Why and How the Euro Zone Crisis Will Be Solved

GUSTA JOHNSON: Good evening, ladies and gentlemen. Thank you for joining us here at the Carnegie Council. Tonight there will be a discussion with Jacob Kirkegaard on how and why the euro zone crisis will be solved. Our moderator for the evening is Julian Harper, an investment professional with Franklin Templeton Investments. Thank you so much.

JULIAN HARPER: Thank you. Thank you all for coming tonight.

It’s my great pleasure to introduce Jacob. Jacob has been a research fellow at the Peterson Institute since 2002, and he’s also senior associate at the Rhodium Group, a New York-based research firm. Before joining the Peterson Institute, he worked at the Danish Ministry of Defense, the United Nations in Iraq, and in the private financial sector. He is a graduate of the Danish Army’s Special School of Intelligence and Linguistics; the University of Aarhus in Aarhus, Denmark; and Columbia University in New York. His current research focuses on European economies and reform, pension systems and accounting rules, demographics, offshoring, high-skill immigration, and the impact of IT.

His talk today is highly topical, as the euro zone crisis carries deep implications for the future of the European Union and repercussions on the global economy and financial system. The euro zone crisis has provoked a wide range of opinions, which have been overwhelmingly bearish on the future of the euro and economic stability in Europe. Earlier this year, Citigroup economists epitomized the widely negative emotions circulating the crisis in asserting there was a 90 percent likelihood that Greece would leave the euro. Since then, attitudes have dramatically improved and forecasts have become rosier.

Jacob has consistently held a contrarian view and argued that the euro zone would survive the crisis. I’ll turn to you, Jacob, and let you have a chance to tell us more about your recent predictions and how you think the euro zone will overcome and evolve out of the crisis.

JACOB KIRKEGAARD: Thank you very much. I’d like to thank the Council for inviting me. I guess I should start out by saying that I am what The Washington Post once referred to as “the most euro-bullish person in Washington.” Now, admittedly, about a year ago that was not very difficult. Sentiment has somewhat shifted, I would like to say in my direction, since then.

But I am basically fundamentally very optimistic about what is going on in the euro area. I believe that the probability that even Greece will drop out of the euro area is very close to zero. I also believe that ultimately Europe, whether it’s the eur -area or the EU 27 or some mixture thereof, will ultimately emerge from this crisis in a much more integrated, and therefore economically and politically more coherent and resilient, construction.

The reason that I think this is the case is that this crisis really should be viewed, first and foremost, as an opportunity, because the reality is that the challenges that Europe face could not be solved without a crisis, simply because of the intractable political nature of the crisis. Whether we are talking about labor market reforms in Spain or Italy, whether we’re talking about fiscal consolidation in Greece or Portugal, or, even more so, things like creating a unified banking supervision system for the euro-area, or even putting together a fiscal union or a political union—none of this would be possible in a normal political situation.

The simple reality in Europe is that when your bond yields are 7 percent for the 10-year rather than 3 percent for the 10-year, there are things that you are willing to do that you otherwise wouldn’t be willing to do. That is essentially the dynamic that has driven forward the euro crisis.

I think a lot of the bearish nature of the narrative and the talks and the publications about the euro area crisis is really about a misunderstanding of the diagnosis of the crisis, which really needs to be—we first need to agree on what is wrong in Europe.The problem there is actually partly driven by the sheer complexity of the European crisis because it actually has a little bit for everyone.

So if you’re a person who is really concerned about fiscal policy and government deficits, etc., you will look at Europe and you will look at Greece and you will say, “Look, this is the first sovereign default in an industrialized country in 60 years,” and you will look at other countries in Europe and you will say, “Jesus, this is a fiscal crisis, obviously.”

If, on the other hand, you’re a person—or I should say this is particularly prevalent for economists, because economists tend to be people with tunnel vision—they are either focused on fiscal policies; or others are focused on, say, the role of the banking system in the economy, they’re really worried about too-big-to-fail banks.

They look at Ireland and say, “Geez, Ireland did everything right, except that it screwed up, brutally, its banking system and it went bankrupt as a result of that.”

Then you look at the situation in Spain right now, you look at undercapitalized banking systems in other Euro area countries, and you say, “Oh, my God, this is clearly a banking crisis.”

Or, if you are industrialists or you are trade economists, you will look at the euro area periphery and you look at a country like Spain, which used to run double digit current account deficits, as clearly illustrating there is a huge competitiveness problem in these countries. There is just no way that they can share a currency with Germany; Germany is simply too competitive. So, what we have here is really a current account competitiveness intra-euro area imbalance type of crisis.

But the reality in my opinion is that all of the above is true, and it’s important to obviously understand that this means that you have not one crisis but many crises in the euro-area and they are actually mutually reinforcing. But, underneath all that, I believe you have a basic crisis of institutional design, because what the crisis has shown is that the Maastricht Treaty, or the design of the euro, the common currency as it was laid out in the 1990s, doesn’t work.

