). Public goods theory says that the government has a responsibility to discourage the first type of behavior and promote the second.

Critics of public goods theory have tried to show how goods and services that are commonly regarded as public could conceivably be provided by markets under the right conditions. In 1960, Ronald Coase argued that externality problems are often property rights problems, and the solution is often to expand the rights of producers to make sure they profit from socially useful activity. In the classic case he studied, radio broadcasting could become a profitable activity only when broadcasters owned the frequencies on which they broadcast so they were free of interference. The argument can be extended to justify many forms of privatization. On the other hand, some goods seem irrevocably public. Maintaining a favorable global climate requires public action, since no business can own the climate enough to have a profit motive to protect it.

Non-Keynesian economists, especially James M. Buchanan and Gordon Tullock, have tried to counter public goods theory with “public choice” theory. It questions the very idea that government spending can work for the benefit of all. What is more likely to happen is that:

 …[I]ndividuals can use the powers of government for special-interest programs, or “rent-seeking,” gaining benefits for some at the expense of others….On an issue where the taxpaying majority is poorly organized, a well-organized special interest group may use plausible arguments (and campaign contributions) to persuade legislators to grant it monopolistic privileges or to tax the general public for the group’s benefit.

This is reminiscent of Adam Smith’s criticism of mercantilist government, favoring some economic interests over others instead of letting the market decide what’s best. Of course, a public goods theorist would question the assumption that what is most profitable is really best for society.

White concludes his treatment of public choice theory with the observation, “By rebuilding the intellectual case for the limited-government constitutionalism of the American founders, Buchanan and Tullock might today be called patron saints of the constitutionalist wing of the Tea Party movement.” This remark dramatizes the close association between economics and politics. Is the Tea Party trying to restore limited government and economic freedom, or is it trying to render government too impotent to stand up to powerful private interests and carry out needed economic reforms?

Continued

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The Clash of Economic Ideas

May 13, 2013

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Lawrence H. White. The Clash of Economic Ideas. Cambridge: Cambridge University Press, 2012.

George Mason University economist Lawrence White provides a lively and accessible introduction to economic ideas. He zeros in on the main economic arguments with a minimum of quantitative formulas and technical details. Rather than present economic theories devoid of social context, he tries to “trace the connections running from historical events to debates among economists, and from economic ideas to major economic policy experiments.”

White’s focus is primarily on the twentieth century, but he takes occasional excursions into earlier times to provide additional background on the thinkers he discusses. In the Introduction, White poses the central question that has shaped twentieth-century economic debate: “Are competitive markets, guided by impersonal forces of profit and loss, better than government command-and-control for directing investment toward the greatest prosperity?” His next sentence places the field of economics squarely on the affirmative side: “The key insight of economics as a discipline–its greatest contribution to understanding the social world and to avoiding harmful policies–is that, under the right conditions, an economic order arises without central design that effectively serves the ends of its participants.”

Nevertheless, the strengthening of government’s role in the economy is central to the story of the past century. The book’s first chapter is “The Turn Away from Laissez-Faire.” (“Laissez-faire” is a shortened form of the phrase “laissez-faire, laissez-passer“–literally “let do, let pass”–attributed to an eighteenth-century free-trade advocate named Vincent de Gournay.) Economists since Adam Smith have appreciated the social value of letting individuals produce whatever they can profitably exchange with others, without interference from the state:

By directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this…led by an invisible hand to promote an end which was not part of his intention….By pursuing his own interest, he frequently promotes that of the society more effectually than when he really intends to promote it.

The doctrine of laissez-faire was a reaction against mercantilist policies such as trade barriers and state-sponsored monopolies, policies oriented more to the protection of existing wealth than to the expansion of national production. It became a centerpiece of liberal thinking in the nineteenth century. Where free-market capitalism came to prevail, support for laissez-faire was increasingly support for the status quo, so that classical economic liberalism came to be considered conservative.

