The Political Economy of the Euro-Zone Crisis

by Kenneth Anderson

In this week’s Weekly Standard, Christopher Caldwell of the WS and FT has an essay specifically on the political economy of the euro-zone crisis, Euro Trashed: Europe’s Rendezvous with Monetary Destiny.  He notes that the European Union is built on a theory of successive crises, and that the euro was foreseen, perhaps intended, to provoke a crisis that would lead toward greater union; he quotes some of its founding fathers to that end.  (I think he might have added the dialectical ideology that underlay that sentiment, but does not.):

As we contemplate the macroeconomic storm that is now passing through Europe, we must bear in mind that this is a storm that the EU’s promoters knew would come. The euro’s designers understood Rahm Emanuel’s philosophy about not letting a crisis go to waste. “Europe will be forged in crises,” the European Community’s founding father Jean Monnet wrote in his memoirs, “and it will be the sum of the solutions brought to these crises.” When the French statesman Jacques Delors laid out his plan for the euro in the late 1980s, he drew a clear trajectory: A common market had made possible a common currency. A common currency would make possible a common government.

But how would that happen? After all, if a currency worked well within the existing political arrangements, there would be no reason for those arrangements ever to change. New institutions could result only from the currency’s blowing up. Economic crisis would be the accidentally-on-purpose pretext for replacing a system based on parliamentary accountability with a system based on the whims of a handful of experts in Brussels. Europe’s countries now face the choice of giving up either their newfangled money or their ancient national sovereignties. It is unclear which they will choose.

Toward the end, the essay points out that although Greece is every bit as corrupt and profligate as the newspapers suggest, that was not the case with Spain, nor with Ireland, certainly not in the sense of Greece.  That is, Spain had quite good fiscal management and undertook measures that were thought quite strict at the time to protect its banks from the subprime crisis in the US, while many other European banks were as much a part of it as the US ones.  True, Spain’s economy has many structural problems – a sclerotic labor market for those in the protected sectors and, today, unemployment for everyone else.

But the adjustment mechanisms by which democratic market societies overcome interest group recalcitrance – monetize the debt and let devaluation lower wages (behind the veil of money, as we Marxists like to say) – were not available to it, having joined the euro.  Spain was overcome by a one-size fits all monetary policy, which to overcome in a democratic society through internal fiscal and regulatory means alone would require superhuman willpower (and perhaps, in the regulatory arrangement of the EU and eurozone at this moment, could not be achieved in any case, on account of too many arbitrage avenues around internal controls, of the kind designed for the purpose of one-size fits all):

The euro is an end-of-history currency. The late Dutch central banker Wim Duisenberg called it “the first currency that has not only severed its link to gold, but also its link to the nation state” … Fans of the euro used to sell this post-national vision as a matter of hope. But today they are just as happy to sell it with fear. France’s finance minister, Christine Lagarde, told a German newspaper recently that any wavering from European unity would be a “disaster.” She said, “We need to go further towards a convergence of our economic policies.” One need not be particularly ideological to feel this way. One need only assume that, when economics speaks, politics must fall into line.

Last summer, at the height of the Greek debt crisis, economists looked ahead to other problem countries and came to the uncomfortable conclusion that most of them had not been badly, incompetently, or corruptly run. There were exceptions, of course. Greece was corrupt by any historical or geographical standard. It would today be a basket case whether it had been using the euro, the drachma, or wampum. Ireland’s ruling Fianna Fáil party certainly retained elements of the traditional cronyism that is Irish political culture’s besetting sin, and which no one who has observed Boston politics for even a week will fail to recognize.

But these are not the main problems the euro has wrought. The big damage has been in the private, not the public, sector. Politicians in Ireland may have got the occasional backhander from an unscrupulous property developer, but in the quantitative terms of balancing the budget, the Irish were model fiscal stewards until the property market collapsed. Greece itself proved contagious partly because of the private-sector trade imbalances the euro created, which left French and German banks searching for debt to invest in. It was the Western private sector, as much as the Greek public sector, that rendered Greece too big to fail and put an end to the EU’s no-bailouts rule.

And then there is Spain, the other country whose rescue appears to be coming as inevitably as Christmas. Spain not only balanced its budget—it took precautions to keep its home lending sector from overheating. Unfortunately, even that was not enough to keep the artificially low real interest rates that the euro gave it from doing their damage. According to the Spanish macroeconomist Angel Ubide, Spain “probably should have been running fiscal surpluses of the order of 5–6 percent of GDP to offset the negative real interest rate its borrowers enjoyed.”

