Europe’s Unfinished Currency

ALEXEI MONSARRAT: Thanks for your patience. We’re eagerly awaiting the arrival of Fred Kempe, but in his stead I wanted to get things started. And I will speak very slowly on the off chance that he actually manages to make it upstairs on time. (Laughter.) If not, I will – I will pinch-hit.

Thomas Mayer,
Senior Fellow, 
Center of Financial Studies,
Goethe University

Frederick Kempe,
President and CEO,
The Atlantic Council

Introductory Remarks by:
Alexei Monsarrat,
Director of the Global Business and Economic Program,
The Atlantic Council

The Atlantic Council,
Washington, D.C.

Wednesday, October 24, 2012

Transcript by
Federal News Service
Washington, D.C.

I’m Alexei Monsarrat. I’m the director of the Global Business and Economics Program at the Atlantic Council. And I want to thank you for joining us today to have a conversation with Thomas Mayer. And, you know, it was interesting to us that the whole – the whole European economy and Transatlantic economy situation was not covered in the last debate on foreign policy in the presidential debates, but we’re looking forward to giving them some fodder for their discussion later on.

And – you know, as you know, and core to our mission here, we believe this is a crucially important issue, and so we’re very pleased to have Dr. Mayer with us today to talk about this.

This is an on-the-record event, so if you’d like to cover it, you may. And – sorry, so this is part of our Deutsche Bank series that we’ve run for the last few years called “Mapping the Economic and Financial Future.” And we’ve had the good fortune to have a whole number of people come through, including people like Bob Zoellick of the World Bank and Christine Lagarde, both as IMF head and as French finance minister; several other European commissioners; Senator Dodd when they did the Dodd-Frank legislation. So it’s really been a great discussion about where we are in the financial regulatory reform process and increasingly, of course, engaging what Europe is working through right now. And so I always want to thank Deutsche Bank for that – for that – for their support of that.

And for those who don’t already know, Dr. Thomas Mayer is a senior fellow at the Center for Financial Studies at Goethe University in Frankfurt. In addition to being a senior adviser to Deutsche Bank’s management and some of its clients, I would stress that what Dr. Mayer’s talking with us about today has nothing to do with his affiliation with Deutsche Bank and his independent thoughts. For many years, over two decades, you said you were heading their research team and most recently their chief economist. And you have written a book that we’re very interested to hear about, “Europe’s Unfinished Currency,” which is something we’re all very concerned about here.

So we look forward to hearing about what it is you’ve got to say in the book but then also engaging on some current topics. And I’m sure Fred will do his best to ask you very difficult questions and put you through your paces. So thanks for joining us and I would welcome you to the stage. (Applause.)

FREDERICK KEMPE: Thomas, let me first apologize to you and also the audience for being a bit late – late plane, rush hour traffic, but nothing like the financial issues you’ve been dealing with.

You’ve been introduced, but let me introduce you in my own fashion. I have been stealing Tom’s ideas for now 25 years – have we been talking about this. And it really got to the point where my editors at the Wall Street Journal said, you have to quit quoting him. And I remember one conversation I had with you and I said, would you mind if I quit quoting you, because I still want to talk to you, but I can’t quote you anymore.

But I just have found him a prescient thinker. He sees things ahead of time. He puts things into context. He can put issues into English, which not all economists can do.

And so I’m really looking forward to this conversation. And I think we’ll do a little Q&A here and then I’ll come to the audience as quickly as I can if that’s all right. And, as I understand it, you’re not giving any opening comments.

THOMAS MAYER: No. We can go right into the substance.

MR. KEMPE: Then let me start with the following. When we started – we go back to talking to the economics of German unification and how could one afford East Germany, et cetera, et cetera.

Let’s talk first about something you wrote not so long ago where you said Greece – when we first saw Greece as a growing issue, problem, and in that moment of time, perhaps if one had thrown enough at it, one could have nipped some of this in the bud.

But you said Greece is the canary in the coal mine, and the problem is that European leaders are blaming the canary and that doesn’t take care of the problems in the coal mine. Talk to us about the coal mine now. How dangerous is the European coal mine still. Is the toxicity out of it? And what canaries ought we be watching?

MR. MAYER: I think Greece remains a very important canary. It was the canary in the sense that is started the euro crisis, which is a genuine part of the global debt crisis that we have, of the credit crisis that we have, because what you had here as a subprime problem in the private sector we have in Europe as a subprime problem in the government sector. And Greece was clearly a subprime borrower. And when the credit bubble burst, then the canary fell basically off its rail.

The euro was in fact supported by the expansion of the credit bubble because, you know, the EMU, the Economic and Monetary Union, did not fulfill the basic requirements that you can read up in the economic literature of the 1960s of Bob Mundell and Peter Kenen. You know, there is not the efficient economic flexibility there and we don’t have a big system of transfers. And that’s why a number of economists predicted this exercise to fall apart very soon.

But what they didn’t reckon with was that there was cheap credit available in almost unlimited ways to patch this thing together. If you did not – if you were not able to balance your budget, you go to the market and you got credit. If you had a current account deficit because you were uncompetitive because your wages were you too high, well, you went to the market and you funded it. And when that funding dried out –

MR. KEMPE: And country risk, national risk goes away.

MR. MAYER: Went away. We had, you know, 18 basis points, 0.2 percent around it spread between Greece and Germany at the peak of the bubble. And when the global credit bubble burst, the glue came off. And, of course, you know, things break at the weakest part, and this was in the area, the domain of euro insolvency, this was Greece. Greece fell off.

