Zsolt Darvas is a Research Fellow at Bruegel (Brussels European and Global Economic Laboratory). He is also Research Fellow at the Institute of Economics of the Hungarian Academy of Sciences and Associate Professor at the Corvinus University of Budapest.
When did the euro crisis start and what are some of the main milestones we hit along the way?
The euro crisis has several roots which were not really apparent before the crisis and also even after the collapse of Lehman. It started with the huge budget deficits of Greece. Greece initially planned a 3% budget deficit for 2010, but at the end of the day it was 16%. So then markets realized that Greek budget deficit was increasing, getting higher and higher. They first denied funding to Greece and its European partners. The IMF, in early 2010, stepped in and provided financial assistance to Greece. At that time, European politicians thought that the crisis had been solved because Greece is a very small country. But later it turned out that Ireland also had major problems, primarily related to the banking system. The Anglo-Irish bank cost almost 25% of Irish GDP to the Irish government; so public denial also started to skyrocket. Then Ireland also needed a bailout. Then it was followed by Portugal. Portugal had very weak economic growth and was not a bright prospect. And now we are in Spain, where Spain asked for assistance for supporting its banks. But after that program has been announced, markets became nervous, and the situation is unfortunately affected further.
So following up on the timeline as to how things first happened; what’s been the impact on the global markets, particularly in the recent three months?
The major market is certainly in Europe; thereby government bonds in the euro area are suffering. Also, European banks are suffering, in the sense that share prices are falling and their borrowing costs are increasing. And since Europe is a major financial trading partner of the rest of the world, including the United States, through trade and financial linkages; the global economy is also impacted. If Europe is doing worse, then the rest of the world is also is doing worse. If European banks are in trouble, then also those American and other banks that each do business with the European banks, they also face some troubles.
Can you talk specifically about how, for example, the American economy might be impacted by a euro zone crisis?
The major question, I think, is what would happen to the euro? Because if the euro will stay together, but there will be weak economic growth and certain problems with the government and banks, then the impact on the American economy will not be that high because the U.S. is a largely closed economy. For example, the share of exports in U.S. GDP is less 10%. But if there would be a major disruption to the euro area and one or more countries would exit, or if the whole euro area broke up; that would mean a catastrophic financial crisis in the European Union. Not just in the European Union, but due to the heavy financial links, also many U.S. banks would probably face messy, messy losses. In that case, the impact on the American economy could be very, very significant.
So, in your estimation, what are the odds of something catastrophic happening in terms of the actual euro currency, the euro Zone, and the potential of it breaking up? Is that likely to happen, in your opinion?
I’m convinced that euro zone politicians understand the risks, but the problem is that they are heavily constrained by the electorate and by political reasons. Thereby, for example, the German public does not want anymore rescue, does not want to see massive European Central Bank lending to weaker countries. So it’s possible to save Europe, it’s possible to save the euro; but due to political risks there is certainly a probability that the whole thing will break up. I cannot really give you a probability assessment, but the probability of a breakup is certainly increased and is probably significant.
You talked about national interests; of course those are very significant. Could you tell us a little about the key players? You mentioned Germany, what about some of the other capitals in Europe and what are their positions on this particular issue?
The major player is certainly Germany, which is the biggest economy and biggest economic power. Now we also have France, the second biggest economy, but France and Germany typically work together. Now with the new French president Francois Hollande, who is a socialist candidate, he changed somewhat the position of France. He also has constraints and did not change so dramatically. So Mr. Hollande is more favor of various kinds of solutions; like European Central Bank lending, euro bonds, and this kind of stuff. It mostly will depend on Germany on what will be the fate of the euro.
Besides the European Central Bank, what are other decision making bodies in Europe?
So the major decision making body is the so-called European Council, which is the collection of European heads of states and governments. In Brussels, we have the European Commission. The European Commission is not a decision making body; it makes proposals for the European Council and the European Council will decide.
What is the decision making process?
For most decisions, unanimity is needed. So if one country is against a certain measure, then that measure will not happen. So therefore, the Council has a very strong role and even the smaller countries have a very strong role in influencing decisions
There are essentially a number of short term solutions and policies that need to be implemented to save the euro at the moment. Then there are some long-term, largely political decisions that need to be made as well. Could you talk a little about each of those, and the challenges presented by each?
