European Disunity: The High Cost of Not Being in the ZonePublished: October 25, 2011 in Knowledge@Australian School of Business
On the eve of the 14th debt management summit in less than two years, euro zone countries are facing fraught and crucial questions. The future of the European Union is at risk and the consequences of the wrong decision by frustrated euro zone leaders may be more costly in the long term. In fine focus remains indebted Greece. Should it be cut adrift and left to default or rescued once more in an orderly way? Wolfgang Buehler, a professor at the Australian School of Business, likes the latter option. The impact of Greece being left to go it alone and leave the European Monetary Union would be dire and far-reaching, he warns, affecting the economies of the US, China and Australia. In an in-depth analysis of the ongoing crisis, Buehler explores a range of possible scenarios. Not one looks easy, but this crisis does offer one upside for the future of a unified Europe, Buehler tells Julian Lorkin of Knowledge@Australian School of Business. It has highlighted the need for more powerful institutions to shore up the benefits of being in the zone.
An edited transcript of the interview follows.
Knowledge@Australian School of Business: Let's start by looking at what the mood is like in Germany.
Wolfgang Buehler: There are two different moods. There is a mood in the pub and a mood among politicians. If we start with the first one: 75% to 80% of Germans have the opinion that we shouldn't throw good money after bad money, that is, Greece should be allowed to default. But they may not have fully understood the consequences of what that means. Fortunately, the German parliament – following a basically positive decision in Germany's highest court where the vote was almost 90% in favour – voted to support the extension of the European financial stability facility from 440 billion euros to 780 billion euros. And, according to my opinion, that was the right decision.
Knowledge@Australian School of Business: Yet this move by the European Central Bank (ECB) to provide unlimited liquidity to euro zone banks not only involves a huge amount of money but it looks like piling debt on debt.
Wolfgang Buehler: Yes, we have the sovereign debt crisis – particularly in Greece, Ireland and Portugal – and the banking crisis. These two problems were always tied together. First, we need to consider what happens with the money Greece is getting: it's turned around and it's going back to the European banks, so basically it's saving banks. And of course we avoided the default of Greece but we also reduced the problems of German, French and Italian banks. So this was always tied together.
If you look back to February 2010, when it became obvious that Greece had a big problem, there would have been two strategies at that time. First would be an unlimited guarantee for Greece: this would have built a fence against Italy and other countries, but this didn't happen. For moral hazard reasons, you want to have some pressure on the Greek government. The other possibility would have been to let Greece go bankrupt. At that time it would have been easier to do it.
What the ECB is doing now follows the first strategy, giving an unlimited guarantee in order to calm down the markets. But the very big question is whether the markets will believe it. Giving a guarantee up to 100 or 200 billion euros wouldn't be a possible strategy now. They either have to say "no" or make it unlimited. The consequences of that could be enormous. The major consequence is possibly a big increase in inflation.
Knowledge@Australian School of Business: Yet we're looking at these different funds that are coming through, trying to ensure that there is enough cash in the markets. The European stability mechanism will be coming through in 2012 as well, but the cash has to come from somewhere. The German taxpayer and other taxpayers in some of the richer European countries must be hurting.
Wolfgang Buehler: Of course, they don't love it. (The stability funds are) not yet approved fully ... two countries have to approve it. But we have to say that many people think up to 780 billion euros is not enough. We need up to 2 trillion euros. Until now, the money has been basically guarantees. Only between 5% and 10% of that money from the European Financial Stability Facility (EFSF) has been spent so it doesn't mean definitely that the taxpayers have to pay for that, but the probability is pretty high.
And then we come to the basic questions. What are the problems? We have an economic problem, a cost problem. What would it cost if Greece went bankrupt? What does it cost to try to bail it out? These costs are both not certain but there are estimates on the table. Then we have the social and the political problem. People do not talk too much about it, but I just want to remind everyone that the European Union – not to be confused with the European Monetary Union – started out with the Treaty of Rome (1958) and was a trade union. The idea was to form the united states of Europe and that was a consequence of World War II. People have forgotten about that, and that is costly without any doubt. But a revolution in one of those countries would be even more costly on the political/social side.
If these huge costs on the economic and political sides could be avoided – even if there's only, say, a 5% probability – there is currently no other good alternative than to try to get the Greek problem isolated, to make a fence around Greece. Ireland, which is not insolvent, also needs to be bailed out, along with Portugal. Hopefully, Italy and Spain will recover in another two years. The aim is to keep the situation stable and try to get an orderly bankruptcy procedure for Greece.
This implies that the decisions of the Greek government – and other European nations – will be underlined by more restrictions. If you don't change anything in the countries nothing is solved. The Greek economy has to be improved. So, talking about moral hazard – that is, if you help the Greeks [and] then the other states want help at the same level – is not the point. They will pay their bill, but in an orderly way and in a way that means the whole European or even the world economy does not suffer.
Knowledge@Australian School of Business: Certainly, German chancellor Angela Merkel says that under no condition will she allow Greece to have an uncontrolled insolvency. But the Greek economy is not looking healthy, is it? The estimate for economic growth this year is -5.3%, a very poor figure. What can Greece do to turn around its own economy in these circumstances?
Wolfgang Buehler: It's hard for Greece. The International Monetary Fund (IMF), the ECB and the European Commission impose hard authority rules on Greece. The consequences? Private demand and the GDP go down. These matters are not fully in the hands of the Greek government, rather it's a macro-economic problem. And, with the debt ratio – that is, debt relative to GDP – the denominator is hard to control. Of course, the austerity measures have had a huge impact. We need to consider what is under the control of the government. How much do they save? The savings for individual people are really strong. Public servants' pensions have gone down dramatically. I know a pensioner whose pension was reduced from 560 euros to 300 euros a month – that's really substantial. But I think we have to accept that this is not a short-term project, where you just switch something and it works. It will take a few years, and people have to be calm and know this is a deep crisis. It will take time.
