By Barry Eichengreen, Professor of Economics and Political Science at the University of California, Berkeley; and formerly Senior Policy Advisor at the International Monetary Fund. Cross posted from VoxEU
Irish interest spreads did not fall and contagion continues. Here one of the world’s leading international economists explains why. Short-sighted, wishful thinking by EU and German leadership designed a package that is not economically feasible in the long run (it would trigger a vicious debt deflation spiral) and it is not politically sustainable in the short run. The Eurozone had better have a Plan B for when the new Irish government rejects the package next year and imposes a haircut on Irish bank bondholders.
The Irish “rescue package” finalised over the weekend is a disaster. You can say one thing for the European Commission, the ECB, and the German government – they never miss an opportunity to make things worse.
It pains me to say this. I’m probably the most pro-euro economist on my side of the Atlantic. Not because I think the Eurozone is the perfect monetary union, but because I have always thought that a Europe of scores of national currencies would be even less stable. I’m also a believer in the grand European project. But given this weekend’s abject failure of EU and German leadership, I am going to have to rethink my position.
A solvency problem postponed is a problem made intractable
The Irish “programme” solves exactly nothing – it simply kicks the can down the road. A public debt that will now top out at around 130% of GDP has not been reduced by a single cent. The interest payments that the Irish sovereign will have to make have not been reduced by a single cent, given the rate of 5.8% on the international loan.
According to the deal, not just interest but also principal is supposed to begin to be repaid after a couple of years. At that point, Ireland will be transferring nearly 10% of its national income as “reparations” to the bondholders, year after painful year.
The inevitable populist backlash
This is not politically sustainable, as anyone who remembers Germany’s own experience with World War I reparations should know. A populist backlash is inevitable. The Commission, the ECB, and the German Government have set the stage for a situation where Ireland’s new government, once formed early next year, rejects the budget negotiated by its predecessor.
Do Mr Trichet and Mrs Merkel have a contingency plan for this?
Infeasibility of a wage-cutting exit plan
Nor is the situation economically sustainable. Ireland is told to reduce wages and costs. It must engage in “internal devaluation” because the traditional option of external devaluation is not available to a country that lacks its own national currency.
But the more successful it is at reducing wages and costs, the heavier will be its inherited debt load.
Public spending then has to be cut even more deeply. Taxes have to rise even higher to service the debt of the government and its wards such as the banks.
This in turn implies the need for yet more internal devaluation, which further heightens the burden of the debt in a vicious spiral. This is the phenomenon of “debt deflation” about which the Yale economist Irving Fisher wrote in a famous article at the nadir of the Great Depression.
What should have been done
For internal devaluation to work, therefore, the value of debts, expressed in euros, has to be reduced. This would have been particularly easy in the Irish case.
A bright red line could have been drawn between the third of the government debt that guarantees the obligations of the banks, on the one hand, and the rest of the government’s debt, on the other hand.
The third representing the debts of the Irish banking system could have been restructured.
Bondholders could have been offered 20 cents on the euro, assuming that the Irish banks still have some residual economic value.
If those banks are insolvent, the bondholders could – and should – have been wiped out.
Irish public debt would then have topped out at maybe 100% of GDP. And the Irish programme would have had a hope of working. As it is, the programme will have to be revisited, perhaps as soon as next year. Investors know this, which is why Irish spreads have barely budged.
In fact, this is exactly the policy that the IMF, which at least knows how to add, has been pushing for over the last week. But the Fund was unable to overcome the objections of the Commission, the ECB, and the German government.
Why the mistakes?
One can interpret the intransigence of the German government and its EU allies in two ways.
First, they understand neither economics nor politics. As Tallyrand said of the Bourbons, “They have learned nothing, and they have forgotten nothing.”
Second, policymakers in Germany – and in France and Britain – are scared to death over what Ireland restructuring its bank debt would do to their own banking systems.
If the second interpretation is correct, the appropriate response is not to lend to Ireland – to pile yet more debt on the country’s existing debt – but to properly capitalise the French, German, and British banking systems so that they can withstand the inevitable Irish restructuring.
But European officials are scared to death not just by their banks but by their public who don’t want to hear that public money is required for bank recapitalisation. It’s safer, in their view, to kick the can down the road in the hope that something good will turn up – to rely on “the luck of the Irish.”
As John Maynard Keynes – who knew about matters like reparations – once said, leadership involves “ruthless truth telling.” In Europe today, as recent events make clear, such leadership is in short supply.
