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The Sovereign Debt Dilemma

Interviewee: Sebastian Mallaby, Director of the Maurice R. Greenberg Center for Geoeconomic Studies and Paul A. Volcker Senior Fellow for International Economics, Council on Foreign Relations
Interviewer: Roya Wolverson, Staff Writer, CFR.org
February 5, 2010

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European countries' debt problems--in Greece, Portugal, Spain, Ireland, and elsewhere--have spurred market volatility and raised doubts about whether the global economic recovery is sustainable. Investors fled the euro after the European Union failed to convince them that faltering EU members could rein in government deficits and pay down debt. Investors are also questioning the U.S. dollar's stability--despite its rise against the euro--given the United States' growing deficits, high U.S. unemployment, and loose monetary policy.

While government interventions have led global recovery, the market's reaction to Greece and other indebted countries suggests governments may "have used up all their ammunition" to boost global growth, and their weakness causes a "new source of instability in the system," says Sebastian Mallaby, director of CFR's Center for Geoeconomic Studies and a senior fellow for international economics. Continued economic weakness means governments may have to continue fiscal and monetary stimulus, Mallaby says, though the markets will likely punish them for increasing budget deficits. Emerging markets continue to buy U.S. dollars "because they can't figure out where else to put their savings," he says, but once a viable alternative arises, "they will all jump." Mallaby says the United States is not at risk of inflation, since unemployment numbers remain high and industrial production low. That leaves room for the Federal Reserve to continue so-called "quantitative easing," or buying government securities to promote lending when interest rates are already near zero.

What does the market volatility--resulting from doubts about European countries' sovereign debt in Greece, Portugal, and elsewhere--say about the state of the global recovery?

Two big things: The first is that in 2008 and 2009 we got used to thinking of governments as the saviors that would charge in and rescue everything in sight. So, in the United States, a series of financial institutions were rescued and bailed out, and in Europe, pretty much the same story. Governments were the rescuers. Now, we may be getting to a point where governments have used up all their ammunition, and their own resulting weakness is the new source of instability in the system. That's what we saw a little bit later in 2009 with the scare over Dubai, and now we're seeing it in Europe with the scare over Greece and to some extent, Portugal behind Greece.

The second thing, related to that, is that the recovery globally has been based on enormous public interventions--both these rescues that I mentioned, but also stimulus packages from governments, very low interest rates, and quantitative easing from central banks--and there's a debate over when we should withdraw those government actions to stimulate the recovery. And until now, the debates have been "let's wait and see when recovery appears to be self-sustaining, and then you can take the government medication away. But don't take it away before it's self-sustaining, because the risk of reverting into a recession is more costly than the risk of stimulating too much and getting inflation." Inflation seemed to be a pretty remote danger, and a renewed recession an acute danger.

Now governments may not have the luxury of making that choice [to withdraw stimulus] as they would wish. They may want to carry on stimulating by having budget deficits, but the markets may punish them, as we are seeing in Greece. So they're forced to cut the budget deficit dramatically to keep the markets from panicking. A version of that is visible in the United States, where most voters tell pollsters that they would like to see the budget deficit reduced, but President Obama's plan is only to start the reduction next year in 2011, and this year to have another stimulus package focused on jobs.

The question is: Can he do that stimulus package politically, and also, does it actually encourage more spending in the economy if everybody is really worried that too much government debt is stirring up trouble? You might actually hurt confidence more than help it with another stimulus package. We're reaching a tipping point in the ability of governments to carry on supporting global markets.

"We're reaching a tipping point in the ability of governments to carry on supporting global markets."

Portugal, Spain, Ireland, and Greece are all suffering from deficits. How will that crimp European growth, and, by extension, U.S. and global growth?

It was already the case that if you had to rank where the recovery was healthy, you would say healthiest in emerging markets, particularly Asia; reasonably healthy in the United States where fourth quarter growth in 2009 came in a bit over 5.7 percent; and then most anemic in its recovery has been Europe. As you say, Europe faces the additional problem that the markets are compelling a fiscal consolidation--the withdrawal of stimulus spending--particularly in the southern rim. That's obviously going to reduce growth in its direct effect. The problem is, even if you had the luxury of not withdrawing that stimulus, the lack of confidence in government from the big deficits was itself a drag on growth. So, Europe doesn't have any choice about tightening budgets in these high-deficit economies like Greece, Spain, Ireland, and Portugal. But it is going to bring growth down. That does have a knock-on effect for the rest of the world economy, as slower growth in Europe means less opportunity to sell goods to European consumers. That's bad for growth everywhere. The answer may be that the European central bank has to act more aggressively to sustain growth by reconsidering its plans to withdraw some of its quantitative easing.

What happens if Greece can't refinance its debt? Who, if anyone, steps in, and what implications does that have for the European Union?

If somebody is going to step in, there are two kinds of "somebodies." The first is a European bailout. Greece, being a member of the eurozone, is considered to be Europe's responsibility. The problem is that there is no established mechanism for providing bailout funds for a eurozone member that gets into this sort of trouble.

