Lessons from the Euro Crisis

Lionel Barber – Commencement address at Esade Business School

Barcelona – October 23 2012

Ladies and gentlemen, distinguished guests, it is an honour to speak here in Barcelona at Esade, one of the world’s great business schools in one of the world’s great modern cities, home, I believe, to a well-known football team.

When Javier Solana called me to extend the speaking invitation, I frankly wondered if he had got the wrong number. It was after all almost five minutes to midnight. Maybe he was sending a coded message about the state of Europe. Seriously Javier, you possess so much charm, good humour and tactile urgency that it is impossible to say the word “no”, let alone (Spanish) “no”.

This is a good time to reflect on the Euro crisis. We have lived through the equivalent of wartime for more than three years – and while there are intermittent ceasefires, there is no sign of a truce or a permanent settlement. The stakes are very high, not just for Spain but for the post-war project for closer economic and political integration in Europe.

The uncertainty and volatility which characterises today’s world extends well beyond Europe. In the US, we have a real contest after surging debate performances by Governor Romney; but whoever wins the presidential election faces the fiscal cliff, the medium term budget crisis facing America. In China, we are on the brink of a leadership transition. A few weeks ago, a Beijing friend drily summed up the mood: “Things are not so bad: the economy has slowed, the man who is about to be our next leader has gone missing and our ships are heading toward Japan.”

The epicentre of the global financial crisis remains of course in Europe which has laid bare weaknesses in crisis management and governance in the Eurozone and in a European union of 27 member states. This raises two questions: is the Eurozone a genuinely optimal currency area and are the political terms of a rescue so contentious that public opinion – not just Germany – will find them too impossible to support. Yet without that support, the democratic legitimacy of the enterprise is surely at risk.

Causes and consequences of the crisis:

Before elaborating on the lessons of the Euro crisis, I first would like to provide some economic and political context.

In the summer of 2001, I interviewed Jose Maria Aznar and Silvio Berlusconi in successive weeks. Aznar was at the height of his powers. He had just successfully pressed for better budget terms at an EU summit, and boasted of quietly smoking a fat cigar until Chancellor Schroeder and others came round to his demands.

A few weeks later I was in Rome at Silvio Berlusconi’s private villa next to the Spanish steps. Inside, the roses were purple, the ceilings were high and the women statuesque. When I insisted in conducting my interview in French, il Cavaliere responded by crooning an old Edith Piaff song. Then I mentioned I had just interviewed his old friend Aznar at the Moncloa. Well, said Mr Berlusconi, suddenly serious, Spain is a great success story. Madrid is one of the great cities, bustling with commerce and trade. If Italy does not reform, it will be overtaken by Spain in the next decade.

Berlusconi frittered away his opportunity, but a decade on Spain no longer looks like a nation of conquistadors. The credit crunch has exposed the country’s weaknesses, particularly in the banking system. Not because Spanish banks dabbled in credit derivatives or other sophisticated off balance sheet financing like their American counterparts. In fact, thanks to a vigilant Bank of Spain, Spanish banks were second only to Canadian banks in being among the most tightly regulated in the world. The problem lay in an old fashioned property bubble coupled with a lack of structural reforms in the labour market and in the public sector. These – together with persistent procrastination by successive governments in Madrid– have exacerbated the damage.

Of course, Spain is hardly the sole victim in Europe’s sovereign debt crisis. In my own country, we have suffered the consequences of lax regulation and an over reliance on financial services as engines of growth.

In Greece, the problem was not just a gross lack of competitiveness and indebtedness. In Prime Minister George Papandreou’s own words, the country was corrupt to the bone. Huge swathes of the population, notably the professional middle class, have long viewed it as their birthright to avoid paying taxes. The state has long played a stifling role, as well as a dispenser of patronage. Budget deficits were never brought under control and the national debt spiraled.

Portugal has not suffered from the same double debt syndrome. Its Achilles heel has been low growth. This has been the story for the past decade. In many respects, Portugal enjoyed its best years in the run-up to entry into the Euro. Now it too must adjust to its lack of competitiveness without resort to an adjustment in the currency

In Ireland, virtually all of the country’s troubles grew out of the property boom and bust. Between 1993 and 2000 growth averaged 10 per cent, but then low interest rates plus reckless lending by the banks stoked by huge inflows of foreign capital, created an unsustainable real estate bubble. As the Economist has written, Ireland became a nation of property developers.

The crisis has also revealed flaws in the original construction of the Euro. First, the lack of credible enforcement mechanisms for imposing fiscal discipline in delinquent countries; second, the conceit that the Eurozone did not need a fully-fledged bail-out mechanism for countries in trouble; third, the ineffective so-called peer review process for scrutinising individual member states economic policies; fourth, the excessive focus on German-style budgetary discipline at the expense of other important economic indicators such as current account deficits.

