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’.
{ 20 comments }
P O'Neill 02.18.11 at 2:44 pm
There’s a 1994 paper by Allan Drazen and Paul Masson that brings out the notion of self-defeating austerity very well.
One aspect of the lunacy of current Eurozone policy is that it’s bending over backwards to save the funds of legacy bubble investors in now insolvent banks, while threatening new investors who could actually bring money to the table with unspecified future burden sharing. So the investors who are stuck get paid 100 percent, and the investors who are mobile are told that they might have to get in line when things go pear-shaped. Heckuva job, Eurocrats.
John Quiggin 02.19.11 at 9:23 am
I agree about the unsustainability of the austerity plan. It only takes one country to credibly threaten to abandon the euro and the whole thing will collapse.
But in the spirit of the general argument, you could argue that this is something that needs to be tried, just to convince the hawks that it won’t work.
Myles 02.19.11 at 10:11 am
It only takes one country to credibly threaten to abandon the euro and the whole thing will collapse.
There is basically no plausible way to abandon the euro without pulling the plug on your own economy, so I don’t know how they can be ‘credible’. The point for Merkel to shove austerity down everyone’s throats isn’t purely economic; I think at least it has be recognized from Germany’s perspective that if you can’t even get the Greeks to accept austerity at what is basically economic gunpoint, you might as well give up on the whole currency union idea altogether. This is precisely a political, rather than economic, question, and Germany’s line in the sand.
politicalfootball 02.19.11 at 2:50 pm
It only takes one country to credibly threaten to abandon the euro and the whole thing will collapse.
Myles’ response seems compelling to me. Which country might do this?
Jonathan Hopkin 02.19.11 at 5:30 pm
Remaining in the Euro may actually be the most credible way of pulling the plug on your economy, especially for Greece which is expected to make a huge price/wage adjustment in a (credibly) low inflation environment. Anything is credible if you have barricades burning in the streets, and I’m sure Greek policymakers are smart enough to know this.
Whatever happens now, the EMU settlement will be different in the future because it would be amazing if the markets ever bought the ‘borrowed credibility’ line again. The flows of hot money into the periphery will be slower next time, and realistic default risk will surely be priced in – unless of course financial markets have even shorter memories than we thought they had.
Tim Worstall 02.19.11 at 6:11 pm
“There is basically no plausible way to abandon the euro without pulling the plug on your own economy, ”
Unconvinced.
If you did it swiftly (like close the banks with no notice and then perform the deed) it’s possible although very difficult.
It’s leaving anyone with any time between thinking it’s going to happen and it happening which would crater the economy.
Unless, of course, it were Germany that left: crackpot perhaps but it has been mentioned….
Myles 02.19.11 at 7:17 pm
If you did it swiftly (like close the banks with no notice and then perform the deed) it’s possible although very difficult.
In the sort of country where withdrawing from the euro is an actual necessity, I don’t particularly think the government would be very good at also keeping secrets. The thing would leak out, and within minutes of its leaking out there will be a bank run across the country.
Also, people aren’t stupid. If a country gets to the point where withdrawing from the euro is a serious possibility, people are already fleeing its banks. It’s pretty obvious that the euro is the hardest currency there is, and you’re basically screwed if you didn’t get your money out fast enough and ended up with drachmas or liras or whatever.
John Quiggin 02.19.11 at 11:00 pm
Obviously, withdrawal from the euro is a desperate move – the point is that austerity seems likely to create the necessary desperation. And, if one country does it, others are likely to follow, wiping out the associated stigma. So, once the ECB sees a serious threat, it will have to abandon restrictive monetary policy and relax demands for austerity. The question raised by the discussion is whether this backdown can be managed well enough to prevent collapse.
The other possibility, on which the ECB is presumably betting is that governments will persist with austerity for fear of something worse. Obviously the more they try to win this bet, the harder it will be to switch to the other when/if things go bad.
Myles 02.20.11 at 12:08 am
The other possibility, on which the ECB is presumably betting is that governments will persist with austerity for fear of something worse. Obviously the more they try to win this bet, the harder it will be to switch to the other when/if things go bad.
