y Wenqian Huang
Interview with Markus K. Brunnermeier*
Edwards S. Sanford Professor
of Economics and Director of
the Bendheim Center for Finance,
TI: To start the interview, I’d first like to
ask what you think is the root cause of
the Euro zone crisis? Is it a sovereign debt
crisis or a sudden-stop crisis?
MB: I think it is arguably more of a
sudden-stop crisis, but sovereign debt
problems also played a role. A significant
amount of the cross-border credit flows
were financed short-term on the interbank
market. The classic example is that
peripheral banks granted local long-term
mortgage loans, which they refinanced
short-term on the interbank market.
A large fraction of banks’ funding was
so-called wholesale funding, as opposed
to domestic deposit funding. When the
interbank market froze— the sudden
stop— the ECB stepped in as intermediary
and TARGET2 balances skyrocketed. In
addition, in some countries, governments
borrowed excessively— mostly from
abroad. Hence, sovereign debt also played
a role. When private investors refused to
roll over the funding, the official sector
stepped in, and a lot of the private debt
became sovereign debt.
TI: Was it then a classic liquidity problem?
MB: Not quite. Prior to the crisis we
observed large capital flows in the
peripheral countries. One view was that
these countries borrowed in order simply
to catch up with the core countries.
According to this “convergence view”,
a temporary disruption is an inefficient
run and should be counteracted aggressively.
In contrast, the “imbalance view”
argues that imbalances and bubbles were
building up which were not sustainable in
the long run. Instead of investing wisely,
which would have led to increases in (total
factor) productivity, GDP was artificially
pumped up without an increase in
productivity measures. The sudden stop,
hence, was not only a liquidity run; it also
had an element of correction. Part of the
problem was a solvency problem. Of
course, when a correction occurs, markets
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tend to overreact— and this calls for
a well-tuned intervention.
TI: For the Euro zone as a currency union,
what do you think about the European
quantitative easing (QE) policy? Does the
current monetary policy increase inflation
risk and create bubbles for the next crisis?
MB: It depends on what kind of underlying
problem one tries to solve and what the
alternatives are. If the underlying problem
is that real wages are too high in the
peripheral countries (and hence they are
not competitive), then the solution for
this problem is to meet the inflation
target at least in core countries such as
Germany. So any central bank intervention
should primarily be targeted at the core
If the underlying problem is peripheral
countries suffering from balance sheet
impairment, then QE can subsidize the
peripheral countries. It can help the
balance sheets of peripheral countries by
pushing down the interest rates. In this
sense, QE is redistributive— but might
ultimately help the whole euro area.
After one has identified the underlying
problem, it is not obvious that QE is the
best instrument to tackle the problem.
For example, if the underlying problem is
the difference in competitiveness, then
an alternative policy comes to mind: for
example, an active communication policy
by the central bank that tries to impact
the wage bargaining, say, in Germany.
Central banks should “talk up wages” in
core countries. This would help close the
real wage gap between the peripheral
countries and the core countries. This is
essentially the opposite of what central
banks did in the 1970s when they tried
to “talk down” inflation during a high
TI: Do you think the peripheral countries
have incentives to be over-indebted?
How should the currently high public
debt ratio in these countries be reduced?
Will austerity measures alleviate or
worsen the current situation?
MB: Over the next decades the debt
ratio can come down. If you look at the
debt-to-GDP ratio, you can reduce this
ratio by either increasing GDP or decreasing
debt. It is important that government debt. They are safe in nominal terms
debt will increase by less than GDP.
because the central banks can always
print money to pay off the debts. Within
Austerity is usually associated with two a currency union, however, one cannot
things: a reduction in expenditures and do this anymore. Individual sovereigns
implementation of structural reforms. cannot print Euros. The sovereign debts
However, both measures are independent are as if foreign-denominated sovereign
of each other. A smart approach would debts. Thus, sovereign debt in the EU has
provide some reward for growth-enhancing
structural reform. Knowing that
default risk and liquidity risk.
structural reform measures are contractionary
in the short-run and only yield a asset for Europe, which can be treated as
The idea of ESBies is to create a really safe
higher GDP growth rate in the intermediate
and long run, politicians are reluctant the risky sovereign debts, banks can hold
safe assets for banks. Instead of holding
to undertake them. To encourage
ESBies, which are not risky at all. The way
structural reform for the long-term
that ESBies work is to pool (up to a limit)
growth, our fiscal rules should be such the sovereign debts in Europe, and to issue
that they provide compensation for senior and junior bonds such that the
short-term growth costs in the form junior bonds protect the senior bonds.
of a small stimulus program.
So the senior bonds are very safe and the
risk is all concentrated in the junior bonds.
