He that? We can say hello.
For those who don't know me, I'm Calypso Nicholas. I'm Professor here at Oxford on International Relations.
And I'm here really acting instead of Max Watson,
director of the programme on Financial Market here at the European Centre, but also associated with DPR.
And indeed we really are grateful and welcome you today because as we all know,
we're not quite in term yet, but it's really a testimony to our speakers.
Great reputation and attraction power as it were, that you're here outside term.
And indeed we're really very, very grateful for your coming here and sharing your ideas with us.
I think Ashok Modi doesn't need much introduction, but let me just say, first of all,
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,
and he being a professor, a visiting professor at Princeton Woodrow Wilson School.
We talked then, and I know for a fact my little finger tells me, I don't know if you say this in English,
but in French, my little finger tells me that his students love him.
Faculty love him. There he is, a star at Princeton.
And indeed he came to Princeton from a very illustrious career at the World Bank and the IMF,
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,
working with them closely with several countries, including Germany, Switzerland and above all, to Ireland.
And I understand that your biggest link with Max Watson is definitely your joint involvement with Ireland, for better or worse.
Well known, and I'm just joking, so we won't go there.
So there is no question that everybody comes to us, you know, with an enormous amount of experience.
But he's also one of those, you know, person who's not just a technocrat who is not just, you know,
who really, really bridges the two worlds between academia and the Bretton Woods system.
And in doing so, I think he's been very, very creative in his career.
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.
And that's what he's going to present a Schuman Compact for the Eurozone area, this paper.
And [INAUDIBLE], of course, tell us more about the circumstances.
But he's been writing it at Bruegel in Brussels.
And we know that Bruegel is a very influential think tank as we as he and I were just talking about,
not everybody in Bruegel agrees with the paper, which is what makes it exciting.
But he's not presenting the ideas in this paper around Europe.
He was just in London. He's going back to the continent.
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.
And the paper is something, you know, Max and I, you know,
very much full feel we are in agreement with is very much a paper, as you will hear, which sees and I quote,
seeks to make decentralisation more robust that rather than wish it away or rather
argues that this is what the EU should do when coming when it comes to euro governance,
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.
Okay. Okay. Well, thank you very much. I should just start with.
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.
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.
So I would just start with a a an Oxford anecdote.
I don't know how many of you remember Paul Street and who used to be here.
He was one of the great development economists of his generation, somebody I was fortunate to know and in a period.
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.
So by that standard, this has already been a great success.
And so I'm sort of I'm truly delighted to be here.
So let me just start you know,
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.
So the the presumption in this paper is that the architecture of Europe matters both economically and politically,
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,
and if you wish to discuss it in the discussion period that Europe is a continent which has lost economic vitality and
that therefore its long term growth prospects are modest and certainly more modest than a lot of the current optimism,
as David Vines were just saying to me, I suggest, and that therefore,
in a setting where economic growth is going to be relatively constrained, if you have the wrong architecture,
then you run the risk of greater pitfalls,
great greater susceptibility to shocks and therefore greater vulnerability in terms of even deeper growth problems.
And so so the elixir of growth washes away a lot of of institutional ills.
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.
But a lot of the growth forecasts, especially in my meetings in London, are essentially based on what people are telling each other.
That is, everyone says that growth is going to be good because Calypso says it's good and David Vine says Good, good.
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.
So that's that's the premise of the paper. The the content of the paper then has the following structure.
So a lot of people agreed with the first point.
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.
And then there are three points of view.
One is what we really need is now a truly integrated eurozone with a fiscal
with it with a fiscal system that bridges the nations with a banking union,
fiscal union, banking union. And that's where we need to go.
And we must push make a policy effort to push in and direction.
And then when they recognise that that push has not paid dividends, the fallback position is that Spain, Europe always muddles through that.
This is a muddling through process. But fundamentally, we subscribe to a thesis that I call the falling forward thesis.
And the falling forward thesis is, yes, Europe's can loose, but every time it falls,
it picks itself up and moves forward and that this is an inevitable process and it will occur.
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.
Saying we are muddling through based on the falling forward thesis.
And then there is a third group of people who say, you know, if this is not going to work,
we need to break up the euro because unless the Germans are willing to put a lot of money on the table,
why don't we just forget about it and break up the euro?
