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Will Europe’s Debt Deal Calm Fears of Prolonged Recessions?

October 27, 2011 at 12:00 AM EST
European leaders reached a deal over their debt crisis at an emergency summit Thursday in Brussels. Jeffrey Brown discusses how the new agreement is expected to help solve the eurozone's problems with Joao Vale de Almeida of the Delegation of the European Union to the United States and Eswar Prasad of Cornell University.
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JEFFREY BROWN: And we look at the mix of excitement and continuing worries now with Joao Vale de Almeida, the European Union ambassador to the United States, and Eswar Prasad, Cornell University economist and a fellow at the Brookings Institution. He previously worked at the IMF.

Welcome to both you.

Mr. Ambassador, in some ways, we have been here before. With grand announcements, the market goes up and then a few days later, disappointment. Why is this different?

JOAO VALE DE ALMEIDA, European Union zmbassador to the United States: I think this is different.

We have for the first time a comprehensive plan, one that goes very far in addressing short-term issues, as much as longer-term issues. I think we are dealing effectively with the Greek problem and are avoiding a contagion effect to other countries. We are involving the private sector, the banking sector.

They have responsibilities in finding solutions and they are contributing to the solution. And we are, you know, creating more firepower for our crisis mechanisms, being able to deal with the present situations, but also with potentially future situations.

JEFFREY BROWN: There has been a sense and even a fear around the world that Europe was in a — some in Europe were in a state of denial, not facing up to the scope of the problem, not dealing with some of the comprehensive measures where needed. Do you sense a shift in that regard?

JOAO VALE DE ALMEIDA: Absolutely.

I think there’s a sense of momentum, a sense of urgency. You have to understand that when people sort of criticize the European Union for being slow and complex, we are not a country. We are 27 countries — in euro, where it is 17 countries — very diverse, that require, you know, discussion so that we get to consensus.

It’s complex. Sometimes, the markets would like us to move faster. Maybe sometimes the Americans with would like us to move faster.

JEFFREY BROWN: That’s happened a few times.

JOAO VALE DE ALMEIDA: It has.

I think the important point here today — and this is a good day for Europe, as I think it is a good day for the U.S. and for the world economy — that our leaders came to a set of measures and initiatives that will be far-reaching.

JEFFREY BROWN: Eswar Prasad, take us into some of the details now.

We said some of the many details are not well-known. The question of the rescue fund, for example, what jumps out at you? What do you like and what do you still wonder about?

ESWAR PRASAD, Cornell University: First of all, I think this is a very promising step in the sense that Europe is facing up to some harsh realities in a concerted way.

And this sounds — all sounds very good, because it is in a sense a very comprehensive measure dealing with the banks, dealing with Greece, dealing with long-term governance problems. But the details are really the problem.

So one thinks about bank recapitalization, there was a sense that banks may need somewhere between 100 billion euros and 300 billion euros. Why? Because a lot of capital that they hold is in the form of debt of these economies that are in trouble. So once there was some markdown to market value, the banks need more capital.

There is a sense that 100 billion euros may very much be at the low end of the amount that banks need. Then there is what is the European Financial Stability Facility, which is supposed be…

JEFFREY BROWN: The rescue fund.

ESWAR PRASAD: The rescue fund.

JEFFREY BROWN: Rescue fund.

ESWAR PRASAD: Now, the critical thing to note is that there is no money added to the rescue fund.

But what has been decided is that the EFSF money can be used in a way to leverage up whatever money it has. And the hope is that the EFSF money could be used to basically guarantee the first round of losses that private investors may take if they were to buy new debt. So, if an investor, say an official government, or a private investor were to buy new Italian debt and then there was a default on that debt, then a certain proportion of that, maybe 20, 25 percent, would be covered by the EFSF.

Now, is this going to be enough to draw investors in, either private or sovereign? That is the big question.

