European financial vulnerability and the need for a rules-based international monetary system

David Vines interviewed by Viv Davies, 4 Jun 2010

David Vines of Oxford University talks to Viv Davies about the vulnerability of Europe's monetary union and the need for a rules-based international monetary system. He argues that due to an unprecedented show of cooperation and worldwide coordination of fiscal and monetary policies, an all-out collapse has been prevented: the same level of cooperation and coordination will be needed to address the global savings-investment imbalances that continue to pose a threat to global stability. The interview was recorded in June 2010.

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Viv Davies interviews David Vines for Vox

June 2010

Transcription of an VoxEU audio interview [http://www.voxeu.org/index.php?q=node/5140]

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 CEPR and today I'm talking to David Vines, Professor of Economics at Oxford University. Professor Vines has recently written a paper on the challenge of global macro economic coordination which argues the case for a rules based international monetary system. David began by describing the crucial role of international cooperation, and how this was particularly evident during the run up to the London summit in April 2009.

David Vines: Well, all of a sudden, the great moderation which we had all been so proud of, everything fell apart. The financial system collapsed and spending collapsed. And this was a downturn which for some few months many of us thought was on the edge of turning into the Great Depression Number 2, a really frightened period. And in the run up to the London Summit in April 2009, there was really very concerted work put in London civil servants, but many others elsewhere internationally which lead to really quite remarkable, first of all, action on monetary policy. Secondly, a very great increase in fiscal spending one or two percent of world GDP.

But three, importantly, an understanding by countries that as their tax revenues fell as the recession came, they wouldn't push themselves into the position of having to try and get the same budget deficits by putting up and up taxes.

And this really did mean that by the middle-to-late period of 2009, we began to see that things were turning around, and at least up till now, it's looked as if we’d averted the catastrophe. Indeed, until a month ago, it looked as if recovery was securely on its way.

Viv: Does that mean, then, that cooperation is no longer needed? Or if not, what sort of cooperation do we need now?

David: Good question. I'd said until a month ago, we're beginning to become aware of really three things. Let me take them in turn. First of all, there's need for real international cooperation about fixing the global financial system. We've seen piecemeal attempts. Right back in the London summit more than a year ago, there was an agreement that there would be international cooperation, that things would be done together through the Financial Stability Board and in other ways. That plan to cooperate is basically fragmented. The U.S. is taking action, in some ways important and valuable. Germany has taken its own very particular action in banning short selling and other things. The attempts to regulate financial institutions, to stop too much leverage, to deal with "too big to fail," to possibly break up the banking system, ensure enough cooperation is really disorganized now internationally. There's a first issue serious work done on that.

Secondly, macro economically, this recovery has been, as I said, helped enormously by the fiscal injection which happened a year ago, and the growing deficits. But everywhere we look as if we're running towards a fiscal brick wall. My own view is that this view of there being a brick wall is a very significant mistake.

We've needed the fiscal expansion and in due course, as the recovery is secure, of course we need to stop fiscal deficits from causing debt to mount. But the timing is crucial. Internationally, the timing of how this is done is crucial. At the moment, we are seeing piecemeal pressure applied, country by country, on fiscal tightening. We are also, paradoxically, seeing worrying failure to grapple with this issue, particularly in the US.

The fiscal stuff doesn't look at all tidy, and it's certainly not cooperative.

Thirdly, and in some ways as fundamental as anything, we need cooperation that will end up slowly, gradually, but definitely, removing the global imbalances which have happened because some regions of the world, particularly east Asia but also Germany, are saving a great deal. But other regions, the US, UK, some others, were until the crisis, spending too much. Now it looks as if might go on spending too much. There's cooperation on this front too.

Viv: I see. So there are clearly some risks associated with this, and it looks like not do the deficit countries need to do things, but that also the surplus countries?

David: Yeah. So, everyone knows that one day the US is going to need to run a current account deficit that's no longer as large as it is, probably close to zero. This fantasy idea that the world needed US financial assets because the US was the place that could create good financial assets, an idea which did the rounds around 2005 6, has gone away. The US is going to have to put its fiscal position in order, and politics in the US are difficult on this, particularly with an administration which has very understandable and legitimate wishes to do things about health and about other aspects of social policy. That's a risk.

