Europe’s backfire of vanities
The European crisis started over two years ago, but so far measures to solve or even mitigate it have been ineffectual. Not that European leaders haven’t tried hard; recall the numerous “meetings of last chance” convened in 2011. However, in my view, solutions so far have not paid sufficient due to a fundamental economic rule: People react to incentives.
This is the also the core thesis of one of the bestselling books on economics in the last decade, Levitt’s and Dubner’s Freakonomics: “Politicians have all sorts of reasons to pass all sorts of laws that, as well-meaning as they may be, fail to account for the way real people respond to real-world incentives.”
The European toolbox to solve the crisis illustrates this claim almost perfectly, as can be seen with three prominent measures and ideas: the long term refinancing operations (LTRO) of the European Central Bank, the security market program (SMP) of the same ECB, and the austerity packages currently being implemented in several European countries.
The LTRO are loans from the ECB to European banks for three years at a rate of just one percent. The main aim of this lending program of over 1000 billion euros was to stabilize the banking sector. However, there was a second more implicit idea, which has gained the name of “Sarkozy trade” after the French president suggested last year that European banks could make profits by using the cheap loans to invest in the region’s government bonds. At first this seemed indeed to work; it reduced the interest rates of Spanish and Italian bonds. However, these interest rates have risen again by now, and banks which made such trades have suffered losses.
The SMP, the direct buying of European government bonds by the ECB, also lost much of its power when it became clear in the wake of the Greek default that any ECB bond purchase makes those bonds senior compared with the other outstanding bonds. So for example, if the ECB buys Spanish bonds now, those private investors still holding Spanish bonds become subordinated to the ECB, and hence these bonds lose value.
Finally, the austerity measures lost much credibility because they didn’t take into account that fiscal multipliers are larger than one. This means that if you want to cut your deficit-to-GDP ratio by 1%, you need to save substantially more than 1% of GDP and in some cases nearly 2%, because people react to the cuts, resulting in a growth drop, lower taxes, higher unemployment, etc.
Therefore, measures still in European institutional and national pipelines should be thought through very carefully. If not, they can easily backfire and ultimately even worsen the crisis.