The Big Question: What Would It Take to Save the Euro?

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Hal Weitzman: The eurozone increasingly resembles a bad disaster movie. Whenever the apocalypse appears to have been averted for the umpteenth time, another calamity rears its ugly head. In the past few months alone, we’ve had a banking crisis in Cyprus, political stalemate in Italy, a government program to cut public spending declared unconstitutional in Portugal, and a German public increasingly unwilling to bail out its southern neighbors. The issue seems less about if a country will leave the eurozone and more about who, when, and how.

Welcome to The Big Question, the monthly video series from Capital Ideas at Chicago Booth. I’m Hal Weitzman, and with me to discuss the issue is a top-notch panel.

Anil Kashyap is the Edward Eagle Brown Professor of Economics and Finance and the Charles M. Harper Faculty Fellow at Chicago Booth and a faculty director of the Initiative on Global Markets. He’s also an advisor to the Federal Reserve, the IMF, the Congressional Budget Office, and the Swedish Central Bank.

Veronica Guerrieri is a professor of economics at Chicago Booth. She’s a faculty research fellow at the National Bureau of Economic Research and the recipient of an Alfred P. Sloan Research Fellowship.

And Hans-Werner Sinn is president of the IFO Institute for Economic Research in Munich and a professor at the University of Munich. He’s the author of several books, including The Green Paradox, Casino Capitalism, and Can Germany Be Saved?

Panel, welcome to The Big Question.

Anil Kashyap, let me start with you. Was the euro always doomed? Was it ever going to be possible to have a monetary union between countries like Finland and Germany and Cyprus and Greece?

Anil Kashyap: Well, they knew it was gonna be risky when they set it up. There were protections that were taken that were supposed to prevent some of the things we ran into. So there were controls on how much debt countries could rack up and what kind of deficits they could run. Unfortunately, many countries, including France and Germany, breached those rules in the middle of the last decade. And when they did, they decided to waive the penalties. And that was the beginning of the end.

Hal Weitzman: So there was no discipline right at the start.

Anil Kashyap: Well, three years before they failed the discipline test.

Hal Weitzman: OK. Hans-Werner Sinn, do you think the euro was always doomed or could it have been a great . . .could we have been talking about a great success by now?

Hans-Werner Sinn: Well, it was not always doomed. Actually, I endorsed the euro very much when it came, but nowadays you have to be a muzzle case to think that it was a good idea to have the euro.

It includes too many countries and it’s brought about too much careless investment across the borders. That’s what we know now has been the major problem. A credit bubble was being created in Southern Europe, which turned out to be inflationary and deprived the south of its competitiveness. This would not have happened had the Maastricht contract been taken seriously, which says countries can go bust. And if they go bust, there will be no help. Had that been taken seriously, the investors would have known there was a risk and they would not have come in the first place.

But the actual policy of the EU was to undermine that and say, oh, please come and go. Everything is safe. There was an implicit bailout guarantee in the background. And that lured too much capital to the south, which created all that mess.

Hal Weitzman: And talking about bailouts, the most recent kind of rather botched bailout was Cyprus. And they responded to what was a potential banking run, Veronica Guerrieri, with capital controls. And some people say that effectively means they have already left the euro.

Veronica Guerrieri: Well, I don’t think so, meaning that I think the core of a monetary union is actually having a fixed exchange rate, and that is not a problem with capital controls. There are many examples of monetary unions or systems with fixed exchange rates that have been exposed to limited capital controls, like if you think about Bretton Woods for example.

So the problem is instead that when the euro was formed, I think the hope of having integration in capital markets was one of the main objectives of the euro. So with capital controls, the main advantages of having a euro, a monetary union disappears. And so then the question is: Is it really worth it to have a monetary union with capital controls?

Hal Weitzman: Anil Kashyap, what’s your view on Cyprus, whether it’s still effectively in the euro or not?

Anil Kashyap: Well, I think the Cypriots are gonna suffer greatly, whether they stay in or go out at this point. Whether they’re in or out, it doesn’t matter so much. They’re gonna have a horrifically bad recession. It’s gonna linger for years. Getting out’s gonna mean that they have a bunch of inflation. They’re gonna have terribly high unemployment. They’re gonna be in a very bad way, as will Greece. So if one of these weak countries leaves, it’s not like all of a sudden the deeper problems disappear. And so, if it was that easy, someone would have left. Snd the public probably doesn’t want to leave still in Cyprus or Greece right now.

