Viv Davies interviews Philip Lane for Vox

October 2011

Transcription of a VoxEU audio interview [http://www.voxeu.org/index.php?q=node/7071]

Viv Davies:  Hello, and welcome to Vox Talks, a series of audio interviews with leading economists from around the world. I'm Viv Davies, with the Centre for Economic Policy Research. It's the 5th of October, 2011, and I'm talking to Professor Phillip Lane of Trinity College Dublin, about the Eurozone crisis. We discuss Ireland's export‑led recovery, the implications of a potential Greek default, and the interconnectedness of banking risk and sovereign risk in Europe. Professor Lane presents his and other economists' proposals for European safe bonds. We also discuss banking reform, the role of the EFSF, and the ECB.

I began the interview by asking Philip whether the combination of bailout and austerity in Ireland had worked in terms of enabling the recovery of the country post‑crisis.

Philip Lane:  Well. The first thing to say is, this is not the ideal way to go. The problem for Ireland is that before the crisis, the surplus was more or less around zero. You could argue that they were in line with the Stability and Growth Pact. But given the boom in the economy, having a surplus of zero during a boom is not good enough. What you've seen is the end of the housing bubble, the collapse of the construction sector, and if ever you need a fiscal response, this was it. Because the surplus was not big enough before the crash, the surplus went from zero to double digits very quickly. You need to allow that kind of slide, given the scale of the recession. But because of the weakness in the fiscal policy before the crash, it meant the bailout was necessary.

I don't think it was the ideal way to go, but given that they failed to run surpluses in the good years, it was necessary. And the bailout has helped also in terms of behaviour. It gives the policymakers a target. They can justify difficult tough measures by saying, "This is the agreement we have." That's a classic role for the IMF, to help to provide local discipline in this situation.

In terms of recovery, the economy at one level is impressive. We've had this very big fiscal austerity. But at the same time, right now the economy is more or less stable. Predictions that the fiscal austerity would be self‑defeating in the sense of causing a downward spiral in GDP, that's not happening.

The reason why it's not happening in Ireland is that the export sector has taken over. So it's an export-led  recovery. That I think is good and helpful, but it's maybe not something that every country can do so easily. Ireland has a very big trading sector, and that's a key difference relative to, say, Greece or Portugal.

Viv:  To what extent is continued Irish recovery, then, dependent on stability and growth in Greece and the other peripheral Eurozone countries?

Philip:  I would view that as maybe through the financial risk. The main issue there is ‑ will Ireland be able to return to the private markets? If the fear in the European sovereign debt market continues, because of fear that there's going to be a wave of default and so on, then Ireland would have to receive extra fiscal funding in 2013. Ireland has money until 2013 under the current deal, but maybe extra fiscal funding will be needed in 2014, 2015. That's where the main risk is. Because in terms of our exporting, a lot of the exports go to the US, go to the UK. It's not particularly directed at the Euro area. So Ireland is exposed to the Eurozone crisis mostly through the financial implications, but the trading implications – they're certainly there, but they're limited.

This is a general point about the Euro area; the Euro area is very interconnected in terms of finance. It's not so interconnected in terms of trade. Germany is exporting to markets in Asia; all of these countries have significant trade links outside the Eurozone.

Viv:  Yes, I'd quite like to hear your views on the interconnectedness of banking risk and sovereign risk. Many commentators are currently stressing the importance of recapitalizing European banks through an enhanced EFSF. Is that the right way to go?

Philip:  I think this is the single most important conceptual point about what we're learning about monetary union. If you have monetary union, it seems as if that really does require quite a bit of union in terms of banking policy. It's debatable whether you need fiscal union, except in this one area, which is because there's a single central bank, there's a single money market in Europe. Essentially, if banks in one country get into trouble, there are all sorts of contagion affects across the whole system. As you say, the optimal path there is that there's a collective responsibility for stabilising the system.

For banks which are not systemic, there has to be a mechanism to shut those down. For banks which are too big to fail – recapitalization. I think there's a menu there. First of all, try to get private sector money in, whether it's private sector in Europe, sovereign wealth funds in Asia, rich Americans and so on. But if there's no private sector money, then it's the taxpayer.

And as you say, in order to make sure that there's isn't the doom loop where banking risk in one country infects the sovereign of that country, it's better that recapitalization is done through a European vehicle such as EFSF.

