[Senate Hearing 112-204]
[From the U.S. Government Printing Office]
S. Hrg. 112-204
THE EUROPEAN DEBT CRISIS: STRATEGIC IMPLICATIONS FOR THE TRANSATLANTIC
ALLIANCE
=======================================================================
HEARING
BEFORE THE
SUBCOMMITTEE ON EUROPEAN AFFAIRS
OF THE
COMMITTEE ON FOREIGN RELATIONS
UNITED STATES SENATE
ONE HUNDRED TWELFTH CONGRESS
FIRST SESSION
__________
NOVEMBER 2, 2011
__________
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COMMITTEE ON FOREIGN RELATIONS
JOHN F. KERRY, Massachusetts, Chairman
BARBARA BOXER, California RICHARD G. LUGAR, Indiana
ROBERT MENENDEZ, New Jersey BOB CORKER, Tennessee
BENJAMIN L. CARDIN, Maryland JAMES E. RISCH, Idaho
ROBERT P. CASEY, Jr., Pennsylvania MARCO RUBIO, Florida
JIM WEBB, Virginia JAMES M. INHOFE, Oklahoma
JEANNE SHAHEEN, New Hampshire JIM DeMINT, South Carolina
CHRISTOPHER A. COONS, Delaware JOHNNY ISAKSON, Georgia
RICHARD J. DURBIN, Illinois JOHN BARRASSO, Wyoming
TOM UDALL, New Mexico MIKE LEE, Utah
William C. Danvers, Staff Director
Kenneth A. Myers, Jr., Republican Staff Director
------------
SUBCOMMITTEE ON EUROPEAN AFFAIRS
JEANNE SHAHEEN, New Hampshire, Chairman
BENJAMIN L. CARDIN, Maryland JOHN BARRASSO, Wyoming
ROBERT P. CASEY, Jr., Pennsylvania JAMES E. RISCH, Idaho
JIM WEBB, Virginia BOB CORKER, Tennessee
RICHARD J. DURBIN, Illinois JIM DeMINT, South Carolina
(ii)
C O N T E N T S
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Page
Barrasso, Hon. John, U.S. Senator from Wyoming, opening statement 4
Gordon, David, Head of Research and Director, Global Macro
Analysis, Eurasia Group, Washington, DC........................ 21
Prepared statement........................................... 23
Kirkegaard, Jacob Funk, Research Fellow, Peter G. Peterson
Institute for International Economics, Washington, DC.......... 6
Prepared statement........................................... 8
Appendix to prepared statement............................... 44
Lachman, Desmond, Resident Fellow, American Enterprise Institute
for Public Policy Research, Washington, DC..................... 12
Prepared statement........................................... 14
Shaheen, Hon. Jeanne, U.S. Senator from New Hampshire, opening
statement...................................................... 1
Prepared statement........................................... 3
Stokes, Bruce, Senior Transatlantic Fellow for Economics, German
Marshall Fund of the United States, Washington, DC............. 9
Prepared statement........................................... 11
(iii)
THE EUROPEAN DEBT CRISIS: STRATEGIC IMPLICATIONS FOR THE TRANSATLANTIC
ALLIANCE
----------
WEDNESDAY, NOVEMBER 2, 2011
U.S. Senate,
Subcommittee on European Affairs,
Committee on Foreign Relations,
Washington, DC.
The subcommittee met, pursuant to notice, at 9:35 a.m., in
room SD-419, Dirksen Senate Office Building, Hon. Jeanne
Shaheen, chairman of the subcommittee, presiding.
Present: Senators Shaheen, Barrasso and Corker.
OPENING STATEMENT OF HON. JEANNE SHAHEEN,
U.S. SENATOR FROM NEW HAMPSHIRE
Senator Shaheen. Good morning, everyone.
At this point, I would like to call this hearing to order.
When we scheduled this hearing we thought it would be timely.
We just didn't realize quite how timely.
If I were still a teacher I would ask all of you in the
back to move up but I won't do that. But I am delighted to be
here with my ranking member, Senator Barrasso. I have a brief
statement and then I think he probably will have a statement
before we ask our panelists for their testimony.
The Foreign Relations Subcommittee on European Affairs
meets today to discuss the ongoing European debt crisis. This
crisis presents one of the most complex challenges to European
stability since the creation of the European Union and the
outcome will have lasting effects for the United States and our
transatlantic partnership for decades to come.
This is a particularly timely hearing, given yesterday's
surprise announcement by Prime Minister George Papandreou
calling for a popular referendum in Greece on the recent
Eurozone agreement and, of course, it's also timely because of
the G20 meeting which is scheduled to begin tomorrow in France.
We have a very impressive panel of expert witnesses and we
look forward to engaging with them on these issues.
In today's global economy, Europe is by far America's most
critical ally. Europe is the United States largest trading
partner and our biggest export market.
Together, the United States and Europe account for over
half of the world's gross domestic product, one-third of world
trade and three-quarters of the global financial services, all
of which means jobs and economic growth here in the United
States and in Europe.
But it also means that what happens in Europe can have
significant repercussions for the American economy. Our markets
know this, our businesses know this and we ignore this reality
at our own peril.
Negotiations at last week's Eurozone summit produced a
tentative late-night agreement. The deal included a voluntary
50-percent cut on Greek bonds, a requirement to raise $148
billion in new capital for European banks and a significant
increase in the Eurozone bailout fund.
Despite the announcement, many of the details of the
agreement are unresolved and significant questions remain
unanswered. This agreement is an important first step but
challenges still lie ahead.
One of those challenges is the surprise Greek announcement
that the Papandreou government would seek popular approval of
the bailout package. That decision, as we all saw, roiled
markets yesterday and adds new urgency to the G20 meeting this
week.
It's critical that the implementation of this agreement
does not languish and I encourage our partners in Europe to
continue to act with the urgency this situation requires. It's
important to recognize that American interests in this crisis
go far beyond economic and financial implications and will
affect a broad array of transatlantic issues.
From a foreign policy standpoint, America needs a strong
European partner if we're to meet today's challenges, including
Iran, Afghanistan, and the ongoing ``Arab Spring.'' On the
security side, a Europe focused solely on budget cuts will make
it more difficult for European NATO countries to meet their
resource commitments to this military alliance.
The United States and the transatlantic community have
fought two devastating world wars and spent countless resources
over nearly six decades to bring about a Europe that is whole,
free, and at peace.
Today, the forces of European instability are not war and
fighting but financial uncertainty and the specter of a
continentwide economic breakdown. How Europe responds to this
crisis over the next several months will have dramatic
implications across a broad spectrum of U.S. interests.
The subcommittee looks forward to engaging on these
critical questions in the next hour, and to help us sort out
these issues
we have a very distinguished panel. I just want to take a
minute to introduce each of you before I turn it over to you
for your testimony.
First on our panel today we have Jacob Kirkegaard, a
research fellow from the Peter G. Peterson Institute for
International Economics where he has served since 2002. Mr.
