How to Save the Euro
Featuring Thomas Mayer
Published on: September 16th, 2019 • Duration: 44 minutesThomas Mayer, founder and managing director of the Flossbach von Storch Research Institute, speaks to Ed Harrison about the impact that the creation of the European Union has had on the precarious economic conditions in Europe. Mayer outlines the unsustainable dynamic of the cross-border bank deposits between the central banks of EU member states like Germany and Italy. He also makes the argument that digitalizing the euro might be the solution to the problems facing Europe’s monetary union. Filmed on August 30, 2019 in Cologne, Germany. Learn more about Macro Insiders here: http://www.realvision.com/macro-insiders
THOMAS MAYER: Italy is clearly the elephant in the room, Greece was in a way the canary in the coal mine. There was this school of thought that bring this currency and they will adjust.
We do not have a full monetary union. Look, only the cash, the bank notes that the European Central Bank issues are of the same quality in every Euro area country.
I'm concerned actually that if they don't do anything, that in the next recession, that depressions will become so big that eventually the Euro will break apart.
ED HARRISON: I'm here in Europe because we're going to be talking to Thomas Mayer, who you might know from his previous background as a part of the IMF. He was also at Goldman Sachs and eventually ended up as a chief economist at Deutsche Bank. He's now at the asset management company Flossbach von Storch. We're going to talk to him not just about how the European economy is doing well, because you can talk to a lot of people about that, we're going to talk to him about the structural problems within Europe, and what are potentially what I would call Black Swan or negative scenarios, and how to think about that, particularly with regard to European banks. Hope that you enjoy what we have to say and let's get right to Thomas.
Thomas Mayer, it is a pleasure to talk to you today. Amazing view you have here in your offices at Flossbach von Storch. We already talked about this, I have like three or four different topics I want to cover. We probably don't have enough time to cover them all but I do want to start with you and your journey in economics and finance and how that plays a central role in understanding Europe. Tell me a little bit about where you got started and how you got to Flossbach von Storch.
THOMAS MAYER: Well, basically, I started as a development economist. In that context, I moved on to the IMF in 1983. In the IMF, they had a principle that when you understood something after a while, you were transferred to a place where didn't understand anything about. That's supposed to always to learn and grow. Eventually, I was transferred in the IMF from the developing economics departments to the European department.
As it happened at the time, we had German unification, the Berlin Wall came down, and I was at the German desk at the time. It was fascinating, a fascinating time because no one had ever before thought about how you could turn a communist economy into a capitalist again. A lot of people talked about it is like making an egg out of a scrambled egg, how do you do it? The IMF was very much involved. The German authorities wanted the IMF to be involved because they use the IMF basically, as a messenger to other countries who are the shareholders of the IMF, to tell them what they were doing, because they wanted to do it in a way that will not disrupt the international setting.
I had the opportunity to look deep into what was going on, and we wrote papers about it. Then the usual thing happened, American investment banks got interested because they looked for some and they also thought, well, Europe is going to be interesting, now. You have to increase operations there. They were looking for some wonderful economists who could explain what was going on there to their customers.
I was picked out of the IMF, went to Salomon Brothers. Shortly after that, I was picked out of Salomon's by Goldman Sachs. I was very naive, someone comes around and says, "Don't you want to work for me?" I was like, "Why he wants me?" I went to Goldman Sachs, been there 11 years, then to Deutsche Bank, spend there altogether something like 12 years, came up to chief economist and when the CEO, who made me chief economist, left, he recommend.
I had this great opportunity that my old friends, Bert Flossbach, behind Flossbach von Storch, who I knew from Goldman, who had created this wonderful company, we have now more than 40 billion Euros under management, they called me up and said, "Don't you want to do research here?" I said, "Well, that's great." Someone in at my age being offered the opportunity to do a startup without having to worry to collect money to balance the book every month, and so forth.
That was a great opportunity and now, I'm here for five years. We've created a research institute, we are advising in-house, but we are also showing a profile to the outside world because we want-- in our company, we want our customers to understand what we are doing. One of the jobs that I do here at this research institute with my team is to explain to people how we think about money, how we think about investing because we-- only an informed customer will be a customer who trust us and who sticks with us, even though sometimes markets also go down.
ED HARRISON: That's an interesting path. One of the places that I want to ping in on is when you were in the German desk, because-- I want to talk a lot about Europe in general and I think that that was a pivotal time in terms of where Europe is. The sense that I get from the US is, is that people were very afraid of the unified Germany. It was almost as if reunification and the Euro war of a quid pro quo in order to quell those fears, can you tell me what you were hearing and seeing?
THOMAS MAYER: Historically, the European balance of power was always precarious. Historians say that the rise of the German Empire economically, politically, unbalanced Europe, and it was at least one factor why we had World War I. Then the Intermediate Period, World War I, World War II was very unstable, and again, Germany was a problem. Under Hitler, the Nazis conquered your neighboring countries so Germany was always a problem in Europe.
