In the early 1950s, the American social psychologist Leon Festinger conducted an experiment that provides a valuable insight into Europe’s current troubles.
He encountered a religious cult that believed UFOs were coming to rescue its members from a cataclysmic flood that would destroy the earth. He infiltrated the group to research a theory he called “cognitive dissonance,” or the psychological tension experienced when people are presented with evidence that contradicts their assumptions or beliefs.
When the prophesied Day of Judgment came and went, without so much as a drop of rain or a flying saucer sighting, Festinger observed how the members coped with the dissonance of reality. Because the group had committed considerable expense in support of its view, altering its course was simply too costly. Instead, the leadership transposed its expectation to a future date, and encouraged followers to escalate their commitment and even proselytize others. Some members found a way to lessen the pain of disconfirmation; but ultimately, reality would prevail.
Festinger concluded, “Though they may try to hide it, even from themselves, the believers still know that the prediction was false and all their preparations were in vain. The dissonance cannot be eliminated completely by denying or rationalizing the disconfirmation.”
In many ways, this paradoxical story is analogous to the political psychology of the European debt crisis. Policy makers have committed, at considerable cost, to a path of bailouts and austerity programs. The recent European Council agreement out of Brussels offers more of the same -- billions in additional liquidity, yet no meaningful structural solutions.
It should be painfully clear by now that liquidity is not the answer. Equally evident is that austerity is not the cure. Throughout the European periphery, the disconfirming data mount as the calendar marches forward. Time, once thought a precious ally that could be bought for a price, is proving to be an adversary. It most certainly is not healing all wounds, as the economic data attest.
Thus far in 2011, Greece’s debt burden, budget deficit, cost of funding and unemployment rate are rising, while its economic output and tax revenue are declining. Ireland and Portugal are likely to follow in Greece’s footsteps and need additional support. Complicating matters further is the continued rise in interest rates in Italy and Spain, which puts additional pressure on their anemic economic growth and fragile banking systems. By the fourth quarter, economic contraction is likely to have engulfed the entire European periphery.
Austerity Doesn’t Work
In short, the data are proving that without currency devaluation, austerity simply doesn’t work. Crisis in Europe has not been averted; it has only been modestly postponed. Yet policy makers remain committed to the path of waiting and hoping for the best, seemingly oblivious to the need for significant structural reform.
What action should European leaders pursue? As Sherlock Holmes said, “When all other contingencies fail, whatever remains, however improbable, must be the truth.” Admitted or not, the realization hitting European policy makers is that the survival of the euro region will inevitably require a greater degree of fiscal unification. As German Finance Minister Wolfgang Schaeuble recently confessed, “The nation state as the sole level of policy making has exhausted its effectiveness.” He also admitted, “When we founded this monetary union, Germany was in favor of a political union, too.”
Narrowing the Discussion
Although “political union” is a vague term, European Central Bank President Jean-Claude Trichet has narrowed the discussion. He asked rhetorically in a recent speech, “Would it be too bold, in the economic field, with a single market, a single currency and a single central bank, to envisage a ministry of finance of the union?” Under Trichet’s proposal, the European Union would have the power to veto the budget measures of countries that go “harmfully astray.” In an indirect fashion, his wish has already been partially granted. Greece, Ireland and Portugal are currently subject to governance by the EU, the ECB and the International Monetary Fund.
The argument remains that Europe is far from possessing the political will for increased fiscal union. Politicians view it as unsalable to nationalist constituents. But the lack of action by European leaders may do the selling for them as the crisis deepens. As Jean Monnet, the man who built the very foundation for the European Union, once said, “People only accept change in necessity, and see necessity only in crisis.”
Just as crisis forced Greece, Ireland and Portugal to somehow muster the political will to implement drastic fiscal measures, so it may be with the rest of Europe. The growing financial crisis across the monetary union will ultimately help France and Germany find the political will to lead the euro region into a new era of fiscal alignment.
Although it may not seem plausible now, a lot of things seemed unthinkable in the United States the week before Lehman Brothers collapsed. This time around, wouldn’t it be better for Europe to end the denial and pursue a structural solution to circumvent a financial catastrophe?
Darkest Hours Ahead
As long as economic and fiscal reforms remain unaddressed, the darkest hours of the crisis still lie ahead. Eventually, the darkness will give way to the dawn of a structural solution. In this new day, a fiscal framework will emerge across the common currency, transforming the monetary union from a failing experiment to a sustainable reality.
Unfortunately, it appears that the only way to reach the dawn is to pass through the present darkness of denial. The most resisted resolution for the crisis is also the only viable solution. This is the cognitive dissonance of Europe. Recent policy actions have only delayed the inevitable. The endgame remains clear: Europe will either embrace a closer fiscal union willingly or wait until crisis requires it.
(Scott Minerd is chief investment officer at Guggenheim Partners LLC. The opinions expressed are his own. Guggenheim Partners Asset Management does not own any European sovereign debt securities.) Read more Bloomberg View op-eds.
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