Kirkegaard comes to us from Denmark and is an acclaimed author
and expert in European economies, reform, and high-skilled
immigration.
Next, we have Bruce Stokes, who is currently the senior
transatlantic fellow for economics at the German Marshall Fund,
one of the premier transatlantic policy institutions. Mr.
Stokes is a renowned former international economics columnist
for the National Journal where he remains a contributing
editor.
Next, Dr. Desmond Lachman is a resident fellow at the
American Enterprise Institute. Dr. Lachman has a Ph.D. in
economics from Cambridge University and previously served as
managing director and chief emerging market economic strategist
at Salomon Smith Barney, also as deputy director at the IMF.
And finally, we have Dr. David Gordon, the current head of
research and director of Global Macro Analysis at the Eurasia
Group. Prior to his current position, Dr. Gordon spent more
than a decade working on U.S. foreign and economic policy at
the highest levels of our government including the State
Department, the CIA, and the National Intelligence Council.
Thank you all very much for being here. We look forward to
hearing from each of you, and let me turn it over to Senator
Barrasso for his comments.
[The prepared statement of Senator Shaheen follows:]
Prepared Statement of Hon. Jeanne Shaheen
The Senate Foreign Relations Subcommittee on European Affairs meets
today to discuss an issue critical to the global economy and to long
term U.S. strategic interests. The ongoing European debt crisis
presents one of the most complex challenges to European stability since
the creation of the European Union. This is a particularly timely
hearing today given yesterday's surprise call in Greece for a popular
referendum on the recent Eurozone agreement, as well as the G20 meeting
in France, scheduled to begin tomorrow.
My hope is that we will get a chance today to review some of what
led us to this crisis, evaluate the Eurozone deal announced last week,
and consider where Europe goes from here. But more importantly, I also
wish to discuss some of the broader strategic implications and why a
resolution in Europe means so much for the United States. We have a
very impressive panel of expert witnesses, and we look forward to
engaging with them on these issues.
In today's global economy, Europe is by far America's most
important ally. Europe is the United States largest trading partner and
export market, and together, the United States and Europe account for
over half of world GDP, one-third of world trade and three-quarters of
global financial services.
All of which means jobs and economic growth here in the United
States and in Europe. But it also means that what happens in Europe can
have significant repercussions for the American economy, and as we have
seen over the last year, financial instability and uncertainty in
Europe can easily spill across the Atlantic. Our markets know this, our
businesses know this, and we ignore this reality at our own peril.
As we entered last week's historic Eurozone summit, European
leaders faced a number of difficult realities. Europe had to deal first
and foremost with an insolvent Greek Government by significantly
restructuring its debt. Leaders also needed to recapitalize European
banks so they could withstand a Greek debt write-down. Finally, they
needed to create a credible firewall around much larger Eurozone
countries facing pressures from contagion effects.
After a long series of negotiations, urgency finally gave way to a
tentative late night agreement among Eurozone economies on some of
these critical issues. Leaders announced a voluntary 50-percent cut on
Greek bonds, a requirement to raise $148 billion in new capital for
European banks and a significant increase of the Eurozone bailout fund.
Despite the announcement, many of the details of the agreement remain
murky and significant questions remain, including the fate of credit
default swap purchases and the composition of the bailout fund
increase.
This agreement was no doubt an important step, but it is just a
first step. Significant challenges still lie ahead, and it is critical
that the implementation of this agreement moves forward with the
urgency it deserves.
One of those challenges is the surprise Greek announcement this
week that the government would seek popular approval of the bailout
package--a decision which roiled markets yesterday and adds new urgency
to the G20 meetings this week in France. At the very least, a
referendum would likely set back implementation of the Eurozone plans
at a time when urgency is needed. At the very worst, as the Chairman of
the Eurozone Finance Ministers suggested yesterday, Greece could go
bankrupt if voters rejected the bailout package.
As German Chancellor Angela Merkel said last week, ``The world
[was] watching Germany and Europe''--watching to see if Europe was able
to take on the tough decisions required to address this crisis. The
world is still watching. I encourage our partners in Europe to continue
to act with the urgency the situation requires.
As important as the economic effects of the crisis are for the
United States, it is this committee's responsibility to also examine
the broader picture.
The strategic implications here go well beyond our economic
interests and can affect all transatlantic issues. From a foreign
policy standpoint, America needs a strong Europe to partner with on
issues around the globe. From Iran to Afghanistan to the Arab Spring,
America needs Europe to play an increasingly active role, and a
distracted, internally focused Europe will not be able to help us meet
these difficult challenges.
A protracted austerity program could also worsen the ongoing
problem European NATO countries have faced in meeting their security
commitments to the alliance. As we saw in Libya and in Afghanistan, the
demand for a strong NATO to meet 21st century challenges is not waning.
But a Europe focused solely on budget cuts will surely strain those
already inadequate defense resources.
The bottom line is America needs a strong and active European
partner, and we need Europe to do what is necessary to put the
financial crisis behind them.
The United States and the transatlantic community have fought two
devastating world wars and have spent countless resources over nearly
six decades to help bring about a Europe that is ``whole, free, and at
peace.'' America has made these sacrifices because a stable, secure,
and prosperous Europe is in our own vital interests.
Today, Europe faces a much more complex challenge. The forces of
European instability are not war and fighting, but financial
uncertainty and the spectre of a continentwide economic breakdown. The
future of Europe and the transatlantic alliance is at play.
How Europe responds to this crisis over the next several months
will have dramatic implications across the broad spectrum of U.S.
interests. This subcommittee looks forward to engaging on these
critical questions in the next hour.
We have a very distinguished panel today. I will take a moment to
introduce each of our four witnesses prior to turning it over to them
for their testimony.
First on our panel today, we have Jacob Kirkegaard (``KEER-kuh-
guard''), a Research Fellow at the Peter G. Peterson Institute for
International Economics, where he has served since 2002. Mr. Kirkegaard
comes to us from Denmark and is a widely acclaimed author and an expert
in European economies, reform, and high-skilled immigration.
Next, we have Mr. Bruce Stokes, who is currently the Senior
Transatlantic Fellow for Economics at the German Marshall Fund--one of
the premier transatlantic policy institutions in the world today. Mr.
Stokes is a renowned former international economics columnist for the
National Journal, where he remains a contributing editor.
Today, we also have Dr. Desmond Lachman (``Lock-man'')--a Resident
Fellow at the American Enterprise Institute. Lachman has a Ph.D. in
Economics from Cambridge University and previously served as managing
director and chief emerging market economic strategist at Salomon Smith
Barney and also as Deputy Director at the IMF.
Finally, we have Dr. David Gordon, the current Head of Research and
Director of Global Macro Analysis at the Eurasia Group. Prior to his
current position, David spent more than a decade working on U.S.
foreign and economic policy at the highest levels of our government,
including the State Department, the CIA, and at the National
Intelligence Council.
