Prof. Paolo Guerrieri on the European Debt Crisis

Paolo Guerrieri is Professor of Economics at the University of Rome (Italy) and at College of Europe Bruges (Belgium).  He  has visited IES several times. Recently he was speaking to the IES researchers on the European debt crisis. (See the summary of his lecture in Chinese:  http://ies.cass.cn/Article/xshd/lfxz/201211/5672.asp).  After the lecture, we asked him to elaborate the following questions.)

Q：When people said that Italy was already in a debt crisis, Berlusconi replied: "No. Our restaurants are filled with diners. Where is the crisis?" As an economist, how would define a debt crisis?

A：The former Italia Prime Minister Silvio Berlusconi – as many others indeed - has long underestimated the gravity of the global and Italian crisis. Very recently he fully recognized his serious mistake and he recently apologized to Italians.

The truth is that all advanced area (US and Europe) is still in the midst of the most serious economic crisis since the 1930s. Global recovery from the Great Recession has been limited, Europe is now in its second recession in five years, and even the United States is performing much lower than past average.  The main reason is that this crisis is a debt crisis very different from previous cyclical recessionary phenomena. It is the result of two decade of debt-financed consumption, through both excess private debts and public-sector deficits. As many other times in the past this expansion of consumption led to a boom in asset and housing markets and then a bubble, which after a while burst. It follows a deleveraging phase (reduction of debts), which as past historical experience shows, is very prolonged and costly.

Having outlined these general features of a debt crisis one should add that its nature and content differs across countries and areas. It is particularly true in the case of Europe.

Contrary to the official narrative, the real cause of the Eurozone crisis - with the exception of Greece - is not the fiscal irresponsibility of some EU member countries but rather the unsustainable accumulation of debts among private actors (households and banks) linked to the large and persistent imbalances within the euro area. Removing exchange rate risk with the introduction of the euro encouraged massive capital flows to and as a consequence large current account deficits in the Southern European nations— Greece, Italy, Portugal and Spain. Nordic countries run spectacular current account surpluses, notably Germany (6 percent of GDP in 2011). External divergence also took the form of steadily widening and different competitive positions of the two groups of countries.

For many years, however, very little attention was paid to these imbalances by national authorities and European institutions, even more so because the banks of the core countries (Germany and France) heavily financed the excess demand in the peripheral countries, thus promoting the accumulation of large macroeconomic imbalances within the Eurozone. The global financial crisis in 2008-2009, however, has put an end to this easy financing and has revealed many weaknesses in the Euro architecture. Private funding of imbalances dried up and the system of euro area central banks has had to replace the banking sector as a key source of funding of current account imbalances and private capital movements. This massive intervention was to a certain extent successful, but the cost was the dramatic increase of budget deficits and sovereign debts in deficit countries. In the years after the crisis highly indebted European countries with large external deficits experienced the highest sovereign bond yield spreads. Current imbalances were placed at the heart of eurozone crisis. As a result, the euro system has become exposed to the risk of sovereign and bank defaults. In this perspective high public deficits and debts are much more an effect than a cause of the eurozone crisis.

Q：There is a similar question about the definition of resolving a debt crisis. How would you say that Greece, Ireland or Portugal, etc., will be out of the debt crisis in the future? By saying overcoming a debt crisis, do we have to see 1) positive growth; 2) bringing down debt and deficit to 60% and 3%; 3) returning to capital market; 4) lowering down 10-year bond spread below 6% or 5%; 5) no more assistance from the troika; 6) calm and peaceful streets without protest; 7) no more headlines news coverage about the debt crisis by CNN, Financial Times, Bloomberg, etc; or 8) ... Do we have to see all these nice things happen at the same time or...?

A：All nice trends we are depicting could be the simultaneous results of a successful strategy to address and solve the euro crisis. The diagnosis I sketched above shows us the complex and systemic nature of the eurozone crisis. Countries in the euro area are facing major structural problems and would need prolonged technical assistance to implement the necessary adjustment policies over the next decade.

According to me an effective approach to address the crisis in Europe should involve a composite mix of policies based on austerity, liquidity and growth measures.

First, the excess of private and sovereign debts requires fiscal adjustment and consolidation measures in the highly indebted peripheral countries, In short these countries need a significant dose of austerity to impose a new discipline in the conduct of national economic policies in order to correct previous mistakes. To be effective, however, these adjustment policies need time and adequate financial resources in the hands of the European Central Bank and/or the European Stability Mechanism (ESM) to avert the risk of a liquidity crisis inherent in a currency area such as the eurozone. In addition, the solution to the crisis requires a dynamic growth environment in Europe, which will involve both national reforms and policy strategies implemented at European level.

