GEI welcomes Michael Pettis as regular contributor. A short bio is found at the end of this article and a longer bio at his website China Financial Markets.
If Europe is going to “resolve” the current crisis in an orderly way, it is going to have to move very quickly – not just for the obvious financial reasons, but for much narrower political reasons. I am pretty sure that the evolution of European politics over the next few years will make an orderly solution progressively more difficult.
For ten years I have used mainly an economic argument to explain why I believed the euro would have great difficulty surviving more than a decade or two. It seemed to me that the lack or fiscal centrality and full labor mobility (and even some frictional limits on capital mobility) would create distortions among countries that could not be resolved except by unacceptably high levels of debt and unemployment or by abandoning the euro. My skepticism was strengthened by the historical argument – no fiscally fragmented currency union had ever survived a real global liquidity contraction.
I am now going to veer off into a very different realm, that of politics. I don’t in any sense pretend to be an expert on the subject, but one of the things that surprises me is that as far as I know (perhaps because I am looking in the wrong places) and in spite of very clear historical precedent, very few analysts, even the greatest euro-skeptics, are wondering about of the changes in electoral politics that are likely to take place in Europe over the next few years as a consequence of the euro adjustment. For example Wolfgang Munchau has an excellent article in the Financial Times in which he concludes, like I did in my post last week, that:
The eurozone is manoeuvring itself into a position where it confronts the choice between two alternatives considered “unimaginable”: fiscal union or break-up.
Obviously I think he is right, but I would add that the window for that choice is a small one. If Europe doesn’t move quickly, within two or three years it will probably be very difficult, if not impossible, to engineer fiscal union. By then domestic politics are likely to be too unstable for the European political elite simply to arrange union over the heads of the citizenry.
I have addressed the issue briefly before. After my piece last week on financial prospects in Europe I received a lot of comments and questions from clients, especially about this part:
Political radicalism in these countries will rise inexorably as a consequence of rising class conflict. As Keynes pointed out as far back as 1922, the process of adjusting the currency and debt will primarily be one of assigning the costs to different economic groups, and this is never an easy or conflict-free exercise. Of course the less stable a government becomes as a consequence of this adjustment, the more likely it is to prefer very short-term solutions.
This week then I will ignore China (although as China’s largest export market, what happens in Europe clearly matters to China) and focus on explaining what I meant.
The point I was trying to make in the passage is an obvious historical one – that the resolution of Europe’s crisis will inevitably involve a difficult political debate over apportioning the cost of the resolution. In one of my favorite history books (The Financial History of Western Europe), Charles Kindleberger argued that the political structure of Europe after the First World War guaranteed that different economic interests would necessarily struggle over income distribution.
When it came to deciding how countries would adjust to currency and debt misalignments of the 1920s and 1930s, the main issue, according to Kindleberger, was “whether deflation and unemployment would saddle a major share of the load on the working class, as contrasted with the rentier.” He goes on: “Keynes observed in 1922 that the choice between inflation and deflation comes down to the agonizing outcome of a struggle among interest groups.”
We need to remember what Kindleberger and Keynes meant by this. As everyone knows, markets are very, very nervous about currency and sovereign debt crises in Europe.
How to adjust
But this nervousness will soon pass. I have no doubt that enormous amounts of scotch tape, paper clips, and chewing gum are going to be deployed quickly to hold the whole thing together, and that perhaps in a week or two we will be all throwing sighs of relief as policymakers firmly announce that Europe was put to the ultimate test and proved itself manfully.
But does that mean we can stop worrying – was this really the ultimate test? No, of course not. If previous history is any guide, this crisis will re-emerge in different places every few months until it is truly resolved, and increasingly the crisis will manifest itself in the political realm.
Unfortunately it is going to require a lot more than emergency liquidity loans, no matter how plentiful, to arrive at a final resolution. These loans simply paper over the financing gap until the next big refinancing exercise, and each new loan effectively shortens the duration of the debt or claims a higher level of seniority, so that the capital structure becomes increasingly risky. As the capital structure becomes riskier, it takes a smaller and smaller event to set off the next crisis.
We’ve seen this kind of problem before so many times that I think it is fairly easy to draw the map of outcomes: growth will slow sharply and there will be several short-term liquidity panics, during which time the political consensus will be become increasingly fractured, and increasingly fractious. In some countries the political system might radicalize, and anger will increase. This will go on until finally we have the grand resolutions of the crises.
