How do you define the crisis that Europe is experiencing today? It started as a financial crisis, later it became an economic crisis and then a debt crisis. What are the basic features of this crisis and why is it so difficult to tackle?

If we are talking only about the Eurozone, I don’t actually think that there is just one crisis. It’s a set of several interlinked crises and moreover these interlinked crises are different in nature. So for one thing, I see what I would call a very standard sovereign crisis in countries like Greece and Portugal and to some extent Italy. I also see a garden variety real estate crisis, called banking crisis in Ireland and Spain. Each of these countries has had or has its own crisis, but the actual forms of crisis were of a substantial variety. Reinhart and Roggoff have presented a full list of real estate bubbles and crises during the past twenty years; Sweden, Finland, Japan, Switzerland, UK. In these countries you then got a feedback loop. In Greece, the sovereign getting funding from banks meant that the haircut on the sovereign bankrupted the banks. In Ireland and Spain, the sovereign standing in for the banks and suffering the consequences implicated the sovereign. Now, there’s a third type of crisis, which I think has been very important at least politically and that’s a sort of hidden crisis in the French and German banking systems. Both of these banking systems suffer from banks being fairly weak, meaning weakly capitalized after the Lehman crisis, or rather from lack of a clean-up after the Lehman crisis. Moreover, in the German case, due to lack of profit opportunities, there is excess capacity in significant parts of the German financial system; the only part that’s really profitable is retail banking and that’s dominated by the local savings banks and the cooperative banks. So both the Landesbanken and to some extent the large private banks have trouble making money without “gambling”.

Now, taking a step back we can ask whether we should see all of this as part of one major development. The answer is positive. Over the past decade, the past 15 to 20 years, what we’ve seen is a dramatic expansion of the financial sector, in particular a dramatic expansion of the size of the largest banks and their balance sheets and I believe that some of that is related to the increase of the intensity of the competition. Much of the increase in size was engineered by the increase in borrowing, by reducing equity relative to total assets, which made banks vulnerable. So we have basically an unsound financial sector, extremely high leverage, extremely short-term leverage and that hasn’t really been cleaned up.

Staying at the Eurozone level, how do you assess the handling of the crisis to-date?

It’s been basically muddling through and I think that has been very costly; the major asset that we lost is our good reputation. What I’m really afraid of, is the loss of legitimacy of the European project. During my visit in Greece I heard all about dissatisfaction with the North, dissatisfaction with the ECB. On the other hand, as I was on the plane, I read very harsh comments on the ECB’s decision to cut the interest rate and a very long article in a German newspaper on how the ECB policy was expropriating creditors and in particular Germany. I think the development of populism on all sides is really dangerous.

If you ask what could have been done differently, I’m fairly convinced, leaving aside the question of what happened in 2008, that if in April and May 2010 the Maastricht treaty had been adhered to and Greece had been forced to negotiate with the banks -and by banks I don’t mean Greek banks, but German and French banks- and a haircut had been agreed right then, it would have been better for two reasons; one, liability would have been imposed on those banks right away. The haircut did come anyway but the delay contributed to the sale of the Greek sovereign debt from Northern banks to Cypriot banks with adverse consequences earlier this year. The other reason why I think it would have been better is that the consequences for Greece immediately would have been harsher, because there would have been no additional funding forthcoming, but it would have been left to the Greek political system and the people of Greece to deal with the situation.

I think this is important for many reasons; one of them, is that in such a situation you can’t escape your responsibility to deal with the crisis. The leader of the opposition then delayed many actions for a very long time, basically because he didn’t like being leader of the opposition. Perhaps even more importantly, for a political system in such a situation, is the sense of being in charge of one’s own fate. In the early 1990s I was involved in a committee rebuilding the economics department of the Hamburg University at East Berlin. While I was there I was struck by the extent to which the people from the Hamburg University on this committee accepted the things that the people from the West on the committee were proposing. I was struck by their sort of fatalistic attitude. In roughly the same time I saw an exhibition in Munich, where I was living, on “Building a new city: documents from building ventures in the 1950s”. In seeing this exhibition I was struck by two things; one, how enthusiastic people in the 1950s were about things that looked rugged and ugly forty or fifty years later and on the other hand how documents of the time were permeated by a spirit of exhilaration of being able to do things freely, a sense of liberation after years of being told what to do first by the Nazis then by the occupation regime. In comparing these two experiences one being on a committee that was imposing something, which I think was absolutely necessary, but even so it was an imposition, and then seeing how developments in the 1950s were experienced, made me very much aware of what difference it makes to be able to do things on your own. I’ve discussed this with friends in East Berlin who confirmed this impression and explained their passivity in terms of their belief that there was nothing else that they could do.

