Martin Wolf

Martin Wolf

I am not arguing that these forces will necessarily win. It could break up. But I think people underestimate the strength of these forces. Indeed, in their absence it would have already gone. Since the crisis began three years ago, the eurozone leaders have done much to keep it together.

They’ve created new funds. They have allowed the Central Bank to take enormously aggressive positions of various kinds. Big reforms have happened in countries. Governments have been overturned; they’ve got new governments, sometimes technocratic governments. And they are implementing very painful reforms. So that’s an indication of the seriousness.

The forces? First, the eurozone was the capstone of a project of economic and political integration that goes back to the 1940s. It was started after the war to end the history of division which, in the view of the European elite, had led to endless devastation. This was particularly important for the two leading powers, Germany and France. It was France that promoted this European single currency, and Germany, at the time of unification, conceded it as a way of remaining locked into Europe.

Secondly, it’s the capstone of the process of market integration, particularly the single market. It’s a very strong view in the eurozone, that you cannot have a completely open single market without fixed exchange rates when there are so many countries. It’s rather different from North American Free Trade Agreement (NAFTA), which is really one huge country with two rather smaller ones attached.

But here we’re talking about 17 members. If all their currencies were moving all over the place, nobody would know what was going to happen. Businesses couldn’t plan for the integration of production. The capital market couldn’t integrate. So having fixed currencies, or basically eliminating the currency risk, was essential.

Then there’s the German question. Germany is obviously the dominant power in Europe. Having the European Union and the eurozone around Germany has provided it with stable relationships with its neighbors. It has given its neighbors the belief that, in some sense, Germany is under control. So from both sides, the European Union and the eurozone have proven a really effective way of handling Germany.

And finally, the weaker countries—Spain, Italy, Portugal, Greece, Ireland—have had very troubled political pasts. The European project has been seen as the guarantor of political stability, democratic values, and economic stability. It’s given them all—particularly their elites, their young people—a sense of being part of a project of civilization, and in Spain’s case, after centuries of isolation and impoverishment. So for all these reasons—and I think it’s worth spelling them out—the forces behind this huge European project are far more than merely economic.

Martin Wolf

Absolutely. The fear, whether justified or not, is that if the eurozone were to break, it would end the idea that we’re moving steadily toward a more integrated Europe, and Europe would start to unravel.

They have no legal mechanism for handling this situation. The forces when the exchange rates start to move around could be very powerful. And if it were to unravel, where would it stop? Where would that leave you with European law, which is a crucial part of the whole European project?

So yes, the fear is that it would unravel and we would end up with chaos. Now, the chaos could have many forms. It could be collapse of the European economy, which is the biggest in the world. It could possibly lead to protectionism; political frictions of the highest order; mutual recriminations, because each country would blame the others for the failure; and Germany would be isolated. And for many people it could be uncomfortably reminiscent of the situation before the first world war.

Martin Wolf

Well, we know how to create currency unions. The United States is a currency union. The question is: what is the minimum number of institutions you need to make a currency union work? And can they create those?

We know that they need more than they had. You need more flexible member economies. You need a central bank that behaves more like a central bank.

I think you need a eurozone-wide management of and support for an integration of the banking system. The United States has a national banking system. Having a federal government makes it possible to manage a crisis, which the states could never have managed on their own.

So you need a federal eurozone-wide financial regulation and support mechanism. They’ve gone some way toward that on the regulatory side, but not all the way.

And finally, you need financial fiscal support, which will allow countries the time they need to adjust without being driven into bankruptcy in the process.

I would say you’ve got the nascent parts of all of this, but none are fully constructed on an adequate scale. They’re going to need more money. They’re going to need more integration. But they are moving slowly in the right direction.

Martin Wolf

It’s a very good question. The answer is we can’t be sure. We should separate out the economic and political aspects. The United States played a very large role—a crucial role—in pushing for an integrated Europe.

Admittedly, that was in the context of the Cold War. But Europe remains—and is almost certain to remain—America’s most important partner. It is still, even in these days, its most important economic partner. It’s much bigger than China, still, as a market. And so the political weight of an integrated and effective Europe is important for the United States.

And if the economy were to collapse, if there were to be a real crisis with major sovereign defaults, it’s bound to affect the global financial system very significantly. The eurozone banking system is the largest banking system in the world. It’s a very integrated world economy. So if you put one of the biggest parts of it into real turmoil, it’s bound to affect everyone, including the United States. It could certainly put a big dent in the recovery, and the U.S. economy itself is not that strong.

Martin Wolf

Well, I never predict double dips or anything like that, because I don’t think they’re predictable. What you can do is analyze the underlying processes. And the underlying processes are such that it is very likely that growth itself will be slow, disappointingly slow. And the economy will wobble around that growth.

Furthermore, I don’t think the economy will ever get back to normal, because what was regarded as normal—the economy that existed up until 2007—was unbalanced, uncoordinated, and unsustainable, to coin the phrase that Premier Wen Jiabao uses of China. Look, you can’t go back to that. You will remember that, prior to the crisis, the United States ran a current account deficit of about 6 or 7 percent of GDP. It had a huge housing bubble. It had an extraordinary and unprecedented explosion of household debt. Its households in aggregate had negative savings; basically, they weren’t saving at all.

