The crisis in the eurozone is critically important for Asia. At a distinguished speaker seminar at ADBI on 1 December 2011, three eminent European economists examined the crisis and put forward tentative solutions. In a post based on the seminar transcripts, one of the speakers, Charles Wyplosz, identifies some of the mistakes that have been made in the response to the crisis and puts forward three scenarios for its resolution.
Since late 2009 the European debt crisis has worsened because of the wrong policy responses by European politicians. Some progress has been made but we are not yet there. We have a historic disaster with global implications on the way and unless a miracle happens I am pretty pessimistic about the future.
At each European summit the leaders reveal that they have a total misunderstanding of the problem and that’s the drama of the crisis: at the very top—both in Berlin and Paris—nobody understands what is going on.
The €110 billion bailout of Greece in May 2010 was the “Mother of all Mistakes” because it violated the no-bailout clause of the European treaty. Imposing a tough austerity program on a country in the middle of a recession to improve its budget can’t work—that is economics 101.
The program to save Greece is not working, yet leaders are negotiating a new program that is exactly like the old one, which means lending another €130 billion to a country that already is deeply in debt and which comes with more austerity and more intrusion on Greek sovereignty. It is more of the same, but worse, and there is no reason to expect better results.
We are in a free fall, There are three conditions for the beginning of the end of the crisis: (i) several countries will need to restructure their public debts, which will cause the biggest banks in Europe to go bust because they are exposed to public debts so, (ii) they will have to be recapitalized, and (iii) a floor must be put under the value of public debts, but that is not happening and that is where the battle is happening now.
Europe faces three scenarios.
Central scenario: Nobody will be brave enough to do anything. So the European Central Bank will step in and spend more money buying public debt while swearing it will be the last time. Little by little they may end up buying the €3 trillion that is needed to end the crisis, which means they will take an enormous risk, which means they will have to print more money. In the end we will still have restructuring and it will be disorderly and banks will fail so the ECB will come back again and bail out the banks—it is going to be bad, bad, bad.
Optimistic scenario: Mario Draghi, president of the ECB, will partially warrant the debt, which will effectively force a number of governments to restructure their debts and banks will fail so the ECB will be the lender of last resort for the banks. But this scenario would not be very expensive because Europe knows how to restructure banks.
Pessimistic scenario: No government is contemplating leaving the eurozone because that would be a total disaster. But anger could rise in a number of countries that populist politicians could take advantage of, and that could be dangerous because it could lead to a breakup of the euro, which could lead to a breakup of Europe, which could lead to wars.
You have to respect fiscal discipline, that is the model for Europe and I think it works very well.
What would have happened if Greece had defaulted in May 2010? The political advantage of that is we would not have Angela/Nicolas messing up the situation as they have. It would have been much better if Papandreou had been left to talk to Strauss-Kahn while he was at the IMF. It would have been much better.
The Greek decision officially was to avoid contagion and defaults that would wreck the banking system. What would have happened? Greece would have gone to the IMF and it would have imposed restrictive policies. So instead of burning the image of Angela Merkel in the streets of Athens they would burn the image of Strauss-Kahn. The hate against Germany is a big problem—nationalism is rising in the EU and the Germans are furious about the Greeks and the Greeks are furious about the Germans. Under this scenario they would have been upset with the IMF.
The IMF would have quickly realized that the Greek government needed a haircut to get market access. Some banks, and probably French and German banks, would have suffered. The problem with the French and German banks is that nobody is forcing them to do anything right, so they are very fragile because they are not cleaning up the subprime mess, so they can’t take any hits. It would actually have been good for the banking system to have taken a hit and for the banks to be recapitalized. By now Greece would be just a piece of history, it would now be exiting from the hand of the IMF, the default would have been digested, and it would have been over.
On the aggregate budget, my wish has been for a United States of Europe with a federal government, but that is not going to happen because public opinion is against it. How then can we have fiscal discipline? Fiscal discipline has to be decentralized because politically there is resistance to centralization.
There are three ways for a government to cut its debt—raise taxes, cut spending, or default. Whichever way you go you hurt people. Do you want to hit taxpayers or civil servants or the bond holders?
A big chunk of the public debt is held by bankers, by investors. Investors are risk takers, sometimes they win, and sometimes they lose. I don’t see anything anti-capitalistic or immoral in Deutsche Bank suffering because it bought public debt with interest rates of 10% or 15%—they gambled and they are losing their gamble—tough luck! The bankers created the Lehman crisis; the bankers are fighting to prevent a government default because they want to save their skin at taxpayers’ expense. To me that is the opposite of capitalism.