Coming back to the issues we are talking about, allowing the countries concerned to make the choices on their own I think would be a big improvement. And that’s an opportunity that was missed in May 2010. It was again missed, and there I think it was really bad, in the Irish case when the Irish said that they wanted to impose haircuts on the senior unsecured creditors of their banks and the ECB and others including my own country told them please don’t. I think that was a fundamentally wrong strategy to follow. I’m not really blaming my own government, the European Commission, Monsieur Sarkozy, or Monsieur Trichet, or whoever else was involved for what they did in May 2010. It was an emergency situation and they had to act at short notice. But I am blaming them for the fact that they did not institute, at least as far as I can observe, any kind of group that could have tried to assess what’s the actual situation, what are potential strategies, what do we have to watch.

Do you mean at the European level? Because if they did create such groups at the national level, perhaps they would reach different conclusions.

Even at the national level, as far as I can tell, Berlin did not have anything of this sort. Of course, having this in conjunction with Paris, with the Commission and possibly the ECB would have been even better. But take a simple example: private sector involvement. First, in the case of the Irish banks there was a veto, and then you had a decision to have private sector involvement from 2013 onwards. What does that mean for an outstanding bond with maturity 2020? Oh, we haven’t thought about that. What does that mean for an outstanding bond with maturity 2012 that needs to be refinanced? Oh, we haven’t thought about that. So, months later we had the Finance Ministers, this is November 2010, saying private sector involvement only in cases of insolvency not in cases of illiquidity, as if that was an operational distinction. Then in March of 2011, you had a decision for private sector involvement now, in July you had an involvement of 21%, in October more than 50%. And in the meantime you got the run on the European banks. This sequence of events shows that they had no strategy. It would have been desirable as I was saying before, to have some “think tank” to simply figure out first of all the data, the actual exposures and how they were developing, secondly, strategies, what’s credible and what’s not. Just to say that we will never have a haircut, it’s wonderful but it may not be credible. So I think that’s been the major piece that’s been missing and this is one reason why we had this muddling through. I should add that to some extent the muddling through did reflect political preferences.

You said that part of the crisis in Europe lies with the financial sector. To what extent do you think that the health of the banking sector in Europe has been restored and what are the longer term effects of the deleveraging that is taking place? Do you think that the new regulations are adequate for creating a healthier European banking system?

First, I don’t think we had enough of a clean-up. Let me give two examples, in true there can be more but these are the most obvious ones; if you look at the value ratios that were used at the stress tests of the Spanish banks a year ago, one gets the impression that the implied evaluations for Spanish real estate were maybe appropriate for the period before the crisis but not reflective of developments since then. If you look at right-downs on shipping loans at German banks, and you have some understanding of what’s the nature of competition and what’s the nature of the problem in the shipping crisis -shipping is a very competitive sector with enormous fixed costs and little variation in variable costs, which means that they can earn margins only if at variable cost prices there’s an excess demand. But we have excess capacity and excess capacity has been building since 2008, because it takes a long time to build ships. So if they can’t earn margins and eliminate the excess capacity, it’s clear that this crisis is going to last for a bit longer. Write-downs have been very small. These are two examples and I’m sure that there is a number of instances in other countries where losses that were recorded as a result of over-expansion before 2008 have not yet been fully acknowledged.