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,
a United States of Europe, another that muddle through to that vision in some longer time span.
And the third says, you know, this was all a mistake.
Let's just break it up. And my plea and my proposition in this paper is that the first vision of a fiscal union,
I don't even go into the economics of a fiscal union and a banking union.
I am willing to stipulate that perhaps if that was a realistic possibility, it has good economic properties.
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.
When I did a press conference on this paper, kindly organised by Bruegel, it caught a journalist from The Economist asked me,
But the IMF has just put out a paper on the fiscal union and shouldn't we be discussing it?
And I said for ten years during the period that the IMF, that the Europe Eurozone existed, the Article four Report,
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.
The SGP was the the the the was extolled as the basically fundamentally correct structure to to to guide Europe.
Today, when we know that is not going to happen, there are all these wonderfully crafted, elegantly stated proposals.
So he asked me, So is the IMF drinking Kool-Aid?
And, you know, it was on the record and I didn't say it was.
But but but it seems very much like, you know,
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,
that has some degree of policy realism. So.
Where do I come out?
Vis a vis the folks who say that for let's break up the euro.
Might I fall back on the Barry Eichengreen paper, which says that breaking up the euro, the euro was a mistake.
It should never have happened. But now it's here and breaking it up is extraordinarily costly.
And I take that as a statement.
That is valid. Yeah, there are those.
One of your colleagues, Kevin O'Rourke. Even though another of Barry's proteges, like I am, is inclined sometimes to contest that view.
I think that breaking up the euro at this point is a bad idea.
I think that if the euro has to eventually break up.
That that's the the structure that my paper is proposing, which is a more decentralised structure,
will be a a better launching pad for The Break-Up of the euro.
And that therefore, even to break up the euro,
you'll want to first do it a degree of decentralisation that reduces the interconnections that are so embedded in the system.
So I have no I have no sort of claim or proposition on The Break-Up of the euro.
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.
So in that context then. The first proposition of the paper is that the euro was a false promise.
It was a false promise not just in the sense in the in the economics of it, which was very well known,
although in retrospect not well-known enough that there was that there wasn't a clear realisation.
Although Alan Walters, there is this so-called Walters critique, which was not part of the mainstream critique of the euro.
Most of that came from the so-called common currency area ideas.
But but Alan Walter said something important.
And it it has. It has. It has many implications, which is that when you have a fixed exchange rate regime,
there is a tendency in that regime for banks to do expect or to to discount risk,
because they presume that there is a degree of assuredness in the returns and that therefore, if I'm lending to Ireland or Spain,
the risk that that exchange rate might depreciate if they do poorly because it's eliminated, then my risks are also lower.
And so it is a very well established,
stylised fact of emerging market crises that fixed exchange rate regimes and large capital inflows generate big bubbles and big crashes.
But the irony is that this is not just an emerging market phenomenon.
The VRM was an exact replica of the erm crisis of 92, was an exact replica of these emerging market stylised facts.
And, and Europe had just gone through a cry, a preview of the eurozone crisis.
And instead of taking that crisis and saying, you know what, let's step back and really think about it.
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
tied our hands tightly enough and that if only we did our hands even tighter,
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.
Except that what they didn't realise is that if you die something heart to a mast, then something else has to give.
And so the speculation this time was not on exchange rate, but it wasn't sovereign debt.
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.
And hence, the no bailout clause was not just a political convenience, it was an economic necessity.
In its initial conception, then the eurozone was correctly designed.
If I, if I, if I have a fixed exchange rate, then I should allow default on sovereign debt.
So I come back to that theme in a minute, but I just leave.
I say this to you because it also underlines in my mind an unwillingness to learn from Europe's own experiences.
So looking forward, then, the structure that I'm trying to suggest, Europe needs to think more carefully about what property should it have,
and that the three properties I'm just about to list are not mutually exclusive, as you will see,
but they are sufficiently different that they complement each other even though they overlap.
The first is it must be robust that when there are shocks, you don't pull the system down.
The second is there must be a learning process.
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.
And the third is that it must have political legitimacy.
And the political legitimacy reinforces the robustness and the learning process and vice versa.
So with that in mind,
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
forward had to occur up until the point of Maastricht was an easy integration process where there were very few conflicts of interest.