If you went back to that, it would be frightening because it would merely guarantee another monstrous crisis.

Now that’s why this recession is so long, because the United States has to go back to something stable and balanced, which the U.S. economy hasn’t been since sometime in the 1990s. The U.S. economy has to adjust to being something sustainable and still grow quickly. And what makes it much more difficult for the United States than it was for other countries is that the U.S. economy is so big.  So when the United States changes, everybody has to change.

This is affecting the eurozone, which is big. Japan is also in trouble. Something close to 50 percent of the world economy is in trouble. Now that makes it very difficult for the United States to find a new path to growth. To get a new, stable growth pattern in the United States, you end up with an economy that looks very different from the one that existed before the crisis.

Martin Wolf

That is certainly my view, although it’s a great pity it wasn’t done earlier. This is one of the few things I did get right back in 2006: that the United States would end up with a monstrous fiscal deficit. But as soon as it happened, people got frightened and wanted to cut back again. Nearly all the deficit is simply a result of the crisis itself. It’s not because of the stimulus, which was very modest.

The private sector needed to heal. That meant that the corporate sector and the household sector were going to run large financial surpluses. That is, they were going to spend less than their incomes for a long period while they paid down their debt and improved their asset positions. If you have the private sector running very large financial surpluses—and they are now, as I predicted—and if foreigners are also running a financial surplus, which is what a current account deficit means, somebody by definition must run deficits. And that’s the government. So the government is driven into deficit. If it shrunk its deficits, all it would generate is a deep recession or complete stagnation, as has happened in the United Kingdom. So it would have been better in the short run if the deficits had been even bigger, if monetary policy had been even more aggressive. The central bank can buy the debt, in which case the public’s holding of debt doesn’t rise. So I think the debate on fiscal policy here is, unfortunately, though understandably, completely and utterly misguided.

Martin Wolf

Yes, I think there’s a risk to following the British. You might well do so, under this automatic sequester, these automatic adjustments that are due later this year. I understand there could be a 4 percent tightening of GDP in the United States. In this case, the United States will go back into a deep recession. It will be a bigger mistake than Japan made in ’97. The financial sector will be again damaged. And it will be a policy disaster for the United States and for the world.

The idea that the private sector will offset that event is utterly implausible. And it will be worse than the mistake we’re making in Britain. It would just stop growth altogether.

Martin Wolf

My book was mainly directed at macroeconomic imbalances and the consequences of those. But there’s a different issue, which is the regulation of the financial sector itself. In that book I had not foreseen the full implosion of the financial sector, so obviously we want to rethink the financial sector.

I’ll just make three points. First, a great deal can be done by national authorities—not enough, but a great deal, particularly in a very big country like the United States, which, in some sense, sets the agenda for world finance. The United States has the means, if it wishes, to ensure that major American institutions are sound and that major American markets are soundly regulated. So there is a lot that national regulators can do.

The second point is that there is, in fact, an enormous amount of discussion of international regulation. Particularly if you look at what’s happening in Basel, which is sort of the capitol of regulation of banks and financial institutions, and what they’ve done on capital requirements, on liquidity, though very technical, this is definitely progress. If these rules and regulations are implemented, the system will be somewhat more robust than it was.

But my third point is that it still won’t be enough, because the changes that are required in our financial system to make it robust enough to cope with the sorts of risks it’s subject to and it creates—these changes need to be quite radical. And we’re not prepared to accept them—partly because there are powerful lobbies against them, and partly because we in the West have gotten used to cheap credit.

We like cheap credit. We like subsidized credit. It’s effectively subsidized by putting a lot of the risk on the taxpayer. If we insisted the private sector bore these risks, it would have to be more cautious. There would probably be less credit. And we wouldn’t like it. So there’s a fierce political resistance to some of the changes that will make our financial sector fundamentally more robust. So we have made some progress, but I would be quite surprised if we didn’t have another big crisis at some point in the next few decades.

Martin Wolf

No, I think that would be too much. It’s not in the least plausible nor is it necessary. We can get a long way toward managing our banking system by forcing the entities in different countries to be fully independent subsidiaries.

That leaves you with the main problem: investment banks. The way to get at the global investment banks is through capital requirements, liquidity requirements. Now, that does have to be globally agreed upon to some degree.

Martin Wolf

That goes well beyond Basel, though it’s a subject that is being discussed. The sort of freezing of markets that occurred in the derivatives markets—these are all globally interrelated. But actually, I think the most important globally agreed change probably has to be resolution of bankruptcy. One thing we discovered in the crisis is that institutions, as Mervyn King of the Bank of England said, are global in life and national in death.

It turned out to be very difficult to wind up institutions that have complex international operations. This was the story with Lehman. With subsidiaries, it’s less of a problem. If you have fully integrated global banks or global investment banking operations, and if that entity fails, then you do have to know how you can wind it up smoothly. And it’s very difficult to do that if you’ve got many different bankruptcy regimes involved, all of which are different. Everybody’s bankruptcy regime is fundamentally different.

This is probably the single most important area where you need very close international agreement. They are trying to reach this at the moment between the U.S. and U.K., because those are the two most important financial centers. And the idea is that if those two can agree, they might be able to extend it.

But what I’m trying to say here is, yes, there are some areas where we clearly need more global agreement, and there are other areas where I think we can do without it.