Trust between Eurozone leaders can create self-fulfilling positive outcomes

Paul De Grauwe interviewed by Viv Davies, 13 Jul 2012

Paul De Grauwe of the LSE talks to Viv Davies about his recent Vox column on the potentially destabilising effects of the decisions taken at the last crisis summit of Eurozone leaders. He explains how the new recapitalisation role established for the ESM is doomed to fail and how the ECB is operating on the wrong business model. They discuss how full banking union will not be possible without a degree of political union, and how trust could create self-fulfilling positive outcomes for the Eurozone. The interview was recorded in London on 10 July 2012.


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Viv Davies: Hello, and welcome to Vox Talks, a series of audio interviews with leading economists from around the world. I'm Viv Davies from the Centre for Economic Policy Research. It's the 10th of July, 2012 and I'm speaking with Professor Paul De Grauwe of the London School of Economics about his recent Vox column that describes the potentially destabilising effects of the decisions taken at the last crisis summit of Eurozone leaders. De Grauwe explains why, in his opinion, the new role established for the European Stability Mechanism is doomed to fail. He also suggests that the European Central Bank is operating on the wrong business model, and how full banking union in the Eurozone will not be possible without some degree of political union. De Grauwe maintains that only deeper trust between the Eurozone leaders will be able to create the kind of positive outcomes that will be required to save the Eurozone. I began by asking Paul how significant he thought the recent Eurozone summit had been.

Paul De Grauwe: The immediate reaction of the market was euphoric as usual. Then after a few days when everybody had become more sober, this euphoria disappeared and we saw that in fact nothing really had been solved. We thought that there would now be a mechanism that would create stability, but this appeared to be not the case, and we have to start from scratch, so to say.

Viv: Your recent Vox column focuses on the new role that's been established for the European Stability Mechanism, or the ESM, in that it will now be enabled to directly recapitalise troubled banks and to buy government bonds in the secondary markets in order to prevent further destabilising surges in bond yields such as we've currently witnessed in Spain and Italy. Yet you suggest that the ESM will not only fail to stabilise the bond markets, but the whole idea could in fact be destructive. Why is that?

Paul: It has to do with the following. ESM, the European Stability Mechanism, now has resources approximating 500 billion euros. The debt total of government bonds issued by Italy is close to 2,000. Add to that about 800 billion of Spain, and then your other possible countries and you see immediately that the ESM doesn't have enough resources to make it possible to stabilise the bond markets, right? If one of these countries gets into trouble, it's clear that the ESM doesn't have the money to provide stability. In fact it's worse because, given its limited resources, once it starts intervening investors will immediately see that its resources are depleted. It will start buying, say, Italian government bonds and at the end of the day you look at the balance sheet of the ESM and you'll see there's less left over for further interventions tomorrow. As a result, investors will anticipate the moment where the ESM runs out of resources.

That will be the moment where the ESM cannot intervene anymore and bond prices start declining again. But investors are rational beings, and they will put that to the present and they will therefore have a very strong incentive to sell immediately. As soon as the ESM starts intervening, this will signal to the market that it's time to intervene because they already anticipate that the ESM will be running out of resources and will have to stop that intervention.

It's extremely destabilising. This phenomenon is well known for people who know the literature, for example, about foreign exchange markets and fixed exchange rates that have the same instability feature.

Viv: Paul Krugman wrote about this.

Paul: Paul Krugman has a classic paper. Obstfeld later, also. Another type of crisis model for the foreign exchange market. These people don't seem to learn from what we know.

Viv: Given that Germany won't accept the idea of a Eurozone bond or some other form of debt mutualisation, and that the ECB isn't prepared to directly purchase government bonds, does this mean there's no alternative for countries like Spain and Italy other than to leave the Eurozone?

