Looking at the euro in the long-term

Jean Pisani-Ferry, director of the Brussels-based think tank Bruegel, stresses that restructuring the Greek debt is key to the country remaining in the eurozone. In an interview with Kathimerini, he added that the haircut offered by private investors will have to be large enough to reduce the pressure of the debt to a significant extent.

The acclaimed economist does not reject the possibility of ?one or two? countries eventually exiting the euro, though he believes this would seriously weaken the eurozone and ultimately lead to its fragmentation.

If, meanwhile, Greece were to exit the eurozone, Pisani-Ferry warns that any short-term benefits in terms of competitiveness would be offset by the long-term disadvantages of a likely dramatic fall in foreign exchange rates.

How do you think people can realize that the euro is a long-term project whose success is not decided over the course of five or 10 years?

It?s not obvious. The reality is that after the introduction of the euro everyone was saying it was too weak, after five years it was so wonderful, and it?s not a surprise that problems came after 10 years. Because we know from experience that with a common currency, as with a fixed exchange rate, at the start you get all the benefits, while the costs come later if you run policies that are inconsistent with competition in a monetary union. Now we are in a difficult moment, but we shouldn?t just look at the first 10 years. The euro is a longer-term venture. It?s certainly something difficult to explain. But look at the opinion polls, where people are saying that they are doubtful about the wisdom of participating in the euro, but they still believe that it would be worse to leave than to stay. It?s in a way the recognition that the euro is a long-term project.

What are these inconsistent policies, and how should we address them in order to solve this crisis?

It?s largely the reform agenda that is currently being discussed and being implemented. In a monetary union you lose the possibility of addressing the exchange rate, so you need to have a more flexible economy; and you lose the possibility of inflating away to solve your debt problem, so you need to have better control of your public finances. The governments — the countries, rather, because this is more than government — that did not understand the new rules of the game, that just benefited from lower interest rates to undertake more debt, had excessive wage and price increases and ended up in trouble. There are two mechanisms if you have high inflation: One is that you lose competitiveness and the other that your real interest rate drops and credit demand grows. They were supposed to be in balance, but in fact the second one was much stronger than the first one in the short term. So what you have seen in all countries where inflation started to develop is that it created a boom, because the real interest rate dropped, and people started borrowing and borrowing and borrowing. That is something that was inconsistent, because you knew that it would end in a disaster. Countering it requires that policies respond to that, in part with the system of controlling credit developments that is being put in place and in part through tax measures and regulatory measures. So it?s all sorts of adaptations so that the dynamics of your economy change.

Given the situation we are in, do you think it is possible, or even desirable, that the eurozone will break up along the lines of those different dynamics, between the countries of the north and those of the south?

I don?t believe in the possibility of different groups. One possibility would rather be that one or two countries leave and the rest remain. But this would weaken the rest, because it would show that a breakup is possible, how it can happen, and it would create speculation about who is next. But if the euro area starts breaking up into two groups, then it will fragment further. Now, is a breakup possible? It is a low-probability scenario, but it?s high enough a probability for companies to wonder what it would imply. You can?t say it is impossible; what you can say is that it is highly improbable. But what we learned during the financial crisis is that you have to prepare for very unlikely events. Now is a breakup desirable? No, I don?t think it is desirable for Europe; it would be a recipe for financial disaster, high economic loss, fragmentation…

And what would it entail for the Greek economy and society if Greece were forced — one way or another — to leave the eurozone?

Eventually Greece would regain competitiveness and so there would be some positive effects in the medium term. In the short term, however, an exit would probably imply a dramatic fall in the exchange rate, meaning that everybody who is in debt in other currencies, everybody who wants to purchase equipment would pay a high price. It would imply a chain of defaults, since Greece has lots of companies and banks that have debt denominated in euros, and the burden of this debt would be heavy. Even in anticipation of that you would see capital flight, away from banks, so I think it is very hard to imagine that it could be managed smoothly. It is a fantasy that you can leave the euro area and depreciate by 15 or 25 percent. Remember Argentina: They went to a fixed exchange rate vis-a-vis the dollar, and after a few months the currency went from 1 peso to a dollar to 4 pesos to a dollar. It was an absolutely massive depreciation. So I think the rate precipitates the adjustment, there are no capital inflows, you have to balance your current account all of a sudden, and I?m only counting the macro costs, not the transition cost of how to introduce the new currency. All the computer routines and so on…

And in order for Greece not to leave the eurozone, how important do you consider the private sector involvement, or PSI, and what else is needed?

