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Here is Free Exchange:

SLOVENIA’s banking bail-out announced on December 12th followed a familiar pattern. Having driven over the edge thanks to reckless lending, the country’s three big banks are being hauled back onto the road by taxpayers.

Now this is certainly an interesting coincidence. At the same time that Atlanta and Phoenix banksters were engaging in Reckless Lending in America, the same thing was occurring in small far-away formerly communist country, with a very different economic system.

And in an even more shocking coincidence, the same thing was going on in Greece.

And in Latvia.

And in Spain.

And in Britain.

And in Iceland.

And in Cyprus.

And in Ireland.

. . .

. . .

etc, etc.

Or perhaps this is a lazy explanation. Could there be some sort of common external shock that economic theory predicts would cause Reckless Lending in a large group of countries? Yes, the biggest fall in NGDP since the Great Depression.

“So are you saying . . .”

Here’s precisely what I’m saying:

1. There was some reckless lending (no caps) in America and a few other places. Nothing catastrophic.

2. When oil prices soared in 2007-08, central banks responding to rising headline CPI inflation with tight money, which slowed NGDP growth sharply in the first 9 months of 2008.

3. The sharply falling NGDP growth made the banking crisis much worse, driving the Wicksellian real equilibrium rate so low that even with a 2% inflation target equilibrium nominal rates fell to zero.

4. Central bank error #2, they cut rates far too slowly during this period. Especially in Europe. Now NGDP plunged sharply in late 2008 and the financial crisis became much more intense. Suddenly even more Reckless Lending was exposed.

5. When rates finally hit zero at the end of 2008 in the US (but not in Europe), the Fed had no backup plan to maintain NGDP growth. They did not do what Bernanke had told the Japanese they must do. Now NGDP fell even further, the financial crisis got even worse. More Reckless Lending was exposed.

6. Because the eurozone budget deficits got much worse, fiscal strains appeared in places like Greece, which really had done some (sovereign) reckless borrowing. Or should we call that reckless lending by the Germans, in order to be consistent?

7. Time to raise those VATs, so that the sovereign debt crisis doesn’t get even worse.

8. Higher VATs raise inflation in the eurozone. The ECB must focus like a laser on keeping inflation around 1.9%, unless of course it is lower than 1.9%, in which case inflation should be ignored and attention should switch to stopping “bubbles,” which are of course easy for government bureaucrats to spot. But I’m getting ahead of myself.

9. The higher VATs raise headline inflation, and the ECB in its infinite wisdom decides to target inflation inclusive of VAT at a time of fiscal austerity. They raise interest rates twice in 2011, and a double-dip recession ensues. Right out of the 1937 playbook—tight fiscal and tight money.

10. Now the debt crisis gets even worse, as it always does when NGDP growth plunges. Even more Reckless Lending by the Germans. And they didn’t just Recklessly Lend to Greece, they Recklessly Lent to Spain and Italy and Portugal and Ireland. No bailouts for governments (that creates moral hazard) but Irish banks that borrowed from the Germans must of course be bailed out.

10. And now Slovenia. And we are asked to believe the explanation is simply Reckless Lending. A bizarre epidemic of Reckless Lending suddenly appeared all over the world at roughly the same time. Wildcat banks in the American sunbelt. Sober German banks. British banks. Irish banks. Spanish banks. Cypriot banks.

And now Slovenian banks. And all this at a time when NGDP plunged. And economic theory predicts that plunging NGDP would cause a big increase in debt defaults. And economic theory suggests that central banks are supposed to prevent NGDP from plunging.

Especially when not at the zero bound.

And the ECB has been above the zero bound for more than 95% of the time over the past 5 years.

So how do you prevent reckless lending from occurring? It’s impossible, but a reduction in regulations generating moral hazard would help. How do you prevent an epidemic of Reckless Lending? Simple, a 5% trend growth target for NGDP, level targeting.

PS. The snark is not aimed at P.W., who is only expressing the conventional wisdom.

PPS. Just to be clear, when I say tight money causes “Reckless Lending,” I mean tight money causes NGDP to fall, which causes defaults, which causes loans that were not reckless at the time to later be perceived as reckless.

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