Thank you all for being here. We look forward to hearing from each
of you.
OPENING STATEMENT OF HON. JOHN BARRASSO,
U.S. SENATOR FROM WYOMING
Senator Barrasso. Thank you very much, Madam Chairman. I'd
like to just echo your comments and thank you for your
leadership in arranging for and organizing this important
hearing today.
I'd like to also thank and welcome all of our experts for
being here today to take part in this hearing on the European
debt crisis. I appreciate you sharing your knowledge, your
analysis, and your insight with our subcommittee.
We are meeting today to discuss the European debt crisis
and to examine the implications for the United States. I'm
concerned about the escalating economic crisis in Europe, as
are many Americans. The countries in the Eurozone are committed
to a common currency and a monetary policy but retain a
patchwork of fiscal policies.
Over the past 2 years, there have been a series of
bailouts, credit rating downgrades, and speculation about
defaults from countries in the European Union. The fear of
contagion and euro instability has stifled markets across the
globe.
Last week, European leaders announced their newest proposal
to resolve the debt crisis in the Eurozone. The chairman has
talked about recent overnight activities and activities
yesterday, and tomorrow the G20 summit will begin and the
Eurozone crisis will be a central part of that discussion.
The United States and Europe have a critically significant
relationship based on our deep history, our shared values and
our economic ties.
The countries in Europe include some of our most important
allies. Throughout our transatlantic partnership we work
closely on numerous global issues including international
security, democracy, human rights, and free markets. It's
important that we understand the type of impact the current
crisis in Europe may place on our strategic transatlantic
partnerships.
I believe that the problem in Europe could have a
significant and substantial effect on the United States. The
United States and Europe have the largest trade and investment
relationship in the world. The United States exported a total
of over $170 billion in 2010 to Eurozone countries. An
estimated 15 million jobs in the United States and Europe are a
result of the transatlantic economic activity.
Based on these strong economic ties, the problems facing
the Eurozone can create significant risks to the United States
economy, to transatlantic trade and economic growth around the
world. We must clearly identify these risks and work together
to limit the fallout from this crisis here at home.
In addition, the United States should be learning from the
crisis taking place in Europe. Due to the increasingly
interconnected nature of the global economy, it is clear that
unsustainable government debt levels can lead not only to a
single sovereign default but it can also produce a widespread
global financial crisis.
The situation taking place in Europe must serve as a clear
warning sign to all countries about the dangers of
irresponsible unsustainable levels of debt.
So thank you again, Madam Chairman. I look forward to
hearing the testimony of our witnesses and evaluating the
complex situation taking place in Europe.
Senator Shaheen. Thanks very much, Senator Barrasso.
Would you like to begin, Mr. Kirkegaard?
STATEMENT OF JACOB FUNK KIRKEGAARD, RESEARCH FELLOW, PETER G.
PETERSON INSTITUTE FOR INTERNATIONAL ECONOMICS, WASHINGTON, DC
Mr. Kirkegaard. Senator Shaheen, Senator Barrasso, members
of the subcommittee, it is a pleasure to testify before you
today on the European debt crisis and its strategic
implications for the transatlantic alliance.
The European debt crisis is characterized by an extreme
degree of complexity as the correct diagnosis is not one but at
least four deep overlapping and mutually reinforcing crises: a
crisis of institutional design, a fiscal crisis, a crisis of
competitiveness, and a banking crisis.
None of these four crises can be solved in isolation and no
single comprehensive solution to end the crisis promptly is
consequently available to EU policymakers, indicating that the
drawn out inconclusive crisis containment effort witnessed in
Europe since early 2010 will continue.
At their summit last week, euro area leaders agreed to a
new set of measures which, while inadequate in scope to end the
crisis and calm financial market volatility will, in my
opinion, help militate against a new dramatic economic
deterioration in Europe. The risk of catastrophic spillovers
from Europe to the United States and global economy was
therefore reduced last week, although, of course, Prime
Minister Papandreou's recent announcement has, to some extent,
undone this benefit.
The euro area agreed a voluntary bond swap agreement with
private holders of Greek Government debt, resulting in a 50-
percent reduction in nominal Greek debt value. This is an
urgently needed measure which, however, will not independently
restore Greek fiscal solvency.
To achieve this goal, substantial financial support will in
the years ahead have to be made available to Greece as well as
Portugal and Ireland to avoid a systemic contagion effect in
the euro area.
Such resources should overwhelmingly come from the euro
area itself with a component provided by the International
Monetary Fund. Ultimately, though, euro area reform will only--
or fiscal stability will only be achieved through the longer
term domestic consolidation and reform efforts, particularly in
Italy.
The Greek debt swap is a voluntary transaction which at
this moment looks unlikely to trigger sovereign default swaps.
Apart from the superficial political pride available to
European leaders from being rhetorically able to deny that a
euro area default has ever taken place, a potential short-term
source of dislocation in the financial markets has hereby been
removed as it is the case, although the net outstanding Greek
CDS contract value amounts to less than $4 billion, very little
is known about the extent of individual, including U.S.
financial institutions, gross exposures to CDS.
However, the lack of payout after a 50-percent reduction in
debt may ultimately lead to the demise of the sovereign CDS
product class for at least industrialized nations.
Financial markets will be certain to, in the future, doubt
whether or not any advanced economy sovereign CDS restructuring
will trigger CDS protection. Given the multiple hedging
purposes for sovereign CDS this may, ironically, lead to an
increased financial market volatility in the future including
here in the United States.
Euro area leaders, second, agreed to raise the capital
requirements in euro area or European banks to 9 percent core
tier one equity and adjust for the effects of market prices of
sovereign debt. This is a helpful further step which will help
insulate also U.S. financial institutions against the risk of
sudden bank collapses in Europe but will not make Europe's
banking system stable and well capitalized.
Third, euro area leaders agree to two options to boost the
financial firepower of the European Financial Stability
Facility, or EFSF. Both, however, are, in my opinion, almost
certain to fail.
Option one, to provide credit enhancement for new debt
issued by member state, is a meaningless measure from a
systemic euro area stability point of view. When the overlap
between the insurer and the insured is as big as in the euro
area, the beneficial financial effects will be minimal.
Option two for the EFSF foresees the creation of special
purpose investment vehicles open to investments from private
and public financial institutions and investors. However, in my
opinion, very few if any such investors will exist with the
willingness and ability to invest the hundreds of billions of
euros required to make a material difference for European
financial stability.
China will certainly not bail out Europe and it would not,
in my opinion, be prudent use of U.S. taxpayers' money to
contribute either, just as the statutes of the International
Monetary Fund will in all probability prevent it from direct
participation.
Fortunately, though, this does not really matter, as the
EFSF's principal purpose is political, not financial. The two
EFSF options described here are principally, in my opinion, a
smokescreen created by European leaders to provide political
cover for the European Central Bank to remain directly involved
in the European crisis stabilization measures. This is
critical, as only the European Central Bank in the end commands
the resources to stabilize the European economy.
