Viv Davies interviews Daniel Gros for Vox

July 2010

Transcription of an VoxEU audio interview [http://www.voxeu.org/index.php?q=node/5255]

Viv Davis: Hello and welcome to Vox Talks, a series of audio interviews with leading economists from around the world. I'm Viv Davis from the Centre for Economic Policy Research. It's the 29th of June, 2010 and I'm talking to Daniel Gros, director of the Brussels based Centre for Policy Studies about the Vox eBook he has recently edited with Richard Baldwin on "Completing the Eurozone rescue: What more needs to be done?" I began by asking Daniel, "What went wrong with the Eurozone in the first place?"

Daniel Gros: Actually, everything that could have gone wrong did go wrong. The fiscal constitution of the Eurozone was based on the assumption that no country would be bailed out by the others. And that actually, a bailout would never be needed because the Stability and Growth Pact would prevent countries from running large deficits. And we see that, in the case of Greece, the Stability Pact didn't work. Greece accumulated very large deficits, and we have problem number one.

The second thing that went wrong is that, by creating monetary union, we actually wanted to create an interconnected, integrated banking market. But we forgot that, at that point, banking weakness in any part of the Union would spill over into the entire system. But we didn't foresee any systemic, European wide bank rescue operations. And FBC is now something that is missing that had to be invented very quickly.

So these two key elements were missing. They are actually interconnected: weakness on the fiscal side leads to banking weakness and vice versa. That's why we have now one very big, interconnected mess.

Viv: I see. So does this imply, perhaps, that the basic foundation for the Eurozone was essentially flawed? Many commentators might say, for example, that without a coordinated fiscal policy amongst Eurozone members, the whole concept of monetary union was bound to fail.

Daniel: The design of monetary union was certainly incomplete. That is actually what is done very often in Europe. You build the bicycle, get on it, try to pedal a bit. And if it doesn't work, you add while you are hopefully getting along. Now, this time managed to be different because financial crises require extremely rapid reactions by policy makers, and we see that is very difficult under the current circumstances. It's quite clear that talking about more fiscal policy coordination would really have saved us. This tragedy was not about fiscal policy coordination in the sense of saying, "You, Germany, spend a bit more, France a bit less, and Italy does something different again." This talks about keeping, actually, debt levels under control. Not only debt levels of governments, but also the private sector. Therefore, we need something quite different from just the term "fiscal union."

Viv: Eurozone leaders made what some have called a bold move in May this year, and provide 110 billion Euro bailout package for Greece and a special purpose vehicle to fund future bailouts. Isn't that enough to contain the problem? Or was there a coherent conclusion, perhaps, on what more needs to be done from amongst the authors in the ebook?

Daniel: As we have argued in the book, these measures were needed to prevent total shut down of the European banking system. They could perhaps contain the problem for a while, but they are certainly not sufficient. As we see in the ongoing tension on both the banking market, and the government debt market of a number of countries. Now, just throwing money at a fundamental problem doesn't always solve it and that's the case right here. In the case of Greece, we have a 110 billion package, unprecedented for a country of that size. Does it solve the problem? It just buys time, two or three years. But we know that most markets look ahead, they look ahead much more than two or three years, 10 years, 20 years. And what they see at the end of the adjustment period is not very nice. That's why we have continued problems for Greece to refinance itself, and the Greek saga is certainly not over.

The same for the banking system. This special purpose vehicle which has been created these days legally should be able to provide over 500 billion Euros in financing, unheard of in European history. These sums have never been put together by national leaders. But are they enough? Yet, we don't know because we are discovering a key problem in the case of Spain, for example, is not so much government debt, which is actually quite limited, but is banking debt, and banking problems, not only in Spain, but in Germany, France and other areas.

Therefore, this is an untested vehicle. We don't know whether it will be actually working and we have argued, therefore, that more needs to be done.

Viv: What the book is suggesting is a prioritization of reforms across the Eurozone countries in terms of bank restructuring, fiscal transfers, competitiveness, structural reforms. And other reforms, such as independent fiscal authorities. Could you explain a little bit more about your recommendations?

Daniel: Yes. It is quite clear that the key order of the day is to have stress tests. What does it mean "stress tests?" It means that the national regulators have gone to the banks, seen what they have in terms of credits outstanding on forms in their portfolio, and asked themselves, "What happens if a really bad scenario arrives? Can this bank survive? It doesn't have enough capital.” That has to be done across Europe. It has now been more or less decided to do it for more of the largest banks, which should cover, more or less, the European banking system.