Hal Weitzman: Hans-Werner Sinn, what should we make of the way that policy makers responded to the crisis in Cyprus? They initially said that everybody would suffer including very small depositors in the banks and then they later recounted. But did their actions make bank runs actually more likely across the eurozone?

Hans-Werner Sinn: Yes, of course, because there was after all a haircut at the expense of the depositers, but how can you avoid it? If banks are bankrupt, they are bankrupt. If a country is bankrupt, it’s bankrupt.

The deposit insurance system of Cyprus is bankrupt. So it was the Cypriots’ own decision to involve the small depositers, which was not a good decision. And I’m glad that this has been changed now that the losses are concentrated on the big investors in Cyprus.

It’s a mess, but you know, that’s very natural in a sense because there is no one else who is willing and able to foot the bill. Cyprus, OK, is a small country. You could give it more than it has received. But think of other, bigger countries, which are in similar problems. One cannot reduplicate these decisions. Cyprus has already received more money than people know. One speaks of €10 million. In fact, they have received another €7 million targeted credit, so extra refinancing credit from the printing press. And another €3 million has been awarded already or allowed after these decisions. So we are talking about €20 billion of credit to Cyprus, which is 120 percent of GDP and twice of what is publicly known.

Hal Weitzman: So in fact, was that a model? Could we see that kind of bail-in being used—

Hans-Werner Sinn: Well, I would say there’s way too much taxpayer money involved, in so far I just like to call it a model. On the other hand, given the expectations that there would be a bailout with taxpayer money entirely, it’s an improvement.

It’s a turnaround in the ECB policy and the euro policy, because this is the first time the depositors will also have to share the losses. And this is, I think, the most natural solution. If a bank has negative equity, It has to be refurnished with equity.

Who should bring the money? People who are not involved from other countries or those who invested their money in the bank? Clearly those, the latter ones. There is no alternative to big-scale debt-equity swaps of the kind which we have seen in Cyprus.

Hal Weitzman: Veronica Guerrieri, was the right thing done in Cyprus in the end?

Veronica Guerrieri: In the end, I think so in a sense that I’m also glad that the poorer depositors were saved. And, but on the other hand, it’s true that the banking system in Cyprus was eight times the GDP level, and so it was clear that it needed to be downsized. And without a banking union, that could be an alternative in Europe, that would’ve not been sustainable.

Ex ante, I mean, the first attempt to [inaudible] all the depositers I think was much more problematic in terms of contagion of bank rush or at least risk of bank rush in the rest of Europe.

And that potentially could—

Hans-Werner Sinn: May I ask you a question? What about Luxembourg? There the balance sheet of the banking sector is 22 times GDP, not eight times as in Cyprus. What’s your opinion?

Veronica Guerrieri: What do you mean? If I think that it needs to be downsized or not?

Hans-Werner Sinn: Yes.

Hans-Werner Sinn: Well, I mean, it is at risk. Not now because Luxembourg doesn’t have a problem, but in it’s case, it more for sure is a country that is sensitive to a shock that we cannot predict right now. So I think that it is too big a banking system for a country that is a standalone country and so needs to be ready to protect at least part of the depositors. It may be a problem.

Hal Weitzman: And that point is critical, isn’t it, Anil Kashyap, because a lot of focus has been on Cyprus or whoever the risky countries are at the moment, but there are a huge number of risks to the eurozone. Talk us through which you think are the most important at the moment.

Anil Kashyap: I mean I think the uniting theme is political illegitimacy for the whole project. I mean the public wants the euro when you put it that way, but they don’t want any of the things that would have to come with the euro.

And so it’s kind of a race between the politicians who keep hearing, the public wants the euro, wants to keep this together, and doing everything they can, and then ignore some of the costs where you have, you know, youth unemployment rates in Spain and Greece and Portugal that I think are coming close to what a democracy can tolerate.

