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He that? We can say hello.

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For those who don't know me, I'm Calypso Nicholas. I'm Professor here at Oxford on International Relations.

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And I'm here really acting instead of Max Watson,

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director of the programme on Financial Market here at the European Centre, but also associated with DPR.

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And indeed we really are grateful and welcome you today because as we all know,

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we're not quite in term yet, but it's really a testimony to our speakers.

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Great reputation and attraction power as it were, that you're here outside term.

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And indeed we're really very, very grateful for your coming here and sharing your ideas with us.

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I think Ashok Modi doesn't need much introduction, but let me just say, first of all,

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on a personal level that I have had the pleasure of discussing some of these issues with him when I was myself in New York,

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and he being a professor, a visiting professor at Princeton Woodrow Wilson School.

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We talked then, and I know for a fact my little finger tells me, I don't know if you say this in English,

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but in French, my little finger tells me that his students love him.

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Faculty love him. There he is, a star at Princeton.

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And indeed he came to Princeton from a very illustrious career at the World Bank and the IMF,

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working on the Global Finance Report for several years at the World Bank and then as deputy director in the IMF on the European Research Department's,

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working with them closely with several countries, including Germany, Switzerland and above all, to Ireland.

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And I understand that your biggest link with Max Watson is definitely your joint involvement with Ireland, for better or worse.

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Well known, and I'm just joking, so we won't go there.

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So there is no question that everybody comes to us, you know, with an enormous amount of experience.

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But he's also one of those, you know, person who's not just a technocrat who is not just, you know,

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who really, really bridges the two worlds between academia and the Bretton Woods system.

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And in doing so, I think he's been very, very creative in his career.

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And we the last mark of this creativity and wishing to think outside the box is a paper that is really starting to do the rounds in Europe today.

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And that's what he's going to present a Schuman Compact for the Eurozone area, this paper.

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And [INAUDIBLE], of course, tell us more about the circumstances.

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But he's been writing it at Bruegel in Brussels.

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And we know that Bruegel is a very influential think tank as we as he and I were just talking about,

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not everybody in Bruegel agrees with the paper, which is what makes it exciting.

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But he's not presenting the ideas in this paper around Europe.

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He was just in London. He's going back to the continent.

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And so it's a great privilege because we're kind of the first academic testing ground, as it were, in Europe for the paper.

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And the paper is something, you know, Max and I, you know,

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very much full feel we are in agreement with is very much a paper, as you will hear, which sees and I quote,

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seeks to make decentralisation more robust that rather than wish it away or rather

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argues that this is what the EU should do when coming when it comes to euro governance,

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that more decentralisation is not the solution and no outlook is going to tell us why that's the case and what to do instead.

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Okay. Okay. Well, thank you very much. I should just start with.

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Oh, I'm sorry. I forgot to mention that our dear colleague David Vines is going to be your discussant, but no need to introduce you to him.

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So that's a bit unfair. I mean, given the very sort of extravagant introduction you gave me, you needed to have at least balanced it a little bit.

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So I would just start with a a an Oxford anecdote.

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I don't know how many of you remember Paul Street and who used to be here.

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He was one of the great development economists of his generation, somebody I was fortunate to know and in a period.

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And he said to me once that if when he attends a conference, if he meets one old friend and makes one new friend, he considers it a success.

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So by that standard, this has already been a great success.

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And so I'm sort of I'm truly delighted to be here.

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So let me just start you know,

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I didn't make a presentation because I knew that this is a relatively small group and it's more in the nature of a conversation.

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So the the presumption in this paper is that the architecture of Europe matters both economically and politically,

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and it matters for a number of reasons. But it matters importantly to an economist, because it is my view and I'm going to stipulate this,

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and if you wish to discuss it in the discussion period that Europe is a continent which has lost economic vitality and

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that therefore its long term growth prospects are modest and certainly more modest than a lot of the current optimism,

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as David Vines were just saying to me, I suggest, and that therefore,

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in a setting where economic growth is going to be relatively constrained, if you have the wrong architecture,

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then you run the risk of greater pitfalls,

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great greater susceptibility to shocks and therefore greater vulnerability in terms of even deeper growth problems.

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And so so the elixir of growth washes away a lot of of institutional ills.

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But but when you don't have that elixir and I'm stipulating that Europe does not have that elixir, perhaps maybe there'll be some bounce back in 2014.

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But a lot of the growth forecasts, especially in my meetings in London, are essentially based on what people are telling each other.

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That is, everyone says that growth is going to be good because Calypso says it's good and David Vine says Good, good.

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And so therefore it becomes good. And to some extent that is good policy and it has real effects, but it does not generate long term growth.

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So that's that's the premise of the paper. The the content of the paper then has the following structure.

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So a lot of people agreed with the first point.

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There's some who don't, but a lot of people agree that long term growth is going to be less robust then we think.

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And then there are three points of view.

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One is what we really need is now a truly integrated eurozone with a fiscal

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with it with a fiscal system that bridges the nations with a banking union,

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fiscal union, banking union. And that's where we need to go.

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And we must push make a policy effort to push in and direction.

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And then when they recognise that that push has not paid dividends, the fallback position is that Spain, Europe always muddles through that.

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This is a muddling through process. But fundamentally, we subscribe to a thesis that I call the falling forward thesis.

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And the falling forward thesis is, yes, Europe's can loose, but every time it falls,

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it picks itself up and moves forward and that this is an inevitable process and it will occur.

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So there are those who say we must push forward, those who say that we must push forward, but recognise that that pushing forward is not working.

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Saying we are muddling through based on the falling forward thesis.

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And then there is a third group of people who say, you know, if this is not going to work,

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we need to break up the euro because unless the Germans are willing to put a lot of money on the table,

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why don't we just forget about it and break up the euro?

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So those are the three. That's my understanding of the three views of the future architecture of Europe, one that moves rapidly into a real union,

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a United States of Europe, another that muddle through to that vision in some longer time span.

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And the third says, you know, this was all a mistake.

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Let's just break it up. And my plea and my proposition in this paper is that the first vision of a fiscal union,

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I don't even go into the economics of a fiscal union and a banking union.

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I am willing to stipulate that perhaps if that was a realistic possibility, it has good economic properties.

