Spring 2005

A World Without Rules: A Capital Idea

David Blake

Dreaming of systems so perfect that no-one will need to be good

T. S. Eliot

Back in the 90s, just before the Euro was launched, I was chatting to Hans Tietmeyer at a meeting in Luxembourg. The very first time we had met was many years before, in 1970, when he was a young official in the German Finance Ministry and I was a very young Brussels correspondent for The Times. What brought us to meet on both occasions was monetary union in Europe.

The first time, he had just been appointed to a committee chaired by Luxembourg Premier Pierre Werner which the EU had set up to prepare a plan for monetary union; the 90’s meeting was at a colloque to honour the said M. Werner and to celebrate the fact that 29 years after his report had been published the Euro was finally about to come into being.

And so without wishing to pour rain on the parade, I felt I had to point out that when I had written The Times account of his committee’s 1970 report I had made much play of the fact which they themselves had stressed; that it should be created by the end of the decade. Well, they’ve finally adopted your plan,” I said but I wish you had told me which decade you meant.”

But you are entirely wrong, Herr Blake. This is not the plan which we recommended at all. We believed there would be an economic government for Europe, which would take all the necessary decisions to guide the economy. But states were not willing to give up their sovereignty. So instead we have had to rely on a system based on predetermined rules; and because of that we have had to make the rules much harsher than they would have been if there had been an authority which could be trusted. And we shall see,” (and for the first time in my life I understood what writers mean when they use the phrase his voice darkened’) we shall see how it works out.”

Not very well I think you’d realistically have to say, and therein lies a broader lesson. Compare the economic performance of Euroland with its near neighbours or the USA. Unemployment is at record highs in Germany and touched bottom in the Euro Zone as a whole in Spring 2001. Since monetary policy always acts with a lag, Spring 2001 is when you would expect Europe’s performance to start reflecting the ECB’s stewardship after the Euro’s 1999 launch. Growth in output has been far less than in the US.

The Euro Zone is the most extreme example of a trend which has been rising as faith in politics has been falling. Instead of relying on men and women, the Euro system set some rigid rules for monetary and fiscal policy, the two main pillars of economic management. Interest rates have to be set to keep prices stable. Unlike the US, where the Fed explicitly states it is trying to maintain growth and employment as well as price stability, the ECB is given just one task and interprets it very narrowly.

It was really fiscal policy that Tietmeyer was thinking of when he was talking to me. The Stability Pact is at the heart of the rules-based” system. Countries which wanted to join the single currency had to cut their budget deficits below 3% of GDP; the fear was that once inside the system they would let those deficits rise again. So the pact requires governments to keep their deficit below 3% at all times and to aim for a zero per cent deficit on average. There are elaborate rules for deciding if a country has broken the terms of the agreement and even more elaborate rules for deciding punishments if they do. These budget rules in the Stability Pact have played out in the worst possible way. They have been fudged, cheated on, ignored, broken and yet have been tight enough to prevent a proper fiscal stimulus to the European economies in the wake of 9/11. Both France and Germany have had deficits above 3%. Faced with all this, the EU is trying to rewrite them.

But the new version of the rules seems likely to be even more complex than the current one. It is suggested that the Commission should apply 16 special tests to see if a country deserves an exemption from punishment. The trouble is, of course, that there are two directly opposing motives at work in the current debate. Some, like the ECB, the Austrians and the Dutch, are angry that any country has got away with breaking the 3% ceiling and want the Pact to be tougher in future with quicker and harsher punishment. Others, such as the German government, the French and the Italians feel the rules are too tight and are strangling their economy. Now, I side very firmly with the Germans on this issue, regardless of the irony that it was a German government which was so insistent on the Stability Pact in the first place. But what reason is there to think that the new rules will turn out right, or that even if they are right now they will be right in the future?

The instinctive response when rules turn out badly is to try to make them more complex. But that attempt to get more precision is as likely to open up new problems as it is to solve old ones. Give governments 16 possible exceptions and they will try to tailor their spending to find gaps in the rules. Then there will be calls for the rules to be tightened up and 16 rules will soon become 32. And so on. Trying to get more precision is exactly the wrong way to go. What rule building tries to do is very similar to what the very first, most primitive computers did. It takes a set of procedures which solve a problem and then hardwires them into a computer. Trouble is, the problems keep changing. The ENIAC computer had a team of eight whose sole job was to pull out the wiring and put it back in a different order whenever the problem changed. What the computer scientists understood very quickly was that the only way to make computers viable was to make it easy to change programmes by turning them into separate software.

Economic policy is like that. Decisions about the economy are being taken all the time by millions of agents around the globe. What matters to them changes for all sorts of reasons. Sometimes financial markets hate countries with government deficits, sometimes they love them. Sometimes cutting public spending speeds up an economy, sometimes it slows it down. It would make life easier if this were not so. If we always faced the same problem we could just wire the computer up, weld the box closed and not worry about it any more.

We can’t because of a fundamental fact about the nature of modern western capitalism, which happens to be the fact which has allowed it to see off all alternatives. This is that the strength of the system comes from its flexibility and from the fact that it maximises the number of agents who play a part in decisions; maximises the number of times they get to make decisions; and maximises the freedom which they have in taking each decision on its merits. It’s true that the actual content of the Stability Pact was far too biased towards deflation and took no real account of the need for growth. But that is not the real problem. The real problem is that it reflects a way of thinking whose time has gone, if it was ever there. Economic policymakers love thinking of what they do as like driving a train. We must get the economy back on track” or we cannot yet give a green light on inflation.” But the modern economy is much more like driving a car than driving a train. People jump out into the road at unexpected moments; road works mean that it is sometimes necessary to take to the side road; the driver who should be giving you priority does not see you because he is changing the radio station.

In the past few years, starting in Holland, they have tried a new approach to handling the meeting of people and cars. Instead of building more and more barriers to keep pedestrians off the road, more and more kerbs to keep cars off the pedestrians and more and more traffic lights to tell everyone to stay exactly where they are, the new approach uses a simple principle: EVERYONE should look where they are going. Those who have the most power to injure should be the ones who pay special care. So road markings go, as do kerbs and as do traffic lights. Result: fewer accidents. It’s been so successful that a similar scheme is going to be tried in the Museum area of South Kensington in London. No one suggests that this is the right way for all situations, but that’s part of the point; it’s a mistake to look for one rule which fits all.

At best, returning to monetary questions, numerical targets can have indicative status only. Until Europe realises that, then the latest round of problems on the Stability Pact will have many repeat performances. Indeed, the attempt to refine the details of the Stability Pact is in some ways reminiscent of a problem which occurred in the very early days of the US space programme, long before manned flight was tried. Every object launched into space burned up as it re-entered the atmosphere. The scientists knew that the cause was air friction and they also knew that for aeroplanes the answer to air resistance was to make them sleeker and more streamlined. So each space projectile was made sharper and sharper. But as they got more like a needle, they just seemed to burn up faster. Only then did someone realise that they were looking at the problem the wrong way round. Space vehicles have to use air resistance to slow down and the way to do it is to make the front as big as possible. And so they came up with the idea of having the space module enter the atmosphere backwards, blunt end first with a heat shield to protect it.

No such leap of imagination seems likely from Europe’s economic policy makers. And this is a pity.

David Blake is at Fulcrum Asset Management LLP