LSE Perspectives on the Sovereign Debt Crisis

LSE Public Lectures and Events
Date: November 2, 2011
Host: Charles Goodhart (Chairman)
Panelists:

• Bob Hancké (LSE European Institute)
• Vassilis Monastiriotis (LSE European Institute)
• Dimitri Vayanos (LSE Financial Markets)
• Jon Danielsson (LSE Financial Markets)

Main Theme & Purpose

The episode unpacks the causes, dynamics, and possible resolutions of the Eurozone’s sovereign debt crisis, focusing particularly on the Greek dimension and its systemic implications. The discussion features economic, political, and institutional perspectives, seeking to move beyond day-to-day firefighting to analyze underlying structural faults and envision pathways for reform.

Key Discussion Points and Insights

1. Framing the Crisis: Structural Flaws, Not Just Fiscal Irresponsibility

Charles Goodhart’s Background (00:00–09:35)

• The Eurozone was never an optimal currency area; lacked political cohesion, fiscal union, and labor mobility.
• “From the outset... it was recognized... [the Eurozone] did not have the political cohesion, the centralized fiscal mechanism or the labor mobility to meet large asymmetric shocks.” (02:30)
• Initial convergence of interest rates led to peripheral booms in spending/borrowing; sudden stop in capital flows post-2009 triggered severe crises.
• Bailouts and ECB support address liquidity, but the deeper challenge is restoring competitiveness and growth, especially where “internal devaluation” (i.e., cutting wages/prices) is politically or economically untenable.
• Austerity and structural reforms are slow, and may fuel deflation and poverty if not carefully managed.

2. The North-South Divide and Institutional Dynamics

Bob Hancké (09:35–17:33)

• Underlying the crisis is a divergence between ‘two Europes’:
  • Northwest Europe: Strong wage-bargaining institutions keep unit labor costs competitive.
  • Southern Europe: Lacks such institutions, making it harder to restrain wages and remain competitive.
• ECB’s “one size fits all” interest rate policy exacerbated imbalances: “A low inflation country gets punished... a high inflation country... rewarded.” (13:30)
• Current account imbalances grew, financed by increasing public/private debt.
• “EMU is a closed economy... your competitiveness gain has to be my competitiveness loss.” (15:45)

3. The Greek Lens: Policy Failures and Misguided Beliefs

Vassilis Monastiriotis (17:36–28:38)

• The crisis is not simply due to Greece or North-South asymmetries, but is rooted in:
  1. Over-respect for markets’ discipline, leading to reactive policymaking.
  2. Adherence to rules never truly enforced, i.e., the Stability and Growth Pact.
  3. Excess faith in moral hazard logic—believing bailouts would universally provoke irresponsibility.
  4. Overreliance on supply-side structural reforms, which are ill-suited as short-term crisis responses.
• “Too much respect in the markets is not good... markets do not dictate political developments, maybe the markets are afraid about policy making shifts.” (20:55)
• Imposing strict austerity when capacity to comply is lacking leads to worse outcomes.
• Fixing institutions rather than focusing solely on market or macro targets is essential.

4. The Financial System & Diabolic Loops

Dimitri Vayanos (28:44–40:07)

• The crisis is compounded by deep flaws in bank regulation:
  • Banks treated all Eurozone sovereign debt as ‘risk-free’ post-Euro adoption.
  • National-level bank supervision allowed unhealthy bank-sovereign links (“diabolic loop”).
• “A French bank or a Belgian bank could buy Greek debt... not really penalized by regulators for having a riskier security.” (31:12)
• Proposed reforms for Eurozone stability:
  • Assign risk-adjusted weights to sovereign debt in regulation/collateral.
  • Move bank supervision to the European level.
  • Develop a credible sovereign bankruptcy mechanism.
• Institutional reform must be prioritized; “exiting the Euro would leave the same bad institutions in Greece.” (39:13)

5. The Political Crisis: Europe’s Failure of Leadership

Jon Danielsson (40:13–44:59)

• The crisis is not just about Greece; parallels drawn to subprime as a symptom but not the systemic cause.
• Policy indecision—“muddling through”—generates uncertainty, which is what is truly systemic.
• “If Europe will suffer a systemic crisis, it is because of its dysfunctional political structure and the short sightedness of European national leaders.” (43:31)
• Government reform is more urgent than financial reform: “If government can’t put its own house in order, government reform is much more important than financial reform.” (44:53)

Notable Quotes & Memorable Moments

“From the outset... it was recognized the zone was not an optimal currency area... it really did not have the political cohesion, the centralized fiscal mechanism or the labor mobility to meet large asymmetric shocks.”
— Charles Goodhart (02:30)

“The fiscal crisis that we see in EMU at the moment is only the tip of the iceberg. There’s something much more fundamental going on underneath.”
— Bob Hancké (10:02)

“A low inflation country gets punished... a high inflation country... rewarded... so you have a wider divergence of inflation.”
— Bob Hancké (13:30)

