Saturday, April 24, 2010

A free society means a fair one

Classical liberalism states that markets under perfect liberty will lead to perfect equality. Adam Smith observed, however, that the 'invisible hand ' would not warrant this end and should not be understood as a pure self-regulating mechanism. The metaphor was used in his Theory of Moral Sentiments, to explain the distribution of wealth (1759, p. 350) : 'The rich ... consume little more than the poor, and in spite of their natural selfishness ... They are led by an invisible hand to make nearly the same distribution of the necessaries of life, which would have been made, had the earth been divided into equal portions among all its inhabitants, and ... advance the interest of the society, and afford means to the multiplication of the species"
Contrary to common misconceptions, Smith did not assert that self interest necessarily brings benefits to the whole society, or that all public goods are produced through self-interested labour. His proposal is merely that in a free market, people usually tend to produce goods desired by their neighbours. The 'tragedy of the commons', applied for example to world natural resources,' is an example where self-interest tends to bring an unwanted result.

Moreover, a free market arguably provides numerous opportunities for maximizing one’s own profit at the expense (rather than for the benefit) of others. The tobacco industry is often cited as an example of this: the sale of cigarettes and other tobacco products certainly brings a very good revenue, but the industry’s critics deny that the social benefits (the pleasures associated with smoking, etc.) can possibly outbalance the social costs.

Adam Smith observed that throughout history we find "the vile maxim of the masters of mankind": "All for ourselves, and nothing for other People." He explains that the unproductive class prefers to devote part of the rent to luxury goods rather than provide 'subsistence to a thousand during a year'.

Free societies call for justice. A.Sen explained that freedom is not merely being left to our own device. It also requires that people have the necessary resources to live a decent life. In his recent book**, A.Sen develops a new idea of justice in opposition with the institutionalist vision of John Rawls, Kant and J.J. Rousseau who are engaged in a “long-range search for perfectly just institutions”, and a hunt for “spotless justice”. For Sen, these philosophies are ultimately regressive, because societies full of actual human beings will never agree on a final, perfect set of institutions and rules. More immediately, the search for a perfect set of arrangements for society can distract us from tackling real-life, immediate injustices such as poverty and malnutrition, access to education for women in the developing world or action on climate change. The perfect becomes the enemy of the good.

The competing vision of justice Sen prefers is a “comparative” one, which examines “what kind of lives people can actually lead". For him, as for Condorcet and Stuart Mill, abolishing slavery or giving women the vote would free people to lead lives of their own choosing, even without creating a perfectly just society. The keystone of judging the lives people can actually lead is an assessment of what Sen has labelled their “capabilities” — or, as he explains, “the power to do something”.

The book deserves careful consideration and analysis. The key question is, however, that liberty and fairness are mutually reinforcing and lead to a more egalitarian society. But, we should not overlook what A.Smith said about the masters of mankind, the "merchants and manufacturers," using their power to bring "dreadful misfortunes" and in our day the big transnational l corporations and financial institutions that dominate the world economy, that control today trade, investment and finance above the power of the nation-states. It is the arrogance of these 'masters of mankind' that has led us to the current crisis and its awful consequences for the poor in terms of job losses and wages cuts.

I would like to quote here the great poem by Percy Bysshe Shelley, Ozymandias, which is an ode against tiranny and the course of time:

I met a traveller from an antique land

Who said: ‘Two vast and trunkless legs of stone
Stand in the desert. Near them on the sand,
Half sunk, a shattered visage lies, whose frown
And wrinkled lip and sneer of cold command
Tell that its sculptor well those passions read
Which yet survive, stamped on these lifeless things,
The hand that mocked them and the heart that fed.
And on the pedestal these words appear:
‘My name is Ozymandias, King of Kings:
Look on my works, ye mighty, and despair!’
Nothing beside remains. Round the decay
Of that colossal wreck, boundless and bare,
The lone and level sands stretch far away.

*An Inquiry into the Nature and Causes of the Wealth of Nations: A Selected Edition Adam Smith (Author), Kathryn Sutherland (Editor), 2008, Oxford Paperbacks, Oxford, UK