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I'm not sure of that. But I don't waste time thinking about it because it is so unrealistic that it's not time to think about it.

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When I did a press conference on this paper, kindly organised by Bruegel, it caught a journalist from The Economist asked me,

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But the IMF has just put out a paper on the fiscal union and shouldn't we be discussing it?

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And I said for ten years during the period that the IMF, that the Europe Eurozone existed, the Article four Report,

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the annual Article four reports, never had the phrase fiscal union at a time when Europe was quiet, when these institutions should have been built.

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The SGP was the the the the was extolled as the basically fundamentally correct structure to to to guide Europe.

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Today, when we know that is not going to happen, there are all these wonderfully crafted, elegantly stated proposals.

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So he asked me, So is the IMF drinking Kool-Aid?

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And, you know, it was on the record and I didn't say it was.

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But but but it seems very much like, you know,

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it's that sort of dealing with something that do or do keep themselves busy rather than to do something that is more more productive in a in a sense,

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that has some degree of policy realism. So.

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Where do I come out?

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Vis a vis the folks who say that for let's break up the euro.

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Might I fall back on the Barry Eichengreen paper, which says that breaking up the euro, the euro was a mistake.

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It should never have happened. But now it's here and breaking it up is extraordinarily costly.

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And I take that as a statement.

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That is valid. Yeah, there are those.

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One of your colleagues, Kevin O'Rourke. Even though another of Barry's proteges, like I am, is inclined sometimes to contest that view.

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I think that breaking up the euro at this point is a bad idea.

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I think that if the euro has to eventually break up.

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That that's the the structure that my paper is proposing, which is a more decentralised structure,

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will be a a better launching pad for The Break-Up of the euro.

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And that therefore, even to break up the euro,

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you'll want to first do it a degree of decentralisation that reduces the interconnections that are so embedded in the system.

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So I have no I have no sort of claim or proposition on The Break-Up of the euro.

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I'm quite happy that now that it is here, let's take that as data and let's think I said think about what what to do next.

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So in that context then. The first proposition of the paper is that the euro was a false promise.

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It was a false promise not just in the sense in the in the economics of it, which was very well known,

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although in retrospect not well-known enough that there was that there wasn't a clear realisation.

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Although Alan Walters, there is this so-called Walters critique, which was not part of the mainstream critique of the euro.

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Most of that came from the so-called common currency area ideas.

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But but Alan Walter said something important.

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And it it has. It has. It has many implications, which is that when you have a fixed exchange rate regime,

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there is a tendency in that regime for banks to do expect or to to discount risk,

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because they presume that there is a degree of assuredness in the returns and that therefore, if I'm lending to Ireland or Spain,

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the risk that that exchange rate might depreciate if they do poorly because it's eliminated, then my risks are also lower.

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And so it is a very well established,

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stylised fact of emerging market crises that fixed exchange rate regimes and large capital inflows generate big bubbles and big crashes.

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But the irony is that this is not just an emerging market phenomenon.

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The VRM was an exact replica of the erm crisis of 92, was an exact replica of these emerging market stylised facts.

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And, and Europe had just gone through a cry, a preview of the eurozone crisis.

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And instead of taking that crisis and saying, you know what, let's step back and really think about it.

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They, in effect, doubled the bets. They what they did was they say the reason we erm did not work was that we had not

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tied our hands tightly enough and that if only we did our hands even tighter,

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we'd make it so hard for ourselves to go back on this animal that people will think it's all right and it will work.

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Except that what they didn't realise is that if you die something heart to a mast, then something else has to give.

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And so the speculation this time was not on exchange rate, but it wasn't sovereign debt.

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And so it just moves from from exchange rate to sovereign debt into sovereign debt is was intended in the original structure to be the event.

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And hence, the no bailout clause was not just a political convenience, it was an economic necessity.

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In its initial conception, then the eurozone was correctly designed.

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If I, if I, if I have a fixed exchange rate, then I should allow default on sovereign debt.

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So I come back to that theme in a minute, but I just leave.

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I say this to you because it also underlines in my mind an unwillingness to learn from Europe's own experiences.

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So looking forward, then, the structure that I'm trying to suggest, Europe needs to think more carefully about what property should it have,

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and that the three properties I'm just about to list are not mutually exclusive, as you will see,

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but they are sufficiently different that they complement each other even though they overlap.

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The first is it must be robust that when there are shocks, you don't pull the system down.

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The second is there must be a learning process.

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There must be a way in which there is a true moving forward that you don't just double the bets every time you make a mistake.

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And the third is that it must have political legitimacy.

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And the political legitimacy reinforces the robustness and the learning process and vice versa.

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So with that in mind,

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the the next claim of the paper is that there was never a real falling forward possibility within the context of the euro that whatever falling

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forward had to occur up until the point of Maastricht was an easy integration process where there were very few conflicts of interest.

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There was agricultural policy about which I know very little, but the trade liberalisation and stuff.

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There wasn't a lot of disagreement.

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Wherever there was disagreement, it was always the case that national interest took precedence, even in the.

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Germany always acted in its self-interest whenever there was a divergence with the foreign policy.

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So the fact that today Germany is acting in its self-interest should not be a surprise to anybody.

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It is in the nature of the Germans to act in their self-interest at this point.

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This is not a a claim to them being virtuous, that otherwise that's what they do.

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So so does France. And indeed, there is a question of of why the euro even arose in the first place.

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And one of the claims is when American economists looked at the euro and they saw this ghastly structure.

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They said to themselves that the only reason the Europeans want to do the euro is that it's a political project.

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And nobody. When I started writing this paper, I asked myself, what exactly was this political project?

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What does it mean? What does the phrase political project mean?

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Other than that, it was bad economics at the end,

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and the only sensible way in which it is a political project is that if built into the project was a

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plausible learning process of institutional development that would lead to a United States of Europe.

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And the argument of the paper is that was never the intent of anybody in Europe who was designing the euro,

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that if you look start with the Werner Report of 1970, which is the first, in my view, official document which spells out the euro.

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It clearly said monetary union. No fiscal union.

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The member Peter Cannon had just written is an important paper talking about a transfer union being an essential part of a monetary union.

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I could not find that reference to Peter Cannon in the Werner report or for that matter in the Delors report that came later.

