How to escape the euro crisisTo fix the financial system and emerge stronger European countries have to close ranks, argues Allianz chief economist Michael Heise.
Michael Heise: There is a war of opinions. But I think it is unavoidable for countries that have run into excessive debt to consolidate and to embark on a course of what you may call austerity.
The problem is that many countries are now in recession; they started to cut budgets and increase taxes but did little to improve growth. There are many options for growth oriented reforms. Some have finally been implemented in countries like Italy or Spain where there is a lot of privatization of economic activity, labor markets are being liberalized, and the shadow economy is being pushed back.
Pushing consolidation at first means that demand goes down. But it is hard to see how you can get out of overspending patterns without such a consolidation strategy. Hopefully other countries that are in a better position, like Germany, can stir demand to absorb exports from these countries that are consolidating. Actually that is something that is happening.
What has to be done to embed a common currency into a socially and politically diverse Europe?
I think the absence of a deep political integration has been one of the major flaws of the architecture of the euro zone. There are different perceptions of how economic policy should be conducted.
There is almost complete national sovereignty in fiscal policies but there is only little emphasis on European decision making. So there are many signs that we need to embark on a course of stronger political integration. I think this course is being pursued with reforms recently initiated like the fiscal pact or the reform of the stability and growth pact.
These are steps in the right direction but in the end I think we have to push political integration of the euro zone to a new level. That also means transferring some sovereign rights from national governments to the EU level.
Is it too late for Greece to remain part of the euro zone?
I think the Greek government would be well advised to do everything possible to remain part of the euro system. This is actually what the Greek government is saying and I do hope that despite the experiences of the last three years they will now do what is necessary. That means not only budget cuts. It means structural reform of an economy that has become uncompetitive and has become extremely overleveraged.
Exiting the euro would be a very painful experiment for the Greek people. They would have a new currency which would immediately be devalued and thereby reduce the purchasing power of the people and increase prices.
What would a Greek exit mean for the rest of Europe?
I think it could be a pretty strong shock for the whole system and it could create some contagion with respect to countries like Portugal, Spain, and maybe Ireland. Investors in other European government bonds could panic leading to a major selloff of bonds and further contagion. So I would advise policymakers to really try to avoid this risk as we don’t know how big it is.
Bond markets are very important and I don’t see how we could get them under control. Capital controls are not an option. On the contrary: if European countries introduce some weak controls like Malaysia did during the Asian crisis, investors will fear that these countries are preparing for some kind of haircut or an exit from the euro zone. This would speed up the capital flight that you are trying to prevent. Anyway, capital controls are fundamentally not permitted under EU law.
The only way out is to convince bond markets that the structural reforms in the countries that are in a difficult situation, plus their consolidation efforts, will produce positive results. If we look down the road another year, there will be major signs of improvements that will convince capital markets and finally bring down the risk premiums on government bonds.
Can stability be achieved through eurobonds?
Eurobonds would certainly have a stabilizing effect. But this kind of common debt instrument requires some conditions to be met which we are not yet close to in the European monetary union. If you have a common debt financing instrument you need common fiscal policies otherwise you are liable for the debt of your neighbor whose policy you have no influence on.
This cannot be turned around just for the sake of calming down financial markets. The short term positive effects would probably lead to a lot of controversy and a lot of international conflicts in the medium term if we prematurely introduce eurobonds.
Has the euro crisis demonstrated that it is practically impossible to have common interest rates across such diverse economies?
I don’t think this is the lesson of the crisis. I think the crisis has shown that we need more decision making on an EU level. The other lesson has been that national policies have to obey the rules of the monetary union and this has not happened in many countries in the first ten years of the euro.
Many countries seem to think that the introduction of the euro was like a free lunch and you could benefit from low interest rates, from an easy accumulation of debt, from booming real estate markets, without ever getting the bill. This is not true.
A monetary union only works with consistent fiscal policies that stabilize economies. The union also needs regulatory policies, macroeconomic policies, that prevent financial booms from happening, excessive price increases, excessive debt levels. This is a learning curve countries have to go through.
Whether there are incentives for reform depends on how the resources of the fund are distributed. There is conditionality that means countries that get assistance are expected to embark on policy reforms.
Nonetheless the strategy we are pursuing is correct: to give assistance, to give support under the conditionality that the countries do their homework and help themselves. For this reason an intervention by the European Central Bank (ECB) without any conditionality may be the wrong incentive. If you promise to cap interest rates at a certain level then countries have fewer incentives to save and to cut budgets. So I think it is best if we use the public rescue funds for any type of assistance more so than the ECB.
What’s the role of the European Central Bank?
First of all the ECB is responsible for preventing collapse of the monetary system. It has been doing that by supplying as much liquidity as is needed to the banks in the euro zone regardless of where these banks are situated. Even banks in Greece are getting massive support from the ECB. I think this is the most important contribution that the ECB can make to solve this crisis.
However, if the ECB is supposed to not only guarantee the liquidity of banks but also of governments there will be some controversy, rightly so. I don’t think it is the function of the ECB to get involved in government finance.
The European Central Bank is treading a fine line with the new OMTs – on the one hand to keep the markets in check, on the other to uphold reform pressure on debt-ridden countries. It is to be welcomed that the ECB will not be investing in longer-dated bonds and that it has tied the start of the new government bond-buying program to strict conditionality.
The ECB also stated that it will terminate purchases should the conditions not be met. The decisions announced by the ECB will probably reduce risk premiums substantially and durably, at least at the shorter end of the curve provided that the distressed countries accept the terms. But this does not mean that the debt crisis has been overcome. Responsibility for that still lies with the national governments and political co-operation within the European Union.
What are the biggest risks to the welfare of the euro zone at present?
They have become even more dangerous in a way with the slowdown of the world economy. A major risk is that there is another escalation of the euro zone crisis which endangers the whole system and which could be fatal for the euro as a currency.
Dissolution of the euro would cause economic trouble not only for one or two years but for many years to come. It would erase a huge amount of political capital that has been invested in the integration of European countries. It would basically mean a return to national policies and a lot of conflicts would be sparked by such a currency breakdown.
But I think that this risk is appreciated by most policy makers. Quite a few instruments have been set up that will stabilize the system. The rescue fund helps us buy some time to get the reforms going. Eventually these efforts will not only avoid a fragmentation of the euro but over time will help countries to emerge even stronger out of this crisis.