So, how many European banks are fundamentally insolvent? We don’t know but of course no attempt has been made to enforce a clean-up. Intervention in 2008 and later took the form of providing guarantees and providing preferred stocks, without interfering with the actual management and without looking what’s in the books. Banks were allowed to put staff into bad banks and it’s not clear at what prices they did so. So for one thing, the clean-up has not really been done, which you see reflected in low stock values relative to book values of bank shares. Markets don’t trust the book values. At book values equity is very low. Equity relative to risk-weighted assets meets Basle III requirements, but of course that only indicates that the banks are very good at optimizing risk weights as they call it.

Another problem is that I definitely believe that we have too much banking. Capacity in banking has grown a lot in the past 20 to 30 years, the biggest banks have grown a lot in the past 20 to 30 years. Bank balance sheets relative to GDP are something like three or four times as much as in the US. And it isn’t clear to me that all of this has to do with more economic activity, more benefits to society. Much of it has to do I think, with neutral borrowing and lending in search for very small margins. Now, when I use the term excess capacity people usually ask me what capacity would be right? I tell them I don’t know that but I do know that there is excess capacity when I see a market like Germany, where there are barriers to exit, where the Landesbanken have been maintained with government funds and government guarantees and when I see that banks cannot survive without “gambling”. Take a very extreme example, cover bond finance; in cover bond finance, the cover bond itself has a long maturity, the assets have a long maturity and the regulations require the portfolio of assets to have a value exceeding the value of the cover bond. So that means you have additional funding needs. Because of the intensity of the competition, prior to the crisis, banks all over Europe that were active in this segment, found it necessary to fund this gap with short-term financing. Banks that had a deposit base just used deposits for that purpose. Dexia and Hypo Real Estate did not have a deposit base so they both got their funding from the money market. When that broke down in September 2008, they had serious payments problems.

That is an example of a market where institutions could only survive by gambling on maturity transformation. In that particular market the German cover bond law of 2005 played a big role because that liberalized entry and provided the Landesbanken with scope to expand quite drastically their activities in that market. Dexia and Hypo Real Estate are of course also good examples for another problem; zero risk weights for sovereign exposures meant that banks which were active in funding both real estate and the public sector had enormous balance sheets -I mean equity of the order of 2% of total assets- which is why they were so vulnerable and why Dexia became insolvent. For Hypo Real Estate estate it would have been the same thing except that their holdings of Greek sovereign debt were transferred to a bad bank. This is why their insolvency went unnoticed. So the basic point is that both in terms of losses from the past and in terms of market structure not enough has happened and we are in a sense moving along the road that Japan took in the 1990s.

Now your question about leverage; given the diagnosis, I think that actually we need even more deleveraging. This being said and here again we must take our key from Japan, the deleveraging that takes the form of denying new loans to new firms is bad; deleveraging should take the form of writing-down bad loans and old firms.

In Greece, we see the two taking place at the same time in the sense of right-downs and provisions going up and at the same time because of fear that these may increase further, banks do not provide credit. Is there a way out of this?

If we had a workable banking union with a European supervisor strong enough to examine the books and a European resolution authority strong enough to close banks, we could use the Swedish model to clean the banks up, de-privatize the good banks and hopefully get going. The problem is we don’t.

Are you satisfied with what you have seen up to now in the effort to create a banking union?

No. Even on the Single Supervisory Mechanism, I’m skeptical. First, the ECB as supervisor will have to apply national law. The regulation says the ECB applies all Union law. Now the problem with that is that directives are not applicable and it’s difficult to see how to apply a non-applicable legal norm. The original version of the regulation just said “apply all European Union law”, the final version said in the case of directives it would apply the national legislation that implements the directives. That means that you have 17 plus different legal regimes with 17 plus different jurisdictions. You have administrative courts overseas; I don’t see how this is going to work. All the interesting staff, all the staff that requires judgment is in the directive. The regulation focuses on capital requirements.

