Viewed from the United States – or, maybe better, from an American perspective – the Greek elections highlight the problem of moral hazard in Europe. This is not a normal problem you would expect to arise from a democratic contest. ‘Moral hazard’ describes a condition where one party takes on excessive risks because they believe, whether rightly or wrongly, that any negative consequences can be shrugged off onto someone else. The classic example is a borrower (or a banker) who takes on too much debt and then walks away when it proves unsustainable. When we talk about elections, it is hard to see how this situation might arise. Voters can vote irresponsibly, but they are likely to bear the consequences of their own foolishness.
The Greek elections are different for two reasons, one related to political perception and the other related to economic interdependence. The problem of political perceptions is the easiest to explain because it has captured the greatest media attention. The argument is that the Greek people are throwing their support behind Syriza because of its strident calls to reduce the pressure of fiscal austerity, to slow the pace of economic reform, to redistribute the burdens of adjustment from the poor to the wealthy, and to renegotiate Greece’s sovereign debt. If Syriza comes to power, so the argument runs, it will try to do all of these things at once. However, these are precisely the kinds of things that got Greece into the mess it is in at the moment. What Greece really needs, again following this same line of argument, is to step up the pace of reform, to complete its fiscal consolidation, and to pay back its debts. If this can be done by redistributing the burdens of adjustment so that the wealthy pay their fair share of taxes, that is all the better.
The point in this argument is that any failure to continue with fiscal austerity and market-structural reform would set Greece on a path to perdition and the rest of Europe would have to pay some share of the consequences. That is the source of moral hazard. Therefore, the only responsible thing that the rest of Europe can do is underscore for the Greeks the real dangers they face. That is why there has been such loose talk in Germany about the possibility of a Greek exit from the euro; that is why the ECB has made it clear that Greek sovereign debt is only eligible as collateral so long as Greece remains under European Union (EU) and International Monetary Fund (IMF) supervision; and that is why the Dutch parliament just passed a non-binding resolution that any bond-buying scheme introduced by the European Central Bank (ECB) as a form of quantitative easing should not lead to a mutualisation of sovereign default risk.
The problem of economic interdependence is less widely reported because it is also more subtle and so more difficult to explain. Again, moral hazard is about taking excessive risks where others absorb some or all of any negative consequences. In this case, however, the risk is that politicians will break the delicate lattice of institutions, market confidence, and political legitimacy that underpins market integration in Europe. This moral hazard arises in the context of great political strength and yet a narrow conception of self-interest.
Consider the following examples. In March 2012, Bundesbank President Jens Wiedmann expressed his concern that the system for reallocating credit between central banks in the euro area (called Target2) was generating too many imbalances, with some central banks building up large credit positions while others build up large debits. He suggested that any debits in the Target2 system should be backed with collateral. Had his suggestion been adopted, it would have transformed the single currency into a fixed exchange rate regime because the availability of eligible collateral is limited – much like the availability of foreign exchange reserves. Weidmann’s suggestion was quickly dropped but the risk it implied was considerable and it extended far beyond Germany.
A second example was when ECB Executive Board Member Jörg Asmussen persuaded the government of Cyprus to resolve the country’s two largest banks by taxing small depositors in March 2013. The leverage Asmussen had was a threat from the ECB’s Governing Council to cut off the ability of the central bank of Cyprus to provide the banks with emergency liquidity assistance. The argument within the Governing Council was that these banks were insolvent and so needed to be resolved rather than propped up with emergency liquidity. That argument makes sense but the solution of taxing small depositors violated the principle of deposit insurance and so threatened to provoke a run on the banks. The Cypriot parliament rejected that option and ultimately had to impose capital controls to stop money flowing out of the country. For a brief moment, it looked possible that Cyprus might actually exit the euro area. Were that to happen, the effect would be to demonstrate that the single currency is not irreversible and so to transform it into a fixed exchange rate regime. Again, the implications would have been considerable.
These stories are important because we are witnessing the same pressure being applied on Greece at the moment. As mentioned, the European Central Bank has made it clear that it will not accept Greek sovereign debt as collateral unless Greece remains within an EU/IMF program. There are good arguments to support this claim in principle, but the implication is that the Greek financial system will collapse if Greece does not accept international supervision. Greek sovereign debt instruments could be excluded from any quantitative easing for much the same reason. The problem is that Greece is one of those countries where liquidity is needed most. If the country’s debts are unsustainable, that is due in large measure to the collapse of economic activity. Even fast rates of growth at the moment have a long way to go in catching up. Finally, the demutualization of risk within the euro system is another burden on Greek finances. Again, it is understandable that countries like the Netherlands and Germany would not want to accept the risk of a Greek default. The problem is that by pushing that risk back onto Greece, they only make the situation more likely.
This is a situation of moral hazard because the ECB and the creditor countries in the euro area have the power to impose their will on a country like Greece. But that does not mean they will either escape or absorb the potential consequences of their actions. In other words, the risk they are courting is excessive. If this situation turns out badly, Greece will suffer but the rest of Europe will suffer as well – Germany, the Netherlands, the ECB, and the euro as a single currency included. That is how economic interdependence operates in an integrated market. That said, any attempt by one actor or group of actors to impose their will on another – no matter how well-justified – runs the risk of generating an adverse political reaction. That is how democracy works, for better or for worse. And from an American perspective, the not-so-subtle attempts to influence Greek policy and politics during these elections is a moral hazard to be avoided.
[This essay was originally commissioned as part of a dossier on the Greek elections published today by ISPI. Many thanks to Antonio Villafranca for giving me permission to post it here as well. You can find the ISPI dossier here.]Follow @Erik_Jones_SAIS