And until they can come up with some way to get growth going, I think this is gonna be very, very hard to sustain. And most of the things that are being discussed aren’t really gonna help growth.

And so it’s kind of a matter of time, in my mind, before we reach a snapping point, and it could come in any of many countries, but essentially all of them that are depressed.

Hal Weitzman: OK, but you’re saying there’s a sort of a political factor that’s not been tackled yet.

Anil Kashyap: Yeah, never right?

Hal Weitzman: Selling the project.

Anil Kashyap: Yeah, never, right? There was never an up or down vote in most of these countries. And Greece showed that the public was willing even in difficult times to say they stand behind the euro, but then immediately afterward, when they had to follow through, the follow-through has been pretty weak.

And the government in Portugal is very committed to the euro project. They’ve been willing to impose a lot of austerity, and now their courts are rejecting it. The voters in Italy rejected everything that has to go. I mean, it’s a theme that most of these countries—

Veronica Guerrieri: There’s growing resentment in all the countries, both the southern countries and the northern countries, for different reasons, but the facts are a big political backlash that can be dangerous.

Hal Weitzman: So ultimately is it politics that could sink the euro rather than economics?

Anil Kashyap: In the end, countries stop paying when they don’t want to pay. I mean, these countries can pay a lot more, at least to some degree. And there’s a lot of private wealth. There’s a lot of tax evasion in many of these countries, where if you could get your hand on the tax revenues, things would look different. But they’re not prepared to go there yet.

Veronica Guerrieri: I think also on an economic point of view, I mean, another important factor that we missed since the beginning of the euro is that typically to have a well-functioning monetary union you need also some fiscal transfers, or some form of fiscal union, and that is something that is missing. And hopefully it’s something that we are going in a direction to, and that could also be important to save the euro.

Hal Weitzman: Hans-Werner Sinn.

Hans-Werner Sinn: No, I disagree. I do agree that in the end, we need a political union with fiscal transfers, but I strongly disagree that we can adjust fiscal transfers.

Basically, what we need, if we want to have fiscal transfers, is a binding intertemporal insurance contract, and only the creation of the United States of Europe would be doing that. What some people want is the transfers without these obligations and without signing the insurance contract. That I find difficult and that is the deeper reason. It’s a bit like a marriage. She likes him, but he likes her money. She is not so beautiful. And the question is, will the money be transferred before the marriage contract is signed? That is the deeper European problem.

Hal Weitzman: Right, unlike the relationship that you described, though, there seems to be a lack of sort of will to really stay together. Isn’t that the point that neither—

Hans-Werner Sinn: Yeah, it’s not a love marriage. That is the problem.

Hal Weitzman: A loveless marriage.

Hans-Werner Sinn: And we are not behind the veil of ignorance where we could make an insurance contract. So there’s very much known redistribution, contrary to the Maastricht Treaty. We have in the Maastricht Treaty clear rules that exclude this redistribution. And to introduce that now, retroactively on the way, is a little bit difficult, in particular since the rescue money will not flowing from rich to poor countries, but from poor to rich countries, as we know now.

The ECB has just yesterday published a report on the wealth levels of the European countries. And it turns out that those countries who you think were needy have the highest level of personal wealth. The Italian wealth, for example, is much higher than the German one. The Cypriot wealth per household is €670,000, while the German one is €190,000. And so the question is really why not a wealth tax in Cyprus would have been possible to solve the problem? Why do you have to tax the people in other countries of Europe?

Hal Weitzman: And that raises an intriguing point, Anil Kashyap, because a lot of the focus has been on Southern Europe and whether Greece or Cyprus might exit the eurozone. But what about a Northern European country, for example, you’ve talked about Finland could possibly exit.

Anil Kashyap: Well, if a country that’s got sound public finances wants to get out, the exit can be arranged in a much more orderly fashion. They can leave. Their currency would appreciate. To the extent they owe claims to others in euros, they’d be able to afford them.

If one of these weaker governments leaves, their currency depreciates. Everything they owe in euros becomes all the more burdensome.

So if you were gonna try to organize an exit in an orderly way, it’d make much more sense for one of the better-run countries to get out than the less-well-run countries.