The rules of the euro say that you can't be bailed out, and that you're not supposed to be running these enormous budget deficits in the first place. Now that those rules have been ignored, there is a big budget deficit. There is talk of some sort of ad-hoc bailout, but the politics of that are very difficult. If the German voters felt they were paying for the partying profligacy of southern Europeans, having themselves [the Germans] spent a long time saving up their money, one can imagine how politically unpopular that would be. It would also set a precedent if the Germans felt they were bailing out Greece--well, then, they'd next have to bail out Spain, Portugal, Italy, and so on. So, it's very hard for the German government to approve a European bailout, which German taxpayers would be on the hook for. And because of that, if they did do it, they would probably do it in a fairly stingy way, charging very high interest rates for the bailout package. And then maybe the bailout wouldn't work because it would come with so many tough conditions that it would impose new kinds of stress on the Greek economy. For the Germans to order the Greeks how to run their economy is not going to be popular in Greece. So for lots of reasons, politically a bailout within Europe is very difficult.

That raises the question: Would it be better to bring in the International Monetary Fund to organize a bailout? The IMF after all has a whole machinery, which is expert at providing crisis lending in precisely this kind of situation. I think it would be better to go that route. It's just that there's a certain amount of European pride at stake here. The Europeans feel that their first option should be to sort out their own difficulties without resorting to the humiliation of going to the IMF.

The U.S. dollar benefited from the decline in the euro, as investors fled to it as a safe haven. How long should the United States--which has its own sizeable deficits--expect to enjoy that safe haven currency status?

"The economic allegation is that hyperactive central banks are printing money and risking inflation, but really I don't see much danger of inflation in a world economy that has very high unemployment."

Well, that's an enormous and important and almost impossible to answer question, because it depends on sort of predicting a tip in investor psychology, when you know that the chemistry of that collective psychology is almost impossible to foresee. On the one hand, the U.S. dollar's position as a reserve currency is extremely fragile, because it's a reserve currency that many important powers in the international system don't actually like. The Chinese government, for example, has accumulated a vast amount of reserves held in dollars, and at the same time is calling on other countries to help it to establish an alternative to the dollar as a reserve currency. Its position is, "We're buying all these dollars we hated." That's not a very stable equilibrium.

You see versions of that all around the world, where other emerging-market countries--which have big reserve buildups because they're running current account surpluses--are buying dollars because they can't figure out where else to put their savings. But they're aware that on their sort of medium- to long-term view, the dollar is going to depreciate, and they're going to lose money on these investments. They're not happy about it, so they're looking for alternatives. It's just that there isn't one easily to hand. Private investors, too. U.S. private investors would like to get more money out of dollar instruments into faster-growing emerging-market instruments, and foreign investors who in the 2000s invested a lot in U.S. assets discovered during the subprime crisis that these assets were not always as safe as they had hoped.

So for many reasons, one would expect people to move out of dollars. The problem is, move out of dollars into what? It's not particularly attractive to go into euro instruments at the moment when there is a financial crisis going on in Europe; it's difficult to hold Chinese instruments because of capital controls. There isn't an alternative easily to hand, and so one has this uneasy feeling that everybody is looking for an alternative. When they see one, they will all jump, but when that time comes is difficult to predict.

What policy tools are left to stimulate growth if markets are frowning at both deficit spending and continued monetary stimulus?

There is a backlash against central banks increasing their intervention in the economy. I see it more as a political issue than an economic issue. The economic allegation is that hyperactive central banks are printing money and risking inflation, but really I don't see much danger of inflation in a world economy that has very high unemployment. When you've got a lot of idle workers and spare capacity in your factories, the idea that you're going to run into capacity constraints and experience inflation seems a remote threat relative to the others we are facing. So I don't think there is much constraint on continued central bank activism to pump demand into economies. You could see the Fed--for example, if the U.S. economy went into a double dip--resuming some of the quantitative easing that it has recently discontinued.

A lot of people feel that central banks shouldn't behave in this fashion, pumping money into all corners of the financial system, and there is a severe danger of Congress reacting negatively against the central bank. We saw that a bit in the arguments over Federal Reserve chairman Ben Bernanke's reconfirmation, which at one point looked as if it might be derailed. One could see central bank independence suffering because lawmakers politically don't like seeing central banks, which after all are run by unelected technocrats, having that much influence over the economy.

How should this situation inform thinking about using bailouts to address future financial crises?

When governments do bail out [financial institutions], what you see is governments themselves get into enormous budget deficits, which then themselves become a new source of so-called "systemic risk." So if the question is, "How do you prevent a future bailout of the financial sector?" that gets you into the intricacies of financial reform. We've seen President Obama announce a couple of additional ideas to the financial reform package that's passed the House of Representatives and is pending in the Senate. These are to limit the risks to taxpayers posed by large banks by reining in their proprietary trading, preventing them from running so many hedge funds, and temporarily imposing a tax on their size. These are all steps in the right direction, but definitely not quite enough to get us into a position where we can honestly say we won't expect governments to bail out the private sector next time there is a crisis.

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