All week, we’ll be interviewing experts on the European debt crisis. First up is Barry Eichengreen, professor of economics and political science at the University of California at Berkeley. Compared with some other experts you’ll hear from in this series, he is relatively optimistic about the future of the European Union. (The transcript has been lightly edited for length and clarity.)
Brad Plumer: Markets seem to be reacting positively to the recent steps European leaders have been taking to stabilize the debt crisis there. Is that optimism well-placed or no?
Barry Eichengreen: The markets reacted positively at the beginning of the week because they heard that European policymakers were finally beginning to address the relevant issues. Those issues included: strengthening weak banks by injecting the capital necessary; the need to acknowledge and act upon the fact that Greece is insolvent; and the need to ring-fence other European countries once Greece’s debt was meaningfully restructured. There was the announcement that the 15 banks identified as problem banks in the latest stress tests would get more capital. And there were hints from European policymakers that Greece bondholders would have to take serious haircuts, as opposed to the cosmetic haircuts that they’d been subjected to on July 21. There was also talk of leveraging the European Financial Stability Facility (EFSF) to give it the firepower needed to ring-fence other European countries. That was all good news.
The bad news is that markets got carried away. There was some commentary on this side of the Atlantic, which was not adequately informed by an understanding of European politics, that led investors to believe this would all happen tomorrow. In reality, it will take some months. These steps won’t get done without considerable negotiation, infighting, and posturing by various politicians. The idea that this period of high uncertainty is over is naive. We’re in for a couple more months of volatility at least.
BP: So what are the big hurdles standing in the way of resolving the crisis?
BE: Number one, somebody has to take major losses on Greek bonds, and the holders don’t want to do that. First and foremost, that includes French banks and the European Central Bank. They don’t like the prospect of debt restructuring, and they continue to resist the inevitable. Weak banks don’t like to acknowledge that they’re weak; they don’t like the prospect of diluting their existing shareholders by raising more capital.
There is also a reluctance in German political circles about supersizing the EFSF, about leveraging it and enabling it to provide guarantees so that large-scale purchases of Italian and Spanish bonds can be undertaken to stabilize their bond markets and limit contagion. Germany fears that there may be losses on those purchases, which will end up on the doorstep of the German taxpayer. And there’s mixed feelings in Greece itself about debt restructuring and default. That’s embarrassing to any government under any circumstances, and tends to be resisted even when the writing’s on the wall.
BP: So has the crisis become sufficiently serious that some of the resistance to drastic action is starting to weaken?
BE: The crisis has become more serious. We’re seeing sharp drops in European stock markets and bank shares. There’s increased uncertainty, which has contributed to the slowdown in Europe, and that’s affecting the rest of the world, including the United States. Everything has gotten worse over the summer, leading to an acknowledgment by almost everyone that Plan A, what was agreed to on July 21, will not fly. And that they have to move to a Plan B. That’s the positive answer.
The negative answer is that there’s not yet a consensus about what Plan B is. There still isn’t enough progress on fortifying Europe’s banking system, which is the big problem. There’s still not enough agreement on how to supersize the EFSF. There’s still a reluctance by the European Central Bank to backstop European bond markets. There still isn’t enough progress in Italy on putting pro-growth measures in place that are necessary to avoid becoming another Greece.
BP: Now what about the prospects that Greece could leave the euro?
BE: There’s the question of how this looks from Greece’s point of view. Would abandoning the euro be better or worse for Greece? And the answer is debatable. You could argue that in the medium term, Greece would be better off. It could devalue its new drachma and become more competitive (although that would depend on how wages and prices respond as they start printing drachmas). But you have to balance that against the short-term costs: a full-on bank run, the need to close down financial markets, to close down Greece’s border. So it’s not clear how short-term costs and long-run benefits balance out.
But from the point of view of the rest of the euro zone, Greece leaving would be a disaster. Where Greece led, would others follow? Questions would quickly move to Portugal, and that would be followed by Spain, Italy, France and Belgium. If you think a Greek exit would be chaotic, the implications for the rest of the area would be chaos squared.
BP: So after Europe’s latest steps on the crisis, do you see a euro zone breakup as more or less likely?
BE: The events of last three years have taught us that nothing can be ruled out. We’ve seen many financial events and developments in the last three years that experts never thought they’d see in their lifetimes. We hadn’t seen a bank run in Britain since 1890 and then saw one three years ago with Northern Rock. So anything is possible. But I think European leaders and politicians are being reminded that the costs of allowing or forcing a member state to exit the euro area would be very, very high. Now, the costs of keeping it in are also very, very high. But you’ve got to choose. And European leaders seem to have finally forced themselves to acknowledge that there’s not a third low-cost alternative on the table.
BP: Now, as European leaders are moving to stabilize the current crisis, they’re also proposing longer-term reform measures as a way of reassuring politicians and taxpayers that they won’t have to accept another round of bailouts once this crisis has passed.
BE: I think this linkage has been part of the reason crisis has been so difficult to resolve. Markets won’t wait, they need a resolution now — within the next couple of weeks or months. But these structural reforms will require several years to complete. That’s how politics works in a euro zone of 17 countries. So the idea that you can put all these long-term structural reforms in place, and with that reassurance then the German voters and Bundestag will agree to supersize the EFSF — that’s a little off.
BP: What would you propose for longer-term structural reforms?
BE: In the longer term, my diagnosis is different from most people. This is first and foremost a banking crisis. Somebody lent Greece all this money, and the name of that someone begins with a “b”: banks. And now, the constraint on solving the crisis is that those banks are in a weak financial position. So they need to fix the way supervision and regulation of banks is done. Europe has a single currency, a single financial market and yet 17 separate national bank regulators. That’s madness. They need to have a single bank regulator with real powers. They actually created one at the beginning of this year, the European Banking Authority, but it still has no authority to crack down on national bank regulators who don’t take into account the effects of lax regulation on their neighbors. Where were French regulators when French banks were buying all these Greek bonds?
Number two, I think they do need to deal with sovereign over-borrowing where it’s a problem. But it’s important to be clear: up until the crisis spread to Europe, this was a problem in Greece and nowhere else. Still, this issue is important. But I think it is somewhat naive to think that you can create a single fiscal czar or paymaster who lays down how much each national government can spend. Instead, the E.U. needs to require each country to have a national fiscal council, the equivalent of our Congressional Budget Office, which can make realistic and accurate fiscal forecasts. That council should have the power to say, you’re crossing budget speed limits, and spending cuts need to kick in because revenues have fallen short. The E.U. could also require each country to have a set of fiscal procedures, maybe the equivalent of a balanced-budget amendment.
And number three, they need to have an adequately funded emergency financial facility. When a country does get into trouble in the future, through no fault of its own, there needs to be a way of providing emergency liquidity. The Europeans don’t have an adequate facility at moment; that’s why there’s debate about supersizing the EFSF. They’ve gone about halfway down this road by saying there’ll be a mechanism starting in 2013, but the design there is flawed — it’s a popgun rather than a bazooka.
Notice I haven’t uttered the words “fiscal union” yet. I think fiscal union is a bridge too far. The important steps are centralized bank regulation, E.U. requirements about national fiscal rules and procedures, and a mechanism for providing emergency liquidity.