1. James Hamilton reviews the emergency lending of the Fed from 2008-2011.

Phase 4, then, could turn out to be a return to emergency lending as the Fed tries to contain collateral damage from the unfolding European drama.

2. Olivier Blanchard writes,

What has become clearer this year is that liquidity problems, and associated runs, can also affect governments. Like banks, government liabilities are much more liquid than their assets–largely future tax receipts. If investors believe they are solvent, they can borrow at a riskless rate; if investors start having doubts, and require a higher rate, the high rate may well lead to default. The higher the level of debt, the smaller the distance between solvency and default, and the smaller the distance between the interest rate associated with solvency and the interest rate associated with default.

Blanchard appears to have become fully assimilated into the bankers’ view of the economy. The problem is one of liquidity and managing perceptions. The reality of fiscal and monetary policy, which once dominated macroeconomic textbooks, has slipped into the background.

I long for a Sumnerian rant that says, “You can let banks fail! You can cut government spending! Just make sure that the monetary authorities maintain aggregate demand!”

It’s like Bernanke and Blanchard have two versions of macroeconomics. One version goes into their courses and textbooks, and it is what Scott Sumner keeps expecting from them. But once in power, these economists act on a completely different version of macroeconomics, in which confidence in banks becomes the centerpiece.

Maybe this is what happens when you become a policy maker. I have this “Invasion of the Body Snatchers” nightmare in which Sumner is appointed to a top position at the Fed or the IMF and soon thereafter starts defending “special lending facilities” instead of aggregate demand.

3. John Cochrane writes,

Europeans leaders think their job is to stop “contagion,” to “calm markets.” They blame “speculation” for their troubles. They keep looking for the Big Announcement that will soothe markets into rolling over another few hundred billion euros of debt. Alas, the problem is reality, not psychology, and governments are poor psychologists. You just can’t fill a trillion-euro hole with psychology.

Read the whole thing. Other paragraphs are equally bracing.

The two-drunks model is still looking apt. The banks are dependent on the governments for their solvency. And the governments are dependent on the banks for their liquidity. The longer these two drunks lean on one another to try to hold each other up, the worse it will be if (when) they fall down.

At this point, it looks to me as though the European banks are about as private as Freddie Mac and Fannie Mae. And in Europe, the non-bank financial sector is much smaller than in the U.S.

I think where this leads in ten years is a sort of Third World situation, with small business operating in the underground economy and the legal economy consisting of government-sponsored enterprises. For small business, operating legally only has an advantage if you have access to capital markets, but that access is going to be crowded out by government and government-sponsored enterprises. Meanwhile, the tax cost of operating legally is going to rise.