Democracy or Finance?

"Shorting" is a tactic well known among the financial cognoscenti. It means betting against an asset with borrowed money in the expectation of making a profit when its value goes down.

Of course, a single short seller cannot "make" the price of an asset (unless he is George Soros, whose famous bet against the British pound in 1992 made him a billionaire and forced Britain out of the European exchange-rate mechanism). But if a bunch of speculators decide (rightly or wrongly) that a government’s debt is overpriced, they can force down its price, thereby forcing up its yield (the interest rate that the government must pay).  If the attack persists, speculators can force a government to default on its debt, unless it can find a way to finance its borrowing more cheaply.

The bailout fund created last year by the International Monetary Fund and the European Central Bank to enable Greece and other distressed sovereigns, like Ireland and now Portugal, does exactly that, but on the condition that they implement austerity programs to eliminate their deficits over a short period of time.

"Eliminating the deficit" means, quite simply, eliminating a lot of jobs, in both the public and private sectors, whose existence depends on the deficit. The economic and human costs of deficit reduction in a weak economy are appalling, and the targets won’t be met, either, because the spending cuts will erode the government’s revenue as aggregate demand falls.

So what is the role of elected politicians in the face of a speculative attack? Is it simply to accept the market’s will and impose the requisite pain on their people? This would be a reasonable conclusion if financial markets always, or even usually, priced assets correctly.

But they do no such thing. The financial collapse of 2007-2009 was the result of a massive mispricing of assets by private banks and ratings agencies. So why should we believe that the markets have been correctly pricing the risk of Greek, Irish, or Portuguese debt?

The truth is that these prices are "made" by herd behavior. John Maynard Keynes pointed out the reason many years ago: "the extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made." When you don’t know what to do, you do what the next person does.

This is not to deny that some governments have been living beyond their means, and that shorting their debt is how financial markets hold them accountable. But, in the last resort, it is voters, not markets, which hold governments to account. When these two accounting standards diverge, the popular standard must prevail if democracy is to survive.

The tension between democracy and finance is at the root of today’s rising discontent in Europe. Popular anger at budget cuts imposed at the behest of speculators and bankers has toppled leaders in Ireland and Portugal, and is forcing the Spanish prime minister into retirement.

Of course, there are other targets: Muslim immigrants, ethnic minorities, bankers’ bonuses, the European Commission, the ECB. Nationalist parties are gaining ground. In Finland, the anti-European True Finns party has shot up from nowhere to the brink of power.

So far, none of this has shaken democracy, but when enough people become vexed at several things simultaneously, one has the makings of a toxic political brew. Nationalism is the classic expression of thwarted democracy.

For politicians, the important thing is not to avoid making hard decisions, but to do so of their own volition and at their own pace. When an elected government is under assault from the bond markets, it is essential for the political class to remain united.

A fiscal crisis calls for political self-restraint. Opposition parties should refrain from shorting their government politically at a time when markets are doing so financially.

 

Robert Skidelsky, a member of the British House of Lords, is Professor Emeritus of Political Economy at Warwick University.

Copyright: Project Syndicate, 2011.

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