Wednesday, 26 May 2010

Systemic and Cybernetic Views of the Euro

At the time when Europe was debating adopting a single currency one of my Swiss colleagues asked me about the Euro’s likely success in the longer run. My answer was not an optimistic one. Now, when Europe’s concerns about its currency are increasing by the day, we hear more and more about better fiscal checks and more penalties for those countries that do not comply with the requirements of prudence. Furthermore, some see in the recent decisions to prompt the Euro a whiff of political integration. Let’s reflect upon these concerns and decisions in systemic and cybernetic terms.

It is becoming increasingly apparent that the European Union (EU) is facing a systemic problem; either it accepts that some individual countries, unable to pay their debt, abandon the Euro and take their own decisions or accepts that there is a systemic bond among its members and is prepared to support each of them as they face the relentless and unforgiving forces of the financial markets.  In my view the problem is to go ahead with this second option -apparently the preferred one- without proper acknowledgment that it implies far more than setting stronger controls over the fiscal behaviour. This is a crucial moment for the European project; is it about a European union, as some want, or is it about economic collaboration as some others want? I discuss below the cybernetics of these options.

Are European countries accepting to use a single currency unaware of the operational implications of this acceptance? Is it not that the European Union appears blind to the costly longer term consequences of this acceptance? Let’s discuss the cybernetic argument.

To visualise the argument let’s think about the old Deutschmark at the time of the unification of West and East Germany. At that time Germany made apparent that it was prepared to accept the cost of unification. There we had two countries with significant institutional and economic differences; however the political will to bring them together was unequivocal. West Germany was prepared to allocate the resources, take the time and move relentlessly in the direction of an integrated democratic German state. Over time two states with different degrees of development were prepared to accept the pains of achieving a shared institutional framework, symbolised by the Deutschmark. For the Euro the situation is indeed different. EU countries not only have larger historical, institutional and economic differences but furthermore don’t have the will of an effective integration. Simply, reducing the problem to financial policies supported by strong checks and gruesome penalties is not going to make the trick. The complexity of the situation is far greater; balancing historic, cultural and institutional difference does not happen simply by an institution such as the European Central Bank (ECB) imposing common rules to all member countries. Different institutions in the participant countries imply different meanings for the same rules; some of these institutions may not have the operational depth to produce necessary distinctions nor the practices to achieve expected performance. Even if politicians and economists in these countries shared a similar grasp of these rules the likelihood is that the moment-to-moment actions of millions of citizens in each of these countries will not be aligned. In practice this implies different degrees of compliance with the ECB’s rules and norms. This situation would be very different if countries joining the Euro were ready to leave it as operational stresses suggested that it was better for them, and for the rest of the European Union, to face the situation individually. They would have a larger repertoire of responses; for instance they could devalue their currency, apply local idiosyncratic fiscal policies and even accept a carefully managed default (see Crisis watch by Simon Johnson and Peter Boone, in Prospect, April 2010).

The issue is the degree of cohesion that is expected between the countries belonging to the Euro. The Euro is an institutional mechanism that coordinates operational transactions throughout the countries that accept it as their currency. However, in the end it has to reflect an operational coherence among these countries. If the productivity of some of them is lower than that of others, sooner or later this will be reflected by imbalances in the operational domain. Some countries will succeed exporting their goods and services at the expense of the relative failure of the others. For sometime this imbalance may be absorbed by exports to third countries, however in the end a chronic relative low level of productivity within some countries in the Euro zone will be reflected in financial imbalances. But, the mechanism of devaluation to balance differences in productivity will not be available. Whether or not the financial markets understand the cybernetic underpinning of these imbalances they will taste blood, smell profits and act accordingly.

Audits and checks of the countries’ financial behaviors will not be enough to produce the required balance. Audits may be useful in the informational domain but, unless they are supported by investment and institutional changes the necessary operational adjustments between the member countries will not happen. The loose political arrangements of the Euro zone seem to be a long way from the unification experience of the two Germanys. Operational imbalances are being exacerbated by the recent expansion of the European Union, as well as by the relatively slower economic development of some of the old members. Resources that had supported the development of some of the Mediterranean countries are now flowing to Eastern Europe. The wealth of the union is being spread too thinly and the longer term implications of these policies are glaringly clear; the necessary operational coherence for a shared currency is further and further away.

In summary, in my view, now that the European Union includes 27 countries (and 3 in prospect) of significantly different institutional and economic development, the goal of a unified currency is more and more remote. The cybernetics of this situation supports a looser currency arrangement, where some of the current members of the Euro should be ready to abandon it and where the acceptance of new members into this Club should only happen after passing successfully significant operational and financial tests.