Why This Time Germany is Right (Part 2)

Merkel Miracle: The day following my first post on Germany Angela Merkel told the German parliament there are no “miracle solutions” for the Euro crisis, and “Germany’s strength is not infinite”. She alluded to the same demands she will almost certainly hear once again later this week for debt mutualisation, a bank guarantee scheme, and whatever other new-scheme-for-rescue dreamed up at Germany’s expense.

As described in simplified terms last week, the German position seems to be that the rules of fiscal union must be signed... first. The fiscally constrained countries would appear to require the bank cheques to be signed... first. Hollande’s mealymouthed contribution is classically socialist; he demands “solidarity”... first. Solidarity appears to mean a cheque.

The conversation as reported by Reuters:
Merkel said: “Where solidarity is given, control must also be possible. Liability and control belong together.”
Hollande replied: “There can be no transfer of sovereignty if there is not an improvement in solidarity.”

The prospects for overcoming the great divide are not good at all. Monetary union might collapse and European integration be unwound because of this gap between the French intransigence-solidarity and the German prudence-rules. It is almost impossible to believe that European union could be purchased with money or charity, and certainly not by a revival of the antiquated socialist propaganda of “solidarity” against oppression.

In the previous post I suggested if Germany could only prevail it would generate a watershed ‘cosmopolitan’ moment for which future generations would be grateful.

Regardless of German motives -- which since they are human motives are obviously not selfless motives -- the paths of progress in history are aligned, I am arguing, with the German position. Economic change discloses and drives imperative legal-institutional changes that in turn enable future progress.

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Now I want to follow up, as promised, on the history. It is easy enough to make Merkel’s mention of “miracle” the pivot for the post. It reminded me straight away of previous “miracles”, and the reasons why miracles are either possible or impossible.

1. The Open Society:

I think we need to talk first about Karl Popper’s book Open Society.

George Soros suggested on Monday here in an article at Project Syndicate that Germany may be pursuing its “narrow self-interest”. I cannot really believe Mr Soros thinks the southern “periphery” countries are pursuing a broad ideal of solidarity rather than self-interest.

What really intrigued me was his suggestion that by giving overriding priority to rules and laws (in pursuit of fiscal and subsequently political union) Germany comes into conflict with the ideals of “the open society that fired people’s imagination and propelled European integration for decades”.

Karl Popper never really gave a full description of Open Society, but we at least know for sure he viewed it as a “depersonalized society” whose rules are administered as formal law.

Indeed, Popper’s viewpoint nicely matches the rules-based or rules-first approach of the Bundesbank and German finance ministry.

Popper said “detachment” is needed to limit the “discretionary” powers of politicians. “Impartiality” and “equality before the law” are the goals of institutional construction in the open society. “Direct” interventions -- Popper might well have offered the example of bailouts rescues -- are suboptimal. Popper’s “optimal” form of economic intervention is “institutional or indirect”, which is the method of “designing a legal framework of protective institutions” to guide all economic policy. More or less exactly as the Bundesbank president has frequently said.

According to Popper, discretionary state powers have a tendency to multiply unexpectedly, as every intervention requires future adjustments.The advantage of the indirect institutional approach -- i.e. the one that Germany now proposes as groundwork for fiscal union -- is that it can “make allowances for unforeseen and undesired consequences”. Whereas discretionary economic interventions turn out to be arbitrary and transitory, “the legal framework can be known and understood by the individual citizen [because] its functioning is predictable”.

That is what all Europe’s investors and savers want now -- understandability and predictability.

Popper was adamant that institutions need to be built. Policy leaders should heroically adopt the “constructive technological” principles that guide physical engineering. Obviously analogy can be made with the shelter European Fiscal Union should give countries during an economic crisis -- “if a certain shelter is to stand up to a typhoon, it must be constructed in a certain way”. 

Popper then emphasized why institutions require prior planned rules:

“Institutions play a role in our social life corresponding to the role played in mechanical engineering by, say, the principle of the lever. For institutions, like levers, are needed if we want to achieve anything which goes beyond the power of our muscles. Like machines, institutions multiply our power for good and evil. Like machines, they need intelligent supervision by someone who understands their way of functioning and, most of all, their purpose, since we cannot build them so that they work entirely automatically. Furthermore, their construction needs some knowledge of social regularities which impose limitations upon what can be achieved by institutions. But fundamentally, institutions are always made by establishing the observance of certain norms, designed with a certain aim in mind.”