So first act begins. The first act I think was – I’m sorry that I’m now changing a little bit the images, but the first act of –

MR. KEMPE: You’re free to mix metaphors here.

MR. MAYER: OK. The first act was sort of the big traffic accident so the cars crashing into each other. And, of course, the observers, i.e., financial markets getting extremely worried; ambulances arriving on the scene; and all is considered to be too small to take care of the injured. This is the discussion about the firewall – you know, how big do we have to do it?

And now we have achieved – in the course of this summer, we have now achieved a situation where finally – finally the rescue helicopter is there in the form of the ECB. And now the injured are basically all bandaged. They are all in the ambulances and in the helicopter, and are now shipped off to surgery in the hospital.

So the act one in a sense is over and this created some relief in the market so at least we don’t have to worry about, you know, this really getting very, very bad. And, in fact, so far no one has, quote-unquote, “no one has died.” So this is why – so act one was that.

But I come back to the coal mine analogy, again, Greece. And now, as we think about how to heal these countries, Greece is –

MR. KEMPE: And the important thing in this, whether it’s a bunch of bandaged people being flown off or the canary in the coal mine is really – are we going to have more casualties, or have we done anything to correct this. Because let’s not forget – the problem in the coal mine, if you’re blaming the canary, is coalminers keep dying. And so _

MR. MAYER: Yeah. Greece again here is very important when we now discuss what do we do? What is the treatment that we now give to these people that have arrived from the scene of the accident?

And here we had a progression of thought. And I have to say this: the thoughts, the ideas are really driven out of Berlin. I mean, Brussels tries its best. It remains to be seen. But it’s really Berlin which drives the thought process forward.

And when you look at the progression of the ideas coming out of Berlin, then there was first the idea, a country that cannot maintain its fiscal accounts in order, that is overindebted, well, that has to go into Chapter 11, into debt restructuring. It was initially Mrs. Merkel’s – Chancellor Merkel’s idea and push. And she opened the way for that at the famous walk at Deauville with French President Sarkozy.

Again Greece, right, coal mine. So we had debt restructure. That was first – so we go this way. Also, somewhat parallel, there was this notion also pushed forward in Berlin – not necessarily by Merkel, but pushed forward in Berlin – that if a country can after long trials not engineer the necessary economic adjustment to live in the euro, then one has to let it go. There was a phase in the debate where people said, well, if you can’t keep Greece, it has to go. It can go. It’s not the end of the world.

So, again, now, Greece, canary in the coal mine. So in the process of the first half of this year, they decided – in Berlin they decided that it was not a good idea to restructure Greece. So they bought into the Brussels line – Greece is exceptional and unique. So we closed that one. Again, Greece was here – if you want – the country that set the stage.

And in the course of the summer, while politicians in Germany on the second rank, including the economics minister, where – and the leader of the CSU out of Bavaria, Mr. Seehofer, the prime minister of Bavaria, governor of Bavaria, an important political figure – while they were musing about the possibility of Greek exit, eventually Mrs. Merkel quietly and silently in the course of summer, maybe while she was hiking in Austria, decided no, and closed that as well.

So now we have basically – we’ve set the stage for a treatment of the injured that excludes market-based solutions and substitutes these solutions for other stuff, and the other stuff is basically a politically driven management of EMU. There is a web of treaties that Chancellor Merkel has initiated, six-pack fiscal compact, and now her finance minister sort of was a little bit testing out the mines when he suggested a super commissioner for economic and monetary affairs. The idea is you bind these countries into political structures through treaties, with sanctions meted out eventually by the European Court of Justice.

And I’m afraid that I think this is going into the wrong direction. I don’t buy this idea that we can in Europe move the sovereignty – in key parts of fiscal policy, the sovereignty of the nations up to a Brussels level, be that the commission, which is unlikely, or more likely what she has in mind, the European Council; i.e., the gatherings of the heads of state. I don’t think that the countries will comply.

MR. KEMPE: Why do you think it’s the wrong direction? Why do you think they won’t comply?

MR. MAYER: Well, they won’t comply because the peoples of Europe are not ready for a pooling of sovereignty in essential areas such as tax sovereignty, sovereignty over spending, how much do you give for social spending, all these things. So why am I saying that?

Well, evidence number one, in 2005, we had public referendums in France and in the Netherlands – certainly not peripheral countries – on the treaty. This was an effort to move forward – a very, I would say, limited effort to move forward towards a political union, and it really crashed. It fell through. Neither the French nor the Dutch wanted to move towards a closer political union in Europe. When you do polls now, no one would want to have that.

And I would predict – I’ve been in the business of forecasting for now such a long time, but this is an easy one. If you would run in Germany a referendum whether people would give up their basic law – this is our constitution – in favor of a new constitution shifting essential elements of sovereignty to the Brussels level, my forecast would be you’ll get a resounding no, even in Germany, which is I think the most federally minded country of the lot.

So I think she’s going in the wrong direction. I’m afraid that by going there, they will not achieve their requirements for making EMU work as designed – as a hard currency union. And for that, you need – you go back to the literature – you need economic flexibility. You need fiscal discipline. You need financial stability. And, of course, you also need price stability. This is sort of my rectangle which we want to achieve.

And, by the way, you know, the original Maastricht Treaty had only one powerful institution assigned to secure one of these objectives, price stability, and a very weak pact to look after fiscal discipline and the rest was not covered at all.

And now she wants to do this politically, but I think she will fail and then the outcome will be that when you have deficiencies in the areas of economic flexibility and fiscal discipline and financial stability, the central bank is basically the variable that gives.

