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Interview of Paul De Grauwe, Professor at the London School of Economics, to Dimitris Katsikas, Head of the Crisis Observatory

What do you think are the major weaknesses in the structure of the EMU even before the crisis?

I think that there are a number of design failures. So, I will stick to those that I think are the most important. One is that, while we centralized money, so much of the rest of market economic policies were kept at national level, creating an environment in which countries could diverge. We have seen booms and bubbles in countries such as Ireland, Spain, and also a consumption boom in Greece while in other countries, this didn’t happen. So we had divergence, in the monetary union that was totally unchecked, and there was no mechanism to bring that together, to put some convergence to the system. Then of course, at a certain moment this became unsustainable, countries that experienced a boom, financed it through an excessive debt. And that was one design failure – no mechanism to somehow contain these divergences.

The other design failure has to do with the fact that, when we started the monetary union, something radically changed. It has to do with the way governments finance themselves. Before joining the monetary union, governments issued their own currency and therefore could guarantee to their bondholders that the cash will always be there, because we make the cash ourselves. Therefore, the Greek government could guarantee to the bondholders that the drachmas will always be there to pay them out. This meant that governments could not be pushed into default by the market. This changed dramatically with the start of the monetary union when suddenly all these governments had to issue debt in a foreign currency, in euro. Therefore, they could not guarantee that the cash will always be there. As a result, if you distress the particular government, you feel that the government has not the cash anymore and that can create a self-fulfilling crisis, forcing governments to an excessive austerity, pushing to a recession. Therefore, what was lacking was the will of the Central Bank to provide liquidity in times of crisis. This was the second design failure, and the two together played their role, because these divergences that I was talking about, at a certain moment created this déjà vu for a particular government or for a number of governments and then created a self-fulfilling crisis and pushed them to a bad equilibrium. These are the design failures and we must do something to change them.

Now, the way you describe these weaknesses and their contribution to the crisis, how did they prove to be a problem in handling this crisis? What were the weaknesses, which did not allow for a proper handling of the crisis, even at the time when it had made itself apparent?

They didn’t handle the crisis very well because the diagnosis was fundamentally wrong. They didn’t see the nature of these design failures, the diagnosis was wrong; the source of the divergences that we have seen was in the private sector: in some countries excessive debt accumulation because of euphoria, booms and bubbles. After a certain moment of course, when the crisis came, governments were forced to pick up the pieces, which then led them to a fiscal crisis. In the North of Europe especially, the fiscal crisis that emerged was interpreted to mean all these governments had been undisciplined in the past and that, therefore, we have to discipline them. Consequently, they introduced disciplining devices at the wrong moment, because this was basically a balansheet recession, where the private sector, because of excesses, wanted to deleverage. In this case, it is inevitable for governments to increase their debt. However, because of the wrong diagnosis, they thought that the problem lay in fiscal discipline. They did things that intensified the crisis, they tried to over-discipline governments at the wrong time. I am not saying that we should not do anything about the debt explosion that we have seen; at a certain moment we have to contain that. But the timing was completely wrong. That was the first failure. The second failure has to do with the point I made earlier; with not seeing the fragility of the system. The ECB should have intervened much earlier. Finally, in 2012, they decided that, yes, it had to be the lender of last resort -the back-bone of the system- but they did that too late. As a result, this allowed this crisis to intensify, thus producing the second recession that we are in.

On the other hand, there is criticism from some quarters that the provision of funding through the Eurosystem to banks in the periphery has created significant risks for the creditor countries through Target 2 –you have been actively engaged in an academic debate on this issue. What is your view on this?

First of all, what has happened with the Target system has saved the German banks. The German banks used to have claims to the South. They had provided financing to Southern banks, which then used the funding to fuel the boom; they did that in Greece, in Spain, in Ireland, and then when the crisis came, the German banks were in trouble. Thanks to the Target tool, German banks were able to shift their private claims to the system and make them public claims. Thanks to the Target system, German banks were saved, so I find it very hypocritical for the Germans to complain about that. They should be happy with what happened; otherwise their banks would be in big trouble.

