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Warning signs are flashing red. Bond markets are projecting a 98% chance of default on Greece’s debt. Stock prices for French banks, heavily invested in that debt, have plunged 10% in recent days. Has the European debt crisis hit the breaking point, with Greece — and perhaps others — soon to exit the eurozone? Or, will officials once more cobble together new agreements that keep Greece in the club and prevent a huge contagion effect likely to cripple an already slowing global economy? And might Europe be better off splitting into two economic co-operations zones, roughly along north/south lines? In an interview with Knowledge@Wharton, finance professors Franklin Allen and Bulent Gultekin offer their insight.
An edited version of the transcript follows.
Knowledge@Wharton: Bond markets are pricing in a 98% chance of default by Greece on its debt. It looks more and more as if some kind of a debt default by Greece is imminent. And two recent events seem to have pushed things to the brink. First, and maybe most importantly, the German Constitutional Court seems to have ruled out the possibility of Germany being involved in issuing eurobonds over the medium and long term, although they allowed for some short-term financing to continue. And second, Jürgen Stark, the European Central Bank (ECB) chief economist who opposed European government bond-buying to help bail out members in trouble, resigned late last week, leaving no German member on the board. And this seemed to be an act of protest against the ECB’s bond-buying of troubled debt. So this could be a sign that Germany cannot be expected to continue much longer with the “extend and pretend” that has been going on with Greek debt.
Are we very close to the brink here? Is default imminent and unavoidable?
Franklin Allen: I think it is imminent. The Greek Prime Minister said that it certainly wouldn’t happen, which is usually a signal that it is just about to happen. We are getting closer to it. I don’t believe it’s inevitable. If the Germans and the French decided that they were willing to transfer large sums to Greece, I think it wouldn’t happen. There are probably a lot of negotiations going on behind the scenes as to exactly what forms [any transfers] could take, and what transfers might be given to them.
Essentially, there are two ways it could happen. It could happen in a controlled way, in the sense that [Greece stays] within the eurozone and it is sanctioned by the ECB and the European Financial Stability Facility (EFSF) — and so it’s done with the banks being supported, either directly or indirectly, by the EFSF. That depends on when exactly it happens. They may want to wait until parliaments [in the eurozone] have passed the extended powers [to transfer more money to Greece] — [in which case] it would still be two or three weeks away, or maybe more. Otherwise, it’s going to have to be bilateral help. Or, the ECB is going to have to do it. But that’s going to be more difficult, I think.
The second option — which I think would be better for Greece, in the sense that they would grow faster and they would have more control over their destiny, assuming there are no transfers forthcoming — is that Greece simply leaves the eurozone very quickly. They pass a law that all domestic debt — which I understand is most of the sovereign debt and a lot of the corporate debt and so on, is under Greek law — so they can change one euro into one new drachma [the Greek currency that was replaced by the euro]. If they do that, the contagion effects on the rest of the eurozone are going to be significant. The exchange rate at the beginning would probably [be] two new drachma to one euro. And for people in countries like Italy and Spain, this is going to be a revelation — that something like this could happen. That could potentially drive a massive capital flight from southern Europe to northern Europe. How they would deal with that would be extremely complicated, and it might lead to Italy leaving [the eurozone] and having a similar kind of experience.
There are a lot of things that could happen. It’s very much up in the air, I would say…. And the French are now in trouble, too. We saw [on September 12] that the share prices of French banks dropped by 10%. Their stock market is now at the level it was at the worst time in the crisis. So France is beginning to be dragged back, too. This is a very complicated and difficult situation, with many possible outcomes.
Knowledge@Wharton: Professor Gultekin, do you agree that Greece is on the brink of default? And what do you think is most likely to happen?
Bulent Gultekin: When you say “on the brink of default,” that’s where I would somewhat disagree with Franklin. Mathematically, it’s very difficult for Greece to get out of that situation. In that sense, whether it’s now or later, if it is left alone, the mathematics, or the budgetary arithmetic, shows that Greece just cannot service its debt…. [But] we can postpone [a default]. In late 2010, if [the eurozone had] allowed Greece to default, things would have been somewhat easier. On the other hand, people worried that it might have this contagion effect. That’s why they thought, “Let’s bail out Greece.” We gained some time. But within this time, nothing has been done. That’s the problem. As a result, Greece’s situation is not resolved. We have a situation: If they don’t do anything, it’s imminent. On the other hand, if they try to bail [Greece] out again one way or the other, we are really postponing the situation into the future. And could Europe come up with another structure to deal with that? It remains to be seen, given the complications Franklin described.
