Did a lack of accountability doom the euro area?

Long post today – written fast

TH has been wondering whether institutional arrangements in the Euro area encouraged the European governments to run up bigger debts. So he turned to the literature and was serendipitously pointed to a nice paper by Stephen Ferris,  Bernard Grofman and Stan Winer on just the topic (except it happens to be on Canada and not the Euro area).

The authors’ basic hypothesis is that the institutional arrangements that govern how a nation decides to issue more debt is important. The authors reckon is that when a government is constrained by institutions that keep its decision makers accountable, then debt will be kept to levels that are more easily sustained. For example, they argue that Canada’s Westminster style system helped to keep Canadian debt levels sustainable because, when it comes to the size of Canada’s deficit and debt, the buck stops with the Prime Minister, who in turn is held to account by the voters.

Unfortunately, Ferris et al. can’t test the Westminster hypothesis directly with their data, so they test a bunch of related hypotheses like “did the establishment of the Bank of Canada increase Canada’s debt?” The idea being that, if you have a central bank that can finance the government’s budget by printing money, then it reduces the incentive of the Department of Finance (i.e. the Treasury) to be careful about running deficits and racking up larger debts.

Interestingly, the authors find that, in Canada, this was likely the case. Debt levels were somewhat boosted by the establishment of the Bank of Canada. Even more interestingly, they find that when the mandate of the Bank was narrowed to keeping inflation low and stable, that Canada’s government debt levels fell to more sustainable levels. TH reckons they would find much the same for Australia and New Zealand.

A similar argument has been made in relation to a country’s banking systems. For example, George Fane, argues that countries with currency boards (such as Hong Kong) will have banking systems that take less risk because they know that, if they get into trouble, they won’t be able to rely on lender of last resort loans from the central bank.

All well and good except for one BIG real world experiment (economists rarely get to experiment with the real world, so we get excited when it happens in a big way). In 1999, a bunch of European governments abandoned their central banks in favour of the ECB. According to Ferris et al, the governments should have responded by implementing budgets that would bring debt levels down to more sustainable levels and banks should have taken less risk.

So what went wrong? Perhaps nothing – maybe the argument holds up. With respect to Europe’s banks, they knew that the ECB would stand ready to act as lender of last resort (LOLR) to them, even if it wasn’t willing to fund governments, so the absence of a true national central bank didn’t really change things for them. Moreover, given that regulation of banks was taken at the national level, while LOLR lending would be taken at the supra-national level, there would always be some confusion between the regulatory authorities as to who should provide regulatory guidance to the banks (i.e. should it be the national government or the ECB?). Worse, the national government bank regulators may well have recognised that, if a banking crisis happened, the cost of ECB LOLR lending would be shared over the whole of the Euro area, which would have reduced the incentive for the national regulators to regulate well.

What about euro area governments? Before the crisis, although the euro area governments clearly failed to coordinate their fiscal policies as they had planned to do (all the major players violated the Maastricht treaty) they may have believed that, if push came to shove, policies would be coordinated if they had to. That is perhaps they believed that if one country found itself having to make a substantial fiscal adjustment as Canada (and Australia and New Zealand) did in the 1990’s, the others would run expansionary policies to accommodate. This moral hazard problem could have encouraged excessive deficits.

The other possible reason, related to the above, is that the ECB is a relatively new institution and its credibility had not really had a chance to be tested. So, for the euro area as a whole, perhaps accountability was reduced by the establishment of a supra-national central bank to serve many governments that lacked institutions to promote fiscal coordination in the same way that Ferris et al think a Westminster system increases it.

Having said all that, it is interesting the Christine Lagarde recently called for the ECB to partially cover the costs of a possible Greek sovereign default. If the ECB does, then the hypothesis that weak institutional accountability arrangements tend to cause debt levels to become more unsustainable will have been validated. Maybe they have no choice anymore.


6 thoughts on “Did a lack of accountability doom the euro area?

  1. Torrens,

    I think accountability is at the heart of the euro crisis — but not necessarily in the sense you identify. The architects of the euro zone fashioned a new monetary structure for Europe for the noblest of reasons: to purge the scourge of warfare from the European continent once and for all. Its hard to argue with that.

    The funny thing is, though, they didn’t consult with their citizens; indeed, while I could be wrong, I suspect, their thinking went along the lines:

    1. Europe is not an optimal currency area (OCA);
    2. The people of Europe are unlikely to agree to the structural reforms that are required to transform Europe into an OCA;
    3. Never mind, if we pursue monetary union, the costs of not following through would be so great, that the status quo bias will be broken;
    4. Err, thats it.

    So, they now have a monetary union between sovereign nation states at fundamentally different levels of economic development and comptetiveness, many struggling with high public debt and a lack of policy instruments to deal with declining growth. The only way out for these countries in crisis, we are told, is through structural reforms. In these circumstances, the people may indeed accept structural reforms. But, then again, they may not, particularly if the costs of perservering are considered too great and those that could help ease the pain are unwilling to do so.