This last point is especially relevant. The spectacle of countries being awarded in Brussels the equivalent of gold stars for marginal reductions in public sector deficits while at the same time private sector indebtedness was exploding belongs to one of the most surreal chapters of the Euro story. So too the notion that at the height of the credit boom, Greece was able to borrow on the international money markets at rates close to Germany.

Our best judgment at the FT – reinforced by last week’s ineffectual EU summit in Brussels – is that, notwithstanding the political will to sustain the Euro project, the European Union’s piecemeal tactics are undermining the currency union, perhaps fatally. Ultimately the crisis will not be resolved without a rescheduling of sovereign debt and a recapitalisation of banks – not just in the peripheral countries of Greece, Ireland, Spain and Portugal. However difficult, a rebalancing between creditors and debtors is vital to resolve the crisis and lay the future foundations for future growth.

Crisis management: the audit

When the financial crisis first erupted in the late summer of 2007, the European central bank under the leadership of Jean-Claude Trichet was widely praised for early and decisive action, pumping tens of billions of short term money into the credit markets. By contrast the Bank of England and the Fed were more cautious. Yet subsequently the Fed in particular was much bolder with its unconventional monetary measures (quantitative easing) and the admittedly controversial troubled asset relief programme TARP to recap the banks and other financial institutions.

The EU of course is not a unitary state. Both the EU and ECB have been hampered by a hybrid political model where power is shared between supranational and national institutions. Legal considerations have also played a role: all players have been mindful of the ECB’s mandate as laid down in the Maastricht treaty. The narrow construction placed by the Bundesbank explains the cautious approach adopted by the Trichet-led ECB, as well as the refusal to consider any talk of private sector involvement in sovereign debt restructuring.

Since the arrival of Mario Draghi in Frankfurt, there has been a sea change. It has been remarked that while Mario Monti, his academic namesake and Italian prime minister, is a Catholic, Mario Draghi is a Jesuit. From the outset Mr Draghi has pursued a maximalist intervention strategy in order to salvage the Euro. It still might not work, but no one can criticise him of not giving it his best shot.

Thus he has embarked in two major initiatives – first the LTRO (long term refinancing operation) providing liquidity to banks holding illiquid assets, partly in order to main inter bank lending. Over the summer, Mr Draghi went further with his big bazooka, the outright monetary transmissions OMT – aimed at intervening in the bond markets to lower sovereign borrowing costs. He has deliberately sought to isolate the Bundesbank on the ECB board, at one point taking the unprecedented step of revealing that the Buba member Jens Weidmann had been the sole vote in opposition to the new OMT mechanism.

Crucially, Mr Draghi has also obtained the support of the German government by insisting that his interventions are both legal and conditional: he is acting within the ECB mandate and in return for bond market intervention, member states must respond with structural reforms and budget discipline.

The summer brought other positive news: the June EU summit decision to enhance the European Stability Mechanism, the rescue fund for troubled nations, allowing the recapitalisation of banks directly without going through the sovereign; the German constitutional court’s approval of the ESM; the emergence of a pro-European majority from the Dutch elections; an agreement to forge a banking union for Eurozone members to complement the strengthened ESM. Thus the elements of a deal and a new Eurozone architecture are in place: a banking and fiscal union to complement a refashioned “post Maasteicht” monetary union. But to paraphrase Shakespeare’s play Julius Caesar: the fault, dear Brutus, lies not in our stars but in ourselves – and our politicians.

Politics in the Eurozone

Mr Draghi’s OMT plan has bought breathing space for the politicians – but as has happened so often before in the Euro drama, the actors have subsequently wandered off the (sensible) script. Germany now insists that any direct bank recapitalisation by the ESM be covered by a sovereign guarantee. As Willem Buiter, the distinguished economist, has noted: The distinction between the ESM lending to the sovereign with the sovereign recapitalising its banks – creating an on-balance sheet sovereign liability – and the ESM recapitalising the banks directly but with a guarantee from the sovereign – creating an off-balance sheet contingent sovereign liability – is artificial. Markets will see through it.

Meanwhile, both Italy and Spain have used the prospect of OMT to refinance their debt obligations this year at much more favourable rates, thus relieving what appeared to be unsustainable pressure on borrowing rates early in the summer. As a result, neither is moving ahead with applications for the financial assistance packages which again appeared to be integral to the ECB package. But without a resolution of the underlying issues, the autumn calm is surely temporary.