By the Progressive Era (1890-1920), economists were coming to doubt that the “invisible hand” of the market always produced socially desirable outcomes. In 1907, Irving Fisher published the essay, “Why Has the Doctrine of Laissez Faire Been Abandoned?” He gave two main reasons: that individuals often lack the expertise to make the best decisions, and that actions beneficial to individuals often have external effects that injure society.

The second issue is what modern economists call “externalities”. Buyers and sellers may benefit from the marketing of a certain product, but people who are not parties to the transaction can suffer from the environmental damage resulting from its production.  White does not explicitly link working-class poverty and other social problems deplored by the Progressives to such market failures, but that is the obvious implication. The new “institutionalist” economics looked to improved social institutions, not just free individuals to generate social progress. Scientific expertise, especially the findings of the emerging social sciences including economics itself, was to be an important basis for social reform. The American Economic Association was originally led by institutionalist economists opposed to laissez-faire thinking.

The path away from classical laissez-faire was also the path toward more radical collectivism. White establishes just how widespread socialist ideas were in the early twentieth century, most notably in the centrally planned economies of communist countries, but also in Nazi Germany, India after British rule, and even the US under the New Deal and Britain under the Labour Party. For example, Roosevelt’s National Recovery Administration “organized industries into federally supervised Code Authorities, government-sponsored cartels for arranging collusion among the participating firms. The Code Authorities decided and enforced prices, production quotas, employment, and distribution methods.” The Supreme Court ruled the NRA unconstitutional in 1935. In 1945, the British Labour Party was elected on a platform that called for “a Socialist Commonwealth of Great Britain” where the government would have “a firm constructive hand on our whole productive machinery.” Industries employing about 20% of all workers were nationalized.

The popularity of socialism provoked a strong intellectual reaction, especially among Austrian economists such as Ludwig von Mises and Friedrich von Hayek. In the 1920s, Mises launched a strong attack against socialism, questioning the whole idea that the government could calculate the value of economic inputs better than competitors in a free market. “Mises’s argument embodied the neoclassical marginal productivity theory of factor prices, which teaches that the price of a productive input (raw material, machine-hour, labor-hour), in a market where entrepreneurs competitively bid for it, reflects the value of the input’s marginal contribution to the revenue from output sales.” Hayek’s critique of socialism added the argument that knowledge is distributed widely in society rather than concentrated in government, so that, in White’s words, “The Central Planning Board can’t know all that it would need to know to match the market’s use of knowledge….”

In the worst economic crisis of the century, the Great Depression, market critics and government critics squared off in the intellectual battle that continues to this day. For opponents of laissez-faire, most notably John Maynard Keynes, the Great Depression was a conspicuous market failure (a failure of “aggregate demand” in particular), demonstrating the need for at least moderate economic intervention (more on that in the next post). For Hayek, on the other hand, the Depression resulted mainly from central bank mismanagement of the money supply. Loose monetary policy in the 1920s had over-expanded the money supply, held down interest rates, and encouraged an unsustainable investment boom.

The author himself is more in the Austrian camp than the Keynesian camp. Throughout the book, he seems much more comfortable talking about government failures than market failures. That may be why he is so vague about the reasons for the decline of free-market thinking he describes in the first chapter. Although he tries to present both sides, I notice more criticism of Keynesian ideas than monetarist ideas in the book as a whole.

Continued

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The Great Rebalancing (part 4)

April 12, 2013

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Pettis’s analysis of the European debt crisis is based on the same principles as the rest of his analysis. Crises are caused by economic imbalances. These are both trade imbalances and complementary gaps between savings and investment:  “Any policy that affects the gap between savings and investment in one country must affect in an opposite way the gap between savings and investment in the rest of the world.”

In the European case, the players are on the one hand northern European countries that produce more than they consume, save more than they invest domestically, and run trade surpluses; and on the other hand the mostly southern European countries that consume more than they produce, save less than they invest domestically, and run trade deficits. As usual, Pettis discourages us from attributing the crisis to the moral superiority of the first group of countries over the second:

Confused moralizers love to praise high-savings countries (let us call them all “Germany”) for their hard work and thrift, and deride high-consuming countries (which we will call “Spain”) as lazy and too eager to spend more than they earn. The world cannot possibly rebalance, they argue, until the latter become more like the former….The high German savings rate…had very little to do with whether Germans were ethnically or culturally programmed to save—contrary to the prevailing cultural stereotype. It was largely the consequence of policies aimed at generating rapid employment growth by restraining German consumption in order to subsidize German manufacturing—usually at the expense of manufacturers elsewhere in Europe and the world.