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There is no there. It isn't even it isn't even acknowledged as a possibility.

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It was never, never a it was never on the minds of Europeans to create a monetary union that had a fiscal union as part of it.

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And as time went by, the Delors report said something similar.

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And by 1992, even the great Peter Canon had sort of abandoned his own fiscal union mantra and had begun to subscribe and to start defining the SGP.

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And so by the time we came to the euro in 1999, this was all gone.

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There was no there was no discussion. There was there was never any and there was never any process by which this would happen.

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So then the only other possibility left of falling forward is that the designers of the euro

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knew and expected that this structure was so fragile that one day it would have a crisis,

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and that when the crisis occurred, the necessary well to complete the union would would exist.

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Now, however implausible such a conception is,

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we have now gone through a crisis and we've seen exactly what happened, that in a crisis, when does a crisis work?

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A crisis works. So in America, they use the phrase never waste a good crisis.

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And you see in the emerging market context that sometimes a crisis does, in fact, change the dynamic.

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But for the crisis to change a dynamic that has to be one party that's willing to take losses to crisis arises because interests differ, diverge.

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And when the crisis occurs, somebody has to say, you know,

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it's okay for me to make my interests subsidiary in the greater interest, in the greater good.

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Either that or that party whose interests are submerged is powerless, and therefore it has to be in any it can be steamrollered.

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So in this case, Germany was not going to be steamrollered.

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And Germany was not ahead of a stature that was willing and able, either economically or politically, to subsume its interests for a greater Europe.

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So the crisis didn't work. So given this history, then.

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And and and eliminating for a few minutes a discussion of whether we should or should not have the so.

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So now we have two parties. We have we have the muddling through.

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And we have the did The Break-Up.

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The voices for The Break-Up are coming essentially from the periphery.

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It's sort of the periphery thread that if you guys don't do the right thing by us, then we don't want to be part of you.

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It's an empty threat and is completely meaningless because they're not they're not going away anywhere.

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They have become so dependent on the triplex of transfers that are coming from the

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north that they they have become sort of addicted to those transfers at this point,

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and therefore, they are not going away anywhere.

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So the idea of the showman come back and I'm going to stop in about five or 6 minutes because I need you to tell us the content of the Schumann.

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Yeah. So the content I'm going to tell you. Yeah, the content is essentially the idea.

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That you do not need a complete fiscal union.

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If you allow for the credible no bailout mechanism.

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Okay. It's not ideal, perhaps,

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but if the if there is a vent for taking the losses in some other place and that one some other

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place can only be in the private creditors do either the banking system or do the sovereign.

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Then the need to deal with the so called asymmetric shocks is at least partially dealt with at the national level.

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So the Delors report asked the following question.

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They say perhaps the market should be the disciplining force on sovereigns,

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but then quickly waves its hands and says, you know, but markets are sometimes irrational.

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And so we need centralised supervision, but centralised supervision.

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Has been essentially at best irrelevant and for the most part dysfunctional.

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This is not something that I'm saying that is new.

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It is well documented and the entire process of the SGP has created a strong incentive for game playing amongst member states.

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As somebody who has been on the official side and I have seen these games either in manipulating the deficit

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numbers or in manipulating the growth numbers to deliver a 3% number over some horizon that is mutually acceptable.

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Nobody believes those numbers, but the number 3% had become such a dominant focal point of discourse in Europe that

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pretending that 3% would be achieved was more of an achievement than whether it would in fact,

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be achieved or not. And so it became it became a game.

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And today we have substituted that with something that we call to pack in six back and so on,

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which has which again is something I've not bothered to follow because it is so horrendously complex.

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And it's again an instance of doubling the BEPS.

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You had a system, the SGP, which was relatively transparent.

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It was a stupid system, but it was transparent. You knew what to do.

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It was 3%. Now they say now they say we will monitor something called the structural deficit.

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And the structural deficit, as those of you who have who have tried to estimate structural deficits,

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know that you can make up any number you want and the numbers match.

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In fact, that's what they've done recently. And in the structural deficits like they estimated, they wildly silly.

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Yeah. And and the numbers change from one year to another.

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So we know. And they said, I'm not seeing anything that is not publicly known.

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The Irish structural deficits were small before the crisis.

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And then after the crisis we look back and say, oops, they were huge.

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So it doesn't mean it as these numbers have no meaning.

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And on top of it, a committee of national governments,

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national government representatives will make the decision whether it is a large or small deficit.

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So it's a game they're playing for reasons that are internally static but have no economic or real substantive content.

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So the view is Barry Eichengreen and Juergen Hagen had a paper in 1992 saying This is not just a a,

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this is not just a costless game, because if you create such a system,

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you create a presumption that somebody is minding the shop and that therefore sovereigns are going to have some protection,

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that you create a moral obligation that I've been monitoring these guys, and if they mess up, then I start.

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I, I have some skin in the game and that skin in the game creates the presumption that they will be bailed out,

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then an expectation that is fulfilled later by this, by the whole process.

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So it becomes self-fulfilling. So it's not innocuous that you create these centralised systems.

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So my view is you don't need it. You don't need it in the good times.

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And maybe to the extent it's dysfunctional, let's sort of back off from it.

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Instead, then the question is how do you create?

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So the big question that everybody asks me and I'm not I'm not going to pretend I have a good answer to this is yeah, but you know,

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you are the one drinking Kool-Aid because you will never have a credible sovereign bailout that when it comes to the crunch.

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Sovereigns will always be bailed out, and therefore the absence of a credible commitment to bail out sovereigns means that we don't have any choice.

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I'm not clear. So I have two reactions to that. So I say, if you don't have any option, then what is the alternative?

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The alternative has to be to create huge moral hazard in the system, which is exactly what is happening now.

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Some of the optimism in my mind is directly reflected.

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It is a direct reflection of the fact that efficient creditors in the euro system have become junior to private creditors.

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The signal to private creditors is, don't worry, you will be paid.

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If the debt cannot be repaid, we'll take the hit. That's the message and that's the action.

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This is no longer now in the in the in the pre-crisis days,

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there was an uneasy sense that there was there was a general sense that bailout no bailout would not be implemented.

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We've gone through the crisis and we now know that no bailout will not be implemented.