    It is similar to a situation in which architects have designed a beautiful new addition. The renovations are nearly completed — except, say, for the roof. Winter is coming on, and there is a dispute over who will pay the costs of completing the renovations.

    Shouldn’t there have been an agreement on the nature of the job and the terms of payment before ground was broken? Who do we hold accountable for the disruption that has already occured and for the greater disruption that might yet come?

    Ricardo Smith-Keynes

    1. Welcome to the forum RSK (or is it RiSK?),
      TH has a confession to make, when the euro area was being formed he was, well to be blunt, a hermit. Now he reads with fascination about the ERM and its great failings. He doesn’t understand how Italy ended up with the euro but the UK successfully avoided it. They both were ERM failures (OK, so, he understands, was much of Europe). Was it that the memory of war was more intense in Italy? Was it that Italians didn’t didn’t watch Sesame Street? Was it just because they didn’t wnant to be leftout? He knows that there are some rumours that countries with a common currency never fought a war (or something like that, maybe TH is confused, and he ceratinly doesn’t know if the rumours are true — but a quick back of the brain mental regression finds that having a single currency seems to be very significant in explaining CIVIL conflict (along with other variables such as ethinic divide, etc.). Was it a con job? Torrens doesn’t know because he was buried in a bunker. So he defers to your infiite wisdom on these matters — your explanation seems quite likely right and it is nicely parsimonious — especially point 4!

      But having thought about it, Torrens thinks he is in full accord with you, RSK. The instutional failing was that they didn’t have a contract. Specifically, a treaty for true fiscal federalism that was enforceable. The half baked one that they did have (Maastricht) was only enforceable by, …, umm what do you call it when you have nothing to enforce an agreement with …, oh that’s right, PEER PRESSURE! The only peer pressure in europe 8 years before the crisis seems to have been to violate Maastricht (“Hey, Italy, we’re going to miss our MAastricht targets, its wild, why don’t you do it too? Don’t worry, I hear the ECB has lots of cash if we need it.”)

      TH is ranting here, but thinks there is a meeting of minds, somehow Europe got itself into a bind (literally). THe question is why did the Treasuries get it so wrong, why didn’t they realise that if ever they needed to make a large fiscal correction there would be no depreciation to ease the economic adjustment, no central bank to lower interest rates in response to their specific need? Why did they respond to the great moderation by violating Maastrict rather than reducing debt? Does a commmon currency combined with independent fiscal arrangements doom you to a race to the bottom, rather than a race to the top? Or was it just bad luck?

      TH doesn’t know but thinks that if the experiment is going to work, it will need countries to cede sovereignty to a supra-national agency that is democratically accountable, and able to overcome coordination failures amongst its membership and its institutions — that he thinks is the lesson from the Ferris et al paper.

      (And, Who worries about long posts on their blogs anyway!!)

  2. TH,

    I don’t know either, but it seems to me that there are two possibilities. Either the “Guardians” of the EMU (hat tip: JA) didn’t contemplate failure or they reckoned that the risk was worth taking in order to achieve a greater good. Without prejudice, I’m inclined to the latter (the original “architects”, after all, were highly intelligent men). Think of it in terms of dynamic inconsistency and policy games — at the outset of the process, EZ citizens had a choice: either do the structural reforms that were required to make the experiment work or suffer the costs of crises. Is too far fetched to imagine that they overestimated their abilities to convince their fellow citizens to undertake the needed reforms?

    Ricardo Smith-Keynes

  3. Agreed. Life is risky and you have to take chances. It was a great and bold action and they did what was simplest first, but unfortunately that might have been a serious miscalculation. That said, I think many of us underestimated the importance of monetary arrangements. Its a lesson we shouldn’t forget.

  4. Torrens: Agreed (and thanks). Doing the “easy” bit (monetary union) was a way of precommiting to the hard stuff (structural reforms).


    1. RSK, a good friend once told TH a tale from Homer’s Odessy (oh the Irony that it should be a GREEK tale):

      “As we departed Circe’s Island, she warned me of the impending danger ahead as we passed the island of the Sirens . She instructed me to plug up all of the ears of my crewmen and to have them tie me to the mast as the beauteous melodies that came from the Sirens cast a spell over those who hear it. Their tunes cause men to thrust themselves overboard into the sea and ultimately to their death.

      I vowed to myself that this would not be the fate of my crew. I obeyed Circe’s advice and filled all of my seamen’s ears with wax. They then bound me to the mast tightly. I instructed them to keep me tied up, even if I begged and pleaded with them to untie me. The Sirens weren’t going to get another ship.

      As we sailed by, I became desperate to lunge into the sea, but my crew obeyed my previous orders and just pulled me tighter to the mast. Then, as we sailed away, the music becoming fainter, I gave the signal to unseal their ears and untie me. We had conquered the Sirens.”

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