Paul: Well, if we stay in a situation where these countries like Germany and others, it's not only Germany. Holland and Finland are of the same idea if that goes on, then at some point Spain and Italy will have no other option. They will not accept to be driven into default. Sovereign nations that do not want to do that, will not want to be pushed by financial markets. Then the only option will be to leave the Eurozone, yeah. But that will of course be in an environment of violent instability that I hope we can avoid.

Viv: Of course. You maintain that the ECB is operating on the wrong business model. Can you elaborate a little on that for us?

Paul: Yes, ECB is concerned mainly with its balance sheet. It wants to avoid making losses. It wants to have positive equity. That's an overriding concern of the ECB. But that's wrong for a central bank to have as a primary concern. The primary concern of a central bank should be to maintain financial stability. That's why we need a central bank, to maintain financial stability. Capitalism is often gripped by booms and busts, and financial markets are then very unstable. The banking sector can become very unstable. We need an institution that is primarily concerned with financial stability, not with an institution that doesn't want to make losses. Because these two concerns conflict with each other. When the central bank has to intervene to maintain financial stability, it runs the risk of making losses.

It buys bonds, and it is possible that it will make losses. Not necessarily, but it's possible. If it is too much concerned about avoiding losses, it will not be prepared to buy the bonds in the markets, and as a result fail to maintain stability. Another example, the ECB after having bought Italian and Spanish government bonds, came out saying, "We want seniority on these bonds." Now, the effect of this is that the others, the private holders of these bonds say, "But now we have become junior, so the risk for us has increased," and they sell the bonds.

Here you have a central bank that is overly concerned about its balance sheet, does things that destabilise the financial markets. A central bank has to keep in mind that what it should do is to maintain financial stability. If that leads to losses, so be it. In fact, a central bank can make unlimited losses. Unlimited in the sense that it should not be such that it destroys price stability, because that's another objective.

That's the limit that the central bank should keep in mind, but we are so far from this today. The risk of inflation that the central bank surely should not be concerned today about potential losses.

Viv: The last time we spoke, you mentioned the matter of moral hazard when the ECB are lending. Could expand on that for us?

Paul: Well, when the central bank, when the ECB buys government bonds, for example, it alleviates the pressure of the governments. For example, the Italian government. This may lead to moral hazard in that the Italian government may then feel a little more relaxed. And then, not as much pressure to reduce deficits and debt levels. So that's the moral hazard problem that arises each time the central bank exerts its lender of last resort activity. The same is true for banks. When the ECB provides liquidity to banks, it also leads to moral hazard and the risk, therefore, the banks will take too much risk. That is certainly a problem. There is no doubt about this. The central bank, in times of crisis, must provide the liquidity. Others should then take care of moral hazard issues.

The way we did with it in banks is to say, "Well, you have supervisor regulators that try to limit the risk that banks can take. It's not easy, but this should be other institutions than the provider of liquidity. The one that provides liquidity should not try to solve two problems, namely liquidity crisis and a moral hazard problem. It's like the fireman that is at the same time the policeman.

The fireman that arrives at a burning house has to extinguish the fire, and should not try to be the policeman at the same time that is trying to catch the guilty. If he does that, he will not be a good fireman. The same is true for a central bank and also with respect to government bond markets when a central bank buys these government bonds, it provides the liquidity, it creates moral hazard. We should have another mechanism that deals with the potential moral hazard risk that is created by these liquidity interventions. That's also not easy, but that's the way we should do it.

Viv: Do you think full banking union in Europe will ever be possible without political union?

Paul: No. The banking union always implies some political union, not necessarily a full scale political union, but some. Let me give you an example. If banking union also implies that we will have a deposit insurance mechanism that is organised at the European level, in normal times the funding of this insurance mechanism can be provided by the banks that participate in all this. In crisis times, this funding is usually insufficient. As a result, you need a backstop that has to be some European institution then with the power to tax, and to make sure that the system can be kept. That requires some political union.