It works great when markets forget very basic notions of risk weighting and markets are willing to lend to countries like Greece, irrespective of their fundamentals, at interest rates like Germany. Then the euro area, as it was designed in the 1990s, works fine. But obviously that is no longer the case, and I doubt it ever will be again.

What you have to do and what you have to get out of this crisis is a fundamental change of the institutional framework. You basically need to fix the institutional shortcomings of the euro area. That means that it’s fundamentally at heart a political crisis. Unless you understand that it is a political crisis, then you will fail to understand the dynamics of how the crisis has emerged and how the crisis has gradually developed and ultimately, in my opinion, how it will ultimately be solved.

It’s not a coincidence that the Maastricht Treaty was written the way it was written back in the 1990s. It’s not actually because the people that wrote it are all idiots that didn’t understand how to put together a common currency that would be sustainable for the long run.

If you read a lot of the prior literature on this in Europe, you will actually see that everybody was quite aware. This is a long process that goes back, for those who are interested, to the Vienna reports and all the way back to the early 1970s, that if you were to do a common European currency, you would need to have a common fiscal policy and a political unity.

So, why didn’t you get it? Well, the answer is simple: politics. There was no willingness in the early 1990s to do these things, to pool control over your banking system, to pool control over fiscal policy, etc., because it was viewed as an unacceptable infringement of national sovereignty.

So what the crisis is really about is not as a matter of a political vision of a unified Europe, which is what led largely to the Maastricht Treaty. I mean the Maastricht Treaty itself was really a response to German reunification and the need to have a much bigger Germany more solidly anchored in a European construction, an economic and monetary union.This was a shock, this came pretty out of nowhere. So European policymakers basically took the quick-and-dirty economic and monetary union that they could get, that they could agree on, and launched the euro.

But they launched the euro without some very fundamental parts of the institutional framework, those elements that matter most in a crisis. That’s first and foremost.

In pretty much every major crisis, it’s the ability to grant a bailout, to write the check. Also what stabilized the crisis here in the United States? Well, it certainly wasn’t when Congress the first time turned down the TARP [Troubled Asset Relief Program]. In fact, when that happened, that was the biggest decline in the stock market during the entire crisis. The huge advantage that the United States has and had was that it had a Treasury that could issue a check and it had a central bank that could then, through TALF [Term Asset-Backed Securities Loan Facility] and other measures, leverage that money. So it had the capacity to bail out its financial sector.

Well, the problem that the euro zone had when this crisis happened was they didn’t have that; they only had a central bank.

But the problem in the Euro area is a political one, as I said. It has to do with the distributed nature of sovereignty in the euro area, because the fact is that under the Maastricht Treaty until today, or until the crisis in the euro area, control over fiscal policy was solely something that was left to the Member States, control over banking sectors was something that was left to the Member States.

Now, what that means is that it basically makes a full-blown bailout impossible in a way that was never relevant in the United States or any other country, because when Congress writes a law, Congress is sovereign, so it doesn’t have concerns over really moral hazard. It does to a certain extent, but nothing like you have in the euro-area, where the Germans are not going to—in my opinion, perfectly understandably so—write a check to bail out Greece without getting some sort of control over how the Greek finances are run, or they are not going to write a check to bail out the Spanish banking system without getting some sort of say in how the Spanish banking system is managed.

More importantly, what this means is that if you go back about six to nine months, everybody was talking about the need for a European firewall, that you needed a firewall that was big enough to take care of Spain and Italy, in particular.

Well, I always thought that’s complete nonsense, because it ignores the issue of moral hazard because it becomes not only—we can debate whether it’s feasible for Germany to do it if they wanted to—but it becomes politically irrational to do it, because if Germany said, “Look, we’ll bail out the Greeks, we’ll bail out Italy, we’ll bail out the Spaniards, no matter what,” then what will happen is that the likelihood that these countries are going to do the kind of reforms that they have been forced to do now would be very small.

That’s why it was never relevant for a firewall to be big enough, which is why any bailout that is not granted by a fully sovereign entity cannot be anything other than conditional. It’s the basic premise of 50 years of IMF [International Monetary Fund] macroeconomic stabilization programs that you only give the bailout after the countries sign up to conditionality for the IMF program. This is exactly where you are today in the euro area.

One thing that’s particularly important to understand, and which is very misunderstood in my opinion, is the role of the European Central Bank, because a lot of people say, “Ach, the European Central Bank [ECB] is too timid; it’s not doing enough; it should be doing QE [quantative easing]; there’s all these things they should back.”

Well, I take a totally different view, because the reality is that the European Central Bank is easily the most powerful central bank in the world. It is certainly the case that the Federal Reserve, because it is the custodian of the dollar, which is the world’s anchor currency, is probably the most influential central bank in markets today. But the Federal Reserve doesn’t have any power.