So I see the model of EMU changing, changing from the Maastricht model, which was very much a German inspired model. It was after all – (inaudible) – and others who pushed the ECB status, price stability only in its mandate, a very thick firewall between monetary policy and fiscal policy, no bailout of countries. So this was the Bundesbank model of EMU laid down in the Maastricht Treaty.

And I see this model shifting to what I call the Latin Monetary Union which always was a competing model to the German model. And the Latin Monetary Union, you have the central bank as part of an economic government. It’s always a French desire to have an economic government and the central bank part of it helping the government to achieve its goals; namely, growth and funding of its accounts. And I think we’re moving there. We have built a bridge. The only thing we have to do is walk over it, and then we are from the German model, the one side of the river, to – on the other side.

MR. KEMPE: I can see the French becoming Latin American, but the Germans? And play this out a little bit. What is an – obviously, Germany has been the decider, but Mario Draghi has been enabled by Germany’s decisions.

MR. MAYER: Yeah.

MR. KEMPE: So what is Merkel’s game right now? And I’m going to go to the audience right after this and when we can go back and forth a little bit. And what – how do you see the next 12 months playing out in this respect?

MR. MAYER: I think in Germany, the German conservative circles I say a little bit loosely – I think most in the room would know who I mean. I talk about the Frankfurter Allgemeine Zeitung and Bundesbank circles. They blame the ECB for that and they say Draghi is the one who has basically initiated the model shift. And today he was at the Bundestag and was trying to explain to them what he was doing.

I think he’s the wrong one. I think what he did was politically very smart because he put the ECB behind the governments. So he said, if you guys, governments, if you decide that the adjustment program of a country is worth supporting, and you do this unanimously; if the German finance minister says, no, it won’t happen, but if they all say yes unanimously, who am I – an unelected technocrat running a central bank, who am I then to say, no, I won’t help you? Am I – as an unelected technocrat, am I in a position to let the Euro go, to let the Euro implode? No. Can’t do that. So he’s basically played the ball into the court of the governments.

Now if the Germans are serious about insisting on the German model, the German finance minister can say no when the request comes from Spain to intervene, to help them in getting their rates down by intervention, but that is, I would say, the warming up exercise, Spain. The big – this is not the canary, so this is now the elephant in the room is Italy, of course. And if Italy comes and needs help, then if Italy can’t get its act together politically and economically, the ECB will be sucked in.

MR. KEMPE: Yeah. One big question before launching interactive here is if you were betting at whatever the German equivalent of Ladbrokes is, do we still have 17 eurozone countries a year from now, two years from now, five years from now? You know, game out each of those for me and give me your – not only your bet, but what could push in one direction or another.

MR. MAYER: See, I’m now rather confident that we will have in a year’s time still the same membership.

MR. KEMPE: Seventeen.

MR. MAYER: Yeah. In two years’ time, probably as well. When we go forward, in five years’ time, maybe not. Why? Because the act one of the euro crisis is playing in the southern European countries. I should rather say I like more the Latin European countries because France is economically much closer to Italy and Spain than to Germany, so this is why I’m talking about the Latin group.

So right now, the music is playing in the Latin group. And the ECB will have to shift towards helping them to get growth going, so with easy monetary policy, and also to get their rates down. So that’s act one of the play.

Then we have an intermission, which is the gestation period until an easy monetary policy arrives at the inflation rates of an overheating economy. And act two will play itself out in the creditor countries, mostly Germany, but maybe also Holland, Austria, Finland to name the most important ones.

Of course, if you help now the southerners through monetary policy to stabilize their situation, you are – over time, you are going to overheat the creditor countries. And then we have the debate what they will do. And then we go back about the discussion of the exit, German exit. I’m not predicting it, but I think in due course we will have that discussion because the Germans will say we did not go into EMU to have an inflation rate that is 4 (percent) or 5 percent firmly anchored, you know, over several years, which would be the outcome probably of this adjustment.

MR. KEMPE: And this gets back to your argument about domestic politics getting involved and hard to predict where that lands over time with the euro.

MR. MAYER: Well, it takes time. You know, right now, as I say, it’s sort of more the after hour evening talks in the (beerhouse ?) where people get excited, but during the day, from Monday to Friday, they have full employment. They have for the first time since many years real wage increases. It feels good, but the worry is about the future. When the problems crop up and it’s a Monday-to-Friday working hour issue, then it turns into political changes.

MR. KEMPE: So we’ve had a coal mine and canaries, we had a med evacuation and we’ve had a theater in a couple of acts. And so I promise more metaphors if you ask the right questions. But the – I urge you to read this. It’s excellent writing throughout his career, but I think it’s terrific that it’s come out at this time in book form, “Europe’s Unfinished Currency.”

Questions please.

Q: Fran Burwell at the Atlantic Council. Paul de Grauwe had a column in the Financial Times this morning. I don’t know if you saw it, but he was arguing that it is very normal for the ECB to assume the role of lender of last resort. And I wonder if you would comment on that and whether you think it is the appropriate thing.

And also talk about – you put forward two models of a central bank – the German model and the Latin model – but surely there are things in between and other ways that this might evolve where the objective is not just controlling inflation, but is somewhat independent but has other objectives as we have here, for example.

Professor de Grauwe went on to say that the opposition in the Bundesbank and the, shall we say, isolation in the recent meetings of Jens Weidmann was in part the result of the Bundesbank wanting to create a situation or wanting to see a situation where Germany did leave and the Bundesbank would then regain its hegemony, if I can put it that way. And I wonder if you agree with that very political assessment. Thank you.

