Trust between Eurozone leaders can create self-fulfilling positive outcomes

Paul De Grauwe interviewed by Viv Davies, 13 July 2012

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Viv Davies: 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 10th of July, 2012 and I'm speaking with Professor Paul De Grauwe of the London School of Economics about his recent Vox column that describes the potentially destabilising effects of the decisions taken at the last crisis summit of Eurozone leaders. De Grauwe explains why, in his opinion, the new role established for the European Stability Mechanism is doomed to fail. He also suggests that the European Central Bank is operating on the wrong business model, and how full banking union in the Eurozone will not be possible without some degree of political union. De Grauwe maintains that only deeper trust between the Eurozone leaders will be able to create the kind of positive outcomes that will be required to save the Eurozone. I began by asking Paul how significant he thought the recent Eurozone summit had been.

Paul De Grauwe: The immediate reaction of the market was euphoric as usual. Then after a few days when everybody had become more sober, this euphoria disappeared and we saw that in fact nothing really had been solved. We thought that there would now be a mechanism that would create stability, but this appeared to be not the case, and we have to start from scratch, so to say.

Viv: Your recent Vox column focuses on the new role that's been established for the European Stability Mechanism, or the ESM, in that it will now be enabled to directly recapitalise troubled banks and to buy government bonds in the secondary markets in order to prevent further destabilising surges in bond yields such as we've currently witnessed in Spain and Italy. Yet you suggest that the ESM will not only fail to stabilise the bond markets, but the whole idea could in fact be destructive. Why is that?

Paul: It has to do with the following. ESM, the European Stability Mechanism, now has resources approximating 500 billion euros. The debt total of government bonds issued by Italy is close to 2,000. Add to that about 800 billion of Spain, and then your other possible countries and you see immediately that the ESM doesn't have enough resources to make it possible to stabilise the bond markets, right? If one of these countries gets into trouble, it's clear that the ESM doesn't have the money to provide stability. In fact it's worse because, given its limited resources, once it starts intervening investors will immediately see that its resources are depleted. It will start buying, say, Italian government bonds and at the end of the day you look at the balance sheet of the ESM and you'll see there's less left over for further interventions tomorrow. As a result, investors will anticipate the moment where the ESM runs out of resources.

That will be the moment where the ESM cannot intervene anymore and bond prices start declining again. But investors are rational beings, and they will put that to the present and they will therefore have a very strong incentive to sell immediately. As soon as the ESM starts intervening, this will signal to the market that it's time to intervene because they already anticipate that the ESM will be running out of resources and will have to stop that intervention.

It's extremely destabilising. This phenomenon is well known for people who know the literature, for example, about foreign exchange markets and fixed exchange rates that have the same instability feature.

Viv: Paul Krugman wrote about this.

Paul: Paul Krugman has a classic paper. Obstfeld later, also. Another type of crisis model for the foreign exchange market. These people don't seem to learn from what we know.

Viv: Given that Germany won't accept the idea of a Eurozone bond or some other form of debt mutualisation, and that the ECB isn't prepared to directly purchase government bonds, does this mean there's no alternative for countries like Spain and Italy other than to leave the Eurozone?

Paul: Well, if we stay in a situation where these countries like Germany and others, it's not only Germany. Holland and Finland are of the same idea if that goes on, then at some point Spain and Italy will have no other option. They will not accept to be driven into default. Sovereign nations that do not want to do that, will not want to be pushed by financial markets. Then the only option will be to leave the Eurozone, yeah. But that will of course be in an environment of violent instability that I hope we can avoid.

Viv: Of course. You maintain that the ECB is operating on the wrong business model. Can you elaborate a little on that for us?

Paul: Yes, ECB is concerned mainly with its balance sheet. It wants to avoid making losses. It wants to have positive equity. That's an overriding concern of the ECB. But that's wrong for a central bank to have as a primary concern. The primary concern of a central bank should be to maintain financial stability. That's why we need a central bank, to maintain financial stability. Capitalism is often gripped by booms and busts, and financial markets are then very unstable. The banking sector can become very unstable. We need an institution that is primarily concerned with financial stability, not with an institution that doesn't want to make losses. Because these two concerns conflict with each other. When the central bank has to intervene to maintain financial stability, it runs the risk of making losses.

