A: The key point was that 100 billion euros is still a big sum of money. Even a rich continent does not have too many of those bullets to fire, so when you fire the bullet you want it to hit the target. It missed the target because there was a large amount of uncertainty about which fund it was coming from, what the seniority of the position is, and, fundamentally, is it inserting capital or just making a big loan? What the banks need, like the U.S. banks in 2008, is a capital infusion. So the European Union worked its way to bypass some of their procedures to arrange 100 billion euros. But because those questions were left unanswered, the market reacted negatively. So, the point in that case is that you have to try to get ahead of the problem and not only make the tough decisions but execute in a coherent way.
The second big issue is that Spain and Italy have been making difficult reforms on the fiscal side and to a degree on the structural side to improve their competitiveness. But those reforms will take time to show the benefit. So they need a duration match between the time that the benefits show up and their funding. And the lack of assurance about that funding is what leads their bond yields to be creeping up. There are a host of options out there…but Europe is hesitant about making clear that anyone will be the backstop.
Q: Why do you think this crisis has proved so difficult to resolve – so persistent, despite all the steps the euro zone has taken over the last two years?
A: The market situation is tricky. Expectations are very low. That could be good news because if something positive happens you could get a positive reaction. Second, even though market expectations are low, behind that is an assumption that when the Germans say we won’t let it fail, that they mean it, so that, ultimately, Europe will save the euro. The biggest risk is of miscalculation. So as Germany deals with the problem incrementally, or plays brinksmanship, or negotiates, that the snowball starts getting so big going down the hill that you can’t stop it at the last minute…The other variable is France, both politically and economically. Historically, France and Germany have been the drivers of European integration. So if one wanted to look for something that could help, (French President Francois) Hollande is much more of a Europeanist than (former President Nicolas) Sarkozy or (former President Jacques) Chirac. If he were willing to take some steps…that could provide some opportunity to work out with the Germans a compromise. And even if they have not executed it all that would deal with some of the confidence problems in markets. But, Hollande is walking a very thin line because some of his campaign rhetoric, if implemented, could make France part of the problem not part of the solution. So I think this remains a very fragile period. The proposals...put out are an effort to come up with a coherent approach. That is the good news. The bad news is the key countries, particularly Germany, are not yet ready to embrace them. From the perspective of the rest of the world, Europe is now a troubled place that has negative economic effects on some markets, particularly the Balkans and North Africa. And it remains a significant downside risk if things slide out of control.
Q: On the backstop issue, do they need European Central Bank President Mario Draghi to step in? It seems the experience of fiddling with the European Financial Stability Facility and these other ways of helping countries keep market access just are not getting there. They make incremental steps, and nobody believes that enough money will be on the table. Do you have recommendations on how to do it?
A: These are fundamental decisions about the political future of Europe. It’s like the Articles of Confederation period in the United States. What I and others can do is first say be careful you are playing with fire. And there is no shortage of ideas to deal with the banks or the core debt of Spain and Italy. But the specific economic tool is less important than picking one and making it coherent. There is always somebody who says, “Do this, do this…” My key logic would be put more capital in the banking system…The second thing is make sure the countries continue to make reforms. That is where the Germans are correct. You can’t just fund your way out of this by using their credit. You have to make the reforms. But where the Germans have been too cautious is they need to show they would be willing to provide assurance that Spain and Italy can fund themselves at reasonable rates if Spain and Italy continue to make reforms. It is a fair exchange. You have to get an overlap of the politics and the economics to make it work. If it is likely to be workable and it is politically acceptable, that is my say.
Q: But look at the path they have gone down. They have had two years to erect these backstops. Do you feel there is a sustainable solution to Italy and Spain’s funding costs that can be handled on the fiscal side without the involvement of the central bank?
A: Step back. This is a wealthy continent still. If they operated like the United States operates, their fiscal position was shared, this would be a manageable problem. But it is not the United States. Could you still salvage this? Yes. But it would require a combination of the big ones, Spain and Italy, sticking with their reforms, and some form of financial support. You get some people from markets that only look at this in economic terms. This is as much about the politics of reform as it is about the economics. But politics alone won’t do it if you don’t get into the right economic solution set.
Q: But that’s like saying there is enough food in the world – the distribution issues are profound…
A: But these are the political questions about whether Germany and some of the northern tier countries…are willing to offer support while they fix it. So far we have not got that combination right.
Q: Given the experience of the last couple of years, do you agree with the premise that Germany will allow this to be fixed, or do you have any skepticism given the way they have spooled this out so slowly?
A: I take the German leaders at their word. I think they are sincere that their object is not to let it fail. But I am worried that the process could lead to brinksmanship and miscalculation and it could slip out of their control. I am increasingly concerned that the Germans already face problems with their constitution. I am picking up from more and more Germans, people who have been traditionally committed to Europe, that their frustrations are building. So it adds to the complexity of (German Chancellor Angela) Merkel’s and (finance minister Wolfgang) Schauble’s challenge. It is still doable, and they are deeply committed to Europe. But I have seen enough things in policy and politics where the best intentions don’t necessarily get you where you need to go. I have long argued that they need something that underscores Germany’s core objectives on fiscal and structural reform but that would offer the reformers the type of backup and support as long as they continue making the reforms. And so far that has been a little ephemeral. And that shows up in markets. They have pieces, but the pieces have not come together.
Q: You mention the Balkans and the global impact of this. For a while, Europe went through its troubles and the U.S. held up. You now see companies saying it is affecting our earnings. But the worst has not happened. As this has continued over two years, is it as risky as we think it is?
