US And Europe
FOR the first time in months, Europe is enjoying a respite from market pressure. Its latest halting moves toward banking union may not have fully reassured market players but were undoubtedly a step in the right direction, and investors’ cautious optimism reflects that.
By contrast, the “fiscal cliff” looming for the United States at year’s end, when the Bush tax cuts are set to expire and automatic spending reductions take effect, appears as ominous as ever. Partisan rhetoric is as hot as the weather in Washington, and Congress is deeply polarised. But don’t be euphoric about the eurozone, and don’t despair about the United States. The odds of a crisis do differ dramatically between the two situations – but it’s in the United States that one is much less likely.
The crucial distinction is the role of markets. In Europe, individual market behaviour fuels financial distress even as politicians scramble to prevent it, creating the risk that expectations of a eurozone crisis become a self-fulfilling prophecy. The fiscal cliff America is facing, however, is a self-denying prophecy: Lack of market pressure places the crisis firmly in the policy realm, where political incentives virtually ensure that the United States will avoid driving off the cliff. In the decentralised and institutionally flawed European Union, rational behaviour for banks, countries, Eurocrats and international lenders is often irrational for the system. European financial institutions are troubled.
They reduce risk by buying sovereign paper. But some sovereigns are dangerously indebted, so market players shun these countries’ auctions, driving up interest rates and deterring further lending in a vicious cycle that further stresses banks and sovereigns. Rational individual behaviour turns a liquidity issue into a question of systemic solvency, leaving Europe at the mercy of the markets. A coordinated Continent-wide response could end the cycle by backstopping troubled banks and governments, but European politics, despite the recent moves, will not yield this outcome. Extremist parties from Greece’s Syriza to the Dutch PVV gain traction with Eurosceptic rhetoric that inflames populist passions and fuels market fears.
The European Central Bank’s inclinations, bylaws and financial interests make it unwilling to step in decisively. German Chancellor Angela Merkel may have acknowledged that the eurozone is “in a race with the markets,” but she has also placed a definite limit – though no one is certain what it is – on how far and how fast Germany, the key country to any solution, is willing to run. Political dysfunction makes Europe’s crisis management abilities unknown, and markets hate unknowns. In this environment fear and market pressure feed on each other. Panic increases market pressure, which heightens uncertainty, which motivates additional panic.
Apparent solutions only bring more unresolved questions: Last month’s announced decision to recapitalise Spanish banks was trumped by fears of Italian solvency, and a Greek election that saw the best plausible outcome reassured markets for less than five hours. The recent moves toward a banking union, the details of which remain vague in the extreme, will only avert market pressure for so long. Some have said that a crisis resulting from these dynamics would be an “accident,” but there’s nothing accidental about it. Individual financial self-interest drives the system toward collective disaster. The tragedy of the commons becomes the tragedy of the common market. In the United States, by contrast, the key dynamics are political, not financial. There’s little uncertainty, no market pressure, and no investor panic. We Americans know exactly what the fiscal cliff is, which tax cuts will expire, and which spending programs face the axe. Most important, we know this: If the United States does dive off the cliff, virtually every voter and interest group would feel acute pain.
Indeed, the fiscal cliff would have dramatic negative effects on a host of powerful industries and constituencies. Expiration of the Medicare “doc fix” would enrage medical professionals, and lapsing corporate tax preferences would alarm the business lobby. Defense firms, which together with their suppliers and subcontractors have a presence in nearly every congressional district, have already announced that spending cuts would compel massive layoffs in their workforce.
Utility companies would see enormous tax increases, as would voters accustomed to perpetual “patching” of the alternativeminimum tax. The list goes on. The group that would suffer most from a cliff dive, though, would be the congressional incumbents that allow it to occur. It would be political suicide to induce a double-dip recession, particularly when voters would see benefits cut and taxes increase. This provides Congress a powerful incentive to strike a deal. As rumblings about the fiscal cliff grow louder and lobbying groups swing into action, the incentive will only grow stronger. Unlike in Europe, individual self-interest nudges collective political behaviour toward a solution. Ironically, the self-fulfilling aspect of Europe’s crisis buttresses the self-denying nature of the American fiscal cliff.
As Senator Dick Durbin of Illinois said recently, Congress has “a genuine concern that a downturn in Europe or another place will force our hand” – that Europe’s inability to deal with its crisis will be so dire for the U.S. economy that it will deter even America’s fiscal hawks from perching on the cliff. And with markets preoccupied with Europe, the United States faces little pressure over its long-term fiscal trajectory, making deferral of difficult decisions (such as a short-term tax cut extension and a softening of the automatic sequester) even easier. Europe may yet find a way out of the morass, but the eurozone’s financial risks are exponentially higher than America’s political ones. And none of the announcements last week, nor any likely in the near future, will change that.