But if they do win this bet, they will have established for once and all the principle of the euro as the currency of sound money and Europe as the land of balanced budgets and the rest of it. Which is to the ECB essential, because for them at least there’s not much point in having a currency union unless they can rein in Mediterranean habits. The point of the whole project is to drag everybody up to Germany’s level of economic sobriety by hook or crook, it’s not to lower Germany to some mushier consensus.
The problem for the Germans and the ECB isn’t the credibility of individual countries, the problem is the credibility of the currency union as a currency.
ejh 02.20.11 at 9:44 am
unless they can rein in Mediterranean habits
Lovely
Alex 02.20.11 at 2:19 pm
. The point of the whole project is to drag everybody up to Germany’s level of economic sobriety by hook or crook, it’s not to lower Germany to some mushier consensus.
But this is a fantasy. German government finances are a symptom of industrial success, not its cause. Germany didn’t, in fact, implement an austerity plan and let the banks go hang. Nobody seems to have any ideas about how Spanish industry might become as good as German – least of all the Germans, who don’t want better competitors – it’s just meant to arise by magic once a big enough jobs sacrifice has been offered up.
Myles 02.20.11 at 2:58 pm
But this is a fantasy. German government finances are a symptom of industrial success, not its cause.
Well, yes, but the Germans believe it, and they are acting on this belief.
Look, price levels in even Spain, whose government has been impeccable, has been completely out of control. You can either work with higher euro inflation and currency devaluation, or you can work with austerity and internal devaluation. Euro as a soft currency sounds a bit nightmarish and American, and in any case is basically unsustainable (I am feeling ill just thinking about how France + Italy will team up to push for perma-loose monetary policy). Germany didn’t have austerity because for most of the decade they have been clamping down on prices until the pips squeaked.
I was actually in favour of a more American policy until it became obvious how out of whack the fundamentals in places like Greece and Spain are. Spain can’t even begin to have industrial success until prices return to a more realistic level. Thus, austerity.
Jonathan Hopkin 02.20.11 at 3:45 pm
What exactly are ‘Mediterranean habits’, Myles? Let’s be straight about what happened here – flows of hot money coming from less than tropical places such as Germany and the UK piled into Spain and Greece like there was no tomorrow, pushing up prices and wages in large part because there weren’t any national monetary policy levers to deal with it. The Zapatero government was running surpluses – how Mediterranean is that? – but these surpluses would have had to have been in double figures to have compensated for what the private sector was doing.
Oh, and has anyone noticed how the most ‘Mediterranean’ country of all – Italy with its Borgia-like leadership and enormous national debt – has been the least affected by all of this? There were no big capital inflows there, so the crisis for Italy is a bit like it is for Germany – loss of external demand.
The contrast between vice (Italy) and Spain (virtue) shows that the crisis of the Southern periphery has a lot more to do with the nature of the Euro than the deficiencies of the Med countries themselves. It is definitely not a morality play.
Alex 02.20.11 at 4:07 pm
Well, yes, but the Germans believe it, and they are acting on this belief.
It is telling how people’s delusions coincide with their class prejudice.
Myles 02.20.11 at 8:08 pm
It is telling how people’s delusions coincide with their class prejudice.
I am exquisitely amused by the British tendency to associate people’s beliefs with their social choices.
hix 02.20.11 at 8:20 pm
It is telling how people’s delusions coincide with their class prejudice
Anglo-Saxon Ph.Ds class prejeduces are a real pain in the ass. One interesting aspect is that their descriptions of inner EU relations which never asign any negotiation power at all to the mediteranean nation are at least as prejorative as a German Bild headline.
It is definitely not a morality play.
Somehow, everytime someone says that, a bad morality play blameing the victim folows.
ejh 02.20.11 at 9:26 pm
What exactly are ‘Mediterranean habits’, Myles?
It’s a lazy usage, ironically enough, favoured by the sort of people who like to characterise nations by use of stereotypes to give the impression that they have knowledge they actually lack.
ejh 02.20.11 at 9:27 pm
I am exquisitely amused by the British tendency
Oh look. There goes another one.
Myles 02.21.11 at 12:08 am
Oh look. There goes another one.
Strike the “British”, then.
Norwegian Guy 02.21.11 at 11:22 am
“”It is telling how people’s delusions coincide with their class prejudice.”
I am exquisitely amused by the British tendency to associate people’s beliefs with their social choices.”
I am exquisitely amused by the tendency to view class as a social choice…
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