Heikki Patomäki – Uncertain Future of the EU: The Role of Reflexive Anticipations

“The EU system of governance is thus premised on false beliefs that it then reproduces in a self-fulfilling manner. We should evaluate negatively institutions that are responsible for the re-production of false beliefs and their consequences.”

Heikki Patomäki is Professor of World Politics at the University of Helsinki.  Brave new Europe reviewed his latest book Disintegrative Tendencies in Global Political Economy: Exits and Conflicts by Heikki Patomäki

The point of the European integration process has been to channel the multiple and often conflictual European pasts into converging presents. For a short while, the euro may have contributed to this aim, but since 2008 we have been witnessing the deepening of several existing divisions. Why is this happening? First the global financial crisis caused a slump. Subsequently, the effects of austerity during the euro crisis resulted in greater rather than smaller divergences in economic and social outcomes. Causation is often cumulative and many processes are self-reinforcing. The widening of divergences has continued during the semi-recovery of 2015-18.

The most acute phase of the euro crisis ended with Mario Draghi’s 2012 promise that the European Central Bank (ECB) will do “whatever it takes to preserve the euro”. The ECB programme of buying government bonds and other assets with freshly created money started in early 2015. This programme has been euphemistically called “quantitative easing”. By the end of 2018, the ECB has spent some 2.6 trillion euros in buying up mostly government bonds but also corporate debt and other assets.

Meanwhile, the main idea of the Commission has been to increase demand for European goods and services in world markets. This strategy has been modestly successful. Net exports have contributed to growth as the euro area’s current-account surplus leapt from roughly 1% of GDP to nearly 4% by 2016. This has occurred at the expense of the rest of the world, and yet it been insufficient for a full recovery.

In January 2019 a new slump is looming. The euro zone is on the brink of a recession exactly at the time when the ECB is about to halt its asset-buying programme. The fragile recovery of the past few years seems to have been weak and short-lived. This adds to the dismal performance of the euro during the two decades of its existence. The economic impact of the euro has been as deflationary and destabilising as many post-Keynesian economists and critical political economists warned at the time of its introduction. Today, even The Economist concurs with these critics and argues that main constraint of the euro zone has been weak demand in Europe.

Developments have become increasingly uneven. While deindustrialisation has continued across Europe, industrial production is now increasingly concentrated around Germany. The effects of quantitative easing have been equally uneven, reinforcing what some call “secular stagnation” in the peripheries while stimulating, to a limited degree, growth and real investments in the economic centre of the EU. This growth in the centre has been built on external demand, while the US and China struggle with their own troubles. Not everyone can run a surplus simultaneously. Export-driven strategies are contradictory on a global scale.

Social causation is produced by processual complexes in which political economy mechanisms play a key role. But there is also a deep process of learning and unlearning – itself historically generated while breeding expectations and anticipations – that is constitutive of the political economy elements. Economic processes are dependent on ideas and institutions in context.

The currency snake and the European Monetary System were in part developed as a response to the increasing instability of the re-emerging global finance. The regulatory idea was to create stability at least among the European currencies. Somewhat paradoxically, however, the principles of the EMU were then grounded in neoclassical economic theories such as new classical macroeconomics and the rational expectations theory by Barro, Lucas, Sargent and Wallace, and others. These theories were on the rise because of various intellectual developments (such as the popularity of Friedman’s monetarism and the famous Lucas-critique) and as a response to changing circumstances (concern over inflation and the demise of the Bretton Woods system). This rise was facilitated by globalisation and changing relations of power in favour of transnationally and globally mobile capital.

The then ascendant theories constitute a horizon of expectations. Keynesian and socialist economic policies can only serve to bring about higher inflation, itself an undesirable outcome, especially when markets are efficient. The expectation derived from abstract theory is that if economic policy is rule-based and inflation can be kept low but steady, economic growth will be strong and income levels within Europe will converge over the long term. A further assumption is that well-functioning labour markets would even out regional differences, resulting in a balanced and affluent EU. The convergence criteria establish the rules, aiming at ensuring that member-states are equally committed to the prescribed economic policies.

A key methodological problem of social sciences is that in the absence of closure, decisive tests between theories are hard to come by and evidence can always be interpreted in terms of the prevailing theory. This enables the reproduction of the closed circle of operation of the efficient market hypothesis and related economic theories. With hindsight and a firm commitment to the theory, it is always possible to find a variety of ad hoc explanations for the unintended consequences that these policies tend to have in concrete historical contexts. Ad hoc explanations are typically combined with the search for deviations from the free market rules and principles or policy failures that would co-explain why the optimal outcome was not yet reached. In accordance with this logic, the usual political solution has been to impose the free competitive markets ideal even more vigorously, although some contrary re-regulation may at times also occur. This is also the logic behind the so called structural reforms, which have included privatisation, deregulation, cuts in public spending, cuts in marginal tax rate, attempts to increase labour supply for instance by reducing education-time, increasing flexibility in labour markets, and attempts to reap the benefits of economies of scale by increasing the size of administrative units.

Economic theories tend to performative and constitute and restructure social realities. Deep behind the nature and responses of different actors and forms of agency lies the performativity of social and economic theories. The outcomes and their predictability depend also on how these theories organise anticipations about the future. Anticipations tend to be self-altering, either self-fulfilling or self-denying. Self-altering anticipations can generate complex combinations of self-fulfilling and self-denying tendencies occurring in open systems and in tandem with other mechanisms.