What do I mean by “power”? The classic definition of power from Robert Dahl, for those of you who are political scientists, will know that power, by definition, is the ability to get people to do something they otherwise wouldn’t. Well, the Federal Reserve can write big checks, but they can’t get Congress to do something that Congress wouldn’t otherwise do.

The ECB is in a very different category because the ECB is uniquely independent as a central bank. This is something that I am not necessarily endorsing as a normative description, but I’m just giving you how the political economy of the ECB during the crisis has worked.

The reality is that when you are owned by 17 different countries you are owned by nobody. The ECB is totally unaccountable to anybody. Yes, they have to go and testify twice a year before the European Parliament, but the European Parliament has no power over the ECB.

More importantly, unlike the Federal Reserve, which we think of as an independent central bank—but the independence of the Federal Reserve is resided in the Federal Reserve Act, where the last statute explicitly says that Congress can change that if it sees fit—the ECB is independent because of the European Treaty, which is a document that no individual country can change. In fact, it’s basically impossible to change it.

More importantly, because during the crisis there was no treasury in the euro area, there were no other institutions, the euro area was flying on one engine, which was the ECB. It’s the only institution that could act in real time to affect the way financial markets work and, if need be, stem the panic, if you like.

Now, the combination of these things—unaccountability, independence, and the ability of being the only institution in the euro area to effect market behavior in real terms—that equals power, real power, because the ECB very much has the ability to make politicians in the euro area do things they otherwise wouldn’t do. In fact, the ECB, in my opinion, needs to be understood not as a central bank—thinking about Taylor rules and the way you normally interpret actions of central banks is totally misplaced with the ECB—what matters is that the ECB has political power, and it needs to be therefore analyzed as a political actor.

What is it that the ECB wants in this crisis? The ECB—and this is important to understand—unlike the Federal Reserve, which never goes—I’m not criticizing the Federal Reserve; I think the Federal Reserve has done a good job, but it just has a very different institutional and political setting than does the ECB. The Federal Reserve does everything it can to stabilize the market and restore growth through quantitative easing, etc. Its mandate, essentially, is stability and restoration of growth, which is quite normal for a central bank in a crisis.

But the ECB is a very different animal. If you listen to every statement going back to early in the crisis, the ECB wants three things from this crisis: it wants fiscal austerity; it wants structural reform; and it wants a deeper institutional integration in the euro area. You can read pretty much every statement from Jean-Claude Trichet, Mario Draghi, and the other members of the Executive Board, and that’s what they talk about. Jean-Claude Trichet called it “a quantum leap forward in European integration” as early as the summer of 2010.

These are basically many of the things that were politically impossible before the crisis.

So, what has the ECB done? Well, the ECB has explicitly refrained from engaging in quantitative easing, explicitly refrained from trying to stabilize financial markets at all costs, because, at the end of the day, what is it that really makes European political leaders take action is, as I said, market pressure. You do things that you otherwise wouldn’t do when you have to pay 7 percent or more for your 10-year bonds.

What has happened throughout the crisis is essentially an ongoing quid pro quo between European governments and the ECB. Occasionally, the IMF is also involved, but the main ones are really between the euro area governments and the ECB, where the ECB will not, and has not throughout this crisis, really lent its balance sheet in support of market to stabilize the crisis. They only do it when European leaders deliver on the three things that I talked about.

This is what you saw in May 2010, during the original Greek bailout, where the ECB said, “We will start the security markets program”—but only after the European leaders invited the IMF in and created the European Financial Stability Facility (EFSF), which is the first bailout entity of the crisis.

It happened again in the summer of last year, when the ECB sent two secret letters—one of them was leaked subsequently, so we know what’s in it—to then-prime ministers Zapatero and Berlusconi of Spain and Italy saying, “Look, we’d really love to buy your bonds and help you out, but here’s a very long list of things you need to do to be eligible.”

Zapatero did what he was told to do. Berlusconi said, “Yeah, I’ll do it, I’ll do it,” but he didn’t do it. The ECB subsequently said, “Well, okay, we just won’t buy your bonds.” What happened in the fall of 2011 was bond rates kept rising up, and eventually Berlusconi was out of office. That’s regime change perpetrated by a central bank.

Think about it in the U.S. political context. Think about if Ben Bernanke had written a letter to the Congressional supercommittee last fall and basically told them, “Look guys, unless you come up with a long-term budget deal, we are going to liquidate our long-term bond portfolio, we’re going to drive up interest rates, the economy is going to tank, and you guys will all be out of a job.” How long until Congress would have changed the Federal Reserve Act? Forty-five minutes, in my opinion. [Laughter]

But, this is exactly what happened to Silvio Berlusconi, who was a democratically—like him or not, he was a democratically elected head of state, or head of government, of a G7 nation. That’s what happened to him. He was basically forced out of office. It wasn’t just the ECB, but the ECB was instrumental in doing so.

The quid pro quo between the governments and the ECB continues. December last year, the governments sign up to the Fiscal Compact and the ECB launches the three-year LTROs [Long Term Refinancing Operations].