Well I think that the PSI is a precondition, it has to be deep enough, to really alleviate the debt burden sufficiently. It?s not something you want to repeat, it?s something you want to do and put behind you.

Is the proposed 50 percent haircut enough for that?

It depends on the participation rate. It would require a very high level of participation. And that really is the borderline, because you really need to reduce the debt burden sufficiently. So yes, I think that the negotiation of the interest rate terms and the net present value reduction is fully justified because it?s something that will change the medium-term outlook. On the whole, PSI is a precondition, but obviously by itself it doesn?t solve the problem. Then you obviously need to recapitalize the banks, you have to get the banking system functioning again, and the credit to start flowing again in the economy. That, plus a number of reforms may finally create the momentum for recovery.

And if the private sector participation isn?t enough, there is talk about the possible participation of the European Central Bank, should the collective action clauses (CACs) be enacted. Is this a possible scenario?

Well, what I?ve heard is about the enaction of CACs retroactively in the contracts. It?s clear to me that if voluntary private participation cannot be ensured sufficiently because there is a holdout, you have to address that holdout, that part of the holders of debt do not participate. You cannot impose too much of an adjustment burden on those who participate in the negotiation and at the same time some others who do not participate want to be repaid in full. Not only out of fairness but also out of efficiency. You need to ensure broad participation, something like 90 percent. If not, either by changing the legal status of bonds or by introducing collective action clauses, you?ve got to do something. So it?s a matter of moral suasion, creating incentives and in the end having this possible threat, the real possibility of introducing changes to your contracts.

Is there any chance of member states participating more, or the ECB?

Well, you wouldn?t wish to substitute lower private sector participation by higher additional contribution because it would increase the debt burden.

What about a haircut on the bonds that the ECB is holding?

I suppose in the end there will be some sort of transaction so that the ECB can contribute to alleviating the debt burden, but not by being treated as an investor. The ECB was not an investor, it did what it did to support the Greek economy. So that would be questionable in view of what the ECB is doing for other countries too. It would be questionable to create a precedent of imposing losses on the ECB. Now, the ECB doesn?t need to gain either. It bought below market value so there is room for compromise.

Concerning fiscal adjustment, if half of Europe is consolidating, how does one return to growth?

On an individual country basis, in Greece and elsewhere, the recession is part of the adjustment. There is no way out. If you haven?t carried out a number of reforms before, are you going to make them if you don?t feel the necessity? So, the recession may be part of the response. Now the question is that it?s one thing to cut in a thriving environment; then you suffer in the adjustment phase and when you recover you benefit from the external environment. But if this is done simultaneously in many countries that represent half of the euro area, you?re risking that you will not be able to show benefits because the environment will be conducive to a further slowdown. So there is a problem here if you don?t create a growth environment in the eurozone as a whole.

So what?s the answer to that?

I think it lies in how to do the fiscal adjustment. Both quantitatively and in the composition of the adjustment: taxes versus spending cuts, which tax increases, which spending cuts… You can also use a number of community instruments like the structural funds for Greece, but more widely the use of the budget, the monetary policy, the value of the exchange rate… So there?s no magic bullet, but there?s a number of ways to create a growth environment. I think at present this is not sufficiently part of the equation.

Does it also mean that countries like Germany need to boost internal demand?

Germany is not consolidating aggressively. They have a relatively mild fiscal consolidation. That said, if there is a recession coming to Germany they will respond. Now the question to me is, given that Germany has a low unemployment rate, if the euro falls, Germany will benefit massively in terms of the boom in exports, but this may create conditions for wage and ultimately price increases. It would be useful that this not be resisted by the German government, because it is part of the adjustment. It is important to realize that inflation is a target for the euro area as a whole. In order to correct the imbalances that have been built over the last decade, it requires significant differences. And the bigger these are, the faster the adjustment. So if there is 2.5-3 percent inflation in Germany, and zero or close to zero in Greece, it means that the adjustment is taking place. If it is too narrow, if Germany has very low inflation, it means that we are not solving our current problem. And it is important that public opinion and the governments of Northern Europe accept it as a part of the adjustment, and that price stability means price stability for all, on average.

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