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Inevitable austerity

Interview mit Hans-Werner Sinn
arcVision, 01.07.2012

Interview by Enrico Sassoon


Let's start by talking aboutthe European Welfare State modeL Is it too expensive? After almost 50 years of large pensions, almost free education, extensive health systems, should the European countries reexamine their social model?

Yes, it should be revised. The European pension system is very expensive and absorbs a significant share of GDF with negative repercussions for birth rates. Since people get their pensions from a system that socializes the contributions of their "children" rather than directly from them, they have very few children. Everyone has an incentive to free ride on their neighbor's children rather than going through the effort of raising children themselves. Also, some countries draw too many funds from the private sector. The French government share of GDF,' for example, is 55%, one of the highest in Europe and among the OECD countries, after Denmark. Ten years ago the Lisbon Agenda said Europe would be the most dynamic region of the world. In fact, it is the world's laggard, with the lowest growth rate of all continents. So it is time to reconsider this model.

Going back to the European Welfare State model, do you think that State provisions and assistance should be replaced by private schemes, especially where pensions and social transfers are concerned?

We definitely need a private pillar to support the pension system, adding a funded element to the pay-as-you-go element. Two legs stand better than one, and one should certainly be private. In prim-0e the government could build up a fund for future pensions, but it will always be used prematurely: a dog doesn't accumulate a pile of sausages.

President Obama's reform of the US healthcare system is considered by his political adversaries too expensive and too similar to the European systems. What is your view?

As far as healthcare is concerned, I think we're better off in Europe. We obviously need coverage against sickness, although not full coverage of individual expenses. There should always be a deductible fraction borne by the insured, before the insurance company pays. But in the American situation some people are completely uninsured and this is intolerable. So the US reform was an absolute necessity although Obama did not really succeed in bringing it off. We have to avoid extremes: we should not go towards the American system, but the European model also needs to be reformed. Our system is too generous.

Let's consider the economic situation. There is broad consensus these days that the austerity programs needed to reduce budget deficits and sovereign debts have to be implemented along with growth policies to avoid asdepression and ensure social sustainability. Germany seems to be wary about this approach mainly due to its historical fear of inflation. What approach would you suggest? Should the EU continue with financial discipline, which implies huge costs in terms of growth and unemployment, or can we target growth policies and accept some downside inflation risks?

No one would have objected to countries borrowing as much as they wished if they had done it in the marketplace. But what some countries actually wanted was to borrow through public channels from other countries or receive guarantees from them, in particular from Germany This is the concern, not the abstract question of whether to borrow more or less. If a country that wants to borrow raises funds on the American market, without any implicit liability for other European countries, that's fine. But that's not the case. Some countries have difficulties raising finance on the market and now they want to get the money from other European countries instead, and the creditor country here is Germany This is why Germany is concerned. Ifyou have a private borrower and a bank, and the borrower says "I want to grow, I want more credit from you" and the bank says "Sorry, I don't agree, I'm afraid of not getting my money back", that's the situation. Germany was the capital exporter, the southern periphery was the capital importer Now the risk is that they will default, and given this risk Germany doesn't want to lend more money.

On this point, what do you think of the IMF position, also shared by the United States and a large group of other countries, who want a greater focus on growth? Growth policies are favored not only by the weak countries, but by almost the whole world.

Welt honestly who is in favor? The Americans of course, because they invested a lot of money and all the other investing countries are in favor Everyone who invested in the toxic government bonds of periphery countries. They want the bad bank in Luxembourg to take over these toxic assets. Wall Street, the city of London, the French banking sector, as well as the recipient countries in the southern periphery they're all in favor of new credit to replace the old credit because this is the only way to get out of their flawed investments.

What about the IMF suggestion of relaxing monetary policy and lowering interest rates to sustain the economy?