This summer, at the June summit, EU leaders agree to a banking union and further political and fiscal integration. And, lo and behold, three or four weeks later, Mario Draghi says, “I’m willing. Here is the bazooka, but it’s conditional.” The logic is very much the same. It’s a quid pro quo.

This is something that very clearly relies on market pressure to work. But it’s important to understand that it’s the crisis itself that creates the political space for its own solution. The solution is, in my opinion, gradually more integration and the fixing of these institutional-designed defects in the Maastricht Treaty.

Now, we can debate long about what precisely that is. I think you clearly need a banking union. We can debate the timeframe of it, but you need an integrated banking supervisor. The next thing you need is more central control over fiscal policy. And then, you probably also to make that credible need more political integration. These are, sort of roughly, the building blocks, in my opinion, of what you need. But again, the key thing is that I think we have come quite remarkably far in this process compared to where you were before the crisis.

I also think that—there are a lot of people who say, "Well what about the chance of an accident happening?” I am actually much more sanguine about that because, as I said, I think people vastly underestimate the role of the ECB. It’s not that the ECB couldn’t buy stuff; it’s just that it won’t buy because it has the political power not to do so. But, if you look at the share of assets that the ECB has bought as a share of euro area GDP, it’s about 3 percent. The Federal Reserve has bought now, pre-QE3, about 17 percent of U.S. GDP in outright asset purchases. The Bank of England is busy approaching 25 percent of UK GDP. So the ECB has got a lot of room, a lot of space, before it hits anything of that magnitude.

Just to give you some magnitudes, if the ECB bought a trillion euros worth of Spanish and Italian debt, it would still own less assets than does the Federal Reserve as a share of U.S. GDP. So it has a lot of capacity still there. They are not going to run out of ammunition in the way that, arguably, the Federal Reserve is about to do in the United States.

Secondly, and more importantly, the politics in Europe are much, much more stable than the average commentary will lead you to believe.

You hear that a populace party is going to soon take over; there has to be outrage in the streets because of all this austerity, etc. But, the reality is—and this is important, particularly from a U.S. perspective, where the megatrend politically is divergence between the two major parties. In the U.S., they have never been further apart than they are now. But in fact the megatrend in Europe is exactly the opposite. If you look at the mainstream center right and center left parties in Europe and compare them to where they were 10, 20 years ago, today they basically overlap.

Let’s take France. With the exception of the top marginal income tax rate of a very limited number of French high income earners, it is not going to make a big difference whether Sarkozy or Hollande was elected president. Now, compare that to when François Mitterrand was elected president for the socialists the first time in 1981. The first thing he did was he nationalized all the French banks and largely all parts of French industry. Hollande isn’t going to do anything like that.

Does anybody here really think it matters very much for German policy in this whether Merkel or the Social Democrats win next September? I would contend that it probably doesn’t matter very much because the positions very much overlap.

But it's much more important to think about what happened in the peripheral countries. If you look at all the elections, with the partial exception of the first Greek election this spring, they have all resulted in governments being kicked out of office.

But every single election you’ve had in the euro area since the beginning of this crisis has resulted in the election of a centrist government.

You saw it in Ireland. Yes, you kicked out Fianna Fáil, but you put in place essentially a centralist Fine Gael labor government. If the Irish wanted a populist, they could have voted for Sinn Féin. They didn’t.

You saw it in Portugal. Yes, the Socialist Party was kicked out of office, but you got Coelho instead. He’s the guy who said, “Look, I’m going to implement the IMF program to the letter. In fact, I am going to go beyond the IMF program.” He won the election.

It’s what you saw in Spain. Yes, Zapatero lost the election, but Rajoy won it.

In both these cases, if you wanted a populist, there are far left, unreformed communist parties in arguably Spain and Portugal. You could have had that alternative if you wanted to.

In Greece, which is the most interesting example, because Greece of course is unique in the sense that it it has a completely discredited political system. The Greek political class is fundamentally kleptocratic and corrupt. A new democracy and the PASOK [Panhellenic Socialist Movement] party has been running it the way that Mobutu ran Zaire. Or, think about it in the U.S. political context: 1930s Chicago, or 1910 maybe, Chicago style. That’s how.

What you had in the first election is that Greeks, obviously faced with an acute economic crisis, yes they chose a populist party to a large extent, but they basically had the choice between someone who was obviously a crook and someone who was a populist. Well, in the end, they chose to elect the crook because the crook at the end of the day, this being Antonis Samaras, was ultimately a safer harbor than voting for a populist.

I would contend that this dynamic will continue going forward in the euro area, for the simple reason that European electorates are rich, comparably still, and they are aging. They are not risk takers. They are not going to vote for parties that are going to take a huge chance on their savings and the economic future of their country. The reality is that no country can leave the euro—this is true for Greece, this is true for Germany—without incurring enormous economic costs. That is why a party, in my opinion, that chooses that direction is ultimately not electable in Europe, and, as the crisis has shown, has not been electable to date.

