Wednesday


Draghi and Padoan

If the Greek financial crisis were merely a financial crisis, i.e., a financial crisis and nothing else, it would be much less of a crisis than it appears to be today. Many commentators have remarked that Greek GDP represents only a very small portion of the total Eurozone economy, so that the amount of agony expended on the Greek problem is far out of proportion to the size of the problem. But the Greek financial crisis is not merely a financial crisis, it is also a political crisis, and it is a political crisis on many different levels. In so far as the Greek financial crisis is a political crisis, the financial crisis sensu stricto may be viewed as a trigger for larger events. It is this that has magnified the crisis.

Analyses of the crisis sometimes focus on the symbolic importance of a Eurozone nation-state going bankrupt, which is crisis for the idea of Europe, while others focus on the potential fallout and knock-on effects of allowing the Greek financial crisis to run its course without outside assistance (i.e., a bailout and debt forgiveness), which is a financial crisis that ripples outward and grows with its expansion — a trigger event with catastrophic consequences, the textbook case of which is the beginning of the First World War.

A few voices — not many, but a few — have suggested that, implicit in monetary union without banking union was the idea that future crises in the European Monetary Union (EMU) would force a reckoning that would presumptively be resolved by turning to ever closer European integration, so that Europe would gradually, hesitatingly, two-steps-forward-and-one-step-back, lurch its way toward full economic integration, and eventually even to full political integration. This is a more sophisticated analysis that sees the Greek crisis in a larger context, and I will not dismiss it out of hand, but I also cannot bring myself to make the many leaps that this argument requires. When have European crises been resolved by tighter integration? European integration has come about, when it has come about, as the result of peacetime negotiations, and not as a response to crisis.

This scenario has been hinted at (although not made fully explicit — nowhere is this formulation fully explicit) by no less a figure than ECB head Mario Draghi:

“This union is imperfect, and being imperfect is fragile, vulnerable and doesn’t deliver, doesn’t deliver all the benefits that it could if it were to be completed. The future now should see decisive steps on further integration.”

Even more recently, in an article on the front page of the Financial Times, “Italian finance minister says political union needed to ensure euro’s survival” (Monday 27 July 2015), Pier Carlo Padoan is quoted as saying, “The exit and therefore the end of irreversibility is now an option on the table. Let’s not fool ourselves… If we want to take that risk away, then we have to have a different euro — a stronger euro… To have a full-fledged economic and monetary union, you need a fiscal union and you need a fiscal policy… And this fiscal policy must respond to a parliament, and this parliament must be elected. Otherwise there is no accountability.” Here the whole program is laid out with the relentless logic of a domino theory: if you want to have the Euro, you need full-fledged, economic union, and if you want to have a functioning economic union, you need to have a European government with real power. The only thing missing in this account is the expectation that the first formulation of the Eurozone would inevitably result in crises, and the crises would be the trigger for these dominoes to fall.

Those who see the Greek financial crisis in its geopolitical context express concerns of Greek alienation from the Eurozone resulting in closer ties with Putin’s Russia, recalling Cold War fears when Greece was one of the proxy theaters of the Cold War. It is entirely possible that Greece, rebuffed by the Eurozone, may turn to Russia for loans, and the Putin would be ready and willing to provide these loans, despite the desperate condition of the Greek economy (and, for that matter, of the Russian economy as well), for political reasons rather than for economic reasons. (And in a changed political climate Russian loans would likely be paid back even if European loans were not paid off.) This strikes me as a more plausible scenario than the above interpretation involving a purposeful trainwreck.

It was a great Cold War coup that NATO was able to persuade rivals Greece and Turkey both to join NATO in 1952, when Greece was the only Balkan nation-state to be part of the western military alliance. Now other Balkan nation-states are NATO members, and Greece is not isolated in the region as a consequence of its NATO membership, but it would be a source of particularly acute tension to have a leftist Syriza government courting closer ties with Putin’s Russia at a time of European unease over Russian actions in Ukraine.

The attempt to unify Europe economically dates even to before NATO, and began as a geopolitical project to forestall European wars on the scale of the mid-twentieth century, and now that Eurozone is facing its greatest challenge since the implementation of the EMU, the unification of Europe will continue, if at all, as a geopolitical project.

The economic rationale for European economic union seems to be present — i.e., the economic union of Europe seems to make sense, but just because something seems to make sense doesn’t mean that it is practicable. In the particular case of Greece, accession to the Eurozone was highly impractical. Greece entered into the European Monetary Union (EMU) with a wink and a nod. There was a sotto voce acknowledgement that Greece did not meet the macroeconomic requirements of joining the EMU, but everyone looked the other way anyway because it was thought that Greece was hitching its wagon to a star; the EMU and the European wide common market was going to be such a grand success that the problem was going to be keeping the “wrong sort” out (like Turkey, which repeatedly expressed its interest in joining the Eurozone, but excuses were always found to exclude the Turks). Here the political rationale trumps the economic rationale.

