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Europe’s Free Riders

J Bradford DeLong, Professor of Economics at the University of California at Berkeley, was Assistant US Treasury Secretary during the Clinton administration. His last Webdiary piece was Semi-rational exuberance.

By J Bradford DeLong

In the United States, individual states that follow unsound fiscal policies face a penalty. Their bonds sell at a discount relative to those of better-managed individual states. The higher debt service they must pay serves – to some degree – as a form of discipline against the temptation to spend now and pay later.

Of course, the discipline of the market is not perfect: the bond market does not “see” implicit future liabilities (like promised pension payments) to any great degree. Nevertheless, this enforced fiscal discipline, combined with individual states’ own internal budgetary procedures, has prevented a large scale state-level fiscal crisis from occurring in the US since the Great Depression.

Let us now turn to Europe. Before the advent of the euro, there were many fiscal crises in individual nation-states in southern Europe, which produced waves of high inflation. But, with the single currency in place, the road to solving a fiscal crisis through inflation has been closed, as the European Central Bank (ECB) now stands watch over monetary policy.

Nevertheless, even with nation-states no longer able to rely on inflation to solve their unbalanced finances, the single currency allows them to use the debt capacity properly belonging to other members of the European Union to extend their spending sprees and postpone political accountability for periods of laissez les bons temps roulés. To head off this possibility, the EU created the Stability and Growth Pact: government deficits had to be less than 3% of GDP.

Last week, the government of Germany – once the most fiscally prudent and disciplined EU country – broke the pact’s rules for fiscal discipline for the fifth consecutive year, and did so without (much) apology. Finance Minister Peer Steinbrueck signaled that he expected the European Commission to apply some sanctions to Germany: the credibility of the pact would, he said, be at stake if no action were taken. Thus, Germany would not block sanctions this time, as it did two and a half years ago.

But Steinbrueck also made it clear that he expects any sanctions in response to Germany’s predicted 3.4%-of-GDP fiscal deficit to be largely symbolic, not penalties that would cost its government or economy anything of significance. The Stability and Growth Pact is not – or is not yet – working anywhere near the way it was intended to work.

What about market discipline? Is the German government’s willingness to issue more debt and run bigger deficits limited because the market recognizes and penalizes nation states that allow their fiscal positions to weaken?

In a word, no. The interest rates on the euro-denominated sovereign debt of the twelve euro-zone governments are all very similar. So the market does not seem to care that countries have different potentials to generate exports to fund the financial flows needed for debt repayments, or different current and projected debt-to-GDP ratios.

Willem Buiter of the University of Amsterdam and Anne Sibert of the University of London believe that it is the ECB’s willingness to, in effect, accept all euro-zone debt as collateral that has undermined the market’s willingness to be an enforcer of fiscal prudence. As long as the marginal piece of German debt is used as collateral for a short-term loan or as the centerpiece of a repurchase agreement to gain liquidity, its value is much more likely to be determined by the terms on which the ECB accepts it as collateral than by its fundamentals. The ECB’s treatment of all such debt as equally powerful sources of back-up liquidity now trumps any analysis of differences in long-term sovereign risk.

In the long run, this is dangerous. Both market discipline and sound fiscal management are needed to create a reasonable chance of long-run price stability. Omit either a market penalty now for behavior that may become reckless or the institutional levers that give a voice to future generations, and you run grave risks – perhaps not today or tomorrow, but someday, and for the rest of your life.

As time passes, the coming of the single currency and the way that the euro has been implemented is generating more and more unease. Policy as a whole over the entire euro zone is too deflationary. The necessary transfers are not being made to make the common currency bearable to regions that lose out and are already in recession when the ECB tightens policy. The institutional foundations of stable long-run fiscal policy are being eroded. And now, Buiter and Sibert argue convincingly, the ECB is giving the market less scope to reward the thrifty and penalize the profligate than it should.

There is no movement of the soil yet, and there will not be for some time. But the ground under the euro may well begin to shift if things don’t change.

Copyright: Project Syndicate, 2006.
www.project-syndicate.org

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The correct scale & scope of monetary systems

Interesting column...and, I'm also interested in the fact that I'm the first to (belatedly) comment on same. Because, let's face it - the "left" is (still, dammit) essentially uninterested (and, I don't mean "disinterested") in technical economic issues...to their shame, I might add, whilst the right is still (near-criminally, given their scale of values) unwilling to admit that the fiscally-best US administration (by their standards, not necessarily mine) in recent decades was - by far - that of one Bill Clinton...no contest.

So, it's not surprising that such a "responsible" column - by his Treasury Secretary, what's more - should elicit such a deafening silence.

And, folks...them's "fighting words" - by the auld common law definition - so, I'll be most pleased to respond to anyone that (justifiably) takes them as such. Because, to me, both regular "sides" have their heads in the sands on this - and (perhaps) most important issues...

Now, to the meat of the matter. What DeLong highlights here is a question that few - if any - "qualified" economists have properly addressed. That is, the correct size of a monetary regime. The advent of the Euro has - finally - given this question some prominence, and yet our unthinking acceptance of political/cultural nationalism has obscured very similar issues that go back literally hundreds (if not thousands) of years...

For, the size of a language/cultural area does not necessarily equate with the best size for a monetary regime and - in fact - there is a very strong argument (best made by Jane Jacobs) that it almost never does...except, perhaps, under conditions of war. And...that argument is backed by some very solid evidence. Why, for example, are city-states so economically blessed? Why does Switzerland continue to do so well, despite being (by choice) excluded from the "blessings" of monetary union? Contrariwise...why do all large affluent nations retain not only "pockets" of impoverished misery, but also - and, it seems, permanently, entire regions "blessed" by economic depression?

