Viv Davies: Hello, and welcome to Vox Talks, a series of audio interviews with leading economists from around the world. I'm Viv Davies with the Centre for Economic Policy Research. It's the 17th of February 2012, and I'm speaking to Willem Buiter, Chief Economist at Citigroup, about Greece and the Eurozone. Buiter believes Greece should remain a part of the Eurozone, that its public debt should be written off, its banks recapitalized, and that it should be provided with sufficient conditional financial support to undertake the required structural reforms that are needed in order to return the country to a primary surplus.

Buiter is of the opinion that a hindrance to Greek recovery has been political ineptitude and misguided self righteousness amongst European policymakers. I began the interview by asking Willem to explain why, in a recent FT article, he believed that a disorderly Greek sovereign default and Eurozone exit would be disastrous for Greece.

Willem Buiter: Well, sovereign defaults are never picnics. When combined with the abandonment of a common currency, they will have disastrous balance sheet implications, financial implications for Greece. Every contract, every security under Greek law would be redenominated in new drachma and promptly lose half its value, if the new drachma tumbled. The only conceivable advantage to Greece would be that the collapse of the external value of the drachma would buy them a temporary improvement in competitiveness. But since I do not believe that Greece is a Keynesian economy that has highly flexible real wages and very sticky money wages, but in fact is much more like a distorted classical economy, with rigid real wages and flexible money wages, I think its competitive advantage from exiting and having a maxi devaluation, a depreciation of the new currency would be very transitory indeed.

So the country would basically end up with a sky high rate of inflation, and since the demand for the new drachma would be minimal, the country would, for many purposes, remain Euroized, especially in private transactions. So somewhere between high inflation, hyperinflation, and utter financial devastation of every entity with a balance sheet, not just the sovereign, the banks, but also corporates and indeed households with significant assets. I think it is not something that I would recommend as an exercise in good economic health.

Viv: OK, so if we look at the other peripheral countries in the Eurozone, Ireland has regained competitiveness. Spain is geared up now for change, politically. Italy has credible political leadership. Do you think it's plausible that even with the currently proposed bailout of 130 billion euro that Greece will be able to adequately reduce its government debt over the next eight to ten years?

Willem: Well, I don't agree with the first three statements you made. Ireland has regained a little bit of competitiveness. It's still enormously deep in a fiscal hole, and getting in deeper, because of the deterioration of its housing markets and its non performing mortgages. Spain is just at the beginning of reform. It has a 49 percent youth unemployment rate. That is not just an economic problem, that is a social and political disaster. Italy has no credible political leadership. They have the temporary, personally credible technocrat, Mario Monti, a man of greatest talent and integrity, but superimposed on the same crowd that brought the country to its knees earlier. So there is absolutely no political guarantee of the durability of the Monti technocratic cabinet. The fact is that as soon as the political class in Italy begin to view him as a threat to their political futures, then he'll get dumped.

As regards the 130 billion, that Greece may be able to get together, (a) it isn't enough to achieve the official objective of getting its debt over the next eight years down to 120 percent of GDP. And even if it were 120 percent of GDP, after a decade of austerity and upheaval, it's still going to be far too high for Greece to manage. We are wondering if Italy today is capable managing 120 percent. Greece, after the best part of a decade of agony, will not welcome the prospect of sitting on 120 percent of debt.

So it is completely inadequate and insufficient, what is on offer from Brussels, Frankfurt, and Washington at the moment.

Viv: So, what do you think needs to happen, then, in order to make it possible for Greece to stay within the Eurozone and to grow and prosper?

Willem: Well, we have to write off the debt, effectively. Probably the IMF will get paid, because they always do. That's the advantage of the so called “third creditor” status. But all other creditors, be they private or official, including the ECB, the bilateral Euro Area creditor governments, and anybody else that may in the future be contributing to Greece, better recognize that Greece is not capable of servicing the debts. Just write it off. That still leaves a funding gap for the Greek sovereign, depending on your estimate, there still is a primary deficit, a non interest deficit for the general government of between two and four percent at least. So that still would have to be funded. They have to continue funding that, but no more.

And then, really, leave it up to the Greeks to reform themselves. There's no way that we're going to be able to turn Greece into a colony of Brussels, Frankfurt, and Washington, and run it as a vassal kingdom for the next eight years.