The first source of instability is the sea-change in relations between France and Germany. Nicolas Sarkozy might have disagreed with Germany in private, but rarely if at all in public. President Hollande has taken a very different approach. One result is that Germany no longer consults with France on what it is going to propose. But it is clear thatGermany makes the final decision on every issue. (As Mr Aznar said in Seoul the other week, the Eurozone is no longer a European structure, but one overwhelmingly dominated by Germany.)

The second problem is that Chancellor Merkel’s support for OMT has also cost her heavily, in political terms, in Germany. With the next national election less than a year away. The chancellor is very reluctant to propose an ESM bail-out for the two countries still in the front line of the debt crisis: Spain and Greece. Nor is the German government confident it has the parliamentary majorities (and definitely not the coalition majorities) to pass a succession of rescue packages for Spain, Cyprus, Slovenia and modifications for Ireland and Portugal.

The third problem is the indignados phenomenon: domestic political unrest in the periphery. Let us start with Greece. The projection for debt levels is now the same as it was before the PSI. So another debt relief programme is needed. This time, the official sector (OSI) will have to write-off debt. This is political poison inGermany and raises serious questions about foreign direct investment in the shadow of a default.

If Greece is to have any chance of working, there has to be a big enough debt write-down to give the country a chance of surviving in the Eurozone. Most of Europe’s politicians now say they want Greece to stay in (in contrast to what were hinting earlier this year). And a substantial debt write down is necessary to give Greece some chance of growth. In the coming weeks, Germany, the IMF and others will have to decide. At present progress on Greece is blocked and so, therefore, is progress on Spain.

The Spanish dilemma: Premier League or Relegation

More than a decade on from my Aznar-Berlusconi encounters, Spain is slipping. Indeed, in the last months, Italy, even with its crushing debt burden, has managed to hide behind Spain in terms of the market turmoil.

Spain’s most visible challenges are financial and economic in nature: banks devastated by the bursting of a 15-year economic bubble, rising public debt, a steep budget deficit, high and potentially unsustainable government bond yields, deep recession and severe unemployment. Collectively, they explain why Spain’s banking system would have collapsed this year without European Central Bank support, why economic growth is unlikely to return until 2014, and why bankers in Madrid think Mr Rajoy probably has no choice but to ask his European allies for a formal rescue programme.

Yet these challenges mask a more profound crisis of the Spanish state, a crisis that demands a substantial overhaul of the structures established during the post-Franco transition to democracy in the late 1970s. It is fair to say that Spain’s national drama is not just about banks and bond yields; it is political, institutional and regional.

Now I realise I am venturing into sensitive territory here. But is it not time to rexamine the terms of the post Franco settlement. One would begin by asking hard questions about the layers if bureaucracy, an engrained political patronage system and how autonomy came to be granted to all 17 regions in a compact termed café para todos or “coffee for everyone”. As an FT article noted earlier this year: the regions have spawned home grown parties, administrations and interest groups whose raison d’être combines self-perpetuation with the expenditure of centrally allocated public money for which, in most cases, they are not accountable to local voters.

Turning to the present crisis, Spain is now hostage to Greece. Without an ESM programme, there will be no OMT for Spain and, without OMT, there will be no reduction in rates in Spain and no hope whatsoever of recovery. I hear the IMF thinks rates have to be lowered by 300 basis points. It is arguable whether the leadership In Madrid understands the scale of economic problem, even if relevant ministers do. As one senior Spanish businessman told me recently: the government takes three steps forward but they need to take seven more in terms of reform. True, Spain is benefiting from lower rates now and has funded itself to the end of the year. But this will not restore the growth which is crucial for political and social stability.

Conclusion:

John F. Kennedy once noted that the Chinese have two brush strikes for the word “crisis.” One signifies danger; the other opportunity. In a crisis, he declared, be aware of the danger; but recognise the opportunity. This is the modest advice I would offer to Spain’s leaders.

This country’s peaceful transition to democracy is one of the most inspiring stories of post-war Europe. Spain took its rightful place as a front ranking European power. And as its economy grew, a number of world-class companies emerged: Acciona, BBVA, Ferrovial, Inditex, Repsol, Santander – the list goes on.

Now is the time for national renewal. Spain has taken hard knocks but it can come back. But there may be less time than some may realise. The government is going to have to apply for financial assistance. It is not a question of if but when. The key point is to negotiate the right terms with the ECB, the IMF and the commission – ones which give the country a realistic prospect of fixing the banking system once and for all and breaking the link with sovereign borrowing costs, and taking measures to bolster economic growth and create desperately needed jobs.

It can be done – within a domestic and European context. That will of course require movement by Germany. All this requires political courage and decisive action, just like Lionel Messi going for goal. But don’t bet on this match going into extra time.

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