Viv Davies interviews David Vines for Vox

August 2011

Transcription of a VoxEU audio interview [http://www.voxeu.org/index.php?q=node/6830] 

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 2nd of August, 2011 and I'm talking to Professor David Vines of Oxford University about recovery prospects for Greece following its second bailout and the wider implications of the crisis for the Eurozone and in particular for the peripheral countries and Italy. In Professor Vines' view, the bailout was a constructive first-step solution for Greece that now requires the country to develop its competitiveness in order to stabilize and grow. We discuss contagion and the challenges of asymmetric monetary union, Eurobonds and the need for strong federal management and political leadership within the European project.

I began the interview by asking David whether or not he thought the second Greek bailout had accomplished what it had set out to do.

David Vines:  Well, let's start out with the good news. I think two very important things were achieved last week. The first is that at last policy makers recognized that the debt burden on Greece is so large that Greece cannot and will not pay the full amount that it owes. And this was a proper, important beginning of managing that fact. Secondly, the European Central Bank was taken out of the firing line of the consequences of that. It's been a dreadful month to watch in the run up to last week, because when people began to realize that Greece will not be able to pay, honor all its debts, this left the European Central Bank with really monstrous balance sheet problems.

It looked like the ECB ended up having negative net worth. This really bizarre pincer movement developed where the rating agency said "If there's haircut, or some kind of write-down on Greek debt, then we'll declare Greece in default." And the European Central Bank says, "And when that happens we will be forced, as a matter of logic, to remove our financial support both for Greece and the Greek banking system. If you proceed in this way, it will bring down Greece."

This was a very extraordinary argument to see in public. Well, the debts are being written down and the European Central Bank is no longer saying this. It got what it wanted which, was the entry of the European Financial Stability Facility to be able to relieve the European Central Bank of the difficulty created by writing down Greek debt. Those are two very big, important things.

Viv:  Is this a sovereign default we're talking about, or is it what's been called a selective default and what's the difference?

David:  Well, there’s a lot of difficulty in the run up to this. Writing agencies saying, "If you do this that'll be a default." and the European Central Bank saying, "And that'll be a disaster." In the end, carefully and importantly, what's happened is a selective default.

Why default? Because those who lent to Greece will not get back what the contract said they should get back. And the rating agency said, "No matter how much you go round and round in circles, it's our job to say that, if that happens."

But crucially was agreed and was the counterpart to the two important things that I said a minute ago, was that from now on northern Europe will guarantee that Greece can manage to meet whatever it needs to repay those to whom it lends from now on.

The debts have been written down approximately 20%, but from now on there will not be this kind of financial crisis. There’s very nearly an open check. What this means is that during the course of the next week, this Greece defaulting, not honoring its debts, will happen. The debts will be written down. Private sector lenders will take a hit. But then when that's done, everyone will know from then on Greece will honor its debts.

Selective default will be switched back off again, Greece will be in good standing, and we'll go forward. This is not a country with the nightmare of a Lehmanns‑like wreckage hanging around us. This has been a carefully managed move and, again, that's very important.

Viv:  This is not a quick liquidity fix, but a constructive solution towards ensuring the longer term solvency of Greece?

David:  Absolutely. But notice I said in the beginning of my remarks, a first step. Before last week people are projecting that the ratio of public debt to GDP in Greece was heading towards numbers more than 170 percent. Pushing towards two years output of public debt, just unmanageable. Haircut down 20 percent to something like 130 and none of us really believe that this is manageable yet. In the next year there's going to be more. And my hope, I think everyone's hope, is that we will in the course of next year see a proper reconstruction of Greece into a situation where it can become a growing economy.

It's important to say that has two aspects. It doesn't just involve writing down their debt. And it's certainly not something to go on and on and turn Europe into a transfer unit. That's not what's happening. This is a one‑off fix. Secondly, as part of this one‑off fix, the Greek economy is going to have to become more competitive and within a monetary union that's difficult and important.

It's going to involve more wage cuts. It's also going to need to involve the rest of Europe helping Greece, when wage and prices are further cut. Identify projects which are profitable and helping Greece borrow money, more borrowing for productive projects to create export opportunities to enable this country to grow.

Last remark about this, in the original draft of the solution last week, the words "Marshall Plan for Greece." Those words didn't survive into the final communiqué, but all of us believed a constructive solution to investing and growing in Greece is an essential part of what's needed.

Only then, with growing economy will tax revenues rise and the debt solution really be permanently manageable.

Viv:  That's very interesting. But do you think the Eurozone policy makers have “failed to grasp the nettle,” as one commentator put it, in that the markets believe there's a solvency gap in southern Europe that can only be met by debt relief, and that the tight fiscal policy is having an adverse on weak economies' competitiveness. So, current policy may be exacerbating the risk of sovereign default.

David:  You're right. And notice I said not just getting the debt sorted out but also getting into a position where these economies are competitive. When you need adjustment and growth you need not just manageable debts, but also competitiveness. That's two objectives and two ways of getting there. If people spend all their time doing just worrying about the debts and not concerned centrally with getting competitiveness right, you're right, worrying about debts will not solve itself. Absolutely agree.

Viv:  So how serious, David, do you think the issue of contagion still is within the Eurozone? For example, we've seen in recent weeks that apart from the crisis in Portugal and Ireland, Spain and even Italy are being downgraded. Would you agree that there's an issue here?

David:  It's very hard to be in a monetary union in Europe, which is so asymmetric. The North, led by Germany, is recovering after the financial crisis and growing. And the South is not. Greece is the beacon case of difficulty, but Ireland--banking crisis, Portugal--uncompetitive, Spain--housing market collapsed, Italy--political uncertainty. Each of those countries you can identify something that's wrong in being in a union with Germany and finding life very difficult. I think it's very important for me to say that contagion is not a disease that everyone catches automatically. Contagion happens only if countries are not able to manage the position they're in.

