Pull together or fall apart: can the Eurozone stand the stress?

Daniel Gros interviewed by Viv Davies, 02 July 2010

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<p><em>Viv Davies interviews Daniel Gros for Vox<br />
<p><em>July 2010<br />
<p><em>Transcription of an VoxEU audio interview [http://www.voxeu.org/index.php?q=node/5255]</em></p>
<p><strong><em><br />
</em>Viv Davis:</strong> Hello and welcome to Vox Talks, a series of audio interviews with leading economists from around the world. I'm Viv Davis from the Centre for Economic Policy Research. It's the 29th of June, 2010 and I'm talking to Daniel Gros, director of the Brussels based Centre for Policy Studies about the Vox eBook he has recently edited with Richard Baldwin on &quot;Completing the Eurozone rescue: What more needs to be done?&quot; I began by asking Daniel, &quot;What went wrong with the Eurozone in the first place?&quot;</p>
<p><strong>Daniel Gros:</strong> Actually, everything that could have gone wrong did go wrong. The fiscal constitution of the Eurozone was based on the assumption that no country would be bailed out by the others. And that actually, a bailout would never be needed because the Stability and Growth Pact would prevent countries from running large deficits. And we see that, in the case of Greece, the Stability Pact didn't work. Greece accumulated very large deficits, and we have problem number one. </p>
<p>The second thing that went wrong is that, by creating monetary union, we actually wanted to create an interconnected, integrated banking market. But we forgot that, at that point, banking weakness in any part of the Union would spill over into the entire system. But we didn't foresee any systemic, European wide bank rescue operations. And FBC is now something that is missing that had to be invented very quickly.</p>
<p>So these two key elements were missing. They are actually interconnected: weakness on the fiscal side leads to banking weakness and vice versa. That's why we have now one very big, interconnected mess.</p>
<p><strong>Viv: </strong>I see. So does this imply, perhaps, that the basic foundation for the Eurozone was essentially flawed? Many commentators might say, for example, that without a coordinated fiscal policy amongst Eurozone members, the whole concept of monetary union was bound to fail.</p>
<p><strong>Daniel: </strong>The design of monetary union was certainly incomplete. That is actually what is done very often in Europe. You build the bicycle, get on it, try to pedal a bit. And if it doesn't work, you add while you are hopefully getting along. Now, this time managed to be different because financial crises require extremely rapid reactions by policy makers, and we see that is very difficult under the current circumstances. It's quite clear that talking about more fiscal policy coordination would really have saved us. This tragedy was not about fiscal policy coordination in the sense of saying, &quot;You, Germany, spend a bit more, France a bit less, and Italy does something different again.&quot; This talks about keeping, actually, debt levels under control. Not only debt levels of governments, but also the private sector. Therefore, we need something quite different from just the term &quot;fiscal union.&quot;</p>
<p><strong>Viv: </strong>Eurozone leaders made what some have called a bold move in May this year, and provide 110 billion Euro bailout package for Greece and a special purpose vehicle to fund future bailouts. Isn't that enough to contain the problem? Or was there a coherent conclusion, perhaps, on what more needs to be done from amongst the authors in the ebook?</p>
<p><strong>Daniel: </strong>As we have argued in the book, these measures were needed to prevent total shut down of the European banking system. They could perhaps contain the problem for a while, but they are certainly not sufficient. As we see in the ongoing tension on both the banking market, and the government debt market of a number of countries. Now, just throwing money at a fundamental problem doesn't always solve it and that's the case right here. In the case of Greece, we have a 110 billion package, unprecedented for a country of that size. Does it solve the problem? It just buys time, two or three years. But we know that most markets look ahead, they look ahead much more than two or three years, 10 years, 20 years. And what they see at the end of the adjustment period is not very nice. That's why we have continued problems for Greece to refinance itself, and the Greek saga is certainly not over.</p>
<p>The same for the banking system. This special purpose vehicle which has been created these days legally should be able to provide over 500 billion Euros in financing, unheard of in European history. These sums have never been put together by national leaders. But are they enough? Yet, we don't know because we are discovering a key problem in the case of Spain, for example, is not so much government debt, which is actually quite limited, but is banking debt, and banking problems, not only in Spain, but in Germany, France and other areas.</p>
<p>Therefore, this is an untested vehicle. We don't know whether it will be actually working and we have argued, therefore, that more needs to be done.</p>
