Complacency and incrementalism are traps to avoid
Against a backdrop of slow and diminishing growth forecasts, recent months and especially recent weeks have seen an extraordinary level of financial drama. While not rising to the level of the systemic global crisis of 2008, or the period of great uncertainty in the late 1990s around the Asia-Russia-Brazil-Long-Term Capital Management crises, markets everywhere seem to be thwarting political aspirations.
Greece’s relationship with the euro area has been a financial soap opera for months, and it is one that is unlikely to end anytime soon. Concerns about German dominance of Europe are now more salient than they have been at any time in the past 70 years.
China’s stock market has been a rollercoaster despite — or perhaps because of — a remarkable (even for China) level of government involvement. And the ability of the Chinese government to deliver the rapid growth on which its legitimacy increasingly depends is very much open to question.
In the US, while the fiscal picture at the federal level appears healthier than it has in a long time, thanks to a marked slowdown in healthcare costs, Puerto Rico is on the brink of the largest municipal bond default in American history.
Tolstoy observed that all happy families are alike but each unhappy family is miserable in its own way. In the same way, each of these situations is driven by its own dynamics. But their concatenation does warrant reflection on some common lessons for financial policymakers and their political masters. Two stand out.
First, there are economic laws like there are physical laws and, as with physical laws, economic laws do not yield to political will. The financial crisis, the great recession and sharp increases in inequality have all properly led to a negative reassessment of the functionality of unfettered free markets. It does not follow, however, that governments can bring about economic outcomes they prefer by fiat. Greece’s problems, of course, relate to the failings of Greek economic policy. But it should come as no surprise that a fiscal contraction in excess of 20 per cent of gross domestic product in an economy that does not have the freedom to loosen monetary policy or to devalue its currency leads to depression, even if policymakers wish otherwise.
Famously, while you can fool all of the people some of the time and some of the people all of the time, you cannot fool all of the people all of the time. In the same way, markets may well be inefficient and diverge from fundamental value, and they may well be subject to government manipulation for significant intervals, but it is a foolish government that supposes it can indefinitely maintain speculative prices at politically convenient levels, as the Chinese authorities may soon discover.
Likewise, if a default cannot be managed, it is tempting to assume that it cannot occur. This is an obvious fallacy demonstrated most recently by European insistence in 2010 that Greek debt would never be restructured. It dangerously invites complacency on the part of creditors and leaves debtors with such large overhangs that they have little motivation to carry out constructive reform.
Second, fundamental imbalances and problems require fundamental solutions. In all spheres, the temptation to incremental policymaking is enormous. Incrementalism is less politically jarring; it preserves flexibility for the future in an uncertain world; it usually requires less admission of past error; and it gives the appearance of prudence. Yet the American experience in Vietnam should be cautionary to those inclined to yield to the temptation of incrementalism. At every step, policymakers did enough to avoid disaster but not enough to offer a prospect of success — until the moment when helicopters left the Saigon embassy and US policy ended in failure.
Financial problems are in some combination always about two things — arithmetic that does not add up and a loss of confidence. Incremental steps that provide some but not large sums of assistance, that postpone but do not reduce scheduled debt payments, and that defer decisions about the future to the future run the constant risk that they will not bring convincing arithmetic into view and will be insufficient to restore market confidence.
There are dozens of examples in financial history when an exchange-rate peg was maintained too long, or debt was restructured too late, or forbearance was carried out for too long. I can think of none where strong action came too soon. Clear-eyed, bold action is what the world requires if the financial drama is to subside. Let us hope against much of the experience of recent years that it will be forthcoming.
The writer is Charles W Eliot university professor at Harvard and a former US Treasury secretary