There was agricultural policy about which I know very little, but the trade liberalisation and stuff.
There wasn't a lot of disagreement.
Wherever there was disagreement, it was always the case that national interest took precedence, even in the.
Germany always acted in its self-interest whenever there was a divergence with the foreign policy.
So the fact that today Germany is acting in its self-interest should not be a surprise to anybody.
It is in the nature of the Germans to act in their self-interest at this point.
This is not a a claim to them being virtuous, that otherwise that's what they do.
So so does France. And indeed, there is a question of of why the euro even arose in the first place.
And one of the claims is when American economists looked at the euro and they saw this ghastly structure.
They said to themselves that the only reason the Europeans want to do the euro is that it's a political project.
And nobody. When I started writing this paper, I asked myself, what exactly was this political project?
What does it mean? What does the phrase political project mean?
Other than that, it was bad economics at the end,
and the only sensible way in which it is a political project is that if built into the project was a
plausible learning process of institutional development that would lead to a United States of Europe.
And the argument of the paper is that was never the intent of anybody in Europe who was designing the euro,
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.
It clearly said monetary union. No fiscal union.
The member Peter Cannon had just written is an important paper talking about a transfer union being an essential part of a monetary union.
I could not find that reference to Peter Cannon in the Werner report or for that matter in the Delors report that came later.
There is no there. It isn't even it isn't even acknowledged as a possibility.
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.
And as time went by, the Delors report said something similar.
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.
And so by the time we came to the euro in 1999, this was all gone.
There was no there was no discussion. There was there was never any and there was never any process by which this would happen.
So then the only other possibility left of falling forward is that the designers of the euro
knew and expected that this structure was so fragile that one day it would have a crisis,
and that when the crisis occurred, the necessary well to complete the union would would exist.
Now, however implausible such a conception is,
we have now gone through a crisis and we've seen exactly what happened, that in a crisis, when does a crisis work?
A crisis works. So in America, they use the phrase never waste a good crisis.
And you see in the emerging market context that sometimes a crisis does, in fact, change the dynamic.
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.
And when the crisis occurs, somebody has to say, you know,
it's okay for me to make my interests subsidiary in the greater interest, in the greater good.
Either that or that party whose interests are submerged is powerless, and therefore it has to be in any it can be steamrollered.
So in this case, Germany was not going to be steamrollered.
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.
So the crisis didn't work. So given this history, then.
And and and eliminating for a few minutes a discussion of whether we should or should not have the so.
So now we have two parties. We have we have the muddling through.
And we have the did The Break-Up.
The voices for The Break-Up are coming essentially from the periphery.
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.
It's an empty threat and is completely meaningless because they're not they're not going away anywhere.
They have become so dependent on the triplex of transfers that are coming from the
north that they they have become sort of addicted to those transfers at this point,
and therefore, they are not going away anywhere.
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.
Yeah. So the content I'm going to tell you. Yeah, the content is essentially the idea.
That you do not need a complete fiscal union.
If you allow for the credible no bailout mechanism.
Okay. It's not ideal, perhaps,
but if the if there is a vent for taking the losses in some other place and that one some other
place can only be in the private creditors do either the banking system or do the sovereign.
Then the need to deal with the so called asymmetric shocks is at least partially dealt with at the national level.
So the Delors report asked the following question.
They say perhaps the market should be the disciplining force on sovereigns,
but then quickly waves its hands and says, you know, but markets are sometimes irrational.
And so we need centralised supervision, but centralised supervision.
Has been essentially at best irrelevant and for the most part dysfunctional.
This is not something that I'm saying that is new.
It is well documented and the entire process of the SGP has created a strong incentive for game playing amongst member states.
As somebody who has been on the official side and I have seen these games either in manipulating the deficit
numbers or in manipulating the growth numbers to deliver a 3% number over some horizon that is mutually acceptable.
Nobody believes those numbers, but the number 3% had become such a dominant focal point of discourse in Europe that
pretending that 3% would be achieved was more of an achievement than whether it would in fact,
be achieved or not. And so it became it became a game.
And today we have substituted that with something that we call to pack in six back and so on,
which has which again is something I've not bothered to follow because it is so horrendously complex.
And it's again an instance of doubling the BEPS.
You had a system, the SGP, which was relatively transparent.
