Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Friday, 9 December 2011

Restructure, reform, move on

Hapless Eurozone leaders are lurching from one nonsensical solution to the next as the world watches with a mixture of bewilderment, impatience and fear. The common theme in all the solutions put forth so far has been an attempt to tackle the debt crisis through creating more debt. If Greece or any other nation cannot borrow then let those who can, do, and transfer the money to Greece. This is akin to the crew of the Titanic assuming that scooping water from the flooded compartments to the dry ones will ensure survival.

Criticism and analysis of Eurozone failure is easy. More difficult is that task of developing a framework to arrive at viable and practical solutions. Most of the solutions being bandied around now such as monetisation, common Euro-bonds, fiscal union are based on flawed logic.

This flawed logic can be divided into two broad streams. The first is the logic of throwing money at the problem until it is solved. This is what EU leaders are attempting and it leads to monetisation being the end “solution”. It works but then so does dropping a one-ton atomic bomb to bring down a skyscraper. The unintended consequences can be slightly unpleasant. The second is the economist’s logic of propounding solutions for the long-term assuming away all short-term problems. From this springs the idea of fiscal union with a Germanic zeal for balancing budgets. Although it should eventually occur, if implemented immediately without addressing the underlying imbalances, it may make the situation worse in the short-term and jeopardise the union itself. Search for a solution requires some common sense, ability to accept unpleasant truths and the courage to forge a credible plan and move forward.

Three important common sense observations are required to proceed towards a solution. The first is the inherent contradiction in the European welfare state model. Generous benefits and pensions are incompatible with a greying demographic profile, limited immigration and inflexible labour markets. The welfare revolution could be supported post the second world war as European economies grew relatively rapidly and a large working age population supported a comparatively small base of dependents. Protectionism along with industrial backwardness of emerging economies further shielded economies with inflexible labour and product markets. For a time, debt provided short-term relief from the forces of globalisation, industrialisation of the third-world and continued inversion of the demographic pyramid. Now, the tipping point has been reached and the debt-drug can no longer mask the symptoms of the disease.

The second is the irrelevance of sunk cost. This operates both on the level of national policy and multilateral aid decisions. National fiscal policy must not consider debt which has been incurred in the past to determine future course of action. In a recession, fiscal policy needs to be expansionary. This appears counter-intuitive and is derided as the discredited Keynesian model[1] but debt can only be paid off if there is growth. Of course this is to guard against unthinking austerity and not a carte blanche to defer reforms until the economy starts growing again.

In case the level of debt has reached beyond redemption then it needs to be restructured. Any multilateral aid money which has been sunk in the mistaken belief of debt sustainability should be considered partially or wholly lost. It is difficult to follow this since it involves loss of face for the political elite. However they should take heed from history. Beyond a point inevitability sets in and the loss of face is invariably bigger. However, despite historical evidence to the contrary human hubris perennially assumes that it can always triumph over the forces of economics.

The third realisation is to recognise that public policy is aimed keeping the welfare of a country’s citizens in mind and not its financial markets. Starting from the credit crisis, nation after nation has adopted policies in the interests of the latter. Ostensibly the justification has been to protect the ordinary person from the collapse of the system. In reality policy has been demonstrably detrimental to the public interest and involved a large transfer from the public to private vested interests. Current European policy is constructed to target yields on existing debt. This is treating the symptom rather than the cause. The reason for this undue importance on secondary yields is the fact that they affect interest demanded on new debt. However, a few high interest new debt issues are immaterial in the grand scheme of things. Credible and coherent policy acts as a natural barrier to the market’s pessimism. If investors are convinced that the situation will improve in the future they will readily buy and yields will drift back lower. They may not revert to pre-crisis levels but they will certainly not explode exponentially creating a self-fulfilling insolvency. Conversely, short-term ad hoc measures to bring yields down and thus demonstrate “market confidence” are usually counterproductive. European leaders have consistently overpromised and under delivered. This has only served to destroy investor trust and confidence leading to the present unhappy situation.

