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 The euphoria which dominated much of 2009 has, since the New Year, been replaced by a hangover.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.