Streetwise Professor

May 28, 2012

Europe in the Matrix

Filed under: Economics,Financial Crisis II,Politics — The Professor @ 10:01 am

I missed this when it first came out, but apparently a modified Matrix plan to solve the European financial crisis has been bouncing around for a couple of years (h/t Tyler Cowen at Marginal Revolution).  The plan is take both the red and the blue pills.  Well almost: it is to issue both red and blue bonds.

Under the plan, “the senior ‘Blue’ tranche of up to 60 percent of GDP,would be pooled among participating countries and jointly and severally guaranteed.” In contrast, “the junior ‘Red’ tranche, would keep debt in excess of 60 percent of GDP as a purely national responsibility.”

Blue Bonds are essentially Eurobonds, which would mutualize/socialize European government spending, thereby perpetuating the illusion of fiscal bliss.  The Red Bonds are traditional sovereign debt, that require governments to face up to painful fiscal realities.

I seriously wonder if the plan’s authors, Jacques Delpla and Jakob von Weiszsacker had the Matrix in mind when they came up with these labels.

Europe is split into Red Pill and Blue Pill camps.  All the basket case countries are definitely clamoring to take only the blue pill: they want Eurobonds in the worst way.  The French, under newly elected president and alleged babe magnet Francois Hollande (h/t R), are also shouting “BLEU!” (no sacre).  The Germans, Austrians, Finns and Dutch, conversely, are definitely putting it all on red.

Germany in particular has said repeatedly in recent weeks that it will not countenance blue bonds.  Instead, it is pushing a “Six Point Plan” that focuses on structural reforms:

But Merkel is an experienced opponent. She knows that she is now on the defensive in Europe, and she is planning her counter-attack. She believes that euro bonds would enable the crisis-ridden countries to lower their borrowing costs, and that the necessary structural reforms would be postponed. This is why she now wants to counter Hollande’s proposals with a principle familiar to judo fighters: using your opponent’s momentum for your own attack.

. . . .

After Hollande’s statements on Wednesday, Merkel is now presenting her opposing concept. In a six-point plan, she calls for deep-seated structural reforms for Europe. Under the plan, government-owned businesses are to be sold off, protections against wrongful dismissal relaxed and obstructive regulations for companies removed. There is also talk of special economic zones and privatization agencies based on the model of Germany’s Treuhand trust, created at the time of reunification to sell off most of former East Germany’s state-owned enterprises. In short, the Mediterranean region is to become more like Germany, but with better weather.

Jans Weidmann, head of the Bundesbank, is also flashing red.  His interview with Le Monde is refreshing, not least because he calls  bull on the repeated invocation of the Growth Faeries by Hollande and others:

Growth is always a good thing. But to favor growth is like supporting world peace. The real debate is which path to sustainable growth? Growth has always been a pillar of European and adjustment programs through structural reforms. Cyclical wildfire into debt does not lead to the desired growth. In fact, I wonder about that behind these discussions. Do we want to deviate from what was decided? In this case, it is dangerous. [Emphasis added.]

Hear damn hear.

Weidmann damns the blue pill:

A belief that the Eurobonds will solve the current crisis is an illusion. This can only be the culmination of a long process which requires, among other things change the constitution in several states, changse the treaties, to implement a more unified budgett … You do not trust you credit card to someone if you do not have the ability to control his spending.Mutualized debt is can be one face of a coin whose other side is federalism. Governments who support federalism lose elections. Even in countries where governments are demanding Eurobonds, as in France , I see no public debate or public support for the transfer of sovereignty to the support . But it is precisely this debate that we must have.

Weidmann also argues forcefully that growth requires substantive structural reforms, not more leftover Keynesian crack:

But is Keynesian stimulus is an adequate response? Apart from a lack of competitiveness in some countries, the main problem of European countries remains the debt of states and should not be run in a new round of spending. Countries must first regain market confidence, regain credibility: he must set out the announced reforms and not delay the time.

If growth is the true objective, I am foursquare behind the Germans.  Long term growth requires thorough structural reforms that permit resources to flow to their highest value uses; encourage competition; reduce rent seeking; and permit creative destruction.  I understand that big cuts in government spending in the short run (cuts which have not occurred for the most part in Europe, despite all the howling about austerity, as former colleague Russell Roberts has pointed out) are counterproductive.  This suggests that the appropriate policy would be to combine structural reforms that encourage real growth with longer term strategies to reduce government spending to restore fiscal balance.

But that is exactly the problem.  It’s like the old joke: I know where you’re going, but you can’t get there from here.  There is no credible way in democratic countries to commit to these policies.

And this brings us back to the fundamental point, which I’ve made several times previously: Europe’s problems are fundamentally political ones, not economic.  I am a Europessimist precisely because I see no path to addressing these political problems, either at the level of individual nations or at the level of Europe as a whole.

