For the last century, economic-policy debate has beenlocked in orbit around the respective roles and virtues of the state and themarket. Does the market control the state, in the sense that it sets a limit ongovernments’ ability to borrow? Or does the state take charge when the marketfails to perform socially necessary functions – such as fighting wars ormaintaining full employment?
This old debate is at the core of today’s profounddivisions over how Europe should respond toits debt crisis. The same question is dividing American politics in the lead-upto November’s presidential and congressional elections.
During the two decades prior to the financial crisis, mostpeople – including most politicians – assumed that the market was supreme. Now the intellectual pendulum may be swinging back to the belief thatstate action can mop up markets’ messes –just as veneration of the state in the 1930’s followed market worship in the 1920’s.
Two decades ago, judiciousEuropean politicians looked for a “third way,” steeringa zigzag course between the importance ofmarket mechanisms and that of other social priorities, according to which themarket needed to be directed. For example, when the Delors Committee preparedits reportin 1988-1989 on how a monetary union could be established in Europe, experts devoted considerable attention to theissue of whether market pressure would sufficeto discipline states. Many warned that it would not – that bond yields mightconverge at the outset, permitting spendthrift countries to borrow more cheaply thanthey otherwise could.
The result of the debates of the early 1990’s was a set of rough and ready rules ondeficits and debt levels that was never taken quite seriously. Economistsmocked them and Romano Prodi, the president of the European Commission at thetime, called them “stupid.”
Until the second half of 2008, Europe seemed to havereached fiscal Paradise:the market did not differentiate between eurozone governments’ bonds. Someassumed an implicit debt guarantee, but that was always implausible, given thatthe Treatyon the Functioning of the European Union explicitly ruled it out. Rather, investors’ undividedconfidence in all eurozone borrowers reflected something else – a generalbelief in the capacity of rich countries’ governments.
According to this view, advanced countries have a greaterdegree of fiscal sophistication. They are always able to raise tax rates inorder to service their debt. In poorcountries, by contrast, powerful vested interests oftenresist higher taxes on the wealthy, and widespread poverty makes it difficultto impose universal consumption taxes on the poor.
That lesson was reinforced by the experience of countlessdebt crises in peripheral countries, the most destructive of which hit Latin America exactly 30 years ago, after ecstatic borrowing fueled economic booms.Sometimes these were simply consumption booms – whether for households or formilitary outlays and presidential palaces –and sometimes they were investment booms, though much of the investment hadbeen misallocated as a result of politicalpriorities.
The novelty of the world since 2008 is that, for the firsttime in more than a generation, advanced countries are experiencing debt crises– and starting to look like poor countries with weak institutions. Was thisjust a peculiarity of the eurozone, in whichsovereign countries did not control their own currencies?
Europe’s debt crisis has produced a profound division of political – andalso economic – opinion. Those who emphasize the historical uniqueness of Europe’s monetary solution insist that other countries –which control their own monies – could not possibly fall into such a predicament. Here the statistthesis is reflected in its boldest form:there cannot be a bond strike in the United States or the United Kingdom, because theircentral banks have at their disposal the full panoplyof policy tools – including unconventional operations – needed to ensure thatdebt is monetized.
That theory runs counter to muchhistorical experience, as well as to the prevailing approach to central bankingthat emerged in the 1990’s.According to that view, investors punish profligatestates by demanding higher interest rates to hedge against the likelihood ofinflation; so the best way to ensure low borrowing costs is to give centralbanks as much independence from politicians as possible, and then make pricestability their primary mandate.
The European Central Bank is probably the most perfectexpression of this philosophy. Its independence was secured not only bynational legislation within the member states, but also by a treaty betweenthem. Treaties are more binding than national legislation, because they aremore difficult to revoke, amend, or repeal.
Because the debts of the large industrial borrowers – the UK and the US – are externally financed, theargument that their governments can always monetizedebt is not convincing. A moment may come when foreign investors do not believethat their sterling or dollar assets areprotected against inflation, and at that point their willingness to holdlow-yield sterling and dollar assets will end.
The thinking behind the 1990’s approach to monetary policy is stillfundamentally valid, but it requires institutional strengthening. It would bebetter to stop the twentieth-century ideological pendulumand return to some older precepts. Both states and markets work well only whenadequately enforced legal rules provide the necessary certainty.