MR. MAYER: On the lender of last resort question, I’ve agonized a full chapter in this book about it – (laughs) – because it is just for – from a German perspective, it’s very difficult to deal with it, but I come out on the side of saying, yes, the central bank has to be the provider of funds of last resort also for governments.

I mean, when you think of it, what is the lender of last resort function? Normally, it is to avoid that the collapse of a systemically important debtor; i.e., in this case a bank, normally creates a systemic crisis. So why make this difference between a bank that is systemically important and a government, and say we can do it for the bank because here the Bundesbank didn’t have a problem with the LTROs. Mr. Weidmann voted yes for the LTROs and this was after all gross 1 trillion euros so it was not insignificant, but he voted no for OMT. But I can’t see the difference here.

But I’m also saying – and here I disagree with Paul de Grauwe – I’m also saying that the central bank should be the lender of last resort through fiscal authority. It should not just do it on its own because you always – lender of last resort is correct in a liquidity crisis, but it gets very tricky when the liquidity crisis moves over to a solvency crisis. These things are very close together. And very soon, if you are into it alone, a central bank, very soon you may end up basically lending to insolvent entities.

So, therefore, I’ve come up with the – in my word, a variant basically of what de Grauwe has said and actually this is also something that I should mention that we published more than a year ago together with Daniel Gros from Brussels, where we say that the central bank should lend to the fiscal authority – in this case, in my works, the European Monetary Fund – which then can give liquidity support, but pull the plug when the liquidity support turns into funding an insolvent entity.

This means, however, also that in order to make this work, this lender of last resort activity of the central bank, you have to also have mechanisms in place that, when you discover a case of insolvency, to wind down an insolvent bank so you have to have a European Bank restructuring regime. And when you have an insolvent government, you have to restructure that as well. This is the consequence of it, the logical consequence. So in that sense, I’m halfway where Grauwe is, but I would do it a little bit different.

On your second question, is there anything in between? I don’t see this in between. I think this is sort of – should I say, you know, sort of – I look at this really as the two sides basically and there is a river in between and you cross and then you’re in the other model. I don’t see much in between.

The German model is very clearly defined, no bailout and all these things. We all know that. And when you leave that, you’re over. I don’t think that you can stop. The interesting thing is we have built a bridge.

Draghi has in a sense built a bridge, but he has said to the governments, you decide whether we shall cross. If you do the right thing, you know, if you do all the structural reforms, if you get the fiscal act together and the market has confidence in you, we don’t have to cross the bridge. If you don’t do it, you know, I’m not the one who says I’ll burn the bridge. This is the sort of the Bundesbank’s attitude.

Now I come to your third question. The Bundesbank says, let’s kill the bridge. We are here. Burn the bridge. It’s here. Either we succeed or we go under.

Now, I would think it probably goes a little bit too far to think that the Bundesbank has – pursues here the – has the objective of bringing back the Deutschemark. I have a certain sympathy with Weidmann in this regard, what he’s doing. He couldn’t do what he is doing now if he were the ECB president because then he has to take the responsibility for all the outcome. And, you know, without having any inside information and without sort of implicating – (inaudible) – any way, but I think I could very well imagine that he basically went out because he did not want to be confronted with this choice, having to give up his inner conviction and have to do something that was inevitable, right?

But as a Bundesbank president, you can do it because you know that you’re outvoted. And there is a certain, I would say, benefit from having such a voice continuously reminding people, you know, that they are now entering the bridge, and if they’re not careful that they may end up on the other side of the river. So I think what he’s doing has a function in the whole scheme of things.

MR. KEMPE: Please. Here and then there. Yeah.

Q: Thank you. I’m Ben Carliner from the Economic Strategy Institute. I’m wondering if you – why you seem to be suggesting that conditionality is going to fail, because it seems that Mario Draghi has been very clear that OMT requires a country to enter a program – there’s going to be structural reforms, there’s going to be fiscal rules, they’re going to give up sovereignty over their banks. Why won’t this improve governance in the Latin bloc and help move the Latin bloc more towards the German model? And why won’t the ECB be able to continue to wield both carrots and sticks as it tries to herd the politicians along and get towards the promised land?

MR. KEMPE: And for those not familiar with all the acronyms, you may want to explain in a sentence OMT.

MR. MAYER: Yeah. This is the new program that the ECB has launched where they are willing to intervene in the secondary bond market, so not buying issues from the governments directly but in the secondary bond market to support this bond market; i.e., bring yields down, provided that – and Draghi said a necessary condition for that is that the country has a program in the wider sense, not necessarily an IMF-led program but a program in the wider sense, which can also be a memorandum of understanding with the Euro group in place. So some policy conditionality is there. Associated with this, the country has to adopt certain policies. That’s I think roughly what it is.

So why am I skeptical with that? Well, first of all, I would hope that it works. It’s not that I wish here for failure. And I have – in the course of this year, I have really turned skeptical. At the beginning of this year, I was telling people that 60/40 are the odds – you mentioned betting – 60/40 are the odds that the German model will prevail.

At the beginning of this year, we had a new government in Spain, which was elected on a reform platform and was at the beginning very active. We had a new government in Italy with a very respected prime minister who was promising now to do the right thing. We had new ECB leadership that had broken with the past, with the Trichet tradition, had said, no, I don’t like the bond market intervention. It looked pretty good for the German model and I thought this was going to work.

In the course of this year, I have turned increasingly skeptical with regard to the ability of the country – key countries – come to the smaller ones, key countries, Spain and Italy, to really do the necessary adjustment.