So many permutations are possible. And one difficulty that I see is about Greece leaving the euro, and whether that’s the best option…. That certainly works better for Greece — if there were no other side effects. Greece has two problems. One is the budget deficit problem, the solvency problem. And the [other is a] productivity problem. They cannot deal with the productivity problem because they [don't have] their own currency [which they could otherwise devalue]. Or somehow, they [could] have lower wages…. [But even with those measures, it could take] years for them to reach a competitive level with the countries they need to compete with. No society can deal with that.
That is the dilemma. On the other hand, probably Greece would be better off if they default under these conditions. But that doesn’t solve their productivity problem. That addresses it differently. This is a very tough choice — whether you want to get out of the euro, which is going to cause all sorts of other complications. And yet, at the same time, if you default, what’s going to happen? The choices are not really all that attractive.
Knowledge@Wharton: This idea of an orderly versus a disorderly default is interesting. German Chancellor Angela Merkel says that under no condition will she allow Greece to have an uncontrolled insolvency. But is she able to control that, particularly given that the German public is pretty emphatic about not wanting to send good money after bad — in the case of Greece in particular, but perhaps also other countries in southern Europe?
Allen: She is optimistic about her ability to control it. She certainly could, if she was willing to write a big enough check for them. I think that’s the negotiation that they are engaged in. This is a public stand-off [over whether] the Germans and the French are willing to transfer large amounts in one way or another — and the problem is, it’s got to be outside the ECB. The ECB has probably done as much as they can, in terms of lending to Greek banks at low interest rates, buying sovereign debt — all of those things are probably at their limit. It would now require some kind of transfer directly, and not a bailout in the form of, “We’re going to lend you more money.” But they are going to have to start writing off debt, or make it clear that this debt doesn’t have to be paid off. That’s another way of trying to hide the fact that it’s really a transfer.
Knowledge@Wharton: So a restructuring is, in effect, a default that’s controlled?
Allen: One of the things they can do is [that] the EFSF, and subsequently the European Stability Mechanism (ESM), can buy up all their debt and effectively hold it for 50 years and charge a very low interest rate which is not at all meaningful relative to the market rate. If they charged them the 1.5% current policy rate and kept rolling it over, and made it clear behind the scenes that they wouldn’t have to pay it back, that would be a way of doing it. They’re going to have to do something like that, or just a direct grant, to stop Greece from jumping out. As Bulent explained, [Greece is] better off [if it does that]. But everybody else is much worse off from that. They have a gun which they can hold to the heads of the Germans and the French.
Knowledge@Wharton: It seems like a tall order. But let’s say that were doable. Is that enough of a firewall? Or does that start to lead to contagion, and people start to worry about Portugal’s debt and Spain’s debt?
Allen: No. This is the problem. It’s catastrophic for the rest of the eurozone. For them, it’s very bad. But for Greece, it wouldn’t solve their long-term productivity problem. Bulent is exactly right about that. At the moment, they’re shrinking. Last quarter, they shrunk 7% at an annual rate. Their estimate for this year is minus 5.3%. They’re just shrinking away at the moment, so they’re in a terrible situation.
Knowledge@Wharton: It goes to the point you were making: How long can a society continue to do that?
Gultekin: It’s true. These sort of policy-induced deficits are even worse, because they cannot grow [their economy]. They’re just going to create the problem. I want to add one thing to what Franklin said, in terms of Merkel’s position. For the first time, she mentioned this orderly default. It’s interesting, because what would have happened if Greece had defaulted in May [is that] it would have been a shock. Now it’s much anticipated. The question is, how can you prepare the public and the markets for that? Essentially, if you look at Spain or Italy, they have different problems. As a result, if there were time, and if [those problems could] be addressed without really scaring the markets, [there would be a good chance for Spain and Italy to avoid severe problems]. [But] the difficulty is [containing] anything that would trigger a massive run on these governments [such as a default by Greece], let alone banks. We’re not talking about runs on banks nowadays. But with this market being so nervous, [a Greek default] is going to have this catastrophic effect….
