December 7, 2011

With the leaders of France and Germany pushing for tighter integration in the European Union, Standard & Poor's warned that leading European economies could lose their AAA rating as a result of the euro crisis. The credit rating agency's announcement marked the start of a busy week in Europe that will conclude with the leaders of the eurozone gathering at the end of the week to try to stabilize the market and reassure investors of the currency's long-term stability.

Carnegie hosted a media conference call with Uri Dadush on the latest developments, the prospects for this week's meeting, and what steps policymakers should take to contain the crisis.


TOM CARVER:  Hello, this is Tom Carver. I’m the director of communications at the Carnegie Endowment and I have here Uri Dadush, director of the International Economics program here. Maybe I’ll just kick it off by asking Uri what or how high our hopes are of anything concrete coming out of this summit.  Uri?

URI DADUSH:  Well, I think, likelihood is that this will be a fairly productive summit based on the Merkel-Sarkozy agreement.  The markets clearly like what Sarkozy and Merkel have put on the table, because it’s basically, number one, fiscal discipline; number two, an agreement that there should be no more haircuts; and number three, waiting in the wings – implicit, but not explicit – is that the European Central Bank is going to be more supportive of the bonds in the periphery.  So this is very much a deal for the markets. 

There is no clarity – and I’m sure the markets would like this, however – on just how the European – the EFSF, the Financial Stability Facility, is going to be strengthened, and the extent to which the IMF will provide additional firepower.  I don’t know why that is.  Very likely, there are negotiations going on behind the scenes.  And we know that the central banks have said that they’re going to put in the European Central Banks as distinct from the ECB.  The banks – central banks themselves are going to put in a substantial amount of cash into some kind of IMF facility; they are ready to do that, but we don’t know whether and how this will be complemented by others, so – now, there may be news on that tomorrow, or there may just be a general statement about the intention to do that.

So I think – I think this will take us forward.  There are, of course, a very large number of questions associated with this deal.  I can go into those, Tom, or just stop there at this point and then come back.

MR. CARVER:  OK, what – just before we go into them, I mean – so, as you say, Merkel and Sarkozy have basically outlined what they see as the outline of a deal.  So is this summit, then, just going to rubber-stamp that?  Or do you think that other countries will have views which will significantly change the outline of that deal?

MR. DADUSH:  Well, I think there’s going to be a lot of negotiations – must be a lot of negotiation going on right now.  So a number – first of all, on the central question, I suspect that the 17 countries of the eurozone are going to fall behind Merkel and Sarkozy, not because they’re enthusiastic about the deal at all, but because, for a start, five of those, including the two largest ones, Italy and Spain, are desperate for ECB support and are desperate for anything right now that stabilizes the market, OK?  So Sarkozy and Merkel are using their extraordinary bargaining power at the moment to impose a tough deal and the 17 will go with it, I believe – I expect they will go for it.

There is, of course, a question about the broader group, the 27, beginning with the U.K., that want less fiscal – that want less integration and less links, not more links, less disciplines, not more disciplines, by and large.  And so there, I think the language of the communique – I don’t know, but the language of the communique is going to have to reflect the fact that, you know, the 27 are going to have to – the broader group is going to have to consider their positions on all this.  And I – not quite sure how that will play out, but it’s very unlikely that you’re going to get, you know, a kind of blanket agreement across the 27 on these new, rather draconian fiscal disciplines and abdication of sovereignty on fiscal policy.

But most important for the markets, the 17 are likely to go with it.  That’s my view.  Yeah.

MR. CARVER:  And do you see this as more of a German deal than a French deal in the sense that this was what Merkel was pushing for?

MR. DADUSH:  It is more of a German deal than a French deal, because the Germans have the dominant position.  But it also has French elements in it.  What are the French elements?  Well, it’s the French who pushed very hard for relinquishing the idea of private-sector involvement – PSI.  So the French were always against the idea of saying that private-sector people should have – could take a haircut.  But it’s not even there a completely French deal, because the Germans insisted on collective action clauses, which are ways of facilitating, eventually, the restructuring of sovereign debt – but nevertheless succeeded in getting out of the Germans a statement that there will be no private-sector involvement.

But remember that the Germans and the French agree, in the end, on the fundamental point that, you know, they are not going to move forward on euro bonds or, you know, fiscal union until such time as they have confidence that the countries under direct attack have their house completely in order.  So there is a – you know, this is, in essence, a deal by the countries that are at the core of Europe, and that are in the strongest position.  I call it the golden rule:  He who has the gold makes the rule.  And they’re making the rule.  And at the core is the fact that they are not going to be putting in (a lot ?) additional risk on their books to bail out or to help the countries in the periphery.

MR. CARVER:  OK.  Let’s open it up, see if anyone has questions for you at this stage.  Anyone want to jump in?

