If eurozone negotiators miscalculate and allow events to spin out of control, they will risk more than a Greek exit — they will put at risk the future of the monetary union itself, says Wharton management professor Mauro Guillen in this Q&A with Knowledge@Wharton. The situation between Greece and its creditors has been ratcheting up to new heights in recent days, with more hair-raising rhetoric, a postponed payment deadline — allowed on a technicality for now – and each side digging in after their new offers were turned aside. If no agreement comes before June 30, Greece could be in default. Guillen notes that more and more people, including him, are becoming increasingly pessimistic about the eurozone’s future. “The U.K. is considering whether it should be a member. Unemployment is very high. Eastern Europe is not recovering as fast as one would hope. The population is aging…,” he adds. “But if Greece were to exit that would raise even more questions about the whole European project … a lot of people would start thinking that maybe the whole thing is not worth it.”
An edited transcript of the conversation appears below.
Knowledge@Wharton: Thank you Professor Guillen for joining Knowledge@Wharton to discuss Greece and the eurozone situation — the standoff with the European Central Bank, the European Commission and the International Monetary Fund — the Troika.
In many ways, an agreement should be very doable — each side has so much to lose from failure. One of the main sticking points is how much debt Greece must repay annually. The amount is to be based on how Greece’s economy performs, specifically using the primary surplus — the amount left over after the government pays all of its bills, but before debt service — as a base. The creditors now say that Greece should pay back 1% of GDP per year. That would go up to 3% by 2017. Greece wants to pay just 0.5% of GDP this year, slowly rising through 2017.
But the margin of error on those numbers is much higher than the difference between those two numbers. So what’s going on here? Is this really down to politics and emotion?
Mauro Guillen: Politics, of course, plays a big role. Nobody in Europe outside of Greece likes the fact that the government there is backed by a party that has no track record. We don’t know how much we should trust [left-wing political party] Syriza, the party that won the elections. Their leaders are newcomers. This can be refreshing, but at the same time that doesn’t give you any confidence as to whether they’re going to live up to the commitments or not.
“It’s not only the countries in trouble that should do things — the countries that are not in trouble, such as Germany in particular, should do more.”
The other issue in Europe is deflation. Whenever prices fall or they increase only slightly, that is very difficult for countries … that have a lot of debt because if prices are falling, that means you’re actually returning to your lenders more money you borrowed in real terms.
And the Greek population has been suffering now from seven years of austerity measures with no end in sight, with no clear path out of the crisis, with essentially the hopes of one entire generation of young Greeks dashed.
I’ve always mentioned that there are other ways in which you can tackle the situation. But the way that both parties are framing the issue right now leaves very little room for a compromise and makes technical solutions very difficult. It all boils down to politics, yes, and to posturing.
Knowledge@Wharton: This half percent of GDP difference in how much they should pay back annually is not a big difference, but it is [one of the key things] they’ve decided to dig in on. The Troika also wants some structural changes, such as pension cuts and sales tax increases, easier terms for hiring and firing workers. Some of these might be reasonable. Some of these could be watered down from what the eurozone creditors want. It seems like there are ways to work it out if they both wanted to work it out. What do you think about those demands from the Troika?
Guillen: The Troika, which essentially represents the countries and the entities that would stand to lose if Greece were to default or things were to get out of control, wants guarantees that this is not going to set a bad precedent. They want guarantees that the Greek economy will reform itself so that it is sustainable into the future — five, 10, 15 years down the road. You don’t want to provide nice financial terms to somebody who is not willing to change its ways. You want that country to make the structural reforms to regain competitiveness, at a time when they cannot just simply devalue their currency because they don’t have one. It is a very natural thing for the Troika, for any other European country, to ask the Greeks to do.
And countries like Portugal, like Ireland, like Spain … which already engaged in those structural reforms … it’s perfectly natural for them to expect the Greeks and the Italians and everybody else to do the same thing. Otherwise, we’re getting into this situation in Europe in which some countries do their homework and others don’t and you cannot have monetary union when that happens.
