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Monday, Oct. 1, 2012

The elitist pedigree of the euro 'commitment'


By LUIGI ZINGALES

CHICAGO — Since the late 1970s, the academic diffusion of game theory has led macroeconomists to emphasize the importance of "commitment," a strategy that aims to enhance long-term economic outcomes by restricting policymakers' discretion. The idea seems counterintuitive: How can less produce more?

While not historically accurate, one of the best examples of a strategic commitment is provided by the legend of Hernán Cortés, according to which, in his quest to conquer Mexico, he decided to burn the ships that had brought his expedition from Spain. At first, this might seem like a crazy move: Why intentionally destroy the only possible way out in case of defeat?

Cortes allegedly did it to motivate his troops. With no escape route, soldiers were highly motivated to win. Alexander the Great is said to have done something similar when conquering Persia.

To produce its benefit, a commitment strategy should be credible — that is, it cannot be reversed quickly.

In this sense, Cortés' strategy was perfect: In case of defeat, the Spanish would have no time to rebuild the burned ships. To work properly, a commitment strategy should also be costly in case of failure: Had Cortés lost, no Spanish soldier would have escaped alive. It is precisely this cost that helped motivate his soldiers.

The problem is that we are bound to hear about only the successful historical examples of such a strategy. Had Cortés' strategy failed, he would have gone down in history — if he was remembered at all — as an arrogant fool who thought that he could defeat a great empire.

One of the earliest applications of this strategy to economic policy is in the design of central banks. Monetary policymakers, the argument goes, should be independent from the political system, because, when elections near, politicians will likely pressure them to "buy" temporarily higher employment at the cost of permanently higher inflation. To prevent this inefficient tradeoff, governments should tie central bankers' hands by insulating them from political influence.

Many macroeconomists attribute the sustained decline in inflation since the early 1980s to the widespread use of this strategy. And, encouraged by its success, policymakers started applying it elsewhere. Financial liberalization was sold as a commitment to follow market-friendly policies. If a future government deviated from the policy, capital flight would bring it to its knees.

The same applies to extensive government borrowing from abroad, to currency boards, even to currency unions. The creation of the euro is nothing but an extreme form of commitment: European governments tried to lash themselves to the German mast of fiscal discipline.

The diffusion of these mechanisms raises the issue of democracy. When Cortés allegedly burned the Spanish ships, he did not take a poll. Had he done so, he might have won (the strategy was clever), but it was not a foregone conclusion.

But even if the commitment strategy produced beneficial incentives, it might not have been worth the risk. Perhaps Cortés, blinded by his dreams of glory, was ready to sacrifice his troops even when the odds of victory were too slim.

Nowadays, fortunately, democratically elected governments make these decisions, which thus should reflect the people's will. Yet, given their nature, these decisions deserve special scrutiny. After all, they are — by design — irreversible decisions that tie the hands of future governments, which makes them tantamount to constitutional norms. As such, they should not be subject to the same approval process as normal legislation.

This problem is particularly severe when the up-front action that seals the commitment has short-term benefits that are more attractive than burning the ship. When a government starts to borrow abroad or chooses to enter a currency union, these benefits take the form of reduced interest rates. Thus, the immediate benefits become more politically salient than potential future costs. By using this strategy, a Machiavellian government can induce a reluctant electorate to accept a policy that is contrary to its will.

Many people would say that this is exactly the point. For southern European countries, joining the euro was — explicitly or implicitly — a way to force their citizens to accept a degree of fiscal discipline that they were incapable of adopting on their own. But was this a democratic decision, or one that an "enlightened" elite forced upon its unwitting citizens?

I fear that the latter is true — hence the growing resentment against the European Union. To add insult to injury, current European leaders do not "own" their past decisions. They do not admit that they or their predecessors are the ones who burned the ships. They blame Europe. The result is that the euro, sold as a way to integrate Europe further, is tearing it apart.

Luigi Zingales, a professor at the University of Chicago Booth School of Business and a contributing editor of City Journal, is the author of "A Capitalism for the People: Recapturing the Lost Genius of American Prosperity." © 2012 Project Syndicate


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