Secondly, and obversely, on the side of the surplus countries, the structural surpluses in east Asia, which have emerged as countries saving a lot for the future investing, yes, but not as much as they save, and making their growth engine work by exporting to the rest of the world--that's how the early to mid 2000s worked this needs to be turned round.

And, although you will hear speakers in China I heard a very interesting presentation just the other day claiming that this is happening we're not at all sure yet, firstly, because the very large and very welcome Chinese injection has been so much concentrated on infrastructure, and in the end it's going to have to be more concentrated on growing consumer spending, and we don't see evidence of that.

So those two risks--the world is in a curious position still, the same position it was in four years ago, where there are incentives for the deficit countries to go on being deficits and the surplus countries to go on being in surplus. And this will lead to a buildup of international debt, which is frighteningly like the buildup of financial, mortgage and short term debt that happened in the US housing market and elsewhere. There's a parallel: Too much debt in a circumstance where no one knows where the resolution is going to come, just like no one knew how the housing problem was going to sort itself out. That's a risk we carry forward, and we need to be seen, internationally, to be adjusting on this.

Viv: Yes. And what you're describing, it looks very similar in Europe. There must be lessons for Europe here. Could you perhaps elaborate on what we could be learning from these stories?

David: Yes. Europe is a mini world. It's a particularly complicated mini world, because of the European Monetary Union and the effect of that. Let me explain. In Europe, the German economy has been remarkable, as always, in its management and in its achievements. Germany went into the European Monetary Union probably not as competitive as it should have been, but German institutions and German practices have been, in some ways, extraordinarily admirable in forcing down costs and in taking tight control of wage and price setting.

If you look at German unit labor costs relative to the rest of Europe, compared with the ones on the periphery Greece, Spain, Portugal, Italy a 40 to even 50 percent improvement in the German cost position, certainly too far. And Germany now, stealing demand from the rest of Europe, is the parallel in exactly the way that China and East Asia has been stealing demand from the rest of the world, in the wider world picture.

It's very worrying that the German response to this, over the last year, has been to enact a constitutional provision which will ensure that German spending is curtailed as Germany, by being cost competitive, takes demand away from the rest of Europe. Guess what: when you try that, and it's all upward in Europe, it means that the other side, the countries on the periphery, will be in a deficit position, and there will be a shortage of demand in Europe.

Now, of course, that's not the normal way that everyone describes the European problem. Everyone [laughs] starts off saying, "Look at Greece. They're so irresponsible. They've overspent and misbehaved." And that's all true.

Viv: Could you say the same for Portugal and Spain, for example?

David: No, you wouldn't. Portugal and Spain are different. They've been extremely responsible. But they face being stuck with a similar problem. What happened in, let's take Spain. Spain: spectacular housing boom, now the wreckage of that, and 20 percent unemployment, as this huge growth part of the Spanish economy when I say "growth part," this huge part of the Spanish economy collapsed. And all the financial fears about Spain are now beginning to grow, even although Spain had a well managed fiscal position and, in particular, Spain had disciplined, well regulated banks. But these banks are holding a lot of real estate debt, and that's not a good position to be in.

So, here's Europe, with a similar problem I come back to where I began made worse by the fact that the adjustment within Europe is going to be much more difficult because all of these countries are tied to each other and to Germany by a common currency. That's to say there's no opportunity for, particularly Greece, but small places, Spain, Portugal, to become more competitive and to grow their exports.

Viv: And Ireland has a similar problem, too, with their housing...

David: Ireland has a similar problem. And the Irish... Go to Dublin, and you see acre upon acre of finished houses unoccupied. It's a very significant problem there. But Ireland is small for Europe, and quite remarkably, the Irish have been able, politically, to bring about huge cost adjustments by cutting wages and prices. But even that's going to be really tough in Ireland.

Viv: Yes. So David, what do you think is necessary, then, to halt the crisis in Europe? Are we heralding the end of the euro?

David: No, I don't think so. But the move made a month ago now to lend Greece a lot of money, hoping that that would fix the deal, is not enough. Many of us, at the time, thought it was not enough. Let's do Greece and talk about the others in a minute. Because Greece can't devalue, there will need to be, according to present plans, a period of fiscal restraint at a time when exports can't grow, because the country is uncompetitive.

