Confronting the Eurozone Crisis

Author(s): Martin Wolf, Lorenzo Moretti and Cameron Parsons

Source: The Brown Journal of World Affairs , SPRING / SUMMER 2012, Vol. 18, No. 2
(SPRING / SUMMER 2012), pp. 11-16
Published by: Brown Journal of World Affairs

Stable URL: https://www.jstor.org/stable/24590859

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Confronting the Eurozone Crisis
Martin "Wölf
Chief Economics Commentator
The Financial Times, London

An Interview with
Lorenzo
Lorenzo
Moretti
Moretti
and Cameron
and Cameron
Parsons
Parsons
t A • 1 /> rv a

Providence, RI, 17 April 2012

Martin Wolfis Chief Economics Commentator at the Financial Times, London.

He has been a forum fellow at the Davos World Economic Forum since 1999, and
was made a Doctor of Science (Economics) of London University, honoris causa, by
the London School of Economics in December 2006. His most recent publications
are, Why Globalization Works (Yale University Press, 2004) and Fixing Global
Finance (Johns Hopkins University Press, 2010).

Brown Journal of World Affairs: How did the focus of the global economic crisis
move from the United States to Europe? What was the main driving mechanism?

Martin Woif: That's an interesting question. As you implied, the first view in
Europe was that this crisis had nothing to do with Europe. It became obvious
that European banks were quite heavily involved because they held quite a lot
of subprime paper. Already, this made people worry about European banks.
Then it was clear that the European economy was very badly affected by the
downturn in the world economy in late 2008 and early 2009. There was a very
big recession, which made lenders aware of risks.
Associated with that event, a number of things started to happen. Some
asset prices and markets started to collapse—or, at least, were clearly past their
peak—so the speculation in those markets disappeared. Spain and Ireland are
obvious examples of that. And then, if my memory is correct, in early 2010,
people became aware that the Greece's fiscal position was vastly worse than

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Martin Wolf

anyone had expected. This was a situation in which there was already a lot
anxiety about the performance of economies, about asset markets, and abou
banks, which had already gone through a massive squeeze. Don't forget that
lot of European banks were actually operating in the United States. The shock
about Greece—the fact that they had lied, that their fiscal position was terrible,
and that they had a huge debt which was exploding—immediately transmitted
itself to those sovereign debt markets. At this point, there was what I suppose
emerging economies would call a sudden stop in lending. Initially, the priva
sector stopped lending to Greece and very soon after to Ireland and Portugal.
At that stage, it became obvious that there was a significant eurozone crisis
and we have been struggling to deal with it ever since. From my point of view
it's part of the wider crisis. That is to say, during the period after 2007, there
was a global credit bubble—a global underestimation and lack of appreciatio
of credit risk. This affected a very large range of assets, private and public, an
financed a lot of big credit booms, some of which were inside the eurozone.

Journal: You used the word crisis. Do you think that we have truly reache
crisis level at this point?

Wolf: Well, it's a crisis within the eurozone in the sense that a number o
countries—three to be precise—have been unable to finance themselves in th
market and have become utterly dependent on external official credit. They have
become like emerging economies, and that is a crisis for them. Their bankin
sectors have essentially been destroyed, and in the case of Ireland massively so.
There has emerged terrific pressure on bank funding, so large that the European
Central Bank (ECB) had to act as a lender of last resort. Most recently, they did
so on a truly enormous scale, essentially offering trillions of euros in support
with long-term refinancing operations of about a trillion euros in a couple
months. So, this indicates that the banks are under great stress.
And finally, the sovereign risks spreads that are linked with the bank
have ballooned out on a very large scale. There is tremendous pressure on
some very important sovereigns, Spain and Italy particularly, to borrow
and roll over their debt in a normal way. So there's certainly a crisis in th
eurozone, or more precisely there are financial and sovereign debt crises i
side the eurozone. Whether that's a crisis of the eurozone is yet to be seen