Viv: So, would you agree with, I think it was Lord Lamont, who said yesterday that Greece is the canary in the mine, and it's just signaling the potential and likely scenarios in the other peripheral Eurozone countries in months to come?

Willem: No, no, no. Greece is uniquely awful, the situation there. Other countries face challenges. Greece faces a really currently insurmountable challenge. No, I am no more fundamentally worried about the continued existence of the Eurozone, with the possible exception of a Greek exit, than I am about a continued existing United Kingdom. In fact, I'm rather more concerned about that than about the Eurozone breaking up. No, I think that we have to recognize in Europe that a number of sovereigns are insolvent and have to be restructured. Greece is the obvious one, Portugal, and possibly Ireland are in similar boats.

We have to recapitalize the banks in a major way, and then reduce the size of the banking sector and its balance sheet significantly, because it's grown over bloated, and then we need radical structural reform of labor markets and product markets, especially service markets, all through Europe, not just in the periphery, where the problems are at the moment, but also in the so called successful north.

Remember always that Germany, for instance, is a dual economy. It has an incredibly efficient export and manufacturing sector and a pathetically inefficient non traded services sector. There is lots of reform that needs to be ongoing even in the north, if we are going to hand the world to our kids that is worth living and working in.

Viv: Yes. You mentioned the banking sector then. The ECB recently introduced its long term refinancing operation process, which many commentators have welcomed, especially in terms of the signal it gives to markets. However, some economists, like Charles Wyplosz, for example, are of the opinion that the LTROs have made things significantly more dangerous in that a potential wave of sovereign defaults could turn those bonds into toxic assets. It's what he refers to as the “trillion euro bet”. What are your thoughts on that?

Willem: I don't understand Charles' argument. But I think that the LTROs were a necessary part of the solution but by no means sufficient. They are a part of a mechanism for keeping the banks funded. We, of course, have to make sure that the banks become solvent again as well, which will require and inevitably mean that many of the continental European banks will end up in state ownership, those that aren't already. And even if there are no deep pocketed sovereigns to recapitalize the systemically important banks, then the money may have to be got from the unsecured creditors to the banks, from the bondholders, etc. So we're going to have to have major bank restructuring as well as provide the liquidity, but unless we provide the liquidity, we would never be able to get to the point that the structural reforms, the recapitalization, take place.

What I am worried about in terms of the LTROs has been that it has been accompanied by what I call some Balkanization of monetary policymaking in the Euro Area so that we are approaching a world in which there are two different risks.

Either because national central banks now have considerably more discretion over what's acceptable as collateral for national central bank credit, there is a risk of loss of control over the aggregate size of the balance sheets that you may call the "Ruble Zone Problem," that you get 17 different national centers of issuance, effectively.

The other problem is that since in order to minimize the first problem, the loss of control problem, the ECB has departed from the principle that losses of national central banks are pooled and shared - that's no longer the case. They're going to have 17 national central banks in the Eurozone with very different credit risks attached to them, so individual national central banks could go bust.

This is something that I think wouldn't be good for our collective health. We better think and think actively of ways of minimizing both the loss of control problem and the central bank insolvency problem. We have to go back to having a single European monetary and collateral policy. Of course, the application of the single set of rules will still be dependent on local circumstances. That is perfectly consistent with the common policy.

But we can't have national central banks, once again, the way they were before 2007, determining to a significant extent what kind of collateral they are going to accept. There has to be central control of this.

Viv: Currently, in Europe, there's a growing sense of public injustice in the face of increasing austerity whilst at the same time there's a wider political sense of progress towards competitiveness and growth in Europe. Would you agree that the fate of the euro will essentially be determined by whichever prevails between these two?

Willem: I see, as of now, no sense of progress towards competitiveness and growth at all, if only! We still need all the structural reforms. They haven't started yet. Spain is just scratching the surface of its dysfunctional labor markets. So is Italy. So is Portugal. We have - not just in the Euro Area, in the U.K. - we have more than 30 percent youth unemployment, major structural dysfunctionality. So I see that so far there has been no progress made at all on the structural reform. The only progress there has been has been on the austerity side. It's time that they got going on a structural reform agenda to open up labor markets, public markets, facilitate entry and exit and make Europe an attractive place to do business again, and a place that people want to come.