After World War Two, we had this balance, enforced balance by the US-Soviet Union Cold War. Germany was no longer an issue in Europe. But with unification and the demise of the Soviet Union, Germany has become an issue again. I think it was Henry Kissinger who once said that Germany is too big for Europe or too small for the world.
How can you deal with this? My reading of history, and I looked at it as closely as I could as a non-historian and I read books about it, I went to sources, but my take is that even so there was a lot of talk about monetary union beforehand, it was a long story already in the '70s, started with Werner Plan, the German unification eventually, eventually was the catalyst to make it happen, because I think especially France thought that they needed to have some means to control the German economic power, which they were thinking would come about against the unification.
Remember, back at the time, people thought that German Democratic Republic was a formidable economic power. We only later on found out that it was a souffle that collapsed when you had market prices coming up. Back at the time, they thought this is going to be a problem, again, Germany too big for Europe. I believe, and looking at all I could find, I think there was at least an implicit understanding between Mitterrand and Helmut Kohl, the Chancellor at the time, that if Kohl would agree to bring Germany into European Monetary Union, the French would feel much, much calmer about it, so I think it was a quid pro quo.
ED HARRISON: The interesting bit about all of that is that when monetary union happened, from my understanding, not everyone was necessarily prepared economically. You had the original six countries. Of those six, Belgium and Italy, in particular, had very high government debt to GDP ratios. When you're bringing all these countries together, basically, you had a big problem. Now that problems still exist to a certain degree, how do you see that?
THOMAS MAYER: It was very controversial. Back then, there were two schools of thought what you should do about it. One school of thought was we have first to create the necessary basis preconditions for making it work. This was the so-called grounding theory. First, you get fiscal policy in order. First, you get your structures flexible enough so that these countries could work with a unified currency, a single currency.
There was another school of thought, at the time, they will call the monetary. It's nothing to do with Friedman, but a group of thinkers or politicians, mostly, but also economists that said let's do the currency, everything else will fall into place. Eventually these monetarists, they were called at the time, succeeded because-- we talked about it already, because of the political constellation.
The German unification was the catalyst, I think, for that. Then they said, "Well, we can't wait. We can't wait until everyone is ready. We have to move forward." Take the German Bundesbank, the old Bundesbank, not this new one that is not part of the Euro system, they were very skeptical.
First, they said it would not work. Well, the politician said, "Forget it. We have to do it for political reasons." Then they said, "If you do it, do it with a small group of countries. Yes." But then other countries said, "But we want to get in as well." There was a competition to get in. The Bundesbank was pushed back, basically, every single step.
Very interesting is the entry of Italy. Initially, the Italians even accepted that they shouldn't be part of the first group, but then Spain signaled to them, "Well, we want to be in." And the Italian said, "Well, we are a founding member of the European Union, how can we be out and the Spaniards, who came late, in?" They squeezed in and people said, "Well, but your debt ratio is far too high." "But Belgium has this debt ratio that is as high as ours. We have to go in."
Okay, then the German administration back then under Horst K?hler and [inaudible] who later became ECB chief economist, said, "Well, if these guys are all in, can we rely on them?" They devise the Stability Pact, where the fiscal situation should basically be stabilized not only at the time of entry, but continuously. Everyone committed to bring the debt ratio down. Everyone signed to a difference that stability cannot be the only and it has to be growth as well. So they call it the Stability and Growth Pact. But ever since, this adjustment, which they thought would come about by imposing the single currency, forcing the countries to break up their rigid structures, having them abide by this stability, it did not work.
ED HARRISON: When you talk about this adjustment, we think of convergence. In terms of rate, we all saw the Greek rates come down, the Italian rates come down until the Greek crisis. When you look at the economic convergence, it just wasn't there.
THOMAS MAYER: It did not work. Yeah. There was one interesting person, it was the governor of the Bank of England, Eddie George, at the time, who mentioned, "Look, you guys are talking about nominal convergence, bring the rates down, interest rates down and bring the inflation-- have you ever thought about real convergence? Can these countries grow when you impose a single currency on them?" They didn't consider it on the continent.
ED HARRISON: Even today, what is the problem in terms of convergence? Let's look at what we're looking at today, because I think that what a lot of-- Greece had its problems. We can go into the Greek problem, et cetera and so forth, but to a certain degree, you could say that Greece really truly isn't the periphery because it's a relatively small country within the whole of 500 million people in the European Union. However, Italy is a much larger country and what happens there really does matter. Italy, it seems, in terms of has had really no growth for the last decade, what's behind that?
THOMAS MAYER: Italy is clearly the elephant in the room. Greece was in a way the canary in the coal mine, as the British say. The little canneries that the British miners in the 19th century took in the coal mine and the gas was coming, they're falling off the rail, so as a warning thing. Greece was the canary in the coal mine, but Italy is the elephant in the room, it really illustrates the problem. As we said before, there was this school of thought that bring this currency and they will adjust. Italy has not adjusted, they couldn't adjust, so therefore they didn't grow anymore. Their structures proved to wretched.