Europe is America's largest trading and investment partner
and extensive cross-ownership of large financial institutions
exist. It is consequently inescapable that the U.S. domestic
economy will experience a further negative external shock from
any rapid deterioration of the European debt crisis.
However, the possible direct action by U.S. policymakers
have been limited by the fact that the European debt crisis is,
despite increasing global spillover potential, still at heart a
domestic economic crisis inside another sovereign jurisdiction.
The ability of U.S. Government to bilaterally affect the
outcome of the European debt crisis is consequently and,
indeed, appropriately limited. However, the debt crisis will
lead to substantial changes in the European political,
economic, and defense potential.
The crisis will with certainty lead to a more
institutionally integrated euro area, potentially enabling a
more coordinated projection of the continent's remaining
capabilities, potentially creating an enhanced European
partnership role for the United States.
The fact, however, that the United Kingdom is unlikely to
be a part of such a deeper integration of the euro area will,
especially from the perspective of the United States, be a
complicating factor.
The multifaceted character of the European crisis ensures
that it will only be solved through a lengthy and, indeed, very
volatile process. Yet ultimately, in my opinion, the European
crisis can and will be solved through the use of overwhelmingly
European financial resources.
I thank you for the opportunity to appear before the
subcommittee today and look forward to answering any questions
you might have.
[The prepared statement of Mr. Kirkegaard follows:]
Prepared Statement of Jacob Funk Kirkegaard
Senator Shaheen, members of the subcommittee, it is a pleasure to
testify before you today on the European Debt Crisis and its strategic
implications for the transatlantic alliance.
The European debt crisis is characterized by an extreme degree of
complexity, as the correct diagnosis is not one, but at least four
deep, overlapping and mutually reinforcing crises--a crisis of
institutional design, a fiscal crisis, a crisis of competitiveness, and
a banking crisis.
None of the four crises can be solved in isolation and no single
comprehensive solution to end the crisis promptly is available to EU
policymakers, meaning the drawn-out inconclusive crisis containment
efforts witnessed in Europe since early 2010 will continue.
At their summit last week, euro area leaders agreed on a new set of
measures, which while inadequate in scope to end the crisis and calm
financial market volatility will help militate against a new dramatic
economic deterioration in Europe. The risk of catastrophic spillovers
from Europe to the U.S. and global economy has therefore been reduced.
The euro area has agreed a voluntary bond swap agreement with
private holders of Greek Government debt resulting in a 50-percent
reduction in the nominal debt value. This is an urgently needed
measure, which however will not independently restore Greek fiscal
solvency. Meanwhile, as concerns over fiscal sustainability in the euro
area stretches also to Italy, a country ``too big to bail out,'' the
principal challenge is how to avoid contagion and how to ring-fence
Greece so as to avoid a generalized undermining of the ``risk free
status'' of euro area government debt.
To achieve this goal, substantial financial support will in the
years ahead have to be made available to Greece, as well as Ireland and
Portugal. Such resources should overwhelmingly come from the euro area,
with a component provided by the IMF. Ultimately though euro area
fiscal stability will only be achieved through the longer term domestic
consolidation and reform efforts particularly in Italy.
The Greek debt swap is a voluntary transaction which looks unlikely
to trigger sovereign default swaps. Apart from the superficial
political pride available to European leaders from being able
rhetorically to deny that a euro area default has taken place, a
potential short-term source of dislocation in the financial markets has
hereby been removed, as--although the net outstanding Greek CDS
contract value amount to less than $4bn--little is known about the
extent of individual, including U.S. financial institutions' gross CDS
exposures.
However, the lack of payout after a 50-percent reduction in debt
may ultimately lead to the demise of the sovereign CDS product class
for at least industrialized nations. Financial markets will be certain
to in the future doubt whether any advanced economy sovereign debt
restructuring will trigger CDS protection. Given the multiple hedging
purposes for sovereign CDS, this may ironically lead in increased
financial market volatility in the future, including here in the United
States.
Euro area leaders secondly agreed to raise the capital requirements
in banks to 9 percent core tier 1 equity and adjust for the effects of
market prices of sovereign debt. This is a helpful further step, which
will help insulate also U.S. financial institutions against the risk of
sudden bank collapses in Europe, but will not make Europe's banking
system ``stable and well capitalized.'' Substantially more new capital
and an end to the solvency concerns surrounding several euro area
sovereigns themselves will be required to restore market confidence in
the stability of the European banking system.
Third, euro area leaders agreed on two options to boost the
financial firepower of the European Financial Stability Facility
(EFSF). Both are, however, are almost certain to fail. Option one, ``to
provide credit enhancement to new debt issued by Member States \1\'' is
meaningless from a systemic euro area stability point of view. When the
overlap between the insurer and the insured is as big as in the euro
area, the beneficial financial effects will be minimal.
---------------------------------------------------------------------------
\1\ See Euro Area Summit Statement at http://
www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/
125644.pdf.
---------------------------------------------------------------------------
Option two foresees the creation of special purpose investment
vehicles open to investments from ``private and public financial
institutions and investors.'' However, few if any such investors exist
with the willingness and ability to invest the hundreds of billions of
euros required to make a material difference for European financial
stability. China will not bail Europe out and certainly, it would not
be prudent use of U.S. taxpayers' money to contribute, just as the
statutes of the IMF in all probability will prevent it from
participating.
Fortunately though this does not matter, as the EFSF's principal
purpose is political not financial. The two EFSF options described are
a smokescreen created to provide political cover for the European
Central Bank (ECB) to remain directly involved in the European crisis
stabilization measures. This is critical, as only the ECB commands the
resources to stabilize Europe.
Europe is America's largest trade and investment partner and
extensive cross-ownership of large financial institutions exist. It is
consequently inescapable that the U.S. domestic economy will experience
a further negative external shock from any rapid deterioration of the
European debt crisis.
However, the possible direct actions by U.S. policymakers have been
limited by the fact that it is, despite increasing global spillover
potential, still at heart a domestic economic crisis inside another
sovereign jurisdiction. The ability of the U.S. Government to
bilaterally affect the outcome of the European debt crisis is
consequently and appropriately limited.
Yet, the U.S. Government representatives have since the beginning
of the euro area crisis exercised important indirect pressure through
multilateral channels and especially the IMF and the G20 to expedite
the European crisis resolution process and push it in generally
beneficial directions.
The debt crisis will lead to substantial changes in European
political, economic and defense potential. The crisis will with
certainty lead to a more institutionally integrated euro area,
potentially enabling the more coordinated projection of the continent's
remaining capabilities, potentially creating an enhanced European
partnership role for the U.S. The fact that the United Kingdom is
unlikely to be part of a deeper integration of the euro area will
however especially from the perspective of the United States be a
complicating factor.
