Efforts to form a new government in Athens failed over the weekend, raising the prospects of new elections and Greece’s possible exit from the eurozone. Financial markets have responded predictably: equity prices are down while bond yields are at new euro-era highs in Spain, but down in Germany. Meanwhile, ominous warnings issue forth from Brussels about a possible amicable divorce between Greece and its euro zone partners.
Is the end-game nigh? Mohamed El-Erian has a thoughtful analysis of what is happening and what must be done in the Financial Times.
I continue to think that a Greek exit from the euro zone would be disruptive, imparting additional uncertainty to the global outlook, but that it could be contained with sensible policy responses in the rest of Europe. That is the problem. Europe has not demonstrated — how should I put this? — the most prescient policy choices over the past two years. As Paul Krugman might say, policy has been driven by “very serious people” intent on preserving the project of European monetary union who are at times seemingly oblivious to economic realities.
So, while Greece’s exit needn’t pose a particularly grave threat to the rest of the world, I wouldn’t assume that would be the outcome.
The euro architects contend that the problem in Europe is fiscal profligacy. The solution therefore is austerity. This is the economic equivalent of the practice of bloodletting; if the patient doesn’t respond to the treatment, more blood is drawn. The problem in Europe is the dysfunctional monetary arrangements (and lack of supporting institutions) that have been put in place. These arrangements replicate, in effect, the “bad” gold standard of the inter-war period, which put the full burden of external adjustment on deficit countries. Unfortunately, countries in difficulty are now discovering that their fiscal efforts are not rewarded by the markets; rather than restoring confidence, their efforts now lead markets to question the political sustainability of the adjustment effort. This perverse fiscal austerity effect was also the experience of the inter-war period.
The problem then, as now, is that, with the hands of monetary policy tied, there is no offset to the negative impact of fiscal austerity. Most successful fiscal stabilizations occur with the help of stronger external growth, typically after significant exchange rate depreciations. But this is not an option with monetary union, and with the outlook for global growth weighed down by continuing uncertainty, the prospects for countries in distress are bleak.
In these circumstances, people justifiably question the policy frameworks that their leaders have built and to which these leaders cling, hopeful that something will happen to relieve the pressure. Their dogged determination to “stay the course” might be rewarded. But it is unlikely. And, as elections loom, the fraying of the social fabric that the status quo entails creates a polarization of politics — if the ‘sensible’ middle ground of conventional wisdom has failed, radical solutions of both the left and right become more attractive.
What is happening in Europe is an example of Frank Knight’s risk versus uncertainty.[1] Risk, Knight argued, is an outcome to which some probability can be attached: a particular investment that has a range of potential payoffs; each payoff has an associated probability (which sum to unity). Think of uncertainty as an outcome or an event to which individuals cannot attach a probability – the event might happen, but individuals are able to assess whether it is with a 10% probability, or a 90% probability. Such scenarios make it notoriously difficult to price assets. And if the future value of assets can’t be assessed, investors are reluctant to hold them. Forward-looking investors, evaluating the prospects for additional fiscal austerity in the current policy framework, see the potential for more political uncertainty and the possibility of “pole jumping” as policies swing from one extreme to the next.
Europe has seen the tragic consequences of dysfunctional monetary arrangements before. In the inter-war years, they led to the adoption of beggar-thy-neighbour policies “destructive of national and international prosperity” as countries retreated in a Nash-equilibrium of bad policies. They included global economic stagnation and global war.
The Bretton Woods agreement emerged from the wreckage of economic stagnation and global war. It was designed to assist its members strike a judicious balance between financing and adjustment – recognizing that social and political stability is a necessary foundation for sound economic policies. Similar sagacity is required today if the euro is to survive in its present configuaration.
[1]Risk, Uncertainty and Profit (1921).