It was a stupid system, but it was transparent. You knew what to do.
It was 3%. Now they say now they say we will monitor something called the structural deficit.
And the structural deficit, as those of you who have who have tried to estimate structural deficits,
know that you can make up any number you want and the numbers match.
In fact, that's what they've done recently. And in the structural deficits like they estimated, they wildly silly.
Yeah. And and the numbers change from one year to another.
So we know. And they said, I'm not seeing anything that is not publicly known.
The Irish structural deficits were small before the crisis.
And then after the crisis we look back and say, oops, they were huge.
So it doesn't mean it as these numbers have no meaning.
And on top of it, a committee of national governments,
national government representatives will make the decision whether it is a large or small deficit.
So it's a game they're playing for reasons that are internally static but have no economic or real substantive content.
So the view is Barry Eichengreen and Juergen Hagen had a paper in 1992 saying This is not just a a,
this is not just a costless game, because if you create such a system,
you create a presumption that somebody is minding the shop and that therefore sovereigns are going to have some protection,
that you create a moral obligation that I've been monitoring these guys, and if they mess up, then I start.
I, I have some skin in the game and that skin in the game creates the presumption that they will be bailed out,
then an expectation that is fulfilled later by this, by the whole process.
So it becomes self-fulfilling. So it's not innocuous that you create these centralised systems.
So my view is you don't need it. You don't need it in the good times.
And maybe to the extent it's dysfunctional, let's sort of back off from it.
Instead, then the question is how do you create?
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,
you are the one drinking Kool-Aid because you will never have a credible sovereign bailout that when it comes to the crunch.
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.
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?
The alternative has to be to create huge moral hazard in the system, which is exactly what is happening now.
Some of the optimism in my mind is directly reflected.
It is a direct reflection of the fact that efficient creditors in the euro system have become junior to private creditors.
The signal to private creditors is, don't worry, you will be paid.
If the debt cannot be repaid, we'll take the hit. That's the message and that's the action.
This is no longer now in the in the in the pre-crisis days,
there was an uneasy sense that there was there was a general sense that bailout no bailout would not be implemented.
We've gone through the crisis and we now know that no bailout will not be implemented.
And if you don't have a credible sovereign debt mechanism, that's what's going to be the norm.
And, yes, it will create optimism and it may create growth.
But we went to ten years of growth in the Eurozone.
And when the crisis hit, we were blindsided. And maybe this time is different, but this is where the robustness argument comes in.
You don't want a system where you can have another euro crisis of the kind we've just gone through.
And so you want to protect yourself from it, however good that the immediate future looks.
So no say a vastly reduced centralised surveillance, perhaps something like a think tank, like a fiscal council,
but not somebody who is monitoring and reporting with endless reports and back and forth to Brussels.
A it's a sovereign debt mechanism. And my proposal for that.
And Professor Vines, oddly enough, was also a discussion on an earlier paper in which I gave my view of how to create credibility.
And I could discuss more about it. But I say briefly what my proposal is that every time a sovereign issues a bond,
the contract stipulates that there will be default in certain states of the world,
that if XYZ that transpires in terms of debt levels are price levels.
And we can talk about what what triggers it.
But there should be no option but to negotiate, to restructure the debt and that the restructuring then gets priced into the debt issuance.
So the first reaction to that is, oh, but that's going to raise the cost of issuing debt.
And I say, good, that's that's the debt. You did your job.
You have a subsidy in that debt, which is not being priced because there is a presumption of bail out.
And you want to make that subsidy explicit by pricing it, because there is a huge externality cost of it here,
which is when one sovereign begins to teeter, others begin to look weak.
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.
I call this sovereign Cocos in the spirit of Bank Cocos,
which is that they have a contingent convertibility into a different form and different terms, easier terms of repayment.
That's a whole another paper. And again, depending on the interest I'm happy to talk about.
So the fiscal union then has a fiscal a loose fiscal compact agreeing to gender norms of good behaviour,
but then letting countries do whatever they want within that disciplined by a sovereign debt contract,
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.
