Mike Konczal has been having useful fun with Venn diagrams lately. Here’s his explanation of various approaches to dealing with an economy in which large parts of the private sector are engaged in forced deleveraging:

Looks good to me, although there really should be a lot of names, not just mine, in the “liquidity trap” area.

Thoughts on the others: I really don’t understand Koo’s position. I agree with him that a lot of people are debt-constrained, and cannot respond to lower real interest rates by spending more. But not everyone is in this position — if nothing else, by definition there must be creditors as well as debtors, so someone is able to respond to interest rates. In general, it’s almost always a bad idea in economics to assume that incentives of some kind don’t matter at all.

And the diatribes against unorthodox monetary policy seem to me to come completely out of left field, not derived in any way I understand from Koo’s basic analysis. They have the feeling of arguments half-baked on the spot out of annoyance that people aren’t totally buying Koo’s insistence that fiscal policy is the answer; as you can see, I’m for fiscal policy myself, but see monetary policy as a useful supplement.

The queasy quasi-monetarists are, in a way, the mirror image of this position, so focused on the monetary solution that they rail against any suggestion that fiscal policy might play a useful role.

I would submit, by the way, that the quasi-monetarists — QMs? — have actually backed up quite a bit on their claims. They used to say that the Fed can easily and simply achieve whatever nominal GDP it wants. Now they’re more or less conceding that the Fed has relatively little direct traction on the economy, but can nonetheless achieve great things by changing expectations. That’s pretty close to my original view on Japan. But changing expectations in the way needed is hard, especially when the Fed (a) faces massive sniping from the right and (b) has a number of hard-money obsessives among its own officials.

So my view is that we need to use everything we can — fiscal and monetary policy. And we shouldn’t let a desire to promote our pet solutions block other things that might help.

Martin Wolf is, as usual, right on point today. As he says, simply providing enough financing for European nations in debt trouble — hard enough as it is — is far from sufficient, because it doesn’t deal with the risk that

forcing adjustment on the weak will fail, because of a lack of offsetting adjustment in the strong. That would not be a huge problem if those forced to adjust are small. It is a vast problem if they are large. The risk is of a downward spiral as austerity is exported and re-exported.

With a third of the euro area’s GDP in crisis countries, and with the core countries also pursuing austerity, this is a gigantic problem.

One quibble: Wolf describes Ireland as having had a “uniquely successful adjustment”. I know what he means: Ireland, alone among the euro crisis countries, has already achieved significant “internal devaluation”, that is, has managed to reduce its costs and prices compared with the core countries. But it’s really worth bearing in mind what “successful adjustment” looks like:

A few more such successes and Ireland will be back to the 19th century.

My alleged true love insists on watching the Republican debate. I have fled upstairs.

Also, when the questioner used the Erie Canal as an example of American innovation, did she know who built the thing? Hint: not the private sector.

That is all.

Sorry, but if I am not for myself, who will be for me? For readers new to this, back in 2010 Business Week ran a story contrasting my pessimistic views with the bullish outlook of hedgie John Paulson, and making it clear that only a fool would believe the views of some bearded professor.

Today in the FT: Paulson’s costly bet on US rebound unravels.

It’s also worth noting not just that things have in fact gone badly, but the way they’ve gone badly: not via surging interest rates and inflation, but via weak demand associated with low rates, and with markets now expecting very low inflation looking forward.

The point isn’t that I’m infallible, which (as my wife can tell you) is very far from true. It is that Keynesian analysis has worked in this crisis, and those who refused to believe it have lost money as well as credibility.

A correspondent asks a good question: what evidence makes me believe that Keynesian economics is broadly right, given the relative absence of experience with large fiscal stimulus programs?

I’d answer that question with several points.

First, we’re talking about a model, not just a prediction about the impact of spending increases. So you can ask about the ancillary predictions of that model as opposed to rival models. Anti-Keynesians assured us that budget deficits would send interest rates soaring; Keynesian analysis said they’d stay low as long as the economy remained far from full employment. Guess who was right?

Also, there are some features of the approach that can be tested separately. Keynesianism isn’t just about sticky prices, but it does generally assume sticky prices — and there is overwhelming evidence, from a variety of sources, that prices are indeed sticky.

Also also: there’s plenty of evidence that monetary policy can move output and employment — and it’s very hard to devise a model in which that is true that doesn’t also say that fiscal policy can be effective, especially when you’re up against the zero lower bound.