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And if you don't have a credible sovereign debt mechanism, that's what's going to be the norm.

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And, yes, it will create optimism and it may create growth.

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But we went to ten years of growth in the Eurozone.

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And when the crisis hit, we were blindsided. And maybe this time is different, but this is where the robustness argument comes in.

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You don't want a system where you can have another euro crisis of the kind we've just gone through.

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And so you want to protect yourself from it, however good that the immediate future looks.

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So no say a vastly reduced centralised surveillance, perhaps something like a think tank, like a fiscal council,

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but not somebody who is monitoring and reporting with endless reports and back and forth to Brussels.

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A it's a sovereign debt mechanism. And my proposal for that.

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And Professor Vines, oddly enough, was also a discussion on an earlier paper in which I gave my view of how to create credibility.

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And I could discuss more about it. But I say briefly what my proposal is that every time a sovereign issues a bond,

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the contract stipulates that there will be default in certain states of the world,

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that if XYZ that transpires in terms of debt levels are price levels.

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And we can talk about what what triggers it.

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But there should be no option but to negotiate, to restructure the debt and that the restructuring then gets priced into the debt issuance.

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So the first reaction to that is, oh, but that's going to raise the cost of issuing debt.

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And I say, good, that's that's the debt. You did your job.

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You have a subsidy in that debt, which is not being priced because there is a presumption of bail out.

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And you want to make that subsidy explicit by pricing it, because there is a huge externality cost of it here,

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which is when one sovereign begins to teeter, others begin to look weak.

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And so there is a clear public policy basis over here for creating a presumption that in certain states of the world, there is a deep voice.

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I call this sovereign Cocos in the spirit of Bank Cocos,

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which is that they have a contingent convertibility into a different form and different terms, easier terms of repayment.

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That's a whole another paper. And again, depending on the interest I'm happy to talk about.

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So the fiscal union then has a fiscal a loose fiscal compact agreeing to gender norms of good behaviour,

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but then letting countries do whatever they want within that disciplined by a sovereign debt contract,

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a compact which says we will all issue sovereign debt with these Cocos, and then the discipline is exercised by the market on the banking union.

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The the paper was written a few months before the most recent developments,

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and I'm pleased as an author to conclude that pretty much what this paper predicted has happened,

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not as somebody who cares about Europe, but certainly as as somebody who would who was thinking about these issues,

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that there would be an intergovernmental compact, an intergovernmental agreement,

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because that's the only thing the Europeans can agree on, that there'll be no centralised pool of funding,

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that there will be an enormously complex governance system to ensure that all

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parties in the system are protecting themselves against all kinds of eventualities,

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a complexity that essentially renders it ineffective, useless and perhaps worse than that, and that therefore we are back to square one.

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And square one is that we have national resolution legislation and we need to start closing banks down.

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So the entire premise of the banking union discussion is that something will happen in 2008.

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Well, something will happen in 2013 and in 2014 X-Y-Z will happen and by 2016, X-Y-Z will happen.

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In the meantime, the banks are still bleeding and the system we the Europe eurozone recovery has

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already been weaker than the Japanese recovery in the so-called Japanese last decade.

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And today, as we stand, the European financial system is weaker than the Japanese financial system was at this point in its recovery.

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And we know and we know that that weakness of the Japanese financial system constrained it for several years beyond that.

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So we are already baking in with our delays and procrastination, a growth process that even if even in.

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There was great vitality in the system.

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We are we are we are almost condemning Europe to a growth which is either weak and fragile, weak or fragile or more lightly weak and fragile.

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So the hard thing has to be done, which is banks have to be closed.

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Lots of banks have to be closed. So then the question is, yeah, but who's going to pay for the closing?

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And the answer it is everything in the end seems to centre around this vexatious question of who is going to pay for it.

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And the answer is that some people took bets and those bets went bad.

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And we need to share the losses. Nobody has to pay for it.

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In some sense, the creditors of the banks have to take losses, and that's in my mind.

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Eventually, some form of massive debt equity swap has to occur that people who made these banks have to say,

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We told you no, guys, we all got into this together.

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You made bad bets and you have you claim that I owe you €100.

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Why don't we do the reasonable thing? You take a piece of paper which says that in ten years, if I do well, you'll get your and you'll get it back.

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If I don't, you make a loss and I make a loss. And so we have to renegotiate those contracts.

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I'm not saying it's easy. I'm not saying it's pleasant.

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I'm not saying it is. It will not create its own distortions.

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But that is where we are. We are in this situation.

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And I am not able to see unless the elixir of growth works in a way that I do not anticipate.

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Remembering that this was also the mantra in the Japanese process that every time there was this growth that was going to rescue things,

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if growth emerges, then none of this is relevant, then none of this is relevant at least till the next crisis comes.

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But if growth does not emerge, then some form of loss of recognition through debt equity swaps has to occur.

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There is a continued ambivalence on debt restructuring, even in the banking sector.

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Despite brave talk, the directives have a million exceptions about how risks of contagion might do this, that and the other.

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And on sovereign debt, we we have essentially re-established the claim that sovereign debt is risk free.

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I'm stating it a little more strongly than the European authorities will will feel is fair to them.

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But in effect, that is the de facto principle around which Europe is again operating today.

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So let me conclude by saying. That.

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As somebody who is at once an outsider to Europe,

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but who is also as this enormous respect for the European project as an instrument of of high ideals and peace,

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and wishing that it be successful in those dimensions in which it has truly shown itself to be distinguished,

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that the pursuit of this ill fated euro project is not only a cause that is undermining the economics of Europe,

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but at a time when we need more of certain valuable dimensions of Europe, it is beginning to potentially erode even those gains.

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And today and I'm not a political scientist, so I'm now trespassing a little bit into territory that I should not.

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The mainstream monopoly on the mainstream parties have decided to vacate this area of

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discourse and are allowing fringe parties to be more influential than they deserve to be.

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And if we do not create a functional decentralisation,

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one where the sense of dependency and humiliation that is currently characteristic of the dialogue in Europe is eliminated,

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then the likelihood that the fringe parties will gain greater ground and influence the nature

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of the eventual outcomes in a way that we will all ultimately agree is a loss for Europe.

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That probability continues to grow and so the wiser counsel at this point would be to take a deep breath and say,

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yes, maybe there is some greater vision of a United States of Europe at some point.