The the paper was written a few months before the most recent developments,
and I'm pleased as an author to conclude that pretty much what this paper predicted has happened,
not as somebody who cares about Europe, but certainly as as somebody who would who was thinking about these issues,
that there would be an intergovernmental compact, an intergovernmental agreement,
because that's the only thing the Europeans can agree on, that there'll be no centralised pool of funding,
that there will be an enormously complex governance system to ensure that all
parties in the system are protecting themselves against all kinds of eventualities,
a complexity that essentially renders it ineffective, useless and perhaps worse than that, and that therefore we are back to square one.
And square one is that we have national resolution legislation and we need to start closing banks down.
So the entire premise of the banking union discussion is that something will happen in 2008.
Well, something will happen in 2013 and in 2014 X-Y-Z will happen and by 2016, X-Y-Z will happen.
In the meantime, the banks are still bleeding and the system we the Europe eurozone recovery has
already been weaker than the Japanese recovery in the so-called Japanese last decade.
And today, as we stand, the European financial system is weaker than the Japanese financial system was at this point in its recovery.
And we know and we know that that weakness of the Japanese financial system constrained it for several years beyond that.
So we are already baking in with our delays and procrastination, a growth process that even if even in.
There was great vitality in the system.
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.
So the hard thing has to be done, which is banks have to be closed.
Lots of banks have to be closed. So then the question is, yeah, but who's going to pay for the closing?
And the answer it is everything in the end seems to centre around this vexatious question of who is going to pay for it.
And the answer is that some people took bets and those bets went bad.
And we need to share the losses. Nobody has to pay for it.
In some sense, the creditors of the banks have to take losses, and that's in my mind.
Eventually, some form of massive debt equity swap has to occur that people who made these banks have to say,
We told you no, guys, we all got into this together.
You made bad bets and you have you claim that I owe you €100.
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.
If I don't, you make a loss and I make a loss. And so we have to renegotiate those contracts.
I'm not saying it's easy. I'm not saying it's pleasant.
I'm not saying it is. It will not create its own distortions.
But that is where we are. We are in this situation.
And I am not able to see unless the elixir of growth works in a way that I do not anticipate.
Remembering that this was also the mantra in the Japanese process that every time there was this growth that was going to rescue things,
if growth emerges, then none of this is relevant, then none of this is relevant at least till the next crisis comes.
But if growth does not emerge, then some form of loss of recognition through debt equity swaps has to occur.
There is a continued ambivalence on debt restructuring, even in the banking sector.
Despite brave talk, the directives have a million exceptions about how risks of contagion might do this, that and the other.
And on sovereign debt, we we have essentially re-established the claim that sovereign debt is risk free.
I'm stating it a little more strongly than the European authorities will will feel is fair to them.
But in effect, that is the de facto principle around which Europe is again operating today.
So let me conclude by saying. That.
As somebody who is at once an outsider to Europe,
but who is also as this enormous respect for the European project as an instrument of of high ideals and peace,
and wishing that it be successful in those dimensions in which it has truly shown itself to be distinguished,
that the pursuit of this ill fated euro project is not only a cause that is undermining the economics of Europe,
but at a time when we need more of certain valuable dimensions of Europe, it is beginning to potentially erode even those gains.
And today and I'm not a political scientist, so I'm now trespassing a little bit into territory that I should not.
The mainstream monopoly on the mainstream parties have decided to vacate this area of
discourse and are allowing fringe parties to be more influential than they deserve to be.
And if we do not create a functional decentralisation,
one where the sense of dependency and humiliation that is currently characteristic of the dialogue in Europe is eliminated,
then the likelihood that the fringe parties will gain greater ground and influence the nature
of the eventual outcomes in a way that we will all ultimately agree is a loss for Europe.
That probability continues to grow and so the wiser counsel at this point would be to take a deep breath and say,
yes, maybe there is some greater vision of a United States of Europe at some point.
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.
Let there be a cleansing of the losses that have been accumulated through this process.
And perhaps if Europe begins to re-emerge as a more vital economic region and where the political divisions become less acute,
they may come another day when the march to a United States of Europe continues.
I'm not therefore saying that that should be the outcome or that is even the preferred outcome.
But what I am saying is that for those who see that as an important goal for Europe, even to them,
I say that the current unthinking drive to that system is proving ultimately harmful to your own project.
Let me stop. I thank you so much for, I think, this very, very clear exposition.
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.
But of course, you've had to skip important elements of it, even historically.
And for instance, your analogy with the pre-war US system.
