The Eichengreen Paradox

This does not refer to an observation about international political economy but Barry Eichengreen himself. He seems like a very nice guy and also very smart. He is well-read and has an unusually broad understanding of history and politics. His views on any topic other than economics are insightful and valuable. But when the subject turns to economics proper, he displays a hidebound, and perplexing, orthodoxy.

This paradox is on full view in a short interview with him posted on Five Books. He really understands the politics of the euro, how it is rooted in the reaction to two world wars and the shaped by the national cultures of its leading players. He recognizes that countries like France and Germany have institutions that are superior in many ways to those in the US. I can’t think of anyone I would trust more to take the pulse of decision-makers in the Eurozone. And his economic advice is woefully insufficient.

Read the interview for its many virtues, but, in the meantime, consider where Eichengreen ends up. He makes three proposals going forward: less populist national fiscal policy institutions (quasi-autonomy for fiscal policy the way autonomous central banks are supposed to do monetary policy), stronger euro-wide financial regulation, and a permanent resolution authority along the lines advocated by Germany. Numbers two and three on this list are OK, number one is misguided, and package as a whole is not remotely up to the job.

Without getting into an argument over Keynesian versus deficit hawk fiscal priorities, it should be clear that national budget profligacy was not a factor in most of the countries now facing financial distress. Ireland and Spain in particular had the most orthodox of fiscal policies, but here they are, sinking into the morass of fiscal insolvency. Nor is the failure of financial regulation the factor that separates the objects and subjects of bailouts. Germany too has had its share of banker rule-bending and incompetence (Hypo anyone?), but it has been spared the pity of its neighbors.

The truth is, the countries facing disaster are those that ran large, persistent current account deficits during the past decade. They accumulated enormous private debt, and fiscal freefall is the response to the souring and freezing of this debt: the public sector is leveraging so that the private sector can deleverage. Because of the euro, currency adjustment is unavailable.

Why, you might ask, doesn’t the US face the same dilemmas at the state level? As Paul Krugman has asked, what’s the difference between Ireland and Texas (other than about 30 inches of rain)? There are two answers. First, if a region within the US has a significant trade deficit with other regions—if its industries languish while others forge ahead—its incomes fall and people and jobs relocate. This is difficult in Europe because of linguistic and cultural differences. Second, we have a common fiscal authority which, as a matter of routine, transfers income between regions with domestic surpluses and deficits. The absence of this in Europe, the fact that there is a single central bank but no common Treasury, has crippled its response to the crisis.

With other avenues closed—large-scale migration, fiscal integration, exchange rate adjustment—there is only one remaining degree of freedom. Deficit countries within the Eurozone must either rebalance through austerity or sustain their growth through public and private borrowing. But restoring balance, much less paying down past debts, is nearly impossible through austerity alone. The arithmetic, which tells us that the amount by which national income must fall equals the deficit reduction target divided by the marginal propensity to import, is frightening. But that’s where peripheral Europe is headed unless there is a much more aggressive program than Eichengreen is willing to contemplate.