What about – let’s talk a bit about the ECB.  What do you – what’s your sense of – I mean, how – you talk about an implicit deal about the ECB backstopping these countries:  Is that going to be – kind of become more explicit, do you think?  I mean, are the markets going to demand that?

MR. DADUSH:  Well, this is – there are a number of big questions associated with this – with this deal.  Of course, it’s a – you know, it’s a step.  You have to interpret it as a step in a very long journey, which will go on for years to deal with the crisis.

So a very important question is the one you’ve raised, which is the – which is the – what the European Central Bank is going to do.

Now, I think – I guess that the European Central Bank, based on reports, et cetera, will be stepping up its activities both in support of the banking system in – across Europe, which is under tremendous credit crunch at the moment, and will also be stepping up purchases of European government bonds of the peripheral countries.  What does that mean?  The markets will probably read this as – you know, there’s going to be a ceiling on – an effective ceiling on – approximate ceiling on the yield of Spanish and Italian bonds somewhere in the vicinity of 6 percent.  That’s the way the market will lead it.

Now, nobody can say for sure what the European Central Bank is going to do and how long they’re going to do it for.  But that is, in fact, very much part of the deal as well, because as I have written on the – on an Italian newspaper recently, this is basically a game of poker.  And so the European Central Bank is keeping its cuts hidden so that it maintains maximum pressure on the countries in the periphery to make their adjustment.  And that is what the Germans want and that is what the – what the French want.

Now, the game of poker also includes the financial markets.  And so you don’t know.  The financial markets – if there are very adverse developments, for example, in Italy or Spain, on the political front, the financial markets may back up and say, hey, we’re not playing.  We don’t want to play this.  So we’re not going to – we are very doubtful about these investments.  And the net effect of that will be that the European Central Bank will have to buy a lot more government bonds than it wants to buy.  And at some point, if they’re buying large amounts of government bonds, the Germans in particular may say, wait a second; we don’t want to play the game either.

So it’s a – it’s a very complex game.  It’s, of course, a very risky game that depends a lot on the external environment, on the political environment in these countries.  And – but the ECB knows that it is the only thing that stands between the eurozone and complete disaster.  So they, too, will be under pressure to kind of, you know, keep the thing together.

But, again, this is not a permanent solution.  It cannot be a permanent solution.  If it was a permanent solution, if the markets and the politicians became convinced that at no – under no circumstance will the ECB let Italian government bond yields go up above 6 percent, that will take the pressure off the Italian politicians, et cetera, et cetera, and is the equivalent of Germany and others signing a blank check, which they absolutely do not want to do.

So it is not a permanent solution, and that is why the combination of some fiscal safety net in the form of an EFSF-IMF facility is very important, remains very important, and I don’t think December 9th, tomorrow, they’re going to be able to deal with this.

And it’s also very important, eventually, to go to the next phase of the fiscal union.  So the idea is, the first phase of the fiscal union is discipline; but surely, the next phase of the fiscal union is something like euro bonds, OK, which both Germany and France basically don’t want to talk about at the moment.

MR. CARVER:  OK.  Anyone on the call wanting to talk, to ask Uri a question?

Where do we get growth from, Uri, in all this?  I mean, where does the recovery for these countries come from?

MR. DADUSH:  Well, this is a – this is the other big question.  So I had a number of big questions.  So the ECB is one big question; the IMF involvement is another big question unanswered by the preparation to December 9th, as far as we can see.

The third one is, can the peripheral countries actually handle this?  You see, in the case of Greece and Ireland, we’ve already seen 15 (percent) to 20 percent declines in domestic demand and large declines in GDP.  And in the case of Greece, actually, the progress towards reducing the fiscal deficit is very slow.  Ireland is a lot faster.  In the case of Greece, also, the current account deficit has come down, but it has only – you know, it’s come down only a relatively modest amount.
The message there is, what we’re talking about in the countries in the periphery is a very long period of falling – not just recession, but a secular multi-year decline in per capita incomes and living standards.

Now, economists – so that – so that’s the other big question, is, how long – with this Merkel and Sarkozy agreement that the markets like and that is a German-French agreement – you know, reflecting German-French interests predominantly and their enormous bargaining power – a huge part of the burden of adjustment is left with the countries in the periphery.  And so that remains the open question, is, can these countries take the pain?  How long will it take to – will they take the pain?  How fast can they actually get back onto a stable growth path?

Now, economists will tell you, particularly economists used to developing – development policy, that structural adjustment can help you re-establish your growth rate.  So what is structural adjustment?  So structural adjustment is a lot of stuff that Italy and Greece are being asked to do – so, you know, introducing competition in the labor market; introducing competition in the professions; restructuring the fiscal account to increase the incentives for people to invest and kind of free up business, et cetera. 