That can, of course, be very difficult since austerity is going to be there for as far as the eye can see. Fiscal tightening will be a companion in most European countries until the end of the decade. So hopefully we will get more accommodating monetary policy. If we cannot have that, then we will have to rely on the animal spirits of our private citizens, hopefully stimulated by structural reforms, to get us out of the hole that we dug for the continent.

Whether people will put up with the austerity remains to be seen. We have not had an experiment in continent wide fiscal austerity on this scale ever, I think, in Europe. It is certainly possible that political unrest and social upheaval will prevent the necessary fiscal austerity and indeed structural reform, because there are so many vested interests, especially vested interests of the elderly and the old that have to be overridden.

Property rights, things that are viewed as property rights in labor markets, in jobs, in pensions, that will have to be expropriated and violated to get this show on the road again. But we will see. If we don't, then the continent has proven that it is possible to go from enormous wealth and prosperity to widespread poverty and misery in a couple of decades flat. It could happen, but I don't expect it to happen.

I expect that we will stick to the austerity and structural reform agenda, hopefully get a bit of help from more accommodating monetary, credit and liquidity policy. And a bit of help from our friends in emerging markets, who despite all this, are still growing like weeds and who will provide markets for the goods and services that we can't sell to each other anymore, but that we can sell to them.

Viv: Finally Willem, returning to the central question of Greece, what would be your immediate advice for the European leaders and policy makers who are currently in two minds about what to do about Greece?

Willem: Write off the public debt, recapitalize their banks, using European resources, obviously, because there aren't any Greek resources. Keep them in the Eurozone, very definitely. It's both in the Greek interest and in our interest. Then provide further minimal financial support. Don't build up another debt burden, but sufficient to run steadily diminishing non interest deficit for the general government and ultimately have that peter out and turn the country into a country with a sizable primary surplus, but not from a position where they spend six or seven percent of GDP on interest. So write off the debt, restructure the banks and then make conditional funding, of the kind that is now available, forthcoming.

But don't get on the self righteous high horses that are ridden by so many European politicians, especially from Germany and my own home country, the Netherlands. It is, I think, offensive. It forgets that there cannot be a reckless debtor without that reckless debtor being accommodated by a reckless creditor.

The Dutch and the Germans savers and greedy investors are as culpable of the financial mess that we've created in Europe as the debtor countries. It takes two to tango here. When you don't know what to do, shut up. I think that would be the best advice I can give to our politicians.

Viv: Well that's great advice. Willem Buiter, thanks very much.
 

Viv Davies: Hello, and welcome to Vox Talks, a series of audio interviews with leading economists from around the world. I'm Viv Davies from the Center for Economic Policy Research. It's the 30th of November 2011, and I'm speaking to Professor Paolo Manasse of the University of Bologna about Italy and the Eurozone crisis. Professor Manasse presents his views on Italy's immediate priorities and explains the political and economic challenges the country now faces. We discuss the prospect of fiscal union in the Eurozone and the role of the European Central Bank. Manasse is of the opinion that the Eurozone requires an expansionary ECB monetary policy and an inflationary environment in order to overcome the crisis.

I began the interview by asking Paolo what he thought were Italy's immediate priorities and the extent to which he considered Mario Monti's government were committed towards addressing them.

Professor Paolo Manasse: I think their priorities are right, in the sense that Italy definitely needs to restore growth and, at the same time, to try and consolidate its budget. And I think that Mario Monti understands very well that it has to do both things at the same time to avoid a downwards spiral of the economy that would lead to higher deficits and to further fiscal stress, and so on. There are two difficulties in that. One is a political difficulty, and one is an economic difficulty. The economic difficulty is that the measures that Mario Monti is now going to implement on the structural reform side are supply side measures. And this supply side measure - like cutting pensions and liberalization of service and goods market and so on, and liberalization of the labor markets and so on and so forth - now, this supply side measure typically has short term negative effects on the economy. For example, if you cut pensions, you not only have budget cuts, which are deflationary, but then, only over time, you may have positive effects, and then people have less money to spend and so on and so forth.

If you add to this structural reform - which may have negative effects in the short run - the fiscal consolidation, then there is a risk that not only the economy would shrink, aggravating the budget, but also that you may run into some sort of deflationary situation, with prices falling, because you have no downward shift, so to speak, in the aggregate demand, and then aggregate supply shifts up, and, as a result, economic activity tends to fall in the short run and prices tend to fall as well.

