An optimistic view of the Euro mess

posted in: Economics | 0

The ever-excellent analysis from the Peterson Institute of International Economics continues. A recent paper argues that the Euro mess will be resolved and will leave the European economy and Union stronger than before.

Fred Bergsten and Jacob Kirkegaard argue conventionally that either the Eurozone adopts a closer political union, or the Euro will fall apart. Most people agree with this I think, though it admits the chance of a long period of chaotic irresolution before the outcome is known.

But they then use a sort of backward induction argument that is commonly applied in game theory, as follows. Since the ending of the Euro would be a political and economic disaster, Europe’s leaders must make sure it doesn’t happen. Therefore they will pick the second outcome, closer political integration. But since this is very hard to get popular agreement on, it will only be achieved right at the last minute, in the face of an appalling alternative.

I think this is a reasonably likely outcome, maybe 50% probable. But it could fail for two reasons.

First, whatever Europe’s political leaders might intend or want, they can easily find themselves swept away by more powerful short term local political pressures. The rise of fringe political parties, mainly right wing, with a common hostility to the EU is one problem. Another is German intransigence on bail outs or the threat (grossly over-estimated in my view) of inflation arising from European Central Bank intervention in sovereign markets.

But the second is what the British call the cock-up factor. Or if you prefer, the risk that events simply get out of control. History is full of cases where the common interest argued for outcome A but the actual outcome was B because leaders are not in full control. It was widely believed ahead of the First World War that the massive cost of war would ultimately discourage actual war. But once the mobilisation plans were set going, with their notorious dependence on the railway timetables, a machine started moving which was impossible to stop. We came very close to nuclear war over Cuba in 1962 because of the remorseless logic of escalation, combined with highly imperfect information and mutual suspicion. In hindsight we are somewhat lucky that the northern hemisphere is still intact.

Game theory also tells us that common interest goals are not always achieved owing to coordination failures or perverse incentives (the prisoner’s dilemma). A trivial but common example is when two people approaching each other along a pavement (sidewalk) move simultaneously to avoid each other, first to one side of the pavement then to the other, while still walking and shrinking the distance between them until they bump into each other. Each is slightly annoyed and humiliated and vaguely blames the other (though in the UK both will apologise with probability one). But it was nobody’s fault, just bad luck in a situation where there is no convention (“drive on the left”) that both sides would use to avoid the other. We notice such clashes partly because of their rarity; it is taken for granted how extraordinarily well most social interaction works and how coherent modern life is. But there are breakdowns occasionally.

So I hope that Bergsten and Kirkegaard are right because the damage from a Euro collapse would be disastrous at the best of times and more so when the world economy is somewhat weak anyway.

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