17/11/2011 10:54 GMT | Updated 16/01/2012 05:12 GMT

Europe's Blame Game

These are sad times for Europe. Three countries, Greece, Portugal and Ireland, are now dependent on external financing in order to repay their debt liabilities while Spain and Italy are widely muted to follow suit. Together they constitute more than 25% of the EU's GDP. The stakes are high.

These are sad times for Europe. Three countries, Greece, Portugal and Ireland, are now dependent on external financing in order to repay their debt liabilities while Spain and Italy are widely muted to follow suit. Together they constitute more than 25% of the EU's GDP. The stakes are high.

The sovereign debt crisis and its staggering mishandling by European leaders have dramatic effects on European economies. Harsh austerity measures are forcing Europe's periphery into ever deepening recession which is bound to affect growth rates in the North. Not surprisingly, the light is still faint at the end of the tunnel.

Humans are naturally inclined to point the finger when things go wrong and every European is doing just that. This tendency has served our evolutionary abilities well by allowing us to learn from past mistakes. What is astonishing in the case of the current crisis though is the disparity of opinions. Even after three years of intense scrutiny, we are still far from reaching a minimum of consensus about the causes of the crisis.

Take the case of Greece. A number of politicians and analysts suggest that the public is mostly to blame for the country's ills as they were asking favors in exchange for votes. The political class was merely responding to their demands. The patriarch of this view is Theodoros Pangalos, the vice-President of the Greek government, who (in)famously proclaimed in Parliament that 'we (i.e. Greeks) all 'ate' the (money) together'.

However, most Greek citizens would argue that they are not to blame for a system that favors cronyism and a complete disregard for the rule of law. Politicians created this system in an effort to maximize their grip on power and retain their access to lucrative state procurement deals. Greece essentially remains a family-run fiefdom whose rulers share a tiny fraction of the appropriated wealth with the public in order to keep them quiet.

Moving from the national level, there is even more confusion. Northerners blame the profligate Southerners and refuse to pay their bills. Why would hard working, tax paying Germans support the welfare provisions of bankrupt states? It was Greece and its likes that recklessly borrowed beyond their means and should now be held accountable.

Yet, others disagree with this view. True, Greece lied about its debt and has been running deficits for years. But Spain and Ireland had fiscal surpluses and negligible public debt before the crisis. In fact, Germany was the first state to disregard the Maastricht treaty rules in 2003! A more careful look reveals that the cause of the crisis lies not in Southern profligacy but in the structural imbalances of the Eurozone. Differences in productivity and labor costs inevitably result in balance of payment crises without proper adjustment mechanisms.

How do we reconcile these views? Are tax evading Greeks responsible for the current mess or Greek politicians for not putting them to jail? Is Italy to blame for the likely collapse of the monetary union or is it the Eurozone's fault to begin with by allowing Greece, Italy and others to join? Depending on your ideological standpoint, you might have different views about the relative importance of each effect. Yet, there seems to be a unifying theme: a failure of institutions.

Institutions, be it formal laws or informal rules of behavior, are important in every society because they shape the incentives to which people respond to. Essentially, institutions set the rules of the game. For example, Greeks evade taxes because there is no strong deterrent (e.g. threat of going to jail) and also because there is a widely shared view that taxpayers' money is wasted by the corrupt and inefficient Greek state. In turn, politicians take advantage of this and hold voters hostage to a political exchange of votes for leniency. This further reinforces the perceptions of the Greek public and the story goes on. There is no clear causal mechanism. It's a case of evolutionary institutional degradation.

Eurozone's crisis has also its roots in weak institutions. As explained before, countries were let in without proper consideration and there was no credible enforcer of the mutually agreed rules. Moreover, the mechanisms intended to promote convergence between European economies are a case study of inefficient design. Instead of directly targeting growth opportunities in different parts of Europe, the EU delegated responsibility to local officials. EU bodies were well aware of the systematic corruption and mismanagement in the distribution of structural funds and agricultural subsidies in a number of countries but chose not to intervene. No wonder differences within Eurozone were amplified.

The clear message here is that individual European countries and Europe as a whole need to fix their institutions in order to recover from the current crisis. Greece needs more respect for the rule of law and less corrupt politicians. Europe needs a change in treaties coupled with more democratic legitimacy for its policies. Economic recovery will then follow. Harsh austerity punishes the wrong people and further weakens the legitimacy of existing institutions.

The bad news is that there are no quick remedies. Building institutions requires not only a change in formal laws but in behaviors alike. And this takes time. Will Europe then persist and force through the required changes or insist on short-term fixes that only make things worse? Judging from experience, one can only be pessimistic about the probability of the former.