**The Idea of Justice by Amartya Sen
Allen Lane £25 pp496

Sunday, April 11, 2010

Germany is not a model for the euro area

Over the last few weeks, there has been a hot debate about the role of Germany in the light of the Greek debt crisis. Is it a model for the eurozone? The immediate answer would be no due to its obsession on monetary stability.
On Greece, the heads of government decided that 'as part of a package involving substantial international Monetary Fund financing and a majority of European financing, euroa rea member states are ready to contribute to co-ordinated bilateral loans"*. Then it continued ' Any disbursement would be decided by the euro member states by unanimity subject to strong conditionality and based on an assessment by the European Commission and the European Central Bank".
Germany, the most powerful euro area member country has imposed its views, but the final outcome was not shared by France, nor by the ECB which is contrary to any intervention of the IMF. But it is not clear whether this is a workable solution.
First, the fiscal consolidation of Greece looks unrealistic as it means reducing the deficit by 10 percentage points of GDP. Simulations made by several economists- including a french economist, Patrick Arthus- point out that a reduction of 1% in public spending causes a decrease in the budget deficit of only half point.
Second, Greece's problem is that it is paying too high interest rates and has a solvency problem. Even if loans will be provided at a 5 per cent rate, Greece should have access to financial markets.
We can understand the political argument that holders of Greek bonds will be reassured that the euro area will never let Greece fail. Why should Europeans accept default for Greece?
Last week's statement says that 'the current situation demonstrates the need to strengthen and complement the existing framework to ensure fiscal sustainability in the eurozone and enhance its capacity to act in times of crises. for the future, surveillance of economic and budgetary risks, and the instruments for their prevention, including the excessive deficit procedure, must be strengthened'.
The idea is that peripheral countries have a structurally weak fiscal position whihc reflects a lack of fiscal discipline (in the German sense). This is true of Greece and to a lesser extent of Portugal. But Ireland and Spain had strong fiscal positions, but weaknesses in private sector deficits due to the house bubble. That means that monitoring and surveillance should focus on the private sector, not only the public sector.
But in fact, the asset bubbles and credit expansion in the private sector in the periphery also reflects the absence of growth in the core. Honest economists must then acknowledge that the cause of the fiscal deficits is the result of the ECB monetary policy to accomadte the weak demand growth in the eurozone's core, and in particular in Germany.
German policymakers are not keen to discuss about weaknesses in global demand and other macroeconomic imbalances in the euro area. They wish to see a rapid reduction in fiscal deficits in euro area countries and this is why they insist on an 'improved economic co-ordination". the risk is that the eurozone might become de facto a big Germany with a structurally weak internal demand. Germany and other economies - like China- might find a way out through increased exports to emerging countries. For its structurally weaker partners - especially those burdened by uncompetitive production costs- the result would be years of stagnation or even deflation. Is this a model of economic 'stability'?
M.Wolf (FT March 30) argues that "the project of monetary union confronts a huge challenge. It has no easy way of resolving the Greek crisis. But the bigger issue is that the eurozone will not work as Germany wishes. As I have argued previously, the eurozone can become Germanic only by exporting huge excess supply or pushing large parts of the eurozone economy into prolonged slump, or, more likely, both. Germany could be Germany because others were not. If the eurozone itself became Germany, I cannot see how it would work. Evidently, Germany can get its way in the short run, but it cannot make the eurozone succeed in the way it desires. Huge fiscal deficits are a symptom of the crisis, not a cause".
As ancient Greeks said, we have the classical definition of tragedy: hubris (arrogance); ate (folly); nemesis (destruction).

IMF will not resolve Greece's crisis

The Greek crisis has divided the 16 eurozone member countries on possible course of action. President Barroso has made efforts to find a compromise on a macro financial assistance instrument which would be coordinated by the EU. Ms Merkel has finally imposed the IMF solution for pure internal reasons and against EU general interest. Though, recent events on financial markets show that the measures decided by the last European Council were not sufficient to provide a durable solution to Greek problems and thereby ensure a more stable governance of the euro area. It is at best a short term compromise for crisis management.

However, IMF aid will not help to resolve Greek problems. A closer look at Greece's economic indicators suggest that we are dealing more with a solvency problem rather than a liquidity one. Greece's public debt to gross domestic product ratio is approaching 120 per cent, its budget deficit has risen to 12,75 per cent and the economy has lost around 30 percentage points in terms of international competitiveness over the past decade. As Latvia and Ireland's recent experience suggests, attempting to bring Greece's budget deficit down towards 3 per cent of GDP limit by savage expenditure cuts and without a recourse to currency devaluation could result in a cumulative contraction in Greece's GDP by 15-20 per cent over the next few years.

At the same time, attempting to correct Greece's large competitiveness loss through deflation will necessarily involve an eventual decline in Greek prices and wages of around 20 per cent.

In that scenario- with a decline of GDP and a sharp fall of prices and wages- the debt to GDP ratios would then overshoot instead of decreasing. If this is plausible, one would then think than it would be better to pursue debt restructuring rather than the IMF kicking Greece down the road.

This means that EU leaders will have to design new (not tougher) rules for economic governance such as burden sharing allowing for temporary solidarity mechanisms for countries running high deficits, especially in times of global crisis.