Saturday, June 11, 2011

Breaking the rules and the euro crisis

Jamie Whyte, in an FT editorial, "Why our masters insist on breaking the rules" provides an interesting perspective on the crises within the EU. The EU has tried to provide stability and structure within the union but whenever there have been times to avoid following the rules countries and the group as a whole have always chosen to break the rules.

Remember that budget deficits were never to be above 3% of GDP. Everyone, even those who developed the idea of budget constraints, has broken the rules. If the budget deficits were all below 3%, the crises never could have occurred. There were supposed to be penalties. None were imposed. There were supposed to be no bail-outs, yet they have occurred. There was supposed to be no acceptance of non-investment grade collateral yet the ECB has accepted all bonds.

This gets back to the issues of creditability from governments. There is little. The issue was addressed in the 1980's with research on time or dynamic inconsistency in monetary policy. The basic idea is that if you do not follow the rules that you place upon yourself there will be limited creditability and policies will have to be more extreme. There is no anchor on what could be the actions taken by government other than they will be addressed at the time of a crisis. This is not a system of government or economics but a system of chaos.

There is the hope that governments in their infinite wisdom will be able to provide the right solution that makes sense. The argument that flexibility is good under the assumption that rational decisions can be made. Do we really have confidence that this can happen in a crisis?

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