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Greece is becoming increasingly unable to implement the measures against which the European Union and International Monetary Fund offered it generous financial support. Euro zone countries are increasingly losing patience and two independent studies of Reuters and Bloomberg show that over 98 per cent of the economists surveyed expect the default of the country within the next 12 months. GRReporter regularly publishes interviews with Greek and foreign economists who analyze the Greek debt crisis. Today we give the floor to the Professor of Economics and Finance at the University of Geneva, Harald Hau, who was kind enough to answer Maria S. Topalova’s questions.

How would you comment the European policy toward Greece? It has proved to be disappointingly ineffective. Why?

In such crisis situations, any external influence is necessarily limited. Europe's politicians should not overestimate their ability to influence Greece's internal politics. Reform must come from inside. Also many European politicians were (and some still are) in denial about the severity of the debt crisis.

There is some turbulence inside the European Central Bank escalating to the resignation of the member of its Executive Board Jürgen Stark earlier this week. What is your explanation about it and what should be the behavior of the European Central Bank in the current debt crisis?

The German illusion was that the European Central Bank would just be the continuation of the Bundesbank at the European scale. And this promise was enshrined in Maastricht treaty, for example by outlawing the direct purchase of sovereign debt by the European Central Bank. But just like with the sovereign debt limits, such legal commitments did not withstand political opportunism. The Germans now find themselves outvoted by board members from southern Europe with apparently much less political independence; pressing for decision in direct contradiction the founding principle of the common currency. In Germany, this has created a big disappointment and a sense of betrayal. And this is undermining the legitimacy of the European Central Bank. The best would be to change voting rights and at least adjust them for the GDP of a country. One could also consider that board members enjoy only voting rights if their "home country" is not in breach of the Maastricht criteria.

How could the USA help in the European debt crisis? What is the effect of the presence of US treasury secretary Timothy Geithner at the meeting of the Eurogroup financial ministries?

The US influence is unlikely to be useful in the crisis. US mutual and pension funds are likely to be hit by European sovereign default, hence the US might not find it in their interest to support a default with its likely debt restructuring to the detriment of financial investors. 

Many politicians, economists and bankers see the solution of the crisis in the euro bonds. Would you agree with them and why?

Eurobonds are the equivalent to playing Russian roulette: You double the stakes and either win or end up with a bullet in your head. It is the opposite of responsible politics. I can understand that some in the financial markets see it as the best strategy to extract some additional rents from the tax payer. But if these people get their way, we are digging the grave for the Euro, because we cannot built an effective legal framework fast enough that constrains fiscal irresponsibility. Sovereign default is the ultimate backstop which needs to be national.

You have said that the solution for the crisis is the recapitalization of the European banks. Could you explain why it is necessary and how it could be done?

The banking sector is the weak spot of any restructuring plan involving sovereign default. Here, direct bank support through bank recapitalisation is a much more effective and cheaper solution than a full guarantee of sovereign debt. The taxpayers could get bank equity in exchange for their money. If this crisis is like others, there is a chance that share values recover and taxpayers break even in the long run. The 2007-2009 crisis has shown that governments are indeed able to contain a banking crisis by resolute action like forced recapitalisation and temporary nationalisation of banks.

The better prepared we are for such an event the smaller will be the impact on the economy. Europe's governments have had plenty of time to prepare over the last year, so why was such a solution not even considered? The reasons are political. Such a solution would have upset powerful vested banker interests, even though it would have imposed the costs on those most responsible for the massive credit misallocation. A strong negotiating position of politicians confronts two important obstacles: First, the finance ministry and banking authority typically lack competence and information in order to prepare contingency plans for bank recapitalisation.

There is an acute skill shortage in the finance ministry and what talent there is meets a wall of secrecy put up by an uncooperative banking sector. Secondly, the strong lobbying power of the banking sector deters politicians from preparing in advance and taking risks in favour of the taxpayer. Conflicts of interest between the politicians and the bankers are rampant. After the disastrous risk-management performance of many bankers revealed in the 2007-2009 banking crisis, it is surprising that the same people still enjoy great influence in the policy process. The consequences are predictable.

If you ask a frog to come up with a plan for draining a swamp, you are like to end up with a proposal for more flooding. Bankers were asked to come up with a plan for private-sector involvement under the leadership of Ackermann and the Institute for International Finance; what they came up with was a plan for more support.We would never ask the tobacco industry to work out a new public health policy. A further problem is the fragmentation of political power in Europe. This prevents the political authority from taking a strong negotiating position against the sovereign-debt creditors. In 1982, when the US faced a sovereign-debt crisis brought about by US banks’ lending to Latin American nations, US finance minister Baker rejected private-sector demands that the US taxpayer bail out of creditors. While this seems similar to the position of German Chancellor Merkel, her position is much weaker.

How do you see the future of the Greek bank system? The local banks struggle with the liquidity problem, they are very much exposed to the Greek bonds, the investors do not trust them much. What ways of recapitalization do they have?

If the Greek politician can save nothing, their priority should be to at least save their banks. If I were prime minister of Greece, this is what I would try to negotiate with Sarkozy and Merkel. The Greek banks need a lot of new capital if a default occurs -- as soon as possible. And with a banking system in default as well, the ensuing economic crisis could be twice as big.