And Greece faces a very real threat that these cuts will force the economy to contract further. Of course, that further cuts fiscal revenues. Means there'll need to be more cuts. And in these circumstances, the burden of the debts which the Greeks bear, will rise in... This is Irving Fischer's debt deflation.

And that debt deflation, viewed as economics, it can become an unstoppable spiral. Viewed as politics, it can provoke unrest, and in the end, resistance to the whole strategy. And I think, like increasing numbers of people now, that there will need to be a write down in some way, a hair cut, a restructuring of Greek debt. And like the Irishmen, if I wanted to get to a good place, I wouldn't start from here. This is not easy, because someone is going to have to bear the burden of this debt, and if it's written down, there are German and French banks in there.

Quite possibly German and French tax payers are going to have to pay. Because the financial system, and the banking system, is too fragile to bear this debt. Greece is small, but you can see that I'm speaking in code also about Spain.

And I would add one last thing. It won't be just enough to write down the debts in Greece, which is a form of forgiveness for Greek citizens. Even you could say, forgiveness for their bad behavior. But Greece is not competitive. As generally all of us have heard the story of rather annoyed Germans saying that they're going to take their holidays in Turkey this year. And at the same time as there's a debt write down, there will need to be the politics of managing a really significant wage cut in Greece. Much bigger than has happened in Ireland. So this is really tough.

And as it happens, we've got to also be working on how to deal with the fear in financial markets. That, me speaking about Greece, but actually speaking in code about Spain, that doesn't turn out to create a Spanish nightmare which will be much larger.

Viv: Yes. OK, David. Thank you, for what was a very interesting presentation of the very difficult issues currently facing Greece, as well as the wider European Union more generally. Before we wrap up, I'd like to return to where we began by talking a little more about your policy brief on the challenge of global macro economic coordination. And in particular to ask you to explain what changes would be needed to the IMF, to make international cooperation more possible?

David: This is a very major challenge. You heard me earlier in my talk, talk about the risks that the surplus countries in east Asia will not be able or willing to adjust and spend more, that the deficit countries in the US and elsewhere won't be willing or able to adjust their fiscal positions. And my fear that this would cause, what you might call, a global debt crisis. Debt crises are national things in all our minds. But I chuckle only because the idea of a global debt crisis is big. Then you heard me also say that there is a smaller within Europe problem. But it's related, and it's frightening financially.

These are global issues about global rules of the game. Let me say two things about the recent past, and about the far away past. Recently during the great moderation, when we were all so proud of ourselves--the policies looked as if they were wonderful five years ago--rather foolishly proud of ourselves: One of our ideas was that delegating to individual countries the responsible management of their own policies, was how the world worked best.

When I say delegating, there's no man or woman in control of the world, standing in the middle of things doing this delegating, but a system that just left countries to get on with their own stuff, was how we thought the world should work. And it did work well. Not true. Those risks that I talked about require global rules of the game. They require IMF surveillance at the very least, but also a willingness of countries to take notice of IMF surveillance. And actually an international court of policy, opinion, and influence which causes countries to act. Not only in their best interests, but the world interests.

This takes us right back to 1944, and the design of the Bretton Woods System. At that time Maynard Keynes, who'd lived through the Great Depression in the 1930s, which was a nightmare, and any reading of history will show you, caused by countries needing to do in their own interest, things which damaged others. And they set about designing at Bretton Woods, and setting up the IMF, rules of the game for the world, which constrained countries’ actions in the interest of the greater good.

And all of us macro economists and people thinking about international relations, and global politics need to think over the next five years, of how we can really make the International Monetary System, managed by the International Monetary Fund in Washington, how we can make it stand up to the mark. And help us find rules of the game again, that stop us walking into another mess like the one we've got ourselves into now.

Viv: Well I very much hope that that can come about, David. Thanks very much indeed for talking to us today. It's been a pleasure.

David: Real pleasure for me, too. Thank you.

Topics: EU policies, Monetary policy
Tags: European Monetary Union

Professor of Economics, Oxford University; Fellow of Balliol College, Oxford; Director of the Centre for International Macroeconomics, Oxford; CEPR Research Fellow

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