Basically, everything depends on how the crisis will impact Italy, because now Spain is in trouble. Spain has requested assistance for supporting the banks, which did not help market sentiment. So the yields of the Spanish government bonds have increased further. Spain may need a full-fledged bailout program like the ones that the Greece, Ireland and Portugal have received previously; which is still feasible because Europeans, along with the IMF, have the financial means to support Spain. But Italy will be too weak. Italian public debt is close to two trillion euros, which is really enormous. So if Italy would follow the other four countries, then it simply would not be possible to lend to Italy. So there will be basically three options, which are short term options. One is massive European Central Bank financing, because the European Central Bank has the capacity to create as much money as it wishes. It can, for example, purchase Italian government bonds to limit the interest rate increase. Many Germans are extremely against the solution. The second solution could be a so-called euro bond, which would be the joint share of liability of euro zone member states. Since the euro zone as a whole has a reasonably healthy public finance situation, for example public debt is below 90% of GDP and the budget deficit is about 3- 4% of GDP, if the euro zone as a whole would guarantee that bond, it would probably enjoy an AAA credit rating. And in that case, the borrowing cost of Italy, Spain, and other countries could also go down. But again, there are major political hurdles here. Germans fear that if a euro bond could be introduced, then the liability of the German taxpayer would increase enormously, and therefore there is a very negative sentiment against euro bond. So I said European Central Bank, I said euro bond; these are basically the two solutions. And the third one is a catastrophic financial crisis, because if none of this were to happen, then Italy would probably default. That would have a really dramatic impact, not just on the Italian economy, but also rest of Europe and also the rest of the world.
There have been a number of proposals about a more unified bank oversight; more linkages between national capitals in terms of the financial system. Is this likely to happen? Maybe you could explain how it would happen?
Now there are a lot of talks about the so-called banking union, whereby various policy measures would be centralized at the euro zone level. First of all, supervision of banks; the European Council, at the end of the term, already decided that instead of the national supervisors which exist in each country, there will be a common euro zone level financial supervisor who will take a look at all the banks in the euro area. In addition to that, certainly a joint deposit grant assistant would also be needed, and the resolution fund, which solves the problem whenever a bank is in trouble. Either two solutions could happen: either closing down the banks or recapitalizing the banks. The major problem now, which was the fate of Ireland and also seems to be the fate of Spain, is that in the absence of this European resolution fund, the national government has to rescue the banks. For Ireland it was a too big job and for Spain it could be too big a job. But if there was a euro zone level rescue fund for banks, then basically the governments would not depend that much on the banks. As I said, the European Council has already decided to move this way. In September, the European Commission will present the proposal, so I hope indeed there will be a reasonable proposal, and the European Council will endorse the details. Because, you know, merging supervision is a very difficult task. Also, setting up a rescue fund for banks is a very difficult task, and would require some money from the member states. But this is only for the bank side, which I think will come; and must come and will come. But another related problem for the euro area is the weak growth prospect, in particular to the euro area periphery where they had two high wage increases in the past, and they are not competitive anymore. And the problem is that in these countries, there is very significant fiscal consolidation. So the government would try to cut spending and raise expenditures, which would certainly have a negative impact on the economy. Banks are in trouble, so they don’t really lend to the private sector. Now the euro zone economy very much depends on lending; so with no bank lending there’s really not much growth. The wages rose too high in the past, which means that the labor cost compared to productivity is not really favorable. And fourthly, the private sector is heavily indebted, which means they will likely decrease their indebtedness, which means they don’t really want to consume much. If you put together these four issues, then almost no economic growth would come out of this, but a period of stagnation and suffering. What would be needed also at the euro zone level is a kind of federal fiscal instrument that can boost economic growth. For example, in the U.S., the federal government implemented the American Economic Recovery Act, whereby the federal government invested in the United States, thereby reviving economic growth. So what would be also needed in the euro area is a higher level of fiscal integration because economic growth, especially in the euro area periphery is very, very weak. In the United States, for example, the federal government implemented the American Economic Recovery Act; whereby the federal government invested throughout the United States, including lesser states, and it helped to revive economic growth. But in Europe we have nothing of that sort. And in the periphery, where there is very strong fiscal conservation hurting economic growth, the banks are in big trouble and don’t relate to the real economy. Private individuals are heavily indebted and don’t really want to consume much. And on top of that, wages have increased too fast before the crisis, and therefore labor costs compared to productivity is not really favorable in those countries. So under those circumstances, I don’t think any economic growth will emerge in these countries in the coming years; but if economic growth won’t return, then social and political tensions would increase even further and financial markets would also question the viability of the euro.