To what level? Interest rates are already lower than 1%, which is well below the inflation rate. Europe is in a liquidity trap. When interest rates are this low you can hardly reduce them any further We already have negative real interest rates in Europe, with the inflation rate everywhere above 1%. The bitter truth is that growth would not reduce the imbalances in Europe. The crisis is the inevitable consequence of borrowing beyond one's means in the past. If someone borrowed too much, the only way out is to scale down economic activity And if one wants to avoid this, no rebalancing will occur Some politicians say that countries should be growing out of their foreign debt problem. But how can you do that? Ifyou grow, your imports increase, you're borrowing more and the current account deficit increases. So the bitter truth is that if someone lives beyond their means, they have to shrink out of the problem. Hopefully the shrinkage is only nominal with cuts in wages and prices, but unfortunately inside a currency union it is typically also a real shrinkage, as in Greece, Spain and Portugal. Real shrinkage can only be avoided if a country exits and devalues its currency Those countries have lived on cheap credit from abroad for years, since the convergence of interest rates in 1995. From 1995 to 1997 there was a perfect interest-rate convergence, followed by a period of sub-budget constraints, which led to an excessive inflationary growth process and a current account deficit. Somehow we now need to reverse the clock, which is very difficult; it could be so difficult countries could face so much internal friction and mass unemployment that, in the end, they prefer to leave the euro. Borrowing more simply postpones the crunch time, if there is a lender willing to risk his money But there simply isn't You cannot just continue to borrow ifyou have borrowed too much, you cannot solve a debt crisis, public or private, by borrowing even more. This is a recipe for disaster In Europe we have reached a situation where the hard truths have come to the surface and the solution cannot be simply to mitigate the process by postponing a period of austerity Austerity is a necessary implication of overspending, and the only way to mitigate is to exit the euro zone.

So the policy you suggest is to continue with the current fiscal restraint and high taxes, and maintain the present monetary policy?

No, I think the present monetary policy is too generous and unsustainable for the countries that are forced to lend, and at the same the implications for some of the crisis countries are unsustainable. Europe is trapped. The ECB has provided 900 billion euro of credit through its system, a systematic public capital flow from the core countries to the southern periphery replacing the capital market. To some extent, in an acute crisis, such ECB lending is right but you cannot claim an acute crisis every day Ifa country overborrowed and has to stop borrowing, of course it has an acute crisis, but that can't mean it should never stop borrowing. You cannot go on with that po/icy forever At some stage you have to acknowledge there is a deeper problem which cannot be overcome with cheap money but only by recognizing that living standards cannot exceed your income.

So you are suggesting higher interest rates along with higher taxes?

Higher taxes definitely, not higher interest rates. What is needed is higher safety requirements for collateral given to the ECB when banks borrow newly printed money The ECB used to require an A-, then it contented itself with a BBB-, which is close to the non-investment grade, then the government bonds of Greece, Portugal and Ireland were exempted from this minimum requirement and it was said they would be accepted as collateral regardless of what the rating agencies said. Then ELA credits came in (emergency liquidity assistance), enabling national central banks to lend out newly printed money to their banking sector without any collateral. If something goes wrong, the national government steps in. But if a national government goes bankrupt, then the rest of the euro zone bears the losses. All of this implies that capital flows from the North to the South at below-market conditions and that the capital market is undermined by political decisions. This will lead to disaster We have reached the point where we have to stop this, painful as it could be for those countries that used that machinery.

It is obviously very painful and has already started having not only social, but also political consequences in the countries that have recently held elections. So, do you think the process you just described is sustainable? Isn't it more likely to lead to the break-up of the European Union?

Some countries actually wanted was to borrow through public channels from other countries or receive guarantees from them, in particular from Germany This is the concern, not the abstract question of whether to borrow more or less. If a country that wants to borrow raises funds on the American market without any implicit liability for other European countries, that's fine. But that's not the case. Some countries have difficulties raising finance on the market and now they want to get the money from other European countries instead, and the creditor country here is Germany This is why Germany is concerned. Ifyou have a private borrower and a bank, and the borrower says "I want to grow, I want more credit from you" and the bank says "Sorry, I don't agree, I'm afraid of not getting my money back", that's the situation. Germany was the capital exporter, the southern periphery was the capital importer Now the risk is that they will default and given this risk Germany doesn't want to lend more money.

On this point, what do you think of the IMF position, also shared by the United States and a large group of other countries, who want a greater focus on growth? Growth policies are favored not only by the weak countries, but by almost the whole world.

Welt honestly who is in favor? The Americans of course, because they invested a lot of money and all the other investing countries are in favor Everyone who invested in the toxic government bonds of periphery countries. They want the bad bank in Luxembourg to take over these toxic assets. Wall Street the city of London, the French banking sector, as well as the recipient countries in the southern periphery they're all in favor of new credit to replace the old credit because this is the only way to get out of their flawed investments.

What about the IMF suggestion of relaxing monetary policy and lowering interest rates to sustain the economy?

