THE FINANCIAL MARKETS AND EUROPE
This article appears in Bollettino di Dottrina sociale della Chiesa, Anno VIII (2012), numero 1, gennaio-marzo [Italian]
Over the last two years, the former romance of financial markets and the European political establishment has turned bitter. The tension springs from a fundamental incompatibility which was almost certain to emerge in a period of economic, political and financial tension.
Indeed, it is not the romance that was surprising. For the first three or four decades after the Second World War, most of the leaders of continental Europe and most of the bureaucrats and diplomats of the political-economic organisation which would eventually become the European Union looked on the world of financial markets with a mix of disdain and distrust. In return, enthusiasts for free financial markets (FFM) generally dismissed the Continental economic model, including its financial model, as inefficient and wrong-headed.
Before discussing the rapprochement of the 1990s, the hot affair of the early 2000s and the tensions of the crisis that started in 2008, I will summarise the intellectual positions of the two sides. Of course, I can only provide a caricature – in reality everything is much more nuanced – but I do not believe that my simple picture of a fight between what might be called the European Social Market view of finance and the American Free Market view is a misleading oversimplification. I should also say that in my judgement, the recent crisis shows that one side of that fight was basically in the right and the other was basically in the wrong,
The Social Market view
Relative to rival economic models, the theoretical underpinnings of the Social Market are thin. Marxism and Communism were developed out of the Hegelian view of history, the State and freedom. Radical “capitalist” ideology can be traced to the individualism of Locke and the Utilitarianism of Bentham, with some influence from the Social Darwinism of Herbert Spencer. In contrast, the Social Market was largely a pragmatic arrangement developed through trial, error and the desire to avoid both the stultification of the Soviet Communism and the perceived inhumanity of American economic freedom. The result was a shifting mix of economic actors and principles: private enterprises, a large government with a clear social agenda and a general expectation that business and finance should serve the common good.
Catholics with knowledge of the Church’s Social Doctrine sometimes argue, quite correctly, that this intellectual tradition was quite influential on the leaders who established and developed the Social Market. The Church helped many of them learn to endorse both subsidiarity and solidarity, to respect freedom, to promote social justice and to fear greed. However, this tradition provides little more than general moral principles; the actual institutions of the Social Market Economy were mostly developed without much deep theorising. Also, the Catholic Church lost political influence over the decades, so it has had little influence on recent developments.
The lack of clear intellectual framework proved to be a serious flaw in the Social Market. Without clear principles to guide reform and development, change became controversial and stagnation set in. By the 1980s, there was widespread economic disappointment in Continental Europe -- high unemployment, slow increases in Gross Domestic Product and the loss of technological leadership. The intellectual gap also made it difficult for European leaders to discern the moral and practical weaknesses of free market thinking, especially of that tradition’s fascination with free financial markets.
The financial arrangements of the Free Market system, which I will describe in the next section, could hardly be more different from those of the Social Market. Social market finance relied primarily on heavily regulated banks. As much as three quarters of the loans and deposits in Germany, France, Italy and the Netherlands went through institutions which were in some sense “not for profit”. They did not have shareholders who sought a high return (rising dividends or share prices) but were “owned” by customers, labour unions or representatives of the communities in which they operated.
The label “not for profit”, borrowed from American legal terminology, is misleading. While the banks were supposed to give their customers a fair deal and to promote local enterprises through sympathetic lending, many of them actually generated significant operating surpluses. However, the gains were supposed to be used to support the community in some way.
For the most part, financial arrangements were unsophisticated. Most loans were financed with the bank’s deposits and many interest rates were tightly regulated. From the perspective of the overall economy, the Social Market banking system worked quite well. Relatively few institutions succumbed to the lure of excessively generous lending, the greatest danger in financial intermediation. Although banks managers were often loosely supervised and subject to political influence, there was a bearable level of corruption and self-serving, although both probably increased over time.
These Social Market Institutions did not have a monopoly on financial intermediation (gathering assets and making loans or investments). There were also banks and insurers run for profit. The ideological freedom also left space for stock exchanges, where speculation plays at least as large a role as capital-raising for companies, and as investment by individuals.
According to the spirit of the Social Market, governments, which rule by the consent of the governed, should in general spend no more money than they can find political support to collect in taxes. If that spirit had been articulated in clear theory, it is unlikely that substantial peacetime government borrowing would have been considered appropriate for the social economy. In practice, however, European governments did indeed raise substantial sums through borrowing, often by strongly encouraging banks and other intermediaries to invest in government debt.