When a large and diverse geographical area is contained within the borders of a single nation-state — as with the United States, Russia, China, India, or Brazil — this geographical diversity is often expressed in economic diversity, with wealthy regions and cities contrasted with impoverished regions and cities. Within a single nation-state wealth transfers will sometimes be undertaken to offset these extremes in the form of state institutions and mechanisms. These wealth transfers can range from generous to nearly non-existent depending on the nation-state in question. We see this in a much more limited way in the international system, when wealthy nation-states will sometimes give aid and assistance to impoverished regions of the world, but this kind of aid never reaches the level of wealth transfers seen within a single nation-state.

The unification of a nation-state from multiple territories, and the subsequent imposition of a unified system of banking and taxation, constitutes a microcosm reflecting the opportunities and risks that face larger-scale attempts at economic and political unification, as in the case of the Eurozone. The unification of Italy from 1815 to 1871 — a process requiring more than a half century, but roughly corresponding to the span of time of post-war Europe — and the unification of Germany in 1871, both contain detailed lessons for a unified Europe. The unification of Germany has, of course, been a fraught matter. Libraries of books have been devoted to the topic. The unification of Italy has sometimes been cited as one cause of the economic backwardness of southern Italy in comparison to the dynamic north of the country; coupling these diverse norther and southern regions into one national state with a single set of national institutions has not come without consequences.

The reader who has made it thus far may find themselves expecting me to make a case for the rescue of the Greek economy at any cost in order to salvage the geopolitical project of the Eurozone, which was, after all, never conceived primarily as an economic project. It is an economic project secondarily, but a geopolitical project primarily. I am not going to make this argument, which has been made many times, and which is fatally flawed. Europe remains a continent of nation-states (like every continent except Antarctica). Power lies in the sovereign legislatures of each nation-state, in their economic capacity, and in their respective militaries (or the lack thereof). If Europe is salvaged as a geopolitical project, it will be because some European nation-state, or combination of nation-states, determines that it is in their sovereign interest to salvage the Eurozone, and not because some abstract entity like “Europe” commands the loyalty of any population or its military forces.

In Armed Prophets of Revolution I cited Machiavelli’s distinction between armed and unarmed prophets. Here is the passage in question:

It is necessary, therefore, if we desire to discuss this matter thoroughly, to inquire whether these innovators can rely on themselves or have to depend on others: that is to say, whether, to consummate their enterprise, have they to use prayers or can they use force? In the first instance they always succeed badly, and never compass anything; but when they can rely on themselves and use force, then they are rarely endangered. Hence it is that all armed prophets have conquered, and the unarmed ones have been destroyed. Besides the reasons mentioned, the nature of the people is variable, and whilst it is easy to persuade them, it is difficult to fix them in that persuasion. And thus it is necessary to take such measures that, when they believe no longer, it may be possible to make them believe by force.

Machiavelli, The Prince, Chapter VI

While it is no longer the custom in Europe to offer up prayers for ideological programs, the secular equivalents of prayers are daily being published in the organs of mainstream thought in Europe. The Eurozone (and its advocates among Europe’s elite opinion) are unarmed prophets of transnational political unification. As unarmed prophets, we would expect them, following Machiavelli, to be destroyed. But Europe exists under the security umbrella provided by the United States, so that while the Eurozone itself may be an unarmed prophet, it is an unarmed prophet with an armed faction prepared to defend it.

What will the US, as the security guarantor of Europe, see as its geopolitical interest in European unification? Will the US provide the muscle to allow the great European experiment to continue, or will it accept European fragmentation, as long as that fragmentation does not follow the pattern of the Balkan wars following the breakup of Yugoslavia (that other great European experiment in the political unification of the South Slavs, whose earlier fragmentation provided us with the term “Balkanization” and triggered the First World War)? At present, the US is making only cautionary statements and is not actively involved in what is, in effect, the re-negotiation of the Eurozone. With an upcoming US election, one would not expect any new political initiatives from the US in regard to the Eurozone. With the US deeply mired in crises in other parts of the globe, Europe is not high on the agenda.

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During the initial iteration of the Eurozone Crisis I blogged extensively on the problem, and have occasionally returned to the problem in subsequent pieces, including the following posts:

The Dubious Benefits of the Eurozone

Shorting the Euro

Will the Eurozone enact a Greek tragedy?

A Return to the Good Old Days

Can collective economic security work?

Poor Cousins

What would a rump Eurozone look like?

