Liquidity support is essential for supporting reforms in the Eurozone

Giancarlo Corsetti interviewed by Viv Davies, 20 Jan 2012

Giancarlo Corsetti talks to Viv Davies about using cumulated inflation differentials as a guide for pricing sovereign risk across Eurozone countries. They also discuss the fiscal compact, the debate on growth versus austerity in the Eurozone and the recent downgrading of Italy and other Eurozone countries. Corsetti is of the opinion that liquidity support is essential for, and compatible, with reforms in the failing Eurozone economies.

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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 from the Centre for Economic Policy Research. It's the 18th of January, 2012, and I'm speaking to Professor Giancarlo Corsetti of Cambridge University about a recent Vox column he wrote with Professor Hashem Pesaran on using cumulated inflation differentials as a guide for pricing fundamental risk across Eurozone countries. We also discussed the fiscal compact, the debate on growth versus austerity in the Eurozone, and the recent downgrading of Italy and other Eurozone countries. Professor Corsetti is of the opinion that liquidity support is essential for and compatible with reforms in the Eurozone economies. I began the interview by asking Giancarlo to briefly explain his recent paper on the use of cumulated inflation differentials.

Giancarlo:Yes. The idea of this paper, or proposal, actually comes from an empirical observation. What we have noticed is that there is one variable that is actually very strongly correlated with emerging risk premia over time in the Euro Area. This variable is not the current account deficit. It's not the size of the public debt. It's not any proxy for other theories that people have been pushing forward as the root of the imbalances in Europe, but is the cumulated inflation differential, which is nothing else than the price level divergence across Europe. Now, is this a compelling story? Maybe. It's more the fact that any kind of demand imbalance within Europe will, at the end of the day, produce an increase in the price level in the regions that are drifting away, are diverging from the average. And in a way, this drifting away to the price level also indicates, somehow, the size of the adjustment that, in a situation of crisis, can be expected from each camp.

So the idea with Hashem Pesaran is to say, look, we have pretty much an indication that Greece, for example, is a 21 percent price drift, other countries between 14 and 16, Portugal and Spain. Italy's on the downside. It's probably on the low side. It's probably like eight percent. But this can give us the drift, to answer fundamental questions. There is a consensus that we need to intervene with liquidity, to contain interest rates and sovereign spread in Europe.

The problem is, at which level, for which countries these caps on interest rates, these level of interventions, should be decided. Our humble proposal is to start working on this inflation differential to differentiate across these gaps, which, again, should distinguish what is a legitimate interest rate differential to charge to a country, reflecting the fundamental, and what would be the part of the interest rate differential that comes, actually, from a systemic assessment of the situation in Europe, of the weakness of the political process and the European integration process, or simply from market dynamics.

Viv: This measure, do you see it as being a good complement to the proposed fiscal compact that's recently been proposed?

Giancarlo: Well, this is a complex question. It's truly at the heart of the problem. The idea that we need to clarify that the fiscal compact is more than just re proposing old rules, with the idea that we haven't been able to be serious up to now, from now on, we are serious. There is a sense in which the fiscal compact is a European endeavor, is a European initiative. Let me give you an example. There is a table in Europe which, basically, is unattended since the beginning of the crisis, and this is the table in which policymakers in Europe can design, in a coordinated way, a response to the crisis. The reason why we do not sit at this table is very simple. Those who are on the critical side of Europe think that every penny, every euro they put in on the table will be a wasted euro, because you will simply reduce the incentive for the country with the problem or adjustment to do the necessary reform.

On the other side of the table, there are the people who are doing the reforms, and they think that there is a problem there, because whatever they do, the spreads tend to be correlated quite a bit across all the countries and somehow aren't responsive, or not as responsive as they would like, with their initiatives that they have implemented at home. This is the table which is the object of the fiscal compact, which is a table in which there are rules for adjustments, but they also for keeping things together, by making sure that there is a level of trust from the market towards the policymakers that reflects the level of trust that the policymakers must have across each other.

The fiscal compact, the way I see it, is a rebuilding of this table, a rebuilding of institutions that gives to European citizens and markets a sense of their action, with an institutional endpoint towards which the euro area can move successfully.

Viv: So where would you stand, Giancarlo, in terms of whether it should now be growth or austerity that should be the focus of European policymaking?

Giancarlo: Growth is an outcome of the decisions of many, many firms and households. Now, it's true, also, the effect of austerity is an outcome of the decisions of many firms and households across Europe. There is no doubt that there are different elements of correction that the countries now under attack need to implement as soon as possible. But it would be completely foolish to think that there is an independent, country by country solution to the current crisis. This is a position that is very clear. I understand that there is a lack of trust on this, on both sides. So I'm not taking the side of saying that it's all a confidence crisis or it's all fundamentals, but I don't think that the answer to the question that you're asking, whether it's austerity or growth, is anywhere but in this new fiscal compact.