The trouble today is that the Eurozone has an austerity strategy but a very inadequate liquidity policy and no growth strategy at all. This biased composite mix has led to the current recession trends that makes austerity and national reforms self-defeating because in peripheral countries output continues to contract and debt ratios continue to rise to unsustainable levels. Moreover, the social and political backlash in these countries will eventually become overwhelming.

A significant rebalancing of the Eurozone’s strategy is thus needed by introducing effective adjustment mechanisms of both liquidity resources and enhanced growth capability. Only a more composite balanced mix of policies for austerity, liquidity and growth can offer a solution to the crisis in Europe. While the austerity strategy remains the responsibility of each individual member-state, a much more coordinated effort at the European level is needed for liquidity and growth. In this  perspective, two key problems should be solved for the euro area as a whole: the banking sector’s problems and the low growth-stagnation problems.

Q：As you know, Chinese scholars have different views about the future developments of the European debt crisis. Some are optimistic, others are pessimistic. What is your view?

A：Although I recognize that fundamental steps have been taken by euro member countries since the start of the crisis I am still rather pessimistic on the future development of the crisis. Particularly because  - as I already pointed out - European leaders have misdiagnosed the problems and set the wrong policy course based on fiscal austerity. On the conventional (German) reading the crisis is not the product of the flaws of the Eurozone system itself, but of misbehavior of individual countries within the region in terms of fiscal laxity and irresponsibility. Therefore the adjustment should be entirely one-sided and centered on the highly indebted countries. Fiscal austerity measures have thus been introduced and diffused everywhere in the eurozone from Greece’s unique fiscal problems to countries such as Spain and Ireland which have banking and not fiscal crises. The belief is that these countries should restrain from excessive spending enough to restore credibility, bring down interest rates and restart economic growth.

However, what is happening is that growth has suffered and recession has hit all peripheral countries and today the core countries (Germany) as well. That was granted unfortunately. If most Eurozone country governments are cutting spending at the same time, the contractionary effect on GDP is further magnified. Slowdowns in one country will reduce demand for the exports in others.

It is thus very clear that fiscal austerity alone will not solve the crisis. EU countries, particularly those across southern Europe, would be well-advised to take supply-side reforms more seriously than they have in the past. But there are obvious contractionary effects for the eurozone as a whole deriving from such an asymmetric approach. Peripheral Europe cannot possibly succeed in reducing its borrowing substantially unless surplus countries like Germany pursue policies that allow their surpluses to contract.

To avoid further recessionary trends in the eurozone and the potential for another major global crisis, it is crucial that European policymakers modify their policy strategy through a much more articulated and balanced approach  based on a mix of austerity, liquidity and growth (see above).
 
Q：President Hollande was reported to say that "the worst (of the debt crisis) is behind us". Do you agree with him? Why?

A：In the light of what I said so far I agreed only partially. It is true that the new monetary measures (Outright Monetary Transactions) announced between July and September this year by the European central bank to buy sovereign bonds on secondary markets for Spain and Italy, have contributed decisively to the recent sharp drop in the spreads of Spanish and Italian bonds.

But such intervention measures (so far only announced) should not be considered, of course, as the solution to the European debt crisis. They serve to provide liquidity to the system and thus give more time to the European policy makers in order to launch a credible policy plan, somehow innovative, to solve the crisis.  Such a plan should include three fundamental ingredients: a European Banking Union based on a unified banking supervisory system led by the European Central Bank, a deposit guarantee scheme and a banking crisis resolution mechanism. Second a medium long-term strategy is needed to guarantee the sustainability of sovereign debts, in terms of sharing the risks of these debts within the euro countries group, to lower funding costs significantly. Finally, as already pointed out, you have to get to a much more effective coordination of macroeconomic policies based on much more symmetric adjustment mechanisms at the European level, which makes it conducive to sustained growth of the entire Euro area. Without a quick return to growth, the main problems of the Eurozone – sovereign debts - will likely become even more unsustainable.

More than just a fiscal crisis, the situation in Europe is more a crisis of unsustainable private debt accumulation linked to large and persistent imbalances in the euro area. The huge challenge now is to make managing the crisis compatible with the adjustment of these external imbalances. Austerity measures and/or indefinite financing of them is not the solution. The former will exacerbate recessionary trends in the eurozone while the latter will create economic and politically unsustainable tensions among countries. 

Q：In your view, how can China help the EU to deal with the crisis?