How would Karl Popper have regarded the “solidarity-first” position of President Hollande of France? It is not flattering to Hollande to say he occupies the position Popper gives to Plato’s romantic-collectivist philosopher king:

“He developed the technique of appealing to moral, humanitarian sentiments. He transfigured his hatred of individual initiative, and his wish to arrest all change, into a love of a heavenly state in which everybody is satisfied and happy and in which the crudity of money-grabbing is replaced by laws of generosity and friendship. This dream of unity and beauty, this aestheticism and holism and collectivism, is the product as well as symptom of the lost group spirit of tribalism. It is the expression of, and ardent appeal to, sentiments of those who suffer from the strain of civilization… The therapy he recommends is worse than the evil. Arresting political change is not the remedy… There is no return to a harmonious state of nature. If we turn back we must go the whole way -- we must return to the beasts.”

“Solidarity” will be pursued counter-productively among desperate leaders of nervous states needing rescue. But since “solidarity” calls for solid resistance against attack from a common enemy, in an economic context it is the most primitive atavistic impulse. There is no historical precedent for “solidarity” as a solid basis for law-grounded capitalism in a future Europe.

2. The European Miracle:

In his classic book The European Miracle -- which traces the rise of modern European political economies since medieval times -- Eric Jones shows why Europe’s prosperity and stability always resulted from the gradual steps taken to spread and deepen rule of law.

Jones memorably says the historical task is to “remove the impediments to growth”, a dictum immediately recognizable as the reverse of the activist injunctions preferred by development economists who, for example, support industrial policy.

A summary of relevant parts of European Miracle: The conjoining of economic and legal progress began by providing security for persons, property, and enterprise.

The “parameter shifts” which abolished obstacles to business development and gave birth to the modern market system began in mundane ways such as “removal of nuisances like narrow town gates”. But they spread to guarantees for trade, finance, insurance, accountancy, and many innovations which enhanced the mobility of factors of production and created the means of communication that unified markets.

Always it was mainly “rules of conduct” and “laws” for commerce and finance that eroded old practices and disincentives, brought order where there was chaos and insecurity, and enabled growth and development. The process was one of reducing uncertainty in the economic environment to acceptable thresholds, lifting “the depressants on investment”, the “slow planing away of roughness and risk”, and the “withering away of arbitrariness”.

“The historical problem of development is that all economies were politically embedded… Rulers of relatively small European states learned that by supplying the services of order and adjudication they could attract and retain the most and best-paying constituents.”

“The modernizing effect of state action is clear. The results were out of all proportion to the motives. The latent function was to extend the market farther and faster than its evident attractions could do unaided… An Englishman of his day might tend to take public services for granted, but they too had won their way by stages, until Europe as a whole possessed a far more efficient mix of functional agencies than ever before, or than anywhere else. The attainment of minimum stability conditions for economic growth lies so far back in history that we all now take it for granted.”

3. The growth dilemma is identical today:

Popper similarly said the origins of the open society lie in the growth of trade and commerce. The market erodes parochial domination and status distinctions, allows access to new ideas, encourages individualism, and creates pressure for the creation of legal frameworks that apply universally to rulers and the ruled, to insiders and outsiders.

We should view the present dilemmas of fiscal and political union in Europe in that same context, as only the latest extension of the long process. There is an opportunity here to be grasped, but it appears to be only Germany which realizes the “step by step” nature of the task of winning the further consolidation of markets in finance, banking, and insurance.

I see the present euro crisis as a phase in market integration, a process now equivalent to all major market expansions of the past which successively drove creation of new governance structures.

This phase today is an especially monumental one because it involves changing or even superseding the territorial political communities of individual nations which were the basis of economic law. Common market was followed by monetary union and now appears to require some form of fiscal and perhaps banking union. In their essence these changes are no different from purely national stages in the evolution of European market economy since the Middle Ages as described above in the words of Karl Popper and Eric Jones.

At this stage -- the crisis opportunity for reform -- to postpone the institutional advance in favour of rescues (debt mutualisation and the rest) could only lead to withdrawal of pressure for change in the “periphery”. Rescue without victory for rules would be like pouring freshly made cement into the foundations of antiquated structures of political economy that are not fit for purpose in the twenty-first century.

4. Preliminary observation of guillotined miracle

A lot of the rhetoric about the euro crisis revolves around allegedly structural inequalities between the “center” or “core” and the “periphery”. It is also the imagery Mr Soros has used.

The frequently heard complaint is that Germany’s success as an export powerhouse benefitted disproportionately from a cheap currency shared with poorer countries.

The flip side is the benefit poorer countries gained from low interest rates and cheap loans. But since the loans were not used productively and turned to bad debts, advocates of European solidarity feel justified now in asserting Germany is morally bound to atone financially for its prosperity which is “a direct consequence” of monetary union.