<p><strong>Viv: </strong>What the book is suggesting is a prioritization of reforms across the Eurozone countries in terms of bank restructuring, fiscal transfers, competitiveness, structural reforms. And other reforms, such as independent fiscal authorities. Could you explain a little bit more about your recommendations?</p>
<p><strong>Daniel: </strong>Yes. It is quite clear that the key order of the day is to have stress tests. What does it mean &quot;stress tests?&quot; It means that the national regulators have gone to the banks, seen what they have in terms of credits outstanding on forms in their portfolio, and asked themselves, &quot;What happens if a really bad scenario arrives? Can this bank survive? It doesn't have enough capital.&rdquo; That has to be done across Europe. It has now been more or less decided to do it for more of the largest banks, which should cover, more or less, the European banking system.</p>
<p>That, of course, will be extremely important to establish confidence in the interbank market. In the interbank market, we expect banks to lend each other at very low interest rates so there must be very little risk that's left. Banks must be sure that their counterparts can provide.</p>
<p>So we have a stress test. The next question is, &quot;What do we do with the results?&quot; Of course, we publish them. But what do we do when we find that a certain bank has perhaps not enough capital to withstand the stress, or just enough capital? How can you force this bank to take on more capital very quickly?</p>
<p>That is a key trend for policy makers now in the very short run. They have said that they will face up to it. But we have to see, first of all, how the stress tests are being conducted and whether there is a credible way to recapitalize banks which need capital very quickly. That has to be done. Without that, the problems will continue and would actually increase. This is the conditio sine qua non for any group. Once the stress tests have been done, the banking system should come down, the interbank market should work again. And the next order of business is, &quot;What country needs actually fiscal transfers?&quot;</p>
<p>The European Union has to distinguish between different countries. Greece is patently over indebted. Many people think they can't service a debt so a solution must be found. It's no good that policy makers say, &quot;We have a nice adjustment program for Greece, Greece can make it. If the markets don't agree, you can't finance the country in the normal way and therefore, something must be done that gives the market some reassurance that Greece can actually pay its debt. The best way might be just to reduce the debt level that Greece is taking. Other countries are in a much better situation. And therefore, I am optimistic actually, that if a solution for Greece can be found, then the remaining fiscal barriers in Europe should be manageable.</p>
<p><strong>Viv: </strong>And what is the solution for Greece, do you think?</p>
<p><strong>Daniel: </strong>The best way to proceed might be just to recognize that the country needs, for a very long period, some breathing space. So, perhaps one should say to bond holders of Greece, &quot;You have to wait for a bit longer. Greece will give you a zero coupon discount bond for, let's say 10, 20 years. You'll get back the nominal value, but you have to wait for the interest a while.&quot; And then I would add to that some sort of warrant which says that the additional interest that Greece is paying will depend on, really, people, because many people in the market say, &quot;We don't believe these growth rates that have been projected officially.&quot; So I would say let's make that into a special contract. Greece says that if growth is good, it will pay more to bond holders. And the optimistic ones, they can buy, then, these bonds, and the market will find an equilibrium again.</p>
<p><strong>Viv: </strong>Most if not all of these measures that you refer to in the book, in the introduction, with Richard Baldwin, have to be executed at a national level, which will require a considerable amount of national discipline and responsibility. Is it realistic to expect that this can be achieved, given that the Eurozone chain, so to speak, has been shown to be only as strong as its weakest link, i.e., in the case of Greece?</p>
<p><strong>Daniel: </strong>For the short term, actually, I'm rather optimistic. The pressure from the markets and the situation is so strong that governments are taking unprecedented measures, in Greece but also in other countries, and actually show some sign of cooperation. Also, think about the stress tests. One year ago, at the height of the crisis, Europe refused to publish stress tests. Now it's being done. So our policymakers can learn. Perhaps it takes some time, but they have learned at least something. For the longer run, it's quite clear that national fiscal institutions would be very useful to have, to constrain national fiscal policy. But it is also clear that we cannot rely on that only. You have to have some mechanism, as one of our contributors called it, &quot;To reduce debtors' blackmail.&quot; That is something that the European Monetary Fund, which I proposed sometime earlier, together with Thomas Meyer, an institution which would allow the EU to deal with emergencies, to resolve actual crises. And that is actually what is also being discussed at the official level. I hope that something will come out of that.</p>
