"Europe in a major quandary. What can Romania do?"

Reporter: The economy has entered a recession, after two consecutive quarters of economic contraction. How do you think the economy will evolve in the coming months, given a weaker harvest, the drop in investments, the drop in exports and the upcoming period of the presidential elections?

Daniel Dăianu: The economy will end 2014 with a real growth of the GDP of over 2%. 2013 has raised the bar 0nly circumstantially, because the harvest was outstanding. While in the first semester the level of public spending was in line with the schedule, aggregate demand and the dynamic of the economy would been better. In many countries of the Union, demand for loans is limited, and often, it would seem almost non-responsive to the drop in interest rates. So we are not dealing only with a credit crunch in explaining the recession. Everywhere in Europe, companies and households are trying to fix balance their balance sheets after years of excessive leveraging. Because they don't have the power to grow, as the environment is hostile, the cleanup often gets done through downsizing, asset divestment. As this business behavior is quite common, the economic turnaround in Europe is slow in occurring - this is what Richard Koo called "balance-sheet recession", starting from Japan's experience, with the plethora of non-performing loans of more than two decades ago. That is why eased monetary policies have a far lower effectiveness due to the "liquidity trap".

Going back to Romania's situation, it would be better if in the remaining months we saw a reinvigoration of public spending, especially since the execution of the budget shows a deficit of less than 0.1% of the GDP after 7 months. There is a significant fiscal space and it would be best if it were used especially on the public investment side, which would also lead to private investments, directly and indirectly. A greater absorption of European funds increases the odds of exiting the technical recession. More productive investments in general would help.

The outside context includes the geopolitical and security crisis, which includes the military conflict in Ukraine, the confrontation with the Russian Federation; the situation is extremely dire. The geopolitical and security risks are very high. The carousel of sanctions is also being felt in the direct and severe impact on business in various EU countries, compounded by the influence on "market sentiment", the overall state of mind. It is worth noting the dynamic of some indicators that are trying to measure the "climate". The growth outlook in the Eurozone is worse than it was a few years ago and things can continue to deteriorate. Romania is overwhelmingly dependent on the EU economy, and regardless of how much we try to maximize the domestic factors, a worsening of the foreign context can to a large extent invalidate those efforts; I am not saying it would be pointless, but we would be idling in certain respects.

Reporter: What do you think could be done to resolve the problem of the drop in foreign direct investments in Romania, if they can't be replaced by domestic ones?

Daniel Dăianu: The increased risk aversion is caused essentially everywhere by the geopolitical risks coupled with the very slow economic turnaround in the European Union. An important role has also played by the rather ill-advised mix of policies. Structural reforms, which are being urged in Brussels, (within the Commission), in Berlin and elsewhere, take time to be implemented, they don't produce results in the short term. That is why it was and it still is good for more consistent support to exist at the level of the aggregated demand of the Eurozone for the policy promoted by Mario Draghi at the European Central Bank (ECB). The Eurozone is seeing a very large current account surplus, which isn't helping countries recover; for a long time, the Euro was too strong. The argument that this surplus is the result of productivity doesn't really hold water when looking at it in relation to the overall macroeconomic circumstances. The internal devaluations (through revenue cuts) do produce effects, it's true, but they lead to an excessive compression of domestic demand in some countries, especially when consecutive adjustments are made. This seesaw does not help the achieving of structural reforms. With an unemployment of over 20% of the workforce in a few countries of the Eurozone it is very difficult to achieve structural reforms (the overall unemployment rate in the Eurozone is over 11%). There is a political economy of reforms, which isn't nonsense, and which takes into account social, economic and political realities. It is interesting that major heads of central banks, such as Janet Yellen and Stanley Fischer of the Fed, Mark Carney of the Bank of England, don't hesitate to mention the high level of underuse of resources; they note possible social and economic costs of the hysteresis phenomenon. There is an ongoing debate concerning the ability to reinflate the economies and there are voices that are requesting a targeting of nominal GDP rather than inflation.