Viv: The immediate and most pressing problem in the Eurozone has been described recently as being a mix of excessive debt, failing banks, and uncompetitive economies causing a lack of access to financial markets. In addition, unemployment at over 11% is at the highest it's ever been in the Eurozone. Do you think we're moving any closer towards resolving these core problems?

Paul: Well, not really. I'm not very optimistic after all we have seen and the failure to act quite often, also propensity to decide the wrong things. It doesn't look like today we are in the process of solving these problems. We have not set up a mechanism that makes it possible for countries that are pushed into a corner by financial markets and are driven into insolvency to help them out. In addition, macroeconomic policies continue to be deflationary, where we put excessive austerity in some, especially southern European countries, without any compensating macroeconomics stimulus elsewhere. All this makes it very difficult to resolve these problems. Sometimes I am despairing, but I'm trying to convince myself that maybe at some point we will be able to resolve this.

Viv: What would be your immediate advice to the Eurozone leaders right now, Paul?

Paul: The basic requirement is that trust is to be established, because it seems to me that we are failing to come up with the right decisions because there is so much distrust. I see how the Finns, for example now, just a few days after the previous summit meeting. Distrust suddenly come up so much that they come back on these decisions. The Dutch do the same things. Everybody distrusts everybody. That makes it extremely difficult to come to the right decisions. All I can advise them is to tell them, well, start trusting each other. And then, this may even work in a self fulfilling way. Trust has this characteristic of creating self fulfilling positive outcomes. But unfortunately, we are now more in a bad equilibrium, where distrust is taking over, leading us into bad equilibrium.

Viv: Paul de Grauwe, thanks very much.

Topics: EU policies, Europe's nations and regions
Tags: ECB, European Stability Mechanism, Eurozone crisis

The tragic error of excessive austerity

Richard Layard interviewed by Viv Davies, 6 Jul 2012

Richard Layard of the LSE talks to Viv Davies about his and Paul Krugman’s recently published ‘Manifesto for Economic Sense’, which aims to generate a movement of economists who are prepared to speak out against policies they know to be wrong - the excessive austerity of current fiscal policies. They discuss the role of the ECB as lender of last resort and whether the current bank-led capitalist culture can ever be changed. The interview was recorded in London on 5 July 2012.


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Viv Davies:  Hello, and welcome to Vox Talks, a series of audio interviews with leading economists from around the world. I'm Viv Davies from the Centre for Economic Policy Research. It's the 5th of July, 2012, and I'm speaking with Professor Lord Richard Layard, founder and emeritus professor of the Centre for Economic Performance at the London School of Economics. We discuss his recently published Manifesto for Sound Economics, written with Paul Krugman, which aims to generate a movement of economists who are prepared to speak out against policies they know to be wrong.

Professor Layard briefly summarises the manifesto and what he considers to be the errors that have taken root in public consciousness and which have provided support for the excessive austerity of current fiscal policies in many countries.

We also discuss the role of the European Central Bank as a lender of last resort, and whether the current bank-led capitalist culture will ever be changed. I began the interview by asking Lord Layard to summarise why he thought the manifesto needed to be written.

Richard Layard:  Well, I think the majority of economists probably disagree with what is presently going on, and in particular with the assertion that the only way to get growth is to take extra action to reduce public deficits. That, of course, is getting things the wrong way round, because the deficits are not because of low growth; it's the low growth that's the cause of the deficits. We have these deficits, but not because there was irresponsible public borrowing back in 2007, because there was excessive private borrowing and lending, which led to the bust, which lead to reduced private spending. Then the reduced private spending led to reduced tax receipts, and so the lower taxes which are causing the deficits in the public finances.

So when you've got a reduction in private spending, the last thing you want to have is simultaneously a reduction in public spending, thereby cutting the total level of activity in the economy. And you don't want to have, equally, big tax rises reducing private spending.

