Political economy and the euro

February 8, 2010

The reality of  ‘political economy’  is something that irritates many economists — the “purists”, if you like. The political element is impossible to model;  it often flies in the face of  textbook economics;  and democratic decision-making and backroom horse trading can be notoriously difficult to predict and painfully slow.  And political economy is all pervasive in 2010 — Barack Obama’s proposals to rein in the banks is rooted in public outrage; reading China’s monetary and currency policies is like Kremlinology; capital curbs being introduced in Brazil and elsewhere aim to prevent market overshoot; and British budgetary policies are becoming the political football ahead of this spring’s UK election. The list is long, the outcomes uncertain, the market risk high.

But nowhere is this more apparent than in well-worn arguments over the validity and future of Europe’s single currency — the new milennium’s posterchild for political economy.

For many, the euro simply should never have happened —  it thumbed a nose at the belief that all things good come from free financial markets; it removed monetary safety valves for member countries out of sync with their bigger neighbours and put the cart before the horse with monetary union ahead of fiscal policy integration. But the sheer political determination to finish the European’s single market project, stop beggar-thy-neighbour currency devaluations and face down erratic currency trading meant the  currency was born and has thrived for 11 years.

Now the budgetary and bond market upheaval currently afflicting euro member Greece and stalking  Portugal, Ireland, Spain and Italy has reawakened the whole debate. “Will the euro survive?” seems a legitimate question once again.

Apart from financial analysts, Paul Krugman seems to have made his peace with the euro’s existence but he still reckons it was a bad idea. Eric Maskin thinks financial markets are right to question the future of the single currency. And much is being made once again of Milton Friedman — high priest of 20th century monetarism — having reportedly said in 1998 that the euro would not survive the zone’s first serious economic downturn.

But having an opinion about the euro is not the same as knowing whether it is going to survive. And this is what most annoys those who have money at stake. Plugging in a new set of variables into complex econometric equations is probably not going to get any of these experts closer what happens next. Hanging around the corridors of power in Brussels, Frankfurt, Berlin or Paris is likely to prove more fruitful.

In the 1990s, many financial strategists in London, Manhattan and elsewhere often confused what they thought should happen with what was likely to happen and got the call wrong on one of the most far-reaching monetary events of the century.

And for all the grand designs underlying the euro, perhaps the decider for many governments — even Europe’s biggest economy Germany — was that persistent currency and interest rate volatility experienced in the pre-euro  exchange rate mechanism was little short of chaotic. The complication of constant speculation, often with perverse outcomes, led many wavering politicians to distrust free-wheeling financial markets and see them as, on balance, a pernicious influence that made economic policymaking  and corporate planning more difficult.

Fast forward to 2010 and the stick is being wielded by the so-called “bond market vigilantes” rather than currency traders — even if these are really just different pseudonyms for the same macro hedge funds.  The euro zone, clearly, has not fully rid itself of the sorts of erratic market influences that have market pricing signalling a one-in-three chance of a Greek debt default even though few economists think that’s likely.

Reading the runes of how governments will — rather than should — react to this will be difficult. The likely hiatus before we find out merely adds to the uncertainty as long-term investors hold back and allow the speculators make hay.

But after three years of financial turmoil, market overshoot and patently irrational behaviour — culminating in the one of the deepest recessions since the  second world war — the political mood is hardly one that will blithely accept the vagaries of financial trading and the infallibility of credit rating agents. The backlash against “economically valueless” financial activity in tandem with the serious measures proposed to rein in banking activity hardly sit well with then allowing  market speculation to force a monetary meltdown in one of the world’s largest econonic bloc.

Ask Krugman, who doesn’t seem to like the Tyranny of Markets.

The political reaction when it comes may even surprise the most cynical economists.

Ask Friedman, who in 1999 admitted he was impressed at just what the European governments had managed to do.


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In and of itself a Greek bankruptcy or bond default should -in theory- not affect the Euro as such very much, Greece being maybe 3% of the total. However, just as a Californian bankruptcy would reflect badly on the “state of the Union” as a whole so would the default of on EU country, coupled with the rising interest rates and thus further destabilisation of the remaining over-leveraged member states, make investors wonder when sovereign default across the board is likely. Thus they wouldn’t commit themseves to bonds of longer maturity and that’s the beginning of the end.

Posted by CrisisMaven | Report as abusive

Nice piece Mike.
Looking at the debate raging in the Spanish press, the comical spat with FTAlphaville, and so on, I’m in two minds as to whether the penny is dropping in the biggest domino Spain (or is it the UK?).
In recent times, Spain has demonstrated its capacity to slash its fiscal deficit. But go further back and the country has a long history as a defaulter. Spain’s relatively nasty and federated internal politics is also a barrier to reform.
What is clearer is that the crisis has revealed the fundamental imbalances within the Spanish economy that will ensure Spain is a euro zone loser for some time to come. Seeing Spanish (and other) government ministers kow-towing to the City with begging bowls will also give a whole new meaning to mainland Europe’s obsession with perfidious Anglo-Saxon economics.

Posted by SpanishBill | Report as abusive