There has been and there still is a need for a more enlightened, open-minded policy, which would be directed towards the countries that have a large fiscal space. Germany for instance, has a tax surplus and a considerable current account surplus. Draghi's speech at Jackson Hole in the US, in August this year, says a lot in that regard; there are pleas for more flexibility, imagination in the use of fiscal spaces, together with unconventional means in the monetary policy, which would help unlock lending and last but not least, the continuation of some structural reforms. It isn't easy, because this approach deals with large estimates and unknowns. Basically, there is sailing in uncharted waters. What can you do with the monetary policy when inflation is nearing zero (the so-called "zero lower bound"), with the threat of deflation looming (which already exists in Spain)? Let's think of the fact that the inflation target of the ECB is 2%, and for a central bank, success doesn't always mean taking inflation constantly lower. Success means how close the actual inflation rate is to the target. With such a low inflation, what monetary policy can you use? Draghi also speaks about decreasing inflationary expectations, which make the mission of the ECB even harder. Here we find a reason for a potential QE program, which would supplement the unconventional methods used so far.

We are living a veritable crisis of the economic policies which are being applied, as the foundations of economics have been shaken by the crisis. I am referring here to the almost blind faith in the notion that low inflation guarantees financial stability. But unless something is attempted, we could effectively enter debt-deflation in the Eurozone, when the drop in prices would increase the burden of debt. Annual inflation has reached 0.3% in July in the Eurozone, and economic activity has essentially stagnated in Germany, which is the engine of the Union. And economic stagnant with deflation is the path to further aggravation of the crisis. I am saying this because the public debt of the EU has increased by about 30% on average after 2009 and a large portion of companies and households are very indebted. I think that there is a need to combine with cleverness and wisdom the use of fiscal and monetary instruments and structural reforms, which would help the generalized entry into debt-deflation. It is very risky to cut public spending anyway when aggregate demand is decreasing because the private sector isn't making any further investments, more spending, when the savings rate is increasing. Europe was far slower than the US in interpreting the causes of the current crisis and it is threatened by an evolution similar to that of Japan, in other words by economic stagnation. It doesn't even have its own decision-making structures like an authentic union. While in the US the concerns are over a very slow growth - Larry Summers has once again brought up the famous phrase of Alvin Hansen of 1938, "Secular Stagnation", in Europe, the major obsession now is avoiding large scale debt-deflation in the Eurozone. How strange the macroeconomic context is and how big the challenge is for the economic policy can also be illustrated through the fact that getting the volume of investments to match the volume of savings, as a premise for an economic turnaround, would involve, according to some, long-term real negative interests. Even so, it is unclear how good that balance would be in a world with multiple balances and how practicable such a method would be.

Reporter: So what can be done for our economy?

Daniel Dăianu: What can be done in Romania under these circumstances? Protect the level of public spending first of all, even increase it through public investments if we have the fiscal space. When the private sector doesn't invest and the tendency to save increases, the public sector must act, especially if there is room for maneuver. The available fiscal space, like I've already mentioned, can be strengthened through a better absorption of the European funds, which would inject real liquidity in the economy. It would have to operate an actual partnership between the government and the private sector when it comes to the development of the infrastructure. The monetary and exchange rate policy should not tolerate a strengthening of the leu under the circumstances, precisely to encourage domestic output. If inflation is low, we can continue with the easing of the monetary conditions on the domestic market. But we must constantly watch the geopolitical events, possible sudden moves of capital, especially the ones involving speculative capital. Attracting investments from all over the world is another path to follow. It would be great to have more investments in the advanced countries in the Euro-Atlantic region, to which we are tied with economic, military and security alliances. But the world doesn't end on the borders of the EU. Poland, other countries in Central and Eastern and Central Europe realize Europe's economic deadlock and are searching for "energy" in other regions of the world. The investments in the country's capability defenses would actually help in the current circumstances. Last but not least, the new Commission, with the help of the European Parliament and of the European Council should begin a bold public investment program in the Union. Such a program would support aggregate demand at the level of the EU, would reduce unemployment (which affects almost 20 million people), and would help reduce the risk for even greater social unrests and political slip-ups. Such a program can be financed through the issuing of bonds of the EIB, and other methods for raising financing through common bonds are available. Francesco Giavazzi and Guido Tabellini, reputed economists, are proposing for the ECB to buy very long term debt (30 years) of countries in the Eurozone, which would provide them with additional financing sources; they are also suggesting tax cuts which would be complemented by a longer delay for adjusting the deficits. The future head of the Commission, Jean Claude Juncker, is considering public investment programs amounting to several hundred billion Euros over three years. But adequate financing had to be found. Thus, the monetary policy has to be combined with the fiscal one, which would boost aggregate demand. There is a need for much greater coordination at the level of the EU. I also think that investment programs financed through collective decisions should cover the whole Union, even though we have available large volumes of European funds which we did not tap. Berlin could play a decisive role towards that goal. Let's hope that Chancellor Angela Merkel together with the new president of the Council, Polish prime-minister Donald Tusk, won't allow things to get worse. The geopolitical challenge to the Union, should boost the solidarity, halt the political trends for fragmenting.