So I would expect that two or three years from now, the Commission is going to come up with a proposal to put everything in the regulation rather than the directive and that will be another serious conflict. Now the other feature is that without a viable resolution regime, the supervisor has problems. If as a supervisor you look at a bank and this bank is really insolvent and then you look at a neighboring bank and it’s the same thing, five or twenty have the same problem, what do you do? Do you have the temptation to just not question evaluations; I was talking before about evaluations underlying real estate and shipping loans. The temptation not to question those is very big.

On the resolution regime there are two issues; one is what law will be applied, and that is discussed in the recovery and resolution directive, which I think leaves far too much leeway to national governments to not clean up the system. The other is the Single Resolution Mechanism; yes or no? A Single Resolution Mechanism of course raises questions about funding. On all these issues, I share the view of the German government that we need a treaty change and the Commission’s proposal to deal with these things without a treaty change is not really viable.

We can think of these things and say ok, we have such a regime, a resolution authority, a bank levy to provide for a restructuring fund and hope that we do not get another systemic crisis. However, in a systemic crisis, some recourse to the taxpayer is necessary. And this is important because some legal reforms that we have had and which were based on the basic principle that never again will the taxpayer money be used, are just naïve. That concerns the Dodd-Frank Act and the German Bank Restructuring Act. These legal regimes have a stipulation that the Finance Minister can lend money to the resolution authority, but I’m afraid that some of that money will be lost. If you go back to the S&L crisis in the US, out of some 153 billion that the crisis ended up costing, if I remember correctly, something like 29 billion was paid by the industry and 124 billion by the taxpayer.

At the European level then we are talking about ESM as a backstop, except that ESM is not really big enough. If you think about an institution like Deutsche Bank with a balance sheet of more than two trillion, if Deutsche Bank had to go into resolution regime you would need a public guarantee for 2 trillion. Payments in the end would likely be a lot less, but the legal regime must provide scope for a guarantee of that order of magnitude. That’s one bank, I mean it’s one of the biggest banks around, but just one of them and the numbers that we have for ESM just don’t provide for that. And of course the German restructuring fund has exactly the same problem. So at some level we need a fiscal backstop and this is actually a point where I’m in favor of muddling through, namely start by saying that the ESM would be available as a backstop, talk about the scope of ESM later, but in the end I also think it will be really necessary to have some European tax base. It could be either through a fraction of say, value-added tax being provided to ESM, or which could be equivalent to a surcharge on this tax, or it could be through some special tax being assigned to European authorities although, let’s face it, special taxes don’t provide all that much money and the major sources of tax revenue are the value-added tax and the income tax, and income tax is a very heterogeneous across countries, while value added tax is also heterogeneous but much less so.

What about the financial transactions’ tax? Are you in favor of that? Could that be used in such a way?

I’m neutral towards that but I don’t think it will provide a substantial return. It will be easy to avoid. I don’t necessarily share the view that the financial transactions’ tax is going to be very harmful to the extent that we are talking about the productive impact of financial markets, the liquidity provision for investors and the funding of real investment. I don’t really see the financial transactions tax as being that essential for investors who want to save and invest for old age; the liquidity concern is relatively small. Now, it might be the case that for a social investor that has a serious illness and needs to use some old funds for old age to cover such and such a surgery or treatment, liquidity is important. But even then, if you think about orders of magnitude this tax it’s not really important.

I think the real effect of the tax is going to be to reduce or eliminate high frequency trading, to reduce or eliminate liquidity trading as a professional activity and to make markets a little bit less liquid. On elimination of professional liquidity trading and in particular high frequency trading, I’m sort of wondering whether it’s really appropriate for our societies to spend so many resources on that and by resources I mean the brains employed in this way; I usually ask the question, is it really a good use of resources to have trained physicists and computer programmers in banks rather than do research on let’s say, immobility. Obviously no one knows the answer, normally we would say the market knows the answer but the market knows the answers only if there are no distortions in the system such as subsidies to banks. So if we have taxpayers’ guarantees for banks that provide an implicit or explicit subsidy to the financial sector then it’s clear that we have too much activity there. In the context of high frequency trading, having worked on issues of this sort and having thought about the different economics of trading, I have a suspicion that benefits that are not public, play a key role.

