Viv Davies: Hello, and welcome to Vox Talks, a series of audio interviews with the leading economists from around the world. I'm Viv Davies from the Centre for Economic Policy Research. It's the 9th of August 2011, and I'm talking to Daniel Gros, Director of the Brussels-based Centre for European Policy Studies about the recent European Central Bank's intervention in the markets for Spanish and Italian bonds. We discussed the European Financial Stability Facility, the prospect of fiscal union, Eurobonds, the interconnectedness of banking risk and sovereign risk and the likelihood of another global recession. Daniel Gros is of the view that only the unlimited firepower of the European Central Bank can stop market panic.

I began the interview by asking Daniel whether or not he welcomed the recent ECB intervention in the bond markets of Spain and Italy.

Daniel Gros: I think “welcome” is a strong word. It was unavoidable. I would have preferred the ECB to wait a bit longer until Italy had taken stronger adjustment measures but, sooner or later, it had to come.

Viv: And what sort of levels of financing do you think will be needed in order to establish stability in the Eurozone? Or, put differently, how big should the EFSF pot be? Is €440 billion really enough to cover both Spain and Italy?

Daniel: It is obvious that €440 bn is just enough for the three smaller countries, Greece, Ireland and Portugal, but the size of EFSF is not really the point. Because if you were to increase the size of the EFSF, given its current structure, you would lose Spain and Italy first as contributors. Then the remaining burden on the remaining guarantors, namely France and Germany, would be so large that certainly France would lose its AAA status. It would then alter for also the guarantor. And this cascade effect, then in the end, it would be only on Germany and it would just be too big.

So my view would be that the size of the EFSF is not really the key issue. The key issue is whether the ECB would be willing and able to back up the EFSF.

Viv: And would you agree that this change of policy by the ECB nevertheless fails to address the underlying problems in the Eurozone, which are high public and private debt, a lack of fiscal integration and the absence of a Eurozone banking regulator?

Daniel: There's very little you can do right now about the high public and private debt, which are indeed the key issues right now. These debts have built up over decades, and you cannot just wave a wand and do away with them in a couple of quarters or even years. To pay them down slowly will require years of patience and sacrifices in the debtor countries. And that is, of course, a process which the ECB can accompany and perhaps can make a little bit smoother. But it is a process which has to take place in these countries themselves.

Viv: And do you think that there's a risk of other major Eurozone economies, such as France for example, getting drawn into the crisis in the same way as Italy has been?
Daniel: If we were to proceed with the EFSF method for Spain and Italy, then I think there's a real risk that France will also be sucked in, and in order to avoid that we have to change tack. We have to refinance the EFSF not with guarantees from only the AAA countries, but with a credit line from the European Central Bank.

Viv: So, you've written in the past, on Vox in fact, about Eurobonds and fiscal coordination. Do we need fiscal union in the Eurozone and the introduction of Eurobonds?

Daniel: My view would be that fiscal union Eurobonds at this point are really not a solution. They are more chimera of what one could do in a future EU, which is politically be much more integrated and which starts out with a very low debt level. Given the very high debt levels we have at present, Eurobonds are neither economically warranted nor politically feasible.

Viv: How connected would you say the banking risk and sovereign risk are in the Eurozone, and what do you think the likelihood is of another banking crisis occurring in Europe?

Daniel: A pure banking crisis is unlikely at this point. But in each country that gets into trouble, we see that it's either the banks that create trouble for the sovereign, or the sovereign creates trouble for the banks. In the end we know that when there is a financial crisis, the banks and the sovereign are basically the same thing. It doesn't really matter where the problem started in the first place. Then, in the end, the two sink or swim together.

Viv: And given the situation in the US coupled with the Eurozone crisis, would you say that another global recession is inevitable?

Daniel: It is really useless to talk about a recession. One should really take a broader view, and if you take a broader view you see that on both sides of the Atlantic we have had an enormous increase in leverage over the last decade or so. In the US it was more households. In Europe it was sometimes public debt, sometimes bank debt. But, as long as this debt is not pared down to a more manageable level, the economies cannot grow very strongly. Whether they're technically in recession here or there and then have a little bit of growth in between, the upshot is that for the next few years we'll have very low growth prospects.

Viv: So would you like to see the introduction of a European monetary fund?

Daniel: It would, of course, been very nice if we had had such a fund already before this crisis, but we now have most of the elements of a European monetary fund in the form of the EFSF. But the EFSF still needs to be given much more operational autonomy and it needs to get back up financing, and this cannot come only from the AAA countries. In the end, it has to come from the ECB because that's the only institution which has unlimited firepower, and that is what you need right now to stop market panic.

Viv: And would you say that the demonstration of growth in Ireland in the wake of their crisis demonstrates that there is potential for these peripheral countries to grow and develop sustainable economies?

Daniel: Unfortunately Ireland cannot be an example for Greece and Portugal, because the Irish problem was never one of over consumption and excessive public sector indebtedness, as in Portugal and in Greece. The Irish economy, I think, was fundamentally sound. It just allowed an outsized construction sector to develop. But most of the waste which happened in the real estate sector in Ireland was actually domestically financed. So the Irish economy, wasteful of resources, but their own citizens have to bear the consequences. If they do, then I could see the Irish economy as returning to a stable growth path as before.

By contrast in Greece and in Portugal, the countries just over consumed on a vast scale and have an economic structure which is based mostly on consumption and very little on exports. And that needs to be changed, of course, but it cannot change over night. That will take at least 10 years of low growth.

Viv: What would be your advice, then, to the leaders of the Eurozone countries right now?

Daniel: We are in a very difficult situation with accumulated debt levels which we cannot do away with quickly. So, we need patience. We need a clear view that a number of years of sacrifices and slow growth are probably unavoidable. And we need a clear choice that this is actually what we are willing to endure so that the Eurozone can manage in the end. If that's the case, then the ECB is justified in providing liquidity assistance to countries in temporary difficulties. And then, perhaps, after a few years of very low growth we might, then, slowly emerge from this tunnel with a lower debt level and stronger and more flexible economies.

Viv: And what would you say is the key issue that policymakers should keep in mind?

Daniel: I think what is very important to keep in mind is the general phenomenon of an increase in leverage in both the US and in Europe, much less so, of course, in the emerging markets. And that this increase in leverage doesn't cause any problem as long as you are in an environment which is very stable, has very low risk aversion. When, then, the environment changes and you have high risk aversion and less stable growth, then the same leverage as before is no longer sustainable. Investors want to see lower levels of debt, and that's why they're marking down all kinds of assets very rapidly. Whether it is country's debts, bank debts, United States debt, it is really all expressions of the same general phenomenon.

And we have to understand that this is something which will not go away quickly, which is not a uniquely European phenomenon and which, in the end, requires that we have a lot of patience to let this process develop. And that we have to take also, of course, every opportunity to cut debt levels when we can, if that can be done without endangering financial stability.

Viv: Daniel Gros, thanks very much for talking to us today.

Daniel: You're welcome.