Well, as an economic matter, yes. Just as, as an economic matter, the United States should probably have been running surpluses to prepare for the wave of Baby Boom retirements that are fast approaching. But how would you have explained that to the Spanish people? Money burns a hole in the pocket of a democratic electorate. Voters hate reserves, surpluses, or any kind of money lying around. What do they call a 5–6 percent surplus? They call it “my money.”

3 Responses

  1. “Politicians in Ireland may have got the occasional backhander from an unscrupulous property developer, but in the quantitative terms of balancing the budget, the Irish were model fiscal stewards until the property market collapsed.”
    This is in fact very wrong.  Summary notes from “A Preliminary Report on The Sources of Ireland’s Banking Crisis” commissioned by Brian Lenihan (Minister for Finance and a Teachta Dála (TD):
    1.       The response of supervisors to the build-up of risks, despite a few praiseworthy initiatives that came late in the process, was not hands-on or pre-emptive. To some degree, this was in tune with the times. The climate of regulation in advanced economies had swung towards reliance on market risk assessment. Domestically, moreover, there was a socio-political context in which it would have taken some courage to act more toughly in restraining bank credit. The weakness of supervision in Ireland contrasts sharply, however, with experience in those countries where supervisors, faced with evident risks, acted to stem the tide.
    2.       For a long time, Ireland’s overall fiscal policy was considered to be exemplary because the country achieved fiscal surpluses every year from the mid-1990s to 2006, including the creation of a Pension Reserve Fund to make budget surpluses politically more acceptable.
    3.       However, the nominal budget figures mask an underlying deterioration in the fiscal situation after 1999. The cyclically-adjusted fiscal surplus was rather small during much of the last decade according to the data available at the time. As already mentioned, statistical tools to capture the full impact of asset bubbles on tax revenue are not well developed, otherwise it would have become clearer much earlier that the structural, underlying fiscal balance was much less favourable than assumed at the time. The IMF estimates now that in 2007, when the headline budget was approximately in balance, the underlying, structural deficit (taking into account the large positive output gap and the effects of the asset price bubble) had deteriorated to 8 ¾ percent of potential GDP and amounted to 4 to 6 percent in the run-up to the crisis. The conclusion is that overall fiscal policies were pro-cyclical during most years up to, and including particularly, 2007 thus adding markedly to the overheating of the economy.
    Therefore, the electorate of Ireland were the wrong model of “fiscal stewards” due to the ineffective management of the fiscal bottom line. Ireland’s Exchequer did not have significant levels of money and regulators had rather poor counter-cyclical provisions. Regulators could have devised and implemented a decisive macro-prudential strategy that would dampened the property boom. But no, supervisory analysis and implementation fell short in these areas, macro-prudential risk, where the IMF, as noted in the Preliminary Report had hoped that a prudential framework would have proved valuable did not happen.
    There is no question that a prudential framework could have been made to work sufficiently well to mitigate the impact of the credit/property cycle—instead we have a country dragged down and a journalist that is misinformed on the fiscal facts and scapegoating the “private sector” while praising the “public sector”–which instead needs maximum admonishment.

  2. Daybreak:  I do not think you and Caldwell are necessarily in disagreement.  When he refers to the private sector, he does not mean that it did something wrong or irrational – it was following the lead set up for it by monetary policy.  And when he says that the situation did not result from the same kind of profligacy and corruption that characterizes Greece, I think he means that to mean what you say in referring to a prudential framework that could have prevented things – as he says in relation to Spain, if it had run a surplus of 5-6%, that might have offset the effect of exterior monetary policy.  But that is not politically feasible in a democracy, for the reasons that he remarks.  I do not think you are actually at odds on this.

  3. @Professor Anderson:

    I do not think we are in disagreement on the central point of the difficulty politically in running a true budget surplus—one without a structural deficit in a democracy. In retrospect, I should have started by reply by asking who exactly thought Ireland was a “model fiscal stewards”, because Caldwell did not say he actually believed that.
    We probably differ on the absolute conclusion that a structural deficit is the case, after all democracies differ with regards to age, OECD status, size of strength political actors and indeed measures of a budget deficit itself. The compromise could very well be a “balanced budget” as was the case with Ireland.
    That really for me is a significant and profound question. I am familiar with Volkerink, de Haan’s and others work on the political fragmentation hypothesis, so I am not optimistic on democracies carrying a true surplus, so I reluctantly agree with Caldwell—for now. I will say Caldwell’s essay does bring up the very good point of the designers and inheritors of the Euro knowing about the political difficulty of having stable budgets across diverse counties—judging by historical and contemporary events, seized upon that fact to advance the Euro project to create a hierarchical and centrally coordinated “State.” To that, all I can say is very clever and indeed diabolical.
    Thanks for replying.

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