The recent subprime meltdown in the US and the ongoing euro zone crisis will probably be recorded as classic studies in contrast. The diametrically opposite policy responses to these two events, both of which generated systemic risks, reflect a deep ideological divide—intervene swiftly and massively to limit damage, or let the dynamics of the free market play itself out. They also point to the profound limitations of macroeconomic policymaking and the lack of unanimity among policymakers in effectively responding to such macroeconomic crises.
Illustration: Jayachandran / Mint
Replace Greece with AIG, Portugal with Wells Fargo, Italy with Citibank, and Spain with Bank of America. The European Commission and the European Central Bank (ECB) could substitute for the US treasury and the Federal Reserve. The striking similarities between the two events do not end there—overleveraged Wall Street firms are comparable to debt-laden peripheral European economies: These firms posed the “too-big-to-fail” challenge, whereas the economies pose the “too-interconnected-to-fail” problem. Both crises have triggered existential issues for Wall Street and the European Union (EU), respectively.
However, while there are striking similarities in the problems facing them, the remedial actions taken by policymakers could not have been in starker contrast.
In response to the credit freeze that followed the subprime meltdown, the Fed as well as the Bush, and then Obama, administrations moved swiftly to contain the crisis. They hurled every available policy option at the problem in an effort to “shock and awe” financial markets, and the Fed emerged as a lender and insurer of last resort. Even though the bailout programmes changed course repeatedly, were characterized by much confusion and lashed by widespread criticism, the central thrust of bailing out beleaguered financial institutions remained a constant.
It is by now widely acknowledged that the magnitude and swiftness of that response have been responsible for averting a disastrous, long-drawn meltdown of financial markets and have also ensured that Wall Street returns to a semblance of normalcy quickly.
In contrast, till the just announced trillion-dollar joint EU-International Monetary Fund rescue package, the response to the euro zone crisis has been marked by indecision, a stubborn refusal to confront reality, and a reluctance to commit any assistance other than the barest minimum to keep Greece afloat. ECB has been virtually paralysed, primarily by its own ideological reluctance to carry out any monetary expansion for fear of stoking wildly illusory (given the anaemic economic environment) inflationary pressures.
Moreover, unlike the Bush and Obama administrations, the German and French governments have shown greater willingness to let Greece fail (or at least face the consequences of its sins), strongly rationalizing against picking up the tab for its indiscretions. This is all the more surprising, given the fact that any Hellenic default could devastate Germany and France’s massively over exposed banks. A recent report in The New York Times pointed out that the German, French and British banks own $700 billion, $910 billion and $420 billion, respectively, of Greek, Spanish, Portuguese, Italian and Irish debts. Therefore, letting Greece default and force a “haircut” (reduction in principal repayment) on its bondholders would be tantamount to cutting the branch while sitting on it.
As economists such as Paul Krugman have argued—pointing to the decade-long asset bubbles, wage and price increases in these economies financed by foreign capital inflows (with the resultant erosion of external competitiveness)—the origins of the euro zone crisis go much beyond the large national debt burdens. The Growth and Stability Pact governing the macroeconomic management rules of euro members and the single currency have meant that individual members do not have access to any of the conventional macroeconomic stabilization tools—such as lowering rates, stoking inflation, or even devaluation—to address such crises.
The euro crisis, therefore, underlines the ineffectiveness of economic union in the absence of greater wage flexibility, labour mobility across members, and political integration. It also highlights the institutional vacuum within the EU and the importance of a strong central coordinating power and fiscal authority, and the need for a more powerful ECB with greater willingness to aggressively manage crises. Some have suggested setting up a European Monetary Fund to combat debt and balance of payments crises among members.
In any case, both these events are testimony to the fact that the cascading effect of investor panic and crashing market confidence can be far more damaging than any concerns of moral hazard and dangers of “socializing private losses” generated by swift taxpayer-sponsored bailouts. Once the crisis breaks out, a delayed response will only let things slip further and leave policymakers to traverse a path both longer and more risky before some normalcy can be restored.
In fact, it is now certain that the costs to everyone of the inevitable default-cum-bailout of Greece will be much more than what would have been required if a large enough debt restructuring bailout had been executed earlier. The delayed response has also amplified the contagion on other beleaguered peripheral economies, as reflected in their rapidly increasing bond yields. In the circumstances, even the latest bailout may prove inadequate.
Gulzar Natarajan is a civil servant. These are the author’s personal views.
Comments are welcome at firstname.lastname@example.org