Winner of the New Statesman SPERI Prize in Political Economy 2016

Monday 16 June 2014

Does politics dominate economics in Eurozone crisis management?

Athanasios Orphanides, leading academic macroeconomist and from 2007-12 Governor of the Central Bank of Cyprus, does not hold back in a recent paper. Here is just one quote: 

“During the crisis, key decision makers exhibited neither political leadership nor political courage. Rather than work towards containing total losses, politics led governments to focus on shifting losses to others. The result was massive destruction in some member states and a considerably higher total cost for Europe as a whole. European institutions could have been the last line of defense against this destructive dynamic but instead served to facilitate and enable the destruction.”

His complaint will resonate with many from the smaller Eurozone economies. The text of the paper suggests that the way decisions are made in the Eurozone allows large countries to screw smaller countries, for short term economic gain, even if this damages the Eurozone as a whole.

He focuses on two ‘blunders’. The first was the meeting between French President Sarkozy and German Chancellor Merkel in Deauville in 2010, where these leaders suggested that a haircut should be imposed on private sector lenders to solvent governments that got in to funding difficulties. Ireland lost market access for its debt within weeks. However Orphanides notes that German debt became less costly as a result.

The second was in 2013, when the Eurogroup decided to impose a haircut on deposits of Cypriot banks, insured and uninsured. Although the decision was almost immediately recognised as a blunder, Orphanides justifiably asks how such a blunder could have been made. He suggests that it can be explained by the forthcoming German elections, and a need for the government to appear tough. The result was the destruction of Cypriot banks, which in turn gave Germany leverage to end the low Cypriot corporate tax rate.

It has not escaped at least one reader of this paper that such decisions invariably favour Germany. This is not the message Orphanides highlights. The abstract says that the paper is about how politics has dominated economics in crisis management. But what exactly does that mean? And is it really the case that economics is blameless here?

Take the Deauville decision. It is true that this hardly helped calm market nerves at the time, although Ashoka Mody argues that its impact on spreads was not that great. However it does seem to stretch credibility that this was a deliberate ploy by Germany to reduce its own borrowing costs. If it was, did Sarkozy also think it would reduce interest rates on French debt? A much more plausible explanation for this blunder is that Germany wanted to reintroduce some form of no bailout regime into the Eurozone. This may indeed have been a clumsy attempt to do so, but the real culprit was the absence of any clear economic mechanism that would allow the Eurozone to distinguish between sovereign debt crises where default was unavoidable, and sovereign debt crises which represented a self-fulfilling market panic, where the government’s fiscal position was in fact sustainable if support from other governments or institutions was forthcoming.

This problem had not been addressed in the design of the Eurozone, under the pretence that the Stability and Growth Pact would mean that such issues would never arise. It has still not been addressed today: the problem has simply been shifted on to the shoulders of the ECB in consultation with governments, who have to jointly decide whether OMT will be invoked, and under what conditions. It remains unclear under what circumstances, if any, a Eurozone government will be left to default.

It seems quite reasonable to argue in this case that politicians are left floundering, and make the occasional blunder, because the economics of the problem have not been thought through. Orphanides argues that “the domination of politics over economics has led to crisis mismanagement.” I suspect this is a little unfair on politics, and far too forgiving on economics.  


  1. "Although the decision was almost immediately recognised as a blunder, "

    I absolutely don't agree that it was a blunder, and the fact that one year later, Cyprus has lifted all of its capital controls and is revising GDP forecasts upward, suggests to me that the deposit-haircut solution was the right one.

    What I do think was a blunder was a) Cyprus' decision to join the euro in 2008, when it was clear that its governance structures were going to work in the way they did, b) the decision by the supervisors to allow Laiki and BoC to expand their Greek lending as rapidly as they did, funded entirely by Russian hot-money deposits and c) the decision to allow the Cypriot banking system to double and triple up its exposure to GGBs, after Deauville.

    All three of these mistakes can be laid squarely at the door of Athanasios Orphanides, so while he may be a prominent academic and macroeconomist, I think people might be forgiven for placing a fairly large discount factor on his "someone else's fault" theories of the disaster he presided over.

  2. Well, duh, national politicians elected by their country's populations defended their country's interests. That's called democracy. You want to change that? Then the eurozone needs to go to a federal system, which is most easily achieved by making the eurozone equivalent to the EU and forcing out those members which don't want to adapt the euro (bye bye UK).

    I can understand why a Cypriot central banker wants to blame others; but a haircut on Cypriot banks was the right idea, and it was only revised because predictably the Anglo-Saxons put pressure on the continentals (led by the English papers with sob stories about English nationals who would lose some of their savings - well tough).

  3. If you remember, see Krugman blog March 20, 2013 'Round Trips to Cyprus', "Cyprus is, according to official figures, the largest single foreign direct investor in Russia — this from an economy roughly the same size as metropolitan Scranton PA."

    I sometimes watch RT, the Russian state English-language broadcaster, and at the moment, amongst other actions, their view is that the EU and the UK (it's Scottish arm)should both break up.

    If you want a political view of Europe, it is always better to start in 1914 than 1939 - and the Germans should remember that the EU has the spread of European representative democracy at its heart.

  4. "A much more plausible explanation for this blunder is that Germany wanted to reintroduce some form of no bailout regime into the Eurozone. "

    Their macro economic theory would seem to be on sound micro-foundations - especially in relation to moral hazard and incentives.

  5. First the criticism was that not letting for example Irish and Greek banks and/or governments default was in the interest of Germany and France as important creditors.
    But than there was Cyprus, and not surprisingly the argument changed from not defaulting is about saving foreign creditors to default is about ''shifting losses to others'' (read: Cyprus).
    You can't have it both ways. The truth is these criticisms are just sour grapes.


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