That, of course, will be extremely important to establish confidence in the interbank market. In the interbank market, we expect banks to lend each other at very low interest rates so there must be very little risk that's left. Banks must be sure that their counterparts can provide.

So we have a stress test. The next question is, "What do we do with the results?" Of course, we publish them. But what do we do when we find that a certain bank has perhaps not enough capital to withstand the stress, or just enough capital? How can you force this bank to take on more capital very quickly?

That is a key trend for policy makers now in the very short run. They have said that they will face up to it. But we have to see, first of all, how the stress tests are being conducted and whether there is a credible way to recapitalize banks which need capital very quickly. That has to be done. Without that, the problems will continue and would actually increase. This is the conditio sine qua non for any group. Once the stress tests have been done, the banking system should come down, the interbank market should work again. And the next order of business is, "What country needs actually fiscal transfers?"

The European Union has to distinguish between different countries. Greece is patently over indebted. Many people think they can't service a debt so a solution must be found. It's no good that policy makers say, "We have a nice adjustment program for Greece, Greece can make it. If the markets don't agree, you can't finance the country in the normal way and therefore, something must be done that gives the market some reassurance that Greece can actually pay its debt. The best way might be just to reduce the debt level that Greece is taking. Other countries are in a much better situation. And therefore, I am optimistic actually, that if a solution for Greece can be found, then the remaining fiscal barriers in Europe should be manageable.

Viv: And what is the solution for Greece, do you think?

Daniel: The best way to proceed might be just to recognize that the country needs, for a very long period, some breathing space. So, perhaps one should say to bond holders of Greece, "You have to wait for a bit longer. Greece will give you a zero coupon discount bond for, let's say 10, 20 years. You'll get back the nominal value, but you have to wait for the interest a while." And then I would add to that some sort of warrant which says that the additional interest that Greece is paying will depend on, really, people, because many people in the market say, "We don't believe these growth rates that have been projected officially." So I would say let's make that into a special contract. Greece says that if growth is good, it will pay more to bond holders. And the optimistic ones, they can buy, then, these bonds, and the market will find an equilibrium again.

Viv: Most if not all of these measures that you refer to in the book, in the introduction, with Richard Baldwin, have to be executed at a national level, which will require a considerable amount of national discipline and responsibility. Is it realistic to expect that this can be achieved, given that the Eurozone chain, so to speak, has been shown to be only as strong as its weakest link, i.e., in the case of Greece?

Daniel: For the short term, actually, I'm rather optimistic. The pressure from the markets and the situation is so strong that governments are taking unprecedented measures, in Greece but also in other countries, and actually show some sign of cooperation. Also, think about the stress tests. One year ago, at the height of the crisis, Europe refused to publish stress tests. Now it's being done. So our policymakers can learn. Perhaps it takes some time, but they have learned at least something. For the longer run, it's quite clear that national fiscal institutions would be very useful to have, to constrain national fiscal policy. But it is also clear that we cannot rely on that only. You have to have some mechanism, as one of our contributors called it, "To reduce debtors' blackmail." That is something that the European Monetary Fund, which I proposed sometime earlier, together with Thomas Meyer, an institution which would allow the EU to deal with emergencies, to resolve actual crises. And that is actually what is also being discussed at the official level. I hope that something will come out of that.

Viv: Daniel, I was reading yesterday in the FT that, according to recent research conducted by the Economist Intelligence Unit, world business leaders see a growing risk that the Eurozone could break up in the next three years. Half of the 440 chief executives and heads of banks who were questioned say there's greater than a 50 percent chance of one or more countries leaving the Eurozone by 2013 because of deepening problems of debt amongst the members, and more than a third see at least a 25 percent chance of a complete breakup over the same period. Would you agree that this might be a real possibility, and furthermore, that a continued crisis of confidence in monetary union might even lead to Germany pulling out?

Daniel: These are certainly very tough times for the Eurozone, and unfortunately, one can no longer totally exclude a breakup. But I must remind people that in the 1990s, similar surveys said that a monetary union would never come about. So one has to be a bit careful with these predictions. But it is clear that there's a real possibility that perhaps one or two smaller countries will choose to exit the Eurozone. There's a possibility that the panel is good. But, if you had a messy default in Greece, followed by some policy mistakes in Greece and then an exit of Greece from the Eurozone, would that actually weaken the Eurozone or strengthen it? Investors might actually say, "Ah, the Eurozone is actually imposing tough choices on its member countries. That's a currency which will remain strong. That's a currency I like."

