Frances Coppola and Simon Wren-Lewis on the ‘Modest Proposal vs Austerian Federalists’

Frances Coppola responds to ‘Whither Europe?’, authored by Yanis Varoufakis and James Galbraith. The Euro crisis is over, yes? Not so fast. It has simply moved from acute to chronic.

Things are quiet in Europe. Inflation is under control, there are signs of recovery in some periphery countries, unemployment though still too high is not rising any more. Banks are being brought to heel by the ECB, forced to clean up their balance sheets and raise more capital to protect sovereigns from the costs of bank failure. And there are baby steps towards a banking union and even towards fiscal union. The Euro crisis is over, yes?

Not so fast. It is not over – it has simply moved from acute to chronic. The southern European economies are terribly fragile: debt-to-GDP remains on an unsustainable path for many, a path that will not change while growth remains on the floor. Fiscal austerity alone cannot restore their public finances: as Eichengreen and Panizza explain, achieving the sustained fiscal surpluses required to bring debt-to-gdp down to Maastricht limits would be unprecedented. I would add that it would be disastrous not only for those countries but for the Euro area as a whole, creating a seemingly endless depression in the periphery. ‘Endless’ depressions do eventually end – in political unrest, war and revolution. The biggest threat to the Euro’s continuing existence, and indeed to the European Union, is the creeping devastation of the southern European economies – now beginning even to draw in the mighty France. I could even view this as the biggest threat to peace in Europe, were it not for President Putin. But we should not underestimate the strains that the now chronic Euro crisis puts on the European Union. The Franco-German alliance is the core of the union. If it fractures, it is hard to see how the union could survive.

This is of course where the French economist Thomas Piketty and his associates are coming from in their proposal for radical reform of European institutions. Their solution to the strains on the Franco-German alliance is to strengthen it through closer union. This is perhaps understandable. But it is far from clear that a closer union is achievable at the moment. The heart of the Euro area’s problem lies in the attitudes of its peoples. Until there is a common sense of ‘Europeanness’ and a shared concern for people in all parts of the union there can be no real political or fiscal union such as that suggested by Piketty.  Reconstructing institutions will not unite hearts and minds across Europe.

The Glienicke group of economists goes straight to the heart of the matter. The very first paragraph of the Glienicke group’s proposal is entitled “Crisis, what crisis?” and warns about the complacency of Germans. There is no sense of solidarity with other Euro members: depression in Spain or Italy is not the concern of prosperous Germans. The Glienicke group rightly argues that Germans should be concerned about economic troubles elsewhere in the bloc.

But I would go even further. What I see is not complacency so much as righteous anger. Righteous, because of German belief that their prosperity is their just reward for the painful reforms that they went through after reunification: and anger, because of other countries’ inability – or in the case of France and Italy, outright refusal – to implement similar reforms. Why should Germans, who accepted economic pain in order to rebuild their country, support countries that balk at the same pain? While the debate is couched in these terms, no attempt to reform the Euro area will work. Not until the majority of Germans see that the prosperity of Spain, Italy and France is in their own best interests will the Euro area look viable as a currency union.

But worse, even those who do see the prosperity of periphery countries as in their own best interests still believe that fiscal reforms alone will bring about that prosperity. Yet there is zero evidence to support this. On the contrary, the reduction in incomes and shrinking of state safety nets necessary to achieve external competitiveness will force many into poverty. What sort of ‘prosperity’ is it that leaves millions facing malnutrition, disease and shortened lifespans?

The truth is that the attitude of Euro area policymakers, and indeed of many northern Europeans, to periphery countries owes little to common sense, or even good economics, and much to moral and ideological belief in hard money, tight budgets and mercantilism as the path to prosperity. When macroeconomics becomes a morality play, debt is equated with sin, and debtors must atone for their crime with hair shirts and self-flagellation. The Glienicke group’s call for creditors to be held responsible for excessive lending inevitably falls on deaf ears.

And so, sadly, does Varoufakis and Galbraith’s “Modest Proposal”. Modest it may be, but it still amounts to a ‘get out of jail free’ card for highly indebted periphery states. When even the ECB will not provide the Euro area with the monetary expansion it desperately needs because of worries that this would reduce the pressure on fiscal authorities to make painful reforms, what hope is there for political approval of any programme of debt relief and reconstruction for shattered economies, however modest?

Varoufakis and Galbraith’s argument that debt restructuring and a New Deal should precede any deepening of the union makes both economic and social sense. And it is financially well thought through, though hard-money aficionados will no doubt look askance at the idea of pan-European bodies financing states without any backing from taxpayers. But I fear that because it kicks the future of the European project into the long grass, their proposal will be condemned without trial. And that is because the only plans for resolving the Euro crisis that will be acceptable to European policy makers are those that further the political objective of closer union.

