EZ crisis: the answer is commitment

Thomas Cooley interviewed by Viv Davies, 16 September 2011

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<p><strong><a name="fn"></a>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 15th of September, 2011 and I'm speaking to Professor Thomas Cooley of the Stern School of Business about the current sovereign debt crisis in the Eurozone. We discuss his recent Vox article written with Ramon Marimon which proposes how Europe could learn from the U.S. in how to achieve fiscal prudence without loss of sovereignty. We also discuss the role of the European Central Bank and the need for a strong fiscal authority in Europe.</p>
<p>The Eurozone crisis has entered a dangerous new phase with Greece on the brink of default and the core countries also now under threat.</p>
<p>I began the interview by asking Tom whether he thought the Eurozone is heading for meltdown, or if this situation could still be salvaged.</p>
<p><strong>Thomas Cooley</strong>: Well, I think the situation can still be salvaged. I think part of the salvation of the Eurozone is to agree on some kind of commitment mechanism that will take these kinds of fiscal problems off the table in some future states of the world. There are two obvious things that need to happen. We have to resolve the current issues by whatever mixture of debt restructuring or orderly defaults and austerity programs. And I think if those things are done, then the Eurozone can, and I would say should, survive in the long run.</p>
<p><strong>Viv</strong>: You suggested in that earlier Vox article that the Eurozone needed a credible institutional commitment, as you've just said, which you described then as the &ldquo;fiscal parallel of the euro&rdquo;. What exactly did you mean by that?</p>
<p><strong>Tom</strong>: Well, what I meant by that is a commitment mechanism. The analogy I drew was with the U.S. states. It's well known that many of the U.S. states, some of the biggest ones, like California, Illinois, have faced significant fiscal problems and significant fiscal imbalances. And yet they still have access to capital markets at quite favorable rates. The question is why. The answer is that for most of these states there is a constitutional commitment to service general obligation bonds before all other claims on the tax revenues of the governments of the states.</p>
<p>This kind of takes the issue of fiscal brinksmanship off the table. U.S. states are not allowed to go bankrupt, to file for bankruptcy. They constitutionally have to honor their debts first before they pay the police and firemen and the other local government workers.</p>
<p>That imposes an automatic austerity regime. If the fiscal situation gets out of balance in a given state, it's a problem - and it is very much a problem in some states like California - but it's a problem that is a local problem. It's not a problem for the union.</p>
<p><strong>Viv</strong>: In today's FT you mentioned California then, in today's &quot;Financial Times,&quot; as Jean Paul Fitoussi and Philippe Weil suggested a solution to the debt crisis would be for governments to coerce their taxpayers into lending to the government, what they described as forced borrowing. They refer to the fact that California did just that in 2009 when it added a premium to the income tax withheld from paychecks to be repaid the following year. Does that resonate somewhat with your views?</p>
<p><strong>Tom</strong>: Well, it does a little bit. It's a mechanism for collecting taxes that were not part of the original budget. I'm less enthusiastic about that as a solution for Europe because they have problem enough with collecting taxes. I would say that one of the problems that is just endemic in some of the southern European countries - Greece and Italy are the most notorious - is their ability and willingness to actually collect the taxes that they already have. So I don't see this as a great solution.</p>
<p>I think a better solution is to build in some kind of long term commitment. The problem with a tax premium is that it's just a short term fix. The government's ability and commitment to repay those short term premiums is questionable.</p>
<p><strong>Viv</strong>: Sure. You mentioned Greece then. Do you think it would be better to allow Greece and the other heavily indebted countries to leave the Eurozone and for them to revert to their former currencies? Or maybe even for those countries to establish a second tier Eurozone or effectively a north and a south Eurozone?</p>
<p><strong>Tom</strong>: Well, I actually don't think it would be better. I think the cost for both them, for the countries that leave, and costs for the countries that remain would be much higher than trying to work towards a solution which involves everyone staying in the Eurozone. Now, at the same time, I do think that it is going to be the case for a very long time that there is going to be a two track Eurozone, that the slower growing countries, the countries that have been in the most trouble, are in the most trouble for a variety of reasons.</p>
<p>One of them, the biggest reason, obviously, is slow growth. One of the reasons for the slow growth is their failure to invest effectively in education in order to improve the competitiveness of their economies.</p>