Consider the way global financial markets are meant to discipline the euro zone countries and how that system works in practice. Through anticipations of different financial actors, a relatively small change in one moment initiates a sequence of events affecting others, eventually returning to affect the moment that began the sequence in a self-reinforcing manner. For instance, increased demand for credit default swaps is interpreted as a sign that the economic situation in the country in question is deteriorating. Credit rating agencies react to the increased demand for bad credit swaps and reduce the creditworthiness rating of the country in question. The intervention of credit rating agencies raises the price of the credit default swaps, which makes it possible for speculators to make short-term profits. This in turn increases the demand for swaps still further. Banks with bonds issued by a crisis-hit country become alarmed and begin to sell off bonds. In some cases, they are legally obliged to sell bonds if their value drops below a certain level, since retaining them would increase risk of loss to the banks. If the prices of the bonds of crisis countries drop significantly in value, it becomes profitable to “sell them short”.

The outcome of all the foregoing stages is that the crisis country finds itself in a situation in which it can renew its loans only by agreeing to exorbitant interest rates. The system as a whole is based on reflexive self-regulation to the extent that it is purposefully employed in order to discipline public finances through market mechanisms. The system also generates unintended consequences such as financial crises that would not occur in the absence of this causal loop.

The financial markets can thus greatly amplify small differences through self-altering anticipations and related opportunities to make profits. Mario Draghi’s 2012 promise and, to a degree, also the programme of “quantitative easing” were meant to counter the effects of this socially constructed complex mechanism. At the same time, however, the counterproductive rules of convergence were tightened. In line with the prevailing theoretical framework, a number of new institutional arrangements have been introduced or put in place: the stability mechanism, the “six-pack”, the “two-pack”, the European Fiscal Compact and the euro plus. These required the euro countries to maintain a structural budget deficit (adjusted to take account of the business cycle) of no more than 1% of GDP if debt is “significantly” below 60% of GDP, and no more than 0.5% of GDP if debt is above that level. This system establishes what can be called institutionalised reflexivity. Both “preventive” and “correcting” mechanisms of these arrangements rely largely on economic forecasts. For instance, the 2012 European Fiscal Compact involves concepts such as “structural deficit”, “cyclically adjusted debt-to-GDP ratio” and “Medium-Term Budgetary Objective” (MTO), which all make references to the future.

The Compact introduces the concept of structural balance, which refers to the budgetary position of the state when adjusted for cyclical effects, based on estimates of potential GDP. The structural balance ought to converge with the country-specific medium-term objective according to a timetable set by the Commission. Signatories must also set up automatic correction mechanisms at the national level, preferably in the constitution to ensure that any deviations are quickly corrected. States breaching deficit limits need to put forward a plan for structural reforms, assessed by the Commission and the Council.

Each member state must specify which institute is responsible for the economic forecasts used in their calculations. The authority of the last resort in this regard lies, however, with the EU Commission itself. Forecasts affect economic policy, which in turn affects economic developments. Forecasts are thus not independent of what possibilities will be actualised. Predictions or forecasts can be “optimistic” or “pessimistic” depending on what is assumed to be normal as well as on what normative aims are implicit in the background theories (e.g. downsizing the public sector). Predictions of low economic growth in the future are thus likely to become self-fulfilling. For most predictions, this will increase their accuracy.

A key issue about this system is that attempts to reduce public debt can turn out to be self-defeating and recessionary. Through cuts in public expenditure, disposable income is reduced thus potentially inducing or worsening an economic recession through the multiplier effect. This leads to decreased tax receipts and increased expenditure due to the workings automatic stabilisers, such as unemployment benefits. When combined with a fall in GDP, this increase in expenditure results in an increase of debt-to-GDP ratio, potentially leading to a vicious cycle. Crucially however, whether this dynamic is played out depends on the policies of other actors in the system and the prevailing phase of the business cycle, which is not independent of these policies though not reducible to them.

This is a system of circular feedback loops involving self-fulfilling predictions, which tend to increase the divergence of socio-economic developments in Europe. There are thus various ways in which the EU governance system amplifies differences and changes. A negative change is likely to lead to more divergent paths of development, further strengthening the disintegrative tendencies within the Union.

As the euro zone seems to be re-entering a recession, and as storm warnings are being issued for the world economy as a whole, these deeply entrenched mechanisms and loops are likely to spell further trouble for the EU. We can use a partial historical analogy to illuminate the possibility and likelihood of different futures. In the 1980s, deepening regional disparities were a key reason for the disintegration of Yugoslavia, even though the regional policies to ensure the transfer of financial resources to the less developed were much more extensive than in the EU. Gap in GDP per capita between Slovenia & Kosovo widened roughly from 5:1 in 1955 to 8:1 in 1989. This is similar to the gap between Bulgaria and Denmark. The gap between Germany and Greece has widened from 3:2 in 2008 to 5:2 in 2017.

The future of the EU is highly uncertain. Reflexive anticipations based on false or misleading economic theories play a key role in making its future so uncertain. The EU system of governance is thus premised on false beliefs that it then reproduces in a self-fulfilling manner. We should evaluate negatively institutions that are responsible for the re-production of false beliefs and their consequences. The undesirable and unnecessary outcomes could be prevented by building better common institutions.

That said, it should be stressed that the rather partial (and in this text underdeveloped) historical analogy to the break-up of Yugoslavia is itself a reflexive anticipation. It is meant to be a self-denying prophecy, although I am aware it may have potential to invoke self-fulfilling tendencies. I am reminded by the prophetic words of Keynes who, in his Essays in Persuasion in 1931, remarked that he is like a “Cassandra who could never influence the course of events in time”. And he continued: “The volume might have been entitled Essays in Prophecy and Persuasion, for the Prophecy, unfortunately, has been more successful than Persuasion”. Keynes’s moment came, but only at the end of a world war. This time we should be wiser.

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