全球经济研讨会讲话

“The Future of Europe”

I shall take a holistic approach to the future of Europe. I have developed a conceptual framework, which has guided me in my decisions throughout my adult life. The framework is much broader than the financial markets; it deals with the relationship between thinking and reality. What makes that relationship so complicated is that the thoughts and actions of participants are part of the reality they have to think about. Their thinking serves a dual function: on the one hand they try to understand the world in which they live – that is the cognitive function; on the other, they want to influence the events in which they participate – that is the manipulative function. The two functions interfere with each other – I call the interference reflexivity. The cornerstone of my conceptual framework is the human uncertainty principle, which is based on the twin pillars of fallibility and reflexivity.

The human uncertainty principle has far reaching implications for scientific method. It applies only to social phenomena and thereby it separates the social sciences from the natural sciences. Economic theory has sought to imitate the natural sciences, particularly Newtonian physics. Consequently my conceptual framework is in direct conflict with mainstream economic theory.

The differences are especially pronounced in dealing with financial problems in general and the euro crisis in particular. Mainstream economics has pursued timelessly and universally valid laws whose validity can be tested by reference to the facts. I contend that the facts produced by social processes do not constitute a reliable criterion for judging the validity of theories because of the human uncertainty principle. I do not deny the possibility of establishing universally and timelessly valid laws – the human uncertainty principle is one of them – but I consider such laws too vague and general to be of much use in producing specific predictions and explanations.

In any case social phenomena are easier to explain than to predict. The past is uniquely determined while the human uncertainty principle renders the future inherently indeterminate. That is not how Newtonian physics works. Mainstream economics sought to apply the Newtonian approach to social phenomena by introducing the concept of equilibrium. This required elaborate mental gymnastics. It started with the theory of perfect competition, which assumed perfect knowledge and ended with rational expectations and the efficient market hypothesis.

By contrast I emphasize the role of misconceptions, misinterpretations and a sheer lack of understanding in shaping the course of events. I focus on the process of change rather than on the eventual outcome. The process involves reflexive feedback loops between the objective and subjective aspects of reality. Fallibility insures that the two aspects are never identical. That is where my framework differs from mainstream economics.

Feedback can be negative or positive. Negative feedback narrows the divergence between the objective and subjective aspects of reality; positive feedback widens it. Carried to an extreme, negative feedback would lead to equilibrium; positive feedback would result in mayhem. In standard economics equilibrium is the inevitable outcome, in my framework equilibrium is one of two theoretical extremes. Reality ranges from near equilibrium to far from equilibrium conditions, but the distribution of cases does not follow a regular bell curve; it tends to cluster around the two extremes. The extremes act as “strange attractors” because people tend to use dichotomies to simplify matters. A situation can be considered stable or unstable. But people’s opinion can shift quite quickly. This leads to the “fat tails” observed in market volatility- that is inherent in my framework but not in standard economics.

Using this conceptual framework I have developed a boom-bust theory of financial crises, which is the opposite of equilibrium. It consists of a trend that prevails in reality and a misinterpretation or misconception relating to that trend. The trend and the misconception mutually reinforce each other until they grow to such an extent that the misconception becomes increasingly apparent. Eventually an inflection point is reached where the trend is reversed and a positive feedback loop develops in the opposite direction.

Boom bust processes or bubbles are only one manifestation of reflexivity and only occasionally do they grow to a size where they assume macroeconomic importance. There is also a reflexive interaction between the authorities and the markets. Behind the invisible hand of markets lurks the visible hand of politics. Both the markets and the authorities are fallible; that is what makes their interaction reflexive. While bubbles occur only intermittently the interplay between economics and politics is ongoing. We need to study the political economy where every event is unique instead of looking for timelessly valid laws.

My conceptual framework consists of universally valid generalizations; therefore its usefulness in explaining or predicting the political economy is strictly limited. But as a hedge fund manager I have used it to develop specific theories about specific situations and my performance record testifies to their usefulness.

I have followed the euro crisis closely ever since its inception. I have written numerous articles about it that has been collected in a book. I found my conceptual framework particularly helpful because the crisis is the result of a reflexive interaction between financial and political processes and combines historical, cultural, moral and above all legal aspects. That makes it so complicated that it boggles the mind. Misconceptions have played a central role. I shall focus on them instead of presenting a comprehensive analysis.

The design of the common currency had many flaws. Some of them were known at the time the euro was introduced. Everybody, for example, knew that it was an incomplete currency; it had a central bank, but it didn’t have a common treasury. Other defects were discovered only in the crisis. In retrospect the most important defect was that the euro exposed the government bonds of member countries to the risk of default. In a developed country with its own currency, the risk of default is absent because it can always print money. But by ceding that right to an independent central bank, the member-states put themselves in the position of third-world countries that borrow in a foreign currency. This fact was not recognized either by the markets or by the authorities prior to the crisis, testifying to the fallibility of both.

When the euro was introduced, the authorities actually declared government bonds to be riskless. Commercial banks were not required to set aside any capital reserves against their holdings of government bonds and the European Central Bank (ECB) accepted all government bonds on equal terms at its discount window. This set up a perverse incentive for commercial banks to buy the debt of the weaker governments in order to earn what eventually became just a few basis points, because interest rate differentials converged to practically zero.