And what is remarkable is that there is no evidence that doing these things ‑‑ which every country is being told they have to do ‑‑ will produce the growth which people assert is going to be the result. So the IMF in its latest economic outlook has a wonderful chapter where they look at 183 episodes in the past where countries have taken discretionary action to reduce their deficits, and they show that in the vast majority of cases, this led not to faster growth but to slower growth, which is what, of course, the ordinary economics textbook for a depression economy would lead you to expect.

There's another issue. If we slow growth in this way, we're having a bad effect on the future path of deficits. We're going to have higher deficits further into the future, and there's a strong argument put forward by Larry Sumners and Brad DeLong in Brookings papers that if you increase the deficit in the short run, this would have the effect of stopping unemployment becoming endemic, and thereby making it easier to have higher growth in the medium term, and therefore lower deficits in the medium term, which would more than offset the slightly higher deficits you have in the short term.

So, really, just to go on trying to cut deficits in the short term is a very counterproductive policy.

Viv:  The manifesto presents two counterarguments to your proposal. A confidence argument in that austerity increases confidence and the prospects of recovery, et cetera, and a structural argument against expanding demand in that output is constrained on the supply side by structural imbalances in the economy. Could you elaborate a little on these arguments and how you counter them in the manifesto?

Richard:  Well, the confidence argument says that if you increase the deficit, this will raise interest rates, and that will produce lower growth. There really isn't any evidence of that in the conditions we're now in. We would have significantly higher interest rates if we had a higher deficit. Because just look around. You see absolutely massive deficits in the US, Britain and Japan, and you see almost the lowest interest rates that we've ever seen. So it's just not a reasonable spectre to be raising. In fact, the confidence argument is obviously failing, because you can see that businesses are not feeling confident because of the deficit reduction policies. They're feeling, "Oh my god, where is the demand going to come from?"

This deficit reduction policy is just going to impose low growth on our countries for some years. We're not going to invest because we can't see the market. So the confidence argument isn't working. The structural argument is also invalid, because suppose that we were being inhibited from expanding aggregate demand because there were some sectors that were already operating at full capacity.

Then we would have to see some sectors operating at full capacity. We don't see that, we see in most the countries, we see excess capacity and unemployment in every part of the economy, and higher unemployment in every occupation.

It's not a plausible argument, the structural one. It was used during the Great Depression, and lo and behold when people said the American economy can't produce any more, suddenly there was the Japanese threat and from 1940 to 1942 the US GDP rose by 20%. It had been limited by demand rather than by supply.

Viv:  Within a European context, would you be in favour of the ECB acting as lender of last resort to European banks?

Richard:  Well, the European problem is a different one. I perhaps should have referred to it when we were talking about interest rates, because of course European interest rates in many countries are very high. But this is not because these countries were irresponsible in their budgetary policy in 2007. We had falling debt income ratios in Spain and Italy and some other countries in 2007. Even now, Spain and Italy have lower deficits than the US, Britain and Japan, even though they also have higher interest rates.

It's just not the case that the interest rates are caused by those deficits so much as the fact that the countries of Spain and Italy do not have a central bank behind them that will fund their deficits, whereas Britain, Japan and the States do have a central bank behind them that would in the last resort fund these deficits.

So we have to have institutional reform in Europe, and we have to have some system whereby ultimately the central bank will not only be a lender of last resort to European banks but also a funder of governments on certain conditions, of course, and that's why we have to have these much more strict arrangements for European supervision of budget deficits in the different member countries.

Viv:  So it's clear then that the global financial crisis wasn't a blip on the landscape, but what you're advocating calls for a radical and very significant cultural and political shift. Do you think banks, businesses and governments are ready and prepared to go that far? Will they ever be?

Richard:  Well, I think the public is going to demand it. And I think there are sort of very specific reasons relating to this crisis which are going to lead to much greater regulation of banks, and hopefully more government activism in getting us out of the recession. But I also think actually that there will be and needs to be a big cultural change in a different capacity. I've been a co‑founder of something called "Action for Happiness," which is a movement to encourage people, in fact all the members pledge to try to create more happiness in the world and less misery. To lead a moral life in everything they're doing, including their work life.