ED HARRISON: Before you had the Euro, the Italians were able to devalue and they can adjust in that way, but now you have the Euro, and they're not able to do that.
THOMAS MAYER: I heard someone summarize the Italian situation quite succinctly. He said, "After World War II, Italy was in a position to catch up." Because before World War II, it was actually not really industrializing as much as the others and the fascism, Mussolini, this was a sleeping situation. After World War II, they had an opportunity to catch up. In the '70s, they devalued. This was when the Bretton Woods system broke down, '71, the devalued.
In the '80s, when devaluation was no longer opportune because we had created the European Monetary System, they used fiscal policy to stimulate the economy. They moved from devaluation to fiscal policy, they ran up this huge debt. When they came into the Euro, neither the one nor the other was available anymore. They couldn't devalue anymore and they were supposed not to run up for the debt. They stopped growing.
If you do not grow for 10 years, you shouldn't be surprised if Populist Party has come up, if your political system degrades. What has happened in Italy is a very natural and logical consequence, basically, of the straitjacket of the Euro imposed upon a country that couldn't adjust and obviously, the political fallout of it.
ED HARRISON: We've seen monetary unions before in the past, and they've never really worked. What's different about the European monetary? Is this a true monetary union? What's different about this than other ones in the past?
THOMAS MAYER: It's actually as you mentioned, this is quite funny that history not exactly repeats itself, but as Mark Twain had said it rhymes, there was a Latin monetary union where they tried to create a monetary union in 1865, and Greece was a problem. It was temporarily expelled in 1908, Italy was a big problem. Already then, these two countries were big, big problems and the problems reasserted themselves again in a sense, it's almost funny that history can repeat itself like that, but we do not have-- and this is very few people realized it, we do not have a full monetary union.
Look, only the cash, the bank notes that the European Central Bank issues are of the same quality in every Euro area country. The ECB is the debt single data but this is only the smaller part of the money we use. The bigger part of the money we use is side deposits in banks, bank money created through credit extension by the banks. This money is different, of different quality, in every Euro area country, because the quality of this money depends on the balance sheet of the banks in the country, and perhaps even more importantly, respective country's ability to back these deposits through its own insurance, deposit insurance, in case the banks have problems. We do not have a European deposit insurance, therefore, we only have a cash union.
ED HARRISON: There are multiple questions that have based upon that. Let me say the first question on that is with regard to what I would call a TARGET2 system, which is how you deal with the flows across borders within these banking systems. That seems to be a flashpoint for a lot of people in terms of what they consider to be an unsustainable dynamic where we'd have a crisis. What's going on with the TARGET2--?
THOMAS MAYER: There's a big debate about this TARGET2 system, especially here in Germany, not so much elsewhere and there is not enough general understanding what it is all about. Just think about-- simple example, if you want to transfer money from Italy to Germany, it should be as easy as transferring money from California to Texas. If you do this, as a customer, the money flows from the Italian bank to the German bank, but to balance the books, the German bank would now have to give a loan to the Italian bank in return, so that they have both again, the same assets and liabilities, but the German banks, since the Euro crisis, do not trust the Italian banks anymore.
If there is no loan flowing back in principle, the Italian deposit could not be moved. In other words, we would not have a common currency. Here comes in the TARGET2 system, what you now do is the European system of central banks gives the Italian bank, against collateral, a credit within the form of central bank money. Now, you can move the deposit that you want to move to Germany, together with the central bank money that the Italian bank now has, to Germany and the German bank accepted posit because it gets the collateral with it, the central bank money. What you have, the deposit flows and the central bank money flows and the target system is a ledger where they now put in Italian central bank money was created and move to Germany so the Italians get a debit in this ledger of central bank money transfers, and the Germans get a credit.
ED HARRISON: You have an imbalance, basically.
THOMAS MAYER: You have an imbalance, yes, we have now 500 billion Euros negative entries in the Italian ledger of TARGET2 and we have almost a trillion Euros credit in the German ledger. What the target system basically is, is a big risk transfer from the banking sector to the European system or central banks. Without this risk transfer, people would realize that we only have a cash union, you could only carry the bank notes from Italy to Germany, but you could not transfer money electronically from Italy to Germany. The Euro system takes the risk that the banks are unwilling to do.
ED HARRISON: Well, I think politically, there's a lot of desire to keep the Euro system in tax obviously. One thing that a lot of people talk about is the ever closer union, the possibility that, in fact, you could have a European common deposit insurance scheme like you have in the United States. But I think that the problem with that is in places like the Netherlands or in Germany, people would be up in arms about what you would consider a mutualization of risk. How do you see that playing out?
THOMAS MAYER: When you pool your risk with other people, so let's say you move with several people into an apartment to share the cost of the apartment, you have a common money account from which you would pay