Knowledge@Wharton: It would likely spread quickly to the banks, wouldn’t it, if it started with the government?
Gultekin: If there’s a run on the banks, they’re going to run on the government bonds. I don’t want to say it’s interesting, but it would be a very unusual case. In the past, we have had sovereign debt problems or defaults in individual [countries], or maybe a region. But this is the whole eurozone. It’s going to affect countries that are not really in any difficulty. Looking at Spain, they’ve been doing well, in a way. If they don’t have to pay for all the sins of the banking system, they may pull out. Italy, on the other hand, has fiscal problems. But those can be fixed by less corruption and better tax mechanisms. It’s not a solvency problem. In that sense, the question is, can you calm down markets so that while you fix the Greece problem, [you also] make sure that others don’t flare up? That is going to take incredible skill. That’s the tough part because in Europe … there hasn’t been strong leadership to pull everything together.
The fact that the U.S. is in disarray is another problem. In the past, when you had a problem in international markets, under the leadership credibility of some country’s institution, things get back to normal. Right now, that adds another uncertainty, and sometimes things that would not be a problem under normal conditions become very, very serious problems.
Allen: Let me follow up on what you were saying. One of the big issues that came out, and you brought up in your introductory remarks, was that there is a huge tension between the French and the Germans, particularly at the ECB. It seems Jürgen Stark wanted to resign while [Jean-Claude] Trichet [the ECB's outgoing president and former French civil servant] was still in power, and that Trichet apparently lost his temper with a German journalist … who was asking about the ECB’s success — [indicating] a tremendous tension between people in the ECB. I think that’s growing wider. This is a big part of the problem now.
Knowledge@Wharton: Also, the eurozone hasn’t been able to grow itself out of the problem, because growth has been very slow. It would have been better for them, without the world financial fiasco, which helped create the problems. But it’s been very tough. On the one hand, people say this could turn into a double-dip recession if this spins out of control….
How do you reconcile these problems with what’s happening with the regional economy? Are they are likely to exacerbate them? Maybe a related question is, is some of the austerity [program] imposed as a solution going to hurt efforts to resolve the problem of [making] debt repayments?
Allen: Slow growth is becoming a global problem. China has these very low [Purchasing Managers' Index] survey numbers. The government has been tightening quite considerably to bring down the inflation rate. So, there’s considerable evidence of a slowdown there. That the eurozone had growth, particularly in Germany, was driven to a large extent by growth in China and the other emerging economies. The fact that Germany had such slow growth last quarter is an indication that the eurozone has a problem with growth. In the U.S., we also have a problem with growth.
The easiest way to get out of debt problems is to grow. The fact that these countries — even what we think of as the relatively healthy ones — aren’t growing is a big problem. Going back to Italy — Italy has grown very, very little over the last decade. The fact that the rest of Europe is slowing down suggests it may well go into recession. This is going to be a very difficult problem for it.
Gultekin: There is sort of a secular trend in Europe. I don’t think Europe is going to grow like East Asia, or [like it] used to, because demographic structures and technology transfer and diffusion in East Asia certainly created this displacement of lots of work elsewhere…. We should not expect these countries to jump back like emerging markets after a crisis.
There is one problem you mentioned, and Franklin alluded to, that is very serious. In this type of crisis, you need to have very stimulative policies. The reason for that: The costs of these crises are really pretty high. Unfortunately, it happened in the U.S. at the wrong time. Or, unfortunately, that’s always the way, with these crises — they always happen at the wrong time. The political leadership is such that, on one hand, fiscal policy or stimulus wasn’t enough, and the Fed was able to spit in the pool. It turned out it wasn’t sufficient. The same thing is happening in Europe. On one hand, bond markets in particular demand that there should be austerity. At the same time, you need to be more expansionist. The ECB, by decree, is constrained [from not having] QE — quantitative easing. That’s what they should have done but it’s not in their mandate — or at least they’re adamantly against that.