The multifaceted character of the European crisis ensures that it
will only be solved through a lengthy and volatile process. Yet
ultimately Europe's crisis can and will be solved through the use of
overwhelmingly European financial resources.
I thank you for the opportunity to appear before the subcommittee
today and look forward to answering any questions you might have.
The remainder of my written testimony provides additional
background information concerning the complex origin of the European
debt crisis.
[Editor's note.--The above mentioned additional background information
as an appendix to Mr. Kirkegaard's prepared statement can be found in
the ``Additional Material Submitted for the Record'' section of this
hearing.]
Senator Shaheen. Thanks very much.
Mr. Stokes.
STATEMENT OF BRUCE STOKES, SENIOR TRANSATLANTIC FELLOW FOR
ECONOMICS, GERMAN MARSHALL FUND OF THE UNITED STATES,
WASHINGTON, DC
Mr. Stokes. Madam Chairwoman Shaheen, Ranking Member
Barrasso, and distinguished members of the committee, it's a
distinct honor and a privilege to appear before you today. My
remarks here represent my own opinions and are not the views of
the German Marshall Fund of the United States.
But I would note that GMF has launched a project on the
topic of this hearing to look at the foreign and security
policy implications of the euro crisis for the United States.
It is particularly timely that we meet a week after another
European summit about the euro crisis and the announcement of
the Greek referendum yesterday.
It is too early to know whether the measures announced last
week will stem the bleeding and start to heal Europe's wounds
or how yesterday's events will complicate matters. But
experience has taught us that at every juncture in this
unfolding saga European actions have been a day late and a euro
short. We have every reason to be skeptical and we can only
hope for the best.
As you noted, Madam Chairwoman, America has a huge economic
stake in Europe finally resolving its crisis. A European ``lost
decade'' would do profound damage to the U.S. economy. But the
euro crisis is no longer simply an economic problem. It is
increasingly a foreign and security policy challenge for the
United States and this crisis has the potential to undermine
the transatlantic alliance, something, I might note, that the
Soviets never accomplished during the cold war.
Default by one or more euro area countries could well lead
to stagnant economic growth, introspection and self-
preoccupation in Europe. A weakened distracted Europe would
prove a strategic liability for the United States. It would
mean a Europe even less able to defend itself, one that cuts
back on foreign aid, a Europe that falls short in its effort to
curb greenhouse gases.
A weakened Europe will become dependent on China to fund
its debt. It will be less able to stand up to Russian energy
blackmail or to impose trade sanctions to curb Iran's nuclear
ambitions. A Europe where the standard of living is declining
could also face a growing public backlash in the form of rising
nationalism and populism that could pull Europe apart.
And a disintegrating Europe would only accelerate America's
drift toward an Asian-centric foreign policy. That would be a
development that is neither in Europe's nor America's self-
interest.
A Europe that is tearing itself apart will be by definition
less strong, and a Europe that is less strong will be less
useful for the United States. In this regard, the most
immediate strategic problem for the United States created by
the euro crisis will be the coming inevitable budget austerity
in Europe.
Belt tightening is already eroding European capacity to
share the burden of paying for global public goods. Since the
financial crisis began in 2008, European nations have cut
military spending by an amount equivalent to the entire annual
defense budget of Germany, and more cuts are in the works.
The cost of shortchanging defense was evident in the Libyan
crisis where Britain and France would not have been able to
carry out their successful mission without United States
munitions. Faced with our own budgetary constraints,
longstanding American resentment about Europe's lack of burden-
sharing in the military area is only likely to grow, poisoning
future defense collaboration.
More broadly, the euro crisis is undermining Europe's
pivotal job as a democratic free market role model for its
immediate neighbors. The nations of Central and Eastern Europe
joined the European Union to share its affluence and political
stability.
Now the EU looks to be a club of austerity, pain, and
political impotence. In the future, association with the
European economy may no longer look so attractive to Turkey,
accelerating its trajectory as an unpredictable and unhelpful
free agent in the Middle East.
Similarly, as the EU looks less stable and successful, the
former nations of the Soviet Union are likely to slip further
back into Moscow's orbit. With the stability of North Africa in
doubt and the Balkans still unsettled, the last thing
Washington needs is for the European Union to become a
centrifugal force in the region.
Finally, European preoccupation with the euro crisis could
dash all American hope for transatlantic cooperation in coping
with China. Beijing is flexing its muscles in the South China
Sea and the Indian Ocean. It is extending its influence in
Pakistan, in Africa and Latin America. It is developing its own
brand of Chinese state capitalism that certainly looks more
attractive today to many around the world than that being
practiced in Europe or, I dare say, even in the United States.
Washington will be hard-pressed to counter this Chinese
influence on its own and we could find ourselves without an
effective European partner.
In closing, Madam Chairwoman, the euro crisis is also a
crisis of Europe's military and diplomatic leadership and
vision, and, as Europe's strategic partner for the last two
generations, Europe's problems are now America's headache.
It is imperative that the United States do whatever it can
to help Europe resolve its current economic troubles. Most
important, we need to work together to mitigate the foreign and
security policy challenges created by this euro crisis.
Thank you, and I look forward to your questions and
comments.
[The prepared statement of Mr. Stokes follows:]
Prepared Statement of Bruce Stokes
Madam Chairwoman Shaheen, Ranking Member Barrasso, and
distinguished members of the committee, it is a distinct honor and a
privilege to appear before you.
My remarks today represent my own opinions and are not the views of
the German Marshall Fund of the United States. But, I would note, GMF
has launched a project to look at the foreign and security policy
implications of the euro crisis for the United States.
It is particularly timely that we meet a week after another
European summit about the euro crisis. It is too early to know whether
the measures announced last week will stem the bleeding and start to
heal Europe's wounds. But experience has taught us that--at every
junction in this unfolding saga--European actions have been a day late
and a euro short. We have every reason to be skeptical. And we can only
hope for the best.
As my fellow panelists have noted, America has a huge economic
stake in Europe finally resolving its crisis. A European ``Lost
Decade'' would do profound damage to the U.S. economy.
But the euro crisis is no longer simply an economic problem. It is
increasingly a foreign and security policy challenge for the United
States.
And this crisis has the potential to undermine the transatlantic
alliance, something the Soviets never accomplished during the cold war.
Default by one or more euro area countries could well lead to
stagnant economic growth, introspection and self-preoccupation in
Europe. A weakened, distracted Europe would prove a strategic liability
for the United States.
It would mean a Europe even less able to defend itself. One that
cuts back on foreign aid. A Europe that falls short in its effort to
curb greenhouse gases. That becomes dependent on China to fund its
debt. That is less able to stand up to Russian energy blackmail. Or to
impose trade sanctions to curb Iran's nuclear ambitions.
A Europe where the standard of living is declining could also face
a growing public backlash in the form of rising nationalism and
populism that could pull Europe apart. And a disintegrating Europe
would only accelerate America's drift toward an Asian-centric foreign
policy. A development that is neither in Europe's, nor America's self-
interest.