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But this is not the point, and that it's good to take a step back, use a more decentralised structure as a resting stop today.

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Let there be a cleansing of the losses that have been accumulated through this process.

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And perhaps if Europe begins to re-emerge as a more vital economic region and where the political divisions become less acute,

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they may come another day when the march to a United States of Europe continues.

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I'm not therefore saying that that should be the outcome or that is even the preferred outcome.

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But what I am saying is that for those who see that as an important goal for Europe, even to them,

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I say that the current unthinking drive to that system is proving ultimately harmful to your own project.

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Let me stop. I thank you so much for, I think, this very, very clear exposition.

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And I. I can't insist enough for everyone to, you know, read the paper because they can hear how insightful, an interesting and provocative it is.

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But of course, you've had to skip important elements of it, even historically.

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And for instance, your analogy with the pre-war US system.

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You didn't say anything about that.

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So there's a whole load of issues which we might push you on in the Q&A, but also that everyone will find in the paper, which is on the web.

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And I really encourage everyone to do so. But and indeed, including on the politics of all this,

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because your common sense and insight is certainly greater than that of many political scientists that I do know now.

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It's very much appropriate that David would be your discussant indeed.

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Not only because he's been a very,

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very strong pillar of PFM and accompanying it from the beginning and working with Max and all of us and of course, professor here,

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and economics and macroeconomics,

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but also because recently he has become the director of ethics and economics at the James Martin School Institute for New Economic Ideas.

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And that's also an interesting dimension to what we do in Oxford.

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I think to convey your ideas there will also be interested, and perhaps most importantly, because David has written a recent book which again,

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I think we can advise everyone to read their leader less economy, why the World Economic System Fell Apart and How to Fix It with with Peter TEMIN.

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And I think there's no better recommendation than Ashok,

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who was I heard earlier say that it was one of the best reading on his reading

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list for the students because it was so engagingly written and all of that.

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So so in recommending your book, David, and turning back to you, I'm sure you will.

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It's a lot about this process.

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Thanks so much for a really interesting paper, Ashok, and can I recommend to all of you that you read it to back up what you've just heard and,

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and what you've just heard has been a really, I use your words, a very powerful political economy,

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talk quite deliberately that rather than a detailed technical economics talk.

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And you phrased your thing very well at the beginning by saying the three possible

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options rapid fiscal union muddling through or Break-Up you ruled out the first.

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Let me concede that today you come back at the end and say that I keep on wishing there was a way to make it work.

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And we'll talk about that at the end. But let's agree to rule out the first no rapid fiscal union.

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Let's agree that muddling through is a mess and will probably lead to crisis.

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And so we're left with break up. So it's just crisis as a result of muddling through or Break-Up unless we

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invent something else and you very persuasively argue the need for a new way.

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But I think actually today and even in your paper, we're still at the point of reductio ad absurdum where you say there has to be something else.

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Here it is. Voila. So I think there needs to be some economics now to supporting that political economy.

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And I'm I'm afraid to say I don't think it work. So this reductio ad absurdum pushes me back to the problem.

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I have to ask you to listen to me for a minute. That's a big claim.

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So I have to try and explain why I say that there's the macroeconomic problem caused by the link.

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And and let me do this as quickly, but as carefully as I can.

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Why? Because made a strong claim.

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There's a macroeconomic problem caused by the linking of separate countries with separate labour markets within one monetary system.

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Now, there are two points of comparison for that.

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There's a separate country with a floating exchange rate that can pursue adjustment by means of cheapening its currency during the adjustment phase.

389
00:52:42,100 --> 00:52:48,760
Think of the Asia crisis. It may need liquid, probably does need liquidity support from the IMF or wherever,

390
00:52:49,480 --> 00:52:54,730
which would be repaid by domestic taxpayers or it may need sovereign debt.

391
00:52:54,730 --> 00:53:05,110
Write down and Kruger that whole drama may be not just liquidity but sovereign problem and it's.

392
00:53:05,620 --> 00:53:11,890
Banks may be sufficiently hedged or not. In the latter case, there's a whole bank resolution issue required.

393
00:53:13,000 --> 00:53:16,450
That's a country with a floating exchange rate.

394
00:53:17,830 --> 00:53:23,170
Separately, separate, separate a government.

395
00:53:23,890 --> 00:53:27,100
Or there may be separate regions with an individual,

396
00:53:27,160 --> 00:53:36,140
individual country which can pursue adjustment through labour mobility between the regions difficult and through fiscal insurance.

397
00:53:36,910 --> 00:53:39,910
Absolutely. Central U.S., Australia, Canada.

398
00:53:40,180 --> 00:53:44,860
They may need a liquidity support from the Central Fiscal Authority.

399
00:53:45,220 --> 00:53:49,240
South Australia had a banking crisis. That's what happened to American stories.

400
00:53:49,870 --> 00:53:56,440
And they may need insurance and transfers. They're the points of comparison.

401
00:53:57,070 --> 00:54:03,290
A country in a monetary union can't do this. They have these mechanisms of adjustment.

402
00:54:03,310 --> 00:54:09,640
The competitiveness adjustment process will require a very long time.

403
00:54:10,930 --> 00:54:14,200
We go back to how difficult it is to adjust wages.

404
00:54:14,200 --> 00:54:22,510
All this discussion, all these hopeful discussions about wage costs in the European South coming down, it's very, very slow still.

405
00:54:23,110 --> 00:54:31,060
Furthermore, that the debt overhang caused by all the borrowing being being denominated in them,

406
00:54:32,140 --> 00:54:41,140
essentially the foreign currency, the euro, like the Asian crisis, that there'll be a need for liquidity financing.

407
00:54:41,320 --> 00:54:44,890
That's to say fiscal lending to support indebted governments.

408
00:54:45,640 --> 00:54:50,890
And because adjustment will take time if they need to go on saying this,

409
00:54:51,070 --> 00:54:56,020
they will almost certainly at present be requirement for sovereign debt write downs.

410
00:54:56,380 --> 00:55:02,230
What we're seeing in Europe and for bank restructuring and if the shock is large,

411
00:55:05,160 --> 00:55:11,110
that if the shock is large and all these problems are much more difficult than in

412
00:55:11,110 --> 00:55:15,520
the separate country case can devalue or the region willing in a country case,

413
00:55:15,880 --> 00:55:18,460
you can get in your car and move to the other cities.

