No ‘all for one and one for all’ in Greek tragedy
It's the politics, stupid. After years in which market forces dominated, in which economies were supposedly self-regulating and in which the nation state appeared increasingly impotent, markets are now struggling with the return of what might be called ‘political economy’.
Since the beginning of the year, the economic news has been reasonably good. The US economy is expanding, the Chinese economy is booming and European economies are, for the most part, pulling out of recession. Yet the mood in financial markets has changed. The euphoria which dominated much of 2009 has been replaced by a hangover.
The return of politics is unsettling for investors. For many years, investors thought they understood the rules of the game. Central bankers were dedicated to the achievement of price stability. If inflation was too high, interest rates would go up. If it was too low, rates would come back down. Finance ministers were devoted to fiscal conservatism. Not for them big budget deficits and Keynesian demand management policies. Their job was to borrow little, keeping interest rates low to allow private sector investment to flourish. These were simple rules. Investors loved them. Yet the rules have now been torn up.
In their place, we now have policy-making expediency. This is hardly surprising. Markets have not exactly covered themselves in glory in recent years. Yet the fallout from this shift away from market forces is poorly understood. Investors are no longer able to make confident predictions about the future as it will be determined by politics, not markets.
Consider the tragedy unfolding in Greece. It is not really an economic tragedy, even though the rise in Greek bond yields might be regarded as the ultimate market punishment for the fiscally deviant. California is also in a fiscal mess. California, however, isn't facing an economic and financial crisis of the same kind. The reason is simple. California is part of a greater political entity called the United States which happens to have a federal fiscal system. No one expects California to go bust because the American people wouldn't allow it. For Greece, however, the situation is more problematic. There may be a single monetary policy but there is no single fiscal policy.
If California faces a fiscal crisis, financial markets will assume either that California delivers austerity or Washington will provide a bailout. Few will bet California might default on its debt. When it comes to Greece, however, investors are not so sure. The Three Musketeers' “all for one and one for all” may work in the US but, in the eurozone, it's untested.
Will other eurozone nations really bail out Greece? And, if they do, what would Ireland say, having swallowed the bitter austerity pill? The Greek tragedy reveals a weakness within the eurozone. Policymakers in the western world thought it was possible to detach monetary from fiscal policy.
On this view, it didn't seem to matter that fiscal decisions in Europe would be taken at the national level whereas monetary decisions at the European level. Yet the two are linked.
It now looks as though some countries within the eurozone will need to deliver a huge improvement in competitiveness to restore their economies to post-crunch health.
Wages are too high and productivity is too low. But with a low inflation target for the eurozone, the weaker members will only be able to deliver competitive improvement by forcing wage cuts on their citizens.
Lower wages and prices will lead to lower government tax receipts which will deliver an even bigger budget deficit and, perhaps, higher bond yields reflecting rising default risk.
One way to deal with this problem would be to raise the European Central Bank's inflation target, making it easier for weaker countries to stabilise their fiscal positions without having to make spending cuts in cash terms.
Whatever the resolution of Greece's problems, this latest European crisis will leave the eurozone's architects facing a choice. Do they allow the eurozone to lose its way, leading to speculation on defaults from the system? Or, instead, do they strengthen the eurozone's political backbone by creating a federal fiscal system, reducing the economic sovereignty of individual nations further?
How Europe's leaders get there, however, is another matter altogether.