The rolling European crisis – why the politics of credibility gain doesn’t work

by niamh on February 1, 2010

I posted recently on The paradoxical politics of credible commitment, noting the excellent analysis of Gordon Brown’s politics by Sebastian Dellepiane.  He argues that the Labour government did not make the Bank of England independent simply in order to defuse City suspicions of them. This self-binding policy was also in fact enabling, because it made it possible for Brown to adopt a classic Keynesian economic strategy by about 2000.

The Euro started out as a self-binding credibility-gaining mechanism for Eurozone member states. But the Euro also turned to have an ‘enabling’ side to it. It contributed to new kinds of instability by facilitating the extension of cheap credit and by permitting increasingly risky lending practices to spread throughout the European financial system, in Germany and France as well as in the weaker peripheral economies.

This has led me to think some more about the relevance of the logic of credibility gains in the current European crisis.

The self-binding austerity politics now under way in the Eurozone also has some paradoxical features. The crisis has produced an explosion of fiscal deficits and an accumulation of sovereign debt. The ECB favours fiscal austerity to restore stability, and so does German public opinion. This means that every other member state must adjust to low demand conditions and domestic deflation. But while Gordon Brown’s self-binding monetary policy proved to be enabling, Eurozone governments’ self-binding fiscal policy might be seen as self-disabling, because it involves commitment to a strategy that may prove self-defeating. There are two reasons for this.

Firstly, Europe is arguably trying to use fiscal disciplines to solve the wrong crisis. The orthodox view is that fiscal consolidation will generate credibility in the markets. This is meant to build the conditions for renewed growth, and in the case of Ireland and Greece, for their eventual exit from EU-IMF loan programmes and return to the bond markets.

But only in Greece is the emergence of a sovereign debt problem primarily a consequence of poorly managed public finances. In other countries, and especially in the other weaker and smaller peripheral states, it is a consequence of the state assuming private sector debts in order to shore up their crumbling banks.

The peripheral European states faced the most difficult adjustments to the fixed exchange rate regime. Access to low interest rates in an international money market ‘awash with cheap investable funds’ produced an investment surge and an asset price boom. This threw an unmanageably large burden of adjustment onto their domestic cost management. It created enormous problems of control in the financial sector. The SGP was meant to reproduce German fiscal stability and sustained competitiveness across the Eurozone. But the interaction between European and domestic institutions was not taken seriously enough in the institutional design of the Euro.

Secondly, quite apart from the crisis of the European banking system, there are several reasons why governments’ adoption of austerity measures may not produce the anticipated credibility gains that would facilitate renewed growth.

Austerity is even more contractionary when everyone is doing it, under conditions of monetary integration (no devaluation to regain competitiveness) and with low interest rates (distributive conflicts can’t be eased through inflation). Fiscal consolidation to bring about growth may in fact make this impossible.

Countries adopting harsh budgets can find that, rather than gaining credibility, they suffer an immediate loss of credibility, reflected in a downgrade in the rating of their bonds. The markets don’t believe in the capacity of austerity to restore growth independently of other measures.

And ultimately, austerity may lose credibility because it is politically unsustainable. Popular opinion may accept fiscal pain if it is seen as temporary and unavoidable. But a prolonged spell of contraction, involving rising unemployment, growing poverty, and worsening services, may cause a welling up of popular discontent that might even risk continued social stability. And when and if growth returned, policy-makers would find it very difficult to maintain the squeeze on spending and to keep the lid on taxes.

Current Eurozone fiscal self-binding measures have mostly been adopted because a more effective longer-term European crisis resolution strategy does not exist. A ‘wait and see’ approach is likely to make things a good deal worse, where what is arguably needed is a comprehensive approach to debt reduction and a systematic restructuring of European banking.

The orthodox view is that self-binding now will result in growth later, ‘reculer pour mieux sauter’. But the credibility of this approach is now in question in the Eurozone. How long can ‘reculer pour mieux reculer’ go on? What if stepping backwards means ending up being cornered, or even worse, heading ever closer to the cliff-edge?

Angela Merkel’s latest ideas about debt brakes and competitiveness pacts have been widely criticized, for example here and here, and are unlikely to gain any political traction with other EU member states. But there are plenty of good ideas around about what might be done, for example this call for a new direction from the next Irish government, recognizing that ‘at its heart, the Euro is a political not an economic experiment’.