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«The calm in the Eurozone is only temporary»

Paul De Grauwe, Professor of Economics at the London School of Economics, says that European politicians are in a state of denial.

Professor De Grauwe, do you share the perception of the financial markets: Is the Euro crisis over?
Markets have hardly ever been right. During the period up to the crisis everything seemed to be fine according to financial markets. Then they panicked, which turned out to be wrong again. Today markets have calmed down. Are they right this time? We shouldn’t take markets into account when evaluating the sustainability of the monetary union.

Spreads between German bunds and Italian or Spanish government bonds are almost back to pre-crisis levels. What are the reasons?
The trigger has been the announcement of the Outright Monetary Transactions program by the ECB in August 2012. Spreads have declined almost immediately once the central bank announced it will buy bonds of troubled countries in times of crisis. Before that there was a lot of fear in the market. The OMT is certainly the most important reason for the shrinking spreads. But the small recovery in the Eurozone helps, too.

Has the economy in the Eurozone really improved fundamentally or is the ECB just buying time?
The ECB has not only bought time. Sometimes financial markets are gripped by fear and panic. Countries can end up in a very difficult situation. By providing liquidity, the central bank prevents countries from being pushed into a bad equilibrium. The ECB has avoided a  catastrophic outcome by announcing OMT. It was an important action. But of course structural reforms remain essential. Portugal and Spain have implemented strong adjustments. Public debt remains high though. In Italy very little has happened, yet also the yields on Italian bonds have declined. Markets are in general more optimistic about the future of the Eurozone.

What do you think about the Italian reform agenda which is quite ambitious?
It’s very difficult to get things moving in Italy. The new prime minister has made a lot of promises, but now we need to wait for the results. I’m sceptical that he will obtain the necessary majority to implement the reforms.

Until recently it was the common view that no monetary union can exist without a fiscal union. Is this argument still valid?
A fiscal union is inevitable for a monetary union. Economists have been saying this for the last thirty years. But as the economy in the Eurozone has improved, politicians seem to forget about it. They are in a state of denial and seem to think that all the necessary reforms have been made, for example the banking union. I don’t think it is sufficient. Policy makers are living in a fictional world, trying to avoid the inevitable. But if we want to sustain the monetary union we will have to move into a fiscal union which includes also a transfer union. This discussion is problematic in a number of countries, but there is no way out. Eurobonds are also off the table for the time being, as they too would require a fiscal union. Politicians deny the reality. But the current, calm conditions in Europe will only be temporary.

Is the banking union no alternative to a fiscal union?
No. The resolution mechanism for banks as it is planned today is completely insufficient. An effective resolution mechanism is indeed part of a fiscal union in order to guarantee the authority. The banking supervision needs to be able to act quickly in times of crisis, for instance to close banks or to recapitalize banks. This requires an independent decision-making process. We don’t have that today.

What benefit do you expect from the banking stress test?
If it’s done well it will show that a number of banks have poor assets in their balance sheets. But the poor asset quality is also a result of the difficult macroeconomic environment many countries face. Some are still in a recession while others struggle with low growth rates. The banks’ balance sheets reflect this situation.

The German Federal Constitutional Court in Karlsruhe has recently deferred a lawsuit concerning OMT to the European Court of Justice. What do you think of that decision?
The German court considers the OMT to be illegal. Now it asks the European Court of Justice to define conditions for the program, then Karlsruhe will reconsider. There is a danger that it will eventually undermine OMT, which could trigger a new crisis. It’s a very strong action of the German court: A national court declares itself as the guardian of European law. It creates a huge constitutional problem and I don’t know how the European Court of Justice will react.

What do you expect?
The European Court of Justice cannot comply with what the German court wants. It would imply that it accepts a national ruling on the constitutionality of European law. But this authority lies with the European Court of Justice. But maybe it will come up with a face-saving solution for the German court.

Will this imminent lawsuit impact the decisions of the ECB going forward?
There is a danger that the ECB feels constrained. Within the Securities Markets Program the central bank announced in 2010 to buy government bonds, they were faced with the same problem. So the program was limited in time and volume. It didn’t work. In fact it made things worse. In a moment of crisis it created an incentive for bondholders to sell immediately as they knew the ECB will be around as a buyer only for a restricted time and volume. It destabilized the markets.

What are the next steps you expect from the ECB?
The ECB has been shrinking its balance sheet during the last year while all the other major central banks in the developed world have been expanding their balance sheet. This development also explains to a large extent the strength of the Euro. The ECB will have to expand its balance sheet by buying assets. That could be government bonds, company credits or other assets. But the ECB doesn’t want to do it currently.

Why is the so ECB reluctant, considering the fact that inflation is very low? Is it the influence of the Bundesbank?
Yes, I think so. The fear of hyperinflation – as Germany experienced it in 1923 – is still deeply ingrained. It’s almost a phobia. This makes it difficult to act rationally.

Critics accuse the ECB of failing to maintain price stability, its mandate. Do you agree?
The ECB adopts an asymmetric monetary policy. Although the central bank aims at an inflation target of just below 2% and inflation has been below this target for some time now, the ECB doesn’t act. But it surely would have acted had inflation risen above 2%.

Do you think deflation is a real threat for the Eurozone?
Technically we’re not in a deflation: Inflation within the Eurozone is still positive. But some countries suffer from declining prices. The major threat is that the real debt burden rises because of low inflation. It is a big problem especially for countries in the periphery where debt levels are unsustainable anyway.

According to recent remarks, Mario Draghi seems prepared to fight the strengthening of the Euro.
There is a huge gap between what the ECB says and what it does. The central bank shrinks the balance sheet which strengthens the Euro. Then it announces to take measures against the strong currency. The ECB actually creates the situation it wants to prevent.