“Europe will need more rescue packages. We are now finding ourselves in the midst of a deepening recession. The national governments will have to pour more money into the economies,” says PAUL DE GRAUWE, Professor of Economics at the Catholic University of Leuven.
Many economists in the Czech Republic, for example certain members of the banking council of the Czech National Bank, think that the fact that we do not yet have the euro, but still the crown, has protected us from the crisis to a large extent. Do you agree?
I don’t think so. This was recently confirmed in Denmark, Hungary, and Iceland. Any banking crisis – even the present one – has an adverse impact of FX markets. In other words, a crisis simply infects FX markets; from that point of view, it is of no consequence then whether you have the crown or the euro. But the crown may prove to be a more advantageous currency after the crisis. If you then want to restart your economy, give it a new impulse, or revitalise the banking sector, you can do it by devaluing the crown. For example, the Swedes used that measure in response to the banking crisis in the early Nineties. They devalued their national currency, which made their exports more competitive – and they quickly revitalised their entire economy that way.
So you think that the crisis presents more of an argument for keeping our currency? Not because it will protect us from the crisis, but because it will allow for better revitalisation once the crisis is over?
That depends on the “soundness” of the Czech banking sector. By this, I only mean to say that it is difficult to determine whether having one’s own currency is always exclusively an advantage or always exclusively a disadvantage.
The economist Martin Feldstein recently wrote an article in which he claims that the crisis will be a great test for the eurozone, as it is still not a cohesive unit and member states will have a tendency to respond in an uncoordinated fashion, which could potentially lead to the collapse of the European Monetary Union.
It is true that we still cannot talk about a cohesive unit. It is a key structural problem of the eurozone. But, the collapse of the eurozone is another issue altogether. Look: Ireland and Spain are now going through a deeper recession; but before, they enjoyed stronger growth than the other member states. The cycles across the eurozone differ greatly. Ireland and Spain now have a problem, because they cannot intervene against the recession with a monetary policy. But at this point, it is exaggerated to say that that situation will lead to a collapse of the eurozone.
THE CROWN IS BETTER THAN THE EURO. “The crown may be more advantageous after the crisis. It can be devalued,” says Paul de Grauwe.
But you yourself wrote two years ago that the eurozone would collapse within ten or twenty years.
Yes, I think that we got stuck at the halfway point in the centralisation of monetary policy. The differences in the fiscal policies of the individual member states lead to tension, which we can observe today. Spain and France respond very aggressively; whereas, for example, Germany is reluctant to stimulate its economy in any significant way. A danger for the eurozone is also the protectionist efforts of individual member states. For example, the French say to themselves that they will stimulate their economy, which leads to a deficit, but also their neighbour, Germany, will profit from the stimulus – so they try to prepare a package that would clearly benefit only French companies. I argued that the members of the European Monetary Union (EMU) must act in a more coordinated fashion and that political cooperation will probably have to become stronger. Otherwise, the collapse you mentioned may come about.
But, for example, Czech euro-sceptics claim that economic cooperation among the member states can be expanded without deepening political integration.
There is a large debate about that, but I do not agree with that too greatly. In the sphere of monetary policy, we have gone relatively far in terms of the formation of centralised, Europe-wide institutions. Leaving the rest, primarily the sphere of fiscal policy, up to the national level, would be quite incompatible. Now there is an opportunity: the crisis is striking member states in a similar fashion – and the desired response should be coordinated measures.
What do you make of the interventions made by the European Union authorities thus far?
I think that the European Central Bank did what should have been done, especially in terms of providing liquidity to markets. I only criticise the bank for not having reduced its interest rates faster. The intervention of the European Commission is of a different nature, as it is not a measure in the sphere of monetary policy, and hence it is within the sphere of competence of the individual states. Budgetary policies and rescue measures to restore life to the banking sector differ from one country to another within the EMU. The European Commission has no instrument for intervening in these areas on a Europe-wide level.
Generally, however, there may be the conviction – and that is the spirit in which it is being presented to the general public – that the rescue package, those 200 billion euros, were actually provided by the European Commission.
No. It is, more or less, a set of national initiatives. The European Commission merely “gathered” the measures planned by the governments of the member states, packaged them, and said that it is a European stimulation programme. National interventions thus got labelled as a Europe-wide measure. Funds from European Union resources or from the European Investment Bank are too low to have any impact on the macroeconomic level.
Do you think that Europe will need more such stimulus measures?
I am afraid it will. We are currently finding ourselves in the midst of a deepening recession. National governments will have to pour more money into the economy.
Will the present crisis lead to a major drop of the type of the great economic depression of the 1930s, or will it, in the end, be a relatively mild, revitalising recession?