Reporter: Will the cut of the social security contributions lead to imbalances in our economy? If yes, will they be significant?

Daniel Dăianu: There is a need to make some notes on a possible cut of the social security contributions. First of all, this measure should be considered with the budget for 2015 and the coming years in mind. The measure can be applied in many ways; I am referring to the distribution of the percentages of the cut. It should be combined with efforts to fight tax evasion and "the optimization" practiced by major companies, which expatriate profits through transfer pricing. Especially in times of crisis, those who can do that try to move the profits where it works better for them, to recapitalize by avoiding the taxes in the host country. We are seeing that companies are relocating their headquarters away from the US, Great Britain, and other countries to pay lower taxes, or no taxes at all. The Romanian government should fight such phenomena. But it should also fight the tax evasion practiced by the quasi-mob domestic groups, or by those operating on the edge of the law.

And in closing, it would be a good thing if our agreement with the IMF, the World Bank and the EU would be clearer when it comes to measures to fight tax evasion, and tax avoidance. The implementation of the cut of the Social Security Contributions should be thought of as part of a set of measures to encourage the making of investments, to create jobs. And the rate of participation in the labor market must be encouraged. But these desiderata depend on the overall business climate, which in turn depends on what is happening in Europe. This leads us once again to the importance of the policies of the Eurozone, of the Union.

Reporter: How do you think Romania's currency will move given the local imbalances and those of the foreign factors (the overall depreciation trend of currencies)?

Daniel Dăianu: The pressures against our currency will more likely come from the geopolitical events. The macro painting looks quite good from certain points of view; I am referring to the budget execution deficit, to the one of the current account (-1.1% in 2013). Public debt is a little below 40% of the GDP, higher than that of the Baltic countries, but considerably lower than that of Poland and especially Hungary's. This is also visible in the dynamic of the CDSs of Romania's 5-year sovereign bonds (a margin of 140 basis points). And speculative capital which entered Romania in the first part of the year has also processed this kind of data, aside from the Eastern region. If we have real economic growth of more than 2% in 2014 and it doesn't drop in the coming year, if the current account deficit remains within reasonable limits, there shouldn't be any pressures to weaken the leu. On the other hand, there are big geopolitical risks and not just in Eastern Europe. There is an arch of disorder and instability on the southern borders of the Union, with an Arab world shaken by inter-ethnic and inter-religious conflicts, civil wars and uncertainties concerning the relevance of some borders. "The Arab Spring" has kind of run out of steam and new perils are appearing; I am thinking of the new ISIS jihadist movement. These dangers, together with the difficulties of the Eurozone complicate the overall situation in Europe and, implicitly, in Romania; this can lead to pressures to weaken the leu, which could manifest themselves directly and indirectly. Indirect pressures would result from the slowdown of the economy with an uncertain outlook and at the time the Fed decided to reverse the Quantitative Easing program. It is essential for Romania as well as other countries that are not part of the Eurozone to benefit from special arrangements with the ECB for more difficult situations (if the markets froze again or major reversals of capital flows occurred). The buffers available at the Ministry of Public Finance and the reserves of the NBR, the support line provided by the stand-by agreement with the IMF and the EU means a lot, but any additional protection that we can get is worth it. The times are uncertain and with many threats.