I don’t think there is a whole lot of disagreement among economists over what are the possible resolutions. Any country whose domestic cost structure is too high to allow it to compete in a globalized world – whose “currency” is in effect overvalued – must eventually adjust its cost base. There are broadly three ways for a euro-zone country to adjust it cost base to foreign competition:
- The afflicted country can redenominate its debt (and all domestic financial transactions) into a new currency unit, abandon the euro, and devalue the new currency.
- It can regain international competitiveness by forcing down the cost of labor (and deflating other inputs). The most efficient way to do this, of course, and perhaps the only way, is to run very high levels of unemployment for many years.
- It can impose trade barriers so as to protect domestic manufacturers and raise domestic employment while it adjusts.
Similarly any country whose debt levels are too high, so that it faces financial distress costs that will force a slowdown in growth and an unsustainable rise in debt, will have to improve it’s relative ability to repay. In that case there are also roughly three ways it can do so:
- It can regain control of monetary policy by abandoning the euro in favor of a local currency, and then inflate the debt away.
- It can default or threaten to default on the debt, and receive significant debt forgiveness.
- It can regain fiscal credibility by raising consumption or value-added taxes, by raising income taxes, probably on businesses since it will be hard to raise income taxes on households, or by cutting expenditures sharply, probably social welfare expenses.
There is I guess a fourth way – the country can “grow out” of its debt burden – but although we will hear this fourth way invoked a lot, I think we can safely ignore it. High debt levels themselves prevent growth by encouraging disinvestment and altering the incentives for investors and creditors in ways that punish growth (although here reviving Argentina’s GDP warrants can provide a very interesting partial solution).
Most of the afflicted European countries suffer from both of the above problems – an uncompetitive economy and excess debt (in some cases after we include contingent banking liabilities) – and in the aggregate all of the above resolutions accomplish more or less the same thing. They allow the country to bring costs of production, including most importantly the cost of repaying the debt, back to some sort of manageable level, and to reduce financial distress costs.
The means by which each economy adjusts however involves very different distributions of the pain of adjustment. And make no mistake, there is absolutely no way for Europe to adjust without significant pain. Often enough whenever a euro-skeptic says that Country X should abandon the euro, aghast euro-philes insist that country X should never abandon the euro because it would involve heavy costs, which they identify mainly as a rise in debt to GDP and vague – and historically suspect – warnings of hyperinflation. Of course abandoning the euro would involve costs, but under the circumstances so would not abandoning the euro. Abandoning the euro, in other words, is not about taking on costs. It is about distributing existing adjustment costs.
What Keynes and Kindleberger (and the other K: Krugman) remind us is that the distribution of these costs is not determined by economic theory but rather by political interests. That is why I said last week that political radicalism in Europe will almost certainly rise and the process of governing will become increasingly unstable. It is through the political process that the costs of adjustment will be assigned to the different groups, and when the costs are likely to be so high, the squabbling over the assignment of those costs is likely to be quite brutal.
In order to see how, let’s go through the distribution of costs:
- Abandoning the euro and devaluing imposes much of the burden on creditors whose assets are redenominated, especially those with newly mismatched books (i.e. their redenominated assets were funded with non-redenominated euro liabilities). These may include the wealthy, but because they know this, we will probably see significant flight capital as they liquidate assets and take them out of the country. Foreign banks who have lent to the redenominating country will also take big losses. This may sound invidious, but although an approach in which foreigners bear a disproportionate share of the pain may not be fair, it certainly is convenient.
- Forcing down labor costs through unemployment puts the bulk of the burden on workers and the lower middle classes, especially non-unionized workers. Other forms of deflation hurt borrowers, including small businesses and mortgage borrowers.
- Trade barriers may be impractical within Europe (at least before abandoning the euro), but to the extent that they are imposed they force domestic consumers and foreign producers to bear the cost of the adjustment. Remember however that local households comprise both domestic consumers and domestic workers, so the real impact on household income may be positive if trade barriers are expansionary for employment (which they usually are in diversified deficit economies). The question is which households. The unemployed working class may benefit while the struggling middle class may get hurt.