Viv: What effect do you think that Standard and Poor's recent downgrading of half of the Eurozone economies - including France and Austria - what effect will that have on the future of the Eurozone do you think?

Giancarlo: It is hard to say that the downgrade will have an effect per se, because, also, the downgrade came after a substantial deterioration. I would like to answer this question, actually, stressing a point that worries me, which is that time is running out. I have many of my colleagues that really believe that there is a strong element of confidence crisis now pushing Europe towards a substantial deterioration. Even if you believe that everything is in the eyes of the market, the crisis is in the eyes of the beholder, the self fulfilling, belief driven attacks, after many months in which very little has been done, the fundamentals of Europe are changing.

Something that may have started as a self fulfilling crisis nowadays is no longer a self fulfilling crisis. There would be very little surprise if next year the recession would be, actually, much harsher than we believe, simply because, when we talk about interest rates, volatile interest rates for sovereign debt, we also talk about volatile and high interest rates for firms and households trying to finance their business or trying to get a mortgage.

So the whole Eurozone, especially in the south, is now under a severe slowdown, coming from this jurisdiction, this sovereign risk hampering economic activity and making everybody extra cautious starting any kind of business, any kind of economic position.

Viv: In an interview in today's FT, Italy's Prime Minister, Mario Monti, welcomed S&P's downgrading of Italy to a triple B plus, because the report emphasizes the weaknesses of European policymaking and political institutions rather than Italy's prospects for reform and growth. Do you share his view on the Eurozone leaders' inability to make the right decisions at the right time and also his optimism for Italy?

Giancarlo: I think Mario Monti is pointing to a very important and true problem, which is let's take out of the discussion basket cases. Many people believe the Greek economy has, really, no way out. Let's even account for that. Now, in many other economies, the Italian economy, maybe next the French economy, or definitely in Ireland, there are very serious reform efforts. These reform efforts must be coming together on the table. This table is now not there, because everybody is waiting for the other one to finish before sitting at it, to finish a very long process that would solve, by magic, the problem, by itself. This is not in the cards. It cannot happen, simply because we are not talking about Europe as a collection of puzzle pieces that come together after recouping full credibility. We're talking about Europe as an area which is integrated, that can only be saved by a common policy. I completely agree with Mario Monti on this.

Viv: OK. And so I guess if it's a dinner table we're talking about, there must be a host, and I suppose Germany would be that host. How do you see Germany's role in resolving the crisis?

Giancarlo: Well, there must be at some point, a recognition that there are the minimum conditions for starting again a common strategy for the euro. I don't know whether this will come out of a sense of political commitment to Europe or will come out of a sense of fear if, at one point, the German producers and politicians understand the problem that the breakup of the euro may create.

Viv: So, finally, Giancarlo, what do you think needs to be done in the immediate term to avoid a breakup and put the Eurozone firmly back on the path of recovery?

Giancarlo: I think the steps are very easy. We need to have some reform of institutional procedures to make sure that adjustment can take place with the substantial assistance of liquidity. So there would be more funds on the table, which hopefully will not be used, more reasonable rules on the table, which may help reforms at the European level. So there is this thesis that is around, which I consider, actually, dangerous. The thesis is that liquidity support to stem confidence crisis is actually negative at this stage because it would discourage reform in the periphery of Europe. There is no strong theoretical support for this thesis. Actually, if anything, it is exactly the opposite. There is literature on this, for example, Morris and Shin, or papers that Nouriel Roubini, Bernardo Guimaraes, and I have written, but there is also a recent contribution that I wrote with Luca Dedola, just making sure that people understand that the theories support exactly the opposite view.

Liquidity support stemming confidence crisis is actually, at this stage, helpful for reform. And if you think about it, the reason is straightforward. Any government with a painful program of policy for austerity, liberalization, budget correction will have a much higher chance to survive and succeed if the constituency, the electors, the taxpayer, can see some link between what they do and the outcome in terms of interest rate and international market assessment. If that is not there, because of correlated fluctuations in spreads due to confidence factors, well, the political chances of carrying out these reforms are much, much lower.

Viv: Giancarlo Corsetti, thanks very much.
 

Topics: EU policies, Europe's nations and regions, Monetary policy
Tags: Eurozone crisis, inflation

Giancarlo Corsetti
Professor of Macroeconomics, University of Cambridge and Programme Director, CEPR

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