Spain started out doing a few good things. Labor market reform was clearly a step in the right direction. They took serious steps to get the deficit under control. Yes, the economy was much weaker and they won’t achieve the target; I won’t hold it against them.

But they made a gross error, a huge error that you cannot afford to make. They played down, like the Zapatero government, the banking problems. First they played it down. Then they said there is – it’s – we can fix this with a small amount of money. Then they admitted they needed more money. And now they – since the summer, they basically said, yes, we apply for this support, and it’s still not done. Nothing has happened. They’re still – in the details, they are in each other’s hair. And I think this is really a disaster.

All our research that we have done at Deutsche Bank, especially with my colleague Michael Biggs on how do countries get out of such real estate and banking crises, we found out that in every case where you managed a turnaround, bank restructuring was key. Look in the United States, you had – in September, you had Lehman; by April, you had TARP. So this was a little bit more than half a year and things turned around.

The Spaniards are struggling now for almost three years with a banking problem. We have a new government and one year after the new government, they’re still not doing it. It’s costing them growth year after year after year. And when you look at the Spanish economy, no sign of improvement. They’re heading straight downhill. Their forecast for next year is minus 0.5 (percent). That’s a wish and a prayer. When you look at the latest data, third quarter GDP minus half, this is – U.S. numbers would be minus 2 (percent), right. All that we see for the fourth quarter suggests the same. This economy is going downhill at a speed of minus 2 percent, right? I mean, this is quite something. It’s only beaten by Greece. So Spain.

Italy – Mr. Monti came in. He did a good thing, pension reform. Everyone thought, well, he is really now cleaning up the Italian situation. Then probably because of the political – difficult political background, I think he failed to do a substantial labor market reform. All the people I talk to in Italy from the more industrial side – when you talk to the union side, they say different things. But when you talk to the industrial side I have not heard one employer say that they’re going to hire more people based on that reform. In fact, they say it has – on a net basis, it hasn’t brought anything, maybe even harmed because he restricted somewhat the secondary labor market, the temporary employment.

So now, Mr. Monti’s time is running out as we shall have elections at the end of Q-1 next year, so this is not – he doesn’t have any time anymore. And the Italian economy is equally sinking and people get restless. So rather than having made a big push in the first half of this year to get the structural reforms going to engineer a J-curve because after you do the grow thing, your economy goes first down. And in order to turn things around and then to go into the elections in March or April on a J-curve effect and say, look people, we are on the right course. Now don’t give up. They haven’t done it. They’re on a straight line down.

And then in the course of this summer I said, no, it’s not going to work. And then, of course, Mr. Draghi must have come to a similar conclusion that we need seatbelts. This is going to be tricky. And here you’ve got OMT. And now the odds are in favor of what I call Latin Monetary Union.

MR. KEMPE: And the election of Hollande, and Hollande and how he’s positioning himself, how did that play in all of this?

MR. MAYER: Hollande is sitting on the fence. I mean, this is sort of my interpretation. He’s watching that very closely. He clearly is not like Sarkozy, following Chancellor Merkel in her policy, not at all. He’s sitting there on the fence and he’s watching what’s happening. I mean, if Rajoy and if Monti don’t succeed, if these economies keep going downhill, if there is no change, if their political capital gets used up, right, why would he do it? He would say it’s not worth the trouble.

Merkozy was the wrong recipe. We have to go back to what we have said all along in France – let’s have the central bank support the government. Let’s have a growth objective in the ECB’s mandate. That was always a French demand. Let the central bank help these governments fund themselves. That is the right strategy. The cold turkey, radical austerity adjustment, this leads to disaster. So France is presently watching. And then I think they will move over and join Italy and Spain.

MR. KEMPE: Becoming more the leader of the Latin bloc rather than co-leader of Europe with Germany.

MR. MAYER: Yes. We always define the core, which would be Germany, France, always France. I think the core is going to shift. The core is going to be France, Italy and Spain, and Germany is becoming a non-core country.

MR. KEMPE: Very interesting. Please.

Q: (Off mic.)

MR. KEMPE: Very good to have you here.

Q: There are many points that I would like to react on, but I will confine myself to two. And I will not comment either on the – on your statement that all the ideas came from Germany rather than Brussels, that I find somewhat –

MR. KEMPE: Do we have an extra seat? (Laughter.)

Q: – I find somewhat German-centric. But anyhow.

Now, two points. One, you mentioned that there’s been an evolution – or there is an evolution from the German model to the Latin model. I sense some kind of leniency behind the Latin model.

If you – if you speak to others, they see the evolution rather towards a German-U.K. or Anglo-Saxon model in the sense that there is much more discipline, discipline the German way, enshrined in constitutions and very binding laws. And at the same time, there are structural reforms going for flexibility that will provide the resilience of the economy and the flexibility that you said rightly that at the beginning there wasn’t. So, I mean, with this, call it, German – Anglo-Saxon model of discipline plus flexibility, you can have more growth.

And, moreover, if – I mean, the situation in Italy or Spain of decline may rebound because the structural reforms may play a role. So then you may end up with a situation where there is growth and there is flexibility and there is discipline.

So if you put that to the populations, I think that the reaction may be much more positive. And I guess that if this is properly put to the German population and the benefits from being in the euro are properly put, then I think that even the German population can vote for this change.

My second point – I would like to know your reaction to that. The second point, you mentioned that the ECB is now hiding behind the governments. I could put it differently and I think in the right way.

