A fair number of policy commentators are hewing to the view that somehow the EU will cobble together some sort of solution to the Greek fiscal mess because the alternatives look vasty worse. As Paul Krugman noted:
Now what? A breakup of the euro is very nearly unthinkable, as a sheer matter of practicality. As Berkeley’s Barry Eichengreen puts it, an attempt to reintroduce a national currency would trigger “the mother of all financial crises.” So the only way out is forward: to make the euro work, Europe needs to move much further toward political union, so that European nations start to function more like American states.
But that’s not going to happen anytime soon. What we’ll probably see over the next few years is a painful process of muddling through: bailouts accompanied by demands for savage austerity, all against a background of very high unemployment, perpetuated by the grinding deflation I already mentioned.
Yves here. Yet we have the spectacle of Greece signaling that it isn’t exactly up for what its creditors want from it, as the Financial Times reports:
Greece is expected on Monday to resist pressure for an immediate tightening of its current austerity package as it fights to win back the confidence of international financial markets and its eurozone neighbours.
Both Germany and the European Central Bank have been pushing Athens to strengthen its existing fiscal stability plan by adding measures such as a 1 to 2 per cent increase in value-added tax and further public-sector wage cuts in return for financial assistance.
In an appearance on French television on Sunday night Jean-Claude Trichet, the ECB president, called on Greece “to take the extra measures that will be necessary to make credible their turnaround plan”.
But Athens is fighting to postpone any decision on further measures until mid-March, when officials from the European Union, ECB and International Monetary Fund are due to carry out a forensic inspection of Greece’s deficit-cutting plans.
“It makes no sense to rush into additional measures until they are seen to be necessary,” said a senior Greek official.
Yves here. This is not exactly the way to win friends or bolster market confidence.
Ambrose Evans-Pritchard points to another wee problem: the EU made a commitment in advance of member states going along. And right now, they, like Greece, are not making the right noises either:
The EU has issued a political pledge to rescue Greece – and by precedent, all Club Med – without first securing a mandate from the parliaments of creditor nations.
Holland’s Tweede Kamer has passed a motion backed by all parties prohibiting the use of Dutch taxpayer money to bail out Greece, either through bilateral aid or EU bodies. “Not one cent for Greece,” was the headline in Trouw. The right-wing PVV proposed “chucking Greece out of EU altogether”.
Germany’s Bundestag has drafted an opinion deeming aid to Greece illegal. State bodies may not purchase the debt of another state, in whatever guise.
The EU is entering turbulent waters by defying these irascible and sovereign bodies. It had no choice, of course. Europe’s banking system was – and is – at imminent risk as Greek contagion spreads across Club Med. The danger of a “sovereign Lehman” setting off a chain reaction is very real, with Britain too in the firing line. I find myself in the odd position of backing drastic EU action, for fear of worse. We all go down together if this escalates.
The last two weeks have cruelly exposed the Original Sin of monetary union: that EMU was launched without an EU treasury or debt union. This will be tested again and again by bond vigilantes until such a mechanism is created. Europe’s hope of fending off markets with “constructive ambiguity” must fail, as will become obvious this week if EU finance ministers fail to flesh out rescue details.
Yves again. At the danger of taxing the patience of regular readers, I want to reintroduce a construct of Dani Rodrik’s which has direct bearing on the Euro struggles:
I have an “impossibility theorem” for the global economy that is like that. It says that democracy, national sovereignty and global economic integration are mutually incompatible: we can combine any two of the three, but never have all three simultaneously and in full.
To see why this makes sense, note that deep economic integration requires that we eliminate all transaction costs traders and financiers face in their cross-border dealings. Nation-states are a fundamental source of such transaction costs. They generate sovereign risk, create regulatory discontinuities at the border, prevent global regulation and supervision of financial intermediaries, and render a global lender of last resort a hopeless dream. The malfunctioning of the global financial system is intimately linked with these specific transaction costs.
So what do we do?