I think, right now, the Finns are probably not gonna wanna pull the trigger on doing this, but you get this accumulation of all these claims on: We need more help. We need more help. We can’t do it. And at some point, you may reach a breaking point.

Hal Weitzman: Veronica Guerrieri.

Veronica Guerrieri: Yeah, I was thinking about, there would be a problem also for a wealthy country like Germany or Finland to exit, I think, for the banking system, because they have all these assets denominated in euro. So there’s gonna be some uncertainty about what happens. Are they’re gonna stay, are they gonna be converted in marks, or are they gonna be left in euros? In one case, you have a tax for depositors. In the other, you have possibly a bank crisis. And so that—

Anil Kashyap: It’s not free. But the fact of the matter is the reason why one of the sounder countries will leave is because they perceive staying in as getting a huge bill to bail out someone else.

If I was sitting in Finland and I had the choice of bailing out my own banks, getting a divorce once for all and be done versus continually being asked to send money to some country with which I have nothing in common. At some point, that conversation—

Hal Weitzman: And presumably the proof of the pudding would be whatever happens to the new national currency that they adopt.

But Hans-Werner Sinn, you referred to the ECB report. Are we wrong to think of a country like Finland or Germany as a wealthy country?

Hans-Werner Sinn: Yes. That’s what the report showed. Finland, in particular, has a very low private wealth relative to the rest of the eurozone. I know the number precisely now for Germany. Germany has €190,000 per household, while Cyprus has €670,000, more than three times as much. And it’s a little bit awkward to ask Germans to give away their wealth in order to bail out Cyprus, when the rich people in Cyprus are not willing to participate. I think this new ECB report, which was just published and which was held back actually during the time of the Cyprus negotiations, will change the landscape a lot in Europe.

The problem in Europe is that some countries had an underdeveloped tax system or were not willing to tax private households. And therefore, these people were able to develop a lot of private wealth while at the same time the government was financing itself by borrowing.

So you have a strict correlation between high public debt and high private wealth. And therefore, it is not appropriate to solve the public debt problem by mutualizing the debt in Europe, as some people argue.

Hal Weitzman: And we’ve had some research coming out of Chicago Booth that has shown the extent of tax evasion in countries like Greece. So that will maybe explain some of the figures that you talk about.

I wanted to ask another question, though, with the focus on a Southern European country possibly exiting the euro, is it possible for a country to leave a currency like the euro and then come back in, Hans-Werner Sinn?

Hans-Werner Sinn: Yes, of course it is. Take Cyprus. Everyone knows, of course, if you talk about exiting, there will be a bank run, lots of disturbances, and so on. But all these disturbances we have seen in the case of Cyprus, and there are now capital controls, and that’s it. If Cyprus now decided to exit, there would not be any additional turmoil to the one which we have seen.

I don’t want to downplay the difficulties, but one has to see also the difficulties if the countries stay in. If you give a guarantee to be a member of the club, whatever you do, then that’s the recipe for a maximum of moral hazard. Any club needs rules and needs exit conditions. If you don’t obey the rules—this is true for countries like Germany and France that violated the rules—there should have been stricter consequences. This is true for others.

Hal Weitzman: But what about the coming back in part?

Hans-Werner Sinn: You know, the problem in Europe is that the credit, which the euro brought, the cheap credit inflated these countries. It created a bubble that burst, and now they’re all sitting there with prices and wages way up in the sky. They’re too expensive. They have structural current account deficits and they have to get rid of these high prices.

But prices cannot easily fall because households and firms are overindebted. That was the reason for the bubble. So if you cut their nominal incomes, they will go into private bankruptcy. So it’s very, very, very difficult to do that. And an alternative would be to inflate the core, but the ECB is not allowed to inflate the core. It’s only mandate is to keep the prices constant.

So logically, only the exit and the reentry at a new exchange rate would be a possibility. And I think this reentry possibility is a very good option for the countries to give them a future. In the moment for Greece, there is no future. We have youth unemployment approximating or moving toward 60 percent. It’s a catastrophe inside the euro. And the only hope for these countries and the population would be to take more radical moves.

Hal Weitzman: Veronica Guerrieri?