- Inflation hurts everyone on a fixed income. Middle class people with savings, pensioners, and non-unionized workers are usually the ones hurt the most.
- Default and debt forgiveness places the adjustment cost on lenders, in this context especially on lenders to the sovereign borrower. Again, it is worth remembering that if a disproportionate share of lending comes from foreigners, they absorb a disproportionate share of the cost.
- Raising consumption and value-added taxes hurts consumers, mainly the middle and working classes since the poorer you are the higher consumption is as a share of your income, while raising income taxes on businesses puts the pain of adjustment on businesses, especially small businesses who often aren’t able to protect themselves. Finally cutting fiscal expenditures mainly affects the middle classes (medical and education) and the working classes and poor.
Its politics, not economics
There may be other types of resolution and other distribution of costs. For example former Argentine Economy Minister Domingo Cavallo in April advised Greece to raise VAT taxes and reduce payroll taxes. This works broadly in the same way import tariffs would work, with a similar distribution of costs. Sellers of consumers goods, many of whom are foreign, effectively end up subsidizing domestic producers.
But whatever the proposed solution, my main point remains. We cannot escape the fact that these costs have somehow to be assigned to different economic groups, and the process of assignation is wholly a political one. And with such high stakes, it is likely to be angry.
In Latin America in the early and mid-1980s, unemployment pushed most of the burden onto the working classes. By the end of the decade inflation and hyperinflation hit the Latin American middle classes hard. Once US banks had sufficiently rebuilt their capital bases, by the very late 1980s, debt forgiveness passed on a small part of the adjustment onto foreign banks.
This formally began in 1990 with the Mexican Brady Plan. But formal or secret discounted debt buybacks throughout the decade ensured that part of the cost was passed on to foreign lenders earlier – mainly US regional banks and European banks whose exposure was small enough to allow them to absorb the losses.
In retrospect (and even for some of us back then) I think it is pretty clear Latin Americans should have demanded debt forgiveness much earlier. This would have been terrible news for the large American and European banks, but failure to receive debt forgiveness may have condemned these countries to slower or negative growth for much longer than they otherwise would have experienced. (As an aside, check out this fairly common-sense primer on how to default.)
Throughout the decade, and largely because of the debt crisis, Latin American politics were unstable and difficult, with a variety of responses throughout the region, ranging from conservative free-market adjustments to radical and populist adjustment. In her very interesting book, Who Adjusts?, Beth A Simmons focuses on the similar processes experienced by European countries in the 1920s and 1930s. We saw there the same range of outcomes, and Simmons tries to explain why different countries chose different outcomes.
She makes the following point about how different types off governments attempted to resolve the crisis in a cooperative or combative fashion:
Stable governments and quiescent labor movements contributed to international economic cooperation, while domestic political and social instability undermined it.
I interpret this to mean that over the next few years, in countries in which there is significant labor unrest, we are probably far more likely to see sovereign debt defaults and the abandoning of the euro. If this is true, this argument also gives us a sort of conceptual timetable – any solution aimed at preserving the euro or at an orderly debt restructuring that protects the European banking system must take place while the current political elite, left or right, is still in control. The longer we wait the less likely a coordinated solution.
In fact Simmons’ book, for those who are interested, is an interesting study of how different European countries evolved different approaches to adjustment depending on political and social conditions. I suspect that the basic problems and approaches she identifies are pretty much the same ones we will be watching over the next few years.
I am not suggesting that politics will get nearly as crazy or as radicalized as they did in the 1930s. There are much more robust mechanisms today for transferring and sharing adjustment costs, and I assume (hope) we learned enough from the 1930s to recognize that asking one side or the other to pay the full cost is not likely to be good for anyone. But it is hard to imagine that the kinds of disruptive political sectarianism that we saw in some European countries as recently as 20 or 30 years ago cannot revive.
P.S. Yves Smith, over at one of my favorite blogs, Naked Capitalism, comments on this post and argues that I am being overly optimistic in my timing. Yves doubts we have two years to get this right — more like two months. Maybe. One of the commenters on that blog discusses irish politics in a way that suggests that my prediction of a radicalization of European politics may already be stale. Another commenter notes a furious piece by the always lucid Barry Eichengreen in Wednesday’s Handelsblatt. You can find a translation in the Irish Economy blog — a definite must-read.,