To what level? Interest rates are already lower than 1%, which is well below the inflation rate. Europe is in a liquidity trap. When interest rates are this low you can hardly reduce them any further We already have negative real interest rates in Europe, with the inflation rate everywhere above 1%. The bitter truth is that growth would not reduce the imbalances in Europe. The crisis is the inevitable consequence of borrowing beyond one's means in the past If someone borrowed too much, the only way out is to scale down economic activity And if one wants to avoid this, no rebalancing will occur Some politicians say that countries should be growing out of their foreign debt problem. But how can you do that? Ifyou grow your imports increase, you're borrowing more and the current account deficit increases. So the bitter truth is that if someone lives beyond their means, they have to shrink out of the problem. Hopefully the shrinkage is only nominal with cuts in wages and prices, but unfortunately inside a currency union it is typically also a real shrinkage, as in Greece, Spain and PortugaL Real shrinkage can only be avoided ¡fa country exits and devalues its currency Those countries have lived on cheap credit from abroad for years, since the convergence of interest rates in 1995. From 1995 to 1997 there was a perfect interest-rate convergence, followed by a period of sub-budget constraints, which led to an excessive inflationary growth process and a current account deficit Somehow we now need to reverse the clock, which is very difficult; it could be so difficult countries could face so much internal friction and mass unemployment that, in the end, they prefer to leave the euro. Borrowing more simply postpones the crunch time, if there is a lender willing to risk his money But there simply isn't You cannotjust continue to borrow ifyou have borrowed too much, you cannot solve a debt crisis, public or private, by borrowing even more. This is a recipe for disaster In Europe we have reached a situation where the hard truths have come to the surface and the solution cannot be simply to mitigate the process by postponing a period of austerity Austerity is a necessary implication of overspending, and the only way to mitigate is to exit the euro zone.

So the policy you suggest is to continue with the current fiscal restraint and high taxes, and maintain the present monetary policy?

No, I think the present monetary policy is too generous and unsustainable for the countries that are forced to lend, and at the same the implications for some of the crisis countries are unsustainable. Europe is trapped. The ECB has provided 900 billion euro of credit through its system, a systematic public capital flow from the core countries to the southern periphery replacing the capital market. To some extent, in an acute crisis, such ECB lending is right but you cannot claim an acute crisis every day If a country overborrowed and has to stop borrowing, of course it has an acute Crisis, but that can't mean it should never stop borrowing. You cannot go on with that policy forever At some stage you have to acknowledge there is a deeper problem which cannot be overcome with cheap money but only by recognizing that living standards cannot exceed your income.

So you are suggesting higher interest rates along with higher taxes?

Higher taxes definitely, not higher interest rates. What is needed is higher safety requirements for collateral given to the ECB when banks borrow newly printed money The ECB used to require an A-, then it contented itself with a BBB-, which is close to the non-investment grade, then the government bonds of Greece, Portugal and Ireland were exempted from this minimum requirement and it was said they would be accepted as collateral regardless of what the rating agencies said. Then ELA credits came in (emergency liquidity assistance), enabling national central banks to lend out newly printed money to their banking sector without any collateral. If something goes wrong, the national government steps in. But if a national government goes bankrupt then the rest of the euro zone bears the losses. All of this implies that capital flows from the North to the South at below-market conditions and that the capital market is underoined by political decisions. This will lead to disaster We have reached the point where we have to stop this, painful as it could be for those countries that used that machinery.

It is obviously very painful and has already started having not only social, but also political consequences in the countries that have recently held elections. So, do you think the process you just described is sustainable? Isn't it more likely to lead to the break-up of the European Union?

Well, not of the European Union, but possibly of the euro. I think it is inevitable some countries will leave the euro zone.

For example? Greece? Other countries?

Definitely Greece. Greece has no chance of becoming competitive in the euro zone, they have to cut their prices by a minimum of 30%, according to Goldman Sachs calculations. They have to cut their prices by 37% if they want to come level with Turkey They have the same water, the same temples and the same food as Turkey and tourists go where it is cheaper So there is no way for Greece to avoid that. On the other hand, there is no way for Greece to achieve it in the euro zone, and that's the dilemma. How can they cut wages and prices by 35%? It's impossible, unless they leave the euro, return to the drachma and devalue the drachma. There is no alternative.

Does this apply to other countries?