So, if smaller, weaker countries leave the Eurozone, that might actually strengthen it. Would Germany have an incentive to leave the Eurozone? I don't think so, because if Germany were to leave the Eurozone, then German banks would have their claims on the other Euro area countries only in the old Euro, which might be weak, compared to the new D mark, which would be strong. German banks would have to satisfy their own customers in the German D mark, in the new D mark, which is strong. So the German banks would immediately be bankrupt, and the German government would have to save the immediately. So that is not a very winning proposition for Germany, also.

Viv: Daniel, some commentators are of the opinion that it's too late now for tinkering around the edges with national or independent fiscal authorities, and that the only thing that can now possibly save the Eurozone is a much closer political and economic union. Would you agree with that?

Daniel: Yes and no. When I talk about tighter economic or political union, many people have some vague ideas which are not at all helpful. And as one of our contributors, Paul De Grauwe, writes, one has to be realistic. People still feel national first and European second. But one can have some institutions that would actually give us the essence of what we need. We don't need a fiscal policy coordination in the sense that every small fiscal decision has to be vetted and controlled by Brussels. But the key thing is that we have an institution which allows us to say no, to reduce debtors' blackmail. So something like the European Monetary Fund, perhaps even something like this special purpose vehicle that's being created. This vehicle could be used not only to save countries; it could also be used to say no to a country and just save the European banking system instead. That might be a much better way to proceed.

So, in a sense, European leaders have already decided that they're willing to put a lot of money on the table. If they're using this money in a smart way, with institutions which do not only bail out countries, but perhaps also allow the rest of the Eurozone to save its own banks if a country doesn't perform... Then, actually, we could create out of this crisis a system which will be much stronger than before.

Viv: So you, and the book in fact, are optimistic about the future of the Eurozone.

Daniel: I am guardedly optimistic, because we have seen that our leaders, if push comes to shove, they're willing to spend a lot of their financial and political capital to save it. They have taken some first steps, which were needed, not sufficient. They are now about to take another important step in the form of a stress test. If that is done well, then I'm hopeful that this crisis could be salutatory in the end. The stress tests, as I said, are really key. But there, the devil is in the details. They will be out in two or three weeks, so no point in speculating about it. The best way might be to come back once they have been published and actually ask ourselves, "Was that a step forward or backwards?"

Viv: Well Daniel, thank you very much indeed. It's been a pleasure talking to you.

Daniel: OK. Bye bye.

Viv: Bye bye.

Romesh Vaitilingam interviews Richard Grossman for Vox

April 2010

Transcription of an VoxEU audio interview [http://www.voxeu.org/index.php?q=node/5079]

Romesh Vaitilingam: Welcome to Vox Talks, a series of audio interviews with leading economists from around the world. My name is Romesh Vaitilingam, and today's interview is with economic historian Professor Richard Grossman from Wesleyan University. Richard and I met in London in April 2010 at a conference on lessons from the Great Depression for the making of economic policy. Richard had presented some work on the role of the gold standard in propagating the Great Depression, and that's where we began our conversation.

Richard Grossman: The British had been on the gold standard for quite some time. They returned to the gold standard after the Napoleonic Wars, and were, along with Australia, Canada, and Portugal and were really the only countries on the gold standard until the 1870s. And at that point the Germans, flush with money that they had received from the French after the Franco Prussian War, went back to the gold standard. This sort of led to a stampede of countries going to the gold standard. So Germany, during the decade of the 1870s...

The way the gold standard works is that a country fixes the value of its currency in terms of a quantity of gold. Then, of course, any two countries that have their currencies fixed to a certain quantity of gold, that becomes the exchange rate between those two currencies.

And so, the gold standard became the main international monetary basis from sometime during the 1870s. The gold standard is consequently a fixed exchange rate regime, and that brings some problems with it. It constrains a country in terms of what it can do with its domestic monetary policy.

For example, if a country is running a balance of payments deficit, then that means that it's exporting gold. It can't maintain that forever, because eventually it will run out of gold reserves.

And so, what it has to do is something to attract gold back now. They can sell assets that they own abroad, or they can borrow, but eventually those, too, are going to run out as sources of gold. So, what they'll eventually have to do is maybe raise interest rates to attract short term capital flow.

But, if you're running a persistent balance of payments deficit, and you're under a fixed exchange rate system, really the only thing you can do is try to reduce the value of your exchange rate, which means deflation in terms of exportables.