414
00:55:19,990 --> 00:55:29,830
Now, Ashoka says rightly deals with how difficult it is proving to bring about the two necessary things in this in this monetary union.

415
00:55:29,830 --> 00:55:35,650
Fiscal. These are fiscal union and banking union.

416
00:55:36,310 --> 00:55:47,200
We're still on this thing saying it's very hard to imagine working a fiscal union for a region within a monetary system would make possible lending,

417
00:55:47,860 --> 00:55:54,250
ie liquidity financing. Automatic stable stabilisers could work all those things.

418
00:55:55,900 --> 00:56:01,930
It would enable one off transfers, insurance payments when when there's debt problems,

419
00:56:02,230 --> 00:56:07,720
and it would have longer term rebalancing mechanisms so that the transfer was not permanent.

420
00:56:08,620 --> 00:56:14,410
Just notice in passing. That's rather a different list from what German people think of fiscal union involves.

421
00:56:14,980 --> 00:56:20,440
But that's what you need in a fiscal union. The ability to do macroeconomic management.

422
00:56:20,440 --> 00:56:23,710
That's what a fiscal union has to be.

423
00:56:25,870 --> 00:56:33,129
Just as with IMF programs, there will be intrinsic problems in determining in each crisis case,

424
00:56:33,130 --> 00:56:39,340
the extent to which the crisis can be allowed to be just a liquidity crisis.

425
00:56:39,340 --> 00:56:46,719
The crisis with the automatic stabilisers working and governments in difficult situations,

426
00:56:46,720 --> 00:56:55,480
borrowing and going on borrowing and the adjustment takes a long time in going on borrowing and that will

427
00:56:55,480 --> 00:57:03,850
end up being a solvency crisis set of circumstances in many cases in which this need for forgiveness,

428
00:57:04,240 --> 00:57:09,460
for sovereign debt, reconstruction, all of Ashoka stuff will need to be.

429
00:57:09,760 --> 00:57:15,490
That's to say, of debt forgiveness needs to be part of that fiscal union process.

430
00:57:16,510 --> 00:57:20,260
So I'm already saying what I'll say in the end,

431
00:57:20,620 --> 00:57:32,200
his his proposals are necessary for anything that works necessarily with and I've taken this very much from the earlier paper of yours,

432
00:57:32,350 --> 00:57:37,840
which you persuaded me of this, and you'll hear me saying at the end, necessary but not sufficient.

433
00:57:38,590 --> 00:57:39,670
Let me keep on going.

434
00:57:39,940 --> 00:57:50,440
He describes the the the the the burdens which are being imposed imposed on borrowers by refusing to recognise the need to restructure.

435
00:57:51,220 --> 00:57:56,320
And you also described the moral hazard, which this is encouraging.

436
00:57:56,320 --> 00:58:02,200
And lenders need to be these things extraordinarily difficult to bring them about.

437
00:58:03,400 --> 00:58:05,230
They'll also need to be a bank.

438
00:58:05,660 --> 00:58:16,100
Banking union to include not just common ex-ante surveillance, but common ex-post resolution of difficulties in which the losses are pooled.

439
00:58:16,790 --> 00:58:26,690
That's the that's the deal that's necessary for that first hopeful thing, which you don't think can work.

440
00:58:28,100 --> 00:58:40,060
And you've described the difficulties of negotiating this since it seems all of this is fundamentally built on fiscal sharing processes,

441
00:58:41,750 --> 00:58:44,569
and the banking union rests on that, too, because in the end,

442
00:58:44,570 --> 00:58:50,420
the wreck the resolution mechanism has pulled losses and that's got to be underpinned going to.

443
00:58:50,610 --> 00:58:55,100
Yeah. Go. So, so difficult.

444
00:58:56,120 --> 00:59:00,200
Your proposed solution is one of decentralisation.

445
00:59:00,210 --> 00:59:03,980
There would be no attempt to. Now I'm in danger of caricaturing.

446
00:59:04,460 --> 00:59:11,930
No. No attempt to. To impose a fiscal union and no intent attempt to impose a banking union instead.

447
00:59:12,200 --> 00:59:18,439
And I quote because this I've seen this. More or less identical sentence in your earlier paper.

448
00:59:18,440 --> 00:59:20,300
And it's the core of everything here,

449
00:59:20,570 --> 00:59:32,630
where countries have given up the flexibility of exchange rates and and lack the central funded fiscal capacity to absorb absorb shocks.

450
00:59:34,130 --> 00:59:39,910
Such countries require the buffer of sovereign debt restructuring core.

451
00:59:40,950 --> 00:59:45,710
Again, the you'll see me saying necessary.

452
00:59:46,460 --> 00:59:54,710
We're asking is it sufficient which if your claim each sovereign would have the responsibility for its own banks?

453
00:59:56,120 --> 01:00:02,510
Notice, of course, that that would increase the vulnerability of each sovereign, because when,

454
01:00:03,350 --> 01:00:09,260
as I'll describe in a minute, things get bad, the banks get bad, which make them even worse for the sovereign.

455
01:00:11,360 --> 01:00:21,889
It's taken me an awfully long time to get to comparing that with the previous ideas how they work in countries which

456
01:00:21,890 --> 01:00:27,980
have sensible systems and how they're meant to work in a monetary union with a fiscal union and a banking union.

457
01:00:29,960 --> 01:00:33,770
I'm sceptical the ashoka's think is sufficient.

458
01:00:34,730 --> 01:00:39,860
Consider the current difficulties collapse has prevented.

459
01:00:40,160 --> 01:00:49,040
Now I'm describing why what we're doing at the minute requires more fiscal union than we can see in his paper.

460
01:00:49,310 --> 01:00:54,590
Just look at what's going on at the minute. Consider what's happened.

461
01:00:54,770 --> 01:00:58,850
The collapse of prevent has been prevented by OMT.

462
01:00:59,210 --> 01:01:10,880
Draghi saying, I'll do everything that it takes. And that has in turn been implicitly under underpinned by some kind of fiscal union.