“Too much respect for the markets... allowed markets to first guess political developments and... impose economic policy responses.”
— Vassilis Monastiriotis (20:55)

“Countries don’t behave like that [purely by incentives], they follow norms, they have policy learning.... If you impose conditionality… what you do is create austerity.”
— Vassilis Monastiriotis (25:26)

“Banks had very bad incentives… [to] buy Greek debt more cheaply than German debt... they were not really penalized by regulators for having a riskier security.”
— Dimitri Vayanos (31:12)

“This bank sovereign loop is a distinguishing characteristic of the Eurozone crisis. This is what is making the crisis so deep.”
— Dimitri Vayanos (34:59)

“It’s this uncertainty, more than anything, that is creating a systemic crisis.”
— Jon Danielsson (43:31)

“If government can’t put its own house in order... government reform is much more important than financial reform.”
— Jon Danielsson (44:53)

Timestamps for Important Segments

• [00:00–09:35]: Introduction and context, Charles Goodhart's background of the crisis
• [09:35–17:33]: Bob Hancké on North/South institutional divergence and monetary dynamics
• [17:36–28:38]: Vassilis Monastiriotis on Greece, policy failures, and economic beliefs
• [28:44–40:07]: Dimitri Vayanos on financial system flaws and redesign proposals
• [40:13–44:59]: Jon Danielsson on political indecision and the crisis as a failure of politics
• [46:26–59:05]: Panel “role play” as politicians and ECB leaders on strategy & response, infused with humor
  • Bob as Papandreou, Vassilis as Merkel, Dimitri as Draghi, John as God (46:26-59:05)
• [59:33–81:30]: Audience Q&A — Greek euro exit, German politics, Marshall Plan, technocratic governments, institution-building, two-speed euro
• [84:23–89:38]: Panelist closing thoughts: future scenarios and Europe’s political vision

Panel “Role Play”: Leaders Face the Crisis (46:26–59:05)

• Bob as George Papandreou (Greece PM):
  Explains calling a referendum as a two-level bargaining tactic (“if you owe the bank a million pounds, you control the bank”). (47:18)
• Vassilis as Angela Merkel:
  Must balance German political skepticism and the need to invest in European unity—argues for “a Marshall Plan... pushes for growth, more investments... reforms... and reconfiguration of the institutional system,” but doubts her public would accept it. (49:30–52:45)
• Dimitri as Mario Draghi (ECB):
  The ECB is “the main player who can move in fast... it would be good to [intervene] in a very committed way to keep spreads within an appropriate zone.” (57:01)
• John as God (with humor):
  “If God is an economist, we make all of us Europeans German... But I believe God has humor, so... move France to the coast of Canada, let it join NAFTA...” (57:36–59:05)

Audience Q&A Highlights

• Should Greece exit the Euro?
  Dimitri & Vassilis: Exiting won’t solve underlying institutional weaknesses. Would provoke massive redistribution, worsen uncertainty and net investment. (60:11–62:32)
• Marshall Plan for the Periphery?
  Panelists favor targeted development aid over macro targets; macro focus on deficit reduction alone is destructive. Real German benefits from the Euro remain poorly articulated to the German public. (62:32–70:02)
• Can a Technocratic Government Save Italy?
  Bob: Technocratic governments can only go so far; deep coalition-building and institutional reform are required. Charles: Validates some optimism for Italian fundamentals if political dysfunction ends. (75:25–77:33)
• Is a Two-Speed Euro Viable?
  Charles: Implementation risks an immediate run on southern banks, is nearly impossible without triggering a crisis. (78:05)
• Fundamental Flaws: Is a Stable Euro Possible Without Deep Change? Bob: The Euro can't be easily undone ("Hotel California, you can never leave"). Problems are deep, but so is path dependency. (81:30)

Closing Reflections (84:23–89:38)

Jon Danielsson:
Only two endgames: full fiscal union or a rollback to a pre-euro Common Market. Doesn’t see the political support for federalism. (84:38)

Dimitri Vayanos:
The Euro can work with incremental reforms, especially in financial governance, not only via political union. (85:32)

Vassilis Monastiriotis:
Europe has always been a political project aiming for prosperity and stability; what’s lacking is leadership and vision, not simply correct economics. (87:02)

Bob Hancké:
The EU's institutions were crafted for stability between France and Germany after WWII, not the complex macroeconomic challenges now faced—stretching this "meager skeleton" shows its limits. (88:18)

Summary

This wide-ranging episode, set at the height of the Greek crisis, combines clear-eyed structural analysis and institutional critique with humor and pragmatism. The panel diagnoses the Eurozone's woes as not just the product of national failings or unbridled markets, but of institutional mismatch, flawed incentives, and political drift. Though panelists debate pathways—between institutional redesign, leadership, and hard choices—they agree that enduring solutions, if possible, must address the deep structural and political foundations of the Euro project.

For listeners seeking an accessible, multi-dimensional interpretation of the Eurozone debt crisis at its peak, this episode blends deep expertise, sharp debate, and real-time context with a candid, at times wry, assessment of Europe's most existential modern crisis.