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Angela Merkel Is No Alexander Hamilton: The EU Crisis Isn't Over

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Markets last week reacted favorably to news of measures that could ease the European financial crisis. However, for a knotty combination of cultural, political, economic, and social reasons this reprieve will not last long. Be prepared for bad news from Europe for the rest of the year. German Chancellor Angela Merkel is being asked to represent her country, and Europe as a whole. She simply cannot do both. Sadly, there isn't a European leader of the stature of an Alexander Hamilton who is willing to take the risks necessary to create a true European Union.

The EU needs a real president, and incredibly it has four:

  • Herman Van Rompuy, President of the European Council
  • José Manuel Barroso, President of the European Commission
  • Cyprus, holds Presidency of the Council of the European Union
  • Martin Schultz, President of the European Parliament

If you want to see why these gentlemen cannot govern, I highly recommend that you watch this two-minute video recorded at a session of the European Parliament:

From the viewpoint of a functioning union, Europe today is at the same point that the U.S. was between independence in 1776 and the Articles of Confederation, and adoption of the U.S. Constitution in 1789. As EU finance ministers prepare to meet tomorrow in Brussels, I am waiting for a tipping point event, because nothing short of the looming destruction of the EU will force its leaders to create a true union and constitution, with all of the burden-sharing that would entail. Incremental measures to reduce risk won't work in a crisis. The structural weaknesses of the EU have been masked for years by strong global growth Once growth slowed, political problems came to the fore. The same could happen in China. But China is undeniably one nation, with a common cultural and linguistic heritage and strong central leadership.

Ironically it was risk avoidance, and the willingness of investors to believe that they could insulate themselves from risk, that created the Great Financial Crisis. So is it any wonder that continuing to play it safe might only make it worse? The system has seized up and will continue to seize because of a fundamental lack of understanding by governments of what creates a growth environment for the economy. Unable to instill confidence, politicians seem blind and removed from the realities of the lives of their citizens. As Robert Zoellick, outgoing president of the World Bank has warned, it is "far from clear leaders are ready for impending catastrophe." A truly disturbing statement by someone who actually knows what they are thinking.

The warning signals are flashing again. Lackluster U.S. employment figures underline the trend to avoid investing in human capital, and tellingly, teachers have suffered some of the greatest job losses. According to Diane Swonk, chief economist at Mesirow Financial: "The bulk of the losses in public sector employment occurred in cuts to both state and local teaching positions." The markets are reacting to the prospect of fewer workers. There is no doubt that employment is necessary to recovery, in order to create customers and retail demand, but large corporations and small businesses find themselves reluctant to hire.

This is entirely rational in an environment of uncertainty. Not knowing what the tax structure might be in 2013, lack of faith in global markets, and the ability to displace labor with technology all play a part. Governments, companies, banks, and households around the world all feel the imperative to de-leverage their balance sheets rather than take on additional overhead. One bright spot, falsely seen as a malignancy -- credit card debt has begun to increase. The world should thank heavens for the American consumer! Give every citizen a $1000 debit card, to be used on purchases over ninety days, and you would witness the greatest example of a multiplier effect ever seen and a potential increase in the GDP of 2.2 percent.

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Spending is necessary to create growth, but spending is bad, say the bureaucrats. Confusing until you pull this apart. The real issue is misallocation of capital, by governments, financial institutions, and individuals. Over the past few months, austerity has been the battle cry of politicians in full retreat from reality. Growth is the only way out, but either they haven't caught on or they lack the vision required to lead the charge forward. Instead they think regulation-aha! and put pressure on the banks to raise their capital requirements -- in other words, hoard cash. Ambrose Evans-Pritchard quotes What's Next? contributing author Timothy Congdon in the Telegraph: "What they are doing is frightening. If banks shrink their balance sheets, it destroys money. It causes a credit crunch and intensifies the recession. This is why we are facing a global slowdown."

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Gini coefficient of national income distribution around the world (using 2009 data)

(image courtesy of Wikipedia)

The world is a very rich place with a lot of money sitting on the sidelines, especially in corporate treasuries. Like it or not, regardless of one's political perspective, growth will mean income redistribution between individuals, and states. In the past decade, both income and assets have followed a top-heavy migration to the very rich. The Gini coefficient, a measure of the distribution of wealth, is showing income inequality in the US as record levels. The middle class in the developed world has found itself squarely in the hairs of the crossfire, with less money to spend.

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Kuznet's Curve (image courtesy of Wikipedia)

One of the great debates in economics is the relationship between income inequality and growth. Kuznet's Curve describes the situation in which things get worse in terms of income inequality prior to industrialization, after which things get better and everyone gets their fair share. However, this promised U-curve doesn't seem to be working now, and is causing a rip in the fabric of the social contract to allow temporary unequal distribution in order to attain overall prosperity in the long run. The volume of railing against the lucky 1% and attendant civil unrest continues to grow. As José Gabriel Palm at Cambridge University writes, "the statistical evidence for the 'upwards' side of the 'inverted U' between inequality and income per capita seems to have vanished."