TI: You proposed, together with the The senior bonds are held by banks and
Euro-nomics group 1 , European Safe Bonds the junior bonds are held outside of the
(ESBies) as a way out of the Euro zone banking sector. Whenever there is a
crisis. What are the advantages of ESBies? negative shock, the senior bonds are
always safe and the banks do not suffer
MB: ESBies are not a panacea, but they from the double diabolic loop. That is the
solve two specific problems. The double first advantage of ESBies: to switch off the
diabolic loop between the financial sector diabolic loop, which reduces overall risk
and the sovereign risk is at the center and makes the junior bond also less risky.
of the Euro Crisis. When sovereign debts
lose in value, banks that hold a significant The second advantage of ESBies is to
amount of sovereign debt on their balance redirect the cross-country capital flow.
sheet suffer capital losses. This lowers Right now, as the crisis intensifies, capital
their equity, leading them to scale back flies across borders to the core countries
their activities and grant fewer loans to since the safe asset is asymmetrically
the rest of the economy. As a consequence,
the real economy is slowing down junior bonds to senior bonds. Both bonds
supplied. With ESBies, capital flows from
and tax revenue declines. As tax revenues are European bonds; and the safe asset is
decline, sovereign debt becomes less a European asset but not a German asset.
sustainable and, in turn, riskier. That is the So there is no cross-border capital flow,
first diabolic loop. At the same time, there which stabilizes the whole system.
is a second diabolic loop at work. When
banks lose value, the bailout probability TI: Does your new book with Harold James
also goes up. This, in turn, makes the
and Jean-Pierre Landau, entitled “The Euro
sovereign debts riskier and lowers their and the Battle of Ideas”, describe the
prices— which in turn hits banks and ESBies?
increases the probability of a costly
bailout. Both of these amplification
MB: Yes, indeed. Readers interested in
mechanisms enable a small negative learning more about this subject should
shock to have large implications.
read our forthcoming book. It will be
available from the end of August onwards.
To solve this double diabolic loop, one However, the book is much broader in
needs safe assets that are truly safe. scope than ESBies. It explains how
Typically, the safe assets are government different economic philosophies, primarily
1 Euro-nomics is by a group of nine European academic economists, whose objective is to provide concrete,
carefully considered, and politically feasible ideas to address the euro area's current problems.
etween Germany and France, complicated
the crisis management. It explains
how— starting with fiscal problems in one
of Europe’s smallest economies, Greece, in
late 2009— a long-simmering battle over
the appropriate economic philosophy and
future design of the European Union broke
into the open. It is a struggle between
northern (above all, German) and what are
sometimes called southern (but above all,
French) theories. The former emphasize
rules, rigor and consistency, while the
latter focus on the need for flexibility,
adaptability and innovation.
“The idea of ESBies is to
create a really safe asset
for Europe, which can be
treated as safe assets for
TI: How do you view the future of Euro?
Do you think Euro will disappear in future?
MB: I am confident that the Euro will
survive. We experience challenging times,
but the US Dollar also had to face its
challenges in its early phase. The Euro
framework will be adjusted and modified
as we move along. But the question is
what could be the alternative. Let’s say…
if we were to have totally floating
exchange rates. That would be a big
problem within Europe as well. People
always have the impression that there are
some problems in the current framework,
and if we think about the alternative
everything would be hunky dory. But it
won’t be. Because even before we had the
Euro, we had a currency crisis and we had
many problems as well. The problems will
reappear, but people just don’t think about
these problems. So the alternative is not
all that glossy either. It is not a perfect
TI: Before the global financial crisis,
central bankers knew a lot about labor
markets, product markets, inflation,
output and its relation to fiscal and
monetary policy. But the whole 'liquidity'
and financial intermediation sector was
missed. Do you think we are going to the
other extreme: that in the post-crisis era
we are now missing the 'real' side of the
MB: I don’t think so. I think there was too
little emphasis on the financial side before
the crisis. Now the profession is picking
up. There is still a lot of catching-up to do,
and many young economists focus on the
interaction between the macro economy
and the financial side. But there are also
many economists working on the real side.
Many economists have built up their
human capital on labor market issues
and other real side aspects. Overall,
I don’t think that the financial research
is overshadowing the real side at all.
I think we have a more healthy balance
TI: Where do you believe that macro and
finance are heading? For our MPhil
students, what will be the “hot topics”
for the next few years?
MB: How to better understand risks and
how to prevent and get out of a crisis
are some hot topics. Risk comes in many
facets: fundamental risk is different from
endogenous and systemic risk. The latter
is time-varying and depends on balance
sheet constraints. In addition, the risk
premium investors require is also timevarying
and hence contributes to the
endogenous time-varying risk. Currently,
monetary economics (and its interaction
with finance) is being reinvented. There
will be a modern revival of the field
“money and banking” within macro
models. Another interesting research
agenda has to do with safe assets and
their roles in the global financial system.
How should one set up a stable global
I think these are just a few hot topics.
New techniques, including continuous
time technique, will allow us to dive more
deeply into these topics than ever before.
I expect a lot of new insights and a better
understanding of the interaction between
monetary and financial stability as well as
fiscal debt sustainability.
TI: Speaking of the new techniques, what
are the techniques that every macro and
finance researcher should have (but
MB: I think macro and finance can learn
from each other. The historical grand
masters of economics wrote a lot about
the interaction between macro and
finance. Keynes wrote about it; Irving
Fisher wrote about it. After the Second
World War, finance focused more on
the static stochastic models in order to
capture the risk components, while macro
focused more on the dynamic deterministic
models. In the 1970s, macro started to
formally incorporate the risk aspect as
well, and finance got into the dynamic
aspect. But they did it in different ways.
Macro did it in discrete time because of
the quarterly data; finance did it in
continuous time because finance has
much more frequent data.
Both branches of economics developed
useful tools. For example, continuous
time tools, like stochastic calculus from
finance, allow much deeper analysis on
the time-varying risk premium and the
endogenous time-varying risk itself.
On the empirical side, tons of new data
are now available. These will lead to a lot
of interesting empirical analyses— and
will improve our understanding of what is
going on and which theoretical channels
are quantitatively more important.
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