Now, both these things may aggravate, very much, the fiscal outlook, because you get it at the same time, you have lower revenues, and you may even have an increase in expenditure for unemployment benefits and so on. And even more seriously, if you get to the situation where you have negative inflation, which is not unlikely, then real interest rates go up, and that, coupled with negative growth, may make the debt dynamics explode.

The economic risk is this - that in the short run fiscal consolidation plus structural reform may not only depress the economy but also imply a negative spiral of prices. The political risk is that, if that happens, I think Berlusconi may be tempted to come back and, that is to say, may withdraw his support to the Monti government and present himself as the kind of paladin of growth, and that would be a disaster. That would really be a disaster.

Viv: OK. You mentioned fiscal consolidation. Just a few days ago, Angela Merkel and Nicolas Sarkozy announced that they would be proposing modifications to the Eurozone treaties, in order to improve Eurozone governance and to ensure greater integration and convergence among the 17 members. Essentially, they are proposing a move towards Eurozone fiscal union. Are you in favor of that?

Paolo: Yes. But I think one has to be clear what that should mean. If that means a kind of more centralized fiscal policy in which, for example, there is some sort of veto power of European institutions on national budgets, I think that would be a good idea. And then I think what could be reasonable, not to completely give up national sovereignty to the EU, would be to get to a situation like the budget process as it used to be the UK, for example that is, a two stage budget process in which you have a first stage in which the aggregate measures, the difference between spending and revenues, is fixed, then a second stage in which you argue about the composition of spending and taxes. Now, the first stage should be, in a sense, delegated to some sort of European fiscal powers, and it would set the overall, macro outlook. And then, you should leave to the parliament - because you don't want a national parliament to be totally expropriated - you should let the national parliament to decide about the composition of spending and taxes. That may be a reasonable solution, although it would mean just delegating a lot of sovereignty to upper European levels. The problem is that Germany seems to think that if everybody shrinks, problems will be solved. But that is not, clearly, going to be the case.

Viv: What are your views on President Barroso's recent proposal of introducing common Eurozone bonds, or, as he called them, stability bonds, as a way of resolving the debt crisis? Is it a short term solution?

Paolo: Well, that should be a part of the fiscal framework, in the sense that I have written, also on Vox, an objection to the idea of eurobonds, in the sense that a bond has a value and an equilibrium only insofar as people think that it will be eventually repaid. Now, to be eventually repaid, a euro wide bond needs to be repaid by surplus countries. Now, clearly, no surplus country is going to repay a deficit country's debt without having control of the financial situation of those countries. There is no way the eurobonds will be approved, in my opinion, unless it's a part of some sort of fiscal package in which you have, really, power of countries running surpluses to decide the fiscal policy in countries who run deficits, because otherwise no one will be willing to waste its own taxpayer money to finance other countries' expenditures.

The two things could work together, and only together, to be politically viable. It could be a good idea, only insofar as it comes together with a fiscal union of some sort.

Viv: What about the European Central Bank? Do you think the ECB should play a more prominent role in the crisis and effectively become the lender of last resort?

Paolo: I think the short answer is yes. The longer answer is that the BCE is now facing, apparently, a tough trade off, which is a trade off of monetizing the debt of peripheral countries and potentially adding to inflation. That's one part. The other part is the financial stability of the Eurozone at large. This is the sort of trade off. Clearly, one can understand, given the way in which the ECB was born with the German model of the Bundesbank, that Germany doesn't want to give up their role of inflation guardian, so to speak, but this ignores the other part of the trade off. If the other part of the trade off becomes prominent and there is a risk, as it is now, of financial collapse of the Eurozone, then I think anybody, reasonably, would think that you can accept more inflation.

Also, I think this trade off is a theoretical one, in a sense, because as of now the main risk, as I said before, I think, is the kind that, eventually, Europe may spiral down into deflation. This is because, if every country or many countries at the same time are at the same time adopting a fiscal consolidation and a supply side measure, the effect of those, as I argued before, are going to be to reduce inflation and possibly to get to a situation where you have stagnation plus deflation.

And so, in a sense, this is already…what we also observe right now is that we are running into problems of liquidity, very sharp, very huge problems of liquidity in banks. The solution to that would be, really, to have a very expansionary, QE type monetary policy by the BCE, not only providing liquidity to banks at zero interest rates but also be willing to buy debt. Basically, what we need is more inflation right now. We badly need more inflation in Europe. That would take care, also, of a part of sovereign debt problems by reducing the interest cost and real value of debt.