Well, it probably also applies to Portugal because, according to the Goldman Sachs study Portugal has to come down by 35%. In the case of Spain it's not that difficult because it needs to depreciate by 20%, which is manageable. I would say that ifa country doesn't have inflation while the rest of the euro zone inflates, that country gradually becomes more competitive. And if it has some deflation, the process will be faster Twenty per cent is what Germany had since interest convergence began in 1995. From '95 to Lehman we had 22% depreciation in the euro zone by having a lower inflation rate than others. That's what real depreciation is. You inflate less than other countries and you become gradually more competitive. It's a painful process and goes hand in hand with mass unemployment; you don't grow, you have stagnation, but still in the end it works. So if Germany has achieved that 20%, I would say it is possible, Germany took 13 years. That's the magnitude needed in Spain. Spain would have a very painful decade and after that they could make it Italy fortunately is better off, the depreciation needed in Italy according to Goldman Sachs is just 10 to 15%. But still, it would take a couple ofyears of stagnation. So I would think that Italy and Spain could possibly make it in the euro zone, whereas 1 tend to believe that Portugal and Greece will have a hard time. For Greece I think it will be nearly impossible.

What is your expectation if all this actually happens, if Greece and Portugal exit the euro? Nobody knows what will happen to the euro. Do you think it will survive, will it change its shape or what?

Yes, it will survive, and it should survive. I think the exit of some countries from the euro is the only chance for a stabilization of the euro zone in general and those countries in particular If they stay in the euro there is no future for them. There will be unbearable mass unemployment and hardship, which will undermine European cohesion. Ultimately there could be a big explosion and everything could be destroyed.

No mechanism was put in place from the very beginning to indicate how this should be done, how to have currencies go out; so what mechanism do you imagine? A recalculation of the basket? What would happen to the euro if two currencies are expelled?

Inside the euro and without public transfers we risk seeing Greece driven to the brink of civil war They're already in a desperate situation, with youth unemployment of more than 50%. It is an impossible model and trying to keep the country inside the euro has failed completely.

This is what is not to be done, not keeping Greece and the drachma in the euro. But what will happen if Portugal and Greece leave? The costs and risks are huge.

We are comparing two risks. If they stay in, they would have a very long period of mass unemployment which would be hardly sustainable, perhaps even unsustainable. If they go out they will experience a year of turmoil but, after that, the economy will be able to recover Because the country will be cheaper the tourists will come back, exports will increase, Greeks will find imports too expensive and will buy domestic goods. Above all, wealthy Greeks will return home, invest and create jobs.

But what will happen to the rest of the euro zone once these currencies are out?

The rest of the euro zone would be stabilized because this huge problem has been reduced.

Would you expect the euro to keep its value or to lose some ground against other currencies in the world, i.e, the US dollar, the Swiss franc or other currencies?

At first, the euro will weaken, but after a while it will strengthen.

So you are quite optimistic if Greece and Portugal leave, but you see a disaster if they don't leave.

Let's take the example of the Weimar Republic in the 20s. Germany had to pay huge war reparations in Reich marks fixed to gold, while everyone else was devaluing relative to gold. So Germany became more and more expensive and had to compensate by internal depreciation, cutting wages and prices. From 1929 to 1935 we cut all wages by 30% and prices by 23% and that eventually led Germany to the brink of civil war What came in '33 was not a civil war it was even worse. In other words, this sort of austerity program to become competitive within the euro zone is not working, it's not possible.

Don't you think that, in the present situation, Germany should exercise greater solidarity toward the rest of Europe? After all, after World War ll Germany enjoyed the great support of the Marshall plan which financed the reconstruction and created the conditions for its present prosperity.

Yes of course. I am strongly in favor of auxiliary programs. But a new Marshall plan would not be enough. The Marshall plan was not as big as people normally believe. It provided Germany with help for four years, equivalent to 0.5% of GDP i.e., with a total of 2% of GDP Applied to Greece this would be 4 billion euro. In terms of ECB target loans, ECB government bond purchases, official rescue funds and the haircut Greece has received 460 billion euro. This is 116 Marshall plans. And another figure: the liabilities Germany has already taken on with all these rescue operations and ECB policies should Italy Portugal, Spain, Greece and Ireland go bankrupt, which no one hopes, amount to more than 700 billion euro. You can't say there is no German solidarity quite the opposite. Through the ECB system itself, until last May the Deutsche Bundesbank had provided credit lines to other European countries for 644 billion euro and on top of this the Luxembourg funds are also borne largely by Germany So I think many people have the wrong idea.

Let's come to Italy. What is your view of the current Italian situation and the measures and reforms introduced by Mr. Monti and his government?

I think Monti is a very good economist and a good politician too. He has carried out the right reforms. Italy can only be thankful to have such a premier The only difficulty is that his labor reforms have been partially blocked by the unions. This, however, is not Monti's fault.