More importantly, then, you’ll say, “Well, what about all these other populist parties in the core and the periphery, the Freedom Party in Austria and the True Finns Party, etc.?”

What these parties all share are two basic characteristics. It’s a mixture of right wing anti-immigration nationalism, which right now also means, because the EU is going to encroach on banking supervision and fiscal policy and national sovereignty, they’re also anti-EU. But, that’s not all they are. These parties are not just right-wing xenophobic parties. They also have very, very progressive social policies. These are the parties who want retirement at 55, who endorse all the essentially unsustainable welfare policies. These are parties that are tailor-made for low-skilled, blue collar, generally 50-and-above voters.

It’s the same for all of these parties. But the reality is that you can’t get 50 percent when that’s your target audience. In proportional representation systems, like you have in all European countries, with the exception of the UK, this doesn’t matter. They can get 25 percent of the vote, which they have, but it’s irrelevant because of the convergence among the remaining 70. So, the political systems in Europe are far more resilient to this process than is generally believed. Bottom line is: the process going forward to, shall we say, complete the economic and monetary union in Europe, requires crisis because it’s what makes it politically feasible. But we shouldn’t be so afraid that this crisis, in my opinion, spins out of control because of the role of the ECB and because the politics are much more stable than is generally perceived.

JULIAN HARPER:Thank you, Jacob.

You mentioned France briefly. It’s a huge economy within the euro zone and has a very difficult fiscal situation. Politicians there have been pretty reticent to really address the structural reforms they need to.

What do you think is going to take place in France for the next five years? How do you think the situation in France is going to affect the euro zone? Do you think there is a greater risk because it is a larger economy than dealing with an economy like Greece, which at the end of the day is just a very small portion of the overall European economy?

JACOB KIRKEGAARD: As you can hear, I’m basically pretty bullish on the continent, but the biggest medium-term threat I see is France. The reason is that if you believe, like I do, that ultimately the euro area will stick together, you are in a situation where the countries in the periphery are being put through the meat grinder. It’s not pretty. I am not endorsing 25 percent unemployment rates in Spain or other countries.

But you have now had the first meaningful labor market reform in Spain since the Franco era as a result of this crisis. Otherwise, it wouldn’t have happened. The same is basically certainly true in Greece. It’s true in Portugal. It’s true in Italy.

Where it’s not true, and fundamentally I would argue still—and certainly, if we think about what the world looks like two years from now—to date, if the status quo continues, France will be the most unreformed economy and the most uncompetitive economy in Europe.

I think the real issue is: Will Hollande turn out to be more like, say, a François Mitterrand, or will he be more like a Gerhard Schroeder, meaning will he actually have the political will to take on parts of his own constituents in France to restore French competitiveness and, related to that, the French fiscal outlook, which, as you say, is not exactly great? That is really the question.

I think so far you can argue it both ways. This is a guy who is a great political chameleon. He ran on being the great Keynesian and to end austerity and focus on growth.

What he also did was that he announced the audit by the French Court of Auditors of the French fiscal situation to be published immediately after the parliamentary elections in June. Lo and behold, that audit showed that all this talk about stimulus, that that didn’t really work so well. So he has implemented austerity, €30 billion in cuts in his new budget, despite running on the opposite. So, he’s not a guy who is particularly attached to keeping his election promises.

He has now told the labor units and the social partners in France that say, “You’ve got until the end of the year to come up with a deal that will help restore French competitiveness.” Will they be able to do so? I strongly doubt it.

Early next year, we will see whether or not he is willing to take on his own constituents and force through serious structural reform of France. If he’s not, then, as I said, gradually, in the medium term, the situation in France will deteriorate, and at some point markets are going to be responding to that.

But, as you said, the problem is that France is obviously a bigger economy and it’s much closer integrated with the euro area core. So the market volatility associated with that scenario will be quite violent, in my opinion, and probably will need to be quite violent, in order to get the French political classes to get the picture.

So no. I think the biggest question mark is France.

JULIAN HARPER: In my mind, one of the big stumbling blocks for the Greek situation is that the debt still isn’t sustainable and any projection of having it at 120 percent of GDP as being sustainable just doesn’t really make a whole lot of sense numerically. We have had a private sector involvement with a big haircut there, but the majority of debt now is held by public institutions. What sort of measures can some of these sovereign governments and some of the Central European institutions take to further reduce debt and bring Greece on a more sustainable debt trajectory?

JACOB KIRKEGAARD: The bottom line is Greece is not a sustainable country at this moment. The recession in Greece is much too deep for that.

But as you said, I think the key thing is on Greek debt that most of the debt is held by the public sector, which means it’s intragovernmental debt, and in three elements: there’s what’s held by the IMF; there’s what’s held by the ECB; and then there is the component that is held by the euro-area governments.

The two first entities, the IMF and the ECB, are politically untouchable. There will never be haircuts, obviously not on the IMF, but there will never be haircuts on the ECB either.

