Interviews & Speeches
Remarks at the World Economic Forum at the Central Sporthotel, Davos, Switzerland
I have just published a book which tries to explain and, to the extent possible, predict the outcome of the euro crisis. It follows the same pattern as my other books: it contains an updated version of my conceptual approach, the application of that approach to a particular situation and some kind of real time experiment to test the validity of my argument.
The book is not complete because the crisis is still ongoing. Indeed, what I am saying today is a part of the real time experiment. I won’t repeat or summarize what’s in the book. You’ll have to read it for yourselves. All I can do is to bring you up to date.
The measures introduced by the European Central Bank in December, including the LTRO, have relieved the liquidity problems of European banks but they did not cure the financing disadvantage from which the highly indebted member states suffer. Since the high risk premiums on Italian and Spanish bonds endanger the capital adequacy of the banks which hold those bonds, half a solution is not enough. It leaves the weaker members of the eurozone relegated to the status of third world countries that became highly indebted in a foreign currency. Instead of the IMF, Germany is acting as the task master imposing tough fiscal discipline. This will generate both economic and political tensions that could destroy the European Union.
I have proposed a plan that would allow Italy and Spain to refinance their debt by issuing treasury bills at around 1%. I named it after Tommaso Padoa-Schioppa, in memory of my friend who as central banker helped to stabilize Italy’s finances in the 1990’s. The plan is rather complicated, but it is legally and technically sound. It allows the ECB in partnership with the EFSF and the ESM to do what the ECB couldn’t do on its own: act as lender of last resort. I describe it in detail in my new book.
The authorities rejected this plan in favor of the LTRO which provides unlimited amounts of liquidity to the banking system for up to three years. That allows Italian and Spanish banks to buy the bonds of their own country and engage in a very profitable arbitrage at practically no risk because if the country defaulted the banks would become insolvent anyhow.
The difference between the two schemes is that mine would provide an instant reduction in interest costs to governments while the one actually adopted has kept the countries and their banks hovering on the edge of a precipice. I am not sure whether the authorities have deliberately prolonged the crisis atmosphere in order to maintain the pressure on these countries or if they have been driven to their course of action by divergent views which they could not reconcile in any other way. Which interpretation is correct is not inconsequential because the Padoa-Schioppa plan is still available and could be implemented at any time as long as the available funds of the EFSF are not otherwise committed.
Either way, it is Germany that dictates European policy because at times of crisis the creditors are in the driver’s seat. The trouble is that the austerity that Germany wants to impose will push Europe into a deflationary debt spiral. Reducing the budget deficit will put both wages and profits under downward pressure, the economy will contract and tax revenues will fall. So the debt burden, which is a ratio of the accumulated debt to the GDP, will actually rise, requiring further budget cuts, and setting in motion a vicious circle.
To be sure, I am not accusing Germany of acting in bad faith. Germans genuinely believe in the policies they are advocating. Germany is the most successful economy in Europe. Why should not the rest of Europe be like Germany? But that is impossible. In a closed system like the euro-clearing system, creditors must always be balanced by debtors.
The fact that an unattainable target is being imposed creates a very dangerous political dynamic. Instead of bringing the member countries closer together it will drive them to mutual recriminations. There is a real danger that the euro will undermine the political cohesion of the European Union.
Interestingly, the evolution of the European Union is following a course that resembles a boom-bust sequence or financial bubble. That is no accident. Both processes are reflexive and are largely driven by mistakes and misconceptions.
In the boom phase the European Union was what British psychologist David Tuckett calls a “fantastic object” – an unreal but attractive object of desire. To my mind, it was the embodiment of an open society –an association of nations founded on the principles of democracy, human rights, and the rule of law in which no nation or nationality dominated. Its creation was a feat of piecemeal social engineering. It was led by a group of far-sighted statesmen who understood that the fantastic object was not within their reach. They set limited objectives and firm timelines and then mobilized the political will for a small step forward, knowing full well that when they accomplished it, its inadequacy would become apparent and require a further step. That is how the coal and steel community was gradually transformed into the European Union, step by step.
During the boom period Germany was the main driving force. When the Soviet empire started to fall apart, Germany’s leaders realized that reunification was possible only in the context of a more united Europe. They needed the political support of the other countries and they were willing to make considerable sacrifices to obtain it. When it came to bargaining they were willing to contribute a little more and take a little less than the others, thereby facilitating agreement. At that time, German statesmen used to assert that Germany had no independent foreign policy, only a European policy.
The boom period culminated with the Maastricht Treaty and the introduction of the euro. It was followed by a period of stagnation which turned into a process of disintegration after the crash of 2008.
The architects of the euro knew that it was an incomplete currency when they designed it. The Maastricht Treaty established a monetary union without a political union. The euro boasted a common central bank but it lacked a common treasury. The architects had good reason to believe, however, that when the time came, further steps would be taken towards a political union. Unfortunately, the euro also had some other defects that the architects ignored and that remain poorly understood even today. These defects set in motion a process of disintegration that makes a political union more difficult to achieve today than it was when the euro was introduced.
