Sunday, November 23, 2014

Ping-Pong and Political Economy

PRINCETON – For the last century, economic-policy debate has been locked in orbit around the respective roles and virtues of the state and the market. Does the market control the state, in the sense that it sets a limit on governments’ ability to borrow? Or does the state take charge when the market fails to perform socially necessary functions – such as fighting wars or maintaining full employment?

This old debate is at the core of today’s profound divisions over how Europe should respond to its debt crisis. The same question is dividing American politics in the lead-up to November’s presidential and congressional elections.

During the two decades prior to the financial crisis, most people – including most politicians – assumed that the market was supreme. Now the intellectual pendulum may be swinging back to the belief that state action can mop up markets’ messes – just as veneration of the state in the 1930’s followed market worship in the 1920’s.

Two decades ago, judicious European politicians looked for a “third way,” steering a zigzag course between the importance of market mechanisms and that of other social priorities, according to which the market needed to be directed. For example, when the Delors Committee prepared its report in 1988-1989 on how a monetary union could be established in Europe, experts devoted considerable attention to the issue of whether market pressure would suffice to discipline states. Many warned that it would not – that bond yields might converge at the outset, permitting spendthrift countries to borrow more cheaply than they otherwise could.

The result of the debates of the early 1990’s was a set of rough and ready rules on deficits and debt levels that was never taken quite seriously. Economists mocked them and Romano Prodi, the president of the European Commission at the time, called them “stupid.”

Until the second half of 2008, Europe seemed to have reached fiscal Paradise: the market did not differentiate between eurozone governments’ bonds. Some assumed an implicit debt guarantee, but that was always implausible, given that the Treaty on the Functioning of the European Union explicitly ruled it out. Rather, investors’ undivided confidence in all eurozone borrowers reflected something else – a general belief in the capacity of rich countries’ governments.

According to this view, advanced countries have a greater degree of fiscal sophistication. They are always able to raise tax rates in order to service their debt. In poor countries, by contrast, powerful vested interests often resist higher taxes on the wealthy, and widespread poverty makes it difficult to impose universal consumption taxes on the poor.

That lesson was reinforced by the experience of countless debt crises in peripheral countries, the most destructive of which hit Latin America exactly 30 years ago, after ecstatic borrowing fueled economic booms. Sometimes these were simply consumption booms – whether for households or for military outlays and presidential palaces – and sometimes they were investment booms, though much of the investment had been misallocated as a result of political priorities.

The novelty of the world since 2008 is that, for the first time in more than a generation, advanced countries are experiencing debt crises – and starting to look like poor countries with weak institutions. Was this just a peculiarity of the eurozone, in which sovereign countries did not control their own currencies?

Europe’s debt crisis has produced a profound division of political – and also economic – opinion. Those who emphasize the historical uniqueness of Europe’s monetary solution insist that other countries – which control their own monies – could not possibly fall into such a predicament. Here the statist thesis is reflected in its boldest form: there cannot be a bond strike in the United States or the United Kingdom, because their central banks have at their disposal the full panoply of policy tools – including unconventional operations – needed to ensure that debt is monetized.

That theory runs counter to much historical experience, as well as to the prevailing approach to central banking that emerged in the 1990’s. According to that view, investors punish profligate states by demanding higher interest rates to hedge against the likelihood of inflation; so the best way to ensure low borrowing costs is to give central banks as much independence from politicians as possible, and then make price stability their primary mandate.

The European Central Bank is probably the most perfect expression of this philosophy. Its independence was secured not only by national legislation within the member states, but also by a treaty between them. Treaties are more binding than national legislation, because they are more difficult to revoke, amend, or repeal.

Because the debts of the large industrial borrowers – the UK and the US – are externally financed, the argument that their governments can always monetize debt is not convincing. A moment may come when foreign investors do not believe that their sterling or dollar assets are protected against inflation, and at that point their willingness to hold low-yield sterling and dollar assets will end.

The thinking behind the 1990’s approach to monetary policy is still fundamentally valid, but it requires institutional strengthening. It would be better to stop the twentieth-century ideological pendulum and return to some older precepts. Both states and markets work well only when adequately enforced legal rules provide the necessary certainty.

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    1. CommentedStamatis Kavvadias

      The actual question of state versus markets cannot be measured just by how attractive the economy appears to foreign investors. As the advantage of capitalism will increasingly move to the east, unemployment and migration should give another dimension to what the state is about. If you do not protect the quality of life of your population, in the name of the interests of foreign investors, then, of course, you have a priori sold out democracy and government to the markets.

      it should become clear, at the current overblown debt levels in the west, that optimal financing is not necessarily in the best interest of populations; foreign investment may have better returns than domestic, driving unemployment and migration. This means that populations will be motivated to mobilize unsustainable debt! Regulation will not solve this problem, which is the source of the conflict identified between economics and democracy. The current debt-based monetary system will no longer serve western populations, as the competitive advantage of the west will be shifted to the east in coming decades.