You have that constraint on the one hand, and the uncertainty on the other hand. If it happens again, I don’t even want to think about it. [A] second recession could even [make it] a whole lot worse.
Knowledge@Wharton: Just to put a couple numbers on it…. The OECD said that its leading indicator of economic activity — and this covers 34 countries, the world’s largest economies — fell for the fourth straight month. Again, it’s a sign that it is a worldwide global slowdown.
Gultekin: Emerging markets are also slowing down — Brazil, Turkey, countries that have had the bounce back … because … their export markets are Europe and East Asia. Once there is a contraction, it affects everywhere.
Knowledge@Wharton: You mentioned China, and I think India, are concerned with inflation causing a certain amount of pulling back. Everyone’s doing that at the same time. So this is not a good time for Europe to be having these problems. Do you see a feedback mechanism being set up here?
Allen: Definitely, yes. These austerity packages will shrink the economies. The models they tend to use to [make projections] are proving to be too optimistic because they’re assuming that people get back to work much more quickly than is in fact happening. It’s not good at all, I would say.
Knowledge@Wharton: I take it from your comments that you think austerity was not the right medicine in Europe at this time. Is that correct?
Gultekin: Not in hindsight. [Not] when you’re shrinking, certainly. This is the difficulty with crises, especially after bubbles. On the one hand, you need to de-leverage. But de-leveraging means you’re basically contracting the economy. How can you do that without causing [further contraction]? I don’t think we’ve found any sensible way. The only way to avoid it is to not get in that situation. But it doesn’t help much once it happens.
Knowledge@Wharton: But if you have households and governments de-leveraging at the same time, is the result not predictable?
Allen: That seems to be what’s happening, yes.
Gultekin: It happens differently [in each country]…. Germany didn’t have a bubble. France didn’t have one, Italy didn’t have one. So, in the U.S., we had that situation. But … these countries needed to be dealt with differently. In the crisis environment, everything looks alike. The problem [is] that people are not able to deal with these issues [separately].
Franklin was explaining very well the difference between the north and the south. That creates tremendous pressure. I was recently in Scandinavia and talking to politicians. Boy, they were angry. It’s amazing. They’re so mad about southern Europe — Italy and particularly Greece. But what they want — [austerity] — is [like] cutting [off] your nose to spite your face. That’s the problem, unfortunately — even though you hate [stimulus], the alternative is a whole lot costlier.
Knowledge@Wharton: Professor Allen, you talked about if Greece dropped out, then it’s not unthinkable that others might, too. There’s also been talk of almost the opposite possibility, which is that some of the northern countries — Germany and the Netherlands, for example — choose to leave and form some sort of northern regional group. How likely, or unlikely, are those scenarios?
Allen: A northern European area consisting of Germany, the Netherlands, Finland, Austria and Luxembourg would make a lot of sense. These countries view the world in very similar ways. They are all fiscally responsible. They would have a good chance of making it as a currency area. The south — Spain, Italy and Greece — also has a lot of convergence. France is interesting [in terms of] which way they would go. They could go either way. But [each of] those two groups view the world very similarly, and it’s the real tension between the two groups that’s causing the problems.
It might well have been better if they’d started with two separate groups. In the next 20 to 40 years, one could see that that would make a lot more sense than what we have got currently. My own view is that euro bonds aren’t a solution, because there aren’t any of the political control mechanisms that you need to have [for] that degree of fiscal union. These countries are just too different. As Bulent was saying, they just view the world radically differently. It’s too soon. We need another 20 to 40 years, in my view, before we can have this very ambitious, common eurozone.
But there’s no [reason] that the EU shouldn’t go forward, with different currencies — maybe not with as many as we had. There are huge gains to be had from currency unions, but it’s just not working at the moment, and it’s causing problems. [A northern and southern split is] not very likely at the moment, but as we go further into this, these kinds of solutions become more and more attractive relative to the alternatives of a chaotic splitting apart and so forth.