Knowledge@Wharton: Is anyone better prepared than they were two or three years ago?
Guillen: There’s been a lot of kicking the can down the road — postponing the big decisions. Some countries in Europe have made or at least initiated reforms, others haven’t.
It’s not only the countries in trouble that should do things — the countries that are not in trouble, such as Germany in particular, should do more. I’ve always advocated that they should try to spend a little bit more money. They shouldn’t try to balance the budget in Germany; they should give German consumers more money so that they buy more goods and services from the countries in Europe that are in trouble. And that would be demand coming from the outside that would help these economies grow a little bit faster.
But the Germans are erring on the conservative side. They don’t want to create even the beginnings of a situation in which inflation could get out of control. They’re being, too cautious about their own economy. And unfortunately that affects everyone else because Germany’s so big in the European context.
“I think to prioritize austerity by itself is a mistake because then you get zero economic growth, or even a contraction of the economy.”
Knowledge@Wharton: Do you grow your way out of the problem somehow, which is what I think you’re suggesting, whether that’s the Germans spending more money in some of these southern countries like Greece and Spain and Portugal, or finding some other way to increase demand. That is, as opposed to austerity — the idea that getting budgets under control is going to balance the economy and lead to growth. That does not seem to have happened.
Guillen: Exactly. The point is how you sequence each of these things. We know demand needs to be higher. The issue is, how do you get there? I think to prioritize austerity by itself is a mistake because then you get zero economic growth or even a contraction of the economy. And you get deflation and you get unemployment, and it’s very difficult for an economy in that situation to get out of the problem within two or three or four years. It takes longer than that. And people have run out of patience because they don’t have jobs and things are not going well.
The only source right now of additional demand, the only two possible sources would be demand from outside of the European Union or the eurozone. This has started to happen because the euro has weakened and so there are more Americans, more Asians, more Middle Easterners who are essentially buying more goods and services from Europe because now they’re cheaper. The fall in the value of the euro has helped. The fall in oil prices has also helped because most of these economies in Europe are net importers of oil.
But what’s missing is the last push, which cannot come from the countries themselves, from Greece or from Portugal because they don’t have any resources to play with. It has to come from the so-called surplus countries. And they’re called surplus countries for a reason, which is that they’re generating surpluses. If they want to continue generating those surpluses, they should help the periphery in Europe get back on its feet so that they can grow again. It’s going to be better for everyone, not just for the countries that are in trouble.
But politicians are too reluctant to go down that path because I think to a very large extent they don’t want to set a precedent. They don’t want to tell Greece, “OK, we know that you haven’t done the right things, but we’re here to help you.” They fear that next time around the Greeks will think, “Oh, somebody’s going to help us so we don’t need to work hard, we don’t need to initiate structural reform.” It’s a carrot and stick kind of game that is being played now. I understand that you have to be careful about not setting the wrong precedents. But at the same time, you don’t want to have 20% unemployment for too long.
Knowledge@Wharton: Now Greece is slipping back into recession, which makes it even more difficult. The taxes raised to pay back debts are going to be less. So it does seem to be self-defeating. Through austerity, their debt has actually increased instead of going down.
Guillen: We are in a situation that is normally referred to as a negative feedback loop. The dynamic is such that things get worse as opposed to better. You have to break that dynamic…. But again, we need that additional demand that has to come from the surplus countries. It cannot come from the deficit countries and the countries that are deeply into debt because it would only aggravate the problem. I agree with the austerity proponents that you cannot stimulate the economy by having the Greek government spend more because that’s only going to make matters worse. The stimulus has to come from somewhere else.
Knowledge@Wharton: The first thing, if things go really badly, would be that Greece would default. What does that look like?