A Europe that is tearing itself apart will be, by definition, less
strong. And a Europe that is less strong will be less useful for the
United States.
In this regard, the most immediate strategic problem for the United
States created by the euro crisis will be the coming, inevitable budget
austerity in Europe. Belt tightening is already eroding European
capacity to share the burden of paying for global public goods.
European defense spending has dropped almost 2 percent annually for
a decade and more cuts are in the works. The cost of short changing
defense was evident in the Libyan conflict, where Britain and France
would not have been able to carry out their successful mission without
U.S. munitions. Faced with our own budgetary constraints, longstanding
American resentment about Europe's lack of burden-sharing is only
likely to grow, poisoning future defense collaboration.
More broadly, the euro crisis is undermining Europe's pivotal job
as a democratic, free-market role model for its immediate neighbors.
The nations of Central and Eastern Europe joined the European Union to
share in its affluence and political stability. Now the EU looks to be
a club of austerity, pain, and political impotence.
In the future, association with the European economy may no longer
look so attractive to Turkey, accelerating its trajectory as an
unpredictable and unhelpful free agent in the Middle East. Similarly,
as the EU looks less stable and successful, the former nations of the
Soviet Union are likely to slip further back into Moscow's orbit.
With the stability of North Africa in doubt and the Balkans still
unsettled, the last thing Washington needs is for the European Union to
become a centrifugal force in the region.
Finally, European preoccupation with the euro crisis could dash all
American hope for transatlantic cooperation in coping with China.
Beijing is flexing its muscles in the South China Sea and the Indian
Ocean. It is extending its influence in Pakistan, in Africa and Latin
America. It is developing its own brand of Chinese state capitalism
that certainly looks more attractive to many around the world than that
being practiced in Europe or, I dare say, even in the United States.
Washington will be hard pressed to counter this Chinese influence on
its own. And we could find ourselves without an effective European
partner.
In closing, Madame Chairwoman, the euro crisis is also a crisis of
Europe's military and diplomatic leadership and vision. And, as
Europe's strategic partner for the last two generations, Europe's
problems are now our headache. It is imperative that the United States
do whatever it can to help Europe resolve its current economic
troubles. Most important, we need to work together to mitigate the
foreign and security policy challenges created by the euro crisis.
Thank you. I look forward to your questions and comments.
Senator Shaheen. Thanks very much.
Dr. Lachman.
STATEMENT OF DESMOND LACHMAN, RESIDENT FELLOW, AMERICAN
ENTERPRISE INSTITUTE FOR PUBLIC POLICY RESEARCH, WASHINGTON, DC
Dr. Lachman. Thank you, Madam Chairman and Ranking Member
Barrasso, for affording me the honor to testify before this
committee.
As you've mentioned, these hearings are occurring at a most
timely moment in the sense that what we're getting is very
clear indications that Greece is now bordering on
ungovernability that is very likely to lead to a disorderly
default on its debt within the next few months.
What is also of significance are developments in the
Italian bond market where the markets are giving you the
clearest of indications that they're not at all assured by the
efforts that the European summit took to try to stabilize the
situation. Italian bond interest rates are now at the highest
level that they've been in the past 10 years.
In my remarks this morning, what I'd like to do is
emphasize the seriousness of the European crisis, to indicate
why I believe that this crisis is going to materially intensify
in the months ahead and why I think that a worsening of the
European situation is going to have a major impact on the
United States economy.
I think a good place to start is looking at the origins of
the crisis. While there are many explanations, I think that the
most basic explanation is that the countries in Europe's
periphery did not play by the rules of a currency union for
many years.
As a result, they developed severe imbalances, both with
respect to their public finances where we had budget deficits
routinely over 10 percent of GDP when the rules required that
they be 3 percent of GDP, and we had a material deterioration
in the countries' external balances. These countries lost like
20 percent competitiveness to Germany, which resulted in very
large external current account deficits.
The essence of the problem in Europe's periphery is that
those imbalances are very difficult to correct without having
the advantage of a currency to depreciate that boost exports.
Following the IMF prescription of fiscal austerity of a
hair-shirt variety in those circumstances leads to very deep
recessions that undermine the willingness of the population to
stay the course and impair the public finances.
I should also mention that the seriousness of the present
Eurozone debt crisis extends far beyond the periphery in the
sense that while the countries in the periphery might be small
they are hugely indebted. Countries Portugal, Greece, Ireland,
Spain between them have 2 trillion dollars' worth of sovereign
debt and too much of that debt sits uncomfortably on the
balance sheets of the French and the German banks.
So if we do get defaults in the periphery, what we should
expect is a major European banking crisis. The ECB itself talks
about the possibility of Europe having its ``Lehman moment.''
The crisis has, clearly, intensified. Greece, as I've
mentioned, looks as it's on the cusp of default. Contagion has
spread to Portugal and Ireland, and now we're having, more
worryingly, Italy and Spain being very impacted. Those
countries in the markets are described as too big to fail but
too big to bail, and we're finding that out.
The European banking system itself is showing signs very
reminiscent of what we saw in the United States in 2008, 2009.
They're at the beginning of a credit crunch that is going to
have a deep impact on the growth prospects of most countries in
Europe.
And finally, I'd say that France and Germany--the high-
frequency data coming out of those countries are suggesting
that those countries are approaching a recession, which is
going to make it all the more difficult for the countries in
the periphery to grow out of their problems.
The European summit at last, at least, moved out of denial
and addressed what were the fundamental problems that we now
have. They tried to do something to stabilize the Greek
situation. They tried to ensure that banks were properly
capitalized and they tried to erect a firewall around Italy and
Spain.
The market reaction to this summit has been lukewarm at
best. Markets sold off in the bond markets on that
announcement, which is hardly an encouraging sign and that was
before the announced referendum in Greece yesterday.
Looking at this package, it's not clear that the haircut
for Greece is nearly large enough. It's not clear that the
Europeans will come up with 1 trillion euros in money for the
firewall. That money will be conditional and it's likely that
the manner in which they're going about bank restructuring is
going to lead to an intensification of the credit crunch.
This all is going to have an impact on the United States
economy. In your opening remark you mentioned the trade
relation with the United States and the investment relation
with the United States. I would emphasize the financial
interconnectivity between Europe and the United States.
It disturbs me that money market funds--the United States
have over $1 trillion in money parked with European banks, that
you've got large exposure to banks, to Germany and France, and
there's unknown amount of credit derivatives written. So if we
do get a series of defaults, as I expect we will in Europe, we
should really be bracing ourselves for an impact in the United
States.
Finally, I have to just say that it's very limited what the
United States can do rather than exhort the Europeans to try to
be more bold and serious in addressing this crisis.
We've extended to them money through the Federal Reserve,
through credit--through dollar swaps and we're doing our part
through the International Monetary Fund. But I think beyond
that there's really very little we can do.