What the ECB says is, I’m ready to do my job, which is monetary policy, but monetary policy alone cannot do it. Therefore, we need both monetary policy and fiscal and structural policies, and that’s not my responsibility so we need to have all of that. And if there is not that, then there is no point in us, ECB doing that. So I think that’s a right way of putting things rather than say that a non-technocratic government is hiding behind the legitimate democratic – (inaudible).

MR. MAYER: First of all, when I say Latin Monetary Union, this is not hyperinflation. This is not Latin American monetary affairs, right? Don’t misunderstand me.

It is a different model from the original Maastricht model, which was clearly a firewall as big as that between the central bank and the governments and no bailout. That was the German model. And now we’re moving towards a model where the central bank is more an integral part of an economic government supporting the governments in their endeavor to generate growth and fund themselves. That’s what I’m saying.

The outcome is going to be I would say elevated inflation overall, but not hyperinflation. That’s not what I mean. And you say that if we explain this to the Germans, and they’re peaceful and quiet and will accept that.

The IMF chief economist, Olivier Blanchard, gave an interview in Frankfurter Allgemeine Zeitung before the Tokyo summit and he tried to do that and he tried to explain it to the Germans. And he said, we should understand that going forward, we could be in a situation – and probably would be and this would be quite all right – where, let’s say the south – he said south – has zero percent inflation and the north would have 4 percent inflation. And then he was making a calculation that north-south is half-half. I would have put France more into the south and you would get one third, two-thirds, but let’s go with it. So Germany has 4 percent inflation, and the south has zero percent, and the ECB still gets 2 (percent) and it’s all fine. OK.

Now tell to someone in Germany who has nominal savings for his retirement – let’s say the person has now accumulated in government bonds and savings account 100,000 euros and wants to supplement his pension in 10 years with that – and you tell him we have now for the next 10 years roughly, we have 4 percent inflation with close to zero interest rates. You have just halved the real value of the savings of that – of that person.

And this is what you can see in Germany, where people are generally, financially technically speaking, they are long fixed income, short real estate because they have nominal savings and they are renters. So they are – 40 percent own, 60 percent rent, and they don’t have equities. So they’re very sensitive even to mid-level inflation rates, which probably are inevitable because of the past.

But you can see why there is already a lot of anxiety cropping up, but we haven’t seen it yet. And this is why I say we are in the intermission period. We haven’t seen the act two really coming. German inflation is running at 2 (percent). Italian still at 3 (percent). It can’t go on like that. Spain has now 1.5-ish (percent), so that has already gone done. Only Ireland has managed to create really negative inflation rates because of sharp plunges in union labor costs. The others haven’t. They can’t. They are struggling.

So if the others can’t get their inflation rates down like Ireland – and I have serious doubts whether they are as flexible as Ireland, right? – you have to actually get the north up even more, and you get into this problem. So this is the issue that I find is going to hit us before long when the intermission is over and it shows up. And as I say, it’s not an Argentinean type of inflation, it’s mid-sized inflation that is still with zero – close to zero rates, killing nominal savers.

Your second question was the way that I characterized the ECB. I think – so the way that I look at it is the following. I mean, the – sorry, I come back to Germany because I think it’s really – Germany is here the key player, I’m afraid. I see that there are many ideas produced in Brussels, but generally, you know, where Berlin pushes, the whole convoy sort of goes off. I’m sorry. We’re having a German –

MR. KEMPE: Even with France, Spain and Italy becoming more the core countries, as you’re saying. In other words –

MR. MAYER: In the future. Right.

MR. KEMPE: – is the balance of power shifting as this coalition –

MR. MAYER: Not yet. Not yet. Not yet. As long as France stays neutral, Mrs. Merkel is still calling the shots.

And now what has happened is basically – and I invoke here the German opposition party which makes this accusation toward Merkel. She says –they say she should have agreed long ago to debt mutualization, so euro bonds in one form or the other. Then the ECB would have been fine, right? We wouldn’t have had a problem. Rates in these countries would come down and the ECB could do its job. And because she said no to euro bonds of any form, whether it’s blue bonds, red bonds or debt redemption funds, she said no, the ECB is now in the fire.

So I think Draghi kind of played this ball back and said, well, you know, I’m not taking responsibility for all this. You guys say whether I can go or not, so, therefore, he has made it again political and tied it to fiscal decisions.

Now, his rationale for that I think is quite stretched because – of course, you know, it’s sold as the making the monetary transmission mechanism work and, therefore, they have to do this. It is really I believe a very stretched argument.

They have to say that because they are challenged in the European Court of Justice. There is one suit already running from an Irish MP. And we are still awaiting the final ruling of the German Constitutional Court on the legality of the ESM. We only have a provisional ruling from the German Constitutional Court on this. And the court has indicated that in its final ruling it will also consider OMT, whether this is not after all a fiscal action. And if the German Constitutional Court has doubts that this is a genuine monetary policy tool and feels that this could be a fiscal action, then they could also push this case onto the European Court of Justice.

So, therefore, the ECB has to be extremely careful right now not to make one wrong sentence or word which could be used against them in the court, and it would be a disaster if they were basically found to have violated their statutes. So this is why the wording here is so important. And I, as an analyst, can be a little bit more liberal.

MR. KEMPE: With that in mind, I just want to remind everyone this is on the record, and I don’t know whether you mentioned that in your opening comments, Alexei, but I just want to make sure everyone knows. Great. Thanks. Harlan?

Q: Have I got some kind of disease? (Laughter.) I’m Harlan Ullman with the –

MR. KEMPE: We’re deciding whether it was going to be a German or a Latin delivery. (Laughter.)