A：China could give it a major contribution by accelerating its domestic shift from export oriented growth to domestic consumption led growth. It could contribute significantly to sustain more balanced global growth.

About half of global growth is now from emerging economies and this is transforming international economic system equilibrium.  The latter is centered on a small number of leading nations — the U.S., EU countries, China, and etc. In the present system, there are various incentives for national policies that are justified for individual countries but harmful for the world economy. A telling example is the present “currency war”, as the Brazilian finance minister called it last year. Every country desires a weaker currency to sustain growth via net export improvement. But there is a fallacy of composition since the total of the world’s net exports by definition equals zero.

In the past, this deflationary bias was at least partially mitigated by the U.S. expansionary and current deficit policies. Today is not possible anymore. Europe and Asia Pacific, driven by export-led growth are no capable of compensating for a protracted shortfall in U.S. consumption and so the global economic slowdown is being reinforced.

In this perspective China’s economic growth is today still too much depending on exports and external demand. It is true that there are relevant shifts under way in the Chinese economy. But it is also true that we are very far from China to be able to  sustain the growth potential of the new multipolar economy. Since not enough it has yet been done so far in China to stimulate domestic consumption through measures to alter significantly the distribution of income or to create a sound social security system.

At the same time the need for concerted action at international level is greater than ever. National policies unfold in an increasingly interdependent world and everyone would benefit from much greater efforts by the leading nations to approach problems in a cooperative manner. A strong coordinated response among G-20 countries is therefore necessary in order to minimize the risk of a mild global economic slowdown or worse another severe prolonged recession. A sort of global leadership is needed. Unfortunately, both Washington, Brussels and Beijing have been distracted so far by domestic constituencies. Should take urgent action to correct these trends.

Q：Theories are important. They can help us understand the debt crisis better. What kind of theories do you think can be useful towards this end?

A：The theories of two great economist of the past - John Maynard Keynes (“effective demand”) and Joseph  Schumpeter (“creative destruction”) - could be very helpful.

One of the most dramatic problem today – as I pointed out above - is the current gap of global demand that has been favoring the underutilization of capacity in all advanced area. But there are problems at the supply side level as well. This is a result of a number of factors. First, the recession has significantly increased structural unemployment (or, in some cases, it has significantly increased the duration of unemployment) and has generated destruction of capital stock in several countries. Second, the rapid growth of the new emerging market economies, like China, has led to the loss of low-skilled manufacturing jobs in advanced economies and new investments in large industrial sectors were only temporary replaced by housing construction, which was sustained by low interest rates and huge deregulation.

Therefore taking potential output back to its pre-crisis levels, and even more importantly boosting the rate of growth of output, will require supporting household consumption and current expenditure (as Keynes suggested) but also producing an effort in reallocating resources toward new products and sectors (as Schumpeter emphasized). In this regard endogenous growth theory (EGT)  aims to provide an economic explanation of the cross country variation in growth rates attributable to those supply forces governing the opportunity and incentives to create innovation and structural change. One version of EGT is based on the ‘Schumpeterian’ creative destruction process that is on the incessant innovation mechanism by which new production units replace outdated ones. In particular job creation and destruction is an integral part of the process by which an economy upgrades its technology and increase its productivity. Increasing the pace of restructuring of the economy is likely to be beneficial.

If the diagnosis sketched above is correct, it means that to avoid a severe contraction that could turn the next decade in our countries into a Japanese style long-term depression, advanced economies, notably US and Europe,  need to implement new policies for economic recovery and growth strategy that should be able to tackle both the lack of demand and supply deficit. It follows that fiscal stimulus measures are needed but should not be wasted by simply increasing current public expenditure and/or by tax cuts to revive debt-burdened consumers in advanced countries, notably in the U.S. We thus need to restructure the economies and restore jobs in advanced economies via massive new investments in new infrastructure, upgraded skills, human capital improvements and low-carbon energy (structural policies). Increased long and medium term  investment would help to stimulate economic activity through demand side, and could address long-term problems  through supply side as well. 

Even in the current sovereign debt crisis, there are many ways how to raise new resources for these investment for growth as well as enhancing a new legal framework for project bonds, debt instruments and more generally credit-enhancing initiatives. The problem is not a financial one, but it is at political level, as to the distribution of the cost of adjustment across countries and within countries.  But it could be and should be solved. For too long now we have let the market alone decide; now the time is ripe to let politics come back to re-design the rules for a better future. It will not be easy because there are so far no signs of economic policies in the direction of the ones advocated above. Neither the U.S. nor Europe has even properly diagnosed the core problem, unfortunately.