In his speech, which opens this debate, George Soros argued that misunderstandings and misconceptions are shaping history in important ways. This is true in general, of course, and it is true in specific ways within the eurozone.
Proponents of the euro expected that under a single monetary policy and in the absence of currency risk economies would converge, as capital, goods and people would move more freely. An implicit assumption, never properly examined, was that national economic institutions would also become more similar. As Jean Pisani-Ferry tells it, in the early 1990s, part of the European elite selected central banks as a good candidate for merging into one tightly knit system, since they were already operating more or less in the same way; whereas welfare systems or industry policy were markedly different. It was perhaps thought that these other institutions would follow suit, eventually.
What seems to have happened, however, is that the monetary union actually served to mask and therefore preserve institutional differences in most other levels of the economy – in business strategies, in wage setting, in fiscal planning. Under the illusion of harmony, imbalances were allowed to get out of control.
As an example, consider the differing approaches to saving and investment of some typical actors within the EU.
A northern European pension fund would want to hold assets that produce a positive cash flow stream at some future period. There may be many layers of holding between the fund and the ultimate assets in the ‘real economy’, but the investor was always assuming that these ‘real’ assets would generate cash in a fairly predictable manner.
A Mediterranean household, on the other hand, may have had the view that a house has an inherent economic value which is not reducible to cash flows. This can be a deep conviction, forged by the experience of many generations, who may have seen financial assets vanish in times of crisis or inflation, while houses have been reliable stores of value.
A Greek employee, furthermore, may have believed that the safest asset for retirement was a job in the public sector, since it guaranteed a comfortable pension. Since her counterparty was the state, she could assume that her future cash flow is secure. Even private sector pensions seemed secure, regardless of how well each pension fund was managed, because there was an implicit state guarantee. In 2001, a reformist minister tried to avoid bankruptcy of the pension system by tightening up the rules, at which time a leading trade unionist notoriously remarked: “The pension system can never go broke; the Greek state would have to go broke first” (the cunning of reason, incarnate). So future cash flow from ‘real’ assets was never a major aspect of Greeks’ collective or individual life plan.
In the eurozone, actors of the first type (northern investors in financial assets) ended up investing massively in the non-financial assets preferred by actors of the other two types (in real estate and in state-backed entitlements) rather than in actual cash generating businesses. Their savings had been created in industry, but they were re-invested in far away bricks and in other peoples’ laws.
Two other types of actor mediated this investment process: banks and governments. Everybody considered them stable and knowledgeable enough, to be able to match the expectations of creditors at one end of the chain to those of debtors at the other end. But these mediators had their own institutional priorities, which did not include being efficient international and intertemporal matchmakers. And they were not compatible even with their own kin. Banks in the core had very different balance sheets from banks in the south, which came to depend heavily on interbank borrowing to fund long-term assets. Governments in the core had very different strategies for sustaining growth from some peripheral governments: trade surpluses were paramount for some, domestic consumption for others.
Mainstream economics tends to view such differences between creditors and debtors and between surplus and deficit economies as reflecting nothing more than intertemporal choice: creditors defer consumption and local investment in order to have more income from international investment in the future, while debtors prefer to consume and invest locally more now, and accept that they will have to pay out more in the future. The two are supposed to have the same rationality in different sequence.
Within one country, that may be a reasonable assumption. When we make economic decisions, we use shortcuts and heuristic devices to narrow our range of options and to assess them. Our rationality is bounded, and the bounds of reason are shaped to a large extent by culture and by institutions. Within the country, debtor and creditor are constrained by the same institutions, have access to the same enforcement mechanisms, probably share a common culture; and if, despite all this, their expectations are mismatched, there is a central authority to intervene and arbitrate. A useful body of work on this is on “varieties of capitalism”, which has explored how in each advanced capitalist economy different aspects of the system, involving different actors, complement each other: structure of finance, distribution of property, mechanisms of wage setting, welfare systems, processes of innovation. Economies are successful if these aspects work well together, though they may be quite different from other successful economies.
