«The banking union should be priority number one now. The negative feedback loop between state finances and banks must be broken»
The Euro crisis is over. That seems to be the verdict in today’s financial markets. Bond yields for peripheral countries like Italy and Spain have fallen to pre-crisis levels of 2010. But Barry Eichengreen does not read that as a sign that the crisis is over. «Investors are being complacent», warns the professor of economics and political science at Berkeley. He sees deflation as a big threat for Europe and urges the European Central Bank to take preemptive action soon.
Professor Eichengreen, bond yields for peripheral European countries are at levels last seen in 2010. Does that mean the worst of the Euro crisis is over?
No. It means that markets overreact. They had overreacted back in 2012 in thinking that the Eurozone was about to break up. And they are overreacting now by concluding that the crisis is over. This is a temporary phenomenon. At some point, some trigger will get the alarm clock off again, and investors will be woken up crudely. This is not over. It’s astounding that Ireland can borrow more cheaply than the United States, given the weak growth of the Irish economy, its debt, and the constraints of the Eurozone. But there is a lot of liquidity out there, investors are looking for yield.
Are investors being complacent?
They are extremely complacent. None of the underlying conditions have been solved. I think growth will disappoint this year, and that could be one trigger for a bond market correction. If it turns out that Europe is not on course to grow by 1% in 2014, markets will be disappointed. Also (ALSN 270.00 -1.46%), the Eurozone banking system is still a mess, and now it’s matched by a banking union that is also a mess: It is excessively complex and will take ten years to be fully funded and in operation. The plan to work down the heavy debts in Europe is to reduce them over twenty to thirty years. Europeans have decided that their children will have to solve their problems. That’s not credible.
But Spain, for example, has succeeded in reducing its current account deficit. Aren’t these signs of improvement?
Yes, there are some signs of movement in the right direction. Spain and Portugal are both doing better in terms of exporting more. Greece on the other hand has reduced labor costs, and still has had no success in increasing exports at all. Italy and France have not improved their cost competitiveness.
What are the key underlying issues that have not been solved?
In countries like France, Italy and Greece it’s the lack of structural reform to increase export competitiveness. In other places like Spain it’s the overleveraged banking system which still has to absorb huge losses. The European banking system is weak and undercapitalized. We are uncertain if Europe is capable of isolating and winding down a bad bank.On top of all that, there is the looming risk of deflation. The IMF says their models predict a 20 to 30% risk of outright deflation in the Eurozone in 2014. I think the risk is higher than that.
ECB president Mario Draghi has said repeatedly that he does not see signs of deflation yet.
By the time he sees them, it will be too late. The ECB is behind the curve. It needs to remember the Bernanke doctrine and act pre-emptively against the risk of deflation.
But isn’t deflation exactly what’s needed for the periphery to achieve their internal devaluation?
If you are a country like Portugal or Spain, yes, deflation will lead to internal devaluation. But for the entire Eurozone, including Germany, deflation means less spending. The European core needs to allow a little more inflation to counterbalance the deflation in the periphery. The worst of all is deflation in the core. And that threat is real.
But what’s so bad about deflation?
A fall in the price level, when you have huge debt overhangs denominated in Euros, both private and public, is a recipe for recession and crisis.
The ECB will conduct a stress test for the European banking system. Is it structured tough enough?
Policy makers have been repeating over and over that this time they mean business. They said it twice before and it was a farce. But this time, we should believe that they mean it. There is a lot of scope for tweaking stress tests, just like they are continually tweaking the Basel III rules. The big problem is that you have to have the money ready to pump into the banks if the stress test shows they are inadequately capitalized. If you don’t have that money available, you could create a panic. Nobody wants that, so there is the risk that they will soften the stress test again.
Couldn’t the ESM be used to recapitalize the banks?
It would be ideal if it is used to capitalize the weak banks directly. But if the ESM pays out to governments and they then use the funds to recapitalize their banks, that would just create more problems. If European leaders could agree to let the ESM recapitalize weak banks directly, that would be a very good sign.
Draghis speech in July 2012, where he pledged to do whatever it takes to save the Euro, was a turning point for financial markets. How come you say he’s still behind the curve?
That speech is a beautiful example of how powerful a central bank can be when it acts swiftly and asserts its function of lender of last resort. With that, he took the risk of a Eurozone breakup off the table. He did not take the risk of deflation off the table, though.
And you think he should act against that threat now?
Yes. A risk of deflation of 30% or more is unacceptable. They should introduce some form of alternative monetary policy, that can be Quantitative Easing, LTRO, funding for lending. They are overdue at this point.
Is credit still shrinking in periphery?
Bank credit to firms and households is still shrinking at an annual rate of more than 3%. Small companies don’t have access to credit.
You mentioned France as a peripheral country. Do you see France firmly in the crisis camp?
Yes, from the point of view of trends in unit labor costs, absolutely. France is an example of a country whose unit labor costs have gone up continuously. They have created themselves a competitiveness problem.
President Hollande has announced several reform steps.
He said many good things, but he has only proposed measures, nothing introduced. Now he needs to act and get things through parliament. His agenda sounded fine, but he made some disturbing remarks when he said that there is no problem about demand. You need two-handled policies for supply and demand. Supply-side reform tends to be deflationary in the short term, so you need support for demand. President Hollande either forgot that part or was confused.
Which countries are on an unsustainable path in terms of their indebtedness?
Portugal is the case that worries me the most. If Portugal is really undergoing an export revolution, then I withdraw my worries. But while they have succeeded in exports somewhat, their product mix is very unfavorable. They compete head to head with producers in Turkey, Asia and Latin America. If they succeed in their export miracle, they’re fine. Otherwise they will have to join Greece in a debt restructuring.
Greece will need another debt restructuring?
Yes, they will need some kind of official debt forgiveness or stretch out. The debt that remains is in official hands. The ECB will have to swallow a hair cut. The Troika made mistakes in its program towards Greece. The IMF has acknowledged that.
That will not go down well in Germany.
It’s a continuing struggle to make the argument that northern Europe is not entirely free of blame for the crisis in southern Europe. Somebody lent them all the money, otherwise they would not have become overly indebted. It was the northern European banks. So yes, it won’t go down easy, but it will have to go down.
You still think the monetary union needs some form of fiscal union in order to survive?
The banking union should be priority number one now. The negative feedback loop between state finances and banks must be broken. So far, what I have seen about the banking union is underwhelming, not impressive and therefore a source of worry. Ultimately, some form of fiscal transfer or insurance union will be needed. But it should be made sure that money doesn’t only move one way.