And I don't think we want people working in businesses unless they think that what they're doing is socially useful. I think we've got to get back to that kind of concept of a life that is dedicated to the common good in some way or other, and not simply dependent on self‑interest.

Viv:  So finally, how would you like to see economists respond to your manifesto?

Richard:  Well, I want everybody to get up and shout and write articles, send off letters, organise meetings and make sure that we stop proceeding in this way, which is bringing in so much misery to our people.

Viv:  Lord Layard, thanks very much for taking the time to talk to us today.


Topics: Global crisis
Tags: austerity, ECB, fiscal policy

The tragedy of the commons at the European Central Bank and the next rescue

Aaron Tornell, Frank Westermann, 22 June 2012



The late, great scholar of crises, Rudi Dornbusch, put it aptly: “In a very rich country you can afford to do very bad things for very, very long.” (Dornbusch and Fischer 2003). The Eurozone is in the process of finding out just how long “very, very long” means.

Topics: EU institutions
Tags: ECB, EFSF, Eurozone crisis

Is LTRO QE in disguise?

Jean Pisani-Ferry, Guntram Wolff, 3 May 2012



With the launching of the three-year longer-term refinancing operations (LTROs) in December 2011, the Eurosystem has entered new territory (see Wyplosz 2012).

Topics: Macroeconomic policy
Tags: Bank of England, ECB, Fed, monetary policy

The ECB’s proportionate response to the Eurozone crisis

Bernard Delbecque, 4 April 2012



When the Eurozone crisis worsened during the summer of last year, a number of experts proposed to appoint the ECB as a lender of last resort in the government bond markets to make these markets less prone to liquidity crises and contagion, and to prevent the weakest Eurozone countries from being pushed into a self-fulfilling debt crisis (see

Topics: EU policies, Macroeconomic policy
Tags: ECB, LTROs, monetary policy

ECB inflation-fighting powers remain intact

Christian Thimann, 30 March 2012



In a recent Vox column, Aaron Tornell and Frank Westermann (2012) argue that with the conduct of three-year liquidity operations, the ECB has “hit a limit in its ability to prevent an acceleration of inflation”.

Topics: EU policies, Europe's nations and regions, Monetary policy
Tags: ECB, Eurozone crisis, inflation

Has the ECB hit a limit?

Aaron Tornell, Frank Westermann, 28 March 2012



In December, the ECB successfully forestalled a financial crisis by stepping in with a big bazooka and inundating the market with liquidity. Unfortunately, the big bazooka has come at a cost; the composition of the ECB’s balance sheet has changed dramatically.

Topics: EU policies, Europe's nations and regions, Monetary policy
Tags: ECB, Eurozone crisis, inflation

Fed versus ECB: How Target debts can be repaid

Hans-Werner Sinn, 10 March 2012



Now that Bundesbank President Jens Weidman has expressed his concern about the rising TARGET balances within the Eurozone in an official letter to Mario Draghi, the issue can no longer be swept under the carpet. In February, the Bundesbank had a TARGET claim of €547 billion on the Eurosystem, while the Dutch central bank had one of €171 billion in January.

Topics: International finance
Tags: ECB, eurozone, TARGET2

Greece and the Eurozone: Political leaders should get off their high horses

Willem Buiter interviewed by Viv Davies, 20 Feb 2012

Willem Buiter talks to Viv Davies about Greece and the Eurozone. Buiter believes that Greece’s public debt should be written off, it’s banks recapitalised and that the country be provided with sufficient conditional support to grow its economy. They discuss the LTROs and the risks of loss of control over the aggregate size of the balance sheet and potential national central bank insolvencies. Buiter suggests that now is not the time for self-righteousness amongst European policymakers. The interview was recorded on 17 Feb 2012. [Also read the transcript]


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Read more on Vox by Willem Buiter here.


