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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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

Willem Buiter
Chief Economist of Citigroup and CEPR Research Fellow