The perils of European incrementalism
By Lawrence H. Summers
The views expressed are his own.
In his celebrated essay ‚ÄúThe Stalemate Myth and the Quagmire Machine,‚ÄĚ Daniel Ellsberg drew out the lesson regarding the Vietnam War that came out of the 8000 pages of the Pentagon Papers.¬† It was simply this:¬† Policymakers acted without illusion.¬† At every juncture they made the minimum commitments necessary to avoid imminent disaster‚ÄĒoffering optimistic rhetoric but never taking steps that even they believed offered the prospect of decisive victory.¬† They were tragically caught in a kind of no man‚Äôs land‚ÄĒunable to reverse a course to which they had committed so much but also unable to generate the political will to take forward steps that gave any realistic prospect of success.¬† Ultimately, after years of needless suffering, their policy collapsed around them.
Much the same process has played out in Europe over the last two years.¬† At every stage from the first signs of trouble in Greece to the spread of problems to Portugal and Ireland, to the recognition of Greece‚Äôs inability to pay its debts in full, to the rise of debt spreads in Spain and Italy, the authorities have played out the quagmire machine.¬† They have done just enough beyond euro-orthodoxy to avoid an imminent collapse, but never enough to establish a sound foundation for a resumption of confidence. Perhaps inevitably, the gaps between emergency summits grow shorter and shorter.
The process has taken its toll on policymakers‚Äô credibility.¬† As I warned European friends quite some time ago, authorities who assert in the face of all evidence that Greece can service on time 100 percent of its debts will have little credibility when they later assert that the fundamentals are sound in Spain and Italy, even if their view is a reasonable one.¬† After the spectacle of stress tests that treat assets where credit default swaps exceed 500 basis points as riskless, how can markets do otherwise than to ignore regulators assertions about the solvency of certain key financial institutions.
A continuation of the grudging incrementalism of the last two years risks catastrophe, as what was a task of defining the parameters of too big to fail becomes a challenge of figuring out what to do when key insolvent debtors are too large to save.¬† There are many differences between the environment today and the environment in the Fall of 2008 or any other historical moment.¬† But any student of recent financial history should know that breakdowns that seemed inconceivable at one moment can seem inevitable at the next.
To her very great credit, new IMF managing director Christine Lagarde has already pointed up the three principles any approach to Europe‚Äôs financial problems must respect.¬† First, Europe must work backwards from a vision of where its monetary system will be several years hence.¬† The reality is that politicians have for the last decade dismissed the widespread view among experienced monetary economists that multiple sovereigns budgeting and bank regulating independently will over time place unsustainable strains on a common currency.¬† The European Monetary Union has been a classic case of the late Rudiger Dornbusch‚Äôs dictum that ‚ÄúIn economics, things take longer to happen than you think they will, and then they happen faster than you thought they could.‚ÄĚ¬† So it has been with the buildup of pressures on the Euro system.
There can be no return to the pre-crisis status quo.¬† It is now clear that market discipline within monetary union is insufficiently potent and credible to assure sound finance, and equally apparent that when banks and sovereigns do not have access to lender of last resort financing the risk of self fulfilling confidence crises becomes substantial.¬† The respective responsibilities of the ECB, financial regulatory authorities and EU officials can be defined in different ways.¬† But there must simultaneously be an increase in the central financial commitment to the financial stability of member states and reduction in their financial autonomy if the common currency is to survive.
Second, the Managing Director is right to point up serious issues of inadequate capital in European banks.¬† Taking even relatively optimistic views about sovereign debt and growth prospects, European banks in at least as problematic a condition as American banks were in the summer of 2008.¬† Unfortunately in many cases they are far larger relative to their national economies.¬† Now is the time for realistic stress testing and then resorting to private capital markets if possible and to public capital infusions if necessary.¬† With delay, private capital markets will close completely and nervous managements will rein in the provision of credit just when credit contraction is most likely to damage real economic prospects.
Third, like her predecessor, Ms. Lagarde has broken with IMF orthodoxy in recognizing that expansionary policies are necessary in the face of substantial economic slack.¬† The oxymoronic doctrine of expansionary fiscal contraction is being discredited every month.¬† Europe needs a growth strategy.¬† Yes, almost everywhere and certainly in the most indebted countries, binding commitments to eventual deficit reductions are a necessity.¬† And in some places credibility has been lost to the point where immediate actions are necessary.¬† But Europe only has a chance of handling its debts and contributing to a stronger global economy if it grows.¬† This will require both aggregate fiscal and monetary expansion.
This last point is an essential lesson of recent American experience.¬† Even though credit spreads and equity values had normalized by the end of 2009 and the financial system was again functioning reasonably normally a year after the 2008 panic, lack of demand has continued to constrain growth.¬† While any one household or one nation can improve its balance sheet by saving more and spending less, the effort by all to cut back means reduced incomes and ultimately less saving for all.¬† Germany in particular needs to recognize that if other European nations are going to borrow less, then it will be able to lend less and that as a matter of arithmetic this will mean a smaller trade surplus.
The world‚Äôs Finance Ministers and Central Bank Governors will gather in Washington this weekend for their annual meetings.¬† The meetings will have been a failure if a clearer way forward for Europe does not emerge.¬†¬† Remarkably, the European authorities that drove Ms. Legarde‚Äôs selection just 3 months ago have rejected important components of her analysis.¬† In normal circumstances comity would require deference by others to European authorities on the resolution of European problems.¬† Now when these problems have the potential to disrupt growth around the world all nations have an obligation to insist that Europe find a viable way forward.
Failure would be yet another example of what Churchill called ‚Äúwant of foresight, unwillingness to act when action would be simple and effective, lack of clear thinking, confusion of counsel until the emergency comes, until self preservation strikes its jarring gong–these are features which constitute the endless repetition of history.‚ÄĚ