The free market view
Free markets are intellectually pure and ideologically clear, but they hardly exist, at least not in the sense the concept is developed in neoclassical economics. The canonical definition of a free market is one which is fair, open and unconstrained. In effect, for a market to be free enough to allow people to buy and sell without constraint, it can have no so-called “frictions”. These include fixed capital, law, regulation, bureaucracy and ignorance – in other words most of the reality of any economic organisation.
More philosophically, the basic psychological picture of an entire economy arranged as a canonical free market is erroneous. Free market economists imagine a social providence, known as the “invisible hand” (in comparison to the visible hand of divine providence), which somehow converts the otherwise diverse congeries of individual self-interests (the sole assumed motivation of each economic actor) into something recognisable as the common good. None of that corresponds with reality.
People are not solely self-interested. They cannot be heaped up but always live in organised communities. They need and always create authorities which help identify and promote the common good. They exist in a moral universe of right and wrong so they expect and accept punishment for acting badly and rewards for acting well. Their transcendental orientation ensures that economic activity cannot be separated from the gift economy of giving to the world in labour and accepting the world in consumption.
Although many of leading industrialists in the 19th century, especially in the United States, identified with the ideology of free markets, reality has tempered the influence of this thinking in most parts of the economy. The praise of free competition and self-interest can still be heard, especially in the United States, but the destructive urges of competition are held in check by such powerful economic structures as corporations, regulations and bureaucracies. When economies work well, the restless force of competitive enterprise is neither smothered nor allowed to run riot.
Financial markets have been something of an exception. The idea that the common good is served by encouraging investors to seek only to maximise their personal gains (adjusted for their tolerance of risk) by freely trading securities is widely accepted.
Free financial markets have been quite effective at raising funds for new enterprises and for existing enterprises which cannot generate enough profits to fund investments in profitable activities. Such markets are also useful forums for arranging corporate mergers and acquisition and for pooling savings.
Free Financial Markets (FFM) are probably more effective at raising capital than are the financial structure of Social Markets. However, most capital in any modern economic arrangement is generated internally, as profits, so the FFM advantage is not crucial. On the other hand, FFMs have been consistently prone to excesses and rapid changes of direction, creating difficulties in the “real economy” of production and consumption. .
In theory, government borrowing in FFM is unproblematic. If an interest rate is agreed, there is no more to be said. In practice, even Free Market enthusiasts worry that government control of the monetary system makes for uneven bargaining between investors and the government.
Social Market finance is not the ideological opponent of FFM. That role is played by Communism, which holds that freedom in finance, as in all other economic domains, is best exercised by the state. Since the early days of the Soviet Union, Communism was also associated with central planning, the idea that the best basis for the allocation of capital and of consumer goods is rational calculations centred on the common good, not the animal spirits of competition. Communism, however, is like Free Markets in its non-existence. In practice, people cannot be controlled as fully as is required in Communist theory.
While FFM and Communism can have a clear debate, the intellectual relationship between the messy reality of Social Market finance and the ideological purity of FFM never rises above a wary and confused dialogue of the partially deaf. Enthusiasts for FFM demand sophisticated financial markets, free trading of everything, free movements of capital and limited regulation. On the other side, politicians and regulators in European Social Market economies dislike the fervour and ideologically grounded confidence of the FFM approach, but they are willing to accept any mechanisms which “work” – which promote some aspect of the economic good.
In the 1980s, FFM thinking was becoming more popular in the United States, for various reasons: many people thought that freer financial markets would lead to better performance from the entire economy, which was thought to be falling behind Japan; the memory of the trouble which FFM-thinking of the 1920s had caused in the 1930s was fading; and, somewhat ironically, the desire for individual freedom which had motivated the sexual and social revolutions of the 1960s and 1970s spread into finance.
Europeans were not immune to the FFM revival. They were particularly open to different ideas because their own Social Market economy seemed to be stagnating. The fall of European Communist governments at the end of the 1980s increased the enthusiasm for its ideological opponent. In addition, and somewhat ironically, supporters of a more unified Europe used FFM to justify a reduction in national controls of finance – fewer national rules make national borders less significant.