How did this shift between private and public claims happen?

Through the payment system. Let me give you an example; German banks lent money to Greek banks and this was used to finance development. At a certain moment, the German banks decided to stop the funding. This raised a liquidity problem when the maturity of the loans ended. As a result, the Greek banks needed to be funded from the euro-system, and the Greek Central Bank accumulated liabilities vis à vis the Bundesbank and then since the German banks didn’t have these private claims anymore, these became claims of the German Bundesbank through the payment system.

In that sense, the German banks turned their claims to the Greek banks, into claims to the Bundesbank, through reserves and deposits. What used to be a deposit in a Greek bank, became a deposit in the Bundesbank and therefore the nature of the claims changed into a much safer claim for the German point of view. If the German banks hadn’t transferred their claims to the Bundesbank, they would have claims vis à vis the Greek banks and they would have collapsed and we would had losses anyway. Therefore, the nature of the risk has not changed.

The risk has originated from the fact that Germany has accumulated critical surpluses, and the counter-part, Greece, accumulated liabilities -financial liabilities- vis à vis the rest of the world, particularly the rest of eurozone. They should not complain. They wanted this and they probably accumulated too high a surplus. Therefore, the risk has not changed at all because of the Target system. That is a really bad analysis. This was just the payment system and the risk was there, so the Germans wanted the surpluses and as a result, they accumulated large risks by accumulating claims on Greek banks, on Portuguese banks, on Spanish banks; they should have known better.

Can the ECB help and if so how?

There was a major thing had happened last year, the announcement of the ECB to provide unlimited liquidity to government bond markets. Of course, the decision to make it conditional is problematic in part, because we don’t know what that means. Does it mean more austerity? I hope not, but at least they did something. Now we should go beyond that, we should try to unlock the banking system, because we know that in a number of Southern European countries, banks don’t want to lend anymore. The ECB should and can do something, and one example is what the Bank of England is doing by buying up repackaged loans by small and middle-sized companies and taking it on its balance sheet. In this way, it could in fact give a boost to lending, which is quite important in a number of countries, in Greece or in Italy, for example, where there is a real credit crisis. It should act, but it is paralyzed.

In this context, I take it that you consider the approach of the Fed and, more recently, the Bank of Japan, more appropriate given the current circumstances. Is such a re-orientation of monetary policy in Europe politically feasible and probable?

Yes of course. There are different ways to do it; in Japan the Central Bank is basically buying government bonds. I think that should be also part of this, the ECB has announced its commitment to do so, but as of yet has done nothing. It should have the will to buy government bonds in the secondary market to lower interest rates to Southern countries. That’s one; the other tool I think maybe more important is the one I just mentioned, trying to boost credit by passing funds to the banking sector. Today the banks don’t want to lend because they sit on a pile of reserves. There is a lot of liquidity from ECB, but they don’t use it. It is not used in the real economy; that is why the ECB should step in itself and organize the lending. There are techniques to do it, like for example with asset securities, setting up guarantees so that asset securities can be used as a collateral to liquidity, I think banks are willing to do that.

A different question: In Greece, we have a huge problem with bad debts in the private sector. Some propose a Korean style quick restructuring, closing down some banks or restructuring the private debts. What is your opinion?

The burden of the debt is there because the economy has collapsed. We really have to boost the economy; that will solve the debt problem. Because the economy is shrinking, there is no confidence. I think there should be debt restructuring such as that, which happened with the government debt. What has happened, as you know is that the privately held government debt was shrunk by more than 50%. Now most of the rest of the Greek debt is in public institutions, that is where the restructuring should occur. You cannot say it explicitly for political reasons – I can see that. However, I think that with some political will we should be able to do it.

There is so much austerity now in Greece, efforts have been tremendous, and you cannot go on telling the Greeks, we have to continue to do that, to take out interest, to finance all the debts, it is unsustainable.

Germans complain that their taxpayers pay you, while it’s the other way around, you Greek taxpayers, pay the Germans, and that should stop. It is perverse that you have to pay the Germans.

