Silvio Berlusconi’s 17-year reign asItaly’s prime minister ended not because the elites revolted or the people took to the streets. It was the rising interest rate spreads between Italian bonds and the German bunds that brought his rule to a close. Spreads over German bunds peaked recently at 60 basis points (0.6 percentage points) inFinlandand theNetherlands, 150 points inAustriaandFrance, 300 points inBelgium, 450 points inIrelandandSpain, 550 points inItaly, 950 points inPortugaland 2,500 inGreece. For some Eurozone members such spreads are manageable.ItalyandSpaincould live with current yields for awhile, albeit not indefinitely. Had Italian spreads stayed under 500 basis points, Berlusconi might still be in power today.
Mr. Berlusconi’s fall is the latest manifestation of the clash between global money markets and local politics. George Papandreou’s fall is another. Confronting the demands of global money with the constraints of local politics creates a witches’ brew that turns princes into frogs and frogs into princes. It can topple governments and shake the global economy. Managing this tension is one of the major challenges of our time. But if that is to happen, politicians need to reassure investors not threaten them as they have been doing.
Financial Markets are not The Monster
Angela Merkel promised last year to show the market who is boss. In the contest over what power the financial markets have and how much room politicians have for deciding policies, she insisted that it was vital to assert the primacy of politics.
Jean-Claude Juncker, the prime minister ofLuxembourg, last year proclaimed: “We have to be able to stop the financial markets. We have the instruments of torture in the basement.” This is a bit like asking the bank manager to extend you a loan – then adding that, if you don’t like the terms, you reserve the right to inflict pain on him.
As the crisis in theEuropedeepens, the anti-market rhetoric has become more common, darker and more conspiratorial, and it has been embraced not just by far-left politicians but also those on the far right and even business people who really ought to know better.
While the bond markets have forced Italian, Spanish and even French bonds into the danger zone, it is a perilous mistake to regard financial markets as a monster to be controlled or as a threat to the government and the economy. We should also not be tempted to say that Ms Merkel and European politicians are losing their battle with the markets.
The markets are not the enemy of European governments or the local community. They are their friends. If the markets will not lend money to governments then the governments can only get more money from the voters. AsEuropeis discovering, that means either higher taxes or cuts in public spending. In fact, financial markets are all that stand between political leaders and angry citizens. They are the only buffer against deep austerity because they could make it possible for governments to finance some of their public spending and roll over some of their public debts at lower interest rates, if only they could be assured that the house of government could eventually be put into some order.
There are many misunderstandings embedded in the common belief that the markets are somehow out to destroy the currency system and the economy. The first is that financial markets are a single-minded entity controlled by Anglo-Saxon or Jewish financiers, rather than a balance of opinion between buyers and sellers. The average politician in office is sadly no better than the anti-capitalist demonstrator ofOccupy Wall Streetin understanding how markets work. Key government offices and regulatory bodies are full of lawyers, academic economists and civil servants, but very short on people who have actually worked in the financial markets.
Sometimes, when financiers bet against misconceived government policies, they are actually doing countries a favor. George Soros made a great deal of money in 1992 by making huge trades based on the idea that sterling would have to leave the European Exchange Rate Mechanism (ERM). The Bank of England lost a lot of money trying to hold off the markets and Mr. Soros. But at the end of the day, leaving the ERM was good news for the British economy.
Similarly for the euro, it is a huge misconception to believe that people in the financial markets want to break it up. On the contrary, it is financiers who are often the most keenly aware that a euro break-up would be enormously disruptive – and could well lead to the failure of many banks and financial institutions. That would mean lost jobs in the City and on Wall Street, as well as in society as a whole.
Exit and Voice as Recuperation Mechanisms
A useful perspective on today’s dilemma can be found in a remarkable slim volume, published four decades ago by Albert Hirschman, called Exit, Voice and Loyalty and subtitled “Responses to Decline in Firms, Organizations and States”. Hirschman’s concern is that from time to time organizations experience performance decline. They suffer from “repairable lapses” that could be corrected with the right balance of information, incentives and flexibility of response. His thesis offers insights into the unfolding events inEuropetoday. The rhetoric of politicians and the pleadings of economists that we read in the newspapers all have a place in his framework.
Hirschman begins by noting that while moralists and political scientists have been much concerned with rescuing individuals from immoral behavior, societies from corruption, and governments from decay, economists have paid little attention to “repairable lapses” of economic actors.
Hirschman identifies two mechanisms through which organizations can repair themselves: exit and voice. Exit refers to the fact that the clients of a firm (or members of an organization or the state) can simply leave and join a competing firm, organization, or state. Voice refers to the expression of discontent: the natural human tendency to complain, protest, and generally “kick up a fuss”. Each of these mechanisms is interesting in its own right, but it is the interaction of the two that gives rise to the most intriguing possibilities.
One of Hirschman’s key insights is that exit will not serve as a reliable recuperation mechanism if it occurs too rapidly in the face of organizational decline.
For competition or exit to work as a mechanism of recuperation from performance lapses, it is generally best for a firm or organization to have a mixture of alert and inert clients (or members). The alert clients are among the first to exit. They provide the firm, organization or state with a feedback mechanism which starts the effort of recuperation, while the inert clients provide it with the time and dollar cushion needed for this effort to come to fruition.