Jacobs' answer is (seemingly) simple...it is because the "correct" unit of economic/monetary union is not the nation/state - much less the multinational monetary union of the EU - but the city and its hinterland...which "solution" I might add is now much more viable (in these times of computerized money trading) than it was when she proposed it on historical grounds (albeit purely speculative monetary trading would need to be reigned-in, even more than it already does today).

Her argument is set forth in "Cities and the Wealth of Nations" - for those who are interested - and, economically, it makes perfect sense. The economies of cities are distinct from those of nation-states and, if tied to the monetary policy of another city - say, Manchester re London - are bound to suffer, because the economic externalities of specific wealth zones - say, the City of London - simply do not reach that far. In consequence, they need their own monetary/economic policy...so they can play the market game properly....

And, lest we forget, this is what capitalism proper delivered in its heyday... Because, for example, there was no central banking regime in the USA in its greatest period of innovation and growth...rather, there was a plethora of money-issuing banks all over. However, this didn't mean that it wasn't a nation, nor that (when national interests were crucial) that it couldn't act as one.

For, we forget at our peril that (relative) social/cultural unity does not mean economic unity - and, if we (foolishly) mistake the two, we are liable - especially today - to foment crises that could easily be avoided had we merely looked at the historical record re the correct scale - and scope - of monetary systems...and, had built our political systems accordingly.

All the best.

Monetary regimes

John Henry Calvinist notes: "For, the size of a language/cultural area does not necessarily equate with the best size for a monetary regime and - in fact - there is a very strong argument (best made by Jane Jacobs) that it almost never does...except, perhaps, under conditions of war. And...that argument is backed by some very solid evidence. Why, for example, are city-states so economically blessed? Why does Switzerland continue to do so well, despite being (by choice) excluded from the 'blessings' of monetary union? Contrariwise...why do all large affluent nations retain not only "pockets" of impoverished misery, but also - and, it seems, permanently, entire regions "blessed" by economic depression?"

Extending this idea globally, why does the world retain pockets (well OK, a very big "pocket") of impoverished misery? And not all city-states are necessarily "blessed", but being small and without a lot of natural resource wealth, they have to build "smart" economies (Hong Kong, Singapore, etc.). Mineral-wealth-rich nations, like the Arab countries, paradoxically, may be "cursed" by all the oil they're sitting on. I've commented on another thread how their development lags, despite the oil. So maybe it's because of the oil? I noted how United Arab Emirates is transforming itself for the day the oil runs out - smart move. A lesson for Australia in that?

Isn't one way to alleviate this poverty to give those impoverished nations access to "affluent" markets and capital? In other words, a more globalised economy and monetary system rather than a more fragmented one? And doesn't the (generally) free movement of capital subject all nations to the same fiscal discipline DeLong notes individual US states must pay attention to? So in effect, don't we already have a global monetary system mediated by interest rates (bond prices) and exchange rates among currencies? By the way, JHC, I agree with your assessment of the Clinton Administration's fiscal success (one time political gridlock paid off) versus the fiscal disaster of the current Bush Admin. Bush's deficits will be a long-lasting legacy.

access and economic self-determination

Thanks Will, for raising some interesting points. Re your divide between "access" and a more "fragmented" world system, though, I suspect you've reached the wrong conclusions from my (necessarily) hasty and partial summary. Jacobs' point was not at all that such city-states should be isolate - and, indeed your exemplars of "smart" economies at that scale are very much central to her argument. Rather, it is that since economically depressed areas within a nation-state cannot in truth have their own economic policies - and inter-regional transfer payments (however generous) are merely band-aids in comparison - they remain trapped within a system permanently skewed against them.

With modern financial technology, there's no particular reason why we couldn't have very easy - essentially "free" - monetary inconvertibility available to all at a retail level... if such a thing was deemed necessary. This would allow us to have all the advantages of both localized monetary regimes and a more integrated global economy. To be sure, the "fiscal discipline" you note would still apply, but - let's face it - such "discipline" is very general and the result of, shall we say, investor enthusiasms and crowd behaviour at least as much as it is of rational calculations of the bottom line. Not only that, but any fully sovereign government has a huge range of fiscal, taxation, and spending options within such "discipline", and to exclude many/most of those at what seems to be the natural scale of government, as Jacobs argues, is almost certainly counterproductive.

Anyway, check her book out - I guarantee you'll find it well-worth your time. All the best.

Re: access and economic self-determination

John Henry Calvinist writes: "economically depressed areas within a nation-state cannot in truth have their own economic policies - and inter-regional transfer payments (however generous) are merely band-aids in comparison - they remain trapped within a system permanently skewed against them."

Yes, I see your point, and I had indeed misinterpreted your comments.

I guess this being "trapped" is why state premiers feel the need to go "global" and run around on trade missions overseas. In essence they have to run their own foreign economic policies.

But aren't the tools of economic competition being used at all scales - global right down to municipal? States and cities are always offering tax breaks etc as inducements for, say, businesses to locate their factories (ie jobs) there?

Did you hear the comments about India's economy this morning on Radio National Breakfast? The interviewee, Clyde Prestowitz, is "president of the Economic Strategy Institute and a former adviser in the Reagan administration. He's also the author of Three Billion New Capitalists: The Great Shift of Wealth and Power to the East."

Prestowitz argued that India will be a greater economic superpower than China in coming decades. Partly because China's population will "age" due to its one-child policy in contrast to India's "younger" demographic distribution, and partly because India has focused on the services and high-tech sector. All helped by the fact that English fluency and literacy is widespread in India.

By the way, I have Jacobs' book in front of me now (university library just a few hundred meters from my office!). I'll give it a read.

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