True freedom

"Freedom means that in some measure we entrust our fate to forces we do not control; and this seems intolerable to those positivist / rationalist who believe that men can master his fate; as if civilization and reason itself were the fate of his making"
F.A. Hayek

Tuesday, May 8, 2012

The European Union and the Price System


The European Union and the Price System                                          May, 2012                       Pablo Paniagua                                                                                                                    

The second World War (WWII) brought out the most terrible side of humankind in Western civilizations along with the most vicious and brutal war of all times. In addition, WWII brought Western civilizations to quarrel and to manifestly ravage each other. We can say far worst things about the cruelty of the war, but if there is anything positive that it may have brought, it was undoubtedly the urgent need for younger Europeans after the war to create a common understanding and a call to unify European values and ethics. This attempt for unification and the necessity to leave the substantial war burden behind brought the first attempts to create a political and economical effort for a common European view.

The need for unification was first reflected politically in 1958 with the establishment of the European Coal and Steel Community (ECSC) and the European Economic Community (EEC). Soon after these two milestones several other treaties and pacts were signed, developing the homogenization and understanding of European nations. In 1985 the Schengen agreement led towards the association of open boarder and passport control, leading to the creation of the European flag one year later.  Soon after the collapse of the iron curtain and the fall of the Berlin Wall in 1989, Europeans could then talk seriously about a unification system. Germany was considered a key figure, politically and economically speaking, towards a real reconciliation among the “old adversaries of the war”.

Once the WWII “old foe” endorsed the cause for unification, the European Union (EU) was formally established when the Maastricht treaty came into force in 1993. Six years later the euro currency was introduced and the European Central Bank was finally able to fully operate. In 2002, euro notes and coins replaced national currencies in 12 states, replacing the old European currency system and bringing to life one of the biggest political and economical rational planning of the XX century.

Let us understand two very significant elements: the first is the human need to create, at whatever cost, a sense of association for understandable humanitarian reasons. This urge for a single and unified moral human system, excelled by the desire to leave the dreadful past behind, resulted in facing the future collectively as “Europeans”. Undermining old detestations and divisions that were, after all, the basic cause for endless wars ever since, was obviously a novel and a very natural reaction among Europeans. The second significant element is political. Politicians saw the unification as the greatest opportunity for the whole continent and themselves to stand in the globalized competitive world as a super power and as a relevant political and economical actor. Contemporarily, it was a manner to prove the world that European leaders would not “get it wrong” another time. Europe and their leaders after all had allowed on their own soil: two world wars, terrible colonization systems and the biggest systemized mass production human assassination of all times. Ultimately the “Union” was the best way to point out the progressiveness and competitiveness of the new “race” of European leaders to the world.

Various other national factors also played in favor of the Unification for politicians. To mention a couple: the policies aimed to ensure free movement for Europeans, goods, services, capital and investments, and several reforms in education, common policies in trade, agriculture, fisheries and regional development. These were signs of good politics and national progress and in this way politicians proved their “efficiency” and willingness of reforms to their own people. The reforms gave nations a sense of prosperity and confidence towards the beginning of the 90s. Presently, Europe is indeed the biggest economic entity and also one of the biggest trading networks. 

All of this positive progress and the possibility for European politicians to stand out in the world were very big incentives to seize the opportunity to thrust the unification forward as fast as possible post the fall of the Berlin Wall. Unfortunately these superior dreams and excellent humanitarian intentions, combined with the urgency and the rush for politicians to get a hold on this political opportunity, blinded not only politicians but the society as a whole. They saw the EU as a global expression of reconciliation, as well as a new dawn for Western civilizations. Contemporarily the EU invigorated the counterfeit notion of successful coordination and international, political and economic planning. 

Sadly in the process, Europe neglected several social and economic issues, which in the long run resulted in being excessively important and essential for the union’s future. If we discard the spontaneous social order and economic fundamentals of markets, these neglects may lead directly towards the very denial of any possible logical existence of a unified European dream. These fundamentals were clearly underlined by Professor Mises and Professor Hayek more than 60 years ago; they referred to the distribution of knowledge by a heterogeneous and extended price system mechanism. This system allows spontaneous social coordination and dispersion of relevant information towards an efficient allocation of wealth. Unmistakably we have seen these fundamental social orders completely neglected. The denial and impediment of the spontaneous price system has been exposed under a unified EU monetary system throughout the last couple of decades; but we were unable to foresee and fully understand its consequences. 

During the end of the 1990s, with the beginning of the Maastricht agreement, government bond’s interest rates among countries started to converge. Countries within the agreement and also those out of it were experiencing an increasingly convergent towards the value of German bond’s interest rates. This process of convergence could be seen as a sort of “harmonization” of government’s interest rates, mainly induced by the single currency program (see Figure 1). Countries that were not part of the EU in 1993 were already working their ways to inclusion. This created feelings of safety and homogenization of political and economic behavior throughout European countries.