You didn't say anything about that.
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.
And I really encourage everyone to do so. But and indeed, including on the politics of all this,
because your common sense and insight is certainly greater than that of many political scientists that I do know now.
It's very much appropriate that David would be your discussant indeed.
Not only because he's been a very,
very strong pillar of PFM and accompanying it from the beginning and working with Max and all of us and of course, professor here,
and economics and macroeconomics,
but also because recently he has become the director of ethics and economics at the James Martin School Institute for New Economic Ideas.
And that's also an interesting dimension to what we do in Oxford.
I think to convey your ideas there will also be interested, and perhaps most importantly, because David has written a recent book which again,
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.
And I think there's no better recommendation than Ashok,
who was I heard earlier say that it was one of the best reading on his reading
list for the students because it was so engagingly written and all of that.
So so in recommending your book, David, and turning back to you, I'm sure you will.
It's a lot about this process.
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,
and what you've just heard has been a really, I use your words, a very powerful political economy,
talk quite deliberately that rather than a detailed technical economics talk.
And you phrased your thing very well at the beginning by saying the three possible
options rapid fiscal union muddling through or Break-Up you ruled out the first.
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.
And we'll talk about that at the end. But let's agree to rule out the first no rapid fiscal union.
Let's agree that muddling through is a mess and will probably lead to crisis.
And so we're left with break up. So it's just crisis as a result of muddling through or Break-Up unless we
invent something else and you very persuasively argue the need for a new way.
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.
Here it is. Voila. So I think there needs to be some economics now to supporting that political economy.
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.
I have to ask you to listen to me for a minute. That's a big claim.
So I have to try and explain why I say that there's the macroeconomic problem caused by the link.
And and let me do this as quickly, but as carefully as I can.
Why? Because made a strong claim.
There's a macroeconomic problem caused by the linking of separate countries with separate labour markets within one monetary system.
Now, there are two points of comparison for that.
There's a separate country with a floating exchange rate that can pursue adjustment by means of cheapening its currency during the adjustment phase.
Think of the Asia crisis. It may need liquid, probably does need liquidity support from the IMF or wherever,
which would be repaid by domestic taxpayers or it may need sovereign debt.
Write down and Kruger that whole drama may be not just liquidity but sovereign problem and it's.
Banks may be sufficiently hedged or not. In the latter case, there's a whole bank resolution issue required.
That's a country with a floating exchange rate.
Separately, separate, separate a government.
Or there may be separate regions with an individual,
individual country which can pursue adjustment through labour mobility between the regions difficult and through fiscal insurance.
Absolutely. Central U.S., Australia, Canada.
They may need a liquidity support from the Central Fiscal Authority.
South Australia had a banking crisis. That's what happened to American stories.
And they may need insurance and transfers. They're the points of comparison.
A country in a monetary union can't do this. They have these mechanisms of adjustment.
The competitiveness adjustment process will require a very long time.
We go back to how difficult it is to adjust wages.
All this discussion, all these hopeful discussions about wage costs in the European South coming down, it's very, very slow still.
Furthermore, that the debt overhang caused by all the borrowing being being denominated in them,
essentially the foreign currency, the euro, like the Asian crisis, that there'll be a need for liquidity financing.
That's to say fiscal lending to support indebted governments.
And because adjustment will take time if they need to go on saying this,
they will almost certainly at present be requirement for sovereign debt write downs.
What we're seeing in Europe and for bank restructuring and if the shock is large,
that if the shock is large and all these problems are much more difficult than in
the separate country case can devalue or the region willing in a country case,
you can get in your car and move to the other cities.
Now, Ashoka says rightly deals with how difficult it is proving to bring about the two necessary things in this in this monetary union.
Fiscal. These are fiscal union and banking union.
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,
ie liquidity financing. Automatic stable stabilisers could work all those things.
It would enable one off transfers, insurance payments when when there's debt problems,
and it would have longer term rebalancing mechanisms so that the transfer was not permanent.
Just notice in passing. That's rather a different list from what German people think of fiscal union involves.
But that's what you need in a fiscal union. The ability to do macroeconomic management.
That's what a fiscal union has to be.
Just as with IMF programs, there will be intrinsic problems in determining in each crisis case,
the extent to which the crisis can be allowed to be just a liquidity crisis.