<p>So when all those countries joined the euro, they joined a strong currency and it made their competitiveness worse in a sense. A lot of the jobs that left, for example, Portugal, left and they're not coming back.</p>
<p>The only answer to that, in the long run, is for those counties to move up the value added chain. The key to that is education. If you look at educational achievement statistics for the southern tier countries, it's very clear that they have missed the boat, that they're running behind the stronger European economies in terms of what they're accomplishing with their educational system.</p>
<p>There are lots and lots of indications that that is true. So I think that for some time to come, until they address that problem - and it's not a problem that can be addressed overnight, it's a 20 year solution - that there is going to be a slow growing part of the Eurozone and a faster growing part.</p>
<p><strong>Viv</strong>: Moody's has just downgraded two of France's largest banks. What do you think that signals? How serious do you think the potential is for the sovereign debt crisis in Europe to become a full blown banking crisis?</p>
<p><strong>Tom</strong>: Well, the latter possibility is definitely there. And part of the reason why Moody's has downgraded them and part of the reason for the issues that are plaguing Europe today, this morning, is that, for example, many of the sources of funding of those banks have pulled out. U.S. money market funds were exposed to European banks. They were doing a lot of business there and they have tried to decrease their exposure because it is a systemic risk - the fact that U.S. money market funds are linked and exposed to European debt problems. Pulling back from that kind of created more problems for European banks.</p>
<p>Now I think that the downgrades are probably justified given the deterioration in their capital position. But I think they are basically strong institutions. I think they can recover from that. But it is a kind of precarious moment.</p>
<p><strong>Viv</strong>: What do you think the role of the European Central Bank should be in relation to the current crisis, and indeed, going forward?<br />
Tom: Well, that is the $64 question, as we say&hellip;or the 64 euro question.</p>
<p><strong>Viv</strong>: Yes, the 64 billion euro question!</p>
<p><strong>Tom</strong>: The 64 billion euro question, indeed. Obviously the original conception of the European Central Bank is that it would be an institution of monetary policy with very clearly articulated goals. The fact that they have gotten engaged in fiscal policy has been a source of very deep controversy and it continues to be. I think the recent resignation of J&uuml;rgen Stark and previous resignation of Axel Weber, these have in large part been in reaction to the willingness of the ECB to get involved in what are properly fiscal issues and something of a protest against that.</p>
<p>It signals that there is a lot of dissention internally in the bank about that. On the other hand, it's hard to see what the alternative would have been given that there isn't a central fiscal authority. Given that back in March, the Europeans came up with only the weakest of solutions to a common fiscal approach to the debt crisis, somebody had to step in and underpin the banking system.</p>
<p>I think one can argue that it is legitimately their role to provide liquidity to the banking system going forward. They crossed the Rubicon when they began to buy Greek debt and now subsequently Italian and other countries' sovereign debt.</p>
<p>So this is going to be an issue of contention for some time. If it's not going to be the ECB engaged in these kinds of fiscal operations, there has to be an alternative institution or an alternative way of addressing them.</p>
<p><strong>Viv</strong>: Finally Tom, how would you summarize the advice you'd give right now to Eurozone leaders and policymakers?</p>
<p><strong>Tom</strong>: Well, I think they really need to change the terms of the compact. They need to decide and they need to make a firm commitment to the role of the central European government in European economic affairs. And that's always been just missing. It's always been a little vague or a little less committed than it needs to be. The answer is commitment. In the U.S., when the U.S became a country after the War of Revolution, Alexander Hamilton and Thomas Jefferson and James Madison and others got together at a dinner and made an agreement about the central fiscal issue at that time, which was assumption of the debt of the Revolutionary War.</p>
<p>It was necessary to agree that they were going to honor all their debts as a union. There had been a lot of disagreement about that between Jefferson and Hamilton. I think Europe needs to figure out what the equivalent of that is.</p>
<p>They need to figure out that there needs to be a strong fiscal authority. They need to insist on the kinds of constitutional changes that I suggested or that U.S. states have or something like that, that provides a degree of commitment for the future.</p>
<p><strong>Viv</strong>: Tom Cooley, thanks very much for talking with us today.</p>
<p><strong>Tom</strong>: It's my pleasure.</p>

Topics:  EU policies Europe's nations and regions Financial markets Global crisis

Tags:  Eurozone crisis, EZ

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Professor of Economics, Stern School of Business and Faculty of Arts and Science, New York University


CEPR Policy Research