It is turning out that we will not likely fall into any sort of a depression. Certain manifestations of the crisis are identical to those from the early 1930s, others are not. We have a banking crisis and general pessimism, which leads to a deflationary cycle. On the other hand, there are two major differences from the situation in the 30s. Now, there are more automatic stabilisers available, at least in Europe – for example, relatively high unemployment benefits. When someone lost his job during the Depression, he soon ran out of money, and therefore was not able to shop and consume; now, that is possible. Secondly, this massive injection of liquidity was also something unknown in the 1930s.
Paul de Grauwe (62)
A top-level European economist, and professor of economic science at the Catholic University of Leuven, Belgium, who is one of the most widely recognised experts on the European Monetary Union. His book, Economics of Monetary Union, published by Oxford University Press, has seen seven editions. De Grauwe, whose theories significantly contributed to the formation of the European Monetary Union, is also close to the world of politics: he was a member of the Belgian Parliament and an advisor to the President of the European Commission, José Manuel Barroso. He plays squash and likes reading novels by South-American authors, but also for example Kundera. He drives a Lexus.
Jean-Claude Trichet, the head of the European Central Bank, said after the recent record reduction of rates that credit flows are not freezing in the eurozone for the time being. Given that the words “credit crunch” have been mentioned in relation to the crisis for nearly a year now, does this surprise you?
Statistics do indeed bear that out. If you look at the figures on the growth of credit in the eurozone, you will definitely not find any stagnation or drop in loans – and only that could be called a real “credit crunch”. Perhaps a certain slow-down is evident, but for the time being, it is by no means significant. But it is possible that loan calendars contracted for before the crisis are running their course.
So do we have to wait some more?
Yes. It is true that the spread between the rates on government and corporate bonds is growing significantly. That means that creditors are lending to governments more and more, and are more and more afraid of the uncertainty related to lending to a private entity, which is, therefore, becoming increasingly risky.
But even the US central bank, the Fed, recently published a study in which it literally states that the “credit crunch” is a myth, as the results do not confirm it.
Let’s not forget that it is mainly large, system banks that got into trouble. Smaller banks have not yet been struck by such a crisis and are still willing to lend. After all, precisely because of the fact that the crisis hit primarily large banks, we have a tendency to perceive it as more serious than it in fact is. Naturally, the fear that the present slow-down will harm some of the smaller banks is not groundless.
We can also view the financial crisis as a failure of theories about the efficiency of markets and the full rationality of market participants. Do you propose – in addition to a reform of the financial system – also a reform of textbook economics?
Yes. We went a bit too far in the development of models with those assumptions. That was a mistake. We need insights from other disciplines, for example from psychology. We must understand that people only have a limited ability to act rationally. It is not true that people always understand the complexity of the world, are fully informed, and can precisely predict the future. Markets are not efficient – prices do not always reflect the actual value. That happens, for example, due to the very fact that people do not understand markets and tend to be too optimistic.
Is this related to the fact that economics has become too infatuated with mathematics and physics, so that most economists are developing models filled with equations, which are ultimately miles away from everyday reality?
Economists are indeed too intoxicated with the technical and mathematical aspects of economic science. And it is precisely the assumptions about rational individuals and efficient markets that make it possible to develop models that are amazing in mathematical terms. Young academics in particular literally love them: I am surprised by how many young economists take them as givens now. But that is merely an act of faith. They do not even bother subjecting them to empirical examination and finding out whether they actually correspond to reality. We, who reject those models, are heretics in their eyes; they do not approach economics as a science, but as more of a religion.
Which form of economics is then the right one in your opinion?
We do need to use mathematics, as it is a tool that allows us to express ourselves more precisely. Words are often imprecise or misleading. It is difficult to test a verbal description; it is easier to test a mathematical description. But we must not fall into a trap, that is, to succumb to mathematical precision and overuse mathematics. Qualitative and historical analyses are important. What cannot be described mathematically must not be – as is done now – considered to be uninteresting. Many things simply cannot be described in equations. Let’s not forget that the social sciences – and economics is such a science – are internally far more complex than the natural sciences. It sounds paradoxical; many people would object that, for example, astronomy is very complex. That is true, but predicting the behaviour of people if often far more difficult than predicting the movement of stars.
So according to you, mathematics is a good servant, but a poor master?
I absolutely agree.
Are you a proponent of interdisciplinary approaches in economics? They would connect economics with other academic disciplines…
Yes, I am. We can learn a lot from psychology and other academic disciplines. In the past, economists were too arrogant; they considered other scientific disciplines irrelevant. I think that it is now evident that this sense of superiority was wrong. I myself have been influenced by the work of the Portuguese neurologist António Damásio in this regard, who explains that in reality there is a very strong connection between emotions and rationality. This connection is so immense that people who lose their ability to experience emotions – for example due to brain damage – lose not only their ability to love and fear, but also their ability to make rational decisions. But economics adopted exactly the opposite thinking for a long time: it removed feelings and emotions and analysed a perfectly rational individual, who coolly, like a machine, maximises his profit or utility: a sort of a “homo oeconomicus”. But we need emotions, we must feel, perceive, and distinguish between good and evil, because only then are we able to make reasonable decisions.