I think the next few months in what happens to Ireland are going to be extremely important, I believe, in showing that the Irish have become much more competitive. Exports are beginning to grow. Their debt is manageable. It's large, but it's manageable. They have a fiscal position that's going to manage it. And they've had very significant banking reform.

Markets are foolish if they think that contagion applies to everyone that's in the periphery. The important thing now is the discrimination to get to work and identify those who are coping and managing and putting themselves in a position for growth and those who are finding it difficult.

Viv:  Would you agree with the view that Italy is in reality, a peripheral economy with too much public debt and not enough growth?

David:  Those who are finding it difficult--you knew and I knew that I meant Italy. Crucially for Italy is the politics. I think there's going to need to be a major political change in Italy. I hope that Italians have a way of ensuring that. I hope, many hope, that this is an end of an era in Italy and that a new political solution can be found. I'm speaking in code, but you know what I mean, with the change in political outcomes in Italy.

Viv:  The UK chancellor George Osborne this week suggested, David, that the “remorseless logic of monetary union” is actually greater fiscal union. Would you agree with that, and if so, what do you think that would mean in practice?

David:  He's right. We're identifying that the European project really does require a much greater degree of federal management of the problems, and central, more than political, leadership of the European project. Let's focus on two things: Fiscal discipline, the fiscal way in which Europe's managed is going to have to change.

What we're watching in Greece is an insurance policy. The Greeks have got into difficulty and they could have either been cut loose, or helped to remain in the monetary union and to get into position to grow again. Europe has chosen very deliberately not to cut them loose, but to help them.

Now, the other side of an insurance policy: When you've claimed to have a fire, the insurance agency makes sure that you don't set about having another fire a few weeks later. That's going to involve, necessarily, with the ability to be looked after by insurance, it's going to become more centralized intervention in fiscal policy.

Secondly, the Irish fiasco has shown us that European integration is going to have to involve Europe wide policy towards financial stability. Many people knew 10, 15 years ago that the monetary union which was being created was a dangerous and unsafe one. Many people discussed that in Britain and saw that this was risky.

A monetary union needs to have central management for financial stability, so that never again could we have what the behavior that happened in Ireland. Now, with fiscal integration and a very great centralization of financial policy, that's two very significant movements towards much more federal integration.

Viv:  We are looking at the situation, in fact, in which Europe's problems are political rather than economic and that the real solution is a matter of political will.

David:  And political leadership. When you look back, Helmut Kohl and before him, way back, Adenauer, in Germany had a vision for European integration. And the French had a related vision about being at the center of this common European project. Germany doesn't look like that at the minute. Political battles are being fought against the European project, and at every stage. One of my colleagues this afternoon was just telling me how her friends and relations in Germany are taxpayers and resisting what's happening. No one understands clearly enough now in Germany, in the North, that there are huge benefits to them in the underlying way Europe will develop if it's managed well. These benefits are much bigger, deeper, and more important than the tax costs of fixing the problem that we're going through now.

Viv:  Do we need Eurobonds?

David:  Well, that goes with my financial stability proposals. It's outrageous that Ireland, which is embarking on such a courageous reconstruction of growth possibilities, should be paying such huge sovereign spreads. 

Why those spreads on Irish debt? The reason is because people are still frightened that this resolution, which happened last week, will fall apart. That fear is inflicting on the peripheral countries huge costs in high interest rates and costs of borrowing. Eurobonds are a necessary part of the making clear there's a commitment to make this work. When this will work, there isn't risk to holding Irish debt, and that's what should be happening now.

Viv:  Do you think, David, that given that there's a tremendous effort on behalf of the Eurozone governments and the IMF to save Greece from defaulting, and to insure the long term stability of the Eurozone economies, and the European project more broadly do you think that, perversely, this could be putting more pressure on the non Eurozone countries like the UK for example, to join the monetary union? Given the show of strength in numbers?

David:  It's a very real argument. There's a fence on one side or the other. My view is that you're quite properly going to the other side of the fence. The British economy is so different from the European, very dependent on European economies, but structurally very different.

It relied very considerably on financial deregulation and financial growth over a period of 20 years. Perhaps too much, but it's a matter of fact that happened, and now it has a very significant reconstruction to do, which will involve exporting more. Changing the balance of activity much more towards manufacturing and productive activity. This has required a huge change in relative prices in Britain and devaluation of the pound.

The central question, however important being at the centre of a political union that's building its strength, however important that is, if you impose on yourself economic constraint to the common currency, which means that you cannot properly adjust to the changes which you need to make, these costs are just more important than the other.

I ask my students, I ask my friends, just imagine what would have happened in early 2009 if Britain had been a member of a monetary union in difficulty? The way Britain helped lead the recovery globally in the early months of 2009 could not have happened. This is not an economy that's capable of constraining itself from the freedom which having a floating exchange rate has given it now and has to go on giving it in the future.

Viv:  Finally, David, what would be your strapline advice for the leaders of the Eurozone countries right now?

David:  Big question, but I come back to what I said in the middle of my remarks. Show real political leadership. This difficulty, which we've seen in Germany of the political body being resistant to the fiscal costs of solving the problems which have happened recently, and complaining that this is a transfer union, is to misunderstand the opportunities ahead. And the need to lead, so that we never again have the extraordinary wrangling that happened between Chancellor Merkel and the European Central Bank in run up to last week. Leadership in the next year is going to require many more difficult choices. We have to hope that our political leaders are wise enough to do their thinking carefully and not do arguing in public ever again in the way they did recently.

Viv:  David Vines, thanks very much for taking the time to talk to us today.

David:  Terrific. My pleasure.