<p><strong>Viv: </strong>Daniel, I was reading yesterday in the <em>FT</em> that, according to recent research conducted by the Economist Intelligence Unit, world business leaders see a growing risk that the Eurozone could break up in the next three years. Half of the 440 chief executives and heads of banks who were questioned say there's greater than a 50 percent chance of one or more countries leaving the Eurozone by 2013 because of deepening problems of debt amongst the members, and more than a third see at least a 25 percent chance of a complete breakup over the same period. Would you agree that this might be a real possibility, and furthermore, that a continued crisis of confidence in monetary union might even lead to Germany pulling out?</p>
<p><strong>Daniel: </strong>These are certainly very tough times for the Eurozone, and unfortunately, one can no longer totally exclude a breakup. But I must remind people that in the 1990s, similar surveys said that a monetary union would never come about. So one has to be a bit careful with these predictions. But it is clear that there's a real possibility that perhaps one or two smaller countries will choose to exit the Eurozone. There's a possibility that the panel is good. But, if you had a messy default in Greece, followed by some policy mistakes in Greece and then an exit of Greece from the Eurozone, would that actually weaken the Eurozone or strengthen it? Investors might actually say, &quot;Ah, the Eurozone is actually imposing tough choices on its member countries. That's a currency which will remain strong. That's a currency I like.&quot;</p>
<p>So, if smaller, weaker countries leave the Eurozone, that might actually strengthen it. Would Germany have an incentive to leave the Eurozone? I don't think so, because if Germany were to leave the Eurozone, then German banks would have their claims on the other Euro area countries only in the old Euro, which might be weak, compared to the new D mark, which would be strong. German banks would have to satisfy their own customers in the German D mark, in the new D mark, which is strong. So the German banks would immediately be bankrupt, and the German government would have to save the immediately. So that is not a very winning proposition for Germany, also.</p>
<p><strong>Viv: </strong>Daniel, some commentators are of the opinion that it's too late now for tinkering around the edges with national or independent fiscal authorities, and that the only thing that can now possibly save the Eurozone is a much closer political and economic union. Would you agree with that?</p>
<p><strong>Daniel: </strong>Yes and no. When I talk about tighter economic or political union, many people have some vague ideas which are not at all helpful. And as one of our contributors, Paul De Grauwe, writes, one has to be realistic. People still feel national first and European second. But one can have some institutions that would actually give us the essence of what we need. We don't need a fiscal policy coordination in the sense that every small fiscal decision has to be vetted and controlled by Brussels. But the key thing is that we have an institution which allows us to say no, to reduce debtors' blackmail. So something like the European Monetary Fund, perhaps even something like this special purpose vehicle that's being created. This vehicle could be used not only to save countries; it could also be used to say no to a country and just save the European banking system instead. That might be a much better way to proceed.</p>
<p>So, in a sense, European leaders have already decided that they're willing to put a lot of money on the table. If they're using this money in a smart way, with institutions which do not only bail out countries, but perhaps also allow the rest of the Eurozone to save its own banks if a country doesn't perform... Then, actually, we could create out of this crisis a system which will be much stronger than before.</p>
<p><strong>Viv: </strong>So you, and the book in fact, are optimistic about the future of the Eurozone.</p>
<p><strong>Daniel: </strong>I am guardedly optimistic, because we have seen that our leaders, if push comes to shove, they're willing to spend a lot of their financial and political capital to save it. They have taken some first steps, which were needed, not sufficient. They are now about to take another important step in the form of a stress test. If that is done well, then I'm hopeful that this crisis could be salutatory in the end. The stress tests, as I said, are really key. But there, the devil is in the details. They will be out in two or three weeks, so no point in speculating about it. The best way might be to come back once they have been published and actually ask ourselves, &quot;Was that a step forward or backwards?&quot;</p>
<p><strong>Viv: </strong>Well Daniel, thank you very much indeed. It's been a pleasure talking to you.</p>
<p><strong>Daniel: </strong>OK. Bye bye.</p>
<p><strong>Viv: </strong>Bye bye. </p>

Topics:  Global crisis

Tags:  eurozone, stress tests, Vox ebook

Click here to download ‘Completing the Eurozone rescue: What more needs to be done?’ (Edited by Richard Baldwin, Daniel Gros and Luc Laeven).

Director of the Centre for European Policy Studies, Brussels


CEPR Policy Research