Can this also be applied to the present financial crisis? Did it occur due to a deficit of the feeling of fear, which led people to invest into excessively risky assets, that is, to irrational investments? Was there no fear, and hence, no rationality?
Of course – and now, when the crisis has burst out, there is again an excess of fear. Everything we do is the result of the effects of reason and feelings at the same time – they cannot be separated. And the other essential thing that I have picked up from other sciences, primarily from psychology, is the limited ability of people to process information and their limited ability to understand the world around them. A rational answer to this reality is the fact that people use heuristics (for example qualified estimates, common sense). That consists of having learned from previous experiences, and a decision is reached with the use of the limited, far from complete, set of available information that is relevant for that decision. I once wrote an article about this in the Financial Times, in which I used the example of an experiment in the introduction of a new kind of praline in a Brussels chocolate shop.
On the first day, one package is sold for ten euros. The next day only for three – but unlike on the first day, nothing is sold. Customers stand by the shop window, shaking their heads: “Only three euros? That must not be good.” And the next day, they increase the price to twenty euros – and the interest is great. “Twenty euros? That will be good chocolate!” Customers simply used heuristics – from their previous experience, they learned that a more expensive product is usually better and they applied it in a new situation.
The snob effect – increasing demand with an increase in price?
But that is only a part of it. It points to decision-making in the world of incomplete information – people apply heuristics: common sense, learning from previous experience. We act on the basis of heuristics all the time.
That runs a bit contrary to textbook economics?
Yes, but heuristics are really omnipresent. What is for example the true value of the dollar in comparison with the euro; what is the objective exchange rate? God only knows. But when the dollar goes up, traders on the FX markets start using heuristics, in the sense that they say: look, it is going up, it would be good for us to buy the currency, as well. And when the dollar weakens, they say that they must have missed some kind of news about the poor state of the US economy; so when others are evidently getting rid of the dollar, they must also get rid of it. That is how bubbles arise, which then pop – a boom and a recession.
Herd behaviour and incomplete information. Collective movements.
So now we are witnessing a downward collective movement?
Yes, everyone is saying: everyone is selling, so I will also sell.
At such times, it is usually good to start buying – to go against the herd.
But the question is of course where the bottom is. And let us not forget that these cycles, which may have a foundation largely merely in crowd psychology, often lead to a drop in stock prices and hence to the insolvency of a bank. Negative moods on the markets simply show up in the balances of banks. Worsened bank results then lead to another drop in shares, and we get into a vicious circle. That is why state authorities are required, which stand outside of the market and which can intervene in such a situation.
Do you therefore think that we should get away from the “mark-to-market” criterion, according to which bank’s assets are valued in line with their current market price (which may, however, be swayed by a momentary mood on the market)?
Yes, I wrote about that in the Financial Times, as well. This criterion is a really bad idea. Again, it is based on the theory of efficient markets, which postulates that the market price is always the most objective price. But in the time of a bubble, the market price is not objective at all; it does not reflect fundamental value. Then, because of the “mark-to-market” criterion, bank balances inflate like a bubble. This leads to virtual profits for banks. People purchase more stock of the respective banks on the basis of those virtual profits – and the increased stock price is also only virtual, simply put, built on water. Then a crash comes and at that point the “mark-to-market” criterion unduly accelerates the drops, as we can see today.
Why do you think the theory of efficient markets became that influential? There is no general agreement with respect to it among economists.
Even notional markets with ideas go through their booms and busts. In the Eighties, the theory fit into the revived free market theory. Now, it is turning out that markets without controls are not the best solution. Even a factory has to be watched, to make sure it is not letting pollutants into the air. Financial markets have to be regulated and we must not believe fairytales about their immense efficiency.
Let’s focus on practical life. It is generally believed that the present crisis was caused by the Bush administration. But you go even deeper into history.
I do not claim that everything was caused by Clinton’s people; that would be foolish. But the basis of the crisis was not the doing of Bush, but Democratic administrations that pushed for banking system deregulation. They did so – and that is related to what was said above – on the basis of the belief that markets are efficient and that they can regulate themselves, so it is not necessary to watch over them so closely. Booms and recessions have always been here and will probably continue to alternate – that is an economic principle that cannot be got around. But what we can avoid is the engagement of the banking system in these cycles.
What to do about it?