Across countries, rationalities are likely to differ. When investors are aware of this, they are cautious and take limited risks abroad. When, for whatever reason, they overlook such differences, pain ensues.
One way to interpret the structural weakness of the eurozone is that actors with mismatched rationalities interacted persistently and on a large scale, under the misconception that they were matched. The scale and duration of the mismatch was magnified by the illusion that common European institutions were forcing a convergence of rationalities: fiscal discipline was mandated by Maastricht, monetary prudence by the ECB.
In the example of savings and investment given above, both sides were wrong in the mismatch. It may well be that German policy is rightly dictated by the future needs of their aging population; therefore that current account surpluses are necessary, so that they can acquire assets abroad that will fund German pensions in ten or twenty years, when there will no longer be enough working age Germans to support the welfare state. If that is the objective, then they should be investing in future cash generating businesses, i.e. in parts of emerging dynamic economies. Investing in economies that are struggling to fund their own pensions now will not fit the bill — except if the investments are picked carefully to enhance the future productive capacity of the receiving country.
Recipients of finance were also wrong, of course. Having a different view of time and cash flow from that of an industrial or a financial player, they judged an opportunity by the ability to attract finance now, rather than by the ability to pay back later. As long as creditors seemed happy, this attitude seemed justified. A building would always be as valuable as today, a state would always be able to refinance. Historical experience suggests that they were as right on this, or as wrong, as the ‘rational’ northern investors who thought they could predict the value of financial assets ten years hence.
Strategies for stability
If this analysis of mismatches and misunderstandings is correct, what does it imply for the future architecture of the eurozone?
One obvious answer, much discussed, is that a stable eurozone requires much stronger central control of governments and of banks, i.e. of the two categories of institution that mediate most of the international flows of capital. Hence, the fiscal compact, and the very recent decision to centralize bank supervision.
This could of course enhance stability, but it will not be enough. Prudent banks and prudent governments are no guarantee that there will be no persistent current account deficits and no internationally fuelled bubbles. As Martin Wolf has argued about Spain, good bank supervision (which Spain had) and stricter lending rules could just result in lending coming directly from abroad; this is not something that can be prevented under current EU rules.
In the long run, the architecture of the eurozone will have to deal with institutional diversity and with mismatched rationalities across countries at the level of firms, of households and of institutional investors .
One radical approach is to try explicitly to restrict national current account deficits and surpluses within the euro zone. The European Commission has taken a tentative step in that direction with the Macro-Economic Imbalance Procedure. As a concept, this is very bold; but it is as yet hard to see how it can be enacted. The precedent of recent bail-outs suggest that for deficit countries “corrective action” would consist of standard reforms to improve competitiveness (flexibility in the labor market, ending closed-shops, etc). Such reforms would influence the current account indirectly and very slowly. They will probably not be enough, in the context of so many cultural and institutional differences.
If current account balances are to be taken seriously as a policy target (and I believe they should be), there seem to be four types of strategy for dealing with institutional diversity, and they are not mutually exclusive.
(a) Convergence: Comparable institutions should have comparable targets and regulation. Ideally, they should also ‘think’ and act in the same way. The crisis has already led governments to agree on a strategy of convergence for fiscal policy and for banks.
How deep this convergence will be remains to be seen. Will the existence of a central supervisory body be enough? Will it set only high-level targets, or will it insist that micro-level practices be harmonized as well? For example, will Greek banks be allowed to discount post-dated cheques — which is a practice unknown in the north, but admirably suited to the Greek microeconomy?
Should there be convergence of other important institutions, such as pension systems? If not, it may be impossible to justify politically the ECB as lender of last resort to governments. If nationals of country A retire at 62 and others at 67, and if the pension system of country A needs state support, would other taxpayers accept this? High-level deficit targets will not be enough to convince voters to accept such different levels of social benefit across countries.
(b) Targeted diversification: For some institutions, national differences could be accepted and fostered. Farms and farmers have always been protected in the EU, in ways that favor some national types over others. Current orthodoxy is that all other businesses should operate in conditions of competition, equal across countries, constrained only by common EU rules on issues such as the environment. That is the theory, but in practice many rules, such labour legislation, vary greatly across countries; which means that equally able entrepreneurs will be successful in some places and not in others.