I don’t believe that for a moment. Germany has proved itself several times over as a flexible adaptive economy. Do not forget the post-war German Miracle. Without the currency advantage of monetary union I think Germany would have tried even harder to lower its costs and add value to its exports. German business would have become even more innovative. Rather, most of Germany’s ‘advantage’ comes from having undergone the structural reforms that peripheral countries refused to undertake. One of the explicit intentions of monetary union was to take away the devaluation tool and force periphery countries to reform.

5. East Asian milagro (miracle) and Latin American malogro (failure):

The debate reminds me of the Latin American theories of “dependency” and “unequal terms of trade” dominant between the 1960s and 1980s. At its most primitive the argument was simply that core countries (Europe and the USA) had structured the global economic system to benefit themselves. Developing countries are consigned permanently to the periphery as producers of cheap stuff for the benefit of consumers in the core.

The situation in Europe now may be simpler, but it is worth being reminded how complex yet wrong and self-serving arguments about structural disadvantage can be.

Latin Americans believed asymmetric terms of trade caused by differential productivity gains from technology, monopolistic pricing, rising wages, and declining demand for food imports in the centre, and rising demand for manufactured goods in the periphery, trapped their countries in permanent one-way transfer of profits to richer countries. As the price of industrial imports rose in the periphery, the price of export commodities, which provided earnings to pay for the industrial imports, declined. It was a senseless error of economic modeling that cost two decades of wasted potential leading up to the 1982 debt crisis.

The thesis was flawed. Policies for dealing with “market failure” in Latin America turned out to be detrimental because from the 1950s until the 1970s trade was the engine of world growth. In Latin America state marketing boards, price controls, and overvalued exchange rates supported import-substitution industrialization but taxed commodity exports and offered no incentives to diversify. While the volume of world trade more or less doubled in twenty years after 1945, the region’s share dropped from more than 10% to less than 5%.

Yet in the 1960s and 1970s, while Latin America still complained about developed country tariffs on manufactures, several East Asian countries were successfully surmounting those same barriers. The theorized structural disadvantage was revealed as completely illusory.

While Latin American countries increased their import tariffs, industrialized countries were steadily lowering their own. In reality, therefore, developed country trade barriers did not constrain Latin American exports either in industrial or non-industrial goods.

Despite weakening evidence, Latin American policymakers continued with their ‘centre-periphery’ critique. It was ideologically persuasive and appealed to nationalists who wanted to believe unequal exchange served the interests of industrialized countries to the detriment of poorer countries. Rather than eliminating domestic causes of market failure by undertaking structural reforms, policymakers reduced reliance on the price mechanism and increased state planning, state investment, and government controls.

The Asian Miracle was founded on outward-looking export-led growth. It was the result of competitiveness created by profound supply-side changes in the structures of East Asian economies. Latin America lost out because it looked inwards, failed to reform, and ran up massive debts to sustain state-subsidies to non-export economic activity. The economic historian David Landes described it as “development without efficiency constraints”.

6. The malogro (failure) of the European periphery:

As noted above something similar occurred in Europe. In fact there was no “structural disadvantage” in the periphery. Instead there was a pincer trap -- premature expansion of state welfare protections combined with failure to undertake supply-side reform of labour, product, and service markets or to invest cheap euro-credit in sustainable productive activity. Periphery countries are quite inexcusably responsible for their inability to compete globally. Charity really is not in their best self-interest unless there is already economic revolution underway. 

Two Italian economists -- Alesina and Giavazzi -- called the situation “frightening” in 2006. Rather than confronting the problems head-on, politicians promised citizens “protection” from globalisation. “The epicentre of protectionism”, the authors noted, “is in France”.

The promises of protection continue today, except now the protection demanded -- in a hopeless reversal of mafia-style predation -- is from Germany.

A bankrupt periphery really must make the structural reforms as proof of commitment in return for rescues. They really must sign-up to the new-rules-first as a concrete and verifiable demonstration of solidarity to protect Europe against repeating ravaging crises.

7. Back to the miracle:

The European miracle, the miracle of modernity, cannot continue by scratching about for broken implements to prop up failed enterprise and failed sovereign.

Economic change creates the pressure for new rules. The new rules then come first. The only true “protection” comes from new rules to help manage economic change. That is the basic and essential lesson of the history of the European miracle.

Germany can perform the miracle for itself again, repeatedly if necessary, with or without the euro. But it cannot perform the miracle *for* Italy, France, and Spain (gratitude has no meaning here). Maybe if they were all in one federation…

Addendum: Complementary to my Germany 1 and 2 blogposts is BBC Analysis program 'Eurogeddon 2'. Listen out especially for Ullrike Guerot and Peter Mandelson.

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