Monday, December 12, 2011

Germany's Financial Rules for Europe: Terrible Now, Possibly Worse Later

-- Posted by Neil H. Buchanan

Chancellor Angela Merkel declared success late last week, having forced the rest of the Euro Zone nations to agree to a series of measures designed to force countries to cut spending, now and in the future. (See news articles here and here.) The Obama Administration, seeing potentially disastrous consequences for the world and U.S. economies (and, as a direct implication, for Obama's re-election chances), was unsuccessful in getting the Germans to ease off on their insistence on continued across-the-board austerity.

The immediate criticism of the new pact followed the line from the Obama team (described in the second news report linked above): Merkel succeeded in enacting supposedly needed reforms that will force "irresponsible" countries to be more fiscally upright in the long run, but at the potential cost of never getting to that long run.

There is a lot to be said for this line of attack. While not precisely analogous to the proverbial rearranging of deck chairs on the Titanic, the new treaty will do very little to prevent the current crisis from getting worse. The bailout fund (in everything but name) is still far too small, and the European Central Bank is still refusing to act as lender of last resort. It is difficult to see how world financial markets, once they realize how little immediate assistance is provided in this deal, will be any more likely to view the sovereign debt of the countries currently under attack as now somehow less risky. The best guess at this point is that the new agreement will soon be seen as yet another failure to deal with the realities of the situation.

Although I agree with this line of reasoning as it applies to the short run, I think the new package is also wrong-headed in the long run. The Obama view -- that Merkel's plan would be a good one, if Europe were not in a short-run crisis -- continues to view rigid fiscal austerity as an inherently good thing. The problem is that the new arrangement is based on the idea that the only "original sin" of the euro zone was in not creating tough enough enforcement mechanisms for the fiscal targets.

(As an important aside, it is important to remember what those fiscal targets were: 3% maximum annual deficits, and 60% maximum total debt (both as a percentage of GDP). Not zero and zero. And this was not as a transitional matter. In other words, the original euro treaty was at least correct in not viewing "balanced budgets" or "no debt" as sensible fiscal goals.)

Merkel's view is apparently that everything would be fine today if there had been mechanisms in place all along to enforce those targets. The new plan requires governments to submit their budgets in advance, with the possibility of court review of unacceptably large projected deficits. There is still not much known about the actual sanctions potentially available to punish countries in violation of the targets, but presumably Merkel thinks the new penalties will be adequate.

Why would anyone think that this -- tougher enforcement of fixed fiscal targets -- would be enough to make the euro sustainable? We are, after all, trying to imagine how a continent of sovereign national governments can coordinate their economic policies in a way that prevents economic hardship -- and thus political crises. We know that countries have given up their ability to run independent monetary policies, and they do not have separate currencies that can adjust to allow countries to save themselves from crisis through increased imports. Merkel's policy says that each country will really, really be forced to meet annual fiscal targets. That leaves only one mechanism for adjustment to any negative future shocks by any individual country: cutting wages. That, as we are seeing anew, is the most rocky of all adjustment paths, both economically and politically.

Consider an analogy to the United States. The promoters of the Euro Zone use the size and diversity of the U.S. economy as proof that it is possible to knit together Europe. Even setting aside the language issues, and the centuries of wars and cultural hatreds, this misses a major difference that will remain between the U.S. and a Merkelized Euro Zone: U.S. states do not have independent fiscal policies. True, each state has a budget, but that budget is only a small part of the taxing and spending that affects the state's economic fortunes. Most of the fiscal action is -- and should be -- at the federal level.

One consequence of this is that the U.S. regularly engages in cross-regional subsidization of the sort that the Germans have recently shown themselves unable to tolerate. While Merkel is responding to public opinion that strongly rejects the idea of helping out Greece, the U.S. government systematically shifts resources from some states to others. One of the oddities of U.S. politics, as many have noted, is that our federal government shifts money from mostly "blue" states to mostly "red" states, yet it is the recipient states that display the most antipathy toward the federal government. In other words, New Yorkers end up making Mississippians slightly less poor each year than they would be otherwise, yet Mississippians claim to want the federal government to get off their backs. In the new Europe that Merkel's plan would create, Greeks would have no prospect of being helped by the rest of their fiscal union. The message is: Give up your right to set independent monetary, currency, and fiscal policies, and then you are on your own.

It is even worse when one considers the inevitable shocks that will come up over time, that will be wholly or partially localized phenomena. In the U.S., if a crisis hits a state like Michigan (a long-term shock) or Louisiana (a series of short-term shocks), what is our general response? The federal government steps in and uses its fiscal tools to help out. Although there is controversy about the nature and degree of appropriate assistance (to say nothing of the competence with which, say, hurricane rebuilding programs are carried out), there is at least the sense that the federal government is empowered -- and is politically prepared (at least, in the pre-Tea Party era) -- to reduce the pain and assist the state in getting back on its feet.

How will that happen in Europe -- again, assuming that it can even get to the envisioned long run, in which things are going fine elsewhere on the continent before a localized crisis hits? There is centralized authority to prevent, say, Belgium from running larger deficits in response to a crisis in Belgium, but no centralized mechanism to assist the Belgians or reverse the economic damage.

The only possible outlet, based on the available reports of the new agreement, is for (most or all of) the other Euro Zone governments to grant permission to a country to run extra-normal deficits. For those of us with recent experience with the U.S. Senate's invented 60-votes-for-everything rule, however, such a requirement hardly looks appealing or sensible. If anything, we know from the current crisis that Europeans are capable of blaming their neighbors' problems on their neighbors, and not on bad luck.

What do I mean by that? Consider the conventional wisdom that the countries in Europe that are now facing difficulties are "spendthrifts," with the Germans and other paragons of fiscal rectitude refusing to become their enablers. The problem is that this conventional wisdom is simply not true (except, to a limited degree, for Greece). Spain was running a balanced budget before the current crisis. Italy's debt was high, as a percentage of GDP, but that ratio was falling. Ireland was considered a model of neoliberal success. All of those countries went down through no fault of their own, yet they are now being vilified as leeches and slackers.

It is not, therefore, easy to picture a future in which European countries readily assist each other when bad things inevitably happen, locally or continent-wide. It is always possibly simply to rewrite history to make it appear that the bad things are an appropriate comeuppance for bad people. Merkel's message, in fact, is that her new policy regime is necessary to force people to be responsible.

The big story is thus even more pessimistic than most people are describing. Not only did Euro Zone leaders spend last week focused on the long run while ignoring an immediate threat to their existence, but they put in place a policy that continues to rest on an incomplete foundation for economic union. Even if we do not soon learn what happens when a currency union breaks up, there is still no basis for optimism about the continent's long-term prospects.