      Why should financing occupy such a huge amount of the money supply spectrum, leaving security of people's savings second place, and, more importantly, all other concerns of society in no place, with the public borrowing from the private sector on interest? At least the FED has an unemployment-related mandate, I think, on equal grounds with inflation. Lets see how this will work out...

    2. CommentedProcyon Mukherjee

      Harold is striking all the perfect chords here as he is bringing the fundamental point, which is intrinsically linked to building of State Capacity, while the market is left on its own where it is able to perform on its own and force regulation where market makes a woefully wrong allocation.

      The question is that the pendulum on this policy debate only appears when the recession is round the corner and it makes an exit in the first signs of recovery. This bias towards the market forces and its ambivalence at the first signs of an upturn and returning to building of state capacity where the market makes a wrong allocation during a downturn, makes a shock therapy of public goods that need more than a careful investment; the current breed of investors have more to gain if this therapy together with political will is put to general scrutiny.

      Leaving too much to government or the market is never a debatable point, as these are neither mutually exclusive nor independent domains, as the tempting metaphor conveniently associates in most political debates.

      Procyon Mukherjee

    3. CommentedZsolt Hermann

      On hand hand such articles are useful since they try to explore what is happening in greater details than the usual knee-jerk reflexes, but even these articles only touch the symptoms and not the core problem.
      What we see is that whatever methods, tools we used to apply before, seemingly reaping profits and benefits the same methods and tools are totally powerless, moreover have become harmful in todays global crisis situation.
      We are still running around in circles in the dark, because although continuously talking about it we still do not want to understand what global and integral truly means.
      In a global, integral system each elements are fully interconnected and intermingled with each other. When one part of the network moves either up or down, the whole network moves with it.
      All the elements are fully dependent on each other.
      The previous fragmented, protectionist, competing and exploitative attitude, relationship, which could succeed in a "loose system" has become highly harmful, "cancer-like" in this new global system.
      The only solution is to shift the priority from the individual, nationalistic level to a global level, since in today's system the individual's prosperity, health and future directly depends on the prosperity, health and future of the single, unified system.

        CommentedEdward Ponderer

        I believe that Mr. Hermann has hit the core of the matter here, but I'd like to sharpen the point.

        It is not merely a lateral interconnection -- our very global world -- but a vertical one as well, through interacting layers of national blocks as the European Union, national economies, local and corporate economies (which alone can transcend to the multinational) -- right down to the individual. [This even more obviously with the individual genius of breakthrough, the innovative entrepreneur, the person with the cell-phone camera at the right place and time, and the lone-wolf terrorist who slips through into the breach...]

        As such, Professor James's use of the word "orbit" takes on a most frightening yet fascinating meaning in its mathematical sense. For the orbit, as the interdependence on which it now resonates, is fractal -- approximately self-repeating at different scales. And a fractal orbit indicates a predilection for deterministic chaos.

        However, while at the level of simplistic adjustments by those wielding economic power, this is bad news, it does offer the possibility of a very successful global economy if we will work with mutual responsibility, in the sense that evolving natural communities appear to as a "phase change" precursor to a higher corporate being.

        It is not a small group of individual cerebral or cardiac cells that maintain our homeostasis, but rather a vast interdependence of organ system, organs, tissues, and individual cells -- and even the internal subsystems going down into the cells. Similarly, it is neither politburos nor banking houses of egoistic humans that will save or stop anything, but rather the rise of Humanity itself that will.

    4. CommentedAbiola Oyebanjo

      Is Harold saying there should be rules and treaties that should stop close powerful nations from unconventional economic agreementsORr that these treaties are already there and the ping-pong is only in a silent relationship? This is where I am confused. As for the issue of striking a balance between market and states in political economy, Harold's arguments doesn't seem to show that these balance will create a safe haven for debt control . Also, I think he was right to note that poor countries do not have the confidence of investors when trouble looms and notably, the rich countries are falling into similar traps if care is forsaken.

    5. CommentedAbiola Oyebanjo

      Is Harold saying there should be rules and treaties that would stop powerful nations from unconventional economic policies or that these treaties are already there and the ping-pong is only a silent relationship? This is where I am confused. As for the issue of striking a balance between market and states in political economy, Harold's arguments doesn't seem to show that that will create a safe haven for debt control but I think he was right to note that poor countries do not have the confidence of investors when trouble looms and so also are these rich countries falling into similar traps if care is forsaken.