That leaves the euro-area bilateral loans and EFSF/ESM [European Financial Stability Facility/European Stability Mechanism] loans. What they will do I think is anybody’s guess. But the bottom line is these are sovereign countries, they don’t mark to market, they can do whatever they want with that.

You could think about it in terms of war reparations, things that are paid down 50 years after. How they are going to restructure it, I have no idea, but they will have to do it, and they will do it at a politically opportune point in time, which is not—I mean the big struggle between the IMF and the European governments right now is how patient is the IMF going to be, because the IMF has some pretty clear rules about this: “We can’t lend to an unsustainable country. We need to have a debt sustainability analysis that shows the country is solvent.” That’s why we come up with this number of 120 percent by 2020, which is total nonsense, but it’s because then we can say it’s a sustainable country, so the lawyers are happy.

The IMF wants official sector involvement or write-down of the euro area holdings right now. The Europeans say, “No, we won’t do it.” The reason they won’t do it is it will reduce their leverage over the Greek government in the same way as I said—it induces moral hazard.

The other reasons are, obviously, that it’s not very convenient to do it because of the German election schedule, where elections are coming up in September. So they want more time.

So they are basically telling the IMF, “Look, we will make the numbers work, one way or the other. You’re just going to have to trust us on that.”

Now, if you follow the IMF statutes to the letter, the IMF would say, “Oh, no, no, we’re not doing that.” But the reality is that I very strongly suspect that the IMF will cave, because the IMF is the members of the IMF and, irrespective of who wins the election on November 6, no one in the United States has a huge interest in creating a big another rerun of the Greek crisis—instability in Europe, spillover to the global economy, etc.

No one in the large emerging markets have any interest in that. The Chinese have no interest in creating another euro crisis that will see the euro decline vis-à-vis the dollar and therefore also vis-à-vis the renminbi because Europe is their biggest export market. The same is true for the Indians and the other large emerging markets.

So ultimately the IMF will cut a deal, which means that the debt sustainability of the Greek debt will show that the country—we will decide that it is a sustainable country because we basically believe the euro area assurances that they will make the numbers work. How they will do it, I have no idea. Maybe they’ll say, “120 percent by 2025.”

You know, a debt sustainability analysis is a very malleable document. You can basically get it to show whatever you want. You just have to assume a few growth rates and some privatization proceeds and say, “2020 is the deadline”—or maybe it’s 2025, maybe it’s 2030—who knows? There are many ways in which this can be done.

As I say, I don’t know how precisely they will do it, but the bottom line is it is 100 percent driven by politics in the euro-area.

QUESTION: What, if anything, will bring Greece out of its very deep recession?

JACOB KIRKEGAARD: I think the sad reality about Greece is that when you compare it to its neighboring countries, Greece is a very rich country. It has a GDP per capita which is running about three times as high as Bulgaria, Macedonia, and until recently, also Turkey. Turkey has grown very strongly in the last number of years.

But what the crisis, I think, showed was that Greece, at least at the beginning of the crisis, did not have the institutions to sustain that wealth, that level of income, basically. What I mean by that is when you have a nominally capitalist economy that doesn’t have a title registry, you don’t know who owns what, which means private property rights is a myth, which means capital in the sort of broadly defined sense doesn’t work. If you don’t have a tax collection system in one way or another that collects revenues of any significance—you know, you can’t have 44 percent of your GDP be government expenditure.

So I think the sad reality is that not very much is going to bring Greece back to where it was before the crisis. Many economists have these macro models that are calibrated to bring you back to equilibrium and restore the ex-ante growth trajectory. But, sadly, in the case of Greece I think the ex-ante growth trajectory was a myth.

So it’s the wrong metric to put up Greece, because they are not going to have growth of any significance unless they get these fundamental institutions in place. If they get a fundamentally more accountable political system—which is, incidentally, also why I think the people who say that they should just go back to the drachma fundamentally miss the point, because Greece is a country that has an export ratio of 10 percent of GDP.

It’s not Argentina. They don’t export anything, frankly. They have a lot of tourism, and certainly tourism would have some benefit from an introduction of the drachma. The problem is that tourism is very susceptible to exchange range fluctuation, but it’s also very sensitive to social unrest. You are not just going to book a trip to Athens if you think that you are going to be stuck in Athens airport.

So I think the sad reality for Greece is that by the time this crisis is over—and I think we’ll have another 18 months, at least, of it—they will probably have sunk somewhere between 25 and 30 percent in living standards, and they’re not going to regain them. They’re not going to go back to where they were pre-crisis because they fundamentally lack the institutional capacity to sustain it.

QUESTION: As far as I know, the U.S. Federal Reserve System can incur obligations without limit, until Congress intervenes, backed by the full faith and credit of our government. The European Central Bank doesn’t have that much power, as I understand it. That is, it has been funded to a certain degree, and if, for example, Germany decides “We don’t want to fund this anymore,” what would happen? Just what are the mechanisms?

