* Edwards S. Sanford Professor of Economics and Director of the Bendheim Center for Finance, Princeton University
To start the interview, I’d first like to ask what you think is the root cause of the Euro zone crisis? Is it a sovereign debt crisis or a sudden-stop crisis?
I think it is arguably more of a sudden-stop crisis, but sovereign debt problems also played a role. A significant amount of the cross-border credit flows were financed short-term on the interbank market. The classic example is that peripheral banks granted local long-term mortgage loans, which they refinanced short-term on the interbank market.
A large fraction of banks’ funding was so-called wholesale funding, as opposed to domestic deposit funding. When the interbank market froze— the sudden stop— the ECB stepped in as intermediary and TARGET2 balances skyrocketed. In addition, in some countries, governments borrowed excessively— mostly from abroad. Hence, sovereign debt also played a role. When private investors refused to roll over the funding, the official sector stepped in, and a lot of the private debt became sovereign debt.
Was it then a classic liquidity problem?
Not quite. Prior to the crisis we observed large capital flows in the peripheral countries. One view was that these countries borrowed in order simply to catch up with the core countries. According to this “convergence view”, a temporary disruption is an inefficient run and should be counteracted aggressively. In contrast, the “imbalance view” argues that imbalances and bubbles were building up which were not sustainable in the long run. Instead of investing wisely, which would have led to increases in (total factor) productivity, GDP was artificially pumped up without an increase in productivity measures. The sudden stop, hence, was not only a liquidity run; it also had an element of correction. Part of the problem was a solvency problem. Of course, when a correction occurs, markets tend to overreact— and this calls for a well-tuned intervention.
“The idea of ESBies is to create a really safe asset for Europe, which can be treated as safe assets for banks.”
For the Euro zone as a currency union, what do you think about the European quantitative easing (QE) policy? Does the current monetary policy increase inflation risk and create bubbles for the next crisis?
It depends on what kind of underlying problem one tries to solve and what the alternatives are. If the underlying problem is that real wages are too high in the peripheral countries (and hence they are not competitive), then the solution for this problem is to meet the inflation target at least in core countries such as Germany. So any central bank intervention should primarily be targeted at the core countries.
If the underlying problem is peripheral countries suffering from balance sheet impairment, then QE can subsidize the peripheral countries. It can help the balance sheets of peripheral countries by pushing down the interest rates. In this sense, QE is redistributive— but might ultimately help the whole euro area.
After one has identified the underlying problem, it is not obvious that QE is the best instrument to tackle the problem. For example, if the underlying problem is the difference in competitiveness, then an alternative policy comes to mind: for example, an active communication policy by the central bank that tries to impact the wage bargaining, say, in Germany. Central banks should “talk up wages” in core countries. This would help close the real wage gap between the peripheral countries and the core countries. This is essentially the opposite of what central banks did in the 1970s when they tried to “talk down” inflation during a high inflation period.
Do you think the peripheral countries have incentives to be over-indebted? How should the currently high public debt ratio in these countries be reduced? Will austerity measures alleviate or worsen the current situation?
Over the next decades the debt ratio can come down. If you look at the debt-to-GDP ratio, you can reduce this ratio by either increasing GDP or decreasing debt. It is important that government debt will increase by less than GDP.
Austerity is usually associated with two things: a reduction in expenditures and implementation of structural reforms. However, both measures are independent of each other. A smart approach would provide some reward for growth-enhancing structural reform. Knowing that structural reform measures are contractionary in the short-run and only yield a higher GDP growth rate in the intermediate and long run, politicians are reluctant to undertake them. To encourage structural reform for the long-term growth, our fiscal rules should be such that they provide compensation for short-term growth costs in the form of a small stimulus program.
You proposed, together with the Euro-nomics group1, European Safe Bonds (ESBies) as a way out of the Euro zone crisis. What are the advantages of ESBies?
ESBies are not a panacea, but they solve two specific problems. The double diabolic loop between the financial sector and the sovereign risk is at the center of the Euro Crisis. When sovereign debts lose in value, banks that hold a significant amount of sovereign debt on their balance sheet suffer capital losses. This lowers their equity, leading them to scale back their activities and grant fewer loans to the rest of the economy. As a consequence, the real economy is slowing down and tax revenue declines. As tax revenues decline, sovereign debt becomes less sustainable and, in turn, riskier. That is the first diabolic loop. At the same time, there is a second diabolic loop at work. When banks lose value, the bailout probability also goes up. This, in turn, makes the sovereign debts riskier and lowers their prices— which in turn hits banks and increases the probability of a costly bailout. Both of these amplification mechanisms enable a small negative shock to have large implications.
To solve this double diabolic loop, one needs safe assets that are truly safe. Typically, the safe assets are government debt. They are safe in nominal terms because the central banks can always print money to pay off the debts. Within a currency union, however, one cannot do this anymore. Individual sovereigns cannot print Euros. The sovereign debts are as if foreign-denominated sovereign debts. Thus, sovereign debt in the EU has default risk and liquidity risk.
