Opinion

Felix Salmon

When fractured politics kills economic solutions

By Felix Salmon
September 8, 2011

Michael Cembalest’s note explaining the EU Mess with lego seems to have touched a nerve, and while a part of that is due to the lego, I like to think that some of it is due to the fact that actually the diagram does very well what few other explanations have done — which is explain just how messy and multipolar the euro crisis really is.

Cembalest’s diagram includes a dozen different stakeholders, each trying to fob off the burden of the euro crisis onto someone else. (The single noble exception here are the opposition parties — the Social Democrats and the Greens — in Germany.) It’s all too easy, looking at Europe from across the pond, to divide the entire continent into two halves: a profligate south, spending beyond its means, piggybacking on the rich north, which doesn’t want to bail them out.

But of course it’s a lot more complicated than that. For starters, there’s the fight between the ECB, which wants a fiscal solution to the crisis, and pretty much everybody else, who wants the ECB to grow up, stop worrying about nonexistent inflation, and help save the euro zone by printing euros. There’s the question of whether and how much shareholders in banks should help pay for the bailout; a separate question about banks’ bondholders; and yet another question about sovereign bondholders. Within the northern countries, Finland has staked out a particularly extreme stance, saying that it won’t lend any money to anyone unless it’s collateralized. And then there’s the Bundesbank, which is particularly keen on imposing a painful regimen of austerity and structural reforms on countries which desperately need growth.

Or, to put it another way: European economic union has failed because European political union doesn’t exist. There’s no political body empowered to make decisions on behalf of the whole, and nor is there an executive able to issue debt on behalf of the whole. Hence the EFSF — a special purpose vehicle partially guaranteed by 16 different states including both Malta and Cyprus, incorporated under Luxembourgish law, and funded by the German Finanzagentur, in a structure which makes CDOs look downright simple. I’m sure it seemed like a good idea at the time, but you can hardly blame Europeans for being suspicious of such a creature.

As a result of all this politics, one thing is certain: we won’t get the best solution, as dreamed up by technocrats. Mark Dow, for instance, a former Treasury and IMF technocrat turned hedge-fund manager, has a solution to the problem that I like a lot: it’s far from painless, but it addresses the issue rather than doing any of the proverbial can-kicking, and it’s aimed at jumpstarting growth rather than trying to rely on austerity measures to do anything but make the situation worse.

Dow’s solution involves cutting loose Greece and Portugal, and probably Ireland too. The first two, certainly, need a devaluation if they’re going to regain economic growth — and so they should be allowed to devalue and default. Depositors in domestic banks would of course need to be kept whole; this might be reasonably expensive. And other European banks would lose a lot of money on the default, upon being forced to accept a hefty haircut on their holdings. So concurrently with cutting loose Greece and Portugal, there would need to be a massive recapitalization of the entire European banking sector — probably something on the order of a trillion euros or more. That would hurt bank shareholders, but keep the bondholders pretty much intact. “Shock and awe, writes Dow, “tired though this cliché has become, needs to be the overarching inspiration.”

As for Spain and Italy, they’re big industrial countries and can regain growth while remaining part of the euro — just so long as they can borrow relatively cheaply. Enter the ECB, committing to lend unlimited amounts of money to them, so long as they implement structural reforms, at a low rate of about 5%. Inflation risk, right now, is the least of our worries; if even the Swiss are happy to print unlimited amounts of money, then the ECB, in a much bigger crisis, should be too.

Now this isn’t the only possible solution; others exist. But something has to be done, and urgently. “Europe has to leapfrog the phase of thinking the unthinkable,” writes Dow, “and start doing the unthinkable”:

Orderly beats disorderly. Plan beats no plan. Proactive beats reactive. The time for the quantum leap in mindset is now.

And this is where Dow, or anybody else with a clever plan, runs straight into political reality. Any plan is going to be unacceptable to some European entity or government with veto power over the whole thing. And while Christine Lagarde, leading from the front, is surely trying to corral Europe’s elected politicians into something approaching a unified stance, her chances of success are slim.

Just look at where we are in the US, a single country with a single central bank and a strong federal executive. Look at the House Republicans during the debt ceiling debate; look at what all the Republican presidential candidates are saying about Ben Bernanke (a Republican originally nominated by a Republican candidate); look at the way that they increasingly don’t even bother to try to find economists willing to defend their stated positions. This is one of the reasons I pretty much want to pull a Rip van Winkle and wake up on November 7, 2012: by the conventions of journalism, there are going to be endless debates about whether or not certain economic-policy proposals make sense or are a good idea, as judged by economists and technocrats and pundits. And all those debates are going to make no difference whatsoever to the outcome of the election.

The principle of e pluribus unum, then, is looking pretty tattered even in its natural home of the US; it never stood a chance in Europe. Ideally, the population would elect a government; the government, duly elected, and with the backing of the people, would put together and enact a plan; and the plan would carry us through the crisis and out the other side. But that kind of thing is looking improbable even in the US; it’s impossible in Europe, not least because there is no European government. (And central bank independence, in this context, doesn’t help much either.)

Instead, we’re likely to end up doing as close to nothing as is economically possible. The slump in growth will accelerate, and probably result in another recession; the opportunity cost, in terms of wealth that might have been, will rapidly run into the trillions and won’t stop growing for a decade or more. Unemployment will savage the European welfare state and the US economy, and the entire global economy will stall. I don’t know or even particularly care what will happen to asset markets; they’re almost the least important part of the whole equation. It’s the real economy which matters, and as it remains stagnant, politics around the world will get ever more poisonous and unhelpful.