One option is to go for global federalism, where we align the scope of (democratic) politics with the scope of global markets. Realistically, though, this is something that cannot be done at a global scale. It is pretty difficult to achieve even among a relatively like-minded and similar countries, as the experience of the EU demonstrates.
Another option is maintain the nation state, but to make it responsive only to the needs of the international economy. This would be a state that would pursue global economic integration at the expense of other domestic objectives. The nineteenth century gold standard provides a historical example of this kind of a state. The collapse of the Argentine convertibility experiment of the 1990s provides a contemporary illustration of its inherent incompatibility with democracy.
Finally, we can downgrade our ambitions with respect to how much international economic integration we can (or should) achieve. So we go for a limited version of globalization, which is what the post-war Bretton Woods regime was about (with its capital controls and limited trade liberalization). It has unfortunately become a victim of its own success. We have forgotten the compromise embedded in that system, and which was the source of its success.
So I maintain that any reform of the international economic system must face up to this trilemma. If we want more globalization, we must either give up some democracy or some national sovereignty. Pretending that we can have all three simultaneously leaves us in an unstable no-man’s land.
The EU tried to have all democracy, national sovereignity, and economic integration, and the result is the unstable no-man’s land that Rodrik foretold.
Krugman’s assumption is that EU members will compromise national sovereignity to achieve the benefits of economic integration. But from Greece’s (and perhaps other nations if the Greece bailout flounders and contagion spreads) is that that giving up some measures of national sovereignity means also giving up aspects of democracy. So that plus the harsh austerity measures looks like a lose-lose-lose (although it may prove hard to persuade Greek citizens that the economic costs of defying the EU are even worse than submitting to its demands).
But we have had critical junctures in the past where an inability to manage politics led to disastrous outcomes. Consider Germany in 1931. The budget deficit had gone into the red as the recession deepened. Germany’s government faced a serious credibility problem in the international markets, embarked on a tough program of austerity measures, and a mere few months later, its bonds were trading at close to par. But it
Thomas Ferguson and Peter Temin argue why things went awry:
The German government found itself in an impossible position as the recession of the late 1920s deepened. Like so many other countries, the German government’s budget went into deficit as the recession progressed. The Weimar government lacked the political will to deal with the impending crisis, substituting rash statements about customs unions and Reparations for serious budgetary action. German banks failed in 1931, but the problem was not primarily with them. Instead, the crisis was a failure of political will in a time of turmoil.
Notice that the austerity measures were effectively imposed against the public’s will:
Pressed to get this mountain of debt under control, Brüning tried a variety of ploys. They all failed. Eventually, a budget calling for savage spending cuts, lower taxes, cuts in the pay of government officials, and smaller transfers to the Laender and municipalities had to be enacted by Noteverordung. But the move outraged deputies and key business figures on the right who wanted deeper cuts, while angering many on the left who considered the budget palpably unfair. As the big business oriented German People’s Party (DVP) committed binary fission, a majority of the Reichstag exercised its constitutional right to reject the decree. Hindenberg and Brüning reacted with a fateful
step: They dissolved the Reichstag, called new elections, and reenacted the Noteverordung with minor changes.
A disaster for the government ensued. In the September elections, amidst the highest voting turnout in the Republic’s history, the Nazis dramatically emerged as the second largest single party in the Reichstag, while the Communists made substantial gains…Not surprisingly, investors stampeded out of Mark assets….The Reichsbank was forced to raise its rediscount rate by a full point…..
What actually happened is that the government responded by redoubling its resolve to continue down the path of austerity so resoundingly repudiated by the electorate. Amid a flurry of sympathetic news stories in papers from Berlin to New York, Hindenberg immediately tapped Brüning to form a new government. Solemnly promising to make fiscal reform and deficit reduction his top priority, Brüning reappointed the entire cabinet. On the basis of more Noteverordungen and additional measures mandating a sinking fund for debt retirement, steep rises in workers’ contributions to the unemployment fund, higher taxes (including new levies on mineral water and individual citizens), and slashes in government spending, civil service pay, and inter-governmental transfers, the government floated a $125 million loan through a syndicate headed by Lee, Higginson.
