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Sunday, February 8, 2015

Where Are The Responsible Adults In Europe?

The political difficulties in Europe overshadow economics, and those difficulties are entirely political. This limits the usefulness of purely economic models for forecasting near-term trends. My instinct is that the verbal fighting between Greece and other European politicians and institutions reflect partisan animosities, which complicates the situation. However, I lean to a hope that Greece will not exit the euro, rather we will have a "muddling through" scenario where domestic reforms continue, but are changed to be less destructive for the economy.

The difficulty that I have in writing about the euro area is that the fate of the euro is entirely political. My background is in fixed income and macro, with an emphasis on mathematical modelling. My usual assumption is that policy makers will do their best to avoid policy errors, at least within the context of their analytical world view. Unfortunately, euro area policymakers are advocating highly damaging policies that appear to be motivated purely by spite.

The Trends Behind Recent Events

The Syriza Government is attempting to do two things:
  1. Launch internal reforms of the governance of Greece. Although some reforms are in opposition to the previous programmes, some are complementary. In particular, the desire to increase taxation amongst the wealthy, and to eliminate some government spending allocated towards groups favoured by the previous government.
  2. Organise a euro area wide political alliance to end the austerity programmes in the periphery. 
In my view, the internal reforms matter mainly to Greeks, although it will matter whether they are acceptable to European transnational entities. The alliance building is what is of interest outside of Greece.

On the other side, massive political pressure is being exerted quickly upon the Greek government to force them to back off their attempt at coalition building. I lack the expertise to guess whether this pressure will be able to meet that objective.

The fact that Syriza is looking to build this international alliance provides a reason for them not to be interested in an immediate euro exit. I could be very rapidly wrong in that assessment, but it seems to be reasonable working hypothesis. On the other side, there does not seem to be a political coalition in favour of ejecting Greece from the euro. As long as that remains true, Greece will be able to limp along within the euro system of payments. I believe that a Greek exit would be highly damaging to the euro, despite the propaganda coming from some quarters. My guess is that this view is fairly widespread, which is why I doubt that the political will to eject Greece exists.

The message I take from recent events is that the Syriza government is (somewhat) isolated from the existing set of elected governments. The German government is ideologically opposed to Syriza, and the bluster from German politicians are just attempts to paint themselves as invincible and the Greeks as puny. This is a standard strategy, which is even used by professional wrestlers.

But this is part of a process. The policies advocated by Germany have been a disaster, and professional politicians will have noted the rapid demise of the Greek mainstream parties. It is reasonable to expect that politicians in other peripheral nations will not want to share their fate. Therefore, it is entirely possible that the anti-austerity coalition will get wider as elections approach. Under this view, all Syriza needs to do on the international front is to play for time, which allows them to concentrate on the difficult task of internal reform.

A anti-austerity coalition will not form in weeks, or even months. Therefore, this problem will not be "solved", but markets may be less fixated upon Greek events if the prospect of an immediate exit fades.

As an outsider, this episode shows the weakness of the "European project". There are no true transnational political parties. In a true federal system, the federal parties at least pretend to take into account the interests of all citizens in all regions of the nation. Similarly, national bureaucratic institutions also take into account the national interest; the European bodies appear to represent a compromise position between a small number of the larger nations.

The End Game

At present, the euro area is in "muddling through" mode, characterised by slow growth, austerity policies, and increasingly desperate emergency aid being channelled through the ECB. This state of affairs is sustainable financially. There are no hard limitations on policy, which is unlike other currency peg systems. (For example, gold holdings within the gold standard). However, the current economic regime is unsustainable politically; extremely high unemployment cannot persist indefinitely.

This muddling through will end in one of three possible ways.
  1. Growth returns to the euro area as the result of the return of business confidence. I seriously doubt that this will happen, but hope for this outcome was the basis for previous policies. It is much easier to trim government spending during a robust expansion. At present, the only catalyst pointing in this direction is the weaker euro. (Of course, problems would probably resurface during the next major recession.)
  2. Exit of one or more nations from the euro. This will be rapid, and will represent a crisis of some sort. Unless there are structural changes made, the euro will continue to lose countries until only a small core remains.
  3. A coalition of nations builds that reverses austerity policies. If automatic stabilisers are allowed to work on a national level, the euro area may be able to continue without a larger supranational fiscal agency. This means that the euro could survive, possibly even without changing the treaties defining the operation of the eurozone. (The Growth and Stability Pact would have to be treated more as a guideline than a regulation, but that is essentially what happened when France and Germany ran afoul of the rules.)
For the United States economy, it should continue on its growth path as long as the euro area avoids a rupture. This would allow the Fed to hike rates this year, but the low level of inflation would allow the pace of rate hikes to be extremely cautious.

Update: I wrote this before the Tsipras speech. It appears that he reiterated his campaign positions; that is, he has not backed off in response to pressure. Although this will help cause panic in markets, this is not too surprising. The question is whether it is possible to reach a compromise that allows Greece to muddle through. To me, it still looks like there is a way to reach that compromise, but neither side wants to look like it is weakening versus partisan opponents. Therefore, they will make it look as ugly as possible.

(c) Brian Romanchuk 2015

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