The eurozone and its experts
This Sunday morning, reading and rereading some of last week’s tweets and comments on the state of the eurozone after the dramatic political events in Greece and Italy, I got the feeling: This is all wrong. In my view the whole debate at the moment is moving in a fatal direction and, no matter whether Europe will manage to kick the can long enough to survive the current crisis or not, the debris it leaves will make it hard to find back to the path of integration which has been one of the most remarkable achievements in world politics.
The following comments are loosely based on a widely noticed recent piece by Nouriel Roubini which provides a thorough overview of concepts and ideas. My critique refers to both the diagnosis and proposed remedies.
Let me start with some brief clarifications:
- In my view, the current crisis is not a problem of individual countries but of how the eurozone conceives itself. Heterogeneity of member countries and economies had been a characteristic of the system from its very beginnings, and singling out conditions in Greece and Italy and other countries means redefining the nature of the common enterprise under financial market pressures.
- Further I think the problem of the eurozone is not rooted in macroeconomic developments such as consumer spending, current-account imbalances and fiscal deficits. None of these triggered the crisis. Instead these variables serve as ex post explanations of phenomena macroeconomists usually are unfamiliar with and therefore prefer to neglect.
- There was a moment when debt in parts of the eurozone became unmanageable as Roubini writes. However, how I perceived it, this was not when housing bubbles burst in Italy and Spain or current-account deficits and fiscal debt became unsustainable. As I wrote elsewhere, it was when financial markets found means to test the promises made by the euro fathers, discriminate between members and debunk the myth of equality and riskless governments.
As a rule, a wrong diagnosis leads to wrong recommendations. The current debate is no exception. Instead of considering the four options Roubini discusses in his text I would like to have a closer look at individual components.
- Restoring growth and competitiveness. Since lack of growth and competitiveness is no explanation for the outbreak of the crisis restoration cannot help eliminate the fundamental problem which is to hinder financial markets to bet again against individual member countries. Even if Greece and Italy would get their economic data “right”, markets would find another justification – or another member country (France? – ht S&P).
- Structural reforms may be needed urgently in some underdeveloped countries and regions in the eurozone and elsewhere. But, they are not a proper way to calm markets in this financial crisis. One reason is different time horizons: While in financial markets many positions are rarely held for long periods of time, and often only for hours or even minutes (and HFT traders make money in microseconds, but this is another story), macroeconomic data need long time to react to policy measures. Markets may be impressed by a policy announcement but this is rarely a lasting effect.
- Austerity measures are needed nowhere as they weaken growth prospects. The resulting further reduced ability of countries to repay their debt will only aggravate the problem to bailout banks – the only aspect policy leaders seems to interest these days.
- Further easing of monetary policy is fraught with high uncertainty and there are many debates about its inflationary and growth effects. Accepting “modestly higher inflation” sounds harmless enough but who guarantees modesty? And if price rises turn out to be more than “modest”, as with austerity measures, wage cuts of 30% and other proposals easily made from a university chair, the burden of the policy outcome will be borne by the common people, not by the culprits of the mess.
- A sharp euro depreciation bears dangers which must be seen in a global context where it may easily trigger a currency war and reinforce existing tensions in world foreign exchange and trade relations. That weaker European countries will benefit from the depreciation must be doubted. More probably it will allow the strong export nations in Europe to increase market shares at the expense of US and Asian competitors. And as far as the measure is directed at promoting economic growth, again the question of its effectiveness in lastingly impressing financial markets arises.
Credibility is the key to any solution to the crisis and in this respect the euro has long lost all credit. Under these circumstances the only way out seems a tabula rasa going back to start as fast as possible. Instead of sitting like a rabbit staring at the snake and awaiting markets’ next assault the euro should be abandoned by all members instantaneously, and at the same time a full debt relief should be announced. This would bereave markets of a target and reestablish members’ sovereignty allowing them to pause and think about the next steps to reactivate the integration process.
Not possible? Too much cost? These arguments neglect the cost the current situation is imposing on the world, eurozone members and nonmembers alike. Many commentators conjure doomsday scenarios. To cite Nouriel Roubini: “ … such a disorderly eurozone break-up would be as severe a shock as the collapse of Lehman brothers in 2008, if not worse.”
How can he know? This statement contradicts all textbook wisdom. In contrast to the Lehman collapse, the euro break-up has long been a foreseeable event with a growing probability of entry (Roubini prides himself to have foreseen a break-up after five years as early as 2006. Had the US authorities had even the slightest suspicion of the Lehman crisis and its possible extent in 2003 presumably it would have passed with much less noise and damage). These days, in Europe business firms are increasingly writing currency clauses into new contracts. There are rumors that the Bundesbank is already printing DM to prepare for a break-up. Many banks have written down “toxic” debt – not for nothing that EU governments kicked the can so long. The biggest worry is that, as in the Lehman case, authorities overlooked a financial market link or instrument, something such as CDSs and CDOs in the Lehman case, which may set in motion a downward spiral that cannot be stopped. But even for this case they are better prepared than the last time, since it will not come wholly unexpected.
A shock it will not be – but a huge challenge.
Where will Europe stand when this mess is over?
The integration process will have suffered a severe setback. The eurozone will have turned out to be a fair-weather union, a class society where one part can decide to throw out ask the other to leave. The illusion of equals is lost and there is a clear divide into core and periphery, North and South, with far-reaching consequences. Risks are distributed unevenly. While the North may be weakened by economic compromises it has unmistakably demonstrated its ability to enforce national interests: as guardian of the euro, promoter of its industries, bailing out its banks and rewriting the rules where necessary. In contrast, periphery countries experience a disproportionate loss of sovereignty and the risk to lose all – even membership – if non compliant.
Markets have learned their lessons, too. Now they know that government bonds are not risk free, euro members are not a group of equals and policy is only committed to the project up to a very low threshold. All this will impede any approach to establish a new, or strengthen the still existing, common currency.
In retrospect, when the worst is over, the role of several actors on the sideline will be worth debating – including economists. It is a deplorable fact that in economics there is too much emphasis on the “real” economy and too much ignorance of financial markets and institutions. As a consequence, when facing a new situation economists retreat to familiar terrain – with the result that, as the current crisis debates clearly demonstrate, solutions are often searched in the wrong direction. There is money, but no stock market. Banks (rarely!), but no institutional investors. No derivatives markets or shadow banks. A central bank, but no supervisory authorities or credit rating agencies. Expectations are modelled, but not trading strategies. In the rudimentary world of monetary policy, targets are “conflicting” where more realistic scenarios would allow for a whole range of policy alternatives.
The crux is that these concepts and ideas are often 1:1 translated into policy recommendations. An old joke says that economists first look for a solution and then search the problem to which this would apply. There is truth in it, which helps explain why some “experts” appear hopelessly overwhelmed with the current crisis where the rules of the game are made outside their familiar textbook world. Where economists are talking about macroeconomic imbalances and long-term austerity programs policy searches to react to markets with a wholly different focus and time horizon looking for short-term hedging or profit opportunities. One lesson of the crisis is that economists must rethink curricula and they must learn to include this other side of the economy – fast.