The Financial Folly of Fairness

When I was a young and naive economics writer, I used to write about developing countries a fair amount.  Time and again they would make these bizarre and pointless moves, like suddenly and for no apparent reason defaulting on a bunch of debt.  They would engage in obviously, stupidly unsustainable fiscal practices that caused recurring crises.  They would divert critical investment funds into social spending which was going to become unsustainable when underinvestment reduced government revenue.  And the other journalists and I would cluck our tongues and say "Why can't they do the right thing when it's so . . . bleeding . . . obvious?"

Then we had our own financial crisis and it became suddenly, vividly clear: democratic governments cannot do even obvious right things if the public will not tolerate it.  Even dictators have interest groups whose support they must buy.

This has come home to me forcefully several times over the last few years, but never more than now.  The leaders of the eurozone have a dual mandate to keep the euro intact, and to not do the things which could keep the euro intact.  They cannot fiscally integrate to the extent necessary because, as I wrote for the Daily the other day, the Greeks do not want to act like Germans, and the Germans do not want to share their credit rating with anyone who won't.

It is obvious that either Germany is going to have to guarantee massive ongoing fiscal transfers to the PIIGS, or Greece and probably Italy are going to have to undergo a massively contractionary austerity program, or they will have to leave the euro.  Yet in the face of these three choice--which exclude both each other, and any other mathematically possible outcome--their governments have chosen d: half measures.  No, half-measures is too generous.  Quarter measures.  Window dressing that only covers a single pane.

With Berlusconi's obviously counterproductive antics tanking markets worldwide, the sort of hopeful pessimism that has pervaded the economic commentariat has now turned to open despair.  Their cri de coeur is ably summed up by Brad DeLong:

I have been complaining for some time now that Reinhart and Rogoff think that the time is always 1931 and that we are always Austria--that the great fiscal crisis is about to erupt and send us lurching down toward Great Depression II. Well, right now guess what? The time is 1931, and we are Austria. The Federal Reserve needs to buy up every single European bond owned by every single American financial institution for cash before the increase in eurorisk leads American finance to tighten credit again and send us down into the double dip. The Federal Reserve Needs to do so now. Paul Krugman: >This Is The Way The Euro Ends: Not with a Bang, But with a Bunga-Bunga: [W]ith Italian 10-years now well above 7 percent, we're now in territory where all the vicious circles get into gear -- and European leaders seem like deer caught in the headlights. And as Martin Wolf says today, the unthinkable -- a euro breakup -- has become all too thinkable: >>A eurozone built on one-sided deflationary adjustment will fail. That seems certain. If the leaders of the eurozone insist on that policy, they will have to accept the result. >Every even halfway plausible route to euro salvation now depends on a radical change in policy by the European Central Bank. Yet as John Quiggin says in today's Times, the ECB has instead been part of the problem. >I believe that the ECB rate hike earlier this year will go down in history as a classic example of policy idiocy... the sheer stupidity of obsessing over inflation when the euro was obviously at risk boggles the mind. I still find it hard to believe that the euro will fail; but it seems equally hard to believe that Europe will do what's needed to avoid that failure.

For all my cynicism, I too want to cray out, "For the love of Mike, why?"

Why can't they do the any of the obvious things--not even necessarily the right ones?  Why are they picking the only path that is obviously not going to work?

But I come back to the answer above: they can't.  Government, like soylent green, is people. And people are not always rational.

The things that fix economic crises are not always intuitive.  As Brad De Long himself once remarked to me, it is nearly impossible to bail out the financial system without also bailing out people who are long assets--aka financiers and rich people.  But oh, how that flies in the face of our intuitions!  It should be true that the most prosperous system is the one which severely punishes everyone who didn't monitor the soundness of their investments.  We feel, very deeply, that financial and economic efficiency should mirror our intuitive sense of justice.  And probably it does, mostly, when you're living in a hunter gatherer tribe.

But in a complex world where mistakes are easy and detecting them is not, I just don't think this holds truet.  The "just world" described above is not some bourgeois paradise; it is the western world during the Great Depression.  It was not a better world for everybody; it wasn't even a better world for anybody that I can think of. After it had finished punishing people who made stupid decisions, it went on to wreak brutal vengeance on a lot of people who had been quietly minding their own business.  Bank runs can afflict the soundest banks, if depositors panic.

Life savings were wiped out overnight not because depositors hadn't done a good job of choosing a sound bank, but because they'd happened to choose a bank which had credit exposure to other banks that had credit exposure to other banks that were unsound.  Many of the most immiserated people were farmers who had quite innocently taken out the then-standard five year mortgages to invest in new farm equipment.  Only back then, mortgages didn't usually amortize--they were what we'd call "balloon mortgages" today--and the standard practice was to roll them over when the notes came due.  And when farm prices fell and credit dried up, they couldn't roll over those mortgages as they'd always done before, and they lost their farms. Then there were the people who had never had anything to begin with, and now had even less because unemployment shot up to 25% and they couldn't get the daily casual labor they needed to feed themselves.

The solution to the problem turned out to be throwing money at it: going off the gold standard, devaluing, and guaranteeing everyone's bank accounts.  Oh, yes, there was moral hazard.  There still is.  What there aren't, is bank runs that wipe out peoples' life savings overnight, or an unemployment rate of 25%.

One can name dozens of examples of things that violate our sense of fairness and obligation, and thereby make us all richer, from limited liability to bankruptcy.  But people most won't believe it.  Oh, they may believe the part of it that supports some larger "fairness" agenda they're committed to.  But their support is almost always piecemeal: try getting a liberal who loves easy bankruptcy to give a second chance to bankers who made a few stupid money decisions, or convincing conservatives who are avid for tort reform that debtors who ran up credit cards with unwise investments in expensive but rapidly depreciating motor vehicles and consumer electronics might also need legal protection from the fullest extent of their past mistakes.

In the years that I have been doing just that, it has been a losing battle on most fronts.  Especially as regards the financial crisis, where the reaction is usually that I am either a worthless dupe, or a paid shill, for the banking industry.  The people on the right who can explain it all in terms of moral hazard, and the people on the left who can explain it all in terms of insufficient regulation/punishment of bankers, can wrap economic and moral theory up in a neat package that claims to deliver justice and prosperity.  All I've got to offer is messy tradeoffs.

So it is in Europe.  The German people feel that it is not fair that they should be asked to pay for the bloated public sectors of nations where tax avoidance is an Olympic event.  The Greeks feel that they should not be asked to take a 40% paycut so that a bunch of rich Germans don't have to bail out their banks.  Berlusconi no doubt feels that he is entitled to keep a job to which he was duly elected.

You can try to explain to all of them why their sense of outrage is rather beside the point in the face of a looming financial explosion which is going to make everyone much worse off if it reaches critical mass.  You can also go home and try to explain this to your microwave, for all the good it will do.  As anyone who has ever spoken to a five year old knows, the sense of fairness is one of the most primal and intractable cognitive instincts we have.  In the best of times, it takes years to change public opinion about what is fair.  These are not the best of times, and we do not have years.

I am very much afraid that the euro zone is about to plunge us into phase two of the global financial crisis--and that as with the Great Depression, phase two may be even worse than the dismal years we've just endured.    In search of fairness, we may all get a lot more justice than any of us really wants.