In addition, rapid rates of exit can deprive an organization of precisely those clients (or members) who, had they remained, would be most inclined to utilize voice to offer the best advice to help an organization recuperate from decline. InEuropetoday, the most important advice that needs to be heeded by governments and their constituencies is that fiscal budgets have to be balanced and huge public debts are simply not sustainable. Those clients (or members) who care most about the quality of the output and who, therefore, are those who would be the most active, reliable, and creative agents of voice are for these very reasons also apparently likely to exit first in case of deterioration. As a result, the rapid exit of high quality conscious clients (or members) paralyzes voice by depriving it of its principal agents.
European politicians claim that much more time is needed to put together an adequate response given that there are 27 countries in the European Union and 17 in the Euro currency zone. This is of course a plea for clients to remain inert so that exit by alert clients could be delayed. One of the most amazing things so far is that investors have until now been very patient with the unfolding crisis inEurope. The financial markets have seemed almost pathetically eager to believe that everything is going to be fine eventually. Every time there is a European Union summit and an announcement of a new deal to solve the crisis, markets bounce for a few days. Then people read the fine print and hopes and markets sink again.
The European challenge is deeply political in two senses. First is the inevitable contradiction between the demands of global finance and local politics. The crisis of the eurozone’s periphery is merely the latest example of this. Nothing stokes public demonstrations and political violence like cuts in public budgets. Nothing assuages the anxieties of jittery foreign investors more than a government fiercely committed to making budget cuts.
While this tension has always existed, the globalization of finance coupled with the speed at which money now crosses borders makes it even harder for politicians to respond to the demands of financial markets without infuriating voters. Since 1990 foreign direct investment increased more than six fold. Since 2000 international credit flows have multiplied by two and a half times. The global foreign exchange market is eight times larger today than it was only 20 years ago. Last year alone 65% of the daily volume of currencies traded was cross-border.
The second troubling aspect of the European challenge is that the voices which politicians care to listen to are overwhelmingly concerned with local problems, even personal ones. And promising to solve these problems by resisting budget cuts and tolerating huge public debts is far more critical for political survival than addressing global threats. To the average voter, global problems are simply too remote to matter in the electoral calculus even in this information saturated age.
Hirschman noted that in the arena of political competition, both exit and voice mechanisms may have important conflicting roles to play.
In a democratic political system, the captive voter (or client) who has nowhere else to go is not the epitome of powerlessness. It is true that he cannot exit, but precisely because of that he will be maximally motivated to bring all sorts of potential political influence into play so as to keep the government from doing things that are highly obnoxious to him. With modern communication technologies able to transmit, coordinate and amplify voice to an unprecedented degree, his influence is awesome. But sadly the message politicians hear from their voters (or clients) is based on a misunderstanding of what is wrong in the eurozone. Politicians also make things worse by blaming global money for the stresses that appear.
In the case of Europe, although money is global and politics is local, there is an imbalance in international trade in manufactured goods that is very much regional; and this is the crux ofEurope’s problems today. Contrary to common wisdom, globalization has not reached this section of the economy. Intra-regional trade of manufacturing accounts for about 58 per cent of trade in the European Union. The misalignment of internal real exchange rates betweenGermanyand the periphery means there is a balance-of-payments crisis, even though the current account balance of the eurozone with the rest of the world has been largely in balance over the past decade.Germanyhas been running a huge current account surplus and the periphery economies in southernEuropeare running a huge combined current account deficit and, as a result, have unsustainable public debts. The crisis will be over if and only if the weaker countries regain competitiveness and economic growth. At present, their structural external deficits are too large to be financed voluntarily.
Manufacturing is an important source of well paid jobs and holds the key to regaining competitiveness and economic growth in the periphery economies. However, the real key to resolving the economic crisis inEuropeis to address the regional structural external deficits. Unfortunately, the region is mired in a toxic brew of global money, local politics, regionally imbalanced trade in manufactured goods among neighbors, and a labour pool mostly confined to national borders. The crisis of the eurozone is economically not difficult to understand, but difficult to resolve politically.
Undoubtedly politicians should do a much better job of explaining to their constituents that what happens beyond the borders of their country or city has implications for what happens inside their homes. The key message European politicians should be telling a voter is that the problem they face is a European problem and it is primarily a regional one. Global money and local politics happen to be the outward manifestations of the regional imbalances withinEurope.
Eurozone in Protracted Stress
The reaction of global money is nothing more than an example of one of Hirschman’s countervailing forces: the exit option. It is the siren song that public spending and public debts have reached dangerous levels and should be rolled back. Protecting economies from the vagaries of global money sounds tempting, but attempts to mitigate the effects of global money are difficult, expensive and can easily lead to decisions to increase public consumption spending that would only make the problem worse. The key issue is to address specifically the structural external deficits betweenGermanyand the rest ofEurope.
The response of local politics is of course Hirschman’s other countervailing force: the voice option. Local politics needs to be infused with awareness of the global imperatives if it is to perform its goal of addressing “repairable lapses” in organizational performance. Undoubtedly, this is easier said than done. It may even sound naïve to suggest it. But I wonder if it would not be even more naïve to dismiss the urgent need to speak the truth to voters – if, in fact, we have no choice but to do this. Only then would global finance become more responsive to local needs and invest in projects that help the weaker economies to regain competitiveness and restore economic growth rather than merely fund public consumption spending.
Next week I shall discuss the future ofEuropefrom this point in its history.