Interview with the senior associate at the Carnegie Endowment for International Peace and director in Carnegie Endowment’s International Economics Program Uri Dadush, conducted by Natalia Bubnova
Would you please comment on the downgrade of the U.S. credit rating by Standard and Poor’s and the ensuing consequences? How is the current situation different from 2008? What are your forecasts and your advice on measures to carry out in order to avoid sinking into a new recession?
The downgrade of the U.S. by S&P is justified by U.S. debt trends and its narrow escape from default due to political differences. Its value is that it sends a clear message to Washington, but it is far from sure that the message will be received. Still, as you can see from the decline in Treasury Interest Rates, the United States retains the confidence of the markets. Because there is no clear alternative to the dollar and U.S. Treasuries, the United States will remain a safe haven for the time being, and U.S. politicians will be tempted to continue to behave irresponsibly. As far as the United States is concerned, the situation is not comparable to 2008, when a depression loomed. However, today the big risk is coming from overseas.
The main danger comes from the combination of slowing growth and the possibility of the sovereign debt crisis in Italy and Spain getting much worse – then we could have another Lehman class shock because of the size of these countries and their debt. I expect (hope) that this will be avoided and that the world economy will resume on its recovery path. But this may well require much more aggressive response from the Europeans, namely moving forward towards a fiscal union and acceleration of fiscal and structural reforms in Spain and Italy – as was recently announced. Even this may not be enough: more help may be needed from the IMF and, possibly, from other individual G20 countries as well.
The Obama administration has been able to reach an agreement with both parties in Congress to increase the U.S. state debt. This has given the country an opportunity to avoid default and has allowed the entire world to breathe a sigh of relief. Would you please explain the details of the agreement? What in particular does it mean for Europe?
The deal is obviously much better than having the government default, which would have been a disaster. At the same time, it’s a very modest deal. It’s nowhere near the $4 trillion target that we wanted. It’s also a deal that, right now, is almost exclusively on expenditure reduction, rather than tax increases. So it’s a very unbalanced deal. When the time comes for a joint commission of Congress to negotiate a joint proposal for further deficit reduction in November – as the deal envisages – there’s again going to be blood on the table because of the failure to agree on a balanced approach, which must include expenditure cuts and tax increases. It’s good news, but it’s not great news.
How will it affect the markets?
Today the markets are mixed; they initially did OK on the news. But I don’t think it’s going to be a euphoric reaction, because I think that the deal leaves many questions open. The large fall in stock markets following the announcement of the U.S. debt deal owes more to new weak data on global manufacturing and renewed concerns about Italian and Spanish debt than the debt deal itself. However, the debt deal may have contributed as some investors switched from equities to U.S. Treasuries once it was clear default would be avoided. There are also genuine worries, which I share, that the deal does not go nearly far enough and sets us up for another big fight in November.
And do you think that with the current state of the U.S. economy, there will be a flight away from the U.S. dollar, or will the U.S. continue to be the main stronghold of the world’s economy?
I think if they hadn’t reached a deal, there might have been flight away from the dollar, but because they did reach a deal, there’s no particular reason for people to run away from the dollar at this point. And the big issue whenever you’re talking about exchange rates is where you go to if you don’t stay in dollars. Right now, the euro, which is the main alternative, or the yen, are not looking very good either, so I don’t anticipate a run away from the dollar.
Speaking about the euro, how do you evaluate the rescue solution for Greece that was decided between Nicolas Sarkozy and Angela Merkel in Berlin and Brussels? Will these decisions be sufficient to help Greece pay off its sizeable debt?
I think they made some steps forward in the way they deal with all the other countries, not just Greece. But they have not altered the fundamental trend in Greece: unsustainable debt. So I think there’s going to be more restructuring of Greek debt, and that is going to have to be done. And we have postponed the decision one more time. At the same time, I think that some of the measures they took are important, not just for Greece, but for Portugal, Ireland, and other countries as well. I’m talking about the reduction in the interest rate, the lengthening of the maturity of the loans by the European Financial Stability Facility, and the fact that the EFSF can now intervene directly in the secondary markets and can recapitalize banks. So these are significant steps that create a lot more flexibility for the system. I think the involvement of the private sector is also important, and it’s good that it was done, but my sense is – and this is the view of many analysts – that the involvement of the private sector is much less than the headlines suggest. In other words, the private sector is getting a very good deal out of the debt swaps that were agreed.