Veronica Guerrieri: I disagree in a sense that I think of course everything is possible, but I think that the euro system has been designed as a quite rigid system.

And there are other types of monetary unions that are more flexible, like with a fixed exchange rate, and Europe has experience with that before the euro. And it was not a big success. It was a disaster because once you have deposit, one, investors anticipate that the countries can exit and enter. Basically it means that there is a flexibility that is taken into account, an expectation. This can generate speculative attacks.

And so I—

Hal Weitzman: So you would expect that if a country leaves, that’s it.

Veronica Guerrieri: No, what I expect is that that would be a much more unstable system, and so it would not be the best option for the European Union.

Hal Weitzman: Anil Kashyap, you said it will be hell for Cyprus whatever happens, but would it be better for the euro if Cyprus or a similar country were to leave?

Anil Kashyap: Yeah, but they need to fix the underlying problems. Kicking out one or two isn’t gonna do it. And Italy and Spain have real problems, and they’re big, and it’s not gonna be easy to get a divorce from Italy and Spain.

I think if we were starting from right now, maybe you could have two currency blocks, one for the better-run countries and one for the less-well-run countries.

Hal Weitzman: A two-speed Europe.

Anil Kashyap: Yeah, and you’d maintain the freedom of goods and labor mobility and all of that. But you’d basically not try to impose one set of rules for two very different sets of countries.

So I don’t think just getting rid of Portugal and Cyprus and Greece is gonna fix anything. The problem is Italy and Spain, and there’s no easy way to do that part.

Hal Weitzman: Hans-Werner Sinn, last year the European Central Bank said it would do whatever it takes to save the euro, and that reassured people. And now, of course, there’s panic again. What would it actually take?

Hans-Werner Sinn: The euro will only have a future if it is possible to make the southern countries competitive. And that means basically reforms that make the wages flexible, to be concrete. Let the wages fall so that the prices fall, and they get real devaluation inside the eurozone.

I’m very skeptical that it will work, but I see only this possibility, and the alternative is to inflate the core. We have to change the relative prices. Maybe we need a little bit of everything, a little bit more inflation in the core, a little bit of austerity in the south. But if you push it too far, you create too much mess, unemployment. So it’s a very tricky thing, and whether the solution set is really available or empty, I personally do not know.

And I think each country itself has to decide what it wants to do, whether it wants to stay in or out. I would not think that Finland or Germany should leave or other countries because, after all, the euro is a good idea. You can do the euro with a limited set of countries.

Whether you will have two zones, yeah, that has been discussed in my country a lot. I hesitate, though, because it will probably mean that France would belong to the south. And then we would have a new border line at the River Rhine between France and Germany. After all, it’s also a political project.

So my idea would be more to shrink the euro a little bit and hope that the remainder who is in the euro will make it through a decade of stagnation with lower inflation, which gradually makes it more competitive.

Hal Weitzman: You talked about reflating the core. A lot of people have pointed out that if Germany only loosened the reins on spending a bit, it would help the entire euro project.

Hans-Werner Sinn: What brings about inflation in the core is the capital market by itself. So the German savings capital no longer likes to go to the south and people invest in Germany. We are having a construction boom, which translates into the whole economy and is in the process of inflating the country. But now comes the EU and says, no, no, the savings are not supposed to be invested in Germany. We’d rather escort the savings from Germany to the south through public rescue operations, through the ECB’s guarantees, and so on. But then you can’t inflate Germany. That is the problem.

You know, they want two things that do not fit together. They want the savings to go to the south. And at the same time, they want Germany to inflate. And this is impossible. Either you invest in Germany. You create the demand inflation in Germany, or you bring the savings to the south. You cannot have it both.

Hal Weitzman: Veronica Guerrieri, what should Germany’s role be?

Veronica Guerrieri: So I think that the only hope for the euro is actually instead trying to be a little bit in this moment less aggressive on austerity measures for the southern countries because the important thing is that these countries start to grow again. And now these austerity measures have proven being very costly, both economically because Spain and Italy are suffering a very big recession, but also politically. And this has created a protest vote in Italy, for example, a lot of political tensions, and so on.

Hal Weitzman: But equally in the north, you have a growing political movement that is against the kind of bailouts that you’re talking about.