But any development economist will – and these are good things.  These are important things.  But any development economist will tell you that we’re talking about stuff that is like watching grass grow, OK?  This is stuff that works over many years.  And it’s certainly not the sort of thing that can suddenly reignite growth within a year, a year and a half. 

So unfortunately, the answer to my – to your question, Tom, is that these countries in the periphery – and there are an increasing number of them, as you know – are in for a very, very hard time.  And the central question will be:  Will their political systems be able to take the German-French, Merkel-Sarkozy agreement, which is almost presented as a fait accompli as they go into the summit?

MR. CARVER:  But this – I mean, even if there is an agreement at the summit, there’s still a long way to actually implement this, isn’t there – because it will require a treaty change, require the role of the European Court of Justice, as Merkel wants, and so forth.

MR. DADUSH:  Yes, it will.  But again, you know, the markets are forward-looking, so they’re responding.  And that’s why the role of the ECB is so critical, because the role of the ECB will be to hold the fort until such time as these treaty changes are made.  And again, bear in mind that it’s not like, all right, so two years from now, we have a treaty change and we agree on automatic sanctions if fiscal deficits go above a certain level, et cetera. 

It’s not like this transforms the world in a very concrete and immediate way.  But what this does is it gives the markets a very strong signal that a maximum amount of pressure is being exercised on the countries in the periphery to get their house in order.  It gives them a very strong signal that, you know, you can buy government bonds.  We’re not going to insist on haircuts, et cetera. 

So the idea is to build the confidence, build back the confidence, establish a safety net in the form of the ECB, and give time to these countries to make their adjustment – which, inevitably, inevitably, will include a huge dose of austerity, as well as some structural reforms.  But again, as your question implies, we are far from being out of the woods.

You know, the markets are reassured, but we’ve got a long road ahead, both because the adjustment itself is going to be difficult – difficult to manage, difficult to predict – and because you don’t know how the treaty change negotiations and, you know, the ratification by national parliaments – in some cases, by referendum – is actually going to play out.  So we are in – in the best of circumstances, we’re in for two or three years of a lot of uncertainly and trouble.

MR. CARVER:  OK, anyone want to join in?  We’ve got a very interesting conversation here, and a very quiet morning, because normally we get – Uri gets barrels of questions.  Is there any – anyone want to say anything?  The benefit is for you, not just for us to talk to each other.

OK, well, let’s just talk about that.  I mean, I haven’t actually asked you, Uri, whether you think, you know, this is the right solution.  I mean, do you think that this is the best that can be done in the circumstances?

MR. DADUSH:  No, I don’t.  I think too much of the adjustment is put on the shoulders of the periphery countries.  There are many other possibilities.  But, of course, this is the way the politics is working right now.  Again, the golden rule – remember what I said about the golden rule.  But so, what would be alternatives? 

So a very important complement to this could be a much bigger IMF-EFSF safety net.  The point of involving the IMF is that – one way to read it is that the risk pool inside Europe is too small to handle a crisis of this magnitude.  In other words, were Italy and Germany really – were Germany and France really going all out to help Italy, it is very likely, certainly, that France would be put under attack by the markets, OK?  France has already been under attack by the markets. 

So in that sense, the risk pool inside Europe is too small.  And that’s, indeed, why we created the International Monetary Fund.  The International Monetary Fund is supposed to be a global facility that pools risk, so that in a moment of difficulty, they can come in and help a specific, particular country.  And so that’s why IMF involvement on a much larger scale would be preferable to this poker game that I have described.

That’s one option, which would require big decisions on the part not just of China, but of the United States and Japan and the U.K., et cetera, et cetera.  Then the other – the other option would be to have more emphasis on expansionary policies on the part of the ECB and on the part of the core countries that have large current account surpluses that are in a position, if they wanted to, to move more aggressively ahead on expansion. 

And, of course, the third possibility, which has been essentially ruled out, is restructuring of the debts of the periphery countries.  So basically, they had a whole menu of options, but the politics is such – and the ideology, frankly, is such, particularly inside Germany – and the economic pressures, particularly on France, but also on Germany, are such that the solution they have opted for is absolutely putting an absolute maximum of pressure on the adjustment of the periphery countries.  And, of course, that has its risks, obviously.

MR. CARVER:  And just on that last part about, you know, the market having to bear some penalty with a restructuring of debt – I mean, do you – do you think that that should have happened, or should happen, in principle – that they should bear some of that pain?

MR. DADUSH:  That the market should bear some of that pain?

MR. CARVER:  Or is that a dangerous route to go?

MR. DADUSH:  It is a dangerous route to go.  And it is, in my view, something to be used as a last resort.  In the case of Greece, I think the argument became pretty overwhelming.  It wasn’t so clear at the beginning, but it became overwhelming that – and they have done it – in the case of – they have done it.

