From technocracy to populism

A blog post for the LSE's EUROPP blog:


In upcoming elections across the Eurozone periphery, voters are likely to react to austerity by replacing technocracy with populism | EUROPP

"As Spain lurches into economic and financial collapse only months after electing a new government with a landslide majority, the difficult relationship between crisis management and democratic politics once again comes into view. Spain’s rapid descent into economic meltdown has been greeted by anti-austerity commentators such as Paul Krugman and Martin Wolf as further evidence of the need for fiscal and monetary expansion on a massive scale in the Eurozone. But it also has important implications for the nature of democracy in the European Union...."

The myth of moral hazard, or why punishing debtors is futile

This crisis, and its Eurozone variant in particular, is teaching us an awful lot about the political economy. Sadly, most of what we are learning is entirely at odds with the conventional wisdom which still informs policy. And a good part of the wrongheadedness that we are subject to revolves around the concept of moral hazard.

The plausible expectation of bailouts creates moral hazard, we are told. Yes, it does. There is plenty of evidence that big financial institutions take risks because they expect governments to pick up the pieces if everything goes pear-shaped. Certainly, if top bankers are anywhere near as smart as their paypackets suggest, they should lever up and max on risk, confident that governments will plug the gap if their bets go bad.

Trouble is, we also know that finance is also prone to bouts of irrational exuberance and panic. Moral hazard may exacerbate the exuberant parts of the cycle, but it also mitigates the panic when things turn bad. Part of (maybe most of) the reason that the Eurozone periphery is in such a self-fulfilling debt trap is that there isn't enough moral hazard around - investors are terrified that if their paper goes bad, they will lose everything. And so the downward spiral accelerates, making bailout infinitely more expensive as panic sets in.

What about governments? Well here the virtuous Northern economies in the Eurozone are afraid that bailouts now will encourage Southern sovereigns to ignore their fiscal problems in the future, leaving Germany and the others on the hook forever. Moral hazard here gives politicians an incentive to run deficits and buy popularity, whilst others pick up the tab.

The trouble with this one is that the politicians that are punished are not usually the ones who exploited moral hazard. Mariano Rajoy took over when Spain's fiscal situation was already out of control, yet he is the politician being exposed to popular anger now. For the anti-bailout policy to work, voters would have to be sophisticated enough to gauge how likely it is that a party's fiscal proposal at time t will result in another party having to impose brutal austerity at time t + 1. Very often, as in Greece, successive alternating governments are responsible for the fiscal mess. How can voters cast a partisan vote that sends the correct signal to politicians, so that the risk of irresponsible policy is averted? Do we really think that if this crisis ever ends Greek voters will become eager observers of fiscal rigour on the part of their politicians, anxious to avoid this all happening again? For this to happen some Greek politicians would have to offer voters fiscal prudence whilst others stuck to deficit-fuelled patronage politics, making elections a clear choice between happiness and hazard. That's rarely the way politics works.

In short, moral hazard is a red herring, and theorizations of its role in the crisis are crude, confused and make no historical sense. In the real world of politics and markets, when you get to the point where bailouts are necessary, it's far too late to worry about moral hazard. This is what we should be worrying about.

Angela's dilemmas and the nightmare scenario

The FT has a nice piece today about the loneliness of Angela Merkel, torn between seeing the Eurozone fall apart and taking decisions that would rescue the periphery but provoke a furious backlash at home. It is indeed easy to criticize Merkel for her cagey approach, which given the fear in the markets seems almost designed to make the costs of rescue as high as they could possibly be. I agree completely with these criticisms, but what people like Martin Wolf and Paul Krugman often miss - focused as they are on debating the stupid austerian policies advocated by many economists - is that this is a political process.

Merkel is not doing what is necessary, but the reason may not be just that she doesn't know what she's doing. First, she is a government leader in a consensus-oriented democracy, with coalition government and federal institutions, and like any other party leader she faces the constant threat of dissent from within her own party. Juggling these various threats to her position are probably her main concern, regardless of how much she understands about the nature of the Euro crisis. It could well turn out that a plan for economic recovery, involving massive bailouts, permanent ceding of German fiscal autonomy, and the collapse of the Euro's monetary conservatism, would cost her her job.

