Europe has a debt problem. Countries like Greece and Spain, for example, have way too much of it. Banks all over the continent do, too. European Union (EU) and European Central Bank (ECB) leaders are struggling to keep this financial and economic crisis from worsening.
Arts & Sciences magazine sat down in July [A Day Late and a Euro Short](and again in October for an update) 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, many scholars have predicted an economic crisis. Is this the crisis that everyone foresaw?
Olivier Jeanne: I don’t think people really predicted the crisis as it happened. Some foresaw problems and touched different parts of the beast, but nobody saw the full beast. The crisis has different layers: 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 what we are talking about now is the sovereign debt crisis and the banking crisis. The part that is probably the least expected is the sovereign debt crisis, the heart of the crisis, and then its implication; the spillovers into the banking sector.
Nicolas Jabko: Some expected that there would be governments that 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 most unexpected. Because of what happened on the heels of the Lehman 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 EU.
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 wasn’t on people’s radar screen was the inability of the European institutions to respond to threats to financial stability. The underlying shocks were not that big. The Greek fiscal problem was not 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 people around the world? Like another Lehman Brothers, caused by a European country or bank?
Robert Barbera: Yes, it’s possible, though less likely now than it was in early summer. Greece could leave the euro, which could cause bank runs there and in other vulnerable nations. People worry that if they have money in a Spanish bank, they could go to bed with 100,000 euros, and wake up in the morning with 100,000 pesetas. That’s a bad trade. If they just take a trip to Frankfurt and put the money in Deutsche Bank, they can conduct business quite comfortably. And if all of a sudden Spain is no longer in the euro, they still have euros in a German bank. This way of thinking invites a bank run, and that was close to happening earlier this year. A bank run threatens financial markets around the rest of the world.
A&S: What policies can help Europe?
OJ: Give power to the EU to go into Greece and enforce the tax code. And in exchange, have an unlimited monetary backstop from the ECB for government debt.
JW: In addition to the strong monetary backstop, I’d like to see a European banking union and a common deposit insurance like the American FDIC that would help prevent bank runs, and then assemble a strong sovereign debt backstop.
NJ: The problem is to a large extent political. Europeans cannot come up with economic solutions because they have political problems that they cannot resolve. They know what would work—joint liability in the form of either euro bonds, which are basically common European debt instruments, or stopgap measures from the ECB. A combination of these things, plus a banking union, are economic recipes that would work. The problem is that they would involve a commitment by member states to come to the rescue of other member states. Public opinion is really not yet ready for that.
RB: The crazy aspect of all of this is that the EU is on a path to destruction, and it is only when the horror of the destruction is front and center, that policy makers agree to take steps that they forswore before. It’s always a day late and a euro short.
A&S: What is the significance of the September ECB decision to promise unlimited buying of short-term bonds subject to some conditions—will this do the trick?
JW: It lessened pressures and perhaps it will turn out to be the big bang, but it’s too soon to tell. The optimistic interpretation is that this is a cleverly crafted, politically feasible way of getting to a monetary backstop. It hasn’t gotten approval from the Bundesbank, but Angela Merkel seems to be willing to tolerate it.
NJ: Basically what’s happened in the ECB is that the governor of the German central bank has been marginalized. Every other member of the governing council voted for that decision, including the German member. And Angela Merkel, faced with slowing growth in Germany and political resistance to austerity across Europe, felt the need to go along. The key term in the new ECB program is unlimited intervention. They’ve never been as clear on their desire to provide the backstop. They may not have become the Federal Reserve, but they’re not far from it. And it’s only the legal aspect of their mandate that really prevents them from saying they will do whatever it takes to save the Euro.
OJ: I think that the monetary backstop is a pretty big development. There are two keywords: unlimited intervention and conditionality. The ECB has never before promised unlimited intervention. In a sens, they have gone further than the Fed, because the Fed has never explained exactly its approach to government debt crises. The question is how this conditionality is going to be defined. One can hope that they are going to adopt a relatively flexible approach.
RB: A lamentable aspect about this step is that the ECB could have done it two years ago. Then Greece was in deep recession, Spain and Italy were going sideways, France was growing moderately and Germany was growing healthily. Instead, the ECB waited until Spain and Italy were in deep recessions, France was no longer growing, and the wheels were starting to come off growth in Germany. This delay superimposed two horrible years on the continent. It’s harder to imagine that this latest step restarts the growth engine, relative to had it been done in 2010.
Christopher Drennen ’95
As the Johns Hopkins experts note, Europe has been forced to face a banking crisis, which weakened most of the European financial system; a sovereign crisis adding significant stress on the financial system; and a complicated, long-standing current account balance crisis. The true challenge facing Europe today is how to break the links between the various crises, deal with their fundamental causes, and create a stronger architecture toward fiscal integration and economic growth.
Recent efforts by the ECB to reassure investors of the solidity of the euro area and the ECB’s willingness to protect the euro will hopefully stabilize volatile debt markets for certain European sovereigns and alleviate pressures placed on many European financial institutions during the crises. In order to deal with some of the more difficult fundamental causes of the crises, governments will need to make broad steps forward in policy coordination, fiscal austerity, and budgetary reforms, much like what has already been undertaken in the United States at the federal, state, and local levels. At the same time, governments will need to pay particular attention to growth to avoid sending European economies into a prolonged period of recession. More coordinated approaches between public and private sector institutions will be needed to support growth in challenging economies like Spain, Portugal, and Greece.
Although many have commented on the slow and often messy pace of European economic and monetary integration, this integration has actually advanced with comparative lightning speed. In less than two decades, Europe has managed to create what took the United States over a century, three banking crises, two foreign wars, and one civil war to achieve.
Christopher Drennen ’95, managing director and head of strategic marketing for BNP Paribas, one of the world’s largest financial institutions, recently served as lead technical negotiator on behalf of private creditors during the sovereign restructuring of Greece—the largest debt restructuring in history totaling over $250 billion. He is adviser to the Greek government (Hellenic Financial Stability Fund) on bank recapitalization and reorganization of the Greek banking system. An adviser to many European governments and official institutions, Drennen is a specialist in public sector capital markets and managing state impacts of financial system stress and financial institution failures.