Now, that means that you have to run contractionary monetary policy, which can have very serious side effects for the economy, and leads to what people have said was sort of sacrificing the domestic economy on the altar of the gold standard.

So that's the set up of the gold standard. After World War One, the British went back to the gold standard at their pre war parity, but in the interim, there had been a great deal of inflation, more so than with a number of other countries. And so, the British currency was overvalued, and so the British ran a persistent balance of payments deficit throughout the 1920s, and continuously had to maintain high interest rates to attract gold, and to push down the price of exports.

John Maynard Keynes famously wrote about this in his "The Economic Consequences of Mr. Churchill." In the United States, it was called, "The Economic Consequences of the Gold Standard." Perhaps Americans in the '20s didn't know much about Churchill.

So basically the British, who returned to the gold standard in 1925, ran contractionary, or very tight monetary policy throughout most of the 1920s. Consequently, they were an intractable million unemployed, and there was a general strike in 1926, and a coal strike also. Again, the effort was to push down the price of exports.

This lasted until 1931, when finally, it became unsustainable. There was a financial crisis on the continent, and eventually pressure fell upon sterling, and the British ended up going off the gold standard in 1931.

What that allowed Britain to do was to run a much looser monetary policy, which helped it enormously during the 1930s, compared with, say, the French, who didn't devalue until later in the '30s, until after 1935. I think it was 1936. By fact, by law it was sometime later.

What you find is that countries that maintained their gold parity, that is that didn't leave the gold standard, did worse than countries that did. So, the British did relatively well after leaving the gold standard. A number of other countries did well after leaving the gold standard. Places like France and the Netherlands, they stayed on the gold standard for much longer, and they didn't do well.

Romesh: So effectively, it was a competitive devaluation. They were forced off it, but in fact it was very beneficial for the economy.

Richard: Exactly, and Eichengreen and Irwin have made this argument recently, that one of the reasons why some countries put on high tariffs is because they didn't devalue, and the only way that they could maintain balance of payments equilibrium was by putting a tariff on imports. And so, that would explain why some countries did that. I'm not fully on board with that, only because I haven't studied it, but that is one view that's current at the moment.

Romesh: What can we learn from the experience of the gold standard for the crisis we're in now, where the big fixed exchange rate regime is the Eurozone, and whether our big issue is being discussed right now, about how to respond to the problems of potentially breaking up the Eurozone?

Richard: Absolutely. Now I know that there's been some work recently on can the Euro, in fact, break up? I imagine that legally, it's possible. I don't know whether it's feasible economically. My old mentor, Barry Eichengreen, is quoted as having said that it will lead to the mother of all financial crises. The problem with a fixed exchange rate regime is that is basically ties the hands of monetary policy makers. So, Europe has one monetary policy, and Europe is composed of a variety of countries that have different needs. If the needs of countries, say more on the periphery, the PIGS, are different, somewhat, than the needs of countries that are closer to the center, say, oh, let's say Germany.

So, I think that there is an inherent problem in that the monetary policy that's good for Germany may not be the monetary policy that's good for Greece. Now, Greece has a number of other problems. There's been a fair bit of mismanagement, and there are other underlying issues that have to be straightened out.

So, the solution that's been offered by people like Barry Eichengreen and Paul Krugman has been that instead of backing out, we need to go further in. That is, to have greater fiscal federalism, and that the approach should be to bail Greece out, or to bail the PIGS out, but to make the loans come with conditions to prevent to recurrence of the various wrongs that were perpetuated by policymakers.

So the idea would be that to give assistance conditional on certain behavior, and that during the meantime to encourage fiscal federalism so that Europe... The thing is, Europe is a number of different countries with one monetary policy, one currency, but however many different governments making fiscal policy.

And so, while having one whole market is a very good idea, having a single market is a wonderful idea, but you now have single markets with one monetary policy, but separate fiscal policies. I think that leads to some difficulty.

And so, there are also wide differences in how well fiscal policy is made, not just in the needs of fiscal policy, but in how well policy is adapted and how well governments work.

And so, I think that one way out it may be the only feasible way out is to have greater fiscal federalism, transfer more authority to the central authority in the European Union.

Well, I understand that this is not... This is another part of giving up sovereignty, and handing over your currency is losing one form of sovereignty, but it's sort of like going half in. I think, at this point, the best thing for Europe may be to have a little bit more...I mean, I don't have an endpoint. I don't have a model of where this should go, but certainly, I think they need more fiscal federalism for the single market to work, and for there to be more harmonization. And that was the idea before going in, that there be more harmonization, and so that countries would maintain certain fiscal postures.

