Continuing her regular column, top economic commentator and What’s Next? author Lyric Hale provides fascinating insight into a series of influential economic meetings in Washington between leading bankers and representatives from the IMF (International Monetary Fund) and the World Bank. She describes how influential figures such as Larry Summers and Jean-Claude Trichet debated over the Eurozone crisis.
By Lyric Hughes Hale
Monday night was a sea of convivial calm at an awards dinner for New York University economist Thomas Sargent. The Chicago Mercantile Exchange Group and the Mathematical Sciences Research Institute recognized Dr Sargent for innovation in quantitative research, in particular regarding the theory of rational expectations.
This theory holds that people make reasoned economic decisions based on their expectations of the future. They cannot be fooled by policy choices that seem okay now, but that will leave them poorer in the future. One oft-cited example: fiscal stimulus. If the government is spending money to try to boost consumption, people might reasonably expect that this will lead to higher taxes in the future. This will cause them to save, rather than consume, nullifying the intended effect.
Before dinner, there was a two-hour discussion on sovereign debt (the subject matter was chosen a year ago) and the loss of its risk-free debt status. But there was no panicked open outcry about the current crisis. Instead, the panelists offered comparisons with sovereign debt crises during the French and American Revolutions. The solace of economic history is that everything bad has happened before, and we are still standing.
How does Sargent’s theory apply to today’s crisis? Not at all obliquely. I spent the weekend in Washington, where the World Bank/IMF meetings were held. As Larry Summers intoned, this was one of the most serious annual meetings in the history of these organizations. Summer’s key message was that if the Europeans signal austerity, people would rationally decrease demand, expecting a long period of slow growth, which would then feed upon itself and create a downwards spiral. He spoke of the need to create a resumption of confidence, as did many others who called upon leaders to foster positive behaviors, rather than engage in policy discounting. His mantra was that the world’s economic leaders needed to create alarm, but not panic.
In response, Jean-Claude Trichet, the head of the European Central Bank and not quite a Keynesian, threw out his prepared remarks. Whenever someone does that, you know that something meaningful will be said.
Trichet has devoted his life to the creation and preservation of the European Monetary Union, which is now under direct attack. He responded to Summers “we are not blind” and seemed to blame the crisis on those who “behaved improperly” i.e. the Greeks. Summers called Greece, “a broken ankle, in the face of multiple organ failure.” You don’t usually have this much fun listening to central bankers.
My reaction in the end was that Summers was correct—you can’t just focus on the past, or deal with facts, you need to deal with expectations in order to create demand and a way out from the edge of a deflationary spiral. Summers also won the debate by saying that policymakers who take incremental steps and say that they cannot reference the future basically don’t know what they are doing. I winced as Trichet, ignoring this fair warning, said later that he could only deal with today. “The day after tomorrow, I don’t want to talk about that!” Scary.
The entire weekend was extremely uncomfortable for most of the Europeans. Jürgen Stark, who recently resigned from the ECB, was on the defensive throughout. There is some sort of regime change going on in European banks at all levels, including the UBS bombshell that was announced in the midst of the meeting. Merkel has lost three key allies. In addition to Jürgen Stark, Jens Weidmann, president of the Bundesbank, and Axel Weber, who stood down from his expected promotion to head up the ECB, have gone over to the other side. Sturm und Drang without a doubt!
I was reminded of all of this when Thomas Sargent remarked that government debt crises have in the past led to revolution. (See Macroeconomic Features of the French Revolution). Sargent talks about “unpleasant arithmetic” which he defines in the following way: “Government budget constraints and the arithmetic of compound interest impose restrictions on government deficits and debt. “ In other words, there is an upper limit to the debt that governments can take on without the risk of eventual default. Default can lead to political change.
Default by one or more member countries might also end the European Monetary Union. In Washington, I ran into another Yale University Press author, David Marsh, who has written a book specifically on the Euro. In an article on MarketWatch yesterday, he draws a comparison with 1931, when Britain left the gold standard. Marsh makes the point that although this might have helped Britain, there were eventually very unpleasant contagion effects that damaged Europe as a whole. Britain could make this move, as the pound was in fact a reserve currency at the time. However, the drachma has not been a reserve currency for a couple of thousand years.
The Germans are very unhappy, yet they still seem committed to the Euro, even though it wasn’t their idea. For that, we can blame Francois Mitterrand. As the price for allowing German reunification, he extracted from Helmut Kohl the promise of a currency union, at the price of dropping the Deutschmark. It is ironic that the weakness of the Euro in the current environment helps German exporters probably more than any other country. But what can Europeans rationally expect in the future? A load of debt, albeit at low interest rates, and even higher taxes in the future. So don’t look for demand in Europe to rise anytime soon. The longer this crisis lingers without a clear resolution, the longer the recovery will take. Sargent talks about human capital, which gets lost when people lose their job. A country cannot lose a job, but it can lose the confidence of its citizens. Larry Summers said it well—it is ironic that confidence got us into this mess, and confidence is also what will allow us to recover. That however, requires leadership at the highest level. Less Sturm und Drang, and more rational expectations.
What’s Next? Unconventional Wisdom on the Future of the World Economy by David Hale and Lyric Hale is available now from Yale University Press. Anatole Kaletsky, who contributes to the book is Editor-at-Large and Principal Economic Commentator of The Times, where he writes a thrice-fortnightly column on economics, politics and financial markets.