It buys bonds, and it is possible that it will make losses. Not necessarily, but it's possible. If it is too much concerned about avoiding losses, it will not be prepared to buy the bonds in the markets, and as a result fail to maintain stability. Another example, the ECB after having bought Italian and Spanish government bonds, came out saying, "We want seniority on these bonds." Now, the effect of this is that the others, the private holders of these bonds say, "But now we have become junior, so the risk for us has increased," and they sell the bonds.

Here you have a central bank that is overly concerned about its balance sheet, does things that destabilise the financial markets. A central bank has to keep in mind that what it should do is to maintain financial stability. If that leads to losses, so be it. In fact, a central bank can make unlimited losses. Unlimited in the sense that it should not be such that it destroys price stability, because that's another objective.

That's the limit that the central bank should keep in mind, but we are so far from this today. The risk of inflation that the central bank surely should not be concerned today about potential losses.

Viv: The last time we spoke, you mentioned the matter of moral hazard when the ECB are lending. Could expand on that for us?

Paul: Well, when the central bank, when the ECB buys government bonds, for example, it alleviates the pressure of the governments. For example, the Italian government. This may lead to moral hazard in that the Italian government may then feel a little more relaxed. And then, not as much pressure to reduce deficits and debt levels. So that's the moral hazard problem that arises each time the central bank exerts its lender of last resort activity. The same is true for banks. When the ECB provides liquidity to banks, it also leads to moral hazard and the risk, therefore, the banks will take too much risk. That is certainly a problem. There is no doubt about this. The central bank, in times of crisis, must provide the liquidity. Others should then take care of moral hazard issues.

The way we did with it in banks is to say, "Well, you have supervisor regulators that try to limit the risk that banks can take. It's not easy, but this should be other institutions than the provider of liquidity. The one that provides liquidity should not try to solve two problems, namely liquidity crisis and a moral hazard problem. It's like the fireman that is at the same time the policeman.

The fireman that arrives at a burning house has to extinguish the fire, and should not try to be the policeman at the same time that is trying to catch the guilty. If he does that, he will not be a good fireman. The same is true for a central bank and also with respect to government bond markets when a central bank buys these government bonds, it provides the liquidity, it creates moral hazard. We should have another mechanism that deals with the potential moral hazard risk that is created by these liquidity interventions. That's also not easy, but that's the way we should do it.

Viv: Do you think full banking union in Europe will ever be possible without political union?

Paul: No. The banking union always implies some political union, not necessarily a full scale political union, but some. Let me give you an example. If banking union also implies that we will have a deposit insurance mechanism that is organised at the European level, in normal times the funding of this insurance mechanism can be provided by the banks that participate in all this. In crisis times, this funding is usually insufficient. As a result, you need a backstop that has to be some European institution then with the power to tax, and to make sure that the system can be kept. That requires some political union.

Viv: The immediate and most pressing problem in the Eurozone has been described recently as being a mix of excessive debt, failing banks, and uncompetitive economies causing a lack of access to financial markets. In addition, unemployment at over 11% is at the highest it's ever been in the Eurozone. Do you think we're moving any closer towards resolving these core problems?

Paul: Well, not really. I'm not very optimistic after all we have seen and the failure to act quite often, also propensity to decide the wrong things. It doesn't look like today we are in the process of solving these problems. We have not set up a mechanism that makes it possible for countries that are pushed into a corner by financial markets and are driven into insolvency to help them out. In addition, macroeconomic policies continue to be deflationary, where we put excessive austerity in some, especially southern European countries, without any compensating macroeconomics stimulus elsewhere. All this makes it very difficult to resolve these problems. Sometimes I am despairing, but I'm trying to convince myself that maybe at some point we will be able to resolve this.

Viv: What would be your immediate advice to the Eurozone leaders right now, Paul?

Paul: The basic requirement is that trust is to be established, because it seems to me that we are failing to come up with the right decisions because there is so much distrust. I see how the Finns, for example now, just a few days after the previous summit meeting. Distrust suddenly come up so much that they come back on these decisions. The Dutch do the same things. Everybody distrusts everybody. That makes it extremely difficult to come to the right decisions. All I can advise them is to tell them, well, start trusting each other. And then, this may even work in a self fulfilling way. Trust has this characteristic of creating self fulfilling positive outcomes. But unfortunately, we are now more in a bad equilibrium, where distrust is taking over, leading us into bad equilibrium.

Viv: Paul de Grauwe, thanks very much.

Topics:  EU policies Europe's nations and regions

Tags:  ECB, Eurozone crisis, European Stability Mechanism

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John Paulson Chair in European Political Economy, London School of Economics, and former member of the Belgian parliament.


CEPR Policy Research