Yes. This is what Ireland said should happen a year ago vis‑à‑vis the Irish banking system. That was rejected at the time; it said, "No, the Irish government should do the recapitalization." But now I think there's a lot of momentum in this direction.

Viv:  You and some other eminent economists have recently been proposing the introduction of European safe bonds, or ESBies. Could you describe what ESBies are, and how they differ from the idea of Eurobonds?

Philip:  Sure. Our group, the Euro‑nomics group, has been looking at different dimensions of the European crisis. There are a few problems with Euro bonds. First of all, you could make the call about whether they're feasible, at least in the near term, in terms of the many countries which will be uncomfortable with guaranteeing the debt of other European countries. And then a second, there's clearly a moral hazard problem: Unless you're very successful with restrictions, the temptation on any individual country in such a federation will be to overborrow, given that the costs of borrowing are essentially shared across the system.

The contrast for us is, you can have a European debt agency, which might be the EFSF in some form, where there's no common guarantee, there's no need for treaty revisions, and so on. Because what this fund will do is, it will buy up national sovereign bonds. So each country is still responsible for its debt, it's still issuing its own bonds.

But through pooling the risks, and then importantly, issuing two types of European securities – one would be the safe bond, the ESBies, which essentially will be super safe. Then there would be a junior security, where the junior security would be the first to get hit, should there be a default by some national government and could further possibly enhance the safety of the European safe bonds by having a layer of a credit guarantee,where that could maybe come from EFSF and so on.

So if you had this situation, this European safe bond would be safer than any individual national bond because of the pooling of the risk, and because you've differentiated, by having the junior bond take the first hit in the event of a crisis. And our idea would be then if this bond existed, it would be the natural main safe asset for European banks.

If you like then, the Greek system would not be overexposed to the Greek sovereign, because Greek banks would be mainly holding this European safe bond.

So there are a lot of attractions to it clearly, and it's one proposal. It can be revised over time, depending on what the political reality is. We think that this is something that can be done without any treaty change, offering a lot of the attractions of Eurobonds, without encountering some of the difficulties.

Viv:  Many commentators, Philip, are currently of the opinion that European leaders have lost control of the situation in Europe, and financial markets are driving the world toward another Great Depression. Would you agree with that view, and if so, what do you think now needs to be done in addition to the introduction of ESBies?

Philip:  There's definitely a reform agenda for the Eurozone, which has other components also. I think that, analytically, the main part of the crisis is clearly the European banking system. The markets are getting nervous about which banks are safe and which are not, which banks are undercapitalized and so on. So the main reform is to build a European banking system which has the features of recapitalizing banks in the same way the TARP programme did in the US in '08‑09. And having European resolution policies – so again there's a way to shut down non‑systemic banks, and a way to recapitalize and stabilise systemic banks, which is done at a European level. You need a European banking system if you're going to have European monetary union.

Then on the fiscal side, clearly there needs to be a way to assure markets that this pattern of excessive indebtedness will be not repeated in the future. So, much greater oversight of fiscal policies in the national governments. And then, in the short term – again, this formula is short-term – the ECB can support demand now through a policy of low interest rates and high liquidity. Those European governments which are not yet, should not be rushing too quickly towards austerity.

I think there's plenty that can be done; it's a combination of ECB policy, EFSF and so on. The ingredients are there, it's just to get it all to work.

Viv:  So finally, Philip, do you think that Ireland and indeed Greece and the other peripheral Eurozone countries, would they be better off outside the Euro Zone in a second-tier currency, or indeed completely independent with their own national currencies and fiscal controls?

Philip:  I think there are two questions. One is – should some of these countries ever have joined the Euro? That's one debate. The second debate is given that they are inside, are there circumstances in which they should leave? I'd be in the camp of... It's very hard to see, given the very simple issue about transitional costs about creating a new currency, exiting the euro, from an individual country point of view, it's doubtful that that would be very helpful. And moreover, from the point of view of Europe, the contagion effect if one country did leave would be horrendous.

This goes back to the Greek situation, that the European system has many incentives to help Greece restructure its debt and yet remain inside the Eurozone. That is where I would see that the path for Europe is. There has to be an ability to restructure debt without the system collapsing. We don't have that yet, but the idea that a monetary union should be broken up is, I just don't think, a very helpful suggestion.

Viv:  Philip Lane, thanks very much for taking the time to talk to us today.

Philip:  Good, thank you. Thank you, Viv.