And so this trade off I was speaking about before is a theoretical one, because just now more inflation would be beneficial, both to the sovereign debt crisis and to financial stability, in a sense.

Viv: Current market signals seem to indicate that investors are losing confidence in German bunds. Also, we saw Italian bonds, yesterday, short term yields rising to eight percent. How serious do you think these problems are?

Paolo: I think they are very serious, because I think the result of our analysis that I alluded to before pointed to the fact that no one would be unaffected by an eventual collapse, for example, of Italy. We already seeing, and have been seeing that for some time, even looking at the EFSF's issues of debt, they have been increasingly going up in terms of bond yields. Now we're seeing that on Germany, whose bonds have begun paying more than UK gilts, for example. I think there are a couple of ways to explain that. Possibly the most convincing is that, come the question of contingent liabilities, Germany eventually may be asked to pick up the bill to some extent. And then, if there is a big crisis, like a breakup in the Eurozone, it's also going to be a problem for Germany if, say, a number of countries, like Italy, exit the euro and devalue sharply, with respect to the new euro or new German mark, or whatever. That would be very tough for Germany in the sense that firms in Germany would suffer from huge competition from countries who devalued in real terms.

So whatever happens, Germany may be affected, and the budget may be affected by saving banks that have invested in Italy, for example, or a few firms that faces tough competition if Europe breaks up and so on. I think, eventually, the crisis will spread to Germany as well if nothing is done in the meantime.

Viv: Italian citizens have, this week, been called upon to be patriotic and buy up government bonds that have been shunned by foreign banks. Is this a realistic way forward?
Paolo: The answer is no, for a number of reasons. First, this is a "you beef up the base," a trick thing, because the one that took place yesterday was not on a first issue of the debt but was debt from the secondary market. Italian houses have been buying debt that already had been issued, so what really happened is that they took debt out from the balance sheets of banks. That's why banks were very favorable to the speech today, because they managed to download the bad assets to the houses. And also, from a point of view of looking at the numbers, housesholds hold something like 14 percent of the Italian debt, so it's very unlikely that this sort of measure would do anything, either to spread or reduce our dependence on foreign creditors, which is about 43 percent of the debt.

Viv: Finally, Paolo, many economists are of the opinion right now that the future of the euro is entirely in the hands of politicians and there is no more that economists can say or advise that hasn't been said already. Regardless of that, do you have a quick solution that you would provide right now, in a nutshell, regardless of whether the policymakers are prepared to listen or not?

Paolo: Well, yes. I think it should have at least the following ingredients. One is, everybody wants more fiscal union, and I think a two step budget procedure may be a possible solution, in the sense that you have more powers at the centre, but it leaves powers to the national government to decide about the composition of the budget, the size of the budget are decided elsewhere, or at least there is a veto power. As for at the Eurozone level, the second part may be a eurobond, when you have this guarantee that, eventually, if you are running deficits and you are kind of under control, you lose your fiscal independence, and that would take care of the fiscal situation. There would be a larger load for the ECB, possibly together with the IMF. And if there are legal problems in terms of the treaty, then some solution, like the ECB lending to the IMF, which may, at that point, take the role of lender of last resort, may be a possible solution.

As far as the situation of countries which are already insolvent, Greece being the obvious example, I think the orderly restructure should be done without other, to reach a station, so to speak, so without losing more time. Such countries should default in an ordinate way and then just move on from then.

Viv: Paolo Manasse, thanks very much for taking the time to talk to us today.

Paolo: Thank you very much.
 

Viv Davies  interviews Harry Huizinga for Vox

October 2011

Transcription of a VoxEU audio interview [http://www.voxeu.org/index.php?q=node/7293]

Viv Davies:  Hello. Welcome to Vox Talks, a series of audio interviews with leading economists from around the world. I'm Viv Davies, from the Centre for Economic Policy Research. It's the 17th of November 2011. I'm speaking with Professor Harry Huizinga of Tilburg University, about his recent paper titled "Does the European Financial Stability Facility bail out sovereigns or banks?"

Using event-study methodology and statistical analysis, Huizinga concludes in his recent paper that the creation of the EFSF has resulted in the bailout of both banks and countries, and that the increased credit worthiness of the heavily indebted countries comes at the expense of a lower quality of debt of the non‑heavily indebted Eurozone countries.

