Thinking about Euro Zone

The Euro Zone

We read of the European financial negotiations as if they were between the chiefs of government of Germany and Greece (or whatever country is financially wounded at the moment). While that image is a convenient vehicle for television news it seems misleading.

As I see the situation, the Euro was created as a common currency for 17 European Union members, but no system was created to assure common fiscal policies among those countries, nor common regulatory standards for the national banking systems. As a result, some countries have gone into debt or allowed their banks to fail, putting pressure on other countries to bail them out. Indeed, there is even the possibility that the "bad behavior" of some governments may draw the entire Euro region into financial crisis and recession.

The issue seems often to be presented as whether Germany should negotiate with Greece a set of financial reforms that is less draconian than those which were negotiated last time and thus more acceptable to the Greek people, or whether it should hold firm as would be more acceptable to the German people. A recent article in The New Yorker describes the possible negotiation in terms of the concepts of fairness as seen from Germany and from Greece. The article uses as an example, the experiment in which a sum of money is offered to two subjects; the first decides how the sum would be divided between the two, the second decides whether to accept or not. It has been found that if the division is seen to be unfair by the second subject, he/she will reject it sacrificing the money himself/herself in order to deny it to the first subject as a penalty for acting unfairly.

I would point out that the best strategy for each subject will depend on whether the decision is a unique simple experience or one of a series of similar decisions. It may make financial sense to discipline unfair divisions early in a chain of decisions if that encourages more fair allocations later in the series. Thus Germans might rationally choose not to renegotiate if it perceives the current crisis as caused by unfair behavior of Greece and as potentially the first in a long series of decisions in which Greek governments may chose to act fairly or unfairly with their German (European) bankers.

Moreover, we hear not only of Greece, but of similar problems in Ireland, Portugal, Spain and Italy. Thus Germany, which has pursued strict fiscal responsibility since the reunification of East and West Germany (with considerable sacrifice of the German citizens), faces not only negotiations with one other nation, but the perception that how it acts with respect to Greece will influence expectations of the other 15 Euro zone nations.

I would expect the chiefs of government of the European Union to take the long term view and consider the overall complexity of the European Union. Indeed, a head of government will have a Minister of Finance reporting to him and a committee of economic advisers whose job will be to bring to his/her attention just such a comprehensive view of the economic and financial decisions. Still, people are people and will think with their brains and emotions as well as their "rational minds".

Moreover, in the European democracies, the party politics of the legislative branches have great impact on the national economic and financial policies, as do the perceptions and voting of the citizens. Thus a chief of government while establishing a negotiating posture is doing so in terms of what he/she thinks is feasible in terms of legislation and acceptable to the public. The leader is sometimes wrong, finding that the negotiated terms finally achieved are repudiated by the nation he/she has led. Even if a politician does not feel that his/her defeat in the next election is the worst catastrophe that could occur, it is rational to negotiate toward solutions that will not be rejected by their own nation.

And of course, the decision making is done under conditions of ignorance and uncertainty. As has become obvious, no one knows in detail all of the risks involved in the current situation. Even when bankers or politicians are not deliberately obfuscating the current dangers, the information systems are not adequate to make them known. Moreover, economists differ as to the right solutions. In the modern global system, even the Euro zone is so influenced by policies and events in other regions that it is not "master of its own destiny". The crash of the U.S. housing market and its implications for the global market in mortgage derivatives has had great impact in Europe, as Euro zone problems may have impacts in North American and Asia.

It would seem that the European Union should move toward a more complete federal union, with a common fiscal policy and common strong banking regulation. I think about how difficult it has been for that to happen in the United States. It was not until the demands were felt by the Union political leaders for financing the Civil War (in the absence of the southern leaders from Congress) that this country began to withdraw from the states the power to authorize state banks to issue currencies and created a national bank. Even today, we find the individual states cutting budgets while the federal government is following Keynesian policies to stimulate the economy. It will be hard to get European politicians to give up power to the federal government, and harder still for the citizens of those countries to support their politicians in doing so.

Not surprisingly, television talking heads don't make sense of this complexity in the minute sound bites devoted to Euro zone economics on the evening news.