The idea of ESBies is to create a really safe asset for Europe, which can be treated as safe assets for banks. Instead of holding the risky sovereign debts, banks can hold ESBies, which are not risky at all. The way that ESBies work is to pool (up to a limit) the sovereign debts in Europe, and to issue senior and junior bonds such that the junior bonds protect the senior bonds.
So the senior bonds are very safe and the risk is all concentrated in the junior bonds. The senior bonds are held by banks and the junior bonds are held outside of the banking sector. Whenever there is a negative shock, the senior bonds are always safe and the banks do not suffer from the double diabolic loop. That is the first advantage of ESBies: to switch off the diabolic loop, which reduces overall risk and makes the junior bond also less risky.
The second advantage of ESBies is to redirect the cross-country capital flow. Right now, as the crisis intensifies, capital flies across borders to the core countries since the safe asset is asymmetrically supplied. With ESBies, capital flows from junior bonds to senior bonds. Both bonds are European bonds; and the safe asset is a European asset but not a German asset. So there is no cross-border capital flow, which stabilizes the whole system.
Does your new book with Harold James and Jean-Pierre Landau, entitled “The Euro and the Battle of Ideas”, describe the ESBies?
Yes, indeed. Readers interested in learning more about this subject should read our forthcoming book. It will be available from the end of August onwards. However, the book is much broader in scope than ESBies. It explains how different economic philosophies, primarily between Germany and France, complicated the crisis management. It explains how— starting with fiscal problems in one of Europe’s smallest economies, Greece, in late 2009— a long-simmering battle over the appropriate economic philosophy and future design of the European Union broke into the open. It is a struggle between northern (above all, German) and what are sometimes called southern (but above all, French) theories. The former emphasize rules, rigor and consistency, while the latter focus on the need for flexibility, adaptability and innovation.
How do you view the future of Euro? Do you think Euro will disappear in future?
I am confident that the Euro will survive. We experience challenging times, but the US Dollar also had to face its challenges in its early phase. The Euro framework will be adjusted and modified as we move along. But the question is what could be the alternative. Let’s say… if we were to have totally floating exchange rates. That would be a big problem within Europe as well. People always have the impression that there are some problems in the current framework, and if we think about the alternative everything would be hunky dory. But it won’t be. Because even before we had the Euro, we had a currency crisis and we had many problems as well. The problems will reappear, but people just don’t think about these problems. So the alternative is not all that glossy either. It is not a perfect world.
Before the global financial crisis, central bankers knew a lot about labor markets, product markets, inflation, output and its relation to fiscal and monetary policy. But the whole ‘liquidity’ and financial intermediation sector was missed. Do you think we are going to the other extreme: that in the post-crisis era we are now missing the ‘real’ side of the economy?
I don’t think so. I think there was too little emphasis on the financial side before the crisis. Now the profession is picking up. There is still a lot of catching-up to do, and many young economists focus on the interaction between the macro economy and the financial side. But there are also many economists working on the real side. Many economists have built up their human capital on labor market issues and other real side aspects. Overall, I don’t think that the financial research is overshadowing the real side at all. I think we have a more healthy balance now.
Where do you believe that macro and finance are heading? For our MPhil students, what will be the “hot topics” for the next few years?
How to better understand risks and how to prevent and get out of a crisis are some hot topics. Risk comes in many facets: fundamental risk is different from endogenous and systemic risk. The latter is time-varying and depends on balance sheet constraints. In addition, the risk premium investors require is also time-varying and hence contributes to the endogenous time-varying risk. Currently, monetary economics (and its interaction with finance) is being reinvented. There will be a modern revival of the field “money and banking” within macro models. Another interesting research agenda has to do with safe assets and their roles in the global financial system. How should one set up a stable global financial system? I think these are just a few hot topics.
New techniques, including continuous time technique, will allow us to dive more deeply into these topics than ever before. I expect a lot of new insights and a better understanding of the interaction between monetary and financial stability as well as fiscal debt sustainability.
Speaking of the new techniques, what are the techniques that every macro and finance researcher should have (but typically doesn’t)?
I think macro and finance can learn from each other. The historical grand masters of economics wrote a lot about the interaction between macro and finance. Keynes wrote about it; Irving Fisher wrote about it. After the Second World War, finance focused more on the static stochastic models in order to capture the risk components, while macro focused more on the dynamic deterministic models. In the 1970s, macro started to formally incorporate the risk aspect as well, and finance got into the dynamic aspect. But they did it in different ways. Macro did it in discrete time because of the quarterly data; finance did it in continuous time because finance has much more frequent data.
Both branches of economics developed useful tools. For example, continuous time tools, like stochastic calculus from finance, allow much deeper analysis on the time-varying risk premium and the endogenous time-varying risk itself.
On the empirical side, tons of new data are now available. These will lead to a lot of interesting empirical analyses— and will improve our understanding of what is going on and which theoretical channels are quantitatively more important.
1 Euro-nomics is a group of nine European academic economists, whose objective is to provide concrete, carefully considered, and politically feasible ideas to address the euro area’s current problems.