I agree with that. It’s a money-making machine. As you say it also has a negative social impact.

Bill Gates made enormous amounts of money, but in his case there is a relation between the money that he made and the products that he provided to society.

A final question on the Eurozone. It seems that one of the things that SDP and CDU seem to agree on, since we are talking about a fiscal backstop, is that it should be used only in extreme times and investors including unsecured depositors should be expected, from now on, to pay a price for their connection to troubled banks.

Not to pay a price but to bare the consequences of their having invested in a risky asset. When you talk about depositors if we are talking about the kind of deposit that I have and I assume you have, where my salary is deposited and where I use the balance for transactions, for buying things, paying whatever needs to be paid and all of that, that is fine, including the possible exception of transactions in the context of a sale of a house. I would say that much of that is covered by the 100.000 euro protection scheme for deposits. So when one is talking about bail-ins of depositors, one is talking about deposits exceeding 100.000 euro.

If you look at the Cypriot case, Cypriot banks had most of their senior unsecured funding in the form of deposits. Some of these might be a deposit of half a million euros. That’s a financial investment just like any bond and if the bank attracts a depositor by offering an interest rate of 4% at the time when the safe rate of interest is 1%, then I think an investor who invests half a million in that deposit must know that this is a risky investment. I have absolutely no patience for the suggestion that the depositor should not be made liable for the consequences of his choice. So I actually think that we do need more liability of investors and a major mistake of German policy in 2008 was not to have such a liability at all, but to bail them all out and this has been a major issue since then. I was talking before about Ireland in the fall of 2010. If the German banks exposed there made irresponsible investment decisions, they should be held liable.

OK, but when you say that, in order to avoid the vicious cycle that could result from such a policy, with the impact on other banks, the real economy, the growth rate and so on, shouldn’t we first have a solid regulatory and supervisory framework to minimize the consequences?

There is a complementarity between regulations, supervision and resolution. On the issue of how to deal with past losses, I can see that it makes sense and that it is important, and that will be unavoidable in the future that the taxpayer will pay, to avoid systemic repercussions. That being said, I would resist or I object to the idea that that means that the taxpayer must pay for everything. If the principle is that the taxpayer ends up paying for everything, it’s not going to be viable, leaving aside the fact that this really undermines the legitimacy of the entire system. My recommendation would of course be, to just require banks to have a lot more equity so that they can sustain losses when they occur and more importantly, knowing that they will be liable, they will be more careful.

Are you satisfied with the course of reforms in the financial sector more generally?

If you ask the question why was this crisis so extensive, and by crisis I now mean the whole lot of it, there are two answers; one, there was an enormous amount on leverage, very little equity and a lot of borrowing. The other is that there was a globalization of interconnectivity. Impact losses from subprime were probably not larger than impact losses from the Japanese crisis. The Japanese crisis had very few effects outside of East Asia. Subprime had dramatic effects all over the world. The difference is the combination of interconnectivity and excessive borrowing; interconnectivity because banks all over the world were holding these assets and when a bank has to sell, the deleveraging fire sales depresses prices. That price decline affects all banks that hold this kind of assets in their credit book and they have to write that down and possibly have to react with sales of their own because they are squeezed for equity. That mechanism is very intense when equity is something like 2% of the balance sheet. In that case, for one million dollars worth of losses you have to sell fifty million dollars worth of assets.