It was easy enough for Europeans to rebalance their financial arrangements with more FFM. The Social Market already had somewhat free capital markets; more financial freedom could be added without either huge practical difficulties or tremendous intellectual contortions. That is what happened through the 1990s. Europeans politicians basically welcomed the demands of financial professionals for more freedom of action, more reliance on their skills and more trust in the judgement of markets.
The hot romance
The arrival of the Euro made both sides more enthusiastic. The single currency gave investors and traders had much larger markets to play in. The new European Central Bank was considered a competent and basically friendly counterparty. Investors supported the euro zone’s finances with a strong currency and low interest rates. European politicians were delighted with investors’ willingness to buy the debt of all member governments, even the most fiscally irresponsible. Financiers claimed to care about the differences among the various members of the euro zone, but in practice they were not too fussy about lending to all members and willing to trust promises of future fiscal probity.
In addition to providing funding, the FFM seemed to provide wealth. The experiment was far too short to demonstrate whether it could improve the efficiency or ingenuity of the overall economy, but the expansion of the financial sector clearly created skilled jobs. The expansion of financial markets, in particular the growth of credit, also contributed to increases in the value of many financial assets, bonds in most of Europe and houses in Spain, France and the Netherlands. Like its counterparts elsewhere, the European Central Bank basically ignored these price increases and the increasing credit-intensity of increases in Gross Domestic Product.
The rise of European finance was also appreciated by many of the region’s leaders for the cachet it brought in the international community. The Asian financial crisis at the end of the last century had only tarnished, not fundamentally shaken, the “Washington Consensus”, the approach to development and international trade relations directly inspired by FFM. Europe would have seemed backwards if it did not a strong “market-oriented” financial structure.
Europeans proved particularly bad at regulating their expanding financial sector. This should not have been surprising; regulatory structures work best when they develop along with the regulated industry. In the region’s romance with a financial tradition that was essentially unrealistic and largely foreign, regulators who were competent to supervise only the simpler and less ambitious Social Market finance became almost irrelevant. The result was that European banks lost vast sums on positions in American securities which no sensible regulator would have approved.
The bitterness of failure
One problem with FFM is that is easily loses contact with economic reality. Another is that unfettered financial markets tend to move to extremes of valuation and risk. Both happened in the euro zone government debt market. Investors forgot the reality of separate fiscal authorities and a central bank that did not necessarily stand behind all of them. The market demanded only slightly higher yields from fiscally weak than from fiscally strong governments. Investors happily moved funds from one country to another inside the euro zone, without considering the effect of such external funding on asset prices (most notably in Spanish property) and labour costs (most notably in Greece).
This reckless enthusiasm reached its extreme at the end of 2007. Then the markets turned in the opposite direction. As I write in mid-2012, investors are worrying that the euro zone will not stay together and are selling what should be only slightly risky securities at a pace which makes a collapse of the single currency much more likely. The FFM extremism has changed what should be a manageable political problem of arranging relatively modest intra-regional transfers into an unmanageable financial crisis.
Unfortunately, European politicians and central bankers have still not learned the ways of FFM. They have been slow to restrict financial freedoms or to counter the wild emotions of investors with steady and strong policies. They have mostly accepted without questions the bankers’ dubious claim that large losses at banks would destabilise the entire economy. Despite the failure of the FFM ideology and four years of economic disappointment, there has been little effort to renew Social Market finance or to develop a new financial paradigm.
Investors generally consider themselves innocent of any responsibility for either the financial crash of the weak economy. Their demands for reassurance become more shrill and exorbitant. There is an irony in the desire of investors who see themselves as proponents of free financial markets calling for government action, but such irony is probably inevitable. FFM is actually an unrealistic ideal; in reality financial markets can only work well if they are integrated into the whole economy, in which social authorities always play an important role.
Still, there is something distasteful about the particularly vociferous complaints from some members of the British and American financial communities, those who neither question the value of FFM as a guiding principle nor countenance the financial pain that in theory should follow freely made mistaken judgements by investors. Calls for political and fiscal union in the euro zone would have been sensible in the period of romance between markets and European governments; now they sound like either blackmail or special pleading.
The long crisis should teach that the FFM ideal is wrongheaded and dangerous. It should also teach that government debt is not just another type of debt. Government debt is neither that nor a substitute for government-issued money. It is usually a sign of political weakness – the inability to balance tax revenues with expenditures. Sound government finances are probably a prerequisite for a strong Social Market economy.
Photo: from 'Casablanca', 1942