CAMBRIDGE – A specter is haunting Europe – the specter of “market confidence.”
It may have been fear of communism that agitated governments when Karl Marx penned the opening line of his famous manifesto in 1848, but today it is the dread that market sentiment will turn against them and drive up the spreads on their bonds. Governments all over are being forced into premature fiscal retrenchment, even though unemployment remains very high and private demand shows few signs of life. Many are driven to undertake structural reforms that they don’t really believe in – just because it would look bad to markets to do otherwise.
The terror spawned by market sentiment was once the bane of poor nations alone. During the Latin American debt crisis of the 1980’s or the Asian financial crisis of 1997, for example, heavily indebted developing countries believed they had few options but to swallow bitter medicine – or face a stampede of capital outflows. Apparently, now it’s the turn of Spain, France, Britain, Germany, and, many analysts argue, even the United States.
If you want to keep borrowing money, you need to convince your lender that you can repay. That much is clear. But in times of crisis, market confidence takes on a life of its own. It becomes an ethereal concept devoid of much real economic content. It turns into what philosophers call a “social construction” – something that is real only because we believe it to be.
For, if economic logic were clear-cut, governments wouldn’t have to justify what they do on the basis of market confidence. It would be evident which policies work and which do not, and pursuing the “right” policies would be the surest way to restore confidence. The pursuit of market confidence would be superfluous.
So, if market confidence has a meaning, it must be something that is not pinned down simply by economic fundamentals. But what is it?
In his Communist Manifesto, Marx went on to say that it is “high time that Communists should openly, in the face of the whole world, publish their views, their aims, their tendencies, and meet this nursery tale of the specter of Communism with a Manifesto of the party itself.” Similarly, it would be nice if markets would clarify what they mean by “confidence” so that we would all know what we are really dealing with.
Of course, “markets” are unlikely to do any such thing. This is not just because markets comprise a multitude of investors and speculators who are unlikely ever to get together to publish a “party program,” but more fundamentally because markets have little clue themselves.
A government’s capacity and willingness to service its debt depend on an almost infinite number of present and future contingencies. They depend not just on its tax and spending plans but also on the state of the economy, the external conjuncture, and the political context. All of these are highly uncertain, and require many assumptions to reach some form of judgment about creditworthiness.
Today, markets seem to think that large fiscal deficits are the greatest threat to government solvency. Tomorrow they may think the real problem is low growth, and rue the tight fiscal policies that helped produce it.
Today, they worry about spineless governments unable to take the tough actions needed to deal with the crisis. Perhaps tomorrow they will lose sleep over the mass demonstrations and social conflicts that tough economic policies have spawned.
Few can predict which way market sentiment will move, least of all market participants themselves. Even with hindsight, it is sometimes not clear why markets go one way and not the other. Similar policies will produce different market reactions depending on the prevailing story, or fad of the moment. That is why steering the economy by the dictates of market confidence is a fool’s errand.
The silver lining in all this is that, unlike economists and politicians, markets have no ideology. As long as they make money they do not care if they have to eat their words. They simply want whatever “works”—whatever will produce a stable, healthy economic environment conducive to debt repayment. When circumstances become dire enough, they will even condone debt restructuring—if the alternative is chaos and the prospect of a greater loss.
This opens up some room for governments to maneuver. It permits self-confident political leaders to take charge of their own future. It allows them to shape the narrative that underpins market confidence, rather than play catch-up.
But to make good use of this maneuvering room, policymakers need to articulate a coherent, consistent, and credible account of what they are doing, based on both good economics and good politics. They have to say: “we are doing this not because the markets demand it, but because it is good for us and here is why.”
Their storyline needs to convince their electorates as well as the markets. If they succeed, they can pursue their own priorities and maintain market confidence at the same time.
This is where European governments (along with their economist advisors) have kept missing the boat. Rather than face up to the challenge, leaders first procrastinated and then buckled under pressure. They ended by fetishizing the pronouncements of market analysts. In doing so, they have denied themselves economically desirable policies that have greater chance of garnering popular support.
If the present crisis gets worse, it will be political leaders that bear primary responsibility – not because they ignored markets, but because they took them too seriously.