During their last mission in Italy, the IMF experts expressed strong appreciation for the steps taken by Monti and said that if all these reforms continue Italy could recover to a growth rate of up to 6%. Do you think is this too optimistic?

Yes I do. Italy still has its problems and there is no doubt that it has become too expensive. Inflation is still rising, despite the crisis. Italy is still losing competitiveness rather than trying to become more competitive through a process of real depreciation, namely with a lower inflation rate than other countries. But having said that, the Italian economy is very solid and the Northern Italian economy in particular is one of the strongest in all of Europe, if not the strongest So I don't think Italy has problems it cannot resolve.

In your opinion, how likely is it Europe can get out of the present crisis and return to the sort of growth we used to have in the past? Do you think this is possible in a reasonable time frame, given what you've been saying, Le. if some countries leave the Euro and all the others implement the right fiscal policy?

Well, if it's done properly yes, than we can have growth everywhere. So if some countries leave, they could escape recession and begin growing. If, and only if, Europe manages to administer the necessary internal price realignment can it return to growth. However if we try to keep the euro zone together as it is, there is no real chance for growth. Every country has to decide for itself I don't know what the Spanish government will do, how much unemployment it is willing to accept. They already have a 24% unemployment rate. How long can a country live with that? What is the tolerance of the population? Let the next winter come—the summer is fine, the sun is shining and somehow you manage—but let the winter come and see what happens. The European situation is extremely uncertain and, for the time being, we have to deal with our crisis. People who say there is no alternative to the euro, that only the euro, that this accounting unit is the only future of Europe, have a narrow view of the world. I think Europe is much stronger than an accounting unit, Europe has a life by itself. I have always advocated the euro and I still do, but I am an economist and I try to understand the possible outcome.

This is a crucial point. The EU is mainly based on the common currency. At the start of the euro the idea was that a common currency would inevitably lead to a convergence of economic behavior within the Maastricht criteria. This did not happen and it's now clear to everybody that the EU needs more governance and stronger institutions with the power to enforce common economic policies. Is this the solution to the present troubles?

I don't think so. What a common currency provides is a strong incentive to overborrow because we have similar interest rates, but what we need are debt constraints, tougher budget constraints. Only a system that respects tough budget constraints can function properly But the debt constraints have not worked. The stability and growth pact has been violated 88 times, without consequences. But even constraints on public debt would not be sufficient for the private sector What we also need are tough banking regulations, very high equity/asset ratios for banks. Only with constraints like this can the common currency work. The question is: do we go one step further and create a United States of Europe? Ok, let's do that, in principle I'm very much Th favor, but the way toward that cannot be through a transfer union, where the current deficits of some countries are financed with the surpluses of others. Everyone has to earn his own living.

Stronger political institutions?

Yes, but we have to get the sequencing right. If we want to create a United States of Europe, we need a common legal system, a common army and a central power A central power is necessary to implement common rules. The monopoly of power defines a nation. Only ifyou have it can you carry out the kind of activity redistribution some people want. Ifyou don't have it, everything would break down. Think of the United States ofAmerica, how difficult it has been. The result of Hamilton's socialization scheme in 1792 was significant conflict among the American states, leading to nine state bankruptcies in the 1830s and 1840s. Debt socialization did not bring peace, but contributed to the political tensions that would later erupt in secession and civil war in 1861. So you cannot begin simply by introducing socialization schemes. The whole thing would explode if we went that way People who say we need Eurobonds, common lending facilities, equal interest rates have not understood history I think that would be a very very dangerous path.

* One of the most respected German economists (the British newspaper The Independent nominated him as one of the "ten people who changed the world" in 2011), Hans-Werner Sinn has been Full Professor at the faculty of economics at Munich University since 1984, Director of the Center for Economic Studies, Munich University since 1991, President of the Ifo Institute and CEO of CESifo Inc. since 1999. At various time he held visiting professorships at the University of Western Ontario in Canada. During sabbaticals he was also a Visiting Researcher at the London School of Economics, Bergen, Stanford, Princeton and Jerusalem universities. Since 1988 he has been an honorary professor of the University of Vienna. In 2006 he became President of the International Institute of Public Finance. He is also a fellow of the National Bureau of Economic Research in Cambridge (Mass.). Since 1989 Sinn has served on the Advisory Council of the German Ministry of Economics and he represents the Free State of Bavaria on the Board of Supervisors of HypoVereinsbank.

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