We should only take into account when we formulate our own
budget policies, when we formulate our own economic policies,
that we've got a sense of realism as to what is going to be
occurring in Europe and not be Pollyannaish about how this is
going to turn out.
Thank you, Ms. Chairman.
[The prepared statement of Dr. Lachman follows:]
Prepared Statement of Dr. Desmond Lachman
Thank you, Chairman Shaheen, Ranking Member Barrasso, and members
of the subcommittee for affording me the great honor of testifying
before you today. My name is Desmond Lachman and I am a Resident Fellow
at the American Enterprise Institute. I am here in my personal capacity
and I am not here to represent the AEI's view.
In the testimony that follows I set out the reasons why I think
that there will be a further significant intensification of the
Eurozone debt crisis in the months immediately ahead. I also lay out
the reasons why I think that the efforts currently underway by European
policymakers to address this crisis will fall short of what might be
needed to resolve this crisis in an orderly fashion. Finally, I attempt
to draw out the serious risks that the Eurozone crisis poses to the
U.S. economic recovery.
origins of the crisis
1. The main underlying cause of the Eurozone debt crisis is that
countries in the Eurozone's periphery persistently did not play by the
currency union's rules. In particular, whereas the Maastricht Treaty
had proscribed member countries from running budget deficits in excess
of 3 percent of GDP, Greece, Ireland, and Portugal all ran budget
deficits well above 10 percent of GDP. Similarly whereas the Maastricht
Treaty had required that member countries keep their public debt below
60 percent of GDP, the Eurozone's peripheral countries have seen their
public debt levels rise to well above 100 percent of GDP.
In addition to compromising their public finances, the peripheral
countries have lost a great degree of external competitiveness as a
result of relatively high domestic inflation. This has contributed to
very large external current account deficits in the periphery and very
high external debt to GDP ratios.
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2. The essence of the peripheral countries' problem is that stuck
within the Euro they are not able to devalue their currencies as a
means of boosting their exports. Attempting to comply with the IMF-EU
programs of massive fiscal austerity without the benefit of devaluation
to redress their internal and external imbalances is producing very
deep recessions in these countries. That in turn is eroding these
countries' tax bases and is sapping those countries' political
willingness to stay the IMF course. It is also not helping these
countries reduce their very high public debt to GDP levels.
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3. The seriousness of the present Eurozone debt crisis is that it
has the potential for causing a full-blown banking crisis in Europe's
core countries. While the Eurozone periphery might not constitute a
large part of the overall European economy, the peripheral countries
are highly indebted. The total sovereign debt of Greece, Ireland,
Portugal, and Spain is around US$2 trillion. A large part of that debt
sits uncomfortably on the balance sheets of the French and the German
banks.
the euro crisis is intensifying
4. Over the past few months, there has been a marked
intensification of the Eurozone debt crisis that could have major
implications for the United States economy in 2012.
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Among the signs of intensification are the following:
a. The Greek economy now appears to be in virtual freefall as
indicated by a 12-percent contraction in real GDP over the past
2 years and an increase in the unemployment rate to over 15
percent. This makes a substantial write-down of Greece's US$450
billion sovereign debt highly probable within the next few
months. Such a default would constitute the largest sovereign
debt default on record.
b. Contagion from the Greek debt crisis is affecting not
simply the smaller economies of Ireland and Portugal, which too
have solvency problems. It is now also impacting Italy and
Spain, Europe's third- and fourth-largest economies,
respectively. This poses a real threat to the euro's survival
in its present form.
c. The Eurozone debt crisis is having a material impact on
the European banking system. This is being reflected in an
approximate halving in European bank share prices and an
increase in European banks' funding costs. French banks in
particular are having trouble funding themselves in the
wholesale bank market.
d. There are very clear indications of an appreciable slowing
in German and French economic growth. It is all too likely that
the overall European economy could soon be tipped into a
meaningful economic recession should there be a worsening in
Europe's banking crisis. A worsening in the growth prospects of
Europe's core countries reduces the chances that the countries
in the European periphery can grow themselves out of their
present debt crisis.
5. The IMF now acknowledges that Greece's economic and budget
performance has been very much worse than anticipated and that the
Greek economy is basically insolvent. The IMF estimates that Greece's
public debt to GDP ratio will rise to at least 180 percent or to a
level that is clearly unsustainable. The IMF is proposing that the
European banks accept a 50-60 cent on the dollar write-down on their
Greek sovereign debt holding. This would have a material impact on the
European banks' capital reserve positions.
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6. The European Central Bank (ECB) is correctly warning that a
Greek default would have a devastating effect on the Greek banking
system, which has very large holdings of Greek sovereign debt. This
could necessitate the imposition of capital controls or the
nationalization of the Greek banking system. The ECB is also rightly
fearful that a Greek default will soon trigger similar debt defaults in
Portugal and Ireland since depositors in those countries might take
fright following a Greek default. This has to be a matter of major
concern since the combined sovereign debt of Greece, Portugal, and
Ireland is around US$1 trillion.
7. Since July 2011, the Italian and Spanish bond markets have been
under substantial market pressure. This has necessitated more than
US$100 billion in ECB purchases of these countries' bonds in the
secondary market. An intensification of contagion to Italy and Spain
would pose an existential threat to the euro in its present form given
that the combined public debt of these two countries is currently
around US$4 trillion.
8. While to a large degree European policymakers are right in
portraying Italy and Spain as innocent bystanders to the Greek debt
crisis, Italy and Spain both have pronounced economic vulnerabilities.
Italy's public debt to GDP ratio is presently at an uncomfortably high
120 percent, while it suffers from both very sclerotic economic growth
and a dysfunctional political system. For its part, Spain is presently
saddled with a net external debt of around 100 percent of GDP, it still
has a sizeable external current account deficit, and it is still in the
process of adjusting to the bursting of a housing market bubble that
was a multiple the size of that in the United States.
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9. Sovereign debt defaults in the European periphery would have a
major impact on the balance sheet position of the European banking
system. The IMF estimates that the European banks are presently
undercapitalized by around US$300 billion, while some private estimates
consider that the banks are undercapitalized by more than US$400
billion. It is of concern to the European economic outlook that there
are already signs of the European banks selling assets and constraining
their lending to improve their capital ratios.
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implications for the united states economy
10. Considering that the European economy accounts for over 30
percent of global economic output, a deepening of the European crisis
could very well derail the U.S. economic recovery. In principle, a
deepening in the European economic crisis could impact the U.S. economy
through three distinct channels:
a. A renewed European economic recession would diminish U.S.
export prospects to an important market for U.S. goods.
b. A weakening in the euro against the dollar, which would
very likely flow from a European banking crisis and from
questions about the euro's survival in its present form, would
put United States companies at a marked disadvantage with
respect to European companies in third markets.
c. In much the same way as the U.S. Lehman crisis of 2008-09
severely impacted the European economy through financial market
dislocation, a European banking crisis would materially impact
the U.S. economy both through the financial market channel and
through a generalized increase in global economic risk
aversion.