The long-standing political dream of a ‘United States of Europe’ which can challenge the USA for political and financial supremacy seems to outweigh all social and economic considerations. And there is nothing quite so good as a crisis for bringing it closer.  As Jean Monnet put it: “Europe makes itself in crises”. Varoufakis and Galbraith’s proposal would waste a perfectly good crisis.

This is, of course, fundamentally undemocratic. No-one in Europe has voted for closer union. Indeed, in the most recent European elections, the success of nationalist parties suggests that many Europeans want a looser union, or even no union at all. There is nothing democratic about using a crisis to force through a political and fiscal union for which the people of Europe have not voted and it is far from clear that they actually want. And if the European Union is not democratic in practice, how can it require ‘democracy’ as a condition of membership for its member states?

The history of the crisis in Greece and Cyprus shows how fragile democracy really is. Voters in these countries no longer have the right to decide how their governments use their money: that is dictated by Brussels.  And the fiscal compact now means that all countries in the European Union are subject to Brussels’ surveillance of their budgets. The opinions of unelected Eurocrats are of the same or even greater importance than those of elected politicians charged by their voters with managing their economies. There is a democratic deficit developing at the heart of Europe. And proposals for closer union would make this deficit worse.

All proposals for closer union seem to involve a commitment from periphery countries to endless fiscal consolidation in return for debt restructuring (not relief) and a vanishingly small amount of investment. Varoufakis and Galbraith point out that such a commitment would lock the periphery countries into an “iron cage” of austerity.

Strong though it is, iron is brittle. Denied a real democratic voice, and facing the prospect of lifelong hardship apparently imposed by external parties, it would be hardly surprising if the people of periphery countries increasingly turned to nationalism. Indeed, the connection between long periods of fiscal austerity and the rise of far-right nationalist parties is well established – the early 1930s in Germany is a good example. Tightening the iron bands around ‘profligate’ governments may eventually result in their peoples saying: “Let us break their bonds asunder and cast away their yoke from us”.  And at that point the austerity cage would break, and with it the European Union.

I fear that, because of the unholy alliance between those who want closer European union and those who want tight money and mercantilism across the whole of Europe, Europe is heading for the rocks. And this ship is not for turning.

Further modest suggestions: a reply to Varoufakis and Galbraith

SIMON WREN-LEWIS 25 September 2014

Simon Wren-Lewis responds to ‘Whither Europe?’, authored by Yanis Varoufakis and James Galbraith. The European Monetary Union needs to be improved, not transformed.

Galbraith and Varoufakis provide a valuable service in charting the evolution and interrelationships between various plans to ‘save’ the Eurozone. It is clear where their sympathies lie: for reforms that can be implemented now, rather than schemes for yet further (fiscal and political) integration. As that is also where my sympathies lie, there seems little point in my trying to find detailed issues on which we might disagree. Instead I want to provide a complimentary, and I hope non-technical, account of why further integration is not the only way to fix the Eurozone. I think it is interesting that I come to the same conclusions as they do, although perhaps by a different route.

We need to begin with the financial markets after the Eurozone was formed. Those markets made two mistakes. The first was to assume that no Eurozone government would be allowed to default, so interest rates on periphery government debt became virtually identical to rates on German government debt. Lower interest rates encouraged agents in the periphery to borrow, and the second mistake that markets made was to supply too much credit to these agents.

The architects of the Eurozone anticipated and then obsessed about the first mistake, because they thought the resulting lack of market discipline (national interest rates would not increase if individual governments borrowed more) would encourage some governments to become profligate. So the Stability and Growth Pact (SGP) was all about trying to restrict government borrowing. They ignored the second problem, despite the warnings of economists before and after the Euro was created. As a result, countries like Ireland and Spain experienced a boom which drove up inflation, but it also meant that their government’s fiscal position passed the SGP criteria.

The markets realised their second mistake following the Great Recession in 2009, which ended the periphery boom, and banks in periphery countries got into trouble. They realised their first mistake a year later, and interest rates on periphery government debt rose rapidly.

For those advocating further integration, this history implies that a monetary union without a fiscal union is doomed. But it is important to see how the crisis that began in 2010 came to an end. It did not come to an end because austerity convinced the markets that their fears about Irish or Spanish default were unfounded. It ended because the ECB introduced OMT, where it promised (with caveats) to support any government it judged as solvent. It promised to be a sovereign lender of last resort.