So we consider it necessary to try and do something against these factors which created the crisis and we have two very simple prescriptions; one, have a lot of equity, like 20 to 30% and relate that to the total balance sheet rather than to what’s called “risk-weighted” assets. The idea with risk-weighted assets is that if a bank invests in risky assets it should have more equity. What they really mean is if a bank claims that its investments are not risky, it doesn’t need any equity. Logically it’s the same but in terms of politics, there’s a world of difference between the two standards. What’s wrong with risk weights? First, many of the most important risks aren’t even calculated, for example sovereigns, the funding risk for long term lending, this was the problem of Dexia that I referred to earlier, or correlations. Here you have three major risks that contributed to major crises over the past thirty years that are not even taken into account in this kind of regulation. The other element is this risk-weighting regime increases interconnectivity by giving banks the incentive to engage in derivative contracts, which is wonderful except you don’t know whether the counter party can pay. And quite often it so happens that the counter party cannot pay exactly when the counter party is called upon to pay. Namely, if the counter party has lots of contracts of the same type and they all fall due at the same time. The first time someone agreed to a credit default swap with AIG, that was a wonderful way to secure that credit risk. But by the time AIG had written 500 billion dollars worth of swaps, the AIG itself was a credit risk that had to be bailed out in September 2008. So encouraging all this hedging is a way to sweep risks under the rug, put them somewhere nobody knows where they are. Some hedging is useful but in this case you have a regulation that provides extra encouragement for it and in the end doesn’t really capture what’s going on and that’s dangerous.

So our prescription would be get rid of the risk weighting and raise equity to 20 or 30% of total assets. We use this imprecision of 20 to 30% for two reasons; one of them is that in the end one has to worry what are the accounting conventions. Our view would be that everything should be on balance the sheet. The other reason for this imprecision is that we think we should get away from a regime where either the banks are in compliance and then the supervisor doesn’t tell the bank anything, or the bank is not in compliance and then the supervisor can intervene very strongly. We think it would make much more sense to have a regime where above a certain threshold the bank is fully in compliance and the supervisor doesn’t say anything, then there is an interval where it’s not fully in compliance but the supervisor can only impose a restricted set of measures, such as no dividend payouts, no bonus payments and then there should be a lower threshold below which the bank should be asked to recapitalize. So this is why we use this formulation 20 to 30%.

What you say seems to make the system more robust, but without changing the system itself. Would you adopt more “radical” reform proposals?

I’m sort of torn back and forth in that respect. For one thing, I think that all the proposals that are based on the assumption that we split the two, we let the investment bankers do what they want and we just protect the deposits, is fundamentally wrong. Lehman Brothers was an investment bank, the AIG was an insurance company. Investment banks can do so much systemic damage that we can’t afford to let them go under. And the notion that it’s enough to protect commercial banking and in particular retail, deposits and small firm lending, I think is just naïve, and so is the notion that we need to regulate investment banks less than commercial banks. I think that the opposite is true, we probably should regulate investment banks more than commercial banks, the reason being is what Kaleb called scalability; activities are scalable if you can run them back or down without any costs. In trading, if you add a zero or two or three to a contract it doesn’t cost you anything, but of course the risks change dramatically. In lending, if you add another client, presumably you do another credit risk assessment and that’s costly, so lending is not scalable. Trading is. Moreover, in trading, risks can be changed very quickly. The scandals that we’ve seen have involved positions that were built in a matter of days, at most weeks. That’s a problem for the internal governance of the banks; it’s also a problem for the supervisor. So that observation makes me think that maybe a separation of the two types of banking is useful, but not with a view to letting investment bankers gamble as they wish, but with a view to imposing stricter liability to investment banking than to commercial banking.

Otherwise I tend to refrain from changes in structure or in activities, because that’s an area where an outsider will find it difficult to know what’s appropriate to do. If we go back and think about previous eras, it’s true that between the 1930s and the 1970s banking was very safe, but it’s also true that the breakdown of the last era’s system involved very severe problems including the S&L crisis, including the hidden commercial banks’ crisis in 1990. The real issue was that the previous era was built on the premise that through interest rate regulation, we could ensure margins for depository institutions. Once the money markets funds emerged that presumption turned to be wrong; the money market funds put a squeeze on margins, forced commercial banks and savings banks to adapt the deposit rates to whatever the market rates were, which meant that the savings banks were insolvent right away as of the early 1980s. This was just hidden and carried along for ten years until the crisis broke into the open. Commercial banks were not immediately insolvent, their maturities and lending were shorter than for savings banks, but they were also under pressure and this is why in the 1980s the commercial banks went and poached in investment banking. So I’m ambivalent about separation. The benefits that I could see would be based on quite a different notion from what’s around on the public discussion namely, be stricter with investment bankers.