Right now it looks as though the purported rescue of Greece by the European Union and the International Monetary Fund will fall to bits on the socialist shoals of Syriza. Since the last showdown with the EU, Greece has continued to operate as if there were no fiscal tomorrow. Its two latest manoeuvres are straight from Prime Minister Alexis Tsipras’ domestic playbook: more food stamps and free electricity for low income Greeks. The utter unwillingness of Greece to introduce any form of deregulation, anywhere or any time soon, is an unintended Godsend to the EU. It makes its decision to let Greece float off into the sunset easier than it would have been if Greece had sought to make some sensible structural reforms: perpetual bailouts are nothing that the EU can afford in its own weakened state.
The sorry situation with Greece, however, is not the major story. More serious difficulties loom with the larger and more powerful countries inside the EU as they fall prey to many of the same vices that have brought Greece to the edge of its self-inflicted financial ruin. As I have argued elsewhere, the rest of the EU, Germany included, is far from a free market bastion. EU leaders therefore find it awkward to insist that Greece enter into fundamental labour market and regulatory reforms that the larger nations in the EU are unwilling to adopt themselves. Their illness is not as severe as Greece, but it continues to get worse. The challenge is for the EU to find ways to heal itself.
Yet ironically, that is exactly what its key players are not doing. A recent story in the Wall Street Journal highlights the serious dilemma that the EU faces. Right now it continues to rely on yet another round of stimulus to jump-start its own economies. The centrepiece of that program is another large dose of quantitative easing, which means that the European Central Bank has decided to cut interest rates in order to make it easier for people to borrow in the hope that this borrowing will stimulate corporate activity. The plan is for the ECB to print euros that will allow it to buy bonds. How they will be able to sell those bonds in the future is never quite explained.
The oddest thing about this all-familiar scenario is that it ignores the one principle of economics that matters as much for macroeconomic as it does for microeconomics. Any effort to pull the levers of government power should be examined on all margins, not on just one hopeful margin. With incredible lack of foresight, the ECB, like the Federal Reserve, seems to think that the only effect of quantitative easing and low interest rates is that it will make it easier to borrow.
Unfortunately, there are at least two other effects that have to be taken into account to complete the circle. The first is that the low interest rates paid by borrowers translates into low interest rates that are paid to lenders. The second is that the potential lenders will not regard themselves as prisoners to the euro, but will ask the simple question of whether they are better off by converting their euros into some other currency that promises a higher rate of return.
The clear evidence of recent weeks is that the outflow of funds from the EU is no transitory phenomenon, but is fast becoming a steady trend. Even if there are some short-term stock gains from low interest rates and QE, over time the constant withdrawal of funds from the EU will reduce its ability to expand the output of goods and services needed for sustainable economic growth. In addition, the expanding flow of capital into other currencies can create all sorts of distortions for such places as the United States, Denmark and Switzerland. All of these nations have seen their currencies appreciate against the euro, which in turn has at least two consequences.
The first is that it increases uncertainty in the near term, which is a cost borne by every player in the financial system. No one today can afford to follow Polonius’s sage familial advice by deciding “neither a borrower or lender be.” The additional uncertainty in relative prices necessarily induces pull backs on both sides of the market. Remember that the fundamental theorem of all trade is that the gains from any exchange to all parties, whether of goods or currencies has to exceed the costs to all parties of executing the transaction. Everyone loses when government intervention introduces new sources of financial variation. Indeed, the change in exchange rates disrupts established patterns of selling, allowing the EU to export its losses on to other nations. The new financial developments are of uncertain duration. But at present the wide swings in currency valuation require imperfect counterstrategies, one of which is cutting back on investments with an added dimension of risk. Uncertainty plays no favourites.
The second problem is at least as big. The great sin of socialist Greece is that the government will not undertake any serious reforms in dealing with key regulations in the labour and licensing markets. The current rules are further illustration of the proposition of how easy it is for a protectionist government to ruin the operation of ordinary markets, by keeping out those competitors that could revitalize the economy.
I do not pretend that these forces are not alive and well in the United States, when there are many concerted efforts to use the heavy hand of regulation to keep out new competitors like Uber and Lyft, or to force franchisors like McDonald’s to bear the heavy cost of regulation. But what determines the direction of capital flows and the relative risk between rival nations? It is a battle of relative imperfections. On this score, therefore, the key factor is that the level of regulation inside the EU is far higher than it is within the United States.
The point here is especially clear with respect to the dynamic elements of American federalism. It takes only a couple of weeks to get a building permit in Texas, as compared with a couple of years in New York City. Lo and behold it is no surprise that the internal migration of people and capital is out of states like New York into those like Texas. The same story can be said with respect to an issue closer at hand, namely the state option to pass right-to-work laws that allow individual workers to keep their jobs even if they do not join a union or pay union dues. The expansion of these rules in states like Indiana, Michigan and Wisconsin has put real pressure on laggard states like Illinois, which has just elected a small government governor in Bruce Rauner, who again shifts the needle toward smaller government.
However, it is possible to detect two key differences between the EU and the USA. First, intellectually the pro market forces are better organized and more vocal in the United States than they are in the EU, which means that it is relatively more difficult to secure big government initiatives. Second, the movement of people and capital, across state lines in the United States is, all things easier, than the movement across national boundaries in the EU. A common language makes a big difference.
It is therefore not surprising that in a world of imperfect choices many investors are thinking that the EU has become an ossified and hopeless cause, and hence are taking their capital elsewhere. No one knows how long this will last, but there is little chance that the situation will reverse itself unless and until the EU takes to heart the message that no manipulation of fiscal or monetary policy can undo the wreckage of improvident deregulation.
Protectionism is always a hard nut to crack because the more entrenched the system, the more that incumbent unions and businesses will resist the movement toward market institutions. Yet by the same token, the worse the entrenchment the greater the gains from undoing protectionist institutions. But make no mistake about it, capital outflows should be regarded as a harsh judgment on the EU that no amount of sweet talk can undo. Deregulation increases market efficiency, reduces administrative costs, and controls for unnecessary forms of legal uncertainty. There are no novel macroeconomic policies that promise a fraction of those gains. EU—wake up, or face the medicine.