Reporter: Do you think that Romania is ready to join the European Banking Union? Can we handle the new banking model?

Daniel Dăianu: The new banking model should be judged from several points of view: the reformed regime of regulation and supervision, which also means new capital requirements and liquidity for banks (Basel III is probably insufficient, in the long run there is probably a need for more equity, in line with the argument made by Admati and Hellwig); new business models for banks, which are not confined just to risk management, but also to the organization of major banks (separation of activities, size reduction for some organizations, etc); the organizational system of the Eurozone. I have already talked about such issues in your newspaper, as I support a radical reform of the regulation and oversight of the financial markets. The overfinancialization is a big cost for the real economy, increased by the speculative nature of much of the current financial sector. Looking at the Eurozone, it is a good thing that the SSM is proceeding ahead (single supervisor mechanism). When we think of what happened recently in Portugal (the case of the Espirito Santo bank), Bulgaria (with two major banks), we understand even more why. And it is a good thing that we are proceeding with resolution mechanisms. Unfortunately, the biggest weakness of the Eurozone persists: the lack of fiscal arrangements. The resolution mechanisms are "national" and we know that the national budgets, each country's strength, is different in the Eurozone, in the Union. There won't probably be a collective deposit guarantee scheme any time soon. But let's admit that there is no other pragmatic solution other than these gradual steps. If the effort to form a Banking Union is not accompanied by better economic policies in the Eurozone, which I have mentioned earlier, we will see further complications in the banking and financial system. Because the ties between banks and economies can not be broken; just like the connections between the banks and countries through sovereign debts (banks are still buying government bonds). The bailing mechanisms have a certain rationality, but they do contain perverse effects. And a threat for the Eurozone, for the Union is the fragmentation that is taking place. Romania's closeness to the Eurozone should be done with eyes open, given the troubles that the single currency is faced with, which rely on an institutional organization and policies with essential flaws. The Banking Union seems to be a an attempt to deepen the integration without tinkering with political arrangements. But I don't think we can run too far ahead without changing the fiscal arrangements, in other words without what van Rompuy called the shared "fiscal capacity". Here is where we have the core of the problem, it is on something like this that the answer to "to be or not to be", the future of the Union, depends on.

Reporter: How do you think Romanian bank depositors will react, if the bail-in procedure comes into effect?

Daniel Dăianu: I don't think there is a relevant number of individuals in Romania that would see their deposits threatened according to the current bail-in rules, if they were applied; I am referring to the limit for the guarantee of deposits. In other EU countries, where people are richer, the situation is more complicated. It is unclear to me though, how many people with small and medium revenues are doing/would do jurisdictional and fiscal arbitrage. Just like the qwerty keyboard, there is a dependency on the path/history. People who have a lot of money do arbitrage. Let's also take into account that the capital markets are less developed in Europe, ensuring only 25-30% of the financial intermediation (compared to 70% in the USA). And there is something else that needs to be said: even the stock market investments are placed in bank accounts. It is extremely important for an economy, a country, if there are resources to intervene in the event of a failure of a big bank.

In Romania, where more than 80% of the banking sector is dominated by banks with foreign shareholders, it is desirable for the parent banks to be involved in a resolution effort as well.

Reporter: Do you think that we will see quantitative easing in the EU?

Daniel Dăianu: The nearing of the debt deflation point increases the chances of QE in the Eurozone. It has to be said that the ECB has used non-conventional means before, among which ultra-cheap financing lines, the recently introduced real negative interest, and "directing" financing to certain sectors of the economy (like the Bank of England has tried as well). Malicious voices are saying that this resembles what central banks in Eastern Europe used to do in the first years of post-communist transition. The fact is that in extraordinary periods, of major "structural tension" (a notion which I've used in a study which I wrote for the IMF two decades ago), unconventional methods are being used and the conventional ones get put in the drawer.