Second, while we don’t have a lot of postwar experience with fiscal stimulus, we do have a lot of experience with anti-stimulus, that is, austerity — and that turns out to be reliably contractionary. Again, it’s hard to think of a model in which austerity is contractionary but stimulus isn’t expansionary.

Finally, there is evidence from fiscal expansions in the 1930s, which actually did lead to economic expansion too.

Mainly I’d stress the first point. We have a model of the way the world works, and the world does indeed seem to work that way. And an implication of that model is that fiscal stimulus will work under conditions like those we face now. If interest rates had soared, if the rise in base money had led to rising GDP and/or soaring prices despite the zero lower bound, I would have sat down to reconsider what I thought I knew about macroeconomics. In fact, however, my preferred model has passed the test of events with flying colors, while the other guys’ models have been totally wrong.

Some readers have been asking me to go make a speech at one of the OWS demonstrations. If you think about it, however, you’ll see why I can’t.

I’ve been granted the enormous privilege of expounding my own views twice a week in the world’s greatest newspaper. I try to make the best use of that privilege, doing all I can to get the truth across and also advocating for what I believe to be the right policies. There are, however, some restrictions that come with the privilege; one of them is not crossing the line between advocate and activist. And there are good reasons for drawing that line.

Just in case you were wondering.

Kash Mansori has a very good piece on the eurozone crisis, making some points I’ve also tried to hit. Basically, he sees the peripheral countries mainly as victims of an overwhelming tide of cheap money from the core, who are now suffering whiplash when that inflow came to a sudden stop:

THE IMPLICATION IS that the very creation of the common currency area sowed the seeds for this crisis, not the behavior of the periphery countries. While these countries didn’t necessarily do everything right, they were playing against a stacked deck. But if the easy explanation for this crisis—namely, that it was due to the irresponsible behavior of the periphery countries—is not the right answer, then we need to reevaluate how it has been handled.

To start with, if the crisis is the result of inexorable forces beyond the control of the periphery countries, it’s not appropriate to wag fingers or punish those countries through the bitter medicine of insufficient assistance. This crisis should not be turned into a morality story.

But more importantly, since the periphery of the eurozone bore the bulk of the systemic risks inherent to the common currency area, while the benefits were shared by both the core and the periphery, it’s deeply unfair that the burden of solving the crisis has been placed so overwhelmingly on the periphery countries through the debilitating austerity measures demanded by the core countries. The core eurozone countries like France and Germany were in the driver’s seat when it came to setting up this system, and they were happy to take advantage of the common currency when it was to their benefit. They now need to recognize that the responsibility for fixing this mess should really rest largely with them.

A small niggle: does nobody in the modern era understand the difference between principle and principal? Or, for that matter, between periphery and peripheral?

I read David Brooks citing the Tax Foundation this morning, and I thought he must have misread them. They couldn’t possibly have compared one year’s take from higher taxes on the rich with the total stock of debt, could they? They can’t possibly be that stupid, or think that their readers are that stupid, can they?

Yes they did. They actually find that their version of the “Buffett rule” would collect $120 billion a year, which is a seriously significant sum. But they try to make it look small by comparing one year’s revenue with the total debt outstanding.

I mean, the standard scoring method in Washington involves using 10-year projections — and even that is flawed, because the real budget issues are much longer-term than that. But nobody, nobody thinks it makes sense to estimate the effect of a revenue proposal on future debt by looking only at the first year’s receipts.

This deliberate fraud — because that’s what it has to be — is an example of the reasons knowledgeable people don’t trust the Tax Foundation.

Oh, my. Jeff Immelt, who President Obama for some reason appointed to head his job creation panel, insists that what’s good for GE is good for America:

I want you to root for me. Look, every one in Germany roots for Siemens, everyone in Japan roots for Toshiba, everyone in China roots for China South Rail, I want you to say, win GE.

I think this notion that it’s the population of the US against big companies is just wrong.

Wow. First, the macro picture. Here are corporate profits versus employee compensation, both measured as index numbers with the 2001 business cycle peak= 100:

We’ve all grown together! Or, actually, not.

Also, GE isn’t in any important sense an “American” company. More than half its employees are overseas. I’m sure Immelt would claim that this is just what he needs to do to compete; but in that case, he can’t have it both ways and also demand that we cheer for GE as an American champion.

Awesome cluelessness. And this is the head of a job-creation task force in a Democratic administration?