Investors thought that this convergence may lead to a German flare for European competitiveness and monetary behavior within the Union. This sensation of monetary protection and diligence of being under the German Umbrella created a sense of fortification, lowering risk perception among entrepreneurs and governments. With this psychological effect, investors lowered their inflation expectations for all European countries. This process was undertaken on the false belief that the now heterogeneous countries so diverse such as Italy or Portugal will now behave more like the Bundesbank (the German central bank).    

The low interest rates throughout Europe permitted countries to enlarge their deficits in the 90s. These interest rates gave them long-term possibilities to accumulate massive government debt for extended periods of time. This entire process was being conducted and hidden under the single currency, the homogenization of interest rates and the feeling of security under a single controlling “inflation hawk”, the European Central Bank. These variables severely affected the heterogeneous and affluent price mechanism that was working before the introduction of the single euro currency. The previous system was one in which each single currency reflected relevant information about each country’s competitiveness (or lack of it) and political risk.

The new single currency system obscured relevant information about the current health and state of the European economies, as well as their lack of competitiveness. This insufficient information misled investors and affected the entire process of European wealth allocation. Therefore what we observe in Figure 1 is more than just a convergence of rates between 1999 and 2008; it is the central political intervention of the division of knowledge and the narrowing spectrum of the price mechanism, which dampened the possibility to reveal relevant information in order to make efficient capital and wealth allocation. The fundamental intrusion of the price system by a collective currency could have led nowhere else than a resource misallocation crisis. 
  
As we notice, one of the most crucial problems of modern societies is the competent allocation of resources. Professor Hayek stated that this could only be achieved by the spontaneous distribution of knowledge and information by singular individual actions and not by unification, harmonization of information and central planning. The complex system of actions either from individuals or European governments translates into economy through prices, including exchange rates. This complex price mechanism gives the right signals to investors and entrepreneurs as to where to allocate their capital and wealth. Under this spontaneous system, heterogeneity is essential. It is only thanks to different views and the subjectivity of actions that prices can reflect real and relevant information. As Figure 1 explicitly shows, this was undoubtedly abandoned in the single currency system.

To put it into Professor Hayek’s words, “Knowledge of the circumstances of which we must make use, never exits in concentrated or integrated form, but solely as the dispersed bits of incomplete and frequently contradictory process”. We noticeably recognize then that although the feeling of unification and the need to overcome the sufferings of the war are good intentions, the system required for a successful complex society and a market based price system needs to be based in the distribution of heterogeneous facts and not in the centralization of them.   

To believe that we can achieve prosperity by putting at disposal of a central authority “all the knowledge” to be used to rule and plan the future of European societies as their monetary policies, is just solely pretence of knowledge and abuse of reason. The solution that Professor Hayek provides to this conundrum is the proper use of individual knowledge throughout decentralization. “We need decentralization because only thus can we assure that the knowledge of the particular and relevant circumstances of time and place will be promptly used”. 

It is through knowledge dispersion and decentralization of information among European countries that the relevant facts such as competitiveness, productivity and government debts are reflected in currency prices and interest rates of the sovereign debt. In this way, prices coordinate the separate actions of individuals and thereafter the order of heterogeneous nations. The price system is then the only relevant organization system that sustains the whole idea of the division of knowledge in a complex society. Obviously centralization and a single currency are totally counterintuitive and against the natural order of societies. Currency unification will then be obvious in continuous conflict of communicating relevant information among investors. Therefore the new counterintuitive system will lead to systematic clashes and further misallocations. 

In a nutshell, The European Union as a monetary system was just a political system and a human collective dream. It had immense economic and social repercussions, which central planners failed to foresee. Central knowledge under unification discards the basic and fundamental individual knowledge dispersion in society.  Once again the insights of Professor Hayek might enlighten us to see how humans throughout history have undervalued the price mechanism: “The price system is only one of those spontaneous formations that human has discovered and learn to partially use, after we stumble upon it without fully understanding it”. Hence we can recognize that is not a product of human reason nor planning, and every attempt to rationally replicate it is futile. Ultimately it seems that once more society has forgotten the benefits of spontaneous order and price relevance without human design. European politics had discarded what Professor Hayek brilliantly realized. And so political dreams, arrogance of knowledge, and power for extended control have damaged the Open Society.   

*Edited by Vicki Finn

Figure 1: Interest rates on 10-year Government Bonds for 7 European Countries

 

Source: FTI Consulting and BBC news.


Sources
  
-          F.A. Hayek, Individualism and Economic Order, “Economics and Knowledge”, the University of Chicago Press 1948.
-          F.A. Hayek, Law Legislation and Liberty, Vol2 “The Mirage of Social Justice”, “The market Order of Catallaxy”, The University of Chicago Press 1976.
-          F.A. Hayek, The Counter Revolution of Science, Studies on the Abuse of Reason, “Scientism and the Study of Society”, The Free Press 1952.
-          Martin J. Dedman, “The Origins and Development of the European Union 1945-2008: A History of European Integration, Routledge 2009
-          Philipp Bagus, The Eurozone: A Moral-Hazard Morass, Mises Daily, Ludwig von Mises Institute 2012.
                                                                                 

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