<p><strong>Viv Davies</strong>: Hello, and welcome to Vox Talks, a series of audio interviews with leading economists from around the world. I'm Viv Davies, from the Centre for Economic Policy Research. It's the 14th of December, 2011, and I'm speaking to Professor Paul De Grauwe, of the University of Leuven, about the crisis in the Eurozone and the decisions taken at last week's Brussels summit.</p>
<p>De Grauwe suggests that the fiscal compact is incomplete, in that it fails to address the main problem of imbalances between the north and south in the Eurozone. He maintains that the ECB needs to act decisively, and questions why its moral hazard considerations should not apply equally to banks and to sovereigns.<br />
We also discussed the idea of a sovereign debt guarantee fund as a potential solution to the problem of sovereign liquidity.</p>
<p>I began the interview by asking Paul whether he thought that the decisions that came out of the Brussels summit were a case of too little, too late.</p>
<p><strong>Paul De Grauwe</strong>: I'm afraid it's a case of too little, too late. We have seen that before, and again, today, or last week, we have the same stuff, that is, some agreement, but clearly not doing all the things that are necessary to get out of the crisis. With so much focus on austerity and discipline, of course, these things are necessary, but I guess, most economists agree today that there is much more going on in the Eurozone than budgetary problems. In fact, the main problem seems to be the imbalances between the north and the south, and they are not dealt with at all in this agreement.</p>
<p>In addition, the diagnosis that is at the basis of the fiscal compact, as it is called, is incomplete. Many countries have problems, not so much with the government budget, and that's prior to the crisis, but with time, the debt accumulation that was unsustainable. Well, we all know the example of Ireland and Spain, and these countries surely would have had no problem following the fiscal compact, but that would not have prevented them from getting into trouble.</p>
<p>So it's a completely incomplete agreement that will not pacify the markets.</p>
<p><strong>Viv</strong>: Since the summit, we've witnessed bond prices falling and the political commitment to the fiscal compact, as you say, unraveling, country by country. Italian and Spanish yields are currently down, above sustainable levels. And the ECB efforts in buying debt in secondary markets has also been ineffective. And the euro, now, is also losing value against both the dollar and the pound. And the markets are turning seriously against the euro. Do you see any way of getting them back?</p>
<p><strong>Paul</strong>: I think we will have to act at different levels. Again, I'm telling things that, nowadays, many economists will agree on. In a very short run, there the ECB is the key to the crisis. This is the only institution that has the resources to deal with the crisis, that make sure that the fear and the panic that today exist in the bond markets is stopped, because it is fear that drives the prices of government bonds of Italy, Spain, and others down. This can only be stopped if the ECB is willing to provide liquidity and make sure, in doing that, that the interest rates on these bonds must not continue to increase. That's key, the ECB can do it, it refuses to do it for all strange reasons.</p>
<p>The euro is serious money, small hazard, of course. But what strikes me so much is that the ECB has not hesitated one second last week to provide billions and billions to banks, although the same moral hazard occurs there, right? When you give all this liquidity to banks, there we also get the signal that now they can relax a little bit, and in the future, can take on more risks.</p>
<p>All the same kinds of analysis that one can do to the banks, then what the ECB is doing with governments. But it attaches so much weight to moral hazard, as soon as you talk about intervention in the government bond market, and zero weight to moral hazard when interventions have to be done in the banking sector. It's very inconsistent, and I don't understand why this difference is made in the analysis and the importance of moral hazard.</p>
<p>Yet, by not intervening in the government bonds market, a banking crisis is inevitable and the way the ECB is now doing it, structuring this, it's now going to intervene in the banking sector, trying to prop up liquidity of the banks.</p>
<p>But the source of the problem, that is, the sovereign debt crisis, is not dealt with, and this is going to be like a leaky bucket. Providing liquidity to banks while the price of the government bonds on the asset side of their balance sheet continues to drop, will not help the banks, and as a result, the ECB will have to spend much more trying to prop up the banks.</p>
<p><strong>Viv</strong>: Yes, your recent Vox column highlighted that point. You suggested that the ECB is more likely to wait until the sovereign debt crisis has degenerated into a full scale banking crisis before it acts. How far do you think we are away from that point right now?</p>
<p><strong>Paul</strong>: It's difficult to say. How these things depend so much on collective movements of panic and fear, and they are very much unpredictable. The timing, I'm afraid I cannot predict, but I think we are getting closer to that moment, right, where there will be some big casualties. Some banks will fail, unraveling the whole system. Yeah, I think there's no time to waste, how we, the ECB, should act where it can be effective.</p>
<p><strong>Viv</strong>: I think you also suggested the liquidity injection required for bailing out the banks would be much greater than it would be if it were purely for sovereigns.</p>
