January 17, 2012
Martin Wolf is widely considered to be one of the world's most influential writers on economics. Since joining the Financial Times in 1987, where he is chief economics commentator, he has received numerous awards for excellence in financial journalism. His most recent publications are Why Globalization Works (Yale University Press, 2004) and Fixing Global Finance (Johns Hopkins University Press, 2008 and Yale University Press, 2009).
I spoke with Martin at his office in London on January 12.
The consensus seems to be that ultimately the European Central Bank (ECB) will have to print money to shore up the banks. That will run the risk of inflation. Do you foresee that as part of the inevitable end game for how things will play out in Europe?
I would say it's a possible part of the end game. It's wrong to think that this is a crisis that can be managed by financing a loan, which is what we are talking about. But maybe one way of thinking about this is that there is an adjustment problem in the Eurozone, which is an underlying real adjustment problem. It derives from the fact that there was a long period when people in the core countries with surplus savings were willing to invest and lend to the peripheral, weaker countries.
After the financial crisis in 2008, that stopped.
You ended up with a structural balance-of-payment problem within the Eurozone. That meant that neither the private sectors nor the public sectors in those countries were able to borrow abroad. But something had to finance their large external deficit. In practice, the governments and predominantly the ECB financed that.
Financing of this kind essentially transfers of resources through the monetary side or the fiscal side of the policy machine, and that is what allowed us to avoid a collapse in the banking sectors and the economies of these peripheral countries. But in the long run they need to restore competitiveness, and they need to reverse their current-account deficits. Or, alternatively, they need to generate new assets that people want to buy. There is a very big real adjustment problem.
The ECB can't solve that problem except to the extent that its monetary policy ends up generating higher inflation in the core than in the periphery – which it might do – but that will take a very long time to work through, given where we are now with inflation that is very low.
Will the Eurozone go into recession?
The core is going into recession, or at least it is weakening. Differential inflation is very low. The ECB has to act as the dominant financier of these deficits, which it has been. In financing the banks, it's financing these balance-of-payments deficits.
It is very important to understand that there is a macroeconomic side of what the ECB is doing; it is not just financing the banks.
The ECB can't allow the banking sector to collapse. Therefore it is committed essentially to funding the banks, predominantly through lender-of-last-resort operations, but also through its so-called long-term refinancing operation (LTRO). I expect that to continue to the extent necessary. The balance sheet of the ECB will therefore expand a great deal. At the moment, this is having absolutely no inflationary effect at all because the credit growth in the Eurozone is very, very low – incredibly low. The banks are accumulating reserves. But in the long run the ECB needs to create inflation. That is not a bad thing.
If you are optimistic about the outcome, it is because the ECB will act in this way.
In his most recent letter, at the end of the third quarter, Jeremy Grantham wrote that he had no particular insights into the Eurozone crisis, but that it was a terrifying situation. Is he right to be terrified?
I think he’s right. The problem is that we are now in the following situation: We have some very, very large divergences in competitiveness in the Eurozone. We have some enormously over-leveraged banking institutions, which are exposed to some very, very doubtful debt, both private and public. We have an absence of effective adjustment mechanisms, as I've already discussed, profound weaknesses in political coordination, and a lack of political leadership.
Therefore there is the possibility of a break-up.
It's very difficult to imagine a break-up process which would not lead to a chain of both sovereign and private bankruptcies across the Eurozone. The Eurozone has far and away the biggest banking sector in the world. It's much bigger than the American banking sector, which few people realize, because Europe is a very bank-dependent economy.
In a break up, we could have a wave of bank failures, as well as defaults by sovereigns that have no choice other than printing their own new money which could mean genuine hyperinflation in some countries.
The risks here are very broad and very big. Furthermore, if the Eurozone were to break up – I'm not predicting that – it would almost certainly affect the European Union itself. It might affect the ability to stay in the single market. It could lead to protectionism, in other words. That could radiate across the world.
There are very, very big risks involved in a break-up event.
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