Second, even if Merkel understood what Krugman and Wolf eloquently argue day after day, and had the political authority to convince the German political class and electorate of what needed to be done, she would run into another problem - the European-level joint decision trap, Fritz Scharpf's well known conceptualization of the restraints on policymaking in federal states like Germany and intergovernmental organizations like the European Union. What if the European Commission, the ECB and the other Northern Euro member states said no? Merkel would have blown her political clout in Germany for nothing. Getting anything through the European institutions is complicated and time-consuming. Add the permanent subsidizing of the hapless 'Club Med' nations by the virtuous Weberians of Northern Europe, and you get a recipe for the worst kind of Euro-paralysis.

Finally, we get to a further dimension to the politics of crisis that has been widely ignored, even by the smartest commentators - democracy and the people (easy to forget about, I know). Even if all the dilemmas outlined above could be resolved, there is no way a solution to the Euro mess can be sustainable if it doesn't have popular support. So far, this point has been made most obviously in the struggling periphery, where elections have wiped out the governments responsible for crisis and austerity in Ireland, Spain and Greece, whilst Berlusconi has been forced out in Italy. Yet the same problem could easily arise in the North, as Geert Wilders' recent departure from the Dutch governing majority shows. If Merkel signs up for a Eurozone welfare state, there's every chance that an electoral earthquake could shake the German party system just as it already has in Greece.

Which brings me to my nightmare scenario. I still believe that politicians will blink before allowing the Eurozone to implode, wreaking havoc all around. The reason for this is that I think most policymakers are sufficiently aware of what the consequences could be, and are rightly terrified. But democratic elections are a cruder instrument for making decisions. Greek and German voters, exercising the democratic right to express their outrage, could place Europe in an impasse which would lead inevitably to the catastrophe we all fear. Popular pressure for intransigence in the North, to match popular pressure against austerity in the South, could place Europe's leaders in a chicken game that will end badly for everybody.

The only way out is leadership. Come out, explain to people what is going on, and hope for the best. But that has never been the way European integration works.

The Eurozone: an economy without a state

In today's FT Martin Wolf, as ever, nails it (The riddle of German self-interest - FT.com). One of the peculiar features of the crisis is that the Euro was created with the express purpose of facilitating financial and commercial integration, and yet at the first crisis the Eurozone institutions have refused to backstop the cross-border financial commitments that have been made, leading to a flight for safety which has created havoc. Didn't anyone think this could happen?

Certainly the history of financial globalization offered a few hints. Eric Helleiner's excellent book States and the Emergence of Global Finance details the myriad ways in which governments backstopped the increasing financial integration of the period after the 1970s, most notably by stepping in to halt financial crises with bailouts. These bailouts confirmed governments' commitments to the newly integrated financial order and gave investors the confidence to continue treating the global financial arena as a properly functioning market.

The saddest thing about this whole crisis is that it underlines the fatal lack of understanding on the part of policymakers, and the academics who advised them, of how markets actually work. They designed institutions which essentially, like in Alan Greenspan's 'flawed' model, relied on market participants behaving rationally (whatever that means). Rational behaviour is, of course, difficult to define and operationalize, but one thing that we know for sure is that piling money into indebted states with a history of reneging on commitments and overinflated real estate markets was obviously outside any meaningful theory of the self-regulating market. It's time to recognize that the theory was wrong, and that the Eurozone, like any other economy, needs a government.

