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  • Oct 23, 2014
  • Updated: 5:43pm

Financial solutions point to political confrontations

PUBLISHED : Monday, 13 December, 2010, 12:00am
UPDATED : Monday, 13 December, 2010, 12:00am
 

Europe is facing not just the risk of financial instability, but also that of rising political instability. Financial crises create tensions within economic classes that quickly become political tensions.

As far back as 1922 John Maynard Keynes made the point that the choice between inflating debt away and deflating wages came down to the agonising outcome of a struggle among interest groups. Over the next few years many countries in Europe are going to face similar struggles among interest groups.

For many of the European countries struggling with the financial crisis, whose domestic cost structure is too high to allow them to compete, there is an urgent need to adjust their domestic costs to foreign competition. There are broadly three ways for a euro-zone country to do so: it can abandon the euro, and devalue the new currency; it can force down the cost of labour by running very high levels of unemployment for many years; or it can impose trade barriers.

Similarly any euro-zone country whose debt levels are too high will have to improve its ability to repay. In that case there are also roughly three ways it can do so: it can regain control of monetary policy by abandoning the euro and then inflate the debt away; it can threaten to default on the debt, and receive significant debt forgiveness; or it can regain fiscal credibility by raising consumption or value-added taxes, by raising income taxes, or by cutting expenditures sharply.

Most of the afflicted European countries suffer from both of the above problems - an uncompetitive economy and excess debt. In the aggregate, all of the above resolutions accomplish more or less the same thing. They allow the country to bring costs of production back to some sort of manageable level, and to reduce financial distress costs. But although economists agree that any of these strategies can resolve the underlying imbalances, they have less to say about which of these strategies is optimal because that, ultimately, is a political decision.

The means by which each economy adjusts involves very different ways of distributing the cost of adjustment, and the distribution of these costs will not be determined by economic theory, but rather by political interests.

For example, abandoning the euro and devaluing imposes much of the burden on creditors, including foreign creditors. Forcing down labour costs through unemployment puts the bulk of the burden on workers, while other forms of deflation especially hurt mortgagees and small businesses. Meanwhile, trade barriers force domestic consumers to bear the cost of the adjustment.

Inflation can reduce the government's debt burden, but at the expense of pensioners, non-unionised workers and others on fixed incomes. Default and debt forgiveness places the adjustment cost on lenders.

Raising taxes to pay down debt hurts households, consumers or businesses, depending on which taxes are raised. Finally, cutting fiscal expenditures mainly affects the middle and working classes.

There may be other types of resolution and other distributions of costs, but the point is that whatever the solution, we cannot escape the fact that these costs must be assigned to different economic groups. Almost by definition the process of assignation is a political one. And with such high stakes, it is likely to be an angry one.

Latin America during the 1980s and Europe during the 1930s showed just how difficult it is for political systems to apportion the adjustment costs to different economic groups during and after a financial crisis. In each case business, unions, the middle classes, and investors fought hard to implement policies that passed the brunt of the cost onto each other.

This is not to say that European politics in the next few years will be as confrontational as those earlier examples suggest. Stronger social safety nets and more robust transfer mechanisms will reduce some of the worst aspects of the adjustment.

But already certain European countries are witnessing resurgence in radical groups, like Sinn Fein in Ireland, determined to politicise the process as much as possible. This radicalisation has only just begun.

Over the next several years it will almost certainly continue, and politics will increasingly become a confrontation among different economic classes. After 10 to 20 years of relatively benign politics fuelled by rising asset prices and rising consumption, we may be about to revert to the far more confrontational politics of the 1970s and 1980s.

Michael Pettis is the senior associate of the Carnegie Endowment for International Peace and finance professor at the Guanghua School of Management at Peking University

Tom Holland is on holiday

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