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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 17th of February 2012, and I'm speaking to Willem Buiter, Chief Economist at Citigroup, about Greece and the Eurozone. Buiter believes Greece should remain a part of the Eurozone, that its public debt should be written off, its banks recapitalized, and that it should be provided with sufficient conditional financial support to undertake the required structural reforms that are needed in order to return the country to a primary surplus.

Buiter is of the opinion that a hindrance to Greek recovery has been political ineptitude and misguided self righteousness amongst European policymakers. I began the interview by asking Willem to explain why, in a recent FT article, he believed that a disorderly Greek sovereign default and Eurozone exit would be disastrous for Greece.

Willem Buiter: Well, sovereign defaults are never picnics. When combined with the abandonment of a common currency, they will have disastrous balance sheet implications, financial implications for Greece. Every contract, every security under Greek law would be redenominated in new drachma and promptly lose half its value, if the new drachma tumbled. The only conceivable advantage to Greece would be that the collapse of the external value of the drachma would buy them a temporary improvement in competitiveness. But since I do not believe that Greece is a Keynesian economy that has highly flexible real wages and very sticky money wages, but in fact is much more like a distorted classical economy, with rigid real wages and flexible money wages, I think its competitive advantage from exiting and having a maxi devaluation, a depreciation of the new currency would be very transitory indeed.

So the country would basically end up with a sky high rate of inflation, and since the demand for the new drachma would be minimal, the country would, for many purposes, remain Euroized, especially in private transactions. So somewhere between high inflation, hyperinflation, and utter financial devastation of every entity with a balance sheet, not just the sovereign, the banks, but also corporates and indeed households with significant assets. I think it is not something that I would recommend as an exercise in good economic health.

Viv: OK, so if we look at the other peripheral countries in the Eurozone, Ireland has regained competitiveness. Spain is geared up now for change, politically. Italy has credible political leadership. Do you think it's plausible that even with the currently proposed bailout of 130 billion euro that Greece will be able to adequately reduce its government debt over the next eight to ten years?

Willem: Well, I don't agree with the first three statements you made. Ireland has regained a little bit of competitiveness. It's still enormously deep in a fiscal hole, and getting in deeper, because of the deterioration of its housing markets and its non performing mortgages. Spain is just at the beginning of reform. It has a 49 percent youth unemployment rate. That is not just an economic problem, that is a social and political disaster. Italy has no credible political leadership. They have the temporary, personally credible technocrat, Mario Monti, a man of greatest talent and integrity, but superimposed on the same crowd that brought the country to its knees earlier. So there is absolutely no political guarantee of the durability of the Monti technocratic cabinet. The fact is that as soon as the political class in Italy begin to view him as a threat to their political futures, then he'll get dumped.

As regards the 130 billion, that Greece may be able to get together, (a) it isn't enough to achieve the official objective of getting its debt over the next eight years down to 120 percent of GDP. And even if it were 120 percent of GDP, after a decade of austerity and upheaval, it's still going to be far too high for Greece to manage. We are wondering if Italy today is capable managing 120 percent. Greece, after the best part of a decade of agony, will not welcome the prospect of sitting on 120 percent of debt.

So it is completely inadequate and insufficient, what is on offer from Brussels, Frankfurt, and Washington at the moment.

Viv: So, what do you think needs to happen, then, in order to make it possible for Greece to stay within the Eurozone and to grow and prosper?

Willem: Well, we have to write off the debt, effectively. Probably the IMF will get paid, because they always do. That's the advantage of the so called “third creditor” status. But all other creditors, be they private or official, including the ECB, the bilateral Euro Area creditor governments, and anybody else that may in the future be contributing to Greece, better recognize that Greece is not capable of servicing the debts. Just write it off. That still leaves a funding gap for the Greek sovereign, depending on your estimate, there still is a primary deficit, a non interest deficit for the general government of between two and four percent at least. So that still would have to be funded. They have to continue funding that, but no more.