Journal: Do you think that austerity measures are the right recipe to exit this
crisis and, if not, what is the long-term solution that you would propose

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 Confronting the Eurozone Crisis

Wolf: Well, let me tell you what I think you would do in a crisis like this. Es
sentially, this is a crisis in which there has been excessive lending across borders.
So it has an important balance-of-payments element, and associated with the
crisis are large losses of competitiveness in a number of countries, and excessive
private and public borrowing. All that stopped and imploded. The way you re
spond to such crises—which are similar to those that emerging and developing
countries have experienced in the past—is two-fold.
First, you need to finance in the short run and adjust in the medium-to-long
run. Financing in the short run is basically to prevent an implosion. It's what the
International Monetary Fund has always done, and it prevents immediate mass
bankruptcy. This is what the eurozone decided to do. They could have gone for
the mass bankruptcy solution, but they didn't. They could have gone straight
into sovereign debt, but they didn't. I tend to agree with that decision because it
wasn't clear that these countries and these governments were insolvent. Greece
is different. In Greece's case, I have no doubt that they have to write down the
debt. Portugal also will have to, and that may be true in Ireland. I think in the
case of Spain and Italy, it's not obvious that they are insolvent, so you finance.
Quite a lot of financing has been provided, but I think inadequately.
Second, you have to adjust. Fiscal austerity might be part of adjustment,
because the government is borrowing more than it can manage. So the govern- '
ment has to reduce this. But if you have got a situation in which a country's
private sector is very weak because it can no longer borrow—asset prices are col
lapsing and there's a lot of bankruptcy—the private sector is retrenching. If the
public sector retrenches at the same time as a recession, there will be enormous
unemployment that will slowly grind . . . . . ..
, , . . j.I, Theres certainly a crisis in the
down wages, but it will be an incredibly '
painful process, in this situation, what eurozone. Whether it's
you really need is a very big improve- eurOZOne ÎS yet tO
ment in competitiveness, some of which
comes domestically from what happens in the labor market, but some of it
to come internationally from trading partners, who have to raise their pric
and expand demand.
In other words, adjustment has to come from both sides. So, to come
your question, my problems with fiscal austerity are two-fold. First, austerit
too fast and, because it's too fast, it's going to impose unnecessarily extreme
on the private sector. Second, austerity creates huge, permanent losses, which
unnecessary because the economy contracts, investment is weak, and growth
limited. So I think fiscal austerity is too fast and it's too one-sided—particu

Spring/Summer 2012 • volume xviii, issue ii

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 Martin Wolf

when the external sector, competitiveness, and private sector are weak.
I see the necessary path for fiscal adjustment in a slightly different—but
necessary—longer-term, more eurozone-wide context.

Journal. What institutional changes can be made inside the European Unio
to confront the challenges of an increasingly globalized financial world?

Wolf: I would have a package of longer-term reforms to make the eurozon

work, which have the following three main alternatives. First, there has to be
some mechanism for making the financial system eurozone-wide. It is ver
difficult to handle a crisis when the government goes down, and the banking
sector goes down too. So it's quite important that there exist fiscal supports fo
the banking system to operate across the eurozone as a whole. The alternati

AuStGMty is too f3St is t'iat stronger countries basically buy each banki
system. But then the systems become very national
3nd it S tOO OnG-Sided. ;n a clifFerent way. So there has to be some sort
eurozone backup for the financial sector—because it's a currency—that can
naturally go alongside the ECB. There should be a single monetary authorit
and a eurozone-wide financial system.
4 Second, there has to be a mechanism for temporary financing. I don't believ
in long-term fiscal financing because I think there's a great danger in long-term
fiscal transfers. But the temporary financing mechanisms need to be large enoug
to handle the potential liquidity problems of large countries. Therefore, the fund
have to be much larger than they are now. At the moment, these funds have abo
500 billion euros in the European Stability Mechanism (ESM). I don't know how
much is left in the European Financial Stability Fund (EFSF)—probably another
couple of hundred billion euros. But I don't think that's going to be enough. If
Spain or Italy gets into trouble, they have no mechanism to rely upon. Third,
the ECB needs to ensure that inflation is sustained across the eurozone and tha

demand is buoyant. This would imply that the core countries adjust as well
the peripheral countries. This reform is not really a reform; it's more of an unde
standing that this is the job of the ECB. Those are, I think, the three necessary
conditions for success. Even so, this adjustment is going to take up to a decade