With that information, could we rerun history so that the crisis of 2010 did not become an existential threat for the Eurozone? How about this. Instead of the SGP, we had a fiscal regime which encouraged aggressive national countercyclical fiscal policy. So as inflation rose in the periphery, we would have seen much tighter fiscal policies in these countries than actually occurred. But let’s also assume that in Greece this did not happen, and the true extent of Greek indebtedness was revealed at exactly the same time as it was in reality. However at that point, in my counterfactual history, Eurozone governments did two things differently. First they immediately agreed that Greece had to default – not partially but totally. They were prepared to lend money to give Greece some time to put its house in order, as the IMF typically does, but not in an effort to avoid default. At the same time the ECB invokes OMT, and applies it to all other periphery governments, declaring that unlike Greece these governments are solvent.

This combination of countercyclical fiscal policy before the Great Recession and OMT or default after it could have prevented the drawn out 2010-12 crises. Of course Greek default would have been difficult for Greece and embarrassing for the Eurozone as a whole, but it would not have been an existential threat. However, although countercyclical fiscal policy would have reduced the extent of competitiveness loss experienced in the non-Greek periphery, it is unlikely to have prevented it completely. A recession, and austerity to a milder degree, in these countries was therefore inevitable. But in my counterfactual this need not have created a second Eurozone recession for two reasons. First, the ECB could have behaved like its counterparts in the US and UK, and aggressively eased monetary policy (rather than raising rates in 2011). Second, to the extent that this policy was partially unsuccessful because nominal interest rates cannot be negative, the non-periphery Eurozone governments would have agreed a temporary coordinated fiscal expansion.

It is only with this last element that we see a clear case for the need for greater fiscal union. The argument is that without this union, Germany would never agree to fiscal expansion by its government, when demand in Germany was strong because it is enjoying a competitive advantage. Maybe this is true, but the Eurozone roughly consists of three parts: Germany, the periphery plus Italy, and a third that includes France and the Netherlands. While Germany may have felt comfortable with a more modest second Eurozone recession, this third group would not. France is expected by the OECD to have an output gap of over 3 percent next year, and this number for the Netherlands is even higher at about 4.5 percent. With OMT in place, and without the current enhanced and draconian SGP, these countries should have been willing and able to undertake fiscal stimulus to offset any austerity in the periphery. That, together with easier monetary policy by the ECB, would have made competitiveness adjustment in the periphery much easier.

If you contrast my alternative history with what actually happened, what would emerge as the clearest problem with existing arrangements? I do not think it would be the lack of a fiscal union. Instead it is the obsession with public deficits and the need for austerity. Here I arrive at the same point as Galbraith and Varoufakis. Ironically it was the focus on deficits that allowed Spain and Ireland to avoid countercyclical fiscal policy. If instead fiscal policy had focused on relative inflation rates, fiscal policy could have been tighter. It was the belief that austerity could be painless that led governments to pretend they could avoid Greek default, and the ECB to delay OMT for two years. Austerity led to the second Eurozone recession. It is this obsession with austerity that needs to change. As Galbraith and Varoufakis point out, many of the reform proposals that suggest fiscal and political union also see this as a means of applying yet more austerity.

My counterfactual actually involves less central control of fiscal policy decisions. The premise behind the SGP was that the union would diminish market discipline on fiscal actions in member countries. For a time it did, until the markets realised that government default was still possible. Once that happened, market discipline became too intense, which is why the debt crises following the Great Recession were largely confined to the Eurozone, and why OMT was necessary. As long as the option of default, and therefore not implementing OMT, remains credible, the rationale for central control of fiscal policy disappears.

With this in mind, I would make two additions to the “modest proposals” of Galbraith and Varoufakis. The first is to formalise the procedure the Union would adopt if a country applied for OMT. This would put less emphasis on required austerity commitments, and more on the criteria that member states would use to assess fiscal sustainability (I discuss these issues further in this blog post.) In doing this member states would be wise to utilise the expertise of the network of national fiscal councils that is in the process of being completed across the Eurozone.

The second addition is to make the ECB more accountable. While the austerity drive across the Eurozone was a key factor behind the second Eurozone recession, another was the failure of the ECB to act decisively to prevent it. Interest rates were raised in 2011, and there is still no equivalent to the Quantitative Easing programmes of the US, Japan or UK. The ECB has more autonomy than the independent central banks of the US and UK, and its performance has been worse.

Despite these modest suggestions, many will still believe that a complete fiscal and political union could work better than an improved monetary union. However economists typically examine macroeconomic regimes run by benevolent policymakers, with no problems of democratic accountability. The events of the last few years have clearly shown the Eurozone is far from this ideal. Giving much more economic power and responsibility to a system with such a clear democratic deficit seems foolhardy.