That's hard, so either there have to be either community or union wide rules, or else there has to be more in the way of central authority. These are very thorny problems, and I... This is just a sort of general approach, just what one might do to get at them.

Romesh: Looking at historical perspective, what do you see as being the benefits of the fixed range rate system? On the one hand, you're saying if you devalue, that's a good way to come out recession. But at the same time, in the paper, you talk about exchange rate volatility, which is what you get with a floating rate system, actually damaging trade, but actually making it more difficult for economies to come out of recession.

Richard: It's true. This is one of those coins that has two sides. When you do have your own exchange rate, and you have floating exchange rates, you can devalue, and you can do beggar-thy-neighbor policy, so that your exports are more attractive. And so, in some sense, there is a certain benefit to that. But there's also the notion that if you are going to have this single currency, then obviously you can't do that anymore. The benefits, of course, are the single market. I don't pretend to be an expert on labor markets, or factor markets, or product markets in Europe, but I can imagine a situation, and I remember reading a paper about this some time ago, actually, it was in the popular press: They happened to be very efficient at making washing machines in one country in the European Union, and ovens in another one, and something else in another one.

But people weren't buying across borders. Some of it had to do with, still, barriers, in terms of trade and transportation costs. But some of it had to do with everything was priced a little bit differently, and you never knew what a washing machine from Belgium, or from Italy, or from Spain was going to be.

So, the argument, I think, in favor of a European Union in terms of currency is that it makes trade... It facilitates trade.

Again, there will be scholars who are far more immersed in the details than I and the history of the debate and the theory of the debate, but the notion is that you have a single currency, it takes a great amount of uncertainty out of transactions.

It does make it easier to do financial transactions. It makes it easier for some of the periphery countries we've been talking about to float sovereign debt, because it's done in this currency that everyone knows, and trusts, and recognizes.

So, I would say the benefits would be having a strong, a currency that is stronger than those of the individual components, and sort of efficiencies that economists like to talk about, but it's a lot harder to measure.

I think people who live on the borders, people who live near Mostrach, which is near Aachen...People who know about this--I have family members who live in Germany, and they sent a bunch of wedding invitations to family in Aachen so that they could mail them from Belgium or from Holland because the postage rates were lower than in Germany.

So, in the US, I know people who buy their gasoline in one state. I live in Massachusetts and work in Connecticut. I never buy my gas in Connecticut because the taxes on gas are higher.

So, I think the people who live in border regions understand this, and I think that the benefits of having a whole union are substantial, but again, it comes with cost, and the cost is this coordination, having monetary policies linked forever, which is a little frightening, but that's the way it is.

Romesh: For our final question, related. The policy response to this Great Recession, compared to the Great Contraction, globally seems to have been better, more effective. Would you agree with that?

Richard: I would. I think that, first of all, not having to worry about the gold standard so much, at least for the US, has made it much easier to undertake expansionary monetary policy. I should add that this is not new. The Bank of England was doing this in the 19th Century, and there's a wonderful quote from someone at the Bank of England in 1825. He's talking about, "We lent money by every conceivable way we could and on as fine a line as we could, and on some occasions, we were not over nice."

I think that's sort of the Fed, and a number of the other central banks have taken very orthodox and unorthodox approaches to getting money out there.
Fiscal stimulus, I know a little bit more about what's going on in the United States, but there has been substantial fiscal stimulus. So, I would say policy response, I would say, has been much more surefooted. I think that the lessons that we get from looking back at the Great Depression is that people who complain about...

And again, in the US, this is quite common. People say, "Oh, there's too much government and too much..." I think, at this point, we need to have activist fiscal policies. We need to have expansionary monetary policies, and I think that the lesson of the Great Depression is that we did not have activist enough government. We did not have flexible enough monetary policy. We're doing a better job of those things right now.

And so, I think that's a great benefit. We don't want to over-learn the lessons of the Depression. We want to just take that as an experience that we can use, just as we would use the experience from more recent history in making better policy decisions.

But the thing that's useful about the Depression is it's an example of an extremely severe financial and economic crisis similar to what we have today. I would argue that what we have today is not nearly as substantial as the Great Depression, but it's a useful laboratory for examining these questions.

Romesh: Richard Grossman, thank you very much.

Richard: Thank you.