Your analysis notwithstanding, this country has had many structural problems, high level of debts and deficits. In order for such a country to recover, you need to make structural reforms and you need to make some kind of consolidation to face the debt and the deficit. What is your advice on how to do this?

You have done a lot of fiscal consolidation, you do quite a lot, you come from quite far; I am not saying there should be no austerity in Greece, but probably it has been too quick and too intense, and you cannot push any more this situation. You have to produce a primary surplus, you have to tell the population that we have to extract a given sum every year, so much of your income to pay out the creditors in the North of Europe, who complain that they have to sustain you -that doesn’t make sense- it is politically unsustainable, and therefore I think it’s important to do a deep restructuring of the debt, so that you can stop bleeding for the others.

Any special advice for Greece? Official sector restructuring (OSI) is one thing, what else can be done to start changing the situation around?

Greek government lost much of its sovereignty. That is another problem. You have shown that you can go really far, and the intensity of the crisis was quite significant. The Greek government should insist, they should relax now the austerity measures, so you can start growing again. Some measures of restructuring of the debt, should be part of this.

Given the high deficit and debt levels, the lack of competitiveness of the Greek economy and the inability to attract investments, due to a number of reasons, not least the continued uncertainty about the crisis, what would your policy advice be for the least painful path to recovery?

It needs to be a combination; the government and the private sector, the two mechanisms have to work and the ECB has to be willing to organize credits and lower interest rates in Greece, this is a key to push the economy.

What do you think about the Cyprus solution? Is it, as some claim the fairest solution until now? Instead of the burden of the private debts going to the taxpayers, it has burdened the shareholders, creditors and depositors of banks.

I disagree with this. People who claim this do not understand the nature of banking. Banking means trust, if you announce something like this, if you hold deposits in the bank, and that exceeds 100.000 and you should count on losing money if the bank is in trouble, then you will generate a banking crisis. If there is uncertainty about how the bank is doing then people will get nervous and will put their money elsewhere. Since all this remains national, it will concentrate the trouble again -you have a local banking crisis that becomes a sovereign debt crisis.

So, what about banking sector? What efforts should be undertaken?

So little has been done. Banks cannot do whatever they like, but they can do all the activities, even the speculative ones; the only thing that has changed is that there will be more regulation, some capital ratios will be increased. I think we should have taken the opportunity to change the banking model, to separate banking- traditional from investment banking, that is one thing, and the other one has to do with the capital ratio, which should force banks to hold more equity. But not during the recession. During the recession, you don’t want to do that because it would make the recession worse. In the long run we should move towards a system that banks have high capital ratios. Not that long ago banks had leverage ratios of 20%; now they have only 2% or 3% which is ridiculous. If you look around, a normal business typically has capital equity representing 20%-30%. We should really force banks to go towards that direction. They really profit from the fact that they know they are too big to fail and therefore they want to hold as little equity as possible. That is really a huge market failure that we should not allow it.

Are you optimistic that we are reaching the end of the crisis?

I am not convinced- I have been here two days and I have heard several officials all claiming that we see the light at the end of tunnel and we are going to get out of this. I hope so but I have my doubts. If nothing changes in the eurozone, then Greece will continue to be in a situation of negative growth or no growth, making it very difficult to get out of this debt crisis. There are very little prospects for reducing unemployment. It is a time bomb ticking -socially; politically. Therefore, if nothing more substantial is done then I am afraid the light is not yet there.

What are two-three measures at European level that could change the situation fast?

First, the ECB to be willing to solve the credit crunch, which is making it very difficult for the economies to start growing again. The ECB is the key actor there. Second, the nature of fiscal policies in the eurozone should change. Austerity and deflation was forced in all the adjustment programs. This has been done by Northern European countries -that could afford to do that. So they should start to stimulate their economy and especially Germany should do it. But then I am not very optimistic, as there is no political will in Germany to do that.

What about eurobonds?

The Eurobonds are something we need for the long run sustainability of this project, the Eurozone. It won’t turn around the recession, but it’s something that we need for the markets. This will be like signaling that we have reached the point of no return. That creates confidence about the fate of the eurozone project.