463
01:01:11,120 --> 01:01:16,610
Yeah. And there's a lot of discussion about ex-ante exposed, real imaginary promise.

464
01:01:16,640 --> 01:01:23,690
Will it be reneged on? But in the end, the huge balance sheet of the ECB has to end up somewhere.

465
01:01:24,320 --> 01:01:29,030
So the sum. So you don't want that?

466
01:01:29,570 --> 01:01:40,370
That's what we've got at the minute. I don't believe that we could have made where we are now work without this OMT OMT risk we would have had.

467
01:01:40,490 --> 01:01:49,460
You would probably agree without it we would have had a crisis. But I won't say any more on that.

468
01:01:50,390 --> 01:01:57,050
Sovereigns would become without this, sovereigns would become highly risky.

469
01:01:57,590 --> 01:02:02,840
And banks, depending on their own sovereigns would become risky and we'd be in danger.

470
01:02:02,840 --> 01:02:06,440
And here I'm trying to now make the real point about the difficulty.

471
01:02:06,830 --> 01:02:11,240
We'd be in danger of having a monetary union that wasn't really a monetary union.

472
01:02:12,770 --> 01:02:15,979
Just remind yourself of the slow speed of adjustment.

473
01:02:15,980 --> 01:02:20,270
Can't devalue, can't get in the car and drive somewhere else. This takes five or ten years.

474
01:02:20,270 --> 01:02:26,600
The wage adjustment. Just such a system would be fragile and possibly unstable.

475
01:02:28,010 --> 01:02:32,180
So I've taken an awfully long time to get to this final point.

476
01:02:32,570 --> 01:02:40,010
Central argument. Just imagine I shall, quote, set up the system and everyone knows that there's risks.

477
01:02:40,640 --> 01:02:45,560
And so this isn't risk Greece. The sovereign debt isn't risk free.

478
01:02:45,560 --> 01:02:51,500
And the banks have got all this risk and we sell the stuff and we set off happily at the beginning.

479
01:02:52,280 --> 01:03:00,499
Now, now, let there be a downturn in one region. Just ask yourself when and before there are Cocos.

480
01:03:00,500 --> 01:03:07,280
There's all that stuff in place. But now let's turn on the camera and let time run.

481
01:03:10,100 --> 01:03:15,950
Let a country have a downturn, can't devalue, and it's really difficult to adjust its costs.

482
01:03:16,850 --> 01:03:21,260
So the downturn will be prolonged. This is just the gold standard.

483
01:03:21,440 --> 01:03:26,870
But that's that's just rhetoric. This is prolonged, difficult adjustment.

484
01:03:27,650 --> 01:03:33,590
But that will make the sovereign revenues fall and that will create fiscal risk.

485
01:03:34,610 --> 01:03:40,700
It will require cuts, worsening a slump and make the sovereign reverend revenue fall even more.

486
01:03:41,990 --> 01:03:46,040
What does the sovereign need to do in these circumstances? Needs to borrow.

487
01:03:47,180 --> 01:03:50,540
Who from? What does the country need to do?

488
01:03:51,140 --> 01:04:00,880
Needs to borrow? Who? Let's suppose that now let's let's make this always best to consider a case that might work.

489
01:04:00,970 --> 01:04:06,580
Let's suppose that over time, the fiscal adjustment really would be possible.

490
01:04:07,240 --> 01:04:11,170
All this country needs is liquidity financing during the adjustment period.

491
01:04:12,430 --> 01:04:16,570
Would you lend to this country? Would you lend to.

492
01:04:16,690 --> 01:04:23,920
Would you keep your deposits in the banks in this country? Would you hold bank shares of the banks in this country?

493
01:04:25,120 --> 01:04:29,590
Now I'm speaking in shorthand. I'm describing a multiple equilibrium.

494
01:04:30,520 --> 01:04:38,980
This could work. But if you and I look at each other and say it's an awfully long time and there's nobody standing behind this.

495
01:04:39,310 --> 01:04:47,740
This nation is on its own. We look up Washington and we figure out, darling, the IMF, we can't do it inside Europe.

496
01:04:48,340 --> 01:04:53,560
Where is this? And we know from the Asia crisis that in these circumstances,

497
01:04:53,770 --> 01:05:00,640
even when there's not a risk of a solvency crisis, liquidity crises can occur because of multiple equilibria.

498
01:05:02,290 --> 01:05:05,380
That's the risk. That's that's what I'm worried about.

499
01:05:07,750 --> 01:05:13,120
And so I think what you've said is necessary, but not sufficient.

500
01:05:13,300 --> 01:05:18,430
I think the task is even harder than in your paper.

501
01:05:19,510 --> 01:05:23,230
The willingness all the way back at the beginning, I said, what a mess.

502
01:05:23,410 --> 01:05:29,560
Agreed with you. What a mess we're in. And moral hazard. And there should have been more debt write down earlier.

503
01:05:30,430 --> 01:05:36,130
It's clearly necessary. What I've been saying here is I'm not yet persuaded that it's sufficient.

504
01:05:37,300 --> 01:05:44,530
So we have to go back to the beginning and say if we don't want number three bust up and if we don't want number two,

505
01:05:44,530 --> 01:05:47,110
which is muddling through, because in the end it won't work.

506
01:05:47,470 --> 01:05:58,900
We're driven reluctantly back to trying to invent some mixture of your ideas and fiscal union and banking union to make it work.

507
01:05:59,740 --> 01:06:14,650
And if, like, I don't go to bed, sleep well thinking about that, if like you looking at this, I think what's the likely outcome?

508
01:06:15,850 --> 01:06:22,450
And it may be in your final sentence of your paper that we are just stumbling forward to a fatal fall.

509
01:06:24,160 --> 01:06:29,740
And and I'm afraid I don't think your paper helps us. And maybe not enough.

510
01:06:30,280 --> 01:06:34,089
I think you are absolutely right. Necessary, but not sufficient.

511
01:06:34,090 --> 01:06:37,540
Maybe not. No, no, no. I should I take it in the.

512
01:06:38,420 --> 01:06:41,830
I'm first of all, I'm really happy to hear the comments.

513
01:06:42,400 --> 01:06:53,380
And, you know, as Calypso was saying, I do feel I'm amongst friends, so I and I and all that spirit.

