Europe's Third Challenge

ECB President Draghi made clear at yesterday's press conference that new risks have materialized and the central bank's job to reach its mandate is far from over. Current efforts may not suffice to achieve its legal prescribed mandate. Monetary policy will be reviewed and reassessed at the next meeting in March, when new staff forecasts will also be available.

In his opening remarks, Draghi cited the "slightly expansionary" fiscal policy, "reflecting in particular measures in support of refugees."  And hence the two main challenges, the economy and immigration, converge.  Of course, the definition of the economy has to be broad enough to include prices and finance.  Even before the Greek crisis last year was over, German Chancellor Merkel recognized the immigration-refugee problem was going to more intractable than negotiating with Tsipras and Varoufakis.

It seems to be increasing clear that liberal order that has erected in Europe was partly predicated on illiberal regimes in Northern Africa and the Middle East.  The collapse of several strong-man regimes has flooded the Italy and Greece with asylum seekers and refugees.  One of the agreements at very foundation of the liberal project of European integration lies the Schengen Agreement (1985), which does away with internal border checks.

An important part of the policy response to the deluge of hungry and homeless people is the imposition of internal border controls.  The Dutch Prime Minister Rutte told a Davos audience that officials 6-8 weeks to save the Schengen system before the spring when the flow of refugees is bound to accelerate.  Consider that already this month 35,000 refugees have flocked to Greece compared with 1,200 in all of January 2015.  EC President Juncker, never one to mince words, recently warned that without Schengen, the may be no reason for the euro.

This challenges of formidable, perhaps even existential in nature, which is all the more reason why many are surprised that European officials chose now to open up a third front.  The EC has taken an unprecedented measure to open a formal inquiry into whether the Polish government is undermining its democratic institutions.

The Law and Justice Party, known by its acronym PiS (pronounced like "peace") secured 235 seats of the 460 seat parliament last October's election.  Like all political parties it is a coalition of a variety of conservative and nationalistic views.  It is fervently anti-Russian, but it is also rejects many of the values associated the liberal European project.

Out of power for nearly a decade appears to have hardened views and positions.  Poland's President Duda and Prime Minister Szydlo have been regarded as pragmatic conservatives.  The poor performance in Western Europe has failed to provide an inspiration to many Poles.  Instead, the rapid changes taking place has ironically strengthened the desire to hold on to traditional values, God, country, and family. 

The PiS rejects the values it associates rightly or wrongly with Brussels.  These include  anti-religious and permissive.  The Pis is openly opposed to homosexual marriage, for example and abortion. Perhaps what illustrates best the illiberal thrust of the PiS is in its approach to the problem arising out of Swiss franc mortgages. 

Liberals stress the sanctity of contracts.  The PiS does not.  It wants what it says is a fair resolution, which means that despite contractual protection, Polish banks will have to bear some of the burden of the adjustment.  

Much of the criticism of the PiS, like the dispute over appointments to the constitutional tribunal, state institutions, including the security apparatus, are largely minor skirmishes in a country that has a new majority government, but without a well developed core of civil servants.  To the winner go the spoils is a hallmark of a certain stage of democratic evolution.  

More troubling may be the government's attempt to strip the judicial system of its ability to review the constitutionality of acts of parliament.   It is interesting to note that this power is not granted to the US Supreme Court in the US Constitution.  Rather, it was grabbed by the Supreme Court in an early case (Marbury vs Madison).  In a case vaguely similar to the incident in Poland, in his last days in office, John Adams made some judicial appointments that the new Jeffersonian government refused to honor. 

The intensity of the rhetoric on both sides exaggerated the developments in Poland.  While we suspect Poland is vulnerable to further credit downgrades, S&P's decision to do so, based on political considerations seems like a rush to judgement.     The bellicose rhetoric has quieted over the past week or so. 

Why did the EU reaction to Poland so strident?  There seems to be two related considerations.  The EU response to the illiberal practices is Hungary was timid.  This may help explain the over-reaction to Poland.  In addition, the EU may have gotten its back up was that the illiberal practices in Hungary appear to be spreading. 

The confrontation is far from over.  However, we expect the inquiry into Poland's threat to democracy will end without much fanfare or penalty.  The PiS economic policy will ultimately be more important for investors.  The extra though small tax on banks is not a critical point, and the central bank is not objecting.  The central bank also supports the government's drive to raise the tax-free income allowance.  However, it strongly opposes the government's proposals to lower the retirement age, the "fairness doctrine" on franc mortgages. 

The terms of all but one of the members of the Monetary Policy Council come to an end this year.  This will give the PiS government more control of the central bank.  The new appointments will be closely scrutinized.  Many are suspicious that the PiS will stack the MPC with easy money types. However, the one remaining MPC member has suggested that with the government pursuing  a more accommodative fiscal policy may require a different bias from the central bank.  The current MPC has been on hold since last March. 

The EU is wrestling with centrifugal forces threatening it.  The UK will likely hold a referendum on its continued membership later this year.  The political push back against austerity is palpable in Italy, Greece, Portugal and Spain.  The refugee challenge is shaking Europe to its Schengen foundation..   One needs to pick one's fights as carefully as one picks one friends.  While being cognizant that liberal values are not universally embraced in an expansionary EU, an extreme reaction will not help it win the hearts and minds.   Without challenging the PiS values head-on, the EU can insist on civil service reform and staggered terms for MPC members.  

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