Common sense also leads to two unpleasant truths that need to be accepted in order to arrive at a solution. The first is the inherent contradiction between monetary union without fiscal union. An extremely conservative German monetary policy cannot coexist with profligate fiscal policy if periodic default is ruled out. Therefore either there is periodic debasement of the currency or an equally conservative fiscal union or members can be allowed to default periodically. This seems to have been realised by Merkel and German leaders who are trying to resolve this through a fiscal union. Unfortunately at this juncture this is not going to work without a few debt restructurings first.

The second unpleasant truth which is harder to accept is Western Europe’s decline. Ex-communist countries and the “third-world” are out-competing the sclerotic European nations in the globalised economy. The demographics are unfavourable and the debt too high. Banding together nation states with different languages and little labour mobility to mathematically achieve the world’s largest GDP does not confer superpower status. Only to manage this decline the welfare state needs to curtail its benevolence and enhance the pain of taxation. Not only that, the social compact may also need to be rewritten. The present working age population has to accept that they will never have it as good as their parents.

It takes courage to face up to these truths and even more to propose policies which have common sense but are unpalatable to the majority. Unfortunately in this day of instant opinion polls, it is rare to find a politician who can trust him/herself when opinion polls doubt him/her. However this is not an excuse to continue with the current blind ad-hoc policies. Policy prescriptions must still be made. These can be divided into the short, medium and long term based on their impact.

In the short term, the aim is to restore confidence and restart growth. At outset this requires debt restructuring in nations beyond the point of redemption. Futile attempts to pay back and reduce the excessive debt burden destroy confidence and choke growth. Restructuring should achieve a debt level which is sustainable in the long term taking into account the addition to debt which will occur in the near term. Then the government needs to run a fiscal policy guided by the level of economic activity and not by the level of existing debt. At this point critics will argue that debt restructuring will alienate creditors and make it impossible to run anything but a severely contractionary fiscal policy. This is where multilateral aid can make a real difference. Instead of creating ever larger bailout packages which only serve to bailout private creditors, EU and the IMF can lend to tide over governments in the initial emergency period. Vested interests who cry about this being an attack on capitalism[2] should be reminded that one of the precepts of capitalism is caveat emptor. And another is the failure of unintelligent businesses and business models. Taxpayers do not exist to enrich foolish investors. 

Along with these the standard list of reforms need to be pursued. Tax collection has to be more efficient through not only cracking down on evasion but also on closing legislative loopholes. Wasteful government spending has to be eliminated. Loss making public sector enterprises which are nothing more than sinecures should be either closed or sold. These will have an impact in the medium term to return government finances to a more sustainable footing.

Over the long term, the focus has to be to arrest and reverse the decline of Europe. This requires labour market reform and encouraging immigration. It also requires a fiscal and transfer union to complement the monetary union. Moreover there should be an allowance for defaults (equivalent to US Chapter 9 filing for municipalities) rather than a Germanic straitjacket on deficits. Governments like Houdini can wriggle out of rule-based straitjackets (Greece gave a masterly performance to get into the EU) but find it harder to hoodwink a sceptical financial market audience.

These are not novel or revolutionary ideas. Apart from opposition to immigration, which  is the only issue uniting Europe, all others are slowly being accepted. Labour market reform is grudgingly being pushed through against defiant unions. Partial fiscal union is being pushed by Germany in the form of stability union. And transfer union surprisingly actually exists in the form of EU subsidies to poorer EU nations. Lastly ESM (European Stability Mechanism) is nothing but a place to allow defaults/restructuring within the Eurozone. The need is to be bolder and integrate these elements into a single coherent policy. It is going to be the most contentious and difficult policy to pursue. However it will make the difference between realising the European ambition of a united global power and being forced to manage a decline into frustrated (and maybe penurious) old age.


[1] Those making the derisory remarks forget that Keynes suggested running surpluses during economic expansion precisely so that deficits could be generated during recession. Political failure to implement does not imply a flawed theory.
[2] Currently any policy which threatens status quo and inflicts losses on the financial sector is somehow construed as an “attack on capitalism”