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Eichengreen: “In Europe today, as recent events make clear, such leadership is in short supply.” Not merely in Europe but in the world as a whole. To me, this is the salient observation of international policy action in response to the bursting of the Securities Bubble thus far: the pervasive, indeed near total, failure of political leadership. The failure not merely to generate ‘solutions’ nor simply to contain ‘problems’ but in fact the failure of most political leadership to meaningfully engage with _problems_. Political leadership have had extraordinary scales of resource at their disposal to heave hook rugs and carpet bombs of paper over massive, non-self-solving problems, resources put in their hands by central banks among other enablers, and so political leaderships have heaved and averted their gazes from the result.
This aspect—gross leadership incapacity in developed economies—strikes me as a phenomenon of real interest regarding the present crisis in and of itself, which is not to say that I readily understand it. Leave aside the economic and financial particulars of crisis and consider it as a socio-political conjuncture: to solve the crisis, someone has to engage with it, so presuming that someone _could_ engage with it (a result by no means certain), why is it that present leadership doesn’t? Is it that the systemic complexities of this particular crisis are simply so snarled that minds refuse to un-plait the bloody spaghetti? Is it that said leadership operates in a 24/7 news-and-briefing environment whose pace paralyzes interaction with the general by forcing so many particulars at ones attention? Is it the 365-day-forevermore election cycle—most of these developed economies are putative democracies of republican form—which rucks up tired little shills in suits too big for them good at nothing but standing still before a camera? Is it the outcome of the creeping fungus of technocracy, where every problem is deemed the purview of a qualified ‘experts’ who have only to press the proper button on their consoles to make everything better; therefore the only role of political leadership is ‘to call for calm’ until the Mammonmachine reboots? Is it because the governing class is not _personally_ feeling much if any pain, being too rich and too insulated, so that sticking ones fingers in ones ears not to hear the squeeks of citizen pips being mashed in the gears and the ruins is a functional approach, i.e. ‘muddling through’ in the choice historical phrase for those at the wealth class level. While all of these appear to me to be factors, with many more that others are welcome to add, they don’t seem by themselves sufficient explanation to our leadership insufficiency. I might add another here: that the types of personalities capable of rising to the top in electoral politics like globules of fat in stew are not those with any capacity, let alone flair, for actual governance; indeed, if one is any _good_ at governance they are automatically extruded from ‘the process’ as unmanagebly autonomous to the 1% who fund political factions and benefit most from them.
A larger issue is simply that most leadership/governance is poor to bad most of the time most anywhere from the historical standpoint. I don’t consider that a proven conclusion, but it’s certainly the most evident working hypothesis. People are complicated, and societies are hard to manage outside of gross repression (which is hard to sustain, thankfully). Actors are inevitably self-interested in processes where that kind of bias near guarantees suboptimal outcomes. And so on, and so on, but look folks, folks just aren’t particularly good at governance, and societies are not notably manageable, and thus those good at leadership are likely to get frustrated and pursue interests where they can actually lead, such as armies, corporations, and sporting clubs. One could even advance an hypothesis—I haven’t tested it but I rather like it—that in the main leadership is bad, and one only gets good leadership as a direct result of crisies because the normal run of bad leadership fails so quickly and spectacularly in those instances that some few actually good at leadership or governance get a shot at it, by hook or by crook or by acclaimation. That is certainly true for military leadership, though to be sure political leadership has different selection dynamics much of the time.
All that’s to say that the present flatulent, trembly-lipped inefficacy of governmental leadership in this particular crisis isn’t historically unique, it’s the historical norm. And a kind of norm which can run for quite a long time. One could think of periods such as 1530-80, 1720-50, 1885-1914 in Europe, or the first half of the 19th century in China, or many other times when leadership was conspicuous by not only its absence but its near impossibility. Those periods weren’t selected at random, and should fairly be balanced by counterexamples, but they all lead to the collapse of their particular ‘systems’ and the re-ordering of the problem sets behind them. There is a consequence to an extended period of non-leadership, of not knowing where you’re going or how. Problems can be run from or run around only so long before something valuable runs out or gets run over.
We’ve had no leadership anywhere for at least fifteen years, not to call the leadership before then necessarily good. (Pick you’re own deflection point; I mean, I do.) The ruling class isn’t worried by either ‘Long War’ or ‘Long Slide’ and hence there’s little urgency at their altitude to engage with sticky, messy, ultra-disruptive problems. So we can safely assume that fat asses will correlate with fat heads for some time to come. No one can really say when ‘too long’ runs the clock out on muddling through; could be fifteen years, could be five, could be thirty. Depends when you started counting from. But extended absence of leadership turns failure into catastrophic failure. And that, on present evidence, is our current trajectory: Waiting for Goddamn.
[Barry Eichengreen, btw, is one of my preferred observers.]