Yglesias tells us that some Occupy Wall Street protesters have picked up Ron Paulish monetary ideas — although some know better. I thought I’d say a word about one particular idea that sounds plausible to some people but is actually quite wrong: banning fractional reserve banking.

I know that’s a popular theme among some Austrians. But it’s actually neither a good idea nor even feasible.

The crucial thing is to understand what banks do. And it’s not mostly about money creation! Instead, what banks are for is helping to improve the tradeoff between returns and liquidity.

Like a lot of people, my insights draw heavily on Diamond-Dybvig (pdf), one of those papers that just opens your mind to a wider reality. What DD argue is that there is a tension between the needs of individual savers — who want ready access to their funds in case a sudden need arises — and the requirements of productive investment, which requires sustained commitment of resources.

Banks can largely resolve this tension, by offering deposits that can be withdrawn on demand, yet investing most of the funds thus raised in long-term, illiquid projects. What makes this possible is the fact that normally only some depositors want to withdraw funds in any given period, so it’s normally possible to meet those demands without actually having liquid assets backing every deposit. And this solution makes the economy more productive, providing more liquidity even as it allows more productive investment.

The problem, of course, is the vulnerability of such a system to self-fulfilling panics: if people believe that a bank will fail, everyone will in fact want to withdraw funds at the same time — and because the bank’s assets are illiquid, trying to meet those demands through fire sales can in fact cause the bank to fail.

This then leads to the need for policy: deposit insurance and/or lender of last resort facilities to head off bank runs, and bank regulation to reduce the moral hazard from these explicit or implicit guarantees. And by the way, the FDIC-plus-regulations system kept us free of banking crises for 50 years after the Great Depression; it was only when financial deregulation eroded that system that the bad stuff started happening again.

So what would happen if you simply tried to eliminate fractional reserve banking?

First of all, you would be trying to ban a genuinely productive activity. Dick Fuld banking may have been a bad thing, but Jimmy Stewart banking was very much a useful profession.

Second, you would run smack into the problem of defining what constitutes a bank.

One of the great things about Diamond-Dybvig is that it immediately punctures any superficial notion that a bank can be defined by some traditional appearance — that it basically has to be a marble building with rows of tellers, i.e. a depository institution. Any arrangement that borrows short and lends long, that offers investors claims that are liquid while using their funds to make illiquid investments is a bank in an economic sense — and is potentially subject to bank runs. Indeed, what we had in 2008 was mainly a run on shadow banks, on non-depository institutions.

So, are you going to ban fractional reserve strategies by money market funds? Are you going to ban repo? Auction rate securities? Where does it stop?

To be fair, it’s difficult even to regulate shadow banking. But if there are benefits to being under the regulatory regime — insurance, access to lender of last resort, etc. — you have at least a fighting chance of getting most of the dangerous stuff under the umbrella. If you try to ban banks from, well, banking, all the banking is going to take place in the areas not subject to the ban, leaving you more vulnerable to crisis than before.

Let me add that the fractional reserve thing exhibits a characteristic common to a lot of what I see in the Paulist camp: they have an oddly antiquated notion of what money and finance are about, one that misses the “virtualness” of the modern world. They still think of money as being pieces of green paper, rather than what it mostly is now, zeroes and ones in some server somewhere. They still think of banks as being those big marble buildings, in a world in which most banking is a lot more abstract than that.

This is, after all, the 21st century. Things have moved on a bit.

A reader sends me this:

Small quibble: under current conditions, with a large debt overhang, the AD curve should be upward-sloping!

A question to which I think I know the answer: A number of my colleagues in the commentariat write longingly about the need for a “centrist” who will propose doing what needs to be done — combine short-run stimulus with long-term measures that will reduce the deficit.

So, will any of them notice that, according to the CBO score (pdf), Harry Reid’s version of the American Jobs Act does exactly that?

This year’s Nobel goes to Chris Sims and Tom Sargent. Many congratulations. I’d advise both of them to grab as much sleep as they can over the next few months, because it’s gonna be exhausting.

This is a statistical techniques prize — both men worked on methods for extracting insight from the data history provides us, which generally don’t offer anything like a controlled experiment. As the detailed explanation of the prize (pdf) explains, before Sargent and Sims came along, econometrics consisted largely of estimating models you had no good reason to believe based on identifying assumptions (if you don’t already know, you don’t want to) that lacked credibility. S and S played a key role in developing methods that let the data speak instead.