<p><strong>Paul</strong>: When you look at the balance sheets of the banks and the liability of the banks, they are of an order of magnitude of three to four times bigger than the sum of the debts of governments in the Eurozone. It's just much more, but I think you have to support banks. Potentially, you have to set much more liquidity aside than if you decide to act in a government bonds market. That makes it even more perplexing, why the ECB refuses to act where it's going to be most effective, and where, in fact, it can also avoid that the banks are pulled down in this whole crisis.</p>
<p><strong>Viv</strong>: In the FT today, John Paulson suggested the ECB should set up a sovereign debt guarantee program, similar to that which the US successfully implemented following the collapse of Lehman's in 2008. He maintains that this sort of program would provide the necessary firewall that's needed to address the short term liquidity needs of sovereigns. It would immediately calm the credit markets and be non inflationary. It also eased pressure on banks, as sovereign debt concerns subside. Is this suggestion realistic, in your opinion?</p>
<p><strong>Paul</strong>: I've no problems with that suggestion, but, in fact, it's not much different from proposals that I've made and others where the ECB announces that it will intervene in the markets, will use all its firepower and try to stop, or announce, in fact, the interest rate above which it will act, so that, it can, in fact, set a ceiling on the interest rates. In a sense, it's exactly what John Paulson is proposing, right? The ECB announces that it guarantees the liquidity for the sovereigns at a particular interest rate. In other words, the ECB is ready to provide liquidity in the market. It's basically the same thing, that's the way I interpret it. From an announcement where the ECB goes out there and says, &quot;This is the target interest rate that we aim for, we will not allow the interest rate to be above, and we will use all our firepower.&quot;</p>
<p>And then, if the market believes it, then the ECB will not have to intervene, very much like in the scheme of John Paulson. If the markets believes that the ECB will be a guarantor of these bonds at that particular price, they will not have to use it. I think he says that the governments would have to pay one percent, or something?</p>
<p><strong>Viv</strong>: Yes.</p>
<p><strong>Paul</strong>: But that&rsquo;s a good structure, in my proposal, also, you could say, for example, the ECB will make sure that the interest rate of Italian bonds does not exceed 200 basis points above the German bund rate. Something like this, and then you have something similar, the Italian government also has to pay some penalty for the service of the ECB.</p>
<p>The advantage of that approach is that it also gives a strong incentive to investors to buy these bonds, because they get an extra premium, and as a result, they will find it attractive to buy these bonds. Then, also, allowing the ECB not to have to intervene too much in the market.</p>
<p><strong>Viv</strong>: Are we potentially looking at the end of the single currency union, do you think?</p>
<p><strong>Paul</strong>: Well, I hate to come to these conclusions now. I mean, we are certainly in a danger zone, we have manage it well. I think we can, certainly, we have the means to do so. We don't need the IMF, we don't need the EFSF, all that is all constructions that do not function, and they have been constructed because the ECB doesn't want to take its own responsibility. But here we are, we can manage this, but unfortunately the political will do so is lacking. I guess the main reason is that there's so little trust in each other. Northern Europe distrusts southern Europe, fundamentally. If you go to Germany, you hear the stories about &ldquo;lazy Greeks&rdquo; and what have you, and &ldquo;we don't want to spend one euro to these countries&rdquo;. Forgetting, in fact, today, it's not the German taxpayer who pays for the Greek, Portuguese, or the Irish, but the other way around. It's the Irish, the Portuguese, and the Greek who pay for the German taxpayer, through this mechanism of financial assistance.</p>
<p>Nevertheless, so much mythology is going on here and policymakers, instead of fighting this and coming out forcefully for the maintenance of the Eurozone, follow this and, as a result, it's become very difficult to do the right thing.</p>
<p><strong>Viv</strong>: Finally, Paul, in summary, what would be your road map out of the current euro crisis?</p>
<p><strong>Paul</strong>: Well, in the very short run, I would say the ECB has to step in forcefully and announcing that it is 100 percent committed to do so, and then it can stop the panic. Once this is achieved, then we can do all the other things that are necessary. Of course, budgetary discipline will have to be implemented. But also the imbalances that exist within the Eurozone between the north and the south will have to be dealt with and an adjustment will have to be necessary. Also, implying that the northern Eurozone countries will have to do their part of the adjustment, that is, with using their surpluses, because without the willingness to reduce their surpluses, the southern countries cannot reduce their own deficits. Then, in the very long run, we have to take steps towards more political union, to embed the Eurozone in something tight, political union, to have a currency with a country instead of, today, a currency in other countries.</p>
<p><strong>Viv</strong>: Paul De Grauwe, thank you very much for taking the time to talk to us today.</p>
<p><strong>Paul</strong>: You're welcome. <br />
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