On the record...

Chief Economist Thomas Mayer on the future of the euro

January 19, 2011 Mr Mayer, at the beginning of this year Estonia became the 17th state to join the euro area. Estonia is a country that has implemented comprehensive structural reforms in recent years to qualify for euro membership and has succeeded in making a real adjustment to the euro within the framework of its fixed exchange rate system. Can Estonias accession bolster the pro-reform forces in the eurozone? Estonias accession undoubtedly illustrates that the euro is still an attractive EU project. However, the events of last year have also shown that adopting the euro requires careful consideration and thorough preparation.

The current bailout mechanism for the eurozone expires on June 30, 2013. Feverish efforts are currently being made to devise a replacement system that also includes a sovereign insolvency mechanism. Politicians will have a major say in the decision via the Council of Ministers. Wouldnt it be better for an independent institution to administer insolvency proceedings? It is with good reason that we have ensured that the ECBs monetary policy decision-making enjoys statutory protection from political interference. One important reason for the failure of the Stability and Growth Pact with regard to fiscal discipline is that decisions made in this area were framed in political terms. Against this backdrop a European Stability Mechanism also needs to be protected from direct political interference, just like the ECB.

What else can policymakers do to assuage the residual uncertainty about the period beyond 2013 and to boost confidence in the euro? Above all, they must swiftly provide clarity about the planned stability mechanism. Then they must either quickly ensure that heavily indebted crisis countries obtain rescheduling in line with market conditions or, if they do not want this, provide guarantees for the existing debt outstanding. Otherwise the crisis countries will be virtually unable to return to the market after their adjustment programmes expire. I consider a guarantee for existing debt neither feasible nor probable, though.

There will be an increase in country-to-country transfers directly via loans and credit lines or indirectly via guarantees. How can the associated problem of moral hazard between member states be solved? Wont the confidence of the weak in the strength of the strong increase the destructive potential harboured by the EU and the euro over the long term? Without Europe adopting full political union EMU can only have the character of a limited liability union. If, however, EMU does not assume unlimited liability for its members, in a worst case every member can become insolvent if its financial management is unsound. The possibility of insolvency will prompt the market to demand the corresponding risk premia, and the more unsound the fiscal policy, the higher they will be. This will punish budget offenders and preclude moral hazard.

China has been acting as a "white knight" in the markets over recent weeks, buying up the government bonds of ailing euro countries. What role should emerging markets play in stabilising the eurozone going forward? It is good if sovereign investors express their confidence in the euro by purchasing the bonds issued by euro countries. The latter must, however, also earn this confidence by ensuring that they can pay off their debts. Should they have difficulties doing so, the white knight will probably disappear very quickly. He could even turn into a black knight, using every opportunity to present the unpaid bill once again.

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Apart from a permanent crisis mechanism and tightening up fiscal coordination another current topic of discussion is economic governance using a macroeconomic scoreboard. The idea is to use selected macroeconomic indicators to monitor imbalances and to take corrective action if predefined thresholds are breached. Is this the right course of action? In future of course the scope of macroeconomic surveillance has to be wider than in the past. A scoreboard is an instrument for implementing such broader surveillance.

Turning to monetary policy, 2010 was a year of mixed performance in the real economy across the euro area. Germany posted 3.6% growth in real terms, whereas the Greek economy shrank 4.2%. In 2011 growth trends will again be very mixed. How can the European Central Bank still operate a eurozone monetary policy that fits all the euro members? The ECB is obliged to gear monetary policy to the entire euro area. As in the past, monetary policy will therefore continue to be too tight for some countries and too loose for others. Some places have been traded, though: whereas in the past monetary policy was somewhat too tight for Germany and too loose for peripheral countries, the situation now is exactly the opposite. Past experience teaches us that national economic policy has to counteract the undesired side-effects of the joint monetary policy felt at the national level. If it does not do this, the economy becomes destabilised.

Given a continued low interest rate policy and unconventional monetary policy measures there are general fears of increased inflation risks. What do you say to those people who consider our current EMU inflation forecast of 2.0% for 2011 to be too low? At present the price pressure is coming from commodity and food markets. If prices in these sectors should continue rising, inflation could turn out higher this year. Pay settlements for this year are still moderate. It is, however, possible that in 2012 inflation risks will emanate from the wage side.

The measures to combat the debt crisis and bail out the euro have been criticised by broad sections of the population. This applies to countries that have to be supported and have to implement far-reaching reforms as well as to countries that provide the support. How can politicians convince the populations of both country groupings that these measures are necessary and correct? The significance of the euro for our single market and political cooperation in Europe should not be played down. At the same time, however, it must also be emphasised that the euro does not absolve any country of its obligation to manage its own finances and face the consequences of its actions. Crisis countries whether euro members or not need to implement comprehensive economic reforms in order to maintain and increase their prosperity.

Dr. Thomas Mayer is Chief Economist of Deutsche Bank Group and Managing Director of Deutsche Bank Research. Thomas Mayer (+49) 69 910-30800

This interview was conducted by Nicolaus Heinen (+49 69 910-31713)

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