Guillen: Default is a very large category of potential outcomes. And there’s also near defaults. But most defaults are managed and there is a restructuring of the debt. And this is what the Greek government has been asking for, for a long time…. And this is what the Troika are flatly opposed to because of precedent. If there’s a debt restructuring for Greece there could be a debt restructuring from some other member of the eurozone. And who knows where this would end?
On the other hand, if Greece were to ever exit the eurozone that would be bad for everybody who remains in the eurozone because the eurozone is supposed to be a monetary union. But if one of its members exits, that means that it’s no longer a monetary union. It’s just a fixed exchange rate mechanism, and there’s a big difference between those two things. A monetary union is supposed to last forever. A fixed exchange rate mechanism can last for five years or can last for 15. If countries start dropping out that means the eurozone is not so much a monetary union…. That’s what everybody’s trying to avoid.
At all costs, the people who believe that the euro should remain in place should say “We cannot let any member of the eurozone leave it.” But, regarding the potential default, I think what we’re talking about is a restructuring of the debt. And that would essentially mean that the lenders would lose money and Greece as a country would get better terms on its debt.
Knowledge@Wharton: Let’s say there was an exit by Greece…. There is that whole risk of contagion. As soon as that would happen to Greece, there would be a run on Portuguese bonds, a run on Spanish bonds, a run on Italian bonds. Banks would be shaky. European banks are already in some ways on thin ice, right?
Guillen: Absolutely. Investors would then start asking questions about everybody else, every other weak country. They would be very nervous about the whole thing. But there’s another way of looking at it. We actually have evidence as to what happens in these cases, but in a different context, which is when Denmark held a referendum a few years back before the euro was introduced as to whether the country should join the euro or not.
If you remember, against some predictions, the Danish population voted against the euro. And the reaction was very bad, meaning investors just thought that was the end of the world. And that was a country deciding not to become part of the euro when everybody thought that they were going to become part of the euro. So the issue here is that investors don’t like uncertainty; investors believed 15 years ago when the euro was introduced that it was going to be forever. Over the last six or seven years, they’ve realized that that may or may not be the case. This introduces an element of risk and uncertainty, and markets don’t like that.
Knowledge@Wharton: How likely is it that a Greek exit would kick off another financial crisis worldwide?
Guillen: In Europe there would be an identity crisis, this is for sure. Confidence would drop dramatically. There are already a lot of problems in Europe. The U.K. is considering whether it should be a member [of the eurozone]. Unemployment is very high. Eastern Europe is not recovering as fast as one would hope. The population is aging. There’s no shortage of problems in Europe. But if Greece were to exit that would raise even more questions about the whole European project … a lot of people would start thinking that maybe the whole thing is not worth it. It would be a slippery slope. This is why European leaders and the Troika, more broadly, are trying to avoid that kind of an outcome.
Knowledge@Wharton: Are we talking about serious capital flight? Failing banks?
Guillen: Oh sure.
Knowledge@Wharton: How would it affect the U.S.?
Guillen: Capital is very mobile and in the context of a monetary union it’s even more mobile because you don’t even have to exchange one currency into another. Plus, you can compare prices and returns very easily. It’s very clear that there would be major capital outflows from the unsafe countries in Europe to the safer countries in Europe, meaning Germany and the Netherlands and so on.
This is the danger, that the capital flows — given that it’s a lot of investors making that decision — could become a self-fulfilling prophecy if they believe that there’s a lot of risk in the periphery. By moving their capital they just continue to make that risk materialize, they’re just making it happen.
“Europe would still have high unemployment. Europe would still have some economies that have deficits. Europe would still have a problem with sovereign debt and with banks that are shaky. Those problems would not go away.”
The dollar would become a safe haven because right now we only have two safe havens in the world, really, the dollar and the euro. If the euro were to falter then the dollar would benefit. That has already happened over the last couple of years. Dollar reserves increased from maybe 62% to 63.5% of the world’s total. And the share of the euro has declined by about 1.5%.