Veronica Guerrieri: That’s true, but the fundamental in terms of growth, the problems come mainly from the south. And that partly contributed to create all the euro crisis and the run, the speculations, and so on. And so I think if you don’t let these countries give a hope for growth, there is no future for the euro area. So I think that instead, I believe that doing something on the fiscal side is important if we wanna save the euro.

Hal Weitzman: Hans-Werner Sinn.

Hans-Werner Sinn: I’m not quite of your opinion, because if you have a realignment problem in the eurozone and the north has to become more expensive and the south cheaper, then you can’t have it without going through a process of austerity in the south. And growth is not growth in the supply sense, of course. Everyone is in favor of it that. Politicians speak of growth. They just mean Keynesian demand management. And that would be wrong because it would slow down the necessary process of realignment.

Above all, Keynesian demand management means borrowing. If you borrowed at the market rate, fine. Let the countries decide themselves. But they don’t borrow at the market rate. They borrow publicly from other countries in the eurozone through public mechanisms, and that is not so easy.

You can easily speak that way, but you have to have the taxpayers of the north to become the public creditors of the south in order for the south to carry out Keynesian policies, but they don’t want to do that. So we are in a difficult period of growing rescue fatigue in the north and growing austerity fatigue in the south. And I’m very much afraid that this will damage the European project as such, but there is no easy outcome.

Let’s be honest. The whole thing is a mess. The euro was introduced as a peace project, and now we are having a situation of hassle and strife between the countries of Western Europe of a kind which I’ve never seen before in my lifetime.

Hal Weitzman: Veronica Guerrieri, one final, quick comment from you.

Veronica Guerrieri: Yes, no, I believe there is no doubt that in the medium run, austerity has to be taken into consideration, that something has to be done in terms of the fiscal sustainability of this project.

Just, my only concern is that pushing too much into the short run can backfire. And I think that it should be done a little bit more smoothly.

Hans-Werner Sinn: Yeah, but what about the creditors of the north who get very little interest and bear large risk? How can you demand that they put more money on the table? That’s not so easy.

Veronica Guerrieri: I agree, but there are costs to be in the euro for everybody, and unfortunately—

Hans-Werner Sinn: They have been large. We have a total rescue program of €1.3 trillion already, if you take the printing credit from the printing press into account. It’s already very, very much.

Hal Weitzman: I want to finish up by asking each of you: the euro has been around for 14 years. How much longer do we see it continue in its current form?

Anil Kashyap.

Anil Kashyap: I don’t know. I said a while ago that I think it’s 50/50 that in two years, everybody that’s in will still be in.

I think the one other thing is we haven’t talked enough about France. I think Hans-Werner’s exactly right. France is headed toward a mess too.

And so, the main reason why I’m somewhat pessimistic is, who’s doing well by any of this? I mean, it doesn’t look like a win-win for anybody.

Hal Weitzman: The loveless marriage we talked about earlier. Veronica Guerrieri, how much longer for the euro?

Veronica Guerrieri: So I think my best forecast is that actually it’s gonna last, but Europe is gonna go through a very long period of slow growth.

Hal Weitzman: Hans-Werner Sinn.

Hans-Werner Sinn: Yeah, I don’t see any very favorable scenario. Either we get socialization of debt in the eurozone, with lots of hassle and strife because we make creditors and debtors out of neighbors and friends, or we have exits.

I personally believe that the probability for the bigger southern countries to exit has increased recently. Why? Because Greece and Cyprus, we have been able to keep in with lots of public money. These are small countries. If we would do the same for Spain and Italy, it would be impossible. The money is simply not there. And Beppo Grillo and others know that.

And so this is the reason why the political forces in the south, playing with the idea of exit become stronger. After all, Berlusconi said exit is a possibility, and Grillo said it, and both together at 55 percent of the popular vote. So these forces will become stronger.

Hal Weitzman: OK, well, on that note, I’m gonna have to call time. My thanks to our panel, Anil Kashyap, Veronica Guerrieri, and Hans-Werner Sinn.

For more research, analysis, and commentary, visit us online at chicagobooth.edu/capideas. And join us again next time for another The Big Question.

Goodbye.

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