JACOB KIRKEGAARD: Actually no. The ECB has the sole legal right to issue euros. The Federal Reserve can issue dollars and they can also buy government bonds, they can buy municipal bonds up to a six month duration, and then they can do extraordinary things under the crisis statutes, including, for instance, buying private assets. So they are actually quite constrained. There isn’t much they can buy beyond treasuries and government-guaranteed agency bonds. But, of course, they can presumably blow up their balance sheet as much as they want in these asset classes.

The political economy of the ECB is very different also in what they can buy, largely because the model of the ECB was the Bundesbank. So the one thing the ECB is explicitly prohibited from buying is, ironically, sovereign debt in the primary markets, which is one of the few asset classes that the Federal Reserve can buy.

But, beyond that, the ECB is actually capable of buying whatever it wants. It just has to define it as part of delivering price stability in the monetary transmission mechanism, which is what they’re doing now. The ECB can buy anything if there is the political support to do it.

The ECB is sovereign in the sense that it can blow out its balance sheet as much as it wants—there isn’t much Germany can do about it—as long as they don’t incur losses on them. That gets you into a discussion about whether or not a central bank can actually run with negative equity. I think it could. They don’t mark to market, so for a central bank it’s just accounting—it’s a fiction basically—they could if they wanted to.

The real political restrictions on what the ECB can buy are obviously political. They're not legal. Legally they can buy anything except primary market government bonds.

QUESTION: For countries like Portugal, how do you restore liquidity or how do you bring the country back to growth?

JACOB KIRKEGAARD: I think Portugal is a country that shares many of the structural problems that Greece had—not to quite the same degree. But the extraordinary thing about Portugal is not that it has a great recession, but that it has a big recession without a boom. Portugal grew less than 1 percent in real terms from 2000 to 2008, which in my opinion is very indicative of the very deep-seated structural problems that the Portuguese economy has.

Part of it has to do with the monopolies of state-owned financial enterprises and the role of the government in the Portuguese economy. I think it also has a lot to do with labor market relations, national collective bargaining agreements, the closed shop agreements, closed sectoral agreements.

So Portugal, uniquely I think, is really a structural story. How do you deal with that? Well, you do structural reform. But the problem is we know that structural reform takes typically between two, at least two, typically three to four, years to actually restore growth, and that’s the sad reality that Portugal is also facing.

Having said that, I think that if you look at the Portuguese external export performance, it’s actually now doing pretty well, partly of course out of necessity, because Portuguese companies know they can’t sell anything domestically so they have to go outside. This is one of the benefits that the Portuguese economy has, and other peripheral countries have as well, that they are forced to shift into the tradable export-oriented sector.

And certainly—full disclosure, I know Vitor Gaspar quite well, so I might be slightly biased—but many of the structural rigidities that suffered, that was part of the Portuguese economy before the crisis, are now finally being addressed.

If you look at the reform of collective bargaining in Portugal and you look at the transformation of the labor market and the pension reforms that the crisis has brought, that’s the solution. But we need to be honest and say it’s not a short term, so it’s not going to bring back growth in the short run to Portugal, just as it isn’t going to do so in Greece.

QUESTION: You are very optimistic, and that’s refreshing. I am a big proponent of the European Union. But the last few years were, I’d say, bothering in a certain aspect because we saw an enormous amount of private debt put on public balance sheets, which of course evaded the majority of the voters.

Now we’re seeing the European Union going in a direction of higher centralization and, in my opinion, tremendous democratic deficit. We have the leading democracy, save for the United States obviously, in the European Union. Ten years from now, it seems to me, we may be facing a sort of a little bit of a monster of central planning and we all are pushing towards this, including myself, in terms of at least conviction, because we’re all afraid that if it falls apart the costs are tremendous. So we are all driven by fear. But I’m not quite sure the end destination is something we should be really looking forward to.

What do you think about this really?

JACOB KIRKEGAARD: I think, one, the transfer or the shift from private to public balance sheets in this crisis isn’t exactly a euro zone-only thing. I mean Fannie, Freddie, Royal Bank of Scotland—you know, this is something that happens everywhere. That’s number one. It’s what happens in every crisis, basically.

But let me put it this way. I certainly share your concern. As I said, I don’t normatively endorse the fact that the ECB has been able to essentially oust democratically elected governments in the euro area, but they have, in my opinion. But it is a result of the lack of accountable, electable institutions in Europe.

The formative political challenge that the European leaders face is to create such institutions. It needs to go beyond just empowering the European Parliament because you can’t have a fiscal union without that kind of direct democratic electability at the euro zone level.

What's that going to look like? Is it going to be a directly elected head of the EU Council, the EU Commission? How is it going to work? I think that’s really anybody’s guess.

But it needs to happen, because already the degree of fiscal control that the European Commission and the euro group has today as a result of the European Semester, the two-pack, the six-pack—if you read these documents, the European institutions have far more power over Member States’ budgets than the federal government has over state budgets in the United States, far more power, and that’s not sustainable unless it’s enforced by directly elected people. So I share your concerns.

