Central banks have been in the news a lot lately, with Mario Draghi’s dramatic decision to redeploy the full range of unconventional policies alongside Jerome Powell’s more obvious ambivalence about loosening the monetary spigots. In part this is a function of timing. The business cycle is turning and yet central banks have not quite managed to reset their instruments after the last crisis. Part is also due to overload. Central banks have been ‘the only game in town’ for a long time, they have expanded responsibility for prudential oversight, and politicians seem none too eager to assume responsibility for macroeconomic performance. It would be a mistake, however, to focus too much on short term explanations. Three recent books explore some of the deeper forces that have pushed central bankers into the spotlight.
Seasoned observers of Italian politics will tell you that there is a fairly consistent pattern to political crisis. The pattern starts with infighting among the governing coalition; it accelerates suddenly when one of the coalition partners ‘pulls the plug’ on the government; and then things slow down again as the various stakeholders realize how much is at stake for them personally if they let things fall apart. Parliamentary seats are prestigious, the salaries are high, and the pensions are generous provided the members just stay in post long enough to qualify. More important, real crisis comprises a lot of work with very uncertain pay-offs to be gained from an often-fickle electorate. Meanwhile, bad things can happen to the country’s economy, particularly vis-à-vis the banks and bond markets. In such a context, it is only reasonable to expect that cooler heads will prevail. Given the possible threat that an Italian meltdown would pose for the future of the euro (and hence also the European Union), we should all hope these observers are right. Nevertheless, there are four good reasons to believe that this time is different.
At some point in the early months of 2007, the words ‘sub-prime mortgages’ began to filter into the popular press. By the end of that August, they were ubiquitous. This small section of the high-risk, high-yield housing finance market in the United States sparked a global financial and economic crisis that would scar a generation. The stories that emerged to explain how this happened were the stuff of fiction or perhaps something even stranger. Banks booked mortgages to people with no demonstrable assets or income, at introductory rates that quickly reset to terms that only the most resilient of households could afford. By the time the borrowers defaulted, however, the banks had sold the mortgages to other investors using complicated securitization instruments that effectively hid the risks involved. The institutions left holding the bag were not only unaware of the dangers the faced but completely unprepared for the consequences. In his powerful new book on The Political Economy of Housing Financialization, Gregory W. Fuller explains why that happened, how the dynamics differed across countries, and what we might do to anticipate similar crises in the future.
The political independence of the European Central Bank rests on three fictions. The first is that the ECB will make better policy over the longer-term than political considerations would dictate in the shorter-term. The second is that the costs of ECB monetary policy decisions will not fall consistently on the same groups. And the third is that disagreements within the ECB and its Governing Council are essentially technical and not political, meaning they are about how the economy really works and how it can best be managed, and not about who wins and who loses from one monetary policy decision to the next. These are fictions insofar as they rest on the assumptions that monetary policymakers are not politicians, that money is neutral over the longer-term, and that technical disagreements are somehow distinct (or distinguishable) from self-interest. The decision to appoint politicians to the top positions at the ECB because of their political skills challenges those assumptions. Along the way, such appointments necessarily bring the political independence of the ECB into question.
The European Parliament that will sit for the first time on 2 July 2019 is very different from the assemblies that came before it. More Europeans voted in the 2019 elections than ever before and with a higher rate of participation than we have seen since the 1990s. More votes were cast for parties outside the two main formations, the European People’s Party and the Socialists and Democrats. More new political parties have won representation, both from the right and from the left. And more uncertainty surrounds the group formation process and coalition building dynamics than we have seen since the first direct elections in 1979.
Small is beautiful, but also dangerous. That is the central insight in Darius Ornston’s 2018 book. Even good governance can go bad. Consensus makes it easier for a society to work together in facing the challenges presented by world markets. Backed by powerful social groups, political leaders can fend off adversity, compensate losers, agree on how to organize or reorganize machines and labor, and invest in the physical and human capital necessary for future prosperity. This insight will be obvious to anyone familiar with Peter Katzenstein’s classic works. What Ornston adds to Katzenstein’s argument is a cautionary note. The same consensus Katzenstein celebrated in his analysis of small states and world markets also makes it easier for political leaders to misallocate scarce resources and delude themselves and their followers into feeling safe when they are not. Finland’s embrace of Nokia and Iceland’s addiction to banking are good illustrations. Unfortunately, in both cases, the social requirement for conformism can drown out even the most constructive criticism or warning. Success and failure arise from the same dense networks that facilitate deliberation and reinforce trust.
The euro area lacks a framework for sovereign debt restructuring and it lacks a common risk-free asset. Both issues are important in looking ahead to the prospect of any future crisis. Of the two, however, the creation of some kind of sovereign debt restructuring mechanism appears to attract the most political attention. This briefing note outlines the issues that would need to be addressed to bring greater stability to the euro area.