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This has profound political implications. Guardian economic commentator Stewart Lansley points out the dangers of income inequality in Britain and the U.S.:

The economic orthodoxy of the past 30 years holds that a stiff dose of inequality brings more efficient and faster-growing economies. It was a theory that captured the New Labour leadership in the UK - as long as tackling poverty was made a priority, then the rich should be allowed to flourish.

So have the architects of market capitalism been proved right? The evidence says no. The wealth gap has soared, but without wider economic progress. Since 1980, UK growth and productivity rates have been a third lower and unemployment five times higher than in the postwar era of "regulated capitalism". The three post-1980 recessions have been deeper and longer than those of the 1950s and 1960s, culminating in the crisis of the last four years.

The main outcome of the post-1980 experiment has been an economy that is much more polarised and much more prone to crisis. History shows a clear link between inequality and instability. The two most damaging crises of the last century -- the Great Depression of the 1930s and the Great Crash of 2008 -- were both preceded by sharp rises in inequality.

Today we have a prime example of a country that has progressed from almost perfect equality to huge income spreads, particularly between its urban and rural populations -- China. However, the country's growth rate has begun to slow just as the Chinese Gini coefficient hit U.S. levels, creating a wealth gap. The ensuing possibilities for instability there are not lost on China's leaders who have continued to suppress dissent. In any discussion with Chinese policymakers, the phrase most likely to reward one with a spirited response is "income inequality."

This leads me back to the problem of Europe, or rather the European Union. The EU was itself an effort to mitigate political risk, particularly, the risk of war between its member states and maximize economic opportunities. The risk of military conflict does in fact seem remote, but another kind of conflict has taken its place. Political sacrifices will have to be made to solve the current crisis, but this seems unlikely. As Ambrose Evans-Pritchard writes in the Telegraph:

Germany can break the logjam at any time by agreeing to fiscal union, debt-pooling and full mobilization of the ECB, with all that this implies for its democracy. The answer from Chancellor Angela Merkel over the weekend was 'under no circumstances'. In that case, prepare for the consequences.

Germany and France might have a socialist bias, but for its own citizens. Germany continues to view Greece's crisis as a moral issue, which it is not, rather than as a problem of redistribution of income, which really means taxation. EU taxes are a mere 1 percent of European GDP, but federal (not state) taxes in the U.S. make up about 20 percent of GDP. When we pay federal income taxes, citizens of my home state of Illinois know full well that not all of the proceeds will be used within our borders. We know in fact that these funds will be spent as allocated by Congress in poorer states such as Alabama and Mississippi. We accept this as the price of our federal system, our national union. The underlying promise is that we all benefit as a country. Our elected representatives have to work out how much is spent for each particular part of the budget. This is a contentious rather than harmonious process, and we might face a failure of these negotiations in the near future. But the policy debates are more along the lines of defense spending vs. entitlement programs, rather than state or geographic borders. They don't threaten the union itself.

In fact, they once did, but Alexander Hamilton played a role which was recently described by Thomas Sargent in his Nobel Prize lecture in 2011, entitled "United States Then, Europe Now." He says that the crisis Europe is facing today is similar to the crisis faced by the U.S. at its inception, but before the writing of the Constitution during the 1780's:

In terms of fiscal arrangements, the EU today has features reminiscent of the U.S. under the Articles of Confederation. The power to tax lies with the member states. Unanimous consent by member states is required for many important EU-wide fiscal actions. Reformers in Europe today seek to redesign these aspects of European institutions, but so far the temporal order in which they have sought to rearrange institutions has evidently differed from early U.S. experience in key respects. The U.S. nationalized fiscal policy first, and for the U.S. framers, monetary policy did not mean managing a common fiat currency, or maybe even having a common currency at all. The EU has first sought to centralize arrangements for managing a common fiat currency and until now has not wanted a fiscal union. And to begin its fiscal union, the U.S. carried out a comprehensive bailout of the government debts of the individual states. So far, at least, the EU does not have a fiscal union, and few statesmen now openly call for a comprehensive bailout by the EU of the debts owed by governments of the member states.

In Europe however, this consensus for burden-sharing does not exist, and it is plain to see that the privileged are worried about sharing their wealth with their poorer neighbors. After all, the European Union is not a federation. It is a collection of countries with different cultures, languages, histories, and economies that use the same token as currency. The European Union budget as a proportion of the eurozone's GDP is clearly not enough to create the glue that would bind them all together in common cause. If the euro, or the European Union itself collapses, it will be a political rather than an economic failure, which is fair because it began as a political endeavor. A break-up would be more of an annulment than a divorce, because the conditions of marriage were not met from the outset. In particular, "for richer, for poorer, in sickness and in health" -- that promise was never made.

This article is based upon a recent blog for Yale Books London, "For Richer For Poorer: The European Union that Never Was".

What's Next? Unconventional Wisdom on the Future of the World Economy by David Hale and Lyric Hale is available now from Yale University Press.