Financial markets perceived “every sign of returning calm” and hailed “the cessation of the withdrawals of money, especially foreign withdrawals.” The spectacle of the government bowing to foreign creditors (whose connection to the austerity package government’s popularity still more. But the shock of the election and fears about what might happen if Brüning failed forced the SPD and other democratic forces into an agonizing reappraisal. Staring into the abyss, the party came reluctantly to the conclusion that while it could not openly support the Chancellor, it would have to “tolerate” his government as the lesser evil….International support for Brüning grew as his government moved to make good on its tough talk…
Other good news also trickled in. Widely reported indices of German industrial production rose slightly.(Table 1) Unemployment began to trend very slightly down. In an age that venerated gold movements as the ultimate test of economic sustainability, the Reichsbank’s holdings of gold and foreign exchange rose slowly but steadily from January to April. Bankruptcies — even now esteemed as one of the few clear external indicators of possible bank lending difficulties — started falling in February, rose slightly in March, and then fell sharply in April and May (Table 1). Indeed, almost every indicator that subsequent analysts have suggested might herald a banking or currency crisis improved modestly in the early months of 1931.
Yves here, this is a long-form account (the paper is fascinating but much more detailed) but I though this was worth providing to illustrate the difficulties of imposing stringent austerity measures in a democracy.
Ferguson and Temin discuss another key issue: the fact that France, the second biggest international creditor in its day, which had boycotted German bond auctions since 1929, decided to support the German government by making a large loan to Germany. Back to the paper:
Economic conditions in the early months of 1931 therefore did not give much hint of the crisis to come. Conditions were not good in these harsh economic times, but there was little anticipation that they were about to get a lot worse. Expectations appeared to argue the opposite, that conditions were on the mend, as suggested by the slight improvement in the economic data…
The authors looked at a variety of banking data in June 1931 and concluded it did not show the signs of contagion typical of a bank panic; instead, it was flight from the mark (see pages 20-27). And as the paper describes in detail, the trigger for the unwinding was a series of aggressive and nationalistic policy measures which undermined the international cooperation that had shored Germany up economically, in particular, but not limited to, a plan to build pocket battleships and the notorious proposed customs union with Austria:
While the Germans and Austrians were prepared to argue that a customs union did not infringe on these [treaty] prohibitions, internal documents indicate that they knew very well they might be flying into the eye of a hurricane. They were right. When news of the plan leaked, a storm of protest immediately blew up. As France moved convulsively to counter the German thrust, its chilling implications dawned on the press and financial markets. As the New York Times headlined in late March, 1931: “Paris loan market shut by Reich move. Union held to kill prospects for intermediate or long-term credit aid by French.
Outcry in press is fatal. Bankers fear customs plan will shatter regained faith of our investors in Europe’s stability.”
Political and financial machinations ensued for several months, but absent a German/Austrian climbdown, the outcome was inevitable.
Now some readers will argue that this little historical discourse has little to do with Greece and the Club Med woes, but I believe it does.
First, it illustrates what happens when governments try to uphold an economic paradigm (in the case of Germany, the gold standard, in the case of the EU, member states’ inability to conduct independent monetary and currency policies) that imposes strong deflationary pressures as the cure for cross border imbalances. The governments fail, with the risk of being replaced by more radical elements.
Second, it shows the difficulty of maintaining internationalist measures if domestic interests feel threatened. France tried to aid Germany, but as Germany looked more belligerent, France withdrew financial support to Germany.
Many readers will argue that Greece is not anywhere near as influential a force as Germany in the 1930s, but it is important to remember that Greece is merely the most immediate symptom of long-known structural issue in EU that need to be addressed. Unfortunately, while it usually takes a crisis to force resolution, at the same time, a crisis is generally the worst setting in which to undertake fraught and difficult political negotiations.