I am not going to add one more evaluation to the dozens that have been written about Thursday’s Eurozone summit. I think that Joe Stiglitz sums it up rather well. However, I am tempted to comment on the comments, not just of the past two days, but of the past several months.
Competent academic economists, and even outstanding ones, can be quite naïve about the political process. They seem to judge policy making by the benchmark of a rational, intelligent and benevolent dictator, who seeks to optimize social utility of whatever entity she is commanding. Much of the recent commentary on the Eurozone crisis is a clear example of this.
A good economist understands that economic actors optimize within narrow institutional constraints that are particular to their time and place. She understands coordination problems in the economy, that make it hard to arrive at an outcome that all actors may agree is desirable, when each actor hesitates to bear too heavy a private cost to get there unless somebody else starts first. If she has studied business behavior, she also knows that successful firms often have to estimate by simple heuristic rules how much to invest in a particular strategy, often choosing a more costly incremental route instead of going the whole way at once, because market forecasts are usually not reliable enough to justify an all or nothing approach.
Some economists forget all of this when they begin judging policy makers. Regarding the eurozone crisis, several mistakes have crept into their thinking:
1. Actors versus sets of actors. We’ve been reading about “Europe” or “Eurozone leaders” failing to do this or that. Europe is not an actor, it is a collection of national governments, parties, and voters, and of several multilateral institutions (like the ECB and the European Commission) each of which has a narrowly defined mandate. Nor is the group of “Eurozone leaders” an actor: each leader, even when she wears her European hat, is bound by a different set of constraints than the leader sitting next to her. They are not the politburo of a one-party state. To deride this group for failing, for example, to set up a 2 trillion eurozone standby facility for bailouts is to deride them for not being the politburo of the Eurozone.
Isn’t this just a trivial point, that means “leaders” should be trying harder to coordinate, or to articulate a common vision? Not according to standard economic reasoning. Economists often view coordination issues as hard constraints. They accept, for example, that nominal wages are sticky downwards; when a national economy gets in trouble because unit labor costs are too high, they do not usually recommend the ‘obvious’ response to get all workers to agree to a cut in their wage and all firms to agree to cut their prices accordingly. They recommend currency devaluation instead, in order to overcome the coordination problems. Coordination is what they seem to forget when they propose that “Europe” does this or that.
2. Bargaining and asymmetric information. In an arena of negotiation, actors never reveal early their true intentions regarding what they could accept in the end. Trichet has been pilloried for holding out against Private Sector Involvement till last week. It always seemed to me that he would accept some PSI (and more, if needed in the future); but by sticking ostensibly to a hard line until national governments were ready to commit officially to a more flexible EFSF, he prevented more panic sell-offs across the eurozone. His stance forced governments to set up more explicit defenses than they would otherwise. I think he comes out of this with flying colors.
3. Path dependence, institutions and numbers. Many complain that while the mechanics of crisis management were improved substantially last week, the numbers are too small: too little PSI in the case of Greece; too small a kitty in the EFSF to prevent a collapse in Spain or Italy. They are right about the numbers; but numbers are more adjustable than institutions. The difficult part is for actors to agree on new ways of doing things. You start from a set of arrangements, and via negotiation, you add a couple of new mechanisms, or modify existing ones. Next time around, you negotiate new parameter values for your recent arrangements. That is how states evolve, that is how Europe will (hopefully) evolve.
4. Incremental versus grand plans. Anyone who has run a cash-constrained company (this rarely includes academic economists) knows rule number one of corporate financial planning: never set working capital ceilings high enough for the operating guys to feel comfortable. You need to have adequate back up sources of funds, but these should not be “committed” in any formal sense. Otherwise, operations will be asking for more and more lines of credit, until your resources run out. By this line of thinking, it is reasonable that the total debt stock of Greece was not reduced dramatically in last week’s decisions. The principle that it can be written down was established clearly. This helps keep private lenders to Eurozone sovereigns prudent in the future. It also gives reasonable hope to the government of Greece that if it performs fairly well in its own tasks, the debt stock may be reduced further if need be. But at the moment, the small size of the reduction maintains the pressure on Greece to build up primary surpluses and to implement reforms.
All in all, given the institutional set-up of the EU, and the democratic nature of its member states, I think that Eurozone leaders have performed rather well, both in the spring of 2010, and last week.
“Aha”, I hear the other side saying, “but these are extraordinary times, that call for extraordinary leadership. By that standard, they have done a miserable job.” Well, it depends how much faith one has in benevolent dictators: is the power to commit great resources without negotiations a good thing? How confident can we be that a grand strategic plan decided in early 2010 would have worked well? For every proposal that was mooted, there were counter-arguments of substance, not just of process. Take for example, the idea of a big Marshall plan for Greece: what kind of governance would ensure that the funds would be well used to support sustainable growth, rather than being squandered to rent-seekers? Ditto for a massive recapitalization of all European banks – how would the terms of that distribute costs fairly and ensure competent management from then on (not, presumably by getting corrupt or clueless civil servants to be CEOs).
Further, extraordinary leadership is compatible with democracy only if the majority of the people are affected by extraordinary circumstances; and will therefore consent to extraordinary solutions. This is not the case in the Eurozone. In the strongest Eurozone economies, labor and product markets are not yet much affected by the sovereign debt crisis. If there is clear and present danger that they will be affected, their governments have options to address the problem that do not necessarily include massive bail-outs for the peripheral countries. It is natural that, according to the modus vivendi of democracies, they have not tried to commit huge national resources to this issue.
In the past fifteen months we have witnessed the constraints of negotiations among democracies, and we should be satisfied that the system has performed rather well. It has always been just-in-time rather than comfortably ahead of the problems; but it is not “too little, too late”, because there can always be a new round. European leaders and institutions have shown that they can balance the national and the supra-national, and the incremental with the global, well enough.
PS. Stiglitz also writes as if “Europe” were an actor. But he understands and appreciates institutional constraints; perhaps because, apart from being an outstanding theorist, he has also had much experience of front-line policy making in multilateral contexts.