Is this a fresh-water macro prize? Sargent is surely identified with that school, and to some extent these techniques have tended to be associated with fresh-water modeling. But they’re much more widely used than that. For example, Barry Eichengreen, who does a lot of quantitative economic history from a relatively Keynesian perspective, routinely uses Sims-type time-series techniques, e.g. in this paper on multipliers in the Great Depression.

So, again, congrats to the new laureates.

One line I’ve been seeing in various places, including comments here, is the claim that the real way to deal with Wall Street is laissez-faire economics: no more bailouts! On this view, policy makers should raise their right hand in the air, place their left hand on a copy of Atlas Shrugged, and swear in the name of A is A that they will never again step in to rescue failing banks. And all will be well with the world.

Sorry, but that’s a fantasy.

First of all, bank regulation is important even in the absence of bailouts. Don’t trust me, trust Adam Smith. Scotland invented modern banking; it also invented modern banking crises; and Smith, having witnessed such a crisis, favored bank regulations, declaring that

Such regulations may, no doubt, be considered as in some respect a violation of natural liberty. But those exertions of the natural liberty of a few individuals, which might endanger the security of the whole society, are, and ought to be, restrained by the laws of all governments; of the most free, as well as or the most despotical. The obligation of building party walls, in order to prevent the communication of fire, is a violation of natural liberty, exactly of the same kind with the regulations of the banking trade which are here proposed.

Second, there are in fact very good reasons to intervene to support banks during a financial crisis. Bagehot knew it; Diamond and Dybvig showed it theoretically; and it remains true. Letting a financial crisis spread is very dangerous.

Finally, even if you persuade yourself that the moral hazard created by financial firefighting outweighs the benefits of avoiding a 1931-style cascading crisis, the fact is that policy makers will intervene. Hank Paulson set out to make Lehman an example; two days later he was staring into the abyss.

So the only feasible strategy is guarantees and a financial safety net plus regulation to limit the abuse of those guarantees. It’s imperfect; it faces the constant threat of regulatory capture; but it has worked in the past, and it’s the only game in town.

Ezra Klein has a generally reasonable analysis of the Obama administration’s failure to respond with sufficient force to the economic crisis. Broadly speaking, he’s saying that the eurovenn applied: an economically adequate response lay beyond the bounds of the politically feasible.

In general, I’m trying not to do too much looking back; the question is what to do now. Still, I guess this needs addressing.

There’s certainly a lot to Ezra’s thesis. Yet I think he lets Obama and company off the hook too much. A few specific points:

1. I think too much is being made of the fact that subsequent revisions have shown that the economy was in even worse shape in early 2009 than we knew at the time. There was already plenty of evidence that it was in terrible shape and needed a much bigger boost than the administration proposed. And as regular readers know, this isn’t 20-20 hindsight: I was frantic about this at the time.

2. The forecast that assumed rapid recovery even without stimulus has been a deep source of embarrassment, and remains inexplicable to me. We had lots of reason to believe that this was going to be a prolonged slump — not just Reinhart Rogoff, but also the evidence of the last two US business cycles. Again, I was warning about this at the time.

3. This in turn means that the focus on fast-acting policies was misplaced. Shovel-ready wasn’t as important as it was made out to be. And the stimulus would have been a lot closer to adequate if more of it had consisted of infrastructure spending rather than tax cuts.

4. Politically, the administration was wildly naive in believing that it could easily come back for more if the initial stimulus proved inadequate. Again, this isn’t hindsight; I was frantic about this too, right from the beginning. If they thought this likely — as they should have — they should have laid the legislative groundwork for a second round, through reconciliation if necessary, right at the start.

5. Even without that groundwork, my sense is that there was a window for additional action in the fall of 2009, and that the administration sheered off from even trying.

6. Relatedly, the insistence of the administration that the stimulus was just right, long after it was obvious that it had been too small, did a lot of political damage. Remember the “summer of recovery”?

7. The political response to the new jobs bill has been pretty good — which in turn strongly suggests that the “pivot” from jobs to deficit reduction in early 2010 was a big mistake. Maybe — probably — nothing could have passed; but the White House might have been able to make a better case by accusing Republicans of blocking job creation rather than adopting their rhetoric.

Now, Ezra may be right that none of this would have made much difference. But the White House was weak and confused in the face of a political and economic debacle, when it should have gone all out.

And you know what? It should still go all out. The chances of success are lower than they would have been if it had taken a strong position two years ago, but it ain’t over until it’s over.