This had already been addressed by the Glass-Steagall Act: it separated commercial banks from investment banks. Commercial banks therefore could not participate in risk operations on financial markets. The people who pushed for the getting away from that Act (Clinton’s administration in 1999, note of L.K.) forgot how important it is for risky assets to stay off the balances of commercial banks. The route to deregulation had already been opened in the Eighties, but it got strong during Clinton’s era. But also Alan Greenspan, the former head of the Fed, also bears responsibility, as the Fed kept interest rates too low between 2001 and 2004. But all things were definitely not caused by Bush, as is the fashion to declare these days.
But the crisis moved everything even further along. Whereas the Glass-Steagall Act allowed commercial banks to engage in investment banking, in response to the crisis, two remaining investment banks – Goldman Sachs and Morgan Stanley – started to engage in commercial banking and became universal banks. The Glass-Steagall demarcation definitely vanished – even from the other side.
Yes, and that is a very poor solution. But that convergence of investment banks towards commercial banking was there even before the crisis – investment banks were allowed to use short-term inter-bank deposits. Now they have only taken the last step – like traditional commercial banks, they can use the deposits of regular depositors. And those deposits are more certain and stable than inter-bank deposits, in whose case any drop in the mutual trust of banks, albeit small, causes enormous negative effects. But investment banks should not have been enabled to do even the first thing – to get into this kind of debt, to, as we say, “leverage” on the basis of short-term financing. Most of their investments are related to long-term and usually illiquid projects.
Are you therefore in favour of a form of financial system reform that would again separate investment banking from commercial?
Certainly. Commercial banks get funds of a short-term nature, from regular depositors, which is why they should be limited in how they use that money, i.e., for what purpose and to whom they loan it. They should not assist in stock-exchange subscriptions, trade in derivatives, and so forth. And investment banks, they can engage in riskier transactions, but let them also have longer-term financing, for example through capital markets, not short-term – from clients’ deposits or from the funds of other banks.
Do you agree that the reform of financial markets should also include the introduction of some form of asset price targeting, which could prevent the formation of bubbles?
Certainly. A central bank that evaluates only the growth of the price level in goods and services is not a good central bank, because it overlooks possible bubbles on the asset market. If a bubble starts forming on the asset market, for example if demand for real estate goes up, up goes the supply (development) of such properties as well, and investments into new capacities (the bubble makes capital less expensive, which encourages further investments), which can in the end leave the price level relatively unchanged, and the central bank may easily, for a certain period of time, overlook the bubble. And once it pops, it is all of a sudden discovered that investment had been made into unused capacities – and the economy is in a downturn. An increase of rates as an anti-inflation measure also reduces the size of bubbles, but is not sufficient on its own. In the future, prices should also be monitored directly on the asset market.
Alan Greenspan warned that interest rates are too blunt an instrument against bubbles, as they hit all sectors of the economy, not only those that are inflating. He was also sceptical with respect to the monitoring of bubbles…
I think that he never really tried it, perhaps with one exception. Also, let’s not forget that he has lost much of his reputation since he declared that.
Do you think that the US government did its best in rescuing certain investment banks, for example Bear Stearns, whereas later, it let Lehman Brothers fall?
I am one of the critics of this inconsistent process. The position of Lehman Brothers on the credit-default swaps market was indeed key, which is why I consider the fall of the bank to be a mistake. The impact of the bankruptcy of this system company was underestimated.
There are also voices that say that the fall of Lehman Brothers significantly aided Obama’s presidential campaign. Before the bankruptcy of the investment bank, McCain had started to gain ground on his competitor, or even beat him, but then the crisis escalated and the gap between the candidates grew larger again.
We can go even further. Timothy Geithner, whom Obama chose as his Secretary of the Treasury, was – as the head of the New York Fed – a central figure among those deciding about the fall and rescue of Lehman Brothers. Certain people therefore talk about a “deal” – the fall the “Lehmans” in exchange for the position of the Treasury Secretary … I don’t think that it was that way, but I understand that people think so, because they love similar conspiracy theories.
But it is interesting that Obama chose many people for his economic team whom he had considered to be at fault for the crisis. For example Lawrence Summers, his key economic advisor, was one of those who, during Clinton’s administration, vehemently advanced the above-mentioned abolition of the Glass-Steagall Act.
Are you dismayed by that?
No, I am not: I am only saying that there are enough people in Obama’s administration who are in some way responsible for the crisis. This reminds me of the book “The Best and the Brightest”, which is about how President Kennedy “pulled in” the best brains from Harvard to his team – and these people in the end led the United States to the debacle called the Vietnam War. It’s an example of the fact that even the best and brightest make mistakes. Because of their arrogance and conviction that they know everything better than others, which makes it impossible for them to use their common sense.
An abbreviated version of this interview, obtained in Leuven, was published in Týden No. 51-52 on 22 December 2008.