It’s a vicious circle, this situation that we entered with the advent of the global financial crisis, and neither the EU nor the US has the political will or ability to get us out of it. This is a test not only of capitalism but also of federalism and democracy. And right now neither of them are scoring very well.

Comments
8 comments so far | RSS Comments RSS

“The slump in growth will accelerate, and probably result in another recession; the opportunity cost, in terms of wealth that might have been, will rapidly run into the trillions and won’t stop growing for a decade or more.”

Note previously:
“Dow’s solution involves cutting loose Greece and Portugal, and probably Ireland too. The first two, certainly, need a devaluation if they’re going to regain economic growth — and so they should be allowed to devalue and default. Depositors in domestic banks would of course need to be kept whole; this might be reasonably expensive.”

“….we won’t get the best solution, as dreamed up by technocrats. Mark Dow, for instance, a former Treasury and IMF technocrat turned hedge-fund manager,…”

You know, it was technocrats who put the Euro together to begin with. And there was this other technocrat who said subprime was contained…

Posted by fresnodan | Report as abusive
 

Wow ! Felix does not care what happens to asset markets as long as bondholders are kept whole !
As though asset markets can be divorced for long from the real economy. If only one could refarain from pronouncing on days on which he or she has nothing coherent to say …

Posted by ggeorgan | Report as abusive
 

I don’t know what the possible is, even factoring out political constraints, but bailing out all bondholders of banks (again) isn’t entirely attractive. To be honest, I’d like to see depositors in troubled domestic banks get 99 cents on the dollar, just as a Talebian lesson that nothing is perfectly devoid of risk. It may well be that neither of these can be implemented except at even greater cost than keeping creditors whole.

Posted by dWj | Report as abusive
 

Please Felix! Don’t tell me you believe the SDP and Greens are purely noble! Whatever became of sceptical journalists! Wolfgang Schauble has been every bit as noble but as a member of government is in a much more difficult position. He has to convince his constituency that Germany can, and should, finance much of the cost without entering into excessive longterm transfer obligations. And he has to be part of structuring such an agreement.
As much as it troubles economists and markets, the technocrats are going to have to stand back and let a long messy political process work itself out. In the end the troubled countries will continue with austerity or reforms, while Germany, Netherlands and others finance and manage a stimulus program, and limited Eurobonds.

Posted by wpw | Report as abusive
 

Obama lost his mandate when he rammed through a health-care overhaul at all costs in the face of overwhelming opposition by the American people. A majority of all states are presently suing to have that law overturned. Americans did not want a massive expansion of government but no matter.

The well was unalterably poisoned then. Bill Clinton had big ideas but he also understood and respected democracy. Even George Bush did not go to war without a majority of the American people, although they later grew sick of it.

Michael Pettis’ latest piece in Foreign Policy is great:
http://www.foreignpolicy.com/articles/20 11/09/07/an_exorbitant_burden

The ultimate source of the crisis is China’s (and asia’s, Russia’s etc.) continuous currency interventions. There is a lack of global demand but all the people and cash are in China and other asian countries. They should naturally be completing the trade cycle but they aren’t. If the trade cycle were complete, the jobs situation would be dramatically different. We with the world’s dumbest politicians, are the only ones who don’t get this game.

Here, Mitt Romney is the one who is actually talking sense in all of this. On the biggest economy issue of our generation, global imbalances due to interventions, Obama has been a big fat zero. To be fair, Bush was also AWOL on global imbalances, but we weren’t deep in economic doodoo then.

Posted by DanHess | Report as abusive
 

I propose Salmon’s Law of blogging: “The more commenter complaints about specific points from a long post, the higher the quality of said post.” This one passes.

BTW, I think yer man Cembalest touched a extra round of nerves thanks to the inspired use of the Lego pig

Posted by ottorock | Report as abusive
 

Check your geography you can’t cut out Portugal. And to many big companies use Ireland as a phony base, you need to force them to raise their business tax a bit.

Posted by toyotabedzrock | Report as abusive
 

Mr. Salmon makes a comment that money managers and those private investors who read columns such as his are likely shocked by: I don’t know or even particularly care what will happen to asset markets; they’re almost the least important part of the whole equation. It’s the real economy which matters…

It’s the economy, stupid? According to David Ranson, chief economist at macro research advisory, Wainwright Economics, it’s economic policy itself that’s holding back the US and most western economies.

As for the most likely not to succeed among those countries, Greece, Ranson considered Greeks’alternatives, and default must remain a potential alternative.

To withdraw from the euro zone and return to the drachma would not help the Greek economy regain its balance, for two major reasons. The more obvious reason is that most Greek debt is denominated in euros and does not become any easier to pay off if Greece proceeds with a devalued currency.

The other reason is farther reaching. Currency devaluation is a deterrent to private economic vitality. It destroys wealth at a stroke and encourages further private capital outflow by rais¬ing expectations of more currency depreciation down the road. With capital ever harder to hold or attract, the Greek economy would be even less able to create new jobs.

The fastest way out of the Greek mess is to cut the size of its government deeply and quickly on three fronts: spending commitments, manpower and tangible prop¬erty. To the extent this is insufficient, the Greek gov¬ernment should be allowed to default on its debt. Sovereign default is not a good option, but it is much better than de¬valuation. Although it would make it more difficult to fund government spending in the future, it’s something that’s desirable in the short term. It would also lessen the threat of fur¬ther increases in taxation, and that would help make the Greek economy attractive to external capital.

The great underlying feer is if the Greeks do it, i.e., get away with sending the banks packing, who else will take the opportunity of a lifetime?

Luis de Agustin

Posted by LuisdeAgustin | Report as abusive
 

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