The eurozone crisis and global monetary reform: a conversation.

• Author: Zoellick, Robert B.

Sebastian Mallaby: We are here to talk to Bob Zoellick. I have been in Washington 16 years, Bob is the personification of the kind of silo busting polymathic energy which says, I am not just interested in international economics, I am not just interested in international relations, I am not just a U.S. government official, I am also going to do multilateral diplomacy. So Bob has been on all sides of those various divides. He has a voracious intellect, so it is always interesting to speak with him whether he is in office or out of office.

The Eurozone Crisis

Let's start with Europe, since Europe is on everybody's minds. This is a monetary policy conference. I drink there might be some monetary policy lessons that come out of this mess. Questions about what will and won't work as an optimal currency area might be one set of questions. But let me ask you, what do you see as the lessons coining out of the European crisis?

Robert B. Zoellick: Well first Sebastian, thank you for doing this, and I thank Cato for the invitation. When I was the trade representative from 2001 to 2005, I used to interact with Sebastian, but 'always appreciated Cato as one of the last free traders in Washington. So I very much appreciate the support you 'always had on the trade agenda, as important now as ever, I would say.

On the European issue right now, I said in August, and I hold to this, I think we are in a danger zone. We have a combination of three issues: a banking issue, a sovereign debt issue, and a competitiveness issue related to the monetary union. And I think so far the European countries have tended to address these, sort of, a day late and a euro short. And, by and large, they have been trying to provide liquidity measures and some of the fundamental issues still have to be addressed.

I think one of the best ways to frame the agenda now is to relay a description of the eurozone problem that one of the German officials said to me after the meeting in late October. He highlighted five elements that have to move together to be able to help address this problem.

The first was that of building bank capital, obviously the case. But from a broader policy view, and this is something we are working on at the World Bank, one has to recognize that banks can improve their leverage ratio in one of two ways: either add capital or lower assets. And so one has to expect, and we are 'already seeing, for example, trade finance, which is very important and easy to run off. However, it is a short-term product, and it is also a very labor, and organizationally, intensive product--so it is not so easy to replicate. Banks in central and eastern Europe, in the Balkans, which are often linked with European banking systems, are vulnerable. And I think, just in general, you are going to see a broader deleveraging process.

Second is the forgiveness of the Greek debt. Time will tell whether that is a significant enough amount. And a lot of this obviously relates to the Greek policy actions. In a way, Greece is truly a peripheral issue at this point because Greek GDP is only about 2 percent of EU GDP, and there is a funding mechanism to keep rolling Greek debt over.

But the real issue then goes to the third element, which was that Europe was trying to create a European Financial Stability Facility (EFSF) of about $600 billion. This agency was to provide funding to roll over debt in Greece, Portugal, and Ireland, which has been doing better in any event. But the real core issue, and this is the core issue we have seen break over the past seven days, is to be able to assist Italy and Spain with the rollover. And the idea, in late October, was that the European countries would multiply this in some fashion. One of the ideas was to use this money as, in a sense, a first-loss insurance provision. It might have worked, but it has kind of drifted.

And so you are really now in the fourth issue, namely, the actions that are going to be taken by the governments in Italy and Spain. This is, I think, also indicative of a larger change we have seen in Europe, which is that what markets started to do, at least in my view, in August, was start to move away from just making economic and financial calculations to making judgments about governance. In effect, what you saw with the Berlusconi government is even if they talked about various plans, there wasn't confidence that they would be followed through. The challenge now--what markets are really questioning--is whether the Monti government, or the Spanish government "after the elections, will follow through. To give you a sense of validation of this, I just came back from London and Berlin. And in London, if you go back and you look at the British debt to GDP ratio, or budget deficit, numbers aren't so good. But because the government has quite firmly convinced people of the path, Britain's public debt actually has become a safe-haven investment. So what we are seeing right now is, in a sense, a bit of a slow motion run as people are uncertain about that sovereign debt, and obviously the banks that hold the debt, and all the liquidity aspects of this.

And the fifth piece, which would complement the monetary union, is what Chancellor Merkel at her party conference (the CDU Conference over the weekend) referred to as "political union'--or what might be called "fiscal union" on this side of the Atlantic.

These issues are similar to those faced by Alexander Hamilton. But, there is one other aspect that I want to underscore, because even at a monetary conference I think it is useful to come back to this. Ml these measures are about liquidity and buying time. Now I am not against buying time as a policy official, but it is a question of how you use the time. And ultimately, there have to be policies that create the foundations for growth. I am not talking about macroeconomic policies; I am talking about policies that create the right investment environment, the deregulatory environment, the structural growth environment, the innovation. And that is still a very open question...