Sunday, 14 August 2011

Pavlov`s Dog and the Euro

The Malta Independent on Sunday

Pavlov’s discovery of classical conditioning remains one of the most important in psychology’s history. In addition to forming the basis of what would become behavioural psychology, the conditioning process remains important today for numerous applications, including behavioural modification and mental health treatment.

In his digestive research, Pavlov and his assistants would introduce dogs to a variety of edible and non-edible items and measure the saliva production that the items produced. Salivation, he noted, is a reflexive process. It occurs automatically in response to a specific stimulus and is not under conscious control. However, Pavlov noted that dogs would often begin salivating in the absence of food and smell. Pavlov set out to provoke a conditioned response to a previously neutral stimulus. A particular acoustic was chosen to be the neutral stimulus. The dogs would first be exposed to the chosen sound and then the food was immediately presented.

After several conditioning trials, Pavlov noted that the dogs began to salivate after hearing the acoustic stimulus. A previously neutral stimulus changed to a conditioned stimulus that then provoked a conditioned response (salivation).

The financial markets behaved like Pavlov’s dogs last Monday, the first time they opened for business after, on the previous Friday evening, rating agency Standard and Poor’s (S&P) took the unprecedented step of downgrading the sovereign credit status of the United States from AAA to AA+.

Credit Rating of AA+ is still a very strong accreditation, but it is not AAA. It was previously unthinkable that the USA, the most advanced economy in the world and in control of the world’s reserve currency which investors were willing to lend back to the US Treasury for 30 years at less than four per cent, could somehow be deprived of its AAA status. The thinking was that if the USA is not AAA than no one else is.

The unthinkable however had gradually been becoming less and less unthinkable as the US Congress danced close to the edge of the precipice before finding a last minute dirty compromise to raise the US debt legal ceiling. S&P explained that while the USA could still be considered AAA regarding its ability to repay its debts, the shameful and laborious way the debt ceiling was raised created nascent doubts about America’s willingness to pay its debt, especially if the extreme Tea Party right wing branch of the Republicans were to increase its hostage bond on the US legislative process.

On Monday morning, the markets across the world argued that if the US had been downgraded nothing else remained unthinkable, not the breakdown of the euro, not the bankruptcy of other strategically important financial institutions, not even a double dip recession or outright depression, especially as governments had run out of resources to continue supporting the recovery through additional fiscal stimuli. As a result, investors suddenly and without further analysis went into risk aversion mode and sold off shares and bonds to park money into cash, gold and US Treasuries. Yes, like Pavlov’s dogs, investors had been trained to park their funds into US Treasuries whenever anything happened that triggered risk aversion. It was however comical that the downgrade of US credit that triggered the risk aversion forced investors to rush like headless chickens into the same US Treasuries that had just been downgraded.

This could be tragically serious beyond its comical surface. The message that nothing remains unthinkable is forcing financial capital markets into a sudden and spurious meltdown in values. This adversely affects consumers’ confidence, economic tempo, and investment plans. Suddenly, a slow but fragile economic recovery turns into a self-fulfilling recession turning the spurious into real loss of value. In this context, the euro debt problems shift from serious to life threatening. Solution to the euro debt problems largely depends on recovery of economic growth so the austerity measures can be alleviated by some hope of sustainability and return to normalcy. In the context of a double dip recession, the austerity burden becomes unbearable.

It is clear that while the US credit downgrade on 5 August triggered the current turmoil, the ultimate source is also shared by the inability of EU political leaders to get ahead of the market curve and take the hard political decisions needed to force the market to look at the EU as a whole unit rather than judge it by its weakest links.

Some weeks ago I was in favour of our contributing, as a still solid link in the EU chain, our fair share for the Greek bailout. Given developments since, I am changing my opinion. Unless EU leaders get themselves ahead of the markets, piecemeal bailouts will ultimately mean there will be more members in the rescue ward than rescuer members. Contagion will make sure that is a given.

Contagion can only be stemmed by a ‘shock and awe’ solution. This comes in two versions. Either a massive increase in the size of the rescue fund with contributions from sources outside the EU including China, USA and oil exporters; or a major political change in the EU set up permitting the issue of EU-wide Eurobonds on the credit status of the whole euro area rather than on the credit status of the individual components. Such a decision will obviously be the precursor of an eventual economic union, including a fiscal union that will be only one step short of a full political union.

In the absence of either of these measures, the euro system is doomed and will blow out probably sooner rather than later. So, without one of these two measures, I feel entitled to reverse my opinion and counsel against further contributions to bailout without one of these two measures being included in the package alongside the austerity for members seeking rescue.

Big changes in the EU only happen at five minutes to midnight when a strong crisis would be knocking at the door. Unfortunately, that’s the way the EU works. But we cannot continue behaving like Pavlov’s dog in the face of serial demands for bailouts.

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