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.