Knowledge@Australian School of Business: If Greece is effectively ring-fenced – it may end up with a default or want its own currency – then there would be a lot of unpicking of various agreements to be done, in terms of the currency and with the rest of Europe. Surely, if Greece leaves the euro zone, it will be out of the whole European ideal?
Wolfgang Buehler: That's one of the bigger political risks, and the idea of (a unified) Europe will be ruined. Greece may have to leave the European Union. And it will lose the advantages of having a specific relationship to the other European countries. Let's assume the worst case happens and, before risking a civil war, Greece leaves the European Monetary Union. It is less costly for them to leave the European Monetary Union than risk their whole political system. In that case, we would have a European Union with 26 states and a European Monetary Union with 16. It's just one member less. I personally would regret that, but if this is a possibility and if it's done in a reasonable way, that's fine.
The problem is the disorderly default of Greece with the contagion effects that possibly will spill over even to the US and even to Australia. For example, if the exports to Europe went down by 50% that would decrease Australian exports by about 5%, because Europe has about 10% of Australia's exports. Then there's a second-order effect: for example, China would be affected because they export a huge amount of goods to Europe, so the Chinese demand for minerals from Australia would go down.
Knowledge@Australian School of Business: Only recently Timothy Geithner, the US Treasury secretary, said the debt crisis in Europe is posing a significant risk to global recovery. Obviously he's looking at what's happening in the US with all these threats of a double-dip recession. If Europe can't get its house in order, this could mean we'll still be talking about this in 10 years' time.
Wolfgang Buehler: That's true. But what is the alternative? If we do it in a disorderly way now, the consequences will be exactly what Geithner does not want.
UBS had a well-known study recently in which it tried to estimate what would be the cost for a country leaving the euro zone ... so, let's say it's Greece. They estimate for the first year a decrease in the GDP of about 40% and in the subsequent years up to 20%. I don't feel that this can happen without dramatic political consequences within the country. Of course this would have side effects for other countries too.
If a strong country, let's say Germany, decided no longer to pay for the others. If Germany left (the euro zone), estimates are that the German GDP in the first year would decrease by about 25% and in the subsequent years by about 10% to 15%. Where will the costs come from? Mainly a sharp decline in international trade.
In the weak country, we would have a collapse of the banking system – a period in which the payment system could collapse – for the following reason: Assume a country is leaving the European Monetary Union. So they have to introduce a new currency, let's say a new drachma (in Greece). What would the currency rate be? There would be bank runs before that, because every Greek person who is able to do it would try to change euros into another currency, so they will not be exchanged at a false rate (as happened with the currency in Argentina). Then it would be exchanged into drachma at a fixed rate and they would lose a lot of money, let's say 50%.
Here's another scenario: You have a contract between a German and a French firm and Germany would go out of the European Monetary Union. In which currency would they settle the contract? In French francs? In German marks? In euros? That possibly no longer exists if the union implodes. And as long as there are not stable currency rates in the market, nobody will pay.
That is not a way to do it because, with the contagion, there's a possible implosion of the euro. The other way is to try again to inject more money into the system ... up to a certain limit. This limit cannot be told beforehand. Of course, it couldn't be such that even strong nations like the Netherlands, Finland or Germany suffer from it so the whole system blows up. And it's the responsibility of those politicians to have this under control and to balance the costs we were talking about. But this is not a project from now to the end of the year. I think we will talk about it also in 2012, hopefully with less catastrophic words.
Knowledge@Australian School of Business: This must be forcing Europe to look at its future direction.
Wolfgang Buehler: That is the positive aspect of the current crisis. When (former Italian prime minister) Romano Prodi was the president of the EU Commission in 2001, he predicted a crisis would come that would lead to "new instruments". I don't know what he meant by new instruments, but I would say that the crisis will lead to new institutions. On the positive side, if it works out well, we will have new political institutions in Europe and that would be the next step for European unification.
The crisis is forcing the European Union to think about where to go. Do they want to go away from the common currency project and possibly from the European Union? Or do they want to have all the advantages they definitely had from the euro and the European Union? Then they would have to change the system, at least with the common currency. The costs of not doing it are high, so that may provide an impetus for the politicians to make (the current system) work better. More powerful institutions will be needed on the European level. And that will be very difficult to implement because it presents the same problem, as with the ECB (European Central Bank) where countries with a different monetary discipline have the majority. I'm not sure if the Germans would like that. What Angela Merkel doesn't say clearly to the German people is what it would cost if the euro failed. We would have the same problem - like Switzerland.
Just recapping, the European Union was founded as a consequence of World War II with the goal of creating a political union. As always, if you have good times, people start to have very narrow, ring-fenced thinking and that's what's happened. Now this crisis shows us that we have to think about the following basic problem: Do you want to keep Europe and the European Monetary Union alive? Or do we want to forgo all the advantages that these systems have? What should be much more discussed by politicians – and Angela Merkel is saying it, but I don't think people really understand – is that the European Union is at risk. And I have the feeling that people don't want to think about the problem anymore. They seem to just want a decision that will get rid of the problem. But by getting rid of this problem, they will get another much more severe problem.
The crisis now gives us the chance to think about that. And the optimistic view would be that this crisis forces Europeans to establish new institutions on the European level which have much more power at the financial ministry level, for example. And that would be a step in the direction to the unified states of Europe.
Knowledge@Australian School of Business: It may well happen. Equally I'm sure many people are crossing their fingers and hoping the European debt crisis doesn't get any worse. Wolfgang, thank you very much.