The crisis with the automatic stabilisers working and governments in difficult situations,
borrowing and going on borrowing and the adjustment takes a long time in going on borrowing and that will
end up being a solvency crisis set of circumstances in many cases in which this need for forgiveness,
for sovereign debt, reconstruction, all of Ashoka stuff will need to be.
That's to say, of debt forgiveness needs to be part of that fiscal union process.
So I'm already saying what I'll say in the end,
his his proposals are necessary for anything that works necessarily with and I've taken this very much from the earlier paper of yours,
which you persuaded me of this, and you'll hear me saying at the end, necessary but not sufficient.
Let me keep on going.
He describes the the the the the burdens which are being imposed imposed on borrowers by refusing to recognise the need to restructure.
And you also described the moral hazard, which this is encouraging.
And lenders need to be these things extraordinarily difficult to bring them about.
They'll also need to be a bank.
Banking union to include not just common ex-ante surveillance, but common ex-post resolution of difficulties in which the losses are pooled.
That's the that's the deal that's necessary for that first hopeful thing, which you don't think can work.
And you've described the difficulties of negotiating this since it seems all of this is fundamentally built on fiscal sharing processes,
and the banking union rests on that, too, because in the end,
the wreck the resolution mechanism has pulled losses and that's got to be underpinned going to.
Yeah. Go. So, so difficult.
Your proposed solution is one of decentralisation.
There would be no attempt to. Now I'm in danger of caricaturing.
No. No attempt to. To impose a fiscal union and no intent attempt to impose a banking union instead.
And I quote because this I've seen this. More or less identical sentence in your earlier paper.
And it's the core of everything here,
where countries have given up the flexibility of exchange rates and and lack the central funded fiscal capacity to absorb absorb shocks.
Such countries require the buffer of sovereign debt restructuring core.
Again, the you'll see me saying necessary.
We're asking is it sufficient which if your claim each sovereign would have the responsibility for its own banks?
Notice, of course, that that would increase the vulnerability of each sovereign, because when,
as I'll describe in a minute, things get bad, the banks get bad, which make them even worse for the sovereign.
It's taken me an awfully long time to get to comparing that with the previous ideas how they work in countries which
have sensible systems and how they're meant to work in a monetary union with a fiscal union and a banking union.
I'm sceptical the ashoka's think is sufficient.
Consider the current difficulties collapse has prevented.
Now I'm describing why what we're doing at the minute requires more fiscal union than we can see in his paper.
Just look at what's going on at the minute. Consider what's happened.
The collapse of prevent has been prevented by OMT.
Draghi saying, I'll do everything that it takes. And that has in turn been implicitly under underpinned by some kind of fiscal union.
Yeah. And there's a lot of discussion about ex-ante exposed, real imaginary promise.
Will it be reneged on? But in the end, the huge balance sheet of the ECB has to end up somewhere.
So the sum. So you don't want that?
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.
You would probably agree without it we would have had a crisis. But I won't say any more on that.
Sovereigns would become without this, sovereigns would become highly risky.
And banks, depending on their own sovereigns would become risky and we'd be in danger.
And here I'm trying to now make the real point about the difficulty.
We'd be in danger of having a monetary union that wasn't really a monetary union.
Just remind yourself of the slow speed of adjustment.
Can't devalue, can't get in the car and drive somewhere else. This takes five or ten years.
The wage adjustment. Just such a system would be fragile and possibly unstable.
So I've taken an awfully long time to get to this final point.
Central argument. Just imagine I shall, quote, set up the system and everyone knows that there's risks.
And so this isn't risk Greece. The sovereign debt isn't risk free.
And the banks have got all this risk and we sell the stuff and we set off happily at the beginning.
Now, now, let there be a downturn in one region. Just ask yourself when and before there are Cocos.
There's all that stuff in place. But now let's turn on the camera and let time run.
Let a country have a downturn, can't devalue, and it's really difficult to adjust its costs.
So the downturn will be prolonged. This is just the gold standard.
But that's that's just rhetoric. This is prolonged, difficult adjustment.
But that will make the sovereign revenues fall and that will create fiscal risk.
It will require cuts, worsening a slump and make the sovereign reverend revenue fall even more.
What does the sovereign need to do in these circumstances? Needs to borrow.