I would also say, though, that I think there is an element where I’m perhaps not so worried about this issue that the crisis—as I said, I have a prescription of the crisis where the crisis is what delivers all this integration. Then people will say, “Well, isn’t this just ramming down the throats of people something they don’t like and that ultimately there’s going to be a backlash against that?”

I guess I don’t actually think so. I think the reality is that yes, you are going to have a lot of integration in Europe, but I think the issue is that electorates in Europe, like everywhere, are schizophrenic. They want things that are fundamentally incompatible.

Like in the United States, we want a government, we want Social Security, we want Medicare, we want the biggest military in the world, but we don’t want to pay any taxes. Well, that’s schizophrenia, and it works right up until it doesn’t work anymore. Then here in the United States, we’re going to have to make a choice. Do we want to get rid of some of this stuff or do we want to pay more taxes? There is going to be a struggle about that.

But fundamentally we’re going to resolve that, either before the crisis, if we’re smart; or, when the crisis hits, we’ll be forced to realign these inconsistencies and this schizophrenia.

Europe is essentially in the same situation. Because we can debate about whether it was wise to launch the euro, but now we have it. You can then say, “Well, we want the euro because we want to basically fundamentally avoid all the terrible things that happen if the euro collapses, but we also want full national sovereignty, a democracy close to home. You’ve got to know your elected representative, etc., etc. We don’t want this distant Brussels thing.” Well, you can’t have both.

I think fundamentally, whatever comes out—and this is the formative political challenge in Europe, to create these new political integration institutions—will be much more legitimate than many people believe, because they serve to realign fundamentally incompatible or schizophrenic positions, rather than represent just sort of a ramming down the throat of European electorates something that they fundamentally don’t want.

QUESTION: It seems to me that this is the germ of the issue. That is whether within a timeframe they can deliver a solution, not to the immediate problems but to the long-term structural problems of this, in particular, the southern European economies—a solution can be provided, and, if you are right, that this can be a catalyst for a solution, which perhaps is true. You then have to subscribe to the view that all these countries, with their very different cultures and traditions, are going to be capable of giving up sovereignty, because that’s really what we’re talking about—

JACOB KIRKEGAARD: Oh, absolutely.

QUESTIONER: —and to do it within a timeframe that is achievable before the economies of the south collapse. That is because these pro-tem solutions that are being given at the moment, where every few months Greece is not meeting its targets, going back asking for more grace period—“please extend by another two years,” “please give us another loan”—that cannot go on inexorably.

I question—I hope you’re right—whether really this catalyst can product the result of a very substantially redesigned federal system within the timeframe necessary to avoid a disaster.

JACOB KIRKEGAARD: I guess I very fundamentally disagree with the premise that the peripheral countries are necessarily heading for a collapse. I will certainly say that Spain—as I said, Greece faces a collective loss of GDP equivalent of, in fact, beyond the Great Depression—and Spain will probably be in the recession, or the majority, to 2013 as well. So, there isn’t much short-term macroeconomic growth there. But as I said, I believe that ultimately the political systems will be able to absorb that, and I think that in the timeframe.

I think it’s also important to understand that we shouldn’t have expected these economies to have a normal recovery. If you believe, which I do, that Reinhart and Rogoff were onto something when they talk about the aftermath of a financial recession, well that’s what all of these countries had to a very large extent, on top of all the other things.

Ireland and Spain are obviously the prime examples. But if you look at the private sector leverage in all of these countries—Portugal is another one of those—they all share that, which means they all need deleveraging, and that’s not good for growth.

I just basically think that the system will hold together for the reasons that I said, and I think ultimately, if you look at the pace at which fiscal sovereignty and sovereignty has already been handed over as a result of this crisis, I guess I’m less pessimistic because I think that that can be sustained.

To include the necessary things like banking supervision, where going forward it won’t be the prerogative of a national government to decide whether or not its own banks are going to be bailed out or not —I think that that willingness is there, ultimately, and I think the political systems are able to deliver that. And, as I said, there is a central bank that has the capacity to prevent disaster from happening.

JULIAN HARPER: We could keep talking for days. But do you maybe just have any last comments?

JACOB KIRKEGAARD: I guess just don’t believe all the doom and gloom basically, because I think it is premised on, very often, economists fundamentally misdiagnosing the crisis. Also, don’t believe the hype that unless the European Union or the euro area develops into a replica of the United States with a large federal government and federal budget, it cannot survive. It is backhand normative. It’s a normative statement which I do not believe to be verified.

It would certainly work great if it could, but it can’t. But that doesn’t mean that it cannot work because the European Union, and euro-area especially, is a unique creation, which, while it can take a lot of lessons from the United States and other large monetary units, it doesn’t need to replicate them to work.

JULIAN HARPER: Thank you so much for your time.