How do these measures differ from your recommendations formulated in your book published by the Carnegie Endowment in 2010, Paradigm Lost: The Euro in Crisis? Would you suggest anything different today?
I see the euro crisis as ultimately being solved in one of two ways. One is to have much more fiscal union among the countries, a sharing of government revenue, taxes, and borrowing power (for example, establishing a euro bond), combined with much greater coordination on fiscal policy. That in itself could calm the markets down, so long as the issue is limited to the smaller countries – Greece, Portugal, Ireland, and could also include Spain. But if it spreads to Italy, I’m concerned that even that will not be a solution, because Italy is too big and the size of transfers that would be required would test any federal system to the limit, never mind the fragile and incomplete European project. So that’s one avenue.
And the other avenue is for the weaker countries to leave the eurozone. I’m afraid I’ve come to the view that Greece might be better off leaving the eurozone, while remaining part of the European Union, and some other countries may have to follow Greece. So these are the two options in the long term, and the agreements that were reached on July 21, move some way towards the fiscal union, because they give so much more flexibility to the EFSF and what it can do. But for that to work, it’s going to have to go much, much further, and Greece will definitely have to restructure its debt.
And why was the creation of the EFSF opposed by Europe’s richest country, Germany, for so long?
Because they don’t want to pay.
Being of French origin yourself, what is your opinion on the reaction of Germans and French to a decision for which they will largely be paying?
My impression is that somehow the French are more fundamentally ready to be flexible, that they are more inclined to be forgiving of the problems of their Southern European neighbors. And the Germans, I think, take a negative view of any lack of rigor and discipline, and I think the Germans are doing very well at the moment and are very happy with their situation. The average German did not understand at the beginning, but is now beginning to understand just how serious a threat this is to the eurozone and to the euro. Merkel has slowly brought German public opinion and German political leaders to understand that this needs to be done. But I think we are only one part of the way, and there’s a long way to go still in this crisis.
Investors are also concerned about the Italian debt, of which the French banks are the primary holders. The Italian Parliament approved a package of measures to reduce expenses. Do you think that these measures will be enough to alleviate the concerns?
Italy is a very difficult one to read, because the signs are that they are being aggressive on budget consolidation, and their debt-to-GDP ratio is projected to decline somewhat over the next five years. It will still stay very high, but their path is a lot better than many other countries are doing, including the United States., Japan, and others. They’ve really had very conservative fiscal policies throughout the crisis. My concern for Italy is more fundamental – the loss of competitiveness they have suffered over the last ten years compared to Germany and many other countries in Europe, and some other countries. This loss of competitiveness has a lot to do with the fact that their wages have been growing faster than labor productivity, and unless it is reversed – at least in good part – Italy will struggle to grow. At some point, Italians may well ask – what is the purpose of being part of a monetary union if our living standards stagnate for decades and our government is in permanent austerity?
Both pundits and the public at large in Russia have been watching the situation develop around Dominique Strauss-Kahn, many with sympathy. Most people here have tended to believe that there were likely some important interests at play. The case might have been fake, but the human life, dignity, and career that were affected were real. How do you believe the resignation of Strauss-Kahn will affect IMF policies towards the countries, in particular in Europe, that are seeking credit?
I think the Strauss-Kahn case is very sad, because this is a man who is extremely talented and was doing a great job at the IMF. It’s not for me to express judgment on his behavior, and I’m not qualified to do that, but it’s sad from a professional point of view. How will it affect the IMF? It’s difficult to say, because Christine Lagarde, who is his replacement, is also a very talented person, and has many other connections, different of course, than those that Strauss-Kahn had in Europe. So technically, she is capable of playing the role that Strauss-Kahn was playing, being a little bit of a mediator in Europe. However, Lagarde has to be very careful not to come across as biased in favor of the Europeans, because right now the IMF’s loans to Europe are by far the most important, and there are debates going on as to whether the IMF should be so exposed to Europe. She has to navigate very difficult diplomatic waters, especially given the controversy that surrounded her appointment, because the developing countries wanted to have a change. At the same time, I think everyone should realize that the IMF is a big institution with enormous depths in its staff and analytical capacity. It also has very strong procedures for taking decisions, with its executive board, etc., in which 190 countries are represented. So the IMF is a lot more than one person. But I think there’s very little question that Dominique Strauss-Kahn is a loss for the IMF.