514
01:06:53,410 --> 01:07:00,730
Yes. So I'm totally comfortable with with your conclusion in the in the spirit in which it has been said,

515
01:07:00,760 --> 01:07:11,200
let me make do since Max suggested that I make a few comments before inviting comments, yet that there are two distinctions we have to make over here.

516
01:07:12,100 --> 01:07:24,730
One is between legacy of what this crisis has delivered to us today and what what we should think of as a forward looking architecture.

517
01:07:25,670 --> 01:07:33,100
So that distinction is an important one. And the second is between liquidity and solvency.

518
01:07:35,830 --> 01:07:47,140
There is there is a clear there is a clear instrument or institution for managing liquidity in the system, and that is the ECB.

519
01:07:49,720 --> 01:07:57,040
The problem in the euro area has been that liquidity and solvency have been conflated.

520
01:07:58,690 --> 01:08:11,799
So you take the OMT, for example, which is. A central pillar right now in a paper that I've just I've just completed,

521
01:08:11,800 --> 01:08:24,970
I'm claiming that the OMT really was a follow up to an earlier policy of what is inelegantly called OCI or official sector involvement,

522
01:08:24,970 --> 01:08:28,480
which is forgiveness of official sector debt,

523
01:08:29,470 --> 01:08:39,910
is creating a presumption that there will be a floor below which private losses will not be allowed to follow.

524
01:08:40,150 --> 01:08:54,700
That's essentially that presumption. And it is that presumption is being grounded on a basis that if we were to extend OMT, we would have conditions.

525
01:08:57,910 --> 01:09:12,880
Now, that is not the central bank that is in a condition a lender like the IMF and a central bank does not ask does not does not negotiate conditions.

526
01:09:14,200 --> 01:09:19,810
A central bank provides liquidity to deal with panics.

527
01:09:22,300 --> 01:09:37,690
And the basic thesis of the paper is that you need to separate the liquidity role and the solvency problem, and that by not separating them,

528
01:09:38,020 --> 01:09:50,410
you amplify the solvency problems into a contagion like phenomenon, whereas the contagion arises essentially from liquidity considerations.

529
01:09:51,520 --> 01:09:55,970
Now, separating solvency and liquidity is not always straightforward.

530
01:09:55,990 --> 01:10:08,650
We know that as practitioners on the operational side, but that is ultimately what the practitioner has to do,

531
01:10:09,250 --> 01:10:17,470
not dead for do to occupy the territory of solvency as as a pre-emptive measure,

532
01:10:18,730 --> 01:10:25,540
but to to make that decision on all on a practical and considered basis.

533
01:10:26,530 --> 01:10:47,850
And so. If that were to occur, then as Calypso pointed out, you do go back to a monetary union, which is the pre depression American Monetary Union,

534
01:10:48,510 --> 01:10:55,650
where there were no fiscal transfers, where that was a clear assumption of no bailout.

535
01:10:57,000 --> 01:11:03,960
And there was a central bank which in a way was much more dysfunctional than the ECB today is.

536
01:11:04,560 --> 01:11:09,060
And so, at least in one sense, you create a model.

537
01:11:10,170 --> 01:11:19,530
You create a monetary union which is superior to the monetary union that existed in the United States before the Depression.

538
01:11:22,920 --> 01:11:27,270
If there are outside outsized shocks.

539
01:11:28,750 --> 01:11:39,520
It is still David's claim that they structure it pre depression.

540
01:11:39,970 --> 01:11:55,040
The US monetary union is insufficient. It is presumably a plausible thesis, one that certainly no one should or should disregard.

541
01:11:56,330 --> 01:12:12,140
But and here is my sort of further claim that if this structure were put in place, the propensity to accumulate debt would become much less,

542
01:12:12,710 --> 01:12:27,530
and that the entire the extraordinary leverage that exists today would be scaled down so that the the incentives to accumulate the

543
01:12:27,530 --> 01:12:43,579
levels of debt that we just saw and therefore create a condition in which the panic has as real repercussions that would be dampened.

544
01:12:43,580 --> 01:12:56,030
It's sort of like you don't want to you you if you don't if so that it would it would it sort of a little bit more colourfully.

545
01:12:56,030 --> 01:13:04,550
The Buddha said that when you walk into a flowing river, you should walk only to the point from which you can walk back.

546
01:13:04,820 --> 01:13:13,880
Hmm. You don't want to get into the flow of the river till you are prepared to walk into the deep flow.

547
01:13:14,690 --> 01:13:24,500
And I think what the Europeans did was that they walked into the into the hard flow of the river without an ability to walk back.

548
01:13:25,160 --> 01:13:33,230
And and what the system I'm proposing is insufficient in the David Vine sense

549
01:13:33,560 --> 01:13:39,350
that it will not allow you to flow into the into the rapid current of the river,

550
01:13:39,770 --> 01:13:50,299
but it allows you to have an ability to test the river in a more robust way and create a structure

551
01:13:50,300 --> 01:13:57,200
of incentives which does not require to you to get into the rapid which which promotes.

552
01:13:59,700 --> 01:14:08,490
A self-correcting mechanism that does not take you into the rapid currents by preventing the excessive accumulation of leverage.

553
01:14:09,690 --> 01:14:13,490
That's the thesis. And I think.

554
01:14:14,630 --> 01:14:18,640
David, do you want to very quick come back? I can see how that could be so.

555
01:14:20,240 --> 01:14:24,070
I'm not convinced that it's adequate. Yeah.

556
01:14:24,930 --> 01:14:35,330
And and I come back to the fear that for ordinary macroeconomic reasons and a fixed exchange rate regime downturns will be very severe,

557
01:14:35,960 --> 01:14:45,340
testing the credibility of a sovereign, even of a very well behaved kind of aggression gone on the street before that.

558
01:14:45,350 --> 01:14:48,350
Enough. And so we're in in the end,

559
01:14:48,350 --> 01:14:59,510
possibly talking about in numbers about there can be winds that push you in the flow that are not a consequence of structures of incentives.

560
01:14:59,810 --> 01:15:03,110
Just accepted. And that's reasonable in a state. Yeah. Yeah.

561
01:15:03,620 --> 01:15:07,550
So that's part of the big issue. So I will open it up.