I want to bring China into the equation. China, the largest reserve holder in the world, over the last seven or eight years has diversified away from the dollar and into the euro because first they had fears about the dollar. And now China is diversifying away from the euro against the other one. So it’s not just the U.S. and Europe; you have all of these other emerging economies that are accumulating very big surpluses — and therefore they have huge reserves — that are also moving their money around. In this world in which you can move money around so quickly and so easily, the dangers are really important.
Knowledge@Wharton: One of the biggest risks seems to be that once events start moving they can move so quickly that one cannot keep ahead of them.
Guillen: That’s why the stakes are so high now…. Yes, Greece may be a very small country … and yes, perhaps it could be contained. But you can never fully anticipate how the markets are going to react — especially when Europe has so many other problems. So investors know that even if this problem gets fixed by removing Greece from the equation, that doesn’t mean that Europe is problem-free. Europe would still have high unemployment. Europe would still have some economies that have deficits. Europe would still have a problem with sovereign debt and with banks that are shaky. Those problems would not go away.
The only thing that a Greek exit would produce is more uncertainty. And investors would raise even more questions. It’s not a solution.
Knowledge@Wharton: Cooler heads have said that … Greece will never repay all of its debt, but there are a lot of creative financial solutions that could stretch that debt out.
Knowledge@Wharton: It was done with the Latin American debt crisis in the 1980s. They could also change the demands on Greece when it comes to some of these politically touchy issues like cutting pensions and changing hiring and firing rules. They could say, “Well, if you would just reform your legal system and improve tax collections,” do a few things like that.
“I just don’t see the kind of grand political maneuvering here that would somehow bring everybody to the table, align everybody’s interests and produce a grand bargain.”
Guillen: It matters whether the Greeks really mean it when they say that they would be willing to do that. Secondly, it’s whether they have the ability to deliver on those things. Even more important, three years from now or two and a half years from now there’s going to be another election in Greece. If there’s a new party [controlling the] government or a new prime minister, is that person going to live up to the commitments? In a democracy you never know.
The solution will have to involve some additional generosity on the part of the Germans and some stronger commitments on the part of the Greeks in terms of structural reforms. It will necessarily have to involve that. They have to meet each other somewhere in between….
Knowledge@Wharton: Is there a certain amount of recklessness in the way negotiations are going?
Guillen: The markets are reacting to it. The spreads have increased and capital outflows have increased over the last few weeks. So you’re right. Sometimes politicians engage in these calculated risks. And this is certainly a situation that I think has a lot of that. But they could very well be miscalculating them. And things could get out of control, which is what happened in slow motion in 2007 and 2008 — with the big bang in September of 2008.
The biggest problem is that we’re getting to the point where people are going to start losing patience, meaning the Germans are going to start losing patience in that they always have to pay the bills. And then people in Greece who are out of jobs and they don’t have good prospects, they’re going to run out of patience.
If anything, [the Greeks] are going to become even more radical as opposed to less. So the next election could actually give the ruling party now even a bigger majority, even if they don’t get everything that they’re trying to get, because people get more radical out of their hopelessness.
It is a potentially explosive situation. I am personally quite pessimistic because I just don’t see the kind of grand political maneuvering here that would somehow bring everybody to the table, align everybody’s interests and produce a grand bargain … in which everybody gives in to something and compromises, but in the end, within two or three years, this solves the problem. They are kicking the can down the road. They’ve been doing that for seven years now.
Knowledge@Wharton: You don’t think that can go on forever?
Guillen: No, of course not. The issue is when is it going to stop? When will they realize, enough is enough, let’s just rise above all of the little interests and all of the details of the situation and try to strike a bargain that would help us overcome this big problem. But again, even if Europe overcomes that issue, they still have a few others to deal with. And this is why I think, increasingly more and more people, including myself, are becoming quite pessimistic about it.