The political clamor in Europe is clearly in favor of taking the blue pill. Germany and Merkel are under tremendous pressure to submit to these demands. Germany is currently struggling with intense internal conflicts, between the desire to be Good Europeans who will not do anything to destroy Europe for the third time (a desire manipulated by France and others playing guilt trips on Germany), and the understanding (well expressed by Weidmann) that socializing European fiscal problems will not solve anything, and eventually make things worse.

How will this turn out? I have no idea how it will play out in the short run: that hinges on this internal struggle in Germany, and I have no idea which of the conflicting impulses will prevail.  Eventually, however, I think that the whole thing will fall apart.  Whether Europe takes the red pill or the blue pill in 2012 or 2013 will only affect when the collapse occurs, and the distribution of the damage.

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  1. However it turns out, it is good to see France and Germany at odds with each other. Makes a change from the two doing a nice backroom deal (i.e. as they did with CAP reform, or lack of it) days before an EU summit, thus shafting the rest of the continent. No talk about a two-engined Europe now, is there? This can only be a good thing.

    Comment by Tim Newman — May 29, 2012 @ 12:55 am

  2. But does Europe have a specific problem? If I’m following your analysis, basically you’re saying fiscal balance is a desirable thing, and that democracies, or even more generally any regime that tries to please their people, can’t deliver it as it’s easy to do deficit in bad times, if only for the direct short term benefits, and nobody will be interested in balancing boredom in good times. OK, but then everybody has this problem, it’s just a bit more visible in Europe at the moment.

    It seems to me it’d be easier to fix the system on the accounting side to make fiscal imbalances sustainable to infinity, which doesn’t seem a particularly hard problem, rather than try to change human nature into doing politics on an improbably long term basis.

    Comment by cig — May 29, 2012 @ 4:49 am

  3. On the blue/red bonds etymology: my guess is that blue bond are named from the European flag (federal bonds look like the federal flag) while red indicates dangers (member states need to balance them at the member-state level).

    Comment by cig — May 29, 2012 @ 4:52 am

  4. Where does your Weidmann quote come from? Your link is Google translate, but I can’t find the exact words in what Google translate serves me. Did you further rewrite the junk from Google translate on a junk in junk out basis? You cannot responsibly use machine translation — which is barely suitable for translating a toaster’s user manual — for academic-standard politics work.

    The quote that puzzled me was “Governments who support federalism lose elections.”, the matching quote in the original is “Les gouvernements qui y sont favorables négligent ce débat”, which means “Pro-federalism governments put the federalisation debate on the back burner”. This is a very different statement than your quote. In the rest of the article his argument seems to be that federalism is not being debated, and because of that we don’t know if it’s just apathy or if there’s any real voter opposition, and we could know by having the debate. Which is a much more sensible and realistic argument.

    Comment by cig — May 29, 2012 @ 9:32 am

  5. The problem for Europe (and for the US too) is that much of the economic “growth” in the 2000s was phantom. It relied on artificially created bubbles based on debt. Quite simply people have been living at a far higher standard of living – collectively – than they could afford to in Greece, Italy, Spain, and other areas. One way or another, the only way to get back on a sustainable economic growth basis is for people’s standard of living to take a huge cut. Once they are on the correct baseline, real growth is possible. Of course, this is almost politically impossible. All the efforts being done now is not to restart the growth process – it’s to somehow allow people to keep the “gains” made earlier by various chicaneries. But the bills are coming due now, and people can’t continue to float with a little more extra debt to tied them over.

    The Germans understand that collapse is inevitable. If they write checks now, they’ll need to keep writing them until they run out of money. They simply have a longer term vision than everyone demanding they write checks now – because they see in the end it won’t matter. Restructuring is only a matter of time.

    Comment by Chris Durnell — May 29, 2012 @ 12:55 pm

  6. [...] – The Matrix plan for Europe. [...]

    Pingback by FT Alphaville » Further reading — May 31, 2012 @ 1:05 am

  7. dude, you need to actually read the proposal, rather than just use if for an amusing analogy. the whole point of the bruegel proposal is that it retains the incentive for govts to get their finances under control and credibly limits germany’s liability for its neighbours’ debts to a manageable level, while at the same time mutualising government debt – i.e. creating a risk free asset that the ecb can use for monetary policy and that all governments can benefit from equally.

    Comment by bena gyerek — May 31, 2012 @ 8:44 am

  8. @bena-But the proposal is 2 years old and not on the table now, so it is pretty much only useful as the basis for an amusing analogy. It ain’t happening.

    The ProfessorComment by The Professor — May 31, 2012 @ 9:21 pm

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