More on the political economy of the European sovereign debt crisis
I was on BNN with Ryan Avent of the Economist and host Howard Green yesterday, talking mostly about the European sovereign debt crisis. When I find a clip, I will link to the video below. Let me make a few comments here first.
In June, I wrote a post on the political economy of the European sovereign debt crisis, the thrust of which was as follows:
As some euro zone sovereign debtors are near insolvency, a liquidity crisis has begun in which various ‘creditors’, the various national taxpayers and bondholders, must fight to determine how to apportion the losses.
This is not a zero sum game, however, because the magnitude of the losses also depends on how various actors play their hands. For example, austerity decreases output and increases the likely losses. A unilateral default followed by panic and contagion would do so as well. The players know this and are trying to play their hand in order to maximize their own narrow interests.
This is the background issue. We live in a creditor-centric world and the way the political economy of this crisis has played out is in favouring the interests of creditors, as I predicted in that post. My conclusion at that time was that investors would have to avoid periphery sovereign debt – and boy have they. I also concluded that:
The point for policy makers is to socialise enough of the bank losses onto taxpayers in order to recapitalise the banks, survive the crisis and maintain the status quo. Taxpayers will accept this if the economy is robust enough.
And this is the rub. Now, the economies are really breaking down and panic has set in. You see pointless proposals to lord over supposed fiscal free riders from Finland and unelected governments lacking in political legitimacy and taking unfavourable economic policies in both Greece and Italy. Europe is clearly on the edge.
Looking forward, whether “the economy is robust enough” depends on the response of the ECB. Ryan and I have both written posts recently that have surprisingly similar themes on this score.
First, my bit in defense of the ECB:
Conclusion: central bankers always prefer to force elected officials to make the tough political choices that are the essence of fiscal policy. The fiscal agent adds and subtracts net financial assets in the private sector by deficit spending, or cutting spending and raising taxes. Central bankers want the fiscal agent to use these tools as the driver of macroeconomic policy while the monetary agent is tasked with more narrow aims.
So when Mervyn King talks about the ECB “buying sovereign debt of national countries, which is used and seen as a mechanism for financing the current-account deficit of those countries”, he is talking about a policy choice that helps the national governments achieve their fiscal aims, a quasi-fiscal role.
The ECB has balked at doing this – rightly so, I might add (in a brief role as policy advocate). Their position is that the fiscal agent is elected by a democratic process and must solely take on the responsibility of achieving macroeconomic objectives outside of price stability.
To sum up, I am saying the ECB is right to resist acting as a lender of last resort but wrong in trying to impose a solution that is deflationary in a global crisis of Depressionary debt deflation proportions. If I were at the ECB, I would have moved to interest rate caps, what I call rate easing, already, instead of the sterilised quantitative easing they are conducting right now. It would be cheaper politically and in terms of the ECB’s balance sheet. I would not ‘monetise’ periphery debt by engaging in quantitative easing. Credible lenders of last resort use price, not quantity signals.
My concern is that the ECB will play chicken for too long. The buyers of French or Dutch sovereign bonds are pension funds and banks with no risk appetite. They bought these as safe investments with no credit risk. Any bond manager with fiduciary responsibility who benchmarks herself against her peers will be forced to sell these sovereign credits in a down market or risk being fired. This is the essence of liquidity-induced panics. It would behove the ECB to understand this. The longer the ECB waits to act as a lender of last resort, the worse it will get. And it may get ‘worse’ enough to tip us into bank runs and Depression with a capital ‘D’.
Ryan writes in turn about the ‘Rule by Technocracy’:
The ECB’s leaders are playing a very dangerous game in allowing yields to rise when it suits them, for two reasons. First, as another colleague noted yesterday, rising yields are doing serious and lasting damage to sovereign bond markets. The investors buying the long-term debt of large, rich European countries are typically far more interested in safety and stability than high yields and volatility. The ECB is allowing these investors to exit the market, seemingly under the impression that they can be enticed back in once everything settles down. That is a very risky bet.
A potentially serious recession looms ahead, and it will take significant buy-in from the people of the periphery to stay with reforms until they begin to bear fruit down the road. The political role played by the ECB in engineering governmental turnover does not strike me as conducive to these ends. If I were an Italian being asked to endure a deep recession for the good of the euro zone as a whole, and I saw that northern Europeans were praising the ECB for using the conditionality of its support to threaten my country until the central bank got the leader it wanted, I might find my resolve in the face of reforms and budget cuts to be eroding a bit.
Put more simply, the euro zone, and indeed the European Union, has always had a legitimacy problem. Given the clear economic costs of the single currency for much of Europe, it now has a serious legitimacy problem. Residents of every euro zone country are now asking themselves very difficult questions about whether it is in their interest to stick with this project. The idea that having an unaccountable technocracy "orchestrate the fall of elected leaders" in order to eliminate threats to the euro zone is a good thing for the future of that union is bizarre and dangerous, in my view, and highly likely to backfire.
Mr Weidmann is right; the ECB should not be playing this game. I happen to think that he’s wrong in arguing that it should therefore stay its hand and allow the euro zone to collapse in short order. I’d prefer the ECB to act promptly and boldly, without conditionality, damn the political moral hazard. If most euro-zone residents are unhappy that the presence of a leader like Silvio Berlusconi within the single currency is threatening their economies, then they should place political pressure on their leaders to do something about it. If Italian voters can’t be convinced to give up sovereignty in order to secure the euro-zone economy, then they should be given a political choice to stay in the single currency or leave. Ultimately, the critical decisions must be made by elected leaders in member nations. Central banks are independent so that they can take the unpopular steps necessary to prevent financial and economic disaster, not so that they can manipulate a stubborn citizenry.
Europe had better find a legitimate and democratic way to end this crisis or it is going to suffer a very nasty economic downturn and break apart.
Video below (Click on picture or here for link)