A: It remains very risky. It depends on the particular market. For the Balkans and Central Europe in North Africa, Asian banks have stepped in on trade finance. If you are in Latin America or Asia it depends on the sector. If you were an exporter to Europe – this has had an effect on the Chinese. It depends on the ability of countries to offset that effect. So far it has been a drag. But if it slips out of control it will be much worse than a drag because you will have a break in confidence in financial markets – a Lehman moment. There is another downside short of the Lehman break in psychology, and that is a degradation in markets where you get creeping protectionism. One of the benefits of the euro is one market and one currency. Because people are concerned they are trying to have euro assets and liabilities matched country by country. It’s a re-nationalization process…All that has a cost. We are seeing creeping protectionism in trade markets. In the developing world, where countries are recognizing they cannot rely as much on export-led growth and they are moving to domestic demand, some of those countries are also under pressure to not let that domestic demand leak out. And that could lead to a whole series of policies that serves local powers or interest groups or oligarchs but interferes with larger markets. The longer this goes on without a clear pathway, you get more and more strains in the international economy.
There are political and security implications of this. For the past 80 years the U.S. has seen Europe as its major partner. (At a climate conference last week in Rio de Janeiro) the European environment ministers were going around lecturing people on what they should do…and I don’t think they even recognized that many of the other countries were saying who are you to be telling us how to do this stuff? This has long-range implications for European influence in the world.
Q: This has been a concern in Europe, too. People are starting to discuss how Europe is going to be credibly at the table with China, for example, if this continues.
A: The developing countries have been doing better. They have been the principle source of global growth. But they have not escaped this. You see China slowing down. India has its problems. Latin America has to be careful because a lot of their growth is based on commodities, and that is linked to China…The U.S. has its own set of challenges – we have our own looming budget mess, the fiscal cliff; and the second thing is huge regulatory uncertainty in the financial sector, the energy and environmental sector, health care. And so, this creates an environment where if you are a business person and we get a revival, you are going to be careful. You may add some workers, you made add some extra lines, but are you really going to build a new factory? Then you go to Europe, and the problems are multiplied, not just because of the fiscal problems but because of these fundamental issues of the inability of economies to adapt their structure to a world that continues to change, competitively, quickly…Silicon Valley thinks in discontinuous ideas – how do we create a software that changes a business model like Amazon does for bookstores. And I asked about Europe, and they said you cannot get this type of entrepreneurism because if you hire a worker you are stuck with a worker. And in these businesses you either make it or break and start again. The idea of risk and reward is still very different in the United States.
Q: On the U.S. fiscal position, how do you compare the debate here and Obama’s performance in it with what is underway in Europe. They may not have solved their problem, but they have been blunt about these issues – raising retirement ages, for example.
A: There was a missed opportunity in early 2011 when Simpson, Bowles, Domenici, Rivlin offered a pathway that you were starting to build some significant bipartisan support. And I don’t mean to suggest everybody was on board. I can start to feel that you could bring a critical mass around a package. But it won’t happen unless the president of the United States does it. So in that sense the United States missed a moment, and if we had done something then, frankly, we would have had more standing internationally to help with Europe now. That shows the old notion that the United States is still a key player internationally, but to be a key player we have to get our own foundation in place at home. It is not just the budget. You could close the budget gap by raising taxes. It also depends on the regulatory, the competition, how you bring in the private sector. I cannot go to a developing country where people are not interested in public-private partnerships for developing infrastructure. In the middle-income countries, it is not even driven by the desire for capital; it is driven by the realization that the projects are better designed, better maintained, better operated. I find it interesting that in Chongqing, China, the home of Bo Xilai, we are working with them to monetize toll roads. But in many states they are unwilling…So it is not just budget-balancing but how you create incentives for private-sector investment. Around the world there is a huge interest in education, skills training, work force development. And there is a lot of experimentation going on about private-sector players that provide that service. In this country, it has all been locked down to student loans and who is ripping things off, as opposed to seeing what models work.
Q: Is it too broad a brush to say you feel the developing world is intellectually a bit more flexible and innovative when it comes to some of these public administration issues?
A: The developing world is more pragmatic about using what works. It does not mean that they have got it all right themselves. Their income levels are still lower. Their productivity levels are still lower. So they have their own challenges. China has had a very successful growth model for 30 years. It won’t carry them for the next 30 years. They are going to have to change…I am not saying we should look to the developing world for all the models, because our model is still superior. But we should have some of the pragmatism that the developing world is having.
Q: You talk about pragmatic models. You came in at a moment when people were saying do we even need institutions like the IMF or World Bank – things were humming along. What parts of the orthodoxy from that time has had to be unlearned?
A: I have tried to make it a more problem-solving institution. The fundamental notion is that developing countries are clients. Rather than have an hierarchical model where the brilliant economist says here are the three things that the developing world must do, we start by talking to the developing countries and sharing the experience of other developing countries.
Q: Do you buy the argument that came up in the search for your successor -- that the bank’s money now is less important than its expertise?
A: I have long believed that our challenge is how to combine three things: innovative financing to stretch the money further, with the knowledge and learning, while, third, building institutions and markets and capacity. And that varies. In Afghanistan you have a capacity issue. In some middle-income countries it is developing local currency bond markets. It is financial inclusion, helping people have savings and insurance funds. The mistake has been that the pure economists’ view of this institution is simply looking at it as a source of public capital, and that misses what I think its core function is.
Zoellick will be joining the Peterson Institute for International Economics as a distinguished fellow.