Some of the different national rules have been shaped by local collective bargaining, others by the national political process, still others by informal national norms. If they were to be harmonized truly, every country would have to relinquish their own processes. This could only happen in a fully federal European Union.
As we are not there yet, and may never be, there is a strong case for accepting not just different national practices, but also different levels of productivity and different forms of protection to some local industries. This case has been made by Dani Rodrik more generally in The Globalization Paradox. Perhaps the EU should start thinking again in terms of industrial policy, aiming to keep some sort of trade balance among member states. Of course there are a myriad arguments against this, but to claim that common conditions of competition can exist across countries in the absence of strong political integration is pure hypocrisy.
A mild form of industrial policy would be the so-called new Marshall Plan that is being discussed for the bailout countries. In this, EU institutions would fund directly specific investment projects, in infrastructure but also perhaps in tradable-sector businesses. If this happens, this could be an important first step in accepting the principle of targeted diversification.
(c) Transnational integration: One way to deal with different rationalities is to internalize them into a single organization. This is the case with foreign direct investment (FDI), where international investors directly engage with local labour (and other actors) and work out rules that combine both cultures. Successful multinational enterprises have been doing this for decades. If capital flows within the eurozone had been mostly FDI, it is unlikely that current account imbalances would have led to such bubbles.
Northern savers would have much to gain in terms of future income if they could mobilize southern resources into joint productive enterprises. The common currency was supposed to boost this type of investment, but this has been crowded out by investment in financial instruments, where each side retains the freedom to act according to its peculiar rationality. Should we now have an active policy to promote FDI?
And should we perhaps start thinking about other transnational institutions? Perhaps about transnational collective bargaining in specific industries, or transnational pension funds?
(d) Transparency: If most international transactions are to remain at arms length, as they will, then mismatches could be avoided, to some extent, if creditors and debtors had a better grasp of each other’s modus operandi. This requires, first and foremost, much more detailed and useful quantitative information about institutions in each country.
Multilateral agencies such as Eurostat and OECD have been providing international statistical tables, doing their best to compare sometimes very diverse source material. Rating agencies, such as Fitch and Moody’s, narrowly focused on financial assets, have supposedly delved deeper into assessing the dynamics of risk. Yet anybody who has followed the public dialogue about who works longer hours, or who retires at a later age, or which enterprises are more productive, can attest that confusion reigns.
We should think about creating a common European information space, where transactions at a micro level within each economy are registered and monitored by pan-European institutions. This could cover, e.g., all public spending decisions, all pension liabilities, all labor contracts, all permits, etc, at fine detail. It would require creating common databases of rules and numbers.
Technically the task is now feasible. Politically, it would be defended in terms of democratic accountability. National political elites have had it too easy hiding their clientelist practices from their electorates by controlling the flow of information. Supranational independent monitoring bodies would be useful counterweights, and they would be serving both the national demos, and the nascent European one.
The European demos
Of the four strategies outlined above, convergence is where all the debate is focused at the moment. National political elites are directly threatened by it, but common people also do not see how they can shape it. Should it be controlled by governments, by multilateral institutions, by the European Parliament, or by new international forms of deliberation and participation? However it is done, however necessary it may be, many will feel that they have lost power and agency in the process.
The answer for regaining agency for individuals, unions, and civil society organizations may lie in the other three strategies.
The latter two (transnational integration and transparency) are building blocks towards a European demos that do not directly detract from national democracy. They would actually empower new local forces, against the “jealous domestic political classes”, who, as Tony Curzon-Price has argued, have been excluding Europe from the political and democratic table.
As for targeted diversification, it could allow for local rationalities to survive and perhaps thrive as building blocks of a strong European economy, rather than as vestiges from an inefficient past that should be phased out.
The four strategies together are what we need to build a more stable, balanced eurozone, where growth can be coordinated and development diversified. Diversity of institutions will be as much part of the European demos as uniformity. There is no simple formula for moving ahead.