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A Day Late and a Euro Short

A faculty roundtable discussion on the economic crisis in Europe…why it started, who it might harm, and how to fix it.

From left: Robert Barbera, Nicolas Jabko, Jonathan Wright, and Olivier Jeanne.

Europe has a serious debt problem. Countries like Greece and Spain, for example, have too much of it. Banks all over the continent do, too. And leaders of the European Union (EU) and European Central Bank (ECB) have yet to deploy the resources or demonstrate their resolve to keep this financial and economic crisis from worsening. Arts & Sciences magazine sat down with four Johns Hopkins experts on the matter – Nicolas Jabko from the Department of Political Science and Olivier Jeanne, Robert Barbera, and Jonathan Wright from the Center for Financial Economics – to get their opinions on the sources and solutions for what could become the next great global financial meltdown.

Arts & Sciences Magazine: The EU formed in 1999 and gave itself monetary oversight of member nations, but not fiscal oversight. At the time, and since then, many scholars have predicted an economic crisis… so why did it happen anyway?

Olivier Jeanne: I don’t think people really predicted the crisis as it happened. Some people foresaw problems and touched different parts of the beast, but nobody saw the full beast. The crisis has different layers. There is one layer, which is a government debt crisis; another layer, which is a banking crisis; and a third layer, which is a current account imbalance crisis. The theory of optimum currency areas developed by Robert Mundell in the 1960s allowed us to foresee the third layer, the imbalance crisis. But that’s only one layer, and it’s not the one that we are talking the most about now. What we are talking about now is the sovereign debt crisis and the banking crisis.

Robert Barbera: We aspire to worry just about the third layer.

OJ: Yes. The part of the crisis that is probably the least expected is the government debt crisis, the heart of the crisis, and then its implication; the spillovers from that into the banking sector.

Nicolas Jabko: Some people did expect that there would be governments who would not behave, but they didn’t expect that this would trigger a crisis that would spread to the rest of the euro area. The contagion effect is really the part that is the least expected. Because of what happened on the heel of the Lehman Brothers bankruptcy, everybody worries about the possibility of contagion. That is why the problem of Greece, for example, becomes not just a problem of Greece but the problem of the entire European Union.

Jonathan Wright: It was clear from 1999 that this was a political project more than an economic one. The precise way it unfolded was something of a surprise, and one thing in particular that I think wasn’t enough on people’s radar screen was the inability of the European institutions to respond to threats to financial stability. So it really is a case of relatively small initial shocks having outsized effects, and that’s always what you get in a crisis. The Greek fiscal problem was not really that big relative to the size of the European economy. Ditto for Irish and Spanish banks. A better designed monetary power—if the ECB was able to function like the Federal Reserve or the Bank of England—would have been in a better position to stop this in its tracks.

A&S: Is there a real chance of an overnight crisis happening again that affects everyday people around the world? Like another Lehman Brothers, caused by a European country or bank?

RB:Yes, it’s possible.

NJ:Everything is possible.

JW:I think it’s more than just hypothetically possible. It’s a real risk.

RB:Europe could have a recession for the next two years, and our exports to Europe aren’t that important. But a financial system meltdown, as we all now know, would envelop the world, including and especially the U.S.

JW:As long as Europe muddles along without a financial implosion, its effects on the U.S. are probably second order, but if you have the devastating financial implosion, that affects the whole world.

OJ: An overnight crisis is possible and could be a good thing, if it compels European authorities to take the right actions. Looking forward a few years, I would give 20% odds on a rosy, near-perfect outcome where Germany makes the concessions that are necessary for the euro area to work properly. I would say probably 60% chance that the euro’s still there in five years, but with most member countries still experiencing low growth—which probably means an increasingly acrimonious euro area with a future that remains uncertain. And 20% odds that a nation leaves or is thrown out of the euro, with the risk that the whole thing collapses.

RB: Greece could leave. Greece could default. Greece could do a lot of things that could cause uncertainty in places like Spain and Italy. It’s suddenly dawning on people that if I have money in Bankia, or some other damaged European bank, I could go to bed at night with 100,000 euros, and I could wake up in the morning with 100,000 pesetas. That’s a bad trade. Whereas if I just take a trip to Frankfurt and put my money in Deutsche Bank, I can conduct business quite comfortably. If I wake up in the middle of the night and all of a sudden Greece or Spain is no longer in the euro, I still have euros in a German bank. This way of thinking invites a bank run, and that is close to happening right now. A bank run, if it arrives, threatens financial markets around the rest of the world.

A&S: There are so many polices, moving forward, that might help the EU avoid this crisis. But if you could prescribe just one or two, what would they be?

OJ: Give power to the EU to go into Greece and collect and enforce the tax code.

RB: Actual tax receipts.

OJ: Mm-hmm. And in exchange for that, participating nations have a monetary backstop from the ECB for the debt of their governments. That is the ECB saying, “I stand ready to buy your debt to limit the interest rates you have to pay.”

JW: The two things that I would do would be to form a European banking union and deposit insurer, a common deposit insurance like the American FDIC that would help prevent bank runs, and then assemble a sovereign debt backstop like Olivier described.

NJ: There are some political answers, too. The problem is to a large extent political, because the reason the Europeans are not able to come up with economic solutions is that they have political problems that they cannot resolve. They know what would work—some sort of joint liability in the form of either euro bonds, which are basically common European debt instruments, or stopgap measures from the European Central Bank. A combination of these two things, plus a banking union—these are economic recipes that would work. The problem is that they would involve a commitment by the different member states to come to the rescue of other member states at a time when their domestic opinions are really not ready for that.

RB: What I think is the real crazy aspect of all of this is that the EU is on this path to destruction, and it is only when the horror of the destruction—and we haven’t talked about that, but it is horror—is front and center that policy makers agree to take steps that they forswore before. It’s always just enough to postpone the inevitable, but not enough to really stem the tide. And if you look, things that they’ve done in the last 12 months, had they done them two years before, might well have succeeded. So it’s always a day late and a euro short. Right now the biggest change—and Jonathan talked about this—is the issue of bank runs. I don’t believe those were an issue 24 months ago, or 12 months ago. Thus postponing big steps means even bigger steps are now needed. The EU now needs the ECB to be the lender of last resort and backstop the sovereigns and some sort of euro-denominated deposit insurance. Deposit insurance will be very difficult to get… I mean, that’s probably treaty changes, right?

JW: Yes.

The above is from an hour-long roundtable discussion between these four Johns Hopkins experts. Stay tuned for the fall issue of Arts & Sciences magazine, where we will run an update to this conversation.