Reporter: What is your opinion on the recent developments in the relations between France and Germany (who are main pillars in the EU), which are affected by diverging opinions on the austerity policy as a solution to the financial crisis?

Daniel Dăianu: The overall circumstances are forcing cooperation. Germany seems to understand that it can't beat the crisis on its own, regardless of how effective its institutional, social and business model is; the economic dependencies are very big in the Eurozone. The austerity isn't yielding the expected results if there are no policies at the level of the Eurozone, of the Union, that support aggregate demand. The irony is that a fiscal correction made through a unilateral approach has stimulated the strengthening of the Euro by increasing the cumulated current account surplus, which, as I have already mentioned, hasn't helped the economic recovery in the countries on the edge of the Eurozone, meaning the ones that had big problems. And it is a good thing that the Euro has weakened in the last few months. Germany, France and Italy, being the countries with the strongest economies in the Eurozone, they have to devise, together with the Commission, a program for turnaround through public investments. Without avoiding a new recession phase, structural reforms will get stuck and the social tensions will deepen. What would the EU look like with the French and German economy in even greater pain? The scale effects would make their presence felt. These countries aren't Portugal, Ireland or even Spain. Fragmentation will increase in the EU and politics will see further advancement of the forces that don't believe in the European project. Populism, demagogy, vocal nationalism, would win an increasing number of supporters. We also have separatist movements that complicate national political equations and bring new uncertainties into the EU metabolism. And if we add to that the unequalled geopolitical challenge since the fall of the Wall of Berlin we understand the historical gridlock that the Union, Europe are in. Just like Romania, as an economic outskirt of the EU, located on the Eastern border. To say nothing of the competitive pressures in the global area, with Asia's emerging economies that hurt the business of many European groups. The world's economy is revealing an increasing number of "zero sum games", meaning some win what others lose.

Reporter: How will our situation be influenced by Austria's rather precarious state? What about the current situation in Ukraine?

Daniel Dăianu: Some Austrian banks had their own eccentricities in Eastern Europe and the Balkans. Austria wanted to return to regions where it had a long history of economic influence. But major mistakes were made and banks with extended operations have done a very weak due diligence; let's think, for instance, of the expansion of lending at any cost, at the blind struggle for market share. Now, onerous deals are being uncovered, even frauds, arrangements which discredit business models and people. But let's not underestimate Austria's economic strength. Even though its public debt is considerable and there is even a significant debt of the private sector, Austria is part of the hard core, the most economically effective area of the Eurozone. It is unfortunate, and not only for Romania, that its banking sector is dominated by banks with foreign shareholders, which are heavily deleveraging (these groups' exposure to Romania has decreased 30% since 2009). The lesson is that we also need domestic capital in the banking sector, that it would be good if CEC Bank and Eximbank developed as well (they need bigger capitalization). Banca Transilvania is doing well. But we are seeing what has happened in Bulgaria, Portugal. So it shouldn't be just any type of domestic capital; we need to prevent the use of capital which is predisposed to bad business, to malpraxis.

I spoke about Ukraine. What is happening there emphasizes Romania's position as a country on the fringe of the EU. And it is precisely this position that raises the stakes of some security arrangements on the European continent, which would protect our borders. Let's hope that the NATO reunion in Cardiff, new EU initiatives and the firm and concrete dialogue with the Russian Federation will build a security architecture in Europe that will make the outlook less gloomy. And I am not referring here to the economy alone.

Reporter: How do you think the economic growth can be restarted using solid foundations?

Daniel Dăianu: I have already answered that I think. I would also add that there is a need for a model of growth that would direct resources towards tradeables; that would encourage domestic savings, that would increase the efficiency in the use of resources (especially in the public system, which is afflicted by corruption and leeching of resources), which would allocate more resources towards education and healthcare (which involves fiscal receipts adequate to an EU member state), which would help rural modernization, hurry the absorption of European grants which would help the absorption of European grants which are clearly targeted at the base infrastructure (roads, ports, landscaping), etc. But Romania can not exit on its own from the great quandary that the Union, that Europe itself, is in.