Q: Which flu? I’d like to expand the conversation more globally, and my metaphor is the Titanic. And I’d like to know your view about the fragility of strength of the international economy.

Yesterday, you saw the Dow sneeze – not NASDAQ yet. Demand seems to be drying up principally in China but the rest of the BRIC countries. The strength of American corporations with a lot of money, productivity, so forth is now probably more in question as demand declines. The end of the year, we have more than a fiscal cliff, as you know. Dodd-Frank has yet to be fully written or indeed imposed, lots of uncertainty. You’ve got the doc fix, the AMT, et cetera, et cetera, et cetera, irrespective of sequestration.

So I wondered if you could share your views about how you see the strength, resilience or fragility of the international economy occurring in the coming six to 12 months.

MR. MAYER: I think – I think we’re going through a soft patch. Already a couple of years ago, ’09 or so, I was thinking that the new era, the post-great moderation era is basically the inverse of what we saw in the great moderation. This is sort of my template with which I look at, which I use to look at things.

And the great moderation was characterized by high-trend growth, low economic variability and low inflation because at the time we had technical progress and we had the integration of the emerging market economies in the global economy, and all this is facilitated by ever-expanding credit. When you look at the ratio of credit to GDP ,it sort of goes like this, right? So this was basically credit – easy credit was making the great moderation possible.

We are now in the era of deleveraging, which gives us the opposite – low trend growth, because the credit-driven expansion is now over, is no longer there – low-trend growth with a lot of economic variability. So take the great moderation, multiply it by minus one; a lot of economic variability because the deleveraging process is not a straight line. It comes in fits and starts. You have very big, big, big push after Lehman, deleveraging. Then we had a bit of a slowdown in ’09, ’10. Then, the next push coming from Europe. So this is a process of deleveraging that goes with pushes and pauses and pushes and pauses.

At the same time, you will see also inflation gradually creeping up as the central banks go out of their way to avoid a 1930s-type of debt deflation, a la Irving Fisher. So they replace the destroyed outside money as a result of the balance sheet adjustment. They replace that with an expansion of inside money and want to stabilize the situation, put a safety net under it, which gives you overall together with changing structural factors in the global economy, no longer cheap – super-cheap T-shirts out of China – gives you an upward trend in inflation.

So when you are in this environment, you feel like – another metaphor, I’m afraid – you feel like sitting in a low-flying plane that hits air pockets all the time. So you always believe that now you must crash; now you’re crashing; now you’re crashing. So I’m just saying that this is sort of the environment I think in which we’re in.

And, therefore, because these air pockets are all the time there, we have – all the time we have crash fear. This is not the first time. We’ve had that at the autumn of 2010. This was then QE2, right? So now we have QE3. So with every air pocket, we get another push by the central banks.

That’s why there’s always this push whenever we hit an air pocket I think we will not get this recession now. We will see the Chinese again once their new leadership is established give the thing a push. Here, Mr. Bernanke has now initiated QE3. And I would think in the end, the U.S. political sector will find somehow a way to avoid falling off the fiscal cliff. This is all forecast. Forecasts can be wrong, but I’m leaning towards saying it’s just another air pocket that we’re hitting here.

MR. KEMPE: But get ready for more volatility.

MR. MAYER: Definitely. Definitely volatility. This is the name of the game. Volatility will be with us. It’s part of the world we live in. It’s the anti-great moderation world.

MR. KEMPE: An air pocket two or three weeks ahead of an election is also a problem that has some specific opportunity.

Yes, please. I’m sorry. Three questions. Let me pick up a couple here because we’re getting toward the end of our time. Please.

Q: (Off mic.) You haven’t mentioned in your discussion of the broader global issues Japan, which until recently was the world’s second largest economy. How troubled are you about the Japanese debt problems, about the Japanese banking issues, about the long-term future of Japan?

MR. KEMPE: OK. One on Japan. Please, back here.

Q: (Off mic) – necessary is if private capital starts financing the government of Spain again or the governments in the region. I’m just wondering sort of from a banker’s perspective, what do you think it’s going to take to reverse the capital flight – the investment flight that’s taking place out of those countries?

And if you could quickly game out what you think act two will look like once inflation returns to Germany?

MR. MAYER: Sorry, what –

Q: Game out what you think act two is going to look like after the intermission once inflation kicks up in Germany.

MR. KEMPE: I think it’s a great question because I was recently in Spain, and their view was the reason that capital was fleeing or capital wasn’t coming there was investors were still hedging against Spain leaving the euro, which, if that were the case, you’d have to assume a real sharp depreciation. But if you actually assume Spain being in the euro – again, I’m not an economist – they were saying, well, that would make Spanish assets look relatively cheap.

I saw one other question. Did you have question? No. OK. And then – so let’s take those questions.

MR. MAYER: Yeah, Japan, and – and I’ve been mentally struggling with the Japan situation for years. It’s a bit sort of – I mean, it’s an accident waiting to happen – everyone says that – but watching this accident happen is a bit like watching grass grow because it’s driven by demographics, as we all know.

The Japanese situation has long been stable because they can fund their very high deficits and roll their very high debt in the domestic market so they’re not reliant on foreign money.

But with the share of the elderly rising in the total population, and these ever more owners of JGB portfolios not having children who they can bequeath that, we will see in the next few years the tipping point where the system tips over. And, you know, if people say, look, I have saved my whole life and now it sits in the postal savings bank, and the postal savings bank has all invested in JGBs, I want to make as long as I can, you know, a tour of the world. I want to have something of my money. I don’t have any children, I’ll spend it.

