Carmen Reinhart is co-author of ‘This Time is Different,’ the seminal history on financial crises, and a fellow at the Peterson Institute for International Economics. She is also not particularly surprised to see our financial crisis being followed by a massive sovereign-debt crisis. in an interview yesterday, she explained why.
Ezra Klein: There’s one interpretation of the events in Europe, which you often hear from the Obama administration, in which they’re presented as “bad luck.” But one of the lessons I took from your book on financial crises is that aftershocks like this are more predictable than that. It’s more like someone with a weakened immune system catching pneumonia. That’s not bad luck so much as it is a symptom of the underlying problem.
Carmen Reinhart: The immune system metaphor is very much how I view it. We do have a weak immune system. Our ability to withstand shocks is completely different than in quote-unquote more normal circumstances. But it’s not bad luck. Ireland is in a precarious situation for different reasons than Greece. But it wasn’t bad luck that got their gross external debt to 1,000 percent of GDP. It was a bet that things would continue to go well for a prolonged period of time.
EK: One element of your work has been to look separately at financial crises, sovereign-debt crises, currency crises, and various other forms of global economic misery. So what separates or connects a sovereign-debt crisis like the one we’re seeing in Greece from a financial crisis like the one we had here?
CR: Crises morph. It is common to begin with a period of financial liberalization in which there is a lot of cheap access to credit and a huge build-up in private debt. And in the boom years, because private debt is being built-up with the expectation that the collateral -- asset prices or equity prices -- will remain high, you get a lot of bad debts. So then the bubble pops and you get a huge hit. And then, in the most recent wave of crises, you get a blurring of the lines between public and private debt, as the government begins to take on what were originally private debts. So you march from a financial crisis to a sovereign-debt crisis.
This pattern I’m describing is most extreme in Ireland. In Greece, you had the public-debt problem to start with. To say the tax revenue base in Greece is weak is an understatement. Most emerging markets have better revenue bases. But it’s only when economic activity begins to slow down that you really see this big structural debt problem. So on the one hand, you have the Irelands, where the initial source of the problem was private debt, not public debt. Then you have Greece, where it was the public sector. And the US is somewhere in between.
EK: As I understand it though, even the public debt problems have some connection to private debt. If French and German banks hadn’t been lending to the Greeks at very low rates, the Greeks couldn’t have built up that sort of debt, and even if they had, the threat to Europe right now would not be so severe.
CR: Absolutely! Financial integration and liberalization can feed credit of any kind. It can feed private credit or public credit or a combination of both. So the liberalization of capitol markets in Europe led to a convergence in interest rates in which the spread between Greek bonds and German bonds was trivial, and that really facilitated the build-up of Greek debt.
EK: So how bad do you think this is likely to get?
CR: I think the outlook is dire, but it’s not end-of-the-world dire. I don’t think it’s even end-of-the-Euro dire. I think the ultimate endgame in Europe is debt restructuring in Greece and Ireland and Portugal. And, in particular, I mean haircuts. I mean changing contracts to be less favorable to the creditor. I don’t think austerity alone will solve the problem. I think Italy and Spain, for different reasons, will be able to scrape by without a restructuring, and I think that Germany and France will go to great lengths to avoid a dissolution of the Euro.
Let’s take the scenario that is the best shot at a non-collapse scenario: in that scenario, the sovereign debts are restructured and the banks are simultaneously recapitalized. That can stop a run on sovereign debt from becoming a run on banks. But the most likely scenario imminently is continued band-aids. It’s a scenario in which they get some incremental funding now, we continue to pretend that it’ll work, and we’re back in the same situation in December when we have a new round of debts coming due. But in the interim, while this is stretched out, output continues to decline, the Greek banks continue to be stuffed with Greek debts.
If the policymakers were to be proactive, they would restructure Greek debt alongside bank recapitalization and at the same time, restructure both Portugal and Ireland as well. Right now, the spreads show the market is worried about Greece. But once Greece is resolved, people will look to Portugal and Ireland next. So a proactive strategy would ring fence all of them. That would have the best shot at limiting the stamped from one asset to another.
EK: One concern I’ve heard is that the conditions for this aid and restructuring are so onerous and so austere that they make it essentially impossible for the Greek economy to survive the process. Do you worry about that?
CR: I think the austerity will come one way or another. If you don’t do it, I don’t see what the alternative is other than default. And that may be an even more disorderly default. What I would view as cushioning is more expansive monetary policy. You need to get your ducks in order in terms of the debt so you stop the runs every other day. But at the same time you need to keep interest rates as low as possible and you want the central bank actively buying government paper as much as possible. There’s no doubt that would be inflationary in normal times, but these are not normal times. And that’s where the European Central Bank has been more reluctant.
I think the most constructive thing would be for the ECB to purchase literally industrial quantities of the debt of these distressed economies and, secondly, for not just Germany but also individual governments to set aside some funding to recapitalize the banks that are holding these debts so there isn’t as much of a run. But the amount of denial right now is huge.