Stephen King: Another Greek tragedy unfolds

It's not difficult to generate a vicious downward spiral leading to unrest

It's the politics, stupid. After years in which market forces dominated, in which economies were supposedly self-regulating and in which the nation state appeared increasingly to be impotent, markets are now struggling to cope with the return of what might loosely be called "political economy". Since the beginning of the year, the economic news has, for the most part, been reasonably good. The US economy is expanding at a decent pace, allowing the unemployment rate to fall, the Chinese economy is booming and European economies are, for the most part, pulling themselves out of recession. Yet the mood in financial markets has changed dramatically. The euphoria which dominated much of 2009 has, since the New Year, been replaced by a hangover.

The return of politics is unsettling for investors. For many years, investors thought they understood the "rules of the game". Central bankers were dedicated to the achievement of price stability. If inflation was a bit too high, interest rates would go up. If it was a bit too low, rates would come back down again. Finance ministers, meanwhile, were devoted to fiscal conservatism. Not for them the evils of big budget deficits and Keynesian demand management policies. Their job was to borrow as little as possible, thereby keeping interest rates at low levels to allow investment in the private sector to flourish.

These were simple rules. Investors loved them. Yet the rules have now been torn up. In their place, we now have political whim and policymaking expediency. This is hardly surprising. Markets have not exactly covered themselves in glory in recent years. Yet the fallout from this shift away from market forces is, as yet, poorly understood. Investors are no longer able to make confident predictions about the future because the future will increasingly be determined by politics, not by markets. And that makes investors feel uncomfortable.

Consider, for example, the tragedy unfolding in Greece. It is not really an economic tragedy, even though the rise in Greek bond yields might be regarded as the ultimate market punishment for the fiscally deviant. California is also in a fiscal mess. California, however, isn't facing an economic and financial crisis of the same kind. The reason is simple. California is part of a greater political entity called the United States which happens to have a federal fiscal system. No one expects California to go bust because the American people simply wouldn't allow it. For Greece, however, the situation is more problematic. Greece may be part of the eurozone but the eurozone is not the United States. There may be a single monetary policy but, in the absence of a federal budget authority, there is no single fiscal policy.

If California faces a fiscal crisis, financial markets will assume either that California delivers austerity or that Washington will provide a bailout. Few will bet on the third possibility, namely that California might default on its debt. When it comes to Greece, however, investors are simply not so sure. The Three Musketeers' "all for one and one for all" may work in the US but, in the eurozone, it's an untested proposition. Will other eurozone nations really bail out Greece? And, if they do, what would Ireland then say, having already swallowed the bitter austerity pill?

The Greek tragedy reveals an essential weakness within the eurozone, a legacy of pre-crisis conventional economic thought. Policymakers in most countries in the Western world thought it was possible to detach monetary from fiscal policy. On this view, it didn't seem to matter that fiscal decisions in Europe would be taken at the national level whereas monetary decisions would be taken at the European level. Yet, whether policymakers like it or not, the two are linked.

It now looks as though some countries within the eurozone will need to deliver a huge improvement in competitiveness to restore their economies to post-crunch health. Wages are too high and productivity is too low. But with a low inflation target for the eurozone as a whole, the weaker members will only be able to deliver the necessary competitive improvement by forcing wage cuts on to their citizens. Lower wages and prices, in turn, will lead to lower government tax receipts which will deliver an even bigger budget deficit and, perhaps, higher bond yields reflecting rising default risk. In these circumstances, it's not difficult to generate a vicious downward spiral, leading to social and political unrest.

One obvious way to deal with this problem would be to raise the European Central Bank's inflation target, thereby making it easier for the weaker, more deflation-prone, countries to stabilise their fiscal positions without having to make spending cuts in cash terms. No wonder the central bankers in Frankfurt are feeling nervous.

Whatever the near-term resolution of Greece's problems – and policymakers know the clock is ticking – I suspect this latest European crisis will leave the eurozone's architects facing a choice. Do they allow the eurozone to lose its way, leading to rising speculation with regard to defaults and exits from the system? Or, instead, do they strengthen the eurozone's political backbone by creating a federal fiscal system, thereby reducing the economic sovereignty of individual member nations still further? Given the history of European integration over the last sixty years, I suspect it will be the latter. How Europe's leaders get there, however, is another matter altogether.

Meanwhile, closer to home, investors are also uncertain and, again, the connection between monetary and fiscal policy is partly to blame. The Bank of England placed its quantitative easing programme on hold last week, very much in line with market expectations. Investors, however, are beginning to wonder how the Government can fund its budget deficit in the absence of additional central bank purchases of gilts. If no credible deficit reduction package is forthcoming, the obvious danger is an upward spike in gilt yields.

How might this be avoided? One easy option would be to insist banks held more gilts as part of a series of reforms to reduce the risk of another financial crisis. Higher gilt holdings might reduce the risk of a bank going bust. That, at least, is the argument. It's the equivalent of stuffing cash under the mattress to provide insurance against unexpected future events. However, the Government has an incentive to force banks to hold gilts not just for precautionary reasons but also because higher bank holdings of gilts would ease the Government's own funding difficulties.