JEFFREY BROWN: Well, let me ask the ambassador, because what is notable here is, governments aren’t committing, as Eswar said, to put more money in. So, in reality, can a bailout fund be there and be enough if something happens?

JOAO VALE DE ALMEIDA: I think it can. And the reaction of the markets — and I have been talking to some investors throughout the day and people representing the market forces — they seem to be — they seem to consider this as a very promising and a very important package.

Let me say something. In times of difficulty — and we all are in difficult times financially, economic, even socially — one needs to be creative. And I think what this set of measures reveals is also a search for creative mechanisms to maximize the firepower that we have at our disposal today.

And that’s what we have done around the facility, the European facility. We are, you know, leveraging by four or five times with the money that we have put there before. So we need to be creative. We need to involve the private sector. And many people in the United States talk about the role of banks.

I think our leaders were seeking a valid, legitimate and balanced contribution of the banking sector to this particular problem. And the proposals on the table aim at that.

JEFFREY BROWN: Speaking of banks, another part of this, as we said, is the so-called haircut to — regarding Greece.

Now is that — how would that work? I mean, that’s a — it’s call a voluntary haircut. What does that mean and will it work?

ESWAR PRASAD: Now, there are two aspects to whether it will work. The first question is whether this is going to work for Greece.

Now, the presumption is that, in fact, if private bondholders are getting only 50 cents on the dollar, and of course as bonds are already trading at values less than full value, the question is whether that’s going to be enough to get Greece out of this mess.

And even if Greece delivers a lot of privatization revenues, about $100 billion, even if Greece implements its fiscal restructuring, Greece will still be left with about 120 percent of GDP debt in 2020.

JEFFREY BROWN: Still quite a lot.

ESWAR PRASAD: Is this going to be sustainable? Probably not.

JEFFREY BROWN: So the question is whether this just postpones the problem.

ESWAR PRASAD: Yes.

And for banks, there is another problem, which is that they are being asked to raise capital at a time when it’s very difficult to raise capital. Plus, there is the notion that there might be more write-downs coming down the road, not just on Greek debt, but perhaps on the debt of other European countries.

So banks, naturally enough, may be in a mode of conserving cash. And conserving cash means lending less, lending less to households, to corporations, which could affect the European economic growth.

JEFFREY BROWN: What about the political question here that lurks always, is the sense that European voters are not interested in these bailouts anymore, that they don’t want to help other countries, that they are tired at this point of being asked to put out more money? This agreement doesn’t really address that, does it?

JOAO VALE DE ALMEIDA: I think what voters want in Europe is growth and jobs, stability and security for their families. That’s what we’re looking for. And I think this is the debate in the West as well.

So we were faced with a situation of emergency in Europe, you know, difficulty in some countries affecting the whole system, risking bringing down the whole euro area to a very difficult situation.

JEFFREY BROWN: You think it really — it’s close to that or came close?

JOAO VALE DE ALMEIDA: I think we shouldn’t be complacent about the crisis. We were in a difficult situation. So when are you in a difficult situation, you have to think of the alternatives. What are the alternatives?

The alternatives to the kind of measures we are taking now were much more costly for everybody, including those who are already in difficult situations. So, I think — I don’t think that the leaders will go this way if they didn’t know that they could eventually count on the support of the electorate.

And, you know, we’re not talking much about that. But together with these measures that we have been describing here, there were a number of initiatives aiming at enhancing growth in Europe. We have to keep on reforming our economies. We have to keep on reforming our labor market, public finances, pension systems. And all of this is part of the package, right?

When we support Greece or Portugal or Ireland, we are putting on the table very strict conditions. We hope other countries are not being supported to do the same. And this is all part of the, you know, growth-enhancing measures that we’re taking at the same time as we decide what we are describing.

JEFFREY BROWN: All right, Ambassador Joao Vale de Almeida and Eswar Prasad, thank you both very much.

JOAO VALE DE ALMEIDA: Thank you.

ESWAR PRASAD: Thank you, sir.