Europe’s Political Economy Does Not Have to Be Tragic

None of what we are facing now is new or (wholly) unexpected. Of course everyone hoped this set of problems would pass and believed that politicians would do their utmost to make matters better. But no-one  ever completely discounted the possibility that Europe would fall back into crisis.

To show what I mean, I have assembled a series of excerpts from short essays I wrote during the course of the past six months. In each case, I give the date and title of the note as well as a link to the original text. What they provide as a collection is a sense of deja vu all over again.

I am hardly prescient as an observer. On the contrary, I am just one of many voices who have said the same things over and over. That is the point.

There is something tragic in the political economy of Europe at the moment. We witness what is happening like a slow motion train wreck. The victims are all around us. It is time for Europe’s policy-makers to do something about it. The ideas are certainly out there.


“Greece is headed to the polls and Italy faces a presidential election. Populist, anti-austerity, and anti-euro parties are on the rise in various parts of the European Union — both inside and outside the euro area. Ukraine is in turmoil and Russia seems intent to continue its policy of destabilization. And that is not to mention the various problems in the Middle East and North Africa. It is hard against that backdrop to imagine that the European crisis actually ended.” (7 January – Europe Compass)

“one of the lessons we learn from books like George Orwell’s Coming Up for Air or Christopher Clark’s The Sleepwalkers is that moments of crisis may only seem dramatic after the moment has passed and the disaster is upon us.” (11 January – The Euro Area is Already in Crisis)

important parts of the European financial economy remain vulnerable to the forces of disintegration.  Despite the progress made in creating a banking union and the prospect of a capital union on top of it, investors remain unconvinced by the promise of the single market.  This is not a good sign.  The European Central Bank warned last April that Europe had made insufficient progress in re-integrating financial markets since the crisis.  They still have a long way to go.” (18 January – The Threat of Financial Disintegration)

“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.” (23 January – Greek Elections and Moral Hazard)

“This distinction is worth underscoring because it helps to explain why international negotiators appear so much less in control of their craft and why furbizia in these negotiations is more of a liability than an asset. The simple fact is that German political leaders have little or no idea how the newly elected Greek coalition will respond to implicit or explicit threats — any more than they know how to interpret the confusing messages that are coming out of the Greek cabinet, with Finance Minister Yanis Varoufakis claiming that Greek will no longer work with the ‘Troika’ of macroeconomic policy monitors drawn from the International Monetary Fund (IMF), the European Commission (EC), and the European Central Bank (ECB), while Greek Prime Minister Alexis Tsipras claims his government will repay its debt to the ECB and the IMF. The same logic applies in reverse as well. Tsipras and Varoufakis do not know much about what motivates specific German policymakers and politicians. They can speculate in general terms using rules of thumb distilled from personal experience and political science. But they are really only guessing when they look for which buttons to press.” (2 February – Hard Bargaining)

Europe’s central bankers have turned the logic of political independence on its head and now they are openly engaged in what looks to most observers like politics.  If we somehow get out of this crisis without suffering another major setback, people may be willing to overlook this perceived transgression.  If there is another sharp reversal, however, the public is unlikely to be forgiving.  Central bankers will become political targets and so will central bank independence.  The results will not be good for future macroeconomic policymaking.” (10 February – Central Banking as Politics)

The question is whether the commitment to irrevocably fixed exchange rates would remain credible if by some accident Greece were forced to exit the euro. At that point it would be worth questioning whether the parity across countries is ‘irrevocable’, no matter what European policymakers like Draghi might insist. It would also be worth recalculating whether it makes sense for Cyprus to follow Greece rather than remain in the euro. And it would be useful to consider whether market participants should all keep pretending that they face no ‘convertibility risk’ when comparing euro-denominated assets from one country to the next or whether they might be safer changing some of their bets..” (15 February – Credibility as a Powerful Idea)

“A big euro crisis could easily reverse the progress that has been made.  It would not only damage Greece but also the whole European project.  Obviously trust is important in any political arrangement.  So is patience.  The deadline for requesting a bailout is useful in focusing attention but that is no reason to telescope long-term aspirations into a short, fraught negotiation.” (20 February – Now Is Not the Time)

“The political dynamics surrounding the latest Greek agreement are only the most obvious source of threat.  The institutional politics unfolding within the ECB Governing Council are also important.  Finally, we have to worry about the health of the Greek banks.  A sudden deterioration of the climate in any of these three areas could rapidly bring us back to the threshold where Greek politicians have to consider whether to take actions that will result in their country’s expulsion from the euro.  Let’s hope that event never comes to pass.” (1 March – Brexit and Grexit — Process and Event)

“European policymakers are winding back the clock. The imposition of capital controls in Cyprus was the first step. Two years ago Dijsselbloem heralded those negotiations as setting the model for the future. He quickly retracted his words in the face of market pressure, but the experience of Greece suggests he was not wrong in his assessment. A colleague of mine in the Italian Foreign Ministry said to me recently that we need a clear commitment to do ‘whatever it takes’ politically to safeguard Europe and not just the euro. The problem is that it is unclear what kind of Europe politicians want to have.” (8 April – What Kind of Europe?)