What is happening to Europe in general? The “decay of the West” long seemed more of a chimera than a reality and Europe served as a benchmark for many nations. However, a lot of the world’s latest news relates to Europe: the debate around multiculturalism versus interculturalism, the terrible terrorist act in Norway, the recent street violence in London and other British cities. Do you see Europe’s position as changing? In your other recently published book, Juggernaut: How Emerging Markets Are Reshaping Globalization, you predict an increased role for the emerging economies. Could you please comment on this?
Well, the European malaise is not just European. Today, unfortunately, there is a U.S. malaise, and there is a Japanese malaise, and few advanced countries escape this characterization. Maybe Canada and Australia are doing OK, and some of the small rich countries in Asia, like Singapore, for example. But most advanced countries, the big blocks, are in a difficult situation, because they were the ones that were most directly affected by the financial crisis. They are all dealing with the repercussions of the financial crisis, and in my view they will continue to deal with them for many years to come.
Europe has to cope with two big issues that will occupy it for many years to come: One is the aftershock of the financial crisis which affects the whole European Union, beginning with the UK, for example, which is not part of the Eurozone. And then it has to deal with the huge problem of the euro’s weakest institutional underpinnings, and the fragility of the periphery countries.
Against this background, and because they are undergoing a completely different historical evolution, the emerging markets are, as you know, looking very, very good. Ten or twenty years ago, they began to embark on policies of increased reliance on the market, opening up, paying much more attention to macroeconomic stability. They’re now enjoying the “advantages of backwardness” – the fact that they can absorb a lot of technology and techniques and institutions that the advanced countries have established and that they can now adapt to themselves, and by doing so, they can grow very rapidly, which many of them are doing. Also, the emerging markets simply did not suffer as much from the financial crisis. Again, that’s a different, varied picture. I’m sure Russia suffered much more from the financial crisis than did India, for example, which is closed, to a large extent, from international financial markets.
But a lot of emerging markets really were relatively insulated. They suffered mainly a trade shock, but not a financial crisis per se or a banking crisis, and so they are in a much better shape, and they are continuing to grow very rapidly. This is not to say that there aren’t a lot of issues or problems in the emerging markets. It would be foolish to think that they’ve solved all of their problems and that the problems are all in the advanced countries. There’s a lot of overheating going on in emerging markets and probably a lot of bad investment taking place at the moment because there’s too much money – cheap money – that’s coming in. So it’s a good situation for the emerging markets, but it’s not a situation without risks.
You’ve mentioned that you believe that Russia has been affected more seriously than India by the financial crisis. Medvedev has suggested that the ruble should become a reserve currency. Do you think this is realistic? Do you believe that Russia’s long-awaited and long-debated accession to the WTO would benefit the nation’s economy? With many European countries facing sovereign debt crises and the situation in the United States, there have been forecasts that the price of oil will not be growing sufficiently to prevent the Russian economy from a crisis of its own. What is your opinion on this?
I think it would be a significant step forward for Russia to be part of the WTO. Russia is the only G20 country that is not part of the WTO and the only really large economy in the world that is not part of the WTO. I am very aware of what Russia is exporting, and the fact that becoming part of the WTO may not give it some huge advantage on the export side, but I think that if Russia is going to diversify its economy in the long term, and if it’s going to reform its economy domestically, it’s very good that it submits to the same set of rules and obtains the predictability of market access that the WTO gives. So you have to look at it like establishing a stronger rule of law for doing business in many sectors. That’s what the WTO gives. It’s a very important governance improvement, and China is the best example of a country that has used the WTO very well to strengthen its own capacity.
I think we’re a long way from the ruble as a reserve currency. There are many reasons but I don’t want to be dismissive of the improvements in Russia over many years. Russia is a very different economy than it was 20-25 years ago; it had a transition to go through that was the most difficult, in many ways, of any country because of its history and because of its particular situation. So Russia is doing better than a lot of people give it credit for, but it is far from having a reserve currency. A reserve currency should be a relatively stable currency; while the ruble is an oil-dependent currency. A reserve currency should have deep financial markets, strong financial institutions, and a very reliable regulation; I don’t think that condition is fulfilled in Russia today. In order to be a reserve currency, people need to have a lot of confidence in the country’s political stability, in the soundness of its institutions, and again, Russia is a ways away from that, despite all of the improvement. So I’m saying this about Russia, but I could say very similar things about China today. China is also not ready to have a reserve currency.