«We have to change the system – the Italian crisis makes this clear»

Paul De Grauwe, professor for economics at the LSE, sees the set-up in the Eurozone as «unsustainable».

Professor De Grauwe, what is your explanation that populist parties won the election in Italy?
It is caused by the difficulties of countries in the Euro periphery in adjusting after the financial crisis. Many countries lost competitiveness. They tried to restore an economic equilibrium by reducing prices and wages to be competitive, which economists call an internal devaluation. That is a very painful process with austerity imposed on these countries. The internal devaluation intensified recessions, increased unemployment and caused misery for many people. There have been political backlashes, particular in Italy. The country has gone quiet far in imposing austerity. That created quite a lot of dissatisfaction which political parties used. Some responsibility for this lies on the Northern European countries. These countries could have eased the burden of Italy by stimulating their own economy. But they imposed austerity at the same time. This created until recently a deflationary bias in the Eurozone. All the burden was on deficit countries, the creditor countries were not willing to take up their share. There is a fault in the system.

Is it a really a systemic fault? It is not the system’s fault that Northern European countries were not willing to do more.
But there is no mechanism to ensure that adjustments work symmetrical on creditor as well as debtor countries. In a currency union, countries diverge at some point. Therefore there needs to be a mechanism to bring convergence. And this should be symmetrical: countries with deficits need to reduce spending while countries with surpluses should increase their spending. This has not worked. There was no willingness by the creditor countries to do so. The fault is systemic: If there had been a central budget, it would have stabilized the economy for the whole of the Eurozone. The budget would have transferred money to make sure that the impact is more symmetrical. But as we are far away from a central budget, we have to rely on individual countries to be willing to cooperate and do their job. And they do not.

What would be the main reason for an Italian government to leave the Eurozone?
It is the feeling that the country is imprisoned in a cage constructed by the Germans, as Paolo Savona said. Italians see the Eurozone as a constraint for the economy – and it is true to a certain degree. But it is a different matter if the country would be better off outside. The populist parties want to create a narrative that Italy has been oppressed by the outside, especially the Germans, and has to free itself. This became a very emotional topic.

How would you advise an Italian government to proceed?
I would push to increase the capacity for the country to undertake public investments. The infrastructure in Italy is deteriorating in an incredible way. Infrastructure is the key for long-term growth. If a country is not able to invest anymore, it is lost. And it is impossible for Italy to invest enough because of the budget constraints imposed by European rules. My advice to the government would be: Tell Brussels that if you do not allow us to make public investments financed by issuing bonds, we will get out of this thing. But of course, an exit from the Eurozone would bring great uncertainty. The transition to a national currency would be dramatic, resulting in a banking crisis as many banks hold Italian debt which would then be denominated in the national currency. This is scary and stops me from going all out and to say: Get out of the Euro, it will be better for you. If there could be a smooth transition, I would probably advise the government to leave the Euro as it is not good for you.

What do you think of the argument that Italy’s economy suffers under a lack of structural reforms?
Italy has introduced many structural reforms recently. There were major reforms of the pension system and the labour market. You can always argue it is not enough. But it is much more important for growth to have the capacity to invest.

If Italy stays in the Eurozone, how can it deal with its huge amount of debt?
It is a vicious cycle. If Italy does not grow, the debt burden will continue to increase. And if you try to cut debt by austerity, the country will continue to stagnate. The country stands out in terms of stagnation – GDP per capita is now as low as it was 1999. And as the country is in the Eurozone, Italy could not create inflation to get rid of the debt in real terms. The economy needs to grow again. Key is to invest, but the government is not allowed to. In that sense they are in a cage. Italy has to get out of this cage, else they will not grow and the debt burden stays high.

What is your assessment of the proposal by Lega Nord to introduce a parallel currency, Mini-BoT?
I interpret it as just a device to push Italy out of the Eurozone. If a parallel currency were introduced, in no time the country would have to leave the Euro. It is an application of Gresham’s Law: bad money drives out good. The authorities would maintain parity between the Euro and the Mini-BoT as both would be accepted for tax payments. But as the treasury probably would issue Mini-BoTs to cover its budget deficit, it would create a glut of this parallel currency. As a result, the parallel currency would be worth less than the true Euro, it would be quoted in the market at a discount. The true Euro would disappear from the payment system: everybody would pay with the cheaper parallel currency and hold the Euro as a store of value. The people who submitted the proposal probably know this. It is a plan designed to push the country out of the Eurozone.