He also concludes that the use of EFSF funds has been expensive and inefficient and that there is a limit to the extent to which the EFSF can be scaled up. Nevertheless, he suggests that this may indeed be a blessing in disguise.

I began the interview by asking Harry to briefly explain what the EFSF is and what it was designed to do.

Prof. Harry Huizinga:  The EFSF, that's the European Financial Stability Facility, it was set up on May 9th 2010 by announcement of the Eurozone governments. It is supposed to provide loans to Eurozone governments that are experiencing debt difficulties. The EFSF itself gets it funding from the capital markets. It uses guarantees from the Northern European countries.

Viv Davies:  The basis of your recent paper is to question whether the EFSF actually bails out sovereigns or banks. Firstly, how are banks affected by the EFSF? Secondly, how did you go about answering that initial question in your paper?

Prof. Huizinga:  Well, the banks, they do not get funding from EFSF directly, but indirectly they certainly are affected. First, they are affected because they hold a lot of government debt on their books. If the indebted countries in the South – if the credit worthiness of these countries improves – then the evaluation of these debts rises and that helps the banks. Secondly, what's important is that if the indebted countries are made more creditworthy, they also will be able to have a more creditable financial safety net. This helps the banks in indebted countries.

How did we go about looking at all this? Well, we look at the changes in market prices around the announcement date of May 9th 2010 of the EFSF and we look at the free prices particularly. First what we do is we look at the bank stock prices around this date.

We look at whether bank equity holders are affected by change in equity prices. Secondly, what we do is we look at the CDS spreads, which are available on bank liabilities. We see whether the cost of insuring bank liabilities, bank bonds, actually is affected by this. A third thing we have to look at is country CDS spreads. We look at whether the insurance necessary to insure government debts of indebted countries is affected by this announcement.

What you find, if you look at just the prices themselves, you find that the bank stock prices actually fall. Perhaps because bank equity investors expected an even bigger EFSF to come about. Perhaps they were disappointed by what they saw.

But on the other hand we find that the CDS spreads for both bank debts and for country debts, they fell. That's evidence that the market values of bank debt and government debt rose. You can say there's been some bailout of countries and also of at least the bank liability holders.

Secondly, what we do in this study is an event-study using event-study methodology, where we look in more detail at how these prices are affected, also by the exposures that banks have to sovereign debt. For that we use detailed information on the exposures that are available from stress tests that were conducted by a committee of European bank supervisors in 2010.

Secondly, we use information on the fiscal position of the countries by using information on the indebtedness and deficits of the country involved. From that you can get a bigger picture of exactly which banks and banking systems and countries, how they did, and how that depends on the exposure and on the fiscal situation of the countries.

Viv: What are the main results of your analysis?

Prof. Huizinga:  Well, the main results are, if we first look at the bank equity holders, they benefited to the extent that the banks held debt to the PIIGS countries. Those are Portugal, Ireland, Italy, Greece and Spain. But they were hurt to the extent the banks held other Eurozone debt. Then if you move to the bank liability holders, if you look at the CDS spreads there you find that the bank liability holders equally gained to the extent that banks held PIIGS debt, and they were hurt to the extent that the bank held the non‑PIIGS debt.

Also we see that the bank liability holders they gained if the bank is located in a country which has some strained public finances as indicated by a high debt or a high deficit.

Interestingly enough the countries, they saw their CDS spreads fall. So therefore the countries became more creditworthy. If the countries had banking systems with a little exposure to PIIGS debt, and, in contrast, if the bank systems had a lot of debt to non‑PIIGS Eurozone countries, then we saw actually that the CDS spreads rose.

Also, the CDS spreads fell to the extent that the country has a lot of government debt.

Viv:  OK. What can you say about the size or the magnitude of the effects on banks?

Professor Huizinga:  Well, when you look at the magnitudes, you can first look at what happens directly to the valuation of the sovereign‑debt portfolios that banks have. There we found that the announcement increased the valuation of these portfolios of sovereign debts of the banks in the study by about 10 billion. Then, looking at what happens to bank equity prices and to bank liabilities, you find that bank liabilities increase in value by about 29 billion, while bank equities fell in value by about four billion. If you add up the effect on bank liability holders and bank equity holders, you get to a positive amount of 25 billion, while, in fact, the increase in the valuation of the sovereign portfolio was only 10 billion. Banks, as a whole, if you add up the effect of bank liability holders and bank equity holders, it's much larger than the direct effect or the exposure they have to these countries. It seems to indicate that the banks benefited a lot because the financial safety nets in the country involved were made more creditable. If the countries are more creditable, they can more credibly provide support to the banks.