An Alternative to the Euro

The Old World in Turmoil

Gibbon, Sartre, and the Eurozone

Europe and its Radicals

Default in the Eurozone

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Saturday


Euro sign

An introduction to brinkmanship

The emerging consensus in the financial press is that Greece must default on its debt obligations. No longer is the question, “Will Greece default?” but rather then question is, “When will Greece default?” After a pause, another question comes up: “How exactly will Greece default?” Will a Greek default mean Greece leaves the Eurozone (or, rather, the EMU, the European Monetary Union), or will Greece default and a way will be found to keep the country in the EMU? The more these questions are followed by further questions the more obvious it becomes that those asking the questions are seeking justifications and rationalizations to retain Greece within the Eurozone even as it defaults.

During the last episode of Greek default brinkmanship it became increasingly obvious that the powers that be would find a way to avoid Greek default and exit from the EMU (known by the ugly coinage “Grexit”). How do we know this? There was no significant shorting of the Euro in currency markets. Greek bonds took a hit, but they didn’t collapse. In the final analysis, no one really believed that anything dire would happen. Financial markets remained calm. Now that we are once again approaching the brink, and the drumbeat in the financial press is that Greece must default this time, again financial markets are mostly calm. The Euro is not plunging in value (the Euro is lower in value, but not at historic lows), and Greek bonds recently rallied on the assumption that the sidelining of Yanis Varoufakis would make negotiations easier. It seems, once again, that the conventional wisdom is that the worst will be avoided. In other words, a way will be found for Greece to default on its debt and to remain within the EMU so as to create the fewest waves in the markets.

There are at least two interesting things to notice about this process. The first is how far an institution (or institutions) can be pushed in a desired direction in order to obtain a desired result. The Eurozone is today a rather different entity than when the Eurozone treaties were drafted in the late 1990s and the Eurozone was only imagined. Today the Eurozone is at a crossroads, but as important as the crossroads is the long road behind it — a road of repeated and flagrant violations of the Maastricht criteria that were to govern the Eurozone, in which no nation-state has been held to account for its violations. In this context, the further violations required to keep Greece after default in the EMU do not seem particularly outrageous, as they would have seemed to those drafting the Maastricht criteria.

The “convergence” that didn’t happen

Here a little history is in order, and not the history that you are likely to get from those tying themselves in knots to try to find ways not to put the Eurozone asunder. The conditions for accession to the EMU (also known as “convergence criteria”) are known as the “Maastricht criteria” (cf. Who can join and when?):

Price stability, to show inflation is controlled;

Soundness and sustainability of public finances, through limits on government borrowing and national debt to avoid excessive deficit;

Exchange-rate stability, through participation in the Exchange Rate Mechanism (ERM II) for at least two years without strong deviations from the ERM II central rate;

Long-term interest rates, to assess the durability of the convergence achieved by fulfilling the other criteria.

Of course, these are statements of general principle and not quantifiable economic measures, but the Eurozone also has stipulated quantifiable economic measures, and there is a lot of fine print involved in these stipulations.

It is now known and generally acknowledged that Greece did not meet the convergence criteria when it was admitted into the EMU. It doesn’t take much research to find the documentation on this, but you do have to have a memory that goes back more than ten years. Also cf. The politics of the Maastricht convergence criteria by Paul De Grauwe.

Plausible deniability for the Eurozone

To understand why Greece failed to meet accession criteria but was admitted anyway one must enter into the mindset of those laying the groundwork for the EMU. The Eurozone’s monetary union was viewed as a shoe-in for success, and getting in on the ground floor was seen as something as a coup for a marginal economy like Greece, which had hitched its wagon to a star. The people of Greece had only to sit back and watch their economy soar into the stratosphere, pulled along by German and French economies. By allowing Greece into the EMU with a wink and a nod, the EU has plausible deniability when it comes to Greek entry into the Eurozone — their papers were in order, if falsified — but no one at the time really believed the Greece met the Maastricht criteria.

In all fairness, while the Eurozone did not enforce its own accession conditions for the entrance of Greece into the EMU, other nation-states within the Eurozone have repeatedly and routinely failed to meet Eurozone convergence criteria, and they have not been held to account. No consequences follow from having too large of a budge deficit or allowing inflation to get out of hand. The individual economies within the Eurozone appear to enjoy complete impunity in regard to the convergence criteria. This is how the Eurozone has arrived at its present position, which is that of trying to find excuses to allow Greece to default while remaining within the institutional structure of the Eurozone and the EMU.

Cognitive bias as a guide to political economy

To return to the two things I said above deserve to be noted in the present situation, the second thing to notice is that, however far an institution (or institutions) can be pushed, there eventually comes a breaking point — the straw that breaks the camel’s back, as it were — and the real brinkmanship going on is not whether Greece will default or whether Greece will leave the Eurozone, but whether the Eurozone will push its institutions to the breaking point. I want to pause over this ancient problem of brinkmanship and breaking points, because recent scholarship can shed light on this in an unexpected way.