I mean, they haven’t done enough if it, by the way, but they have done it.  I think that in the case of the other four that are directly under pressure now, the case is not yet clear at all that – in other words, they look solvent, still.  They look solvent. 

And so in those circumstances, I can understand that, you know, you would want to explore all other – all other solutions.  You see, asking the markets to participate – private sector involvement appears high – immediately, of course, as we have seen, casts a pall on all of Europe, and justifies things like, you know, Standard & Poor’s very important decision yesterday to put, essentially, the whole of the eurozone under credit watch.

MR. CARVER:  OK.  OK, well, we have a couple more minutes before we’re up.  I just wanted to make sure that there are no questions that people have for Uri.

JOURNALIST 1:  I have one.  Uri, could I get you to comment on the – the thing we keep hearing here in North America, in Canada and the U.S. about – and I guess Australia and other places – about how, you know, this is really something for the Europeans to sort out on their own.  They have plenty of resources to take care of this issue.  I ask you in light of your comment about how you’d like to see greater involvement – more, greater involvement by the IMF in the situation.

MR. DADUSH:  Yeah, I think, frankly, that that position is wishful thinking.  And I don’t think that the Europeans can do this all on their own.  One way to convey that point, Kevin, is the debt of Italy, in absolute terms, is bigger than the debt of Germany.  And Germany already has a debt ratio which is 80 percent of GDP, OK?  So Italy, I mean – so long as it was Greece, Ireland, and Portugal, that position was entirely rational and justified.

When it spreads to Italy, with a serious risk on Spain, I think the amounts of money become too large.  That’s why France has come under attack, and that’s part of the reason that S&P is questioning the credit of the whole eurozone.  So that’s why I’m saying that the risk pool should be widened to include IMF – a much bigger IMF facility which will require contributions by the United States, by Canada, as well as several – as well as China. 

And my point is that it is much more likely that you’ll get the Chinese and the Brazilians and the Russians and others to put in significant amounts of money behind the International Monetary Fund if they see that not only the Europeans, which also need to do more, but also the Americans and others – the big boys – are also putting in money.

Now, this may seem anomalous at a time when we are terribly concerned about the budget situation in the United States, as we are.  But the fact is that these are loans that may never be disbursed.  They’re not gifts.  And the history of the IMF is that these loans are invariably, virtually without exception, repaid.  They’re senior debt.  They go in with big conditions, et cetera, et cetera. 

So my view is that from the point of view of the United States, Japan, China, and others, this is actually an investment in stability.  Because as I say, as I said the other day, the United States, for example, will pay for the euro crisis.  If the euro collapses, it will pay a very, very heavy price.  So the question is not whether the United States will pay, but how it will pay.

Q:  Thank you.

MR. CARVER:  OK, any others?

JOURNALIST 2:  I have a question.  And I signed on a little bit late, so pardon me if you’ve already talked about this, but I’m wondering where you come down on the S&P announcement the other day.  Obviously, there are negative sides to it.  But some have been coming out saying this could be good.  It could spur action, or even that, you know, a loss of a notch for the EFSF could mean that they can get more guarantees from more countries.

MR. DADUSH:  All right.  I’m going to give you an unvarnished view.  I think it’s a good thing, what S&P did.  And I think it was a good thing that S&P downgraded the United States as well.  And the reason I think it’s a good thing is because I think that is the reality of the situation.  And S&P is basically saying that which the financial markets have already concluded. 

OK, so you can blame them for being pro-cyclical and all that, but I would rather them be pro-cyclical and give a very strong message than, sort of, everybody living in a never-never land.  And it really connects to my previous comment, which is, the idea that the Europeans can save Italy and Spain by themselves, given the gigantic amounts of debt, is wrong.  I think they need help.  And it isn’t just a political issue.  It’s an economic issue.

And what S&P is saying is, hey, guys, I’m actually worried about the whole structure.  And I think it gives a very good message.  Now, inevitably, it’s going to be read in a different way depending on where you stand.  So the Germans will read it – and, indeed, have read it – are saying, oh, you see?  We need more fiscal discipline, you see?  That just shows that we’re right. 

But the Italians are going to think, you see?  You didn’t give us enough help; you didn’t give us enough assistance.  You don’t have your act together, et cetera, and that’s why S&P is downgrading.  To me, that’s secondary.  What is important is, the central message is the whole of the eurozone is in danger at the moment.  And something has to be done about it – whether it comes from inside Europe or, more likely, in my view, from outside Europe.

Q:  Thank you.

MR. CARVER:  OK.  Any others?  OK, well, thank you very much, Uri, for that.

MR. DADUSH:  Thank you.

MR. CARVER:  This is obviously a continuing story.  As you say, it’s only the first step in a long road, so I’m sure we will be back with more of these over the course of the next few months.  But thanks for your participation.  And a full transcript will be available online in a few hours.  Thank you very much, bye.