Viv:  What general conclusions can be drawn from your study? What would you say the implications of the study might be for how the EFSF is currently perceived by policymakers in terms of its role in helping solve the Eurozone crisis?

Professor Huizinga:  Well, one implication is the fact that both the banks and the countries were bailed out, and there are some related effects. If banks were located in countries with strained public finances, they were gaining more. On the other hand, if countries have banking systems more heavily exposed to the PIIGS countries, then the countries gained more. Now, the second thing is that we do see that it's bad for banks to have exposure during this episode to the non‑PIIGS Eurozone countries. That suggests that the creditworthiness of the non‑PIIGS countries has actually declined. That suggests that there is no free lunch. On one hand, you can increase the creditworthiness of the PIIGS countries, but it comes at a cost of reducing the creditworthiness of the non‑PIIGS countries.

That will also suggest that there is a limit to how much you can actually scale up the EFSF. While our study does not indicate clearly how far you can go in scaling it up, there is some cost to scaling it up. If you look at more recent experiences, if you look at what's happening in the last several weeks particularly, you see that there, indeed, is a lot of difficulty in scaling up the EFSF. While policymakers have said that, in principle, now the EFSF should be able to scale up to more than about a trillion's worth of lending capacity, you see, in practice, this is very difficult. I think this is consistent with the results we find, where you see the fact that there is no free lunch. You can try to scale it up, but only at a cost, and therefore you can only go so far.

Viv:  What about these discussions recently about turning the EFSF into a bank?

Professor Huizinga:  That's one way to try to scale it up. Then you would use the moneys that are guaranteed by the Eurozone countries as equity to the bank. Then you can try to attract additional funding from other sources, such as from sovereign‑wealth funds. For instance, China is mentioned as a possible provider of money. Then, if you do that, in principle, you could increase the lending capacity of the EFSF to more than a trillion euros. But it's been quite difficult to attract funding this way. It's to be seen whether this is going to be possible. Our study suggests that it would come at a cost of creditworthiness to the north, so perhaps it is not as easy as anticipated by policymakers.

Viv:  Another conclusion from your study is that the EFSF has benefited banks holding PIIGS debt, regardless of whether they are distressed and where they are located.

Professor Huizinga:  Yes. This is one of the, I think, lessons to be learned, that given that the EFSF cannot be too big, given that there is a scarcity of public money available, you should try to use it very well. What has been happening so far is that if you indiscriminately guarantee countries, and therefore also banks that hold this debt, then you do not just benefit the banks which are located in the Eurozone and are distressed, but also banks that are located elsewhere and are not distressed. You can say that this would be an inefficient way of using money. I think one lesson is that if the money is limited, you should use it very efficiently.

Viv:  What would be your key message now for policymakers dealing with the Eurozone crisis, Harry?

Professor Huizinga:  The key message is that if you have little money available, try to make the best of it. Try to use it well. The banks, it would mean that if you're going to bail out the banks, try to do it at low public cost. On one hand, try to have arrangements where the equity holders, they're gaining not too much. One way to do that is to make sure that the countries, or the EFSF, if they bail out banks, they get, say, warrants, which would provide some of the upside potential on equity prices to the providers of public moneys. On the other hand, it's also important that perhaps the bank liability holders provide some of the money necessary to do the bailouts. That would be paramount to a "bail‑in," where some of the money is cut from the bank liability holders. Try to bail out the banks as cheaply as possible.

The same goes for the countries. If you have little money available, in the EFSF, as we've seen, you may not be completely credible – and we've also seen that – while, as a result, you might see very high yields on countries' debts, such as Italy's debts. One benefit of that is that you actually get more leverage on the policymaking, and actually, perhaps you have more influence if you want to get countries to reform, so that you can promote growth. That's exactly what you have seen in Italy, where you've seen it changed. Now there is the government by Monti, and in fact you have more growth‑promoting policies. My message to policymakers would be, try to see their limited resources as a blessing in disguise.

Viv:  Harry Huizinga, thank you very much for taking the time to talk to us today.

Professor Huizinga:  OK, thank you.