Who from? What does the country need to do?
Needs to borrow? Who? Let's suppose that now let's let's make this always best to consider a case that might work.
Let's suppose that over time, the fiscal adjustment really would be possible.
All this country needs is liquidity financing during the adjustment period.
Would you lend to this country? Would you lend to.
Would you keep your deposits in the banks in this country? Would you hold bank shares of the banks in this country?
Now I'm speaking in shorthand. I'm describing a multiple equilibrium.
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.
This nation is on its own. We look up Washington and we figure out, darling, the IMF, we can't do it inside Europe.
Where is this? And we know from the Asia crisis that in these circumstances,
even when there's not a risk of a solvency crisis, liquidity crises can occur because of multiple equilibria.
That's the risk. That's that's what I'm worried about.
And so I think what you've said is necessary, but not sufficient.
I think the task is even harder than in your paper.
The willingness all the way back at the beginning, I said, what a mess.
Agreed with you. What a mess we're in. And moral hazard. And there should have been more debt write down earlier.
It's clearly necessary. What I've been saying here is I'm not yet persuaded that it's sufficient.
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,
which is muddling through, because in the end it won't work.
We're driven reluctantly back to trying to invent some mixture of your ideas and fiscal union and banking union to make it work.
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?
And it may be in your final sentence of your paper that we are just stumbling forward to a fatal fall.
And and I'm afraid I don't think your paper helps us. And maybe not enough.
I think you are absolutely right. Necessary, but not sufficient.
Maybe not. No, no, no. I should I take it in the.
I'm first of all, I'm really happy to hear the comments.
And, you know, as Calypso was saying, I do feel I'm amongst friends, so I and I and all that spirit.
Yes. So I'm totally comfortable with with your conclusion in the in the spirit in which it has been said,
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.
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.
So that distinction is an important one. And the second is between liquidity and solvency.
There is there is a clear there is a clear instrument or institution for managing liquidity in the system, and that is the ECB.
The problem in the euro area has been that liquidity and solvency have been conflated.
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,
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,
which is forgiveness of official sector debt,
is creating a presumption that there will be a floor below which private losses will not be allowed to follow.
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.
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.
A central bank provides liquidity to deal with panics.
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,
you amplify the solvency problems into a contagion like phenomenon, whereas the contagion arises essentially from liquidity considerations.
Now, separating solvency and liquidity is not always straightforward.
We know that as practitioners on the operational side, but that is ultimately what the practitioner has to do,
not dead for do to occupy the territory of solvency as as a pre-emptive measure,
but to to make that decision on all on a practical and considered basis.
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,
where there were no fiscal transfers, where that was a clear assumption of no bailout.
And there was a central bank which in a way was much more dysfunctional than the ECB today is.
And so, at least in one sense, you create a model.
You create a monetary union which is superior to the monetary union that existed in the United States before the Depression.
If there are outside outsized shocks.
It is still David's claim that they structure it pre depression.
The US monetary union is insufficient. It is presumably a plausible thesis, one that certainly no one should or should disregard.
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,
and that the entire the extraordinary leverage that exists today would be scaled down so that the the incentives to accumulate the
levels of debt that we just saw and therefore create a condition in which the panic has as real repercussions that would be dampened.
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.
The Buddha said that when you walk into a flowing river, you should walk only to the point from which you can walk back.
Hmm. You don't want to get into the flow of the river till you are prepared to walk into the deep flow.
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.
And and what the system I'm proposing is insufficient in the David Vine sense
that it will not allow you to flow into the into the rapid current of the river,
but it allows you to have an ability to test the river in a more robust way and create a structure
of incentives which does not require to you to get into the rapid which which promotes.
A self-correcting mechanism that does not take you into the rapid currents by preventing the excessive accumulation of leverage.
That's the thesis. And I think.
David, do you want to very quick come back? I can see how that could be so.
I'm not convinced that it's adequate. Yeah.
And and I come back to the fear that for ordinary macroeconomic reasons and a fixed exchange rate regime downturns will be very severe,
testing the credibility of a sovereign, even of a very well behaved kind of aggression gone on the street before that.
Enough. And so we're in in the end,
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.
Just accepted. And that's reasonable in a state. Yeah. Yeah.
So that's part of the big issue. So I will open it up.