The euro was built on an outdated theory of financial markets which assumed that only the public sector produces imbalances because market excesses are corrected by the invisible hand. In addition, it was believed that the safeguards against public sector imbalances were adequate. Therefore, government bonds were treated as riskless assets that banks could hold without allocating any capital reserves against them.
When the euro was introduced, the ECB accepted all government bonds at its discount window on equal terms. This gave banks an incentive to gorge themselves on the bonds of the weaker countries in order to earn a few extra basis points on the higher yielding bonds. That caused interest rates to converge and that, in turn, caused economic performance to diverge. Germany, struggling with the burdens of reunification, undertook structural reforms and became more competitive. Other countries, benefiting from lower interest rates, enjoyed a housing boom that made them less competitive. So the introduction of the euro caused the divergence in competitiveness which became one of the main components of the euro crisis. It also left the banks loaded with the government bonds of less competitive countries which is another component.
The tipping point was reached when a newly elected Greek government revealed that the previous government had cheated and the deficit was much bigger than had been announced. The Greek crisis revealed two defects in the Maastricht Treaty which could prove fatal: first, that when member countries become heavily indebted they become like third world countries that have borrowed too much in a foreign currency. Second, that there are no provisions for correcting errors in the euro’s design. There is neither an enforcement mechanism nor an exit mechanism and member countries cannot resort to printing money.
Unfortunately the European authorities had little understanding of how financial markets really work and did everything wrong. Financial markets far from combining all the available knowledge, as economic theory claims, are ruled by emotions and they abhor uncertainty. What was needed was a comprehensive solution and ample financial resources to implement it. But Germany did not want to become the deep pocket for bad debtors. Consequently Europe always did too little too late and the Greek crisis snowballed. The bonds of other heavily indebted countries, such as Italy and Spain, were hit by contagion and the European banks suffered losses that remained unrecognized on their balance sheets.
Germany aggravated the situation by imposing draconian conditions and insisting that Greece should pay penalty rates on its rescue package. The Greek economy collapsed, capital fled, and Greece kept failing to meet the conditions. Eventually Greece became patently insolvent. Germany then further destabilized the situation by insisting on private sector participation. This pushed the risk premiums on Italian and Spanish bonds through the roof and endangered the solvency of the banking system. The authorities then ordered the European banking system to be recapitalized. This was the coup-de-grace. It created a powerful incentive for the banks to reduce their balance sheets by calling in loans and getting rid of risky government bonds, rather than selling shares at a discount.
That is where we are today. The credit crunch started to affect the real economy in the last quarter of 2011. The ECB responded by reducing interest rates, buying government bonds in the open market and aggressively supplying liquidity to the banking system. This relieved the credit crunch but left Italian and Spanish bonds dangerously exposed – although the last few days brought some relief.
What lies ahead? Economic deterioration and a process of political and social disintegration will mutually reinforce each other. Up to the introduction of the euro, the European leadership was in the forefront of further integration; now they are clinging to the status quo. Treaties and laws that were meant to be stepping stones have turned into immovable rocks. This drives all those who find the status quo unsustainable or intolerable into an anti-European stance. What is happening in Hungary today is a precursor of what is in store.
This outlook is truly dismal. But there must be some way to avoid it – after all, history is not predetermined. I do see an alternative. It would recapture the European Union as the “fantastic object” which used to be so alluring when it was only an idea.
The European Union as a reality bears little resemblance to that fantastic object. It is undemocratic to the point where the electorate is disaffected and ungovernable to the point where it cannot deal with the crisis that it has created.
This is unacceptable but it can be changed. All we need to do is to reassert the principles of open society and recognize that the prevailing order is not cast in stone and rules are constantly in need of improvement. In short, we must reform the euro and the European Union according to the principles of open society. That is a program that should appeal to the silent majority that is disaffected and disoriented but at heart still pro-European.
When I look around the world I see people aspiring to an open society. I see it in the Arab spring, in various African countries; I see stirrings in Russia, and as far away as Burma and Malaysia. Why not in Europe?
To be a little more specific, let me give you the outlines of a European solution to the crisis. It involves a delicate two-phase maneuver, similar to the one that got us out of the crash of 2008. When a car is skidding, you first have to turn the steering wheel in the direction of the skid, and only after you have regained control can you correct your direction. In this case, you must first impose strict fiscal discipline on the deficit countries and encourage structural reforms but then you must find some stimulus to get you out of the deflationary spiral – because structural reforms alone will not do it. With individual countries under strict fiscal constraints, the stimulus will have to come from the European Union and it will have to be guaranteed jointly and severally. That will require Eurobonds in one guise or another. It is important, however, to outline the path well in advance. Without a clear game plan Europe will remain mired in a larger vicious circle in which economic decline and political disintegration mutually reinforce each other.