So if too many people then start behaving that, you can see a rise in JGB yields, which would create serious solvency issues for the Japanese government, a sharp depreciation of the yen, and, as strange as it may sound, a rise in Japanese inflation will devalue these nominal claims on the government, which then eventually because of demographic reasons cannot be settled.

But it’s one of these things, you know, where economies – economists like with imbalances before we had the great financial crisis, we had said for years these imbalances cannot be sustained. And, eventually, you know, economists gave up saying that because, you know, people feel bored when you come around and say it’s going to happen, it’s going to happen. Not yet. And then, in the end, the last guy, sort of who is a little bit autistic and, you know, doesn’t react to the negative reaction of the public and keeps saying that he’s then the hero because he has just kept saying it’s going to happen, it’s going to happen and then it happens, and he foresaw it. But it is a problem in Japan.

What makes the capital flows go back into Spain? When we look at the so-called target balances, this is – it’s very difficult to explain very briefly, but this is basically the euro systems funding of the balance of payments deficits of a country when you have capital flight. So the euro system pushes the money in. I apologize for all those who are not familiar with the European technicalities.

But what we have seen is that the money that has gone out of Spain, which you can measure through the balances in the inter-bank payment system because that is basically where it shows up, reflects pretty much – not quite but close to the accumulated current account deficit of the country.

So what we are seeing is basically the money that was borrowed from abroad in the course of the first decade of the euro and to fund very large current account deficits – unlike Italy, Spain had very large current account deficits and relied on foreign money to fund its investment boom in the housing market – this foreign money has left and the euro system has stepped in to replace it.

And if the ECB now comes and says, look, I’m going to support the Spanish bond market, you can generate now reverse flows. So I would envisage that in the next couple of months we’re going back to the so-called convergence rates. Those who have until recently taken their money out will say, oh, the ECB will come in and kick the yields down, and now we have to actually pick up these yields at 5.5 percent, 10-year government bond yield, where can you get that? So now we have to go in.

As you then go in, you see then these capital flows reverse and that you can then measure when you look at these target balances how they would come down. So I think we probably are through the worst now as far as that part of the play is concerned.

You mentioned how would act two would look like. I mean, I’ve been speculating a bit also here so this is a commercial parenthesis, this is also in this book, how the act two might look like.

The problem I described, what do you do, you know, if you are a nominal asset holder, and all of a sudden you have to confront zero rates and 4 percent inflation over an extended period of time, your assets going away?

So one of the things that the German government could do immediately would be to offer people government debt, government bonds linked to the German CPI, not as they do now to the euro area HICP. What I – you know, it doesn’t help me if I get compensated for euro area inflation which is 2 (percent) when my inflation may be 4-plus (percent).

That’s the first thing. The government can do that because the government always wins when you have inflation. So that would take care somewhat for the unwelcome distributional effects of inflation because inflation is – the most difficult part of inflation is the distributional effects, that real asset holders benefit and nominal asset holders lose.

So that would be one way, one step. You could imagine that contracts then are shifted to linked contracts. Of course, whenever you have a linked system – whenever you have a linked system, the risk is that an (exceptional ?) shock lets it spiral out of control.

So – and now here, it gets highly speculative. And then I have speculated in this book, if you want to avoid that, you can actually tell the public and also tell the European Central Bank if, let’s say, inflation in Germany is more than five or two years running, we take these contracts and switch them into a new virtual currency to be managed by the Bundesbank as a parallel currency to the Euro.

That is obviously a very speculative look into the future. But I think this has – you have people sort of usually shaking their head when I say this, but I go back to an idea that was quite alive in the ’80s that a European currency should be created as a parallel currency to national currencies. And, in fact, in the early ’90s, the U.K. government revived that idea as a counter-plan to the euro.

Now, if we really cannot make the euro work, if there’s really a serious issue that we cannot cope with, why not use this idea and turning it around? If national virtual parallel currencies in countries that are so far out of line with the majority of the union that are so far non-core that they cannot cope, keep the euro as cash and have then for countries that are out of line, way out of line with the mainstream, have virtual parallel currencies; i.e., currencies that exist only as book money and not as cash.

MR. KEMPE: You know, I could go on for quite some time in this kind of discussion and I have with Tom in the past. But unfortunately we’ve reached the end of our time.

Let me just say a couple of things in closing. One of the reasons that it’s so useful to listen to someone like Thomas Mayer is there are economists in the world, there are politicians and political thinkers and policymakers and then there are sort of people who have imagination and creativity to imagine scenarios of political economy. Tom can do all of that and it’s the reason why if you look at the way he’s looked at issues over time, he’s been more often right than wrong. And so I’ve relied on his advice and thinking for a long time.

You know, whether it’s watching grass grow, or bridges being blown up, or the Titanic sinking or whatever the metaphors are, this is a richly written book and this is rich ideas. I think what we – or the reason we are so captivated by this is – as you’ve captured through this, it’s not certain where this is going to land and this is about history. It’s about the history of Europe. And Europe is a political experiment, it’s an economic experiment and things happen in experiments. And so we are watching this with great attention because Europe is our leading strategic partner in the world to the United States. If you have – if you have a crisis in Europe and a crisis in the United States at an inflexion point in global history, it’s not good.

So thank you very much, Tom. It was great to listen to you. I again recommend everyone read this book. And we hope to have you back here again soon. Thanks.

MR. MAYER: Thank you very much everyone. Thank you. (Applause.)


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