Would it help if there would be risk sharing in the sense that part of Italian government debt would be guaranteed by the other Euro countries?
Let’s be clear: People are nervous about Italian bonds because of political reasons, not because of economics. With the present interest rates, Italy has no problem in servicing its debt. The political problem is that the two parties forming a government have on their agenda to exit the Eurozone. People are not nervous that Italy will not repay the bonds, but that the currency of these bonds will be changed to a new Lira. And the exchange rate of the Lira would drop maybe 20 to 30%, which would be a loss for the bondholders. It is not that the debt is not sustainable. I have been in favour of Eurobonds. In such a proposal, debt until 60 per cent of GDP would be a joint responsibility of the Eurozone and everything above that would be individual responsibility. This would be a good system, but Germany rejected the proposal out of hand.

Would it be a solution if government bonds of different countries in the Eurozone would be pooled together?
The European Systemic Risk Board proposed to create new safe assets, so-called European Safe Bonds, ESBies. The idea is that a financial institution would buy government bonds and issue their own bonds. The idea is to create safe assets by financial engineering. Similar to Collateral Debt Obligations, there would be different tranches: a senior tranche with low risk and a junior tranche which would be riskier as it would take losses first when government bonds default. I am very sceptical about this proposal. The proposal does not solve the problem that the government bond market in the Eurozone is inherently unstable. None of the sovereigns in the Eurozone is backed by a central bank. They issue bonds which de facto are denominated in a foreign currency. The governments might come into a situation where they do not have the Euros to pay out the bondholders. And they can be pushed into such a situation just by speculation. It is a self-fulfilling crisis: if everybody is afraid that a government will not pay, liquidity will disappear from the market and the government cannot find liquidity at reasonable interest rates and has to default. Only a central bank, which is willing to step in, can prevent such a crisis. This cannot be solved by ESBies, because the markets for national government bonds will continue to exist.

Is the bond market not useful for disciplining countries which load up too much debt?
This does not work. After the Euro was introduced, there were eight years of almost zero spread between the countries – the bond market was saying that holding a Greek bond has the same risk as holding a German bond. The market imposed zero discipline. When the crisis came, the market overreacted. Markets usually have it wrong: either they are too lenient or too harsh. In a boom phase, markets as well as rating agencies are too euphoric and nobody sees the risks. But when the crash comes, markets see risks everywhere. This risk aversion brought us two deep recessions in Europe.

The German economist Hans-Werner Sinn discusses in an interview his concern that the claims of Germany in the Euro payment system Target2 are at risk. Do you share his concerns?
The problem of Germany is that for the last 20 years it ran large export surpluses. The counterpart of export surpluses is the accumulation of financial claims on the rest of the world. Before the crisis, these were all private claims like bank loans. With the crisis, the claims on other Euro countries were shifted to the public sector and appeared in the Target2 balances. These balances are a result of the export surpluses and the claims created by it. It was a choice by Germany to accumulate these claims.  Germans should ask themselves: Was it a wise policy to accumulate all these claims? It is risky to be a creditor as debtors might not be willing to repay their debt. This is true if you are in a currency union or not.

What is your outlook now for the Eurozone?
Much of it will depend on how the Italian crisis will be resolved. The Eurozone has been on a path of economic recovery, but now this path is endangered. We should overcome these stupid rules to balance budgets which we imposed on ourselves. We stop ourselves to finance investments with debt. No private company follows such a stupid rule. Else we would still be in the stone age. If you have a good project, you borrow. Governments should be able to do so. In many places, especially among German economists, there is this cynical view that government investments cannot do anything productive.  This is certainly wrong.

How much is the government bond market relying on the assumption that the ECB would eventually intervene?
It is clear that the ECB can stop a crisis in the bond market immediately. That is what we saw in 2012: Just the announcement by the ECB that it would intervene in the market had a drastic effect. So much so that it actually did not have to buy bonds at that moment. The question is if it will intervene now. And that is uncertain. The deeper problem is that we are now in a system where the survival of a government depends on the goodwill of a small number of people sitting around a table in Frankfurt. In a stand-alone country, if the sovereign is in trouble it is always the sovereign which prevails and forces the central bank to provide the necessary liquidity. In the Eurozone it is the other way round: It is the ECB which prevails over the sovereign. That is a governance structure which is unacceptable and cannot be sustained in the long run. It worked as long as the crisis countries were relatively small like Greece. Now it hits Italy, in the future it could hit other large countries like France. People there will not accept that the fate of the sovereign is in the hands of civil servants with no democratic legitimacy at all. We have to change the system and the Italian crisis makes this very clear.