Sunday, April 20, 2014

The Rotten Heart of Europe

Posts have been light lately because, in addition to a flurry of school-related activity, I was working my way through Bernard Connolly's excellent "The Rotten Heart of Europe". I'm fairly certain I first heard of this book through Lars Christensen over a year ago (sometimes I forget the source of reading recommendations, but thanks, Lars!). I had read certain parts of the book before this but never really found myself with the time to plow through the entire thing. I'm glad I finally got round to doing it. It's not the easiest read in some ways because it deals in great detail with the political decisions driving the bizarre economics of the Exchange Rate Mechanism, and it can sometimes be challenging for an outsider to try and understand the perverse choices politicians make. But despite - or maybe because of - the challenging nature of the material, it deserves to be read, and re-read. At many points, I marvelled at Connolly's erudition and prescience, and his ability to write with such insight about both politics and economics. Over and over, I thought to myself "well, that assertion is a little overblown" - and then realized that many things that would've been considered unlikely at the time have already come to pass. I highly recommend it, and rather than trying to summarize it, I just wanted to make a few points that the book revealed to me.

1) The Eurozone is a political construction. That seems obvious, but comes across over and over through this book. Understanding the politics of the Eurozone is absolutely critical to understanding its economics. Lars and I have often lamented that it seems like the political and legal news keeps slipping into the financial section. After reading this book, I realize there simply cannot be any other way. As Connolly notes, "the emergence of 'central bank watchers' implies that markets do not know what decision rules are being used by the central banks and have to try to deduce these uncertain rules from their actions and, perhaps even more important, their pronouncements." Unfortunately, this also means that investors have to make bets on political outcomes that aren't always clear. 

2) We don't sufficiently understand the politics of the Eurozone. Following on from (1), the task of investors and economic actors is significantly complicated by trying to understand political mechanisms that aren't necessarily clear. Despite the surfeit of digital and literal newsprint devoted to the area's politics, I'm still left with the uneasy feeling that there's much of importance bubbling beneath the surface that I and other outsiders will simply never be privy to. Specifically:

- It's clear that there is a tremendous amount of political will from elites to keep the Eurozone together. I didn't understand this point well enough two years ago when I thought the Euro could well break up, and having read this book, I understand its origins better. At times, this political will is all the more baffling when you read just how painful the ERM experience was - and yet politicians decided to take it a step further. Of course, the Russian threat is making clear why some smaller nations desire broader integration with Europe (not to mention what Connolly calls "the Golden Calf of Structural Funds"). But now that everyone understands the political will to keep the Eurozone together, there are two new threats: (a) complacency from top-level officials to (b) the possibility of backsliding from structural reform. Of course, some of this backsliding is a response to the Euro's shortcomings. Connolly notes numerous instances of governments offsetting tight monetary policy with fiscal profligacy and harmful supply-side policies.

- Central bank politics. Connolly quotes an unnamed Bundesbank staffer who quips that "in every central bank, politics is king." Rotten Heart lays bare the unusual political role of the Bundesbank, and the internal struggles between Schlesinger and Tietmeyer. I'm as guilty as anyone of referring to "the ECB", but of course, this supposedly monolithic beast is made up of lots of individuals representing the (often divergent) interests of their own nations and institutions. I was reminded of a quote from James March: "We know more about abstract agents dealing with abstract principals than we do about real bureaucrats dealing with real politicians." Furthermore, Connolly notes that "the biggest problem for the Bundesbank in explicit inflation-targeting was precisely its explicitness...'Price stability' could mean anything it suited the Bundesbank to have it mean." While many commentators have raged at the ECB for failing its mandate, that mandate is actually unacceptably vague, as Jurgen Stark recently reminded us.

3) Never underestimate the importance of luck. Or to be more precise in this instance, the importance of geopolitics (i.e. the interaction of geography and politics). The terrible insecurity France and Belgium seem to feel is in some ways an artifact of history and geography. Similarly, Ireland's willingness to submit itself to boom-bust cycles is driven by its desire to be out of the UK's political sphere of influence. UK citizens can thank their lucky stars (from an economic perspective) that their physical separation from continental Europe has contributed to their avoiding the pull of the Euro.

4) Never underestimate the importance of insecurity. Similar to the above, and understanding "real bureaucrats dealing with real politicians", one must be sensitive to the blinding insecurity that drives so many important decisions. Insecurity towards Germany, the US and the "Anglo-Saxon" model of capitalism seem to have driven France into this unhappy marriage. Connolly is particularly (and rightfully) harsh towards British politicians who fear that Britain will be "left out". Nick Clegg is peddling that line today. In hilarious fashion, Connolly refers to these people as "behaving like the 'Fat Boy' in Pickwick by telling tales to make the flesh creep." Perhaps unkindly, I cannot get away from the image of two drunks clinging to each other feebly for security. The solution is probably to stop drinking, rather than clinging ever more desperately. Equally, the concept of a "Latin Monetary Union" was raised in the past (as it is today), and nothing is more insulting to the insecure as being seen as part of an unwanted club.

5) The Eurozone crisis remains unresolved. Earlier this week, I listened to a nuanced debate on the crisis. That debate and reading Rotten Heart have strengthened my belief that there are, sadly, many ways this could go wrong. I tend to think of myself as an optimistic person, and I don't want to be a perma-bear on Europe (see my earlier post on the conundrum of investing in the Eurozone). It seems, however, that we are in one of those momentary periods of calm that should not be underestimated (or should at least built into one's financial models). Rightfully, there has been much talk about the effects of deflation and low NGDP on prolonging the crisis. However, at least the ECB's task is made easier by generalized low inflation throughout the Eurozone. As I mentioned earlier, it is far from a monolithic creature, and there may actually be greater danger in recovery. Many of the periods of ERM crisis that Connolly outlines are sparked by divergence between the German economy and other ERM members. Trichet's attempt to raise rates in this iteration of the crisis shows the recurrence of this issue. Proponents of the Euro must hope that all its constituent economies recover in tandem. Unlike in Rotten Heart, politicians and central bankers seem to have done a better job of coordinating their rhetoric this time round. Fewer people seem to playing the role of Schlesinger, if you will. But it's a step too far to hope that economic recovery will be synchronous, despite the efforts towards banking union and structural reform. The remaining disparities between Eastern and Western Germany are a warning as to the pace at which convergence can occur (compare the GDP per capita of Hamburg or Bremen to Brandenburg or Berlin). Continued divergence between France and Germany will be particularly dangerous. While sympathetic to the economic views of many Euroskeptic parties, I cannot abide the unabashed racism and xenophobia. There are, however, many who have no such compunction, and their numbers are growing, even in traditionally Europhile France. With remarkable foresight, Connolly warns, "Either [a future ECB] will act in French interests or it will not. If it does, then Germany will destroy it, putting an end to fifty years of a 'European Germany'. If it does not, then it might well destroy France." One cannot help but worry that we'll reach a turning point in this incessant crisis, and sigh, as Connolly's unnamed French official, "Alors, c'est bien foutu, le systeme."


  1. Well-written, brief and to the point. I would recommend that you read Lords of Finance by Liaquat Ahmed (if you haven't already). It describes the situation from 1915 to 1935 and how politics, short-sightedness by the central bankers, and their errant policies exacerbated the effects of the First World War, the Great Depression, and the ensuing hyperinflation and unemployment. The problem then, as it is now in the EZ, is political and there is never an easy fix for that.

    1. Prabal, I enjoyed Lords of Finance a lot - not easy to cover that much material as well as Ahamed does!