This convergence in interest rates caused divergences in economic performance. The weaker countries enjoyed real estate, consumption and investment booms, while Germany, weighed down by the burdens of reunification, had to adopt fiscal austerity and structural reforms. This divergence was not envisioned by the Maastricht Treaty, which assumed that only the public sector produces disequilibrium.

Then came the Crash of 2008. After the Lehman bankruptcy European finance ministers declared that no other systemically important financial institution would be allowed to fail but Chancellor Merkel insisted that the obligation should fall on each country individually, not on the European Union or the Eurozone collectively. That was the onset of the euro crisis but it took markets more than a year to react to it. Only when Greece revealed a much larger than expected fiscal deficit did markets realize that Greece may actually default on its debt – but then they raised risk premiums with a vengeance not only on Greek bonds but on the bonds of all the so-called periphery countries. By then those countries became saddled with much more debt than a third world country would have been able to accumulate.

The outbreak of the crisis put the European financial authorities in a bind. They had to deal with the crisis in accordance with rules that were patently inappropriate to prevailing conditions; yet they couldn’t change the Maastricht and Lisbon Treaties because public opinion especially in France and Germany was opposed to any further steps towards European integration. Consequently, the authorities had to resort to all kinds of legal subterfuges to prevent the euro from collapsing. This made the rules governing the euro much more complicated than they would have been if they had been designed de novo. At the same time some of the changes that arose in practice, notably the risk of default and the bail-in of bondholders were gradually given legal recognition. This has put heavily indebted countries at a large and recurrent disadvantage, which has not been properly acknowledged.

In this context the double meaning of the German word “Schuld” has played a key role. It means both debt and guilt. This has made it natural or “Selbstverstandlich” for the German public to blame the heavily indebted countries for their misfortunes. But that is not justified by the facts, except in the case of Greece. The Greek government had blatantly violated the Treaties, but the other debtor countries had played by the rules. Indeed Spain used to be held up as a paragon of prudent fiscal management. Clearly the faults were systemic. The responsibility for the misfortunes of the heavily indebted countries rests mainly with those who decided the rules that govern the euro, Germany and France foremost among them. But this conclusion would be stubbornly resisted in those countries.

The euro crisis is now over. This became official in the German elections where the rules governing the euro were not even discussed. Yet the system that emerged from the crisis is far from satisfactory. Mainstream economists would call it an inferior equilibrium; I call it a far-from equilibrium situation. The euro crisis has already transformed the European Union into something radically different from what was originally intended. The EU was meant to be a voluntary association of sovereign and equal states that surrendered part of their sovereignty for the common good. It has turned into a relationship between creditors and debtors that is by its nature compulsory and unequal. When a debtor country gets into difficulties the creditor countries gain the upper hand. The rules they have established merely perpetuate this state of affairs. That is liable to be politically unacceptable and it has the potential of destroying the European Union altogether. Only the creditors are in a position to prevent this outcome but they do not seem to show any inclination to do so.

The defects of the currently prevailing situation fall into two categories: political and financial. On the political side Germany has emerged as the de facto hegemonic power. Germany cannot dictate to the others but the European authorities cannot make any proposals without obtaining Germany’s permission. Democracy flourishes in Germany but debtor countries stumble from one political crisis to the next. And the German Constitutional Court has emerged as the most powerful judicial authority in Europe. Since Germany, mindful of its recent history, did not want to play a hegemonic role, it is unwilling to accept the responsibilities and liabilities that go with that role. As a result Germany is reviled in some other countries while Germany feels unjustly accused of occupying a position that it actively sought to avoid.

Contrast that with the United States, which acted as a benign hegemon at the end of World War II embarking on the Marshall Plan; subsequently it was acclaimed as the leader of the free world and enjoyed the lasting allegiance of Europe. Current German attitudes are also in sharp contrast with the attitude prevailing at the time of German reunification. At that time Germany became the engine of European integration in order to achieve that goal.

On the economic front the austerity policy advocated by Germany proved to be counterproductive. Every euro of reduction in the fiscal deficit caused more than a euro of reduction in GDP – in other words the fiscal multiplier turned out to be more than one. The German public found that difficult to understand. The fiscal reforms introduced by the Schroeder government were successful; why should a policy that worked for Germany not work for Europe? The reason is that the Schroeder government operated in an inflationary environment and the current environment is deflationary. It took a long time for the European authorities to recognize this fact but eventually they did and they stopped imposing additional austerity measures. That relieved the downward pressure and allowed the Eurozone to hit bottom and the financial crisis to abate. The Eurozone is now in a mild rebound led by Germany but the heavily indebted countries are lagging behind. The divergence is largely due to their higher debt burden and the higher cost of money. Since these are recurrent, the divergence is bound to get wider with the passage of time.

What needs to be done follows directly from this analysis of what has happened. Recognizing the mistakes and identifying the misconceptions that have created the current situation is the first step; correcting them is the second. Only Germany can initiate the process because, as the country with the highest credit standing, it is in the driver’s seat. If a debtor country tried to do it would merely aggravate its own position. Admitting and correcting mistakes is never easy. In this case there is no shame attached to it because the situation was so complicated that it boggled every mind. Doing it would earn Germany the long lasting gratitude of the rest of Europe. Failure to do is much worse. It has created a nightmare in which the victims of the current policies have to live in their waking lives. Now that the euro crisis has ended, Germany has emerged victorious. But it is a Pyrrhic victory that would be better to avoid. I’m glad that this conference, which is almost unique in recognizing the severity of the problems that continue to confront Europe is exploring the possibilities.