“Moscovici also insisted that Greece could not exit ‘by accident’. I think he was trying to reassure the audience that the ‘Last Chance Commission’ would not make any mistakes. Inadvertently, he suggested that a Greek exit would necessarily require some kind of political decision. Presumably it would also need to be planned. Here again we are confronted with a future that is unthinkable rather than impossible. Greece will never leave the euro because European policymakers would never choose that option, and they would never choose that option because they refuse to accept it as an alternative. This is the essence of conviction as policy. You change the future by refusing to consider scenarios you find unattractive. Hopefully this formula will work out in the end. But in this universe mistakes happen and comets can hit you even when you don’t worry about them.” (19 April – The Politics of Conviction and Conviction as Policy)

“it is conceivable that someone somewhere has built a model to fold the stability of the Greek banking system, the structure of portfolio requirements, and the constraints on ECB purchases into account when pricing in the risk of contagion. But it is more likely that investors are focusing on different models to use in different contexts – one where the Greek banks look relatively solid, another where the banks get into trouble, a third where portfolio responses start to have market implications, and a fourth where the ECB’s implicit commitment to do whatever it takes is found wanting. Each time one of these events is triggered, the markets will jump. The size of the jump is the measure of the extent to which market participants failed to price in ‘risks’ ex ante. We know that these things are possible and we can estimate the risk that they will occur, but I do not see a context where this model switching fails to move prices. And I would be reluctant to bet that the ‘market correction’ will be small.” (25 April – Market Pricing Greece)

Europe’s political leaders have a long track record of embracing policy solutions that have more political than technical merits. If that trend continues, it would be unreasonable to assume that the majority of Europe’s politicians will support doing ‘whatever it takes’ to keep Greece within the euro. This will not stop the ECB from propping up the Greek banking system. The technical arguments Taddei sketches remain compelling. Nevertheless, Europe’s central bankers will have to face the political consequences of their actions. What is unclear is whether those political consequences will do more damage to the single currency than the exit of Greece from the euro.” (16 May — ‘Reasonableness’ and the Link Between Government Default and Euro Exit for Greece)

“I cannot think of any version of history where the framers of the Maastricht Treaty imagined the scenario we face today; it fits nowhere in an imaginable doctrine of original ‘intent’ and so the delegation of authority is hard to accept. If it works, and this crisis dissipates, then the ECB will nevertheless have to defend itself against accusations of overreach like those we see in Germany already. If things go terribly wrong, I suspect the ECB will find itself with few allies among the member states. And if the ECB fails or the euro splinters, there will be no banking union to talk about.” (24 May – Banking Union and Democratic Legitimacy)

The problem is not that the Greek government lost control over its finances; the problem is that the rest of Europe cannot allow the Greek government to default. Moreover, financial market participants have long recognized that fact. That explains why the spreads between Greek and German assets were so narrow for much of the history of the single currency. Again the explanation points back to the link between Greek government finances and the stability of the Greek banks. If this link were severed, then Greek policymakers would face market discipline.” (22 June – Lessons to Learn (and Not to Learn) from the Greek Crisis)

The longer term impact of Greece exiting from the euro will be the creation of a two-tiered (or multi-tiered) Europe – with one tier suffering permanent disadvantages in terms of the cost of capital, the volatility of macroeconomic performance, and the efficiency of market infrastructures. Moreover, this future is consistent with the predictions of both the optimists and the pessimists. Whatever the short-term impact of Greece leaving the euro, there will be expensive and divisive long-term consequences.” (26 June — The Longer-term Consequences of Greece Exiting the Euro Would Be Expensive and Divisive)

The architects of the single currency made a fundamental mistake. They designed the ECB to be a monetary policy authority. In doing so, they forgot that first and foremost central banks are supposed to be banks. A single currency cannot survive without a lender of last resort facility. A lender of last resort has to act to stabilize the financial system in moments of crisis without regard to the longer-term implications for price stability. Of course those longer-term implications cannot be ignored entirely. Over time some reconciliation has to take place. But the hierarchy of needs places the ‘bank’ above the ‘monetary authority’ in moments of crisis. Europe’s monetary union was not designed to respect that hierarchy. That is why the ECB’s mandate is Janus-faced.” (28 June – The Janus-Faced Mandate of the European Central Bank)

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