A good portion of Daniel Kahneman’s book about cognitive biases, Thinking, Fast and Slow (especially Part I, section 9, “Answering an Easier Question”), is devoted to cognitive biases in which we substitute an answer for a difficult question with an easier question that we know how to answer and to which we can give a definitive answer. I don’t think that we can stress strongly enough how important (and how under-appreciated) this insight is in relation to economics and politics. All you have to do is to read the reasoning of traders in volatile commodities, and review their elaborate justifications for investments that miss the point of the biggest questions, in order to see how profoundly this affects our world today. Because it is relatively easy to talk about quantitative measures of the economy, and what these have predicted in the past, but it is very difficult to say exactly when public discontent is rising to the point that an unprecedented disruption (or a revolution) is about to occur, it is not surprising that economists and politicians alike prefer to answer the easy question, and sometimes they even convince themselves that the easy question is the only question.

The theology of the insurance adjustor

Not to worry. Insurance companies are ready for such unprecedented events. I have often reflected on the theology of the insurance adjustor who must adjudicate between events anticipated by the language of a policy and those events not anticipated or predicted, and so come under the all-embracing umbrella of “Acts of God.” Wikipedia says that, “An act of God is a legal term for events outside human control, such as sudden natural disasters, for which no one can be held responsible.” This term of art from the insurance industry can paper over a multitude of sins and cognitive biases: deal with the easy problem you’ve substituted for the difficult problem, and then when the difficult problem asserts itself, call it an “Act of God” (or the political equivalent thereof).

If we are honest, we must admit that we do not know what will become of the Eurozone and the EMU. Trying to predict the future of an enterprise so large and so complex is like trying to predict the weather: we can say pretty well what will happen tomorrow, within certain parameters, but the farther we go into the future the more our models for predicting the future diverge, until at some point different models are making inconsistent if not antithetical predictions. This is the essence of a chaotic system, and financial markets and political communities are chaotic systems.

A political and not an economic union

The Eurozone is not fundamentally economic, but political. It is a political project masquerading as an economic project, and while diplomacy often requires masquerades, when the music stops and the ball comes to an end, the masks must come off. Because the Eurozone is a political project, the glosses on its presumed political meaning are legion. I have read accounts in reputable media claiming that it was the intention of the Eurozone that, once economic unification had started, member states would lurch from crisis to crisis, and these crises would force member states to surrender political sovereignty, thus slowly transforming the Eurozone into a political union — perhaps the political union it should have been from its inception. I wouldn’t go quite this far, but such an account at least understands that only political union would make possible the wealth transfers within the Eurozone that would make the EMU workable in the longer term.

Since these is no clear idea of what the Eurozone stands for, one cannot convict the Eurozone of hypocrisy or contradiction. And there is no question that the Eurozone can find some way for Greece to default and to remain within the Eurozone, but any such arrangement will have to accept that Greece will in no sense be an equal member of the Eurozone and EMU. What, then, will Greece be?

What will become of Greece?

Quite some time ago I noted the possibility of “Euroization,” that is to say, the adoption of the Euro as a currency by a nation-state (or other political entity) not part of the EU, much less the EMU. There is precedent for this in dollarization — the use of the US dollar outside US territories. The Ecuadorian economy dollarized, and the Argentinian economy is partially dollarized, with real estate purchases traditionally transacted in US dollars and its many dollar-denominated financial instruments.

If Greece defaults but remains within the EMU, it will become a de facto “Euroized” economy that employs the Euro as its currency, but which has little real participation in the European economy. The Greek economy is not large enough, even in its presumed implosion, to seriously threaten the economies of the other EMU nation-states. If Greece defaults and exits the EMU, both Greece and the remaining nation-states of the EMU will pass through a painful adjustment, but Greece would probably be better off than languishing in the perpetual twilight of Euroized poor cousin to the EMU.

Some consequences of a Greek exit form the EMU are quite easy to guess. Tourism has been a major component of the Greek economy for some decades, and it is likely that most of the upmarket hotels patronized by foreign visitors will price their rooms in dollars or Euros, and in so doing a major sector of the Greek economy will take in hard, convertible foreign currencies. This alone will keep a substantial portion of the Greek economy in operation, even if no one wants to think of their country as nothing but a tourist destination. This is not at all unusual. Many hotels I have stayed at in South America price their rooms in dollars, and some will only take dollars. I especially noticed this in Argentina when I was there in 2010. Even as the Argentine economy stumbles under mismanagement, those who have a hotel that attracts foreign guests capable of paying in hard convertible currencies can do quite well in such an economy desperate for dollars. But while the Greek economy can subsist, after a fashion, on tourism, agriculture was always the strength of the Argentinian economy, and tourism does not represent a substantial contribution to the overall economy.

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