Using regulation, however, to divert funds away from the private sector towards a bloated public sector would only serve to delay the inevitable austerity. And austerity tomorrow might be even worse than austerity today. Forced to lend to the Government, banks would have less money to lend to everyone else. The risk of future financial crises might be reduced but the cost could well be a period of sustained economic stagnation. Markets are by no means perfect but the alternatives may prove to be a lot worse.

stephen.king@hsbcib.com

Suggested Topics
Start your day with The Independent, sign up for daily news emails
Life and Style
A monstrous idea? Body transplants might no longer be science fiction
Science An Italian neurosurgeon believes so - and it's not quite as implausible as it sounds, says Steve Connor
Sport
Demba Ba (right) celebrates after Besiktas win on penalties
footballThere was no happy return to the Ataturk Stadium, where the Reds famously won Champions League
Arts and Entertainment
Natural beauty: Aidan Turner stars in the new series of Poldark
arts + ents
News
Mia Freedman, editorial director of the Mamamia website, reads out a tweet she was sent.
arts + ents
News
people
Arts and Entertainment
The write stuff: masters of story-telling James Joyce, left, and Thomas Hardy
arts + ents...begging to differ, John Walsh can't even begin to number the ways
News
Image from a flyer at the CPAC event where Nigel Farage will be speaking
news
ebooks
ebooksA special investigation by Andy McSmith
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Recruitment Genius: Telesales / Marketing Executive - B2B - OTE £25,000

£17000 - £25000 per annum: Recruitment Genius: An opportunity to join this new...

SThree: Trainee Recruitment Consultant

£18000 - £21000 per annum + OTE £45,000: SThree: SThree Group have been well e...

SThree: Trainee Recruitment Consultant

£20000 - £25000 per annum + OTE £45,000: SThree: SThree Group have been well e...

Recruitment Genius: Business Control Manager

£36000 - £44000 per annum: Recruitment Genius: Encouraging more businesses to ...

Day In a Page

HIV pill: Scientists hail discovery of 'game-changer' that cuts the risk of infection among gay men by 86%

Scientists hail daily pill that protects against HIV infection

Breakthrough in battle against global scourge – but will the NHS pay for it?
How we must adjust our lifestyles to nature: Welcome to the 'Anthropocene', the human epoch

Time to play God

Welcome to the 'Anthropocene', the human epoch where we may need to redefine nature itself
MacGyver returns, but with a difference: Handyman hero of classic 1980s TV series to be recast as a woman

MacGyver returns, but with a difference

Handyman hero of classic 1980s TV series to be recast as a woman
Tunnel renaissance: Why cities are hiding roads down in the ground

Tunnel renaissance

Why cities are hiding roads underground
'Backstreet Boys - Show 'Em What You're Made Of': An affectionate look at five middle-aged men

Boys to men

The Backstreet Boys might be middle-aged, married and have dodgy knees, but a heartfelt documentary reveals they’re not going gently into pop’s good night
Crufts 2015: Should foreign dogs be allowed to compete?

Crufts 2015

Should foreign dogs be allowed to compete?
10 best projectors

How to make your home cinema more cinematic: 10 best projectors

Want to recreate the big-screen experience in your sitting room? IndyBest sizes up gadgets to form your film-watching
Manchester City 1 Barcelona 2 player ratings: Luis Suarez? Lionel Messi? Joe Hart? Who was the star man?

Manchester City vs Barcelona player ratings

Luis Suarez? Lionel Messi? Joe Hart? Who was the star man at the Etihad?
Arsenal vs Monaco: Monaco - the making of Gunners' manager Arsene Wenger

Monaco: the making of Wenger

Jack Pitt-Brooke speaks to former players and learns the Frenchman’s man-management has always been one of his best skills
Cricket World Cup 2015: Chris Gayle - the West Indies' enigma lives up to his reputation

Chris Gayle: The West Indies' enigma

Some said the game's eternal rebel was washed up. As ever, he proved he writes the scripts by producing a blistering World Cup innings
In Ukraine a dark world of hybrid warfare and murky loyalties prevails

In Ukraine a dark world of hybrid warfare

This war in the shadows has been going on since the fall of Mr Yanukovych
'Birdman' and 'Bullets Over Broadway': Homage or plagiarism?

Homage or plagiarism?

'Birdman' shares much DNA with Woody Allen's 'Bullets Over Broadway'
Broadchurch ends as damp squib not even David Tennant can revive

A damp squib not even David Tennant can revive

Broadchurch, Series 2 finale, review
A Koi carp breeding pond, wall-mounted iPads and a bathroom with a 'wellness' shower: inside the mansion of Germany's 'Bishop of Bling'

Inside the mansion of Germany's 'Bishop of Bling'

A Koi carp breeding pond, wall-mounted iPads and a bathroom with a 'wellness' shower