After German reunification in the early 1990s, Germany adopted a set of policies designed to promote productivity and competitiveness and combat unemployment. It held down consumption with wage constraints and high taxes, while using tax revenue to build infrastructure. It succeeded so well that it became a large net exporter of goods and capital to other countries in Europe. But in accordance with Pettis’s inexorable economic logic, other countries had to be net importers of goods and capital, with consumption greater than production and savings less than investment.

In those respects, the relationship between Germany and Spain resembles the relationship between China and the United States. However, one of the mechanisms by which countries like Spain became so heavily indebted is different. The US and China have two different currencies, one artificially strong because of the dollar’s traditional role as the primary reserve currency of the world, and the other artificially weak because the Chinese government wants to favor exporters over consumers. That helps make Chinese exports cheap and US exports expensive. Before the financial crisis, the demand for dollar-denominated assets like US stocks, bonds and mortgage-backed securities pumped up asset prices and held down interest rates, making Americans feel richer than they were and making it easier for them to borrow.

A different currency mechanism helped create the European imbalances–the European Monetary Union! Here I found Pettis a little vague on the mechanics, but here’s how I understand it: If each country had its own currency, and each currency were valued realistically relative to the others, then countries would find it harder to become too indebted. Less competitive countries would have weaker currencies, and they couldn’t afford to import very much, or borrow without paying high interest rates. The adoption of the strong Euro–which became the world’s second most desired currency after the dollar–created an illusion of financial strength in the less competitive economies, helping them to spend more and borrow at low interest rates. They could grow their economies, although like the US they relied on growth in the nontradable goods sector that sometimes took the form of housing bubbles. Stronger economies like Germany were only too happy to export their products and their excess savings to support the high levels of spending and debt. Only after the formation of the EMU did Spain, Italy, Portugal and Greece routinely run large deficits. “German anticonsumption policies force up the German savings rates and the German trade surplus, and European monetary policies force those surpluses onto the rest of Europe.”

Pettis sees only three possible resolutions to the European crisis:

(1) a reversal of the trade imbalances, which requires that Germany stimulate demand to the extent that it runs a large trade deficit, (2) many years of high unemployment, including, soon enough, in Germany, or (3) the breakup of the euro and sovereign debt restructuring for much of peripheral Europe including, possibly, France.

The second route is the familiar idea of imposing more austerity on the debtor countries. They got themselves into this mess, so the story goes, and so they should pay down debt and reduce consumption. The problem is that the Europe’s economy depends on the consumption of the deficit countries in order to balance the frugality of the surplus countries. If everyone tries to be frugal at once, aggregate demand will collapse, causing high unemployment throughout Europe.

Pettis much prefers the first route of higher German spending, although he admits it would require “a radical change in German understanding and commitment to Europe.” But “if Germany were to stimulate domestic consumption massively by reducing income and VAT taxes, turning its trade surplus into an equally large deficit, Spain and the other deficit countries of Europe would be able to grow their way back into health and earn the euros to repay their external debt.”

If Germany cannot make the transition to a higher-consumption society, and deficit countries cannot accept a crushing burden of austerity, then the EMU may not survive. Indebted countries would then suffer a loss of buying power as they returned to their own weaker currencies. Creditors in richer countries would also be hit, since they would have trouble collecting their debts. Since both kinds of countries share the responsibility for creating the problem, Pettis sees a certain logic in both having to share the consequences:

This makes it illogical for Germans to insist that the peripheral countries have any kind of moral obligation to prevent erosion in the value of the German banks’ loan portfolios. It is like saying that they have a moral obligation to accept higher unemployment in order that Germany can reduce its own unemployment.

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