And then, really, leave it up to the Greeks to reform themselves. There's no way that we're going to be able to turn Greece into a colony of Brussels, Frankfurt, and Washington, and run it as a vassal kingdom for the next eight years.

Viv: So, would you agree with, I think it was Lord Lamont, who said yesterday that Greece is the canary in the mine, and it's just signaling the potential and likely scenarios in the other peripheral Eurozone countries in months to come?

Willem: No, no, no. Greece is uniquely awful, the situation there. Other countries face challenges. Greece faces a really currently insurmountable challenge. No, I am no more fundamentally worried about the continued existence of the Eurozone, with the possible exception of a Greek exit, than I am about a continued existing United Kingdom. In fact, I'm rather more concerned about that than about the Eurozone breaking up. No, I think that we have to recognize in Europe that a number of sovereigns are insolvent and have to be restructured. Greece is the obvious one, Portugal, and possibly Ireland are in similar boats.

We have to recapitalize the banks in a major way, and then reduce the size of the banking sector and its balance sheet significantly, because it's grown over bloated, and then we need radical structural reform of labor markets and product markets, especially service markets, all through Europe, not just in the periphery, where the problems are at the moment, but also in the so called successful north.

Remember always that Germany, for instance, is a dual economy. It has an incredibly efficient export and manufacturing sector and a pathetically inefficient non traded services sector. There is lots of reform that needs to be ongoing even in the north, if we are going to hand the world to our kids that is worth living and working in.

Viv: Yes. You mentioned the banking sector then. The ECB recently introduced its long term refinancing operation process, which many commentators have welcomed, especially in terms of the signal it gives to markets. However, some economists, like Charles Wyplosz, for example, are of the opinion that the LTROs have made things significantly more dangerous in that a potential wave of sovereign defaults could turn those bonds into toxic assets. It's what he refers to as the “trillion euro bet”. What are your thoughts on that?

Willem: I don't understand Charles' argument. But I think that the LTROs were a necessary part of the solution but by no means sufficient. They are a part of a mechanism for keeping the banks funded. We, of course, have to make sure that the banks become solvent again as well, which will require and inevitably mean that many of the continental European banks will end up in state ownership, those that aren't already. And even if there are no deep pocketed sovereigns to recapitalize the systemically important banks, then the money may have to be got from the unsecured creditors to the banks, from the bondholders, etc. So we're going to have to have major bank restructuring as well as provide the liquidity, but unless we provide the liquidity, we would never be able to get to the point that the structural reforms, the recapitalization, take place.

What I am worried about in terms of the LTROs has been that it has been accompanied by what I call some Balkanization of monetary policymaking in the Euro Area so that we are approaching a world in which there are two different risks.

Either because national central banks now have considerably more discretion over what's acceptable as collateral for national central bank credit, there is a risk of loss of control over the aggregate size of the balance sheets that you may call the "Ruble Zone Problem," that you get 17 different national centers of issuance, effectively.

The other problem is that since in order to minimize the first problem, the loss of control problem, the ECB has departed from the principle that losses of national central banks are pooled and shared - that's no longer the case. They're going to have 17 national central banks in the Eurozone with very different credit risks attached to them, so individual national central banks could go bust.

This is something that I think wouldn't be good for our collective health. We better think and think actively of ways of minimizing both the loss of control problem and the central bank insolvency problem. We have to go back to having a single European monetary and collateral policy. Of course, the application of the single set of rules will still be dependent on local circumstances. That is perfectly consistent with the common policy.

But we can't have national central banks, once again, the way they were before 2007, determining to a significant extent what kind of collateral they are going to accept. There has to be central control of this.