Gultekin: I want to add one thing to what Franklin said. In the event of some difficulties, there will be massive capital flow from south to north. If the northern countries had another [separate currency] union, that is exactly what would happen. Then their currency [would appreciate] rapidly, and it would put them in a very difficult position. That’s in the short term. The difficulty with the eurozone is that they did not set the fiscal requirements of a currency union, because [ultimately] these countries, as Franklin described, are not really optimal currency zones. The north might be because they all look alike [economically, with similar] productivity and all that. [In the] south, it’s a different way.
[But] getting out at this point, very difficult. It would cause more problems. What Europe may have to do is create structures to satisfy the requirement of a currency union — that is, have more [fiscal cooperation]. Maybe this would end up with a closer European union, both on the monetary side and the fiscal side. That might be the solution in the long run…. We thought the single currency would provide discipline. But on the contrary, it allowed people to postpone their problems by borrowing at the much cheaper rate. So we end up with a bigger problem. Fiscal union in a non-federal structure is trickier. But this might be the road they might have to choose. Otherwise, it’s very difficult politically to give up euro right now.
Knowledge@Wharton: One last question for each of you. Where do you think all this will settle in Europe, say, in six months to a year from now? Not that it will be totally settled.
Allen: It won’t be that much different than now, unless it bursts. And it may well burst. You might be right that it’s imminent. It could happen this week. But it could easily go on another six months, or a year [because of] this back and forth with temporary solutions and so on. Bulent described one way out. Another way out is what I think they should have done last May, which is allow a default. It wouldn’t have been pleasant, but it wouldn’t have been catastrophic. They could have bailed out the French and German banks, and it would have been fine.
Another solution is to move toward a system where default is allowed. For Ireland and Portugal, this would be a helpful thing. We also need a mechanism for countries to leave. When we had the gold standard, which lasted for many, many years, it was essentially a form of monetary union. If countries got into trouble, they left, fixed their problems and then came back in. What we need is a eurozone that has both those mechanisms in it. I don’t think that’s going to happen in six months to a year, but it’s a more viable solution than a fiscal union, because the countries are not ready for that. The Greeks don’t want the Germans telling them what to do, and so forth. The good thing about having these mechanisms is that you don’t need that. You can control your own destiny, which many countries in Europe still want to do, including, as we said, the constitutional courts, particularly the Germans.
Gultekin: Europe has a very good history of muddling through. They postpone, and the decision-making process is such that they’re going to push [decisions] to the bureaucrats in Brussels, and come back.
Knowledge@Wharton: A little more extend and pretend?
Gultekin: If markets become totally difficult and people realize — and there is quite a bit of awareness among the political class right now — that they really don’t have the same amount of time they had last May, there might be very serious discussions going on right now, even though everyone has a very sort of pleasant public face. I wouldn’t be too surprised, on the other hand, [if they] come up with some solutions, whether they solve the problem or not…. And once you have this latent possibility of a crisis, it could happen any time.
Knowledge@Wharton: There’s always the possibility that outside events — a recession or just slowing economies — could end up being a deciding factor. “Muddling through” suggests some kind of a sense of control, which is maybe what Merkel is referring to. Yet couldn’t that control could be taken away from them, by outside forces or exogenous forces, as they say in economics?
Allen: Yes. That could happen. There’s also a significant chance of some kind of unpredictable accident. For example, the EFSF has to go through 17 parliaments. It may well be that one or more of them fails to pass it. The True Finns [Finland's euro-skeptic opposition party] may persuade other people to vote against it. Once that happens, we can trigger runs and all these problems fairly easily.
Knowledge@Wharton: And once it starts, there’s —
Allen: Then it’s too late. Yes. The political moves just take too much time in Europe to deal with these kinds of crises overnight.
Knowledge@Wharton: Then it becomes like a nuclear chain reaction. There’s just no stopping it.
Gultekin: Even we had difficulty in the States. We had difficulty in the States because the [of the lack of cooperation between] Congress and Senate, and the executive. When you have a division of powers [and you need an] immediate reaction … sometimes you do not have months, or weeks even — [but only] days to respond. That’s the problem in a crisis. As a result, we hope that it doesn’t happen, because the scenarios we discussed are not very appealing at all.