Why Spain is bust and Italy is simply broke (again)

Despite a bad auction today, Italy seems overall in better shape than the rest of Southern Europe as the FT recognized today (Are Italy and Spain decoupling? | Brussels blog). It has run a primary deficit ever since the early 1990s, something way beyond the abilities of the other periphery countries at the moment. The reason for this is, ironically, the fact that Italian public debt has been at crisis levels for a couple of decades - Italy faced a huge fiscal crisis back in the early 1990s, which was resolved thanks to fiscal reforms and spending adjustments pushed through by more or less technocratic governments headed by Giuliano Amato, Carlo Azeglio Ciampi and Romano Prodi. Italy would never have qualified for the Euro had it not made this herculean effort. And although Berlusconi failed to maintain this downward pressure on the debt, his governments continued to run primary surpluses up until the crisis of 2008.

Clearly Italy has intractable structural weaknesses and the future is far from rosy. But at least it didn't delude itself with a glorious decade of debt-fuelled growth, like its Mediterranean neighbours to the East and West. This made the reckoning a lot easier to cope with, particularly since Italian banks don't seem to have abandoned their traditional caution when it comes to home loans and consumer credit. Things are bad, but not as bad as they could be, and if Italy is dragged into default, it will largely be the result of Eurozone-wide contagion, rather than its own specific weaknesses.

Anyway, the point of this post is largely to crow about the fact that I made this point a couple of years ago.

Spain heading for bailout

It's hard to imagine anything more inevitable than Spain needing a bailout, and soon. The Rajoy government's latest trick - recapitalizing a bankrupt bank, Bankia, with bonds from a near-bankrupt state, Spain, is probably the final straw for investors who are paying attention. Bankia, in turn, has been suggesting that one way to return to profitability is to reduce its tax liability: in other words, to help the Spanish government get its money back, they will endeavour to pay less money to the Spanish government.

This is what hiring the likes of de Guindos achieves. After all, employees of institutions like Lehman Brothers are essentially trained to make money through tax avoidance/arbitrage and clever accounting, rather than generating real wealth through smart investment. The Spanish government is now in the hands of people whose ignorance and arrogance led the country into this mess, in both the political and the financial institutions. Rajoy turned a blind eye whilst corrupt regional leaders like Camps and Aguirre fuelled real estate booms which paid for their vote grabbing and created the conditions for today's tragic scenario.

Now it's all down to Europe. Will they blink, or will they bail? Almost certainly they will bail, just like in Greece, but in such a way as to make recovery impossible. If they let Greece go, who will buy into Spain? The endgame approaches.

No democracy please, we're Europeans

So David Cameron wades in on the Greece crisis - sense of irony failure there I think.

Anyway, the Greeks are coming under pressure to vote for mainstream, pro-austerity parties, despite having voted for something else less than a month ago. This tells you everything you need to know about the role of democracy in the Eurozone.

In fact, the decline in democratic accountability is not an accident: it is the result in part of a certain demobilization of mass electorates in western countries, which has a variety of structural causes, but in part also of the determination of powerful interests to remove popular consent from a range of key economic decision making arenas. This, in turn, exacerbates the trend towards popular apathy, or at least resignation.

So currently, a set of institutions of 'governance' in the Eurozone have not only allowed a disaster to take place, but have also blocked any proper discussion of alternative ways out of the disaster. So the key actor in the management of the crisis is the ECB, an entirely unelected and unaccountable body with a tight connection to the world of finance, and largely impermeable to other interests. What makes you think that an institution like the ECB would ever be inclined to adopt policies in the interests of the non-rich majority of the Eurozone population?

The role of electorates, in the ECB/Merkel view, seems to be to elect governments that will follow policies the ECB, and by extension financial interests, want, even if this is going to lead to all of the burden of adjustment falling on the bottom 90-odd%. The Euro system was deliberately designed in this way to avoid politicians responding to popular demands for spending and low taxes. Clearly popular policies are not always in the long term interests of an economy, but surely it is the job of the democratic institutions to determine what those are?

What we have now is a technocratic approach to government which is not only democratic, it is very likely applying the wrong policies. If we have to have wrong policies, let's at least choose them through democratic means. And who knows, given the chance people might surprise the political class and the economics profession by choosing governments and policies that work in their interests.