Viv: Currently, in Europe, there's a growing sense of public injustice in the face of increasing austerity whilst at the same time there's a wider political sense of progress towards competitiveness and growth in Europe. Would you agree that the fate of the euro will essentially be determined by whichever prevails between these two?

Willem: I see, as of now, no sense of progress towards competitiveness and growth at all, if only! We still need all the structural reforms. They haven't started yet. Spain is just scratching the surface of its dysfunctional labor markets. So is Italy. So is Portugal. We have - not just in the Euro Area, in the U.K. - we have more than 30 percent youth unemployment, major structural dysfunctionality. So I see that so far there has been no progress made at all on the structural reform. The only progress there has been has been on the austerity side. It's time that they got going on a structural reform agenda to open up labor markets, public markets, facilitate entry and exit and make Europe an attractive place to do business again, and a place that people want to come.

That can, of course, be very difficult since austerity is going to be there for as far as the eye can see. Fiscal tightening will be a companion in most European countries until the end of the decade. So hopefully we will get more accommodating monetary policy. If we cannot have that, then we will have to rely on the animal spirits of our private citizens, hopefully stimulated by structural reforms, to get us out of the hole that we dug for the continent.

Whether people will put up with the austerity remains to be seen. We have not had an experiment in continent wide fiscal austerity on this scale ever, I think, in Europe. It is certainly possible that political unrest and social upheaval will prevent the necessary fiscal austerity and indeed structural reform, because there are so many vested interests, especially vested interests of the elderly and the old that have to be overridden.

Property rights, things that are viewed as property rights in labor markets, in jobs, in pensions, that will have to be expropriated and violated to get this show on the road again. But we will see. If we don't, then the continent has proven that it is possible to go from enormous wealth and prosperity to widespread poverty and misery in a couple of decades flat. It could happen, but I don't expect it to happen.

I expect that we will stick to the austerity and structural reform agenda, hopefully get a bit of help from more accommodating monetary, credit and liquidity policy. And a bit of help from our friends in emerging markets, who despite all this, are still growing like weeds and who will provide markets for the goods and services that we can't sell to each other anymore, but that we can sell to them.

Viv: Finally Willem, returning to the central question of Greece, what would be your immediate advice for the European leaders and policy makers who are currently in two minds about what to do about Greece?

Willem: Write off the public debt, recapitalize their banks, using European resources, obviously, because there aren't any Greek resources. Keep them in the Eurozone, very definitely. It's both in the Greek interest and in our interest. Then provide further minimal financial support. Don't build up another debt burden, but sufficient to run steadily diminishing non interest deficit for the general government and ultimately have that peter out and turn the country into a country with a sizable primary surplus, but not from a position where they spend six or seven percent of GDP on interest. So write off the debt, restructure the banks and then make conditional funding, of the kind that is now available, forthcoming.

But don't get on the self righteous high horses that are ridden by so many European politicians, especially from Germany and my own home country, the Netherlands. It is, I think, offensive. It forgets that there cannot be a reckless debtor without that reckless debtor being accommodated by a reckless creditor.

The Dutch and the Germans savers and greedy investors are as culpable of the financial mess that we've created in Europe as the debtor countries. It takes two to tango here. When you don't know what to do, shut up. I think that would be the best advice I can give to our politicians.

Viv: Well that's great advice. Willem Buiter, thanks very much.

Topics: Europe's nations and regions, Financial markets, Politics and economics
Tags: debt restructuring, default, ECB, Eurozone crisis, Greece

The ECB’s trillion euro bet

Charles Wyplosz, 13 February 2012



With immense modesty, the President of the ECB Mario Draghi is giving the credit for falling spreads on Eurozone government debt to the courageous reforms announced in a number of countries, especially those where former academic economists act as prime ministers. Oh, how we would love to buy Mario Draghi’s interpretation!

Topics: EU policies, Europe's nations and regions
Tags: ECB, Eurozone crisis, fiscal crises

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