And you mentioned that social unrest; how has this crisis impacted Europeans across the continent in various locations; people on the street?
Different societies or different cultures, I would say, react in a different way. If you look, for example, at Ireland or Latvia; Latvia is not a euro zone member state, but the European Union controls that implemented very significant fiscal austerity. You basically see no demonstrations, even though public sector wages were cut and a lot of reforms were introduced which will hurt economy. If you look at southern Europe, if you look at Greece, there are demonstrations almost every day; if you look at Spain, and now more recently in Italy, also a lot of demonstrations on the street. So people in different countries react different ways; and then people demonstrate too much on the street, and it certainly complicates the job of the government to try to sort out the situation.
Since you are part of a think tank (Bruegel), I’d be curious to know what kind of policy prescriptions are you offering both European Union leaders here in Brussels, and also in the national capitals.
So at the euro zone level, the major issue at the moment is this banking union, and we wrote a lot on how it should be introduced, what are key points that should be decided, and how it should progress. Another major issue is the so-called euro bond, whereby European Union countries would issue joint and several liability bonds. That would certainly require a new institutional framework, which guarantees, that it would not be the Germans paying for Italy’s debt. Now of course you take the national capitals and national countries; what we look at is the economic adjustment these countries are making, and we are trying to make suggestions how they can improve, for example, the functioning of the labor markets and how they can improve competitiveness.
What are solutions to Italy’s crisis?
Italy is the third biggest country of the euro area, and the public debt of Italy is close to two trillion euro; a really huge magnitude. So Italy is simply too big to be saved as smaller countries like Greece, Ireland, Portugal and Spain are being saved. So if Italy will face similar trouble as the other four countries, there are basically two solutions and one disaster scenario. The first solution is massive European Central Bank intervention, whereby the European Central Bank would purchase Italian government bonds to a large magnitude. The second option is the introduction of a euro bond; a joint and several liability of all member states in the euro area. Because since the euro area as a whole has a reasonably good fiscal situation, for example public debt below 90% of GDP, well below the public debt of the United States; then this joint euro bond, supported by a proper institutional framework, would enjoy a AAA credit rating, and I mean, the cost of borrowing would be limited, and therefore Italy would benefit from that. Now, none of these two seem to happen at the moment because there is a strong resistance on the side of Germany. Concerning the European Central Bank, Germans fear that if the European Central Bank purchase large amounts of Italian bonds and, at the end of the day the Italians wouldn’t be able to pay back, then it is the Germans that have to pay back. And the concerns are similar for the euro bond as well. They fear that if they were to merge the debt with Italy, then at the end of the day Germans taxpayers need to pay Italian debt. So at the moment, none of these two solutions are politically feasible. But if Italy would face a very serious crisis, then none of these two solutions would happen, then Italy would most likely default. And if Italy defaults, that would have a major impact on Italian banks; but not just on Italian banks but on the whole euro area because Italian debit is so high and Italian banks are so much interlinked with other banks in the euro area.
Lastly, do European leaders have the political will, in your opinion, to take care of this crisis both in the short term and the long term?
In my view, they understand the problem. They gradually learned; initially they do not understand the problem, but now they do understand the problem. But there are very strong national-political constraints. For example, in Finland, which is one of the healthiest economies in the euro area, politicians simply don’t understand why they have to pay, for example, for Spain or Portugal; countries that behave not in a responsible way before the crisis. So even though politicians understand, there are so many national interests; that it will be very difficult to find a good solution.