Journal. Where could the funds for short-term financing come from

Wolf: Basically, there has to be more from governments. I would like to s

the ECB as a lender of last resort. But if you use the ECB in that way, the

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 Confronting the Eurozone Crisis

the governments will have to put up the money and the funds will have to
be much larger than they are now—large enough to deal with likely risks. I
think—and this is my view at the moment—that insolvency or a default by
a major European borrower such as Italy would be a devastating event for the
world financial system. It's going to be very hard to get them through this, but
that's what you have to do.
So financing has to come from all the states; it's an act of collective insurance.
The question, obviously, is whether collectively these states are prepared to borrow
that much money. I don't know. It's a form of Eurobonds, but it's limited in scale.

Journal: Could the eurozone crisis potentially undermine the U.S. economic recov
ery, and how great is the risk that the United States might experience a similar crisis?

Wolf: I m pretty relaxed about the U.S. situation, both because the world is trying
to buy dollars and because even if it is not and the currency goes down, there
is a currency adjustment, which is lacking in the case of the eurozone. I don't
think there's a close parallel between the U.S. situation and that of the weaker
European sovereigns, although a lot of people think there are. I don't think the
United States is at all like Greece, because they have their own currency, and
the currency is the one the world wants to hold.
And in my view, the Federal Reserve's policies are no way exceptionally irre
sponsible in this particular situation. On the contrary, I think they're responsible.
Now the question of the direct spillover is not so clear. There are two elements
to this which matter: the real side and the financial side. On the real side, if the

eurozone had a very big crisis that led to another decline in GDP, there would
be some effect on America. But American is not very dependent on exports.
It's not very dependent on exports to Europe; the exports in Europe wouldn't
disappear. Yet corporate profits would be down because American firms own
lots of European assets, but I tend to think the real-side effects would not be
that damaging. That is not always true. If you get something like October 2008,
the real-side effects are very big. But that's a very extreme event; we haven't had
an event like this since the 1930s. The other side of this is what happens to the
financial system, and that I don't know. My guess is that by now most American
banks have withdrawn their lines of credit from weak European borrowers and
European banks. That is one of the reasons why European banks have become
so dependent on ECB financing—because they can't get dollar financing. I think
similarly, the commercial paper market and wholesale markets are withdrawing
their funding. So my guess is that the direct link now—but it's a guess—between

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Martin Wolf

the financial system in the United States and in Europe is much weaker than i
was before, and the financial shock effect would be smaller than we might hav
expected a couple of years before. But I have to say I thought the same aft
Lehman [Brothers collapsed], and it turned out to be wrong. Often, people don
know there are some very surprising connections between financial institution

Journal: If I understand you correctly, you think that the euro can survive this
that we don't have to revert to national currencies?

Wolf: I think the euro can survive this. I think it probably will, but not neces
sarily with all its members. So, I would be quite surprised if Greece was still a
member four years from now; I would be moderately surprised if Portugal were
I think Ireland will be; and I'm moderately confident Spain and Italy will b
but that's not with certainty. I think the disappearance of the whole system is
definitely less than 50/50, but it could happen. You can imagine events getting
out of control: a huge crisis would generate huge ill will and people would just
say we're not playing this game anymore; then, we're back to where we starte
This is politics. People are making decisions under stress, constant summits, an
constant aggravation. The popular politics are getting angry; in these circu
stances, terrible things can happen. So I can't be sure, but I am fairly confiden
that it will survive, but not necessarily with all its existing members.©

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