11. Secretary of the Treasury Geithner has correctly asserted that
the United States financial system has relatively limited direct
exposure to the Greek, Irish, Portuguese, or Spanish economies.
However, this assertion overlooks the fact that the U.S. financial
system is hugely exposed to the European banking system, which in turn
is directly exposed to the European periphery. Among the indicators of
this heavy exposure are the following:
a. According to the Fitch rating agency, short-term loans by
U.S. money market funds to the European banking system still
total over US$1 trillion or more than 40 percent of their total
overall assets.
b. According to the Bank for International Settlements, the
U.S. banks have exposure to the German and French economies in
excess of US$1.2 trillion.
c. According to BIS estimates, U.S. banks have written
derivative contracts on the sovereign debt of the European
periphery in excess of US$400 billion.
d. The recent Dexia bank failure in Belgium has revealed
close interconnections between European and U.S. banks.
what is to be done?
12. European policymakers are presently engaged in an effort to put
forward a comprehensive plan to address the crisis ahead of the
forthcoming G20 summit on November 3-4, 2011. After many months of
denial, they now recognize the severity of Greece's solvency problem
and the serious risks that a disorderly Greek default would pose to the
European economy. The plan that the Europeans announced on October 26,
2011, comprised the following three pillars:
a. A revision to the IMF-EU program aimed at putting Greece's
public finances on a sustainable path. The proposed revision
would include the requirement that Greece's bank creditors
accept a 50-percent write-down on their Greek loans than the
21-percent haircut that was earlier agreed upon in July 2011.
b. The erection of a credible firewall around Italy and
Spain. By substantially leveraging up the European Financial
Stability Facility (EFSF), European policymakers hope to have
at their disposal around US$1.4 trillion that could be used to
purchase Italian and Spanish bonds.
c. The recapitalization of the European banking system with a
view to creating an adequate cushion for the European banks to
absorb the losses from a Greek default.
13. Over the past 18 months, the European policymakers' response to
the Eurozone debt crisis has been one of ``too little, too late'' to
get ahead of the crisis. There is the real risk that the efforts
presently underway will also fall short of what is needed to finally
defuse this crisis. Among the areas of concern are the following:
a. It remains to be seen whether Greece's bank creditors will
voluntarily accept the large debt write-downs that are now
being proposed by European policymakers. It is also concerning
that even after the proposed debt write-down Greece's public
debt to GDP ratio would remain as high as 120 percent.
b. It is not clear whether European policymakers will succeed
in leveraging up the EFSF by a sufficient amount to reassure
investors in Italian and Spanish bonds. Nor is it clear whether
they will be able to do so in a manner that allows those
resources to be readily used to effectively prop up the Italian
and Spanish bond markets without excessive interference by the
German Bundestag or without IMF conditionality.
c. There is the danger that leaving it up to the banks to
improve their capital over the next 9 months will result in
increased bank asset sales and credit restrictions. This could
result in an intensification of Europe's incipient credit
crunch that would increase the odds that the European economy
experiences a meaningful double dip recession.
the u.s. role in resolving the crisis
14. To date, the United States has supported the Europeans through
the IMF, in which the U.S. has a 17-percent stake, and the through the
Federal Reserve. Over the past 18 months, in each of the massive IMF-EU
bailout programs for Greece, Ireland, and Portugal, the IMF has
provided around one-third of the total funding. Meanwhile, the U.S.
Federal Reserve has made amply available to the European Central Bank
large amounts of U.S. dollar funding through enhanced U.S. dollar swap
lines.
15. A number of considerations would suggest that beyond exhorting
European policymakers to be more decisive of their handling of the
crisis there is little more that the United States should be doing to
support the Europeans in resolving their crisis. Among these
considerations are the following:
a. The essence of the problem confronting Greece, Ireland,
and Portugal is one of solvency rather than one of liquidity.
Providing additional funding to these countries to essentially
help them kick the can down the road does little to resolve
these countries' solvency problems.
b. Providing funding to help prop up the Italian and Spanish
sovereign bond markets would be putting U.S. taxpayers' money
at risk given the troubled economic fundamentals of these two
countries.
c. In light of the United States own budgetary problems, it
is not clear why additional U.S. taxpayers' money should be
used to either bail out countries in the European periphery or
to support European banks. It would seem that much in the same
way as the United States did not seek European support to help
it resolve the 2009 U.S. banking sector crisis, the Europeans
should now use their own budget resources to resolve their own
sovereign debt and banking crises.
Senator Shaheen. Thank you, Dr. Lachman.
Dr. Gordon.
STATEMENT OF DAVID GORDON, HEAD OF RESEARCH AND DIRECTOR,
GLOBAL MACRO ANALYSIS, EURASIA GROUP, WASHINGTON, DC
Dr. Gordon. Thank you, Madam Chair, and I want to thank
other members of the committee, Ranking Member Barrasso,
Senator Corker, for inviting me here today, and I want to
commend you on your leadership and the attention that you're
drawing to the sovereign debt crisis in the Eurozone.
As my copanelists have emphasized, the failure to resolve
or at least mitigate the crisis will have sharply negative
effects on global markets and on the fragile U.S. economy and
will have negative strategic implications for the United
States, for Europe itself, and for transatlantic relations.
The timing of the hearing, obviously, is very appropriate,
given the meeting in Cannes tomorrow, the European Council
agreements of last week and the political turmoil in Greece.
Let me start my testimony by looking at the three-pronged
plan to which Eurozone leaders agreed in their summit last week
and then move on to U.S. policy and the strategic implications.
To begin with the positive, the specific issues at the
latest European response addresses--bank-recapitalization,
restructuring of Greek debt, expansion of the size and scope of
the EFSF--are, indeed, the three key issues in the almost 2-
year-old crisis.
From a symbolic perspective, then, the Eurozone leaders'
ability to arrive at agreements on these three issues is
definitely a step in the right direction and shows increasing
awareness really for the first time of the scope of the crisis.
Their capacity to act on this in a decisive way, however,
remains very much in question. The latest agreement is an
incremental step forward, not a definitive solution. It's
dominated by half measures and skeletal proposals with little
detail attached to them.
Market sentiment, as Desmond said, reflects this. Following
the announcement of the deal and a lot of enthusiasm last
Thursday, markets have tanked this week. I think that this
latest agreement is not the beginning of the end of the crisis
but rather the end of the beginning, and in fact, I think we're
entering into a potentially more dangerous phase.
The latest agreement creates additional risk. Each step
that the Europeans have highlighted is necessary but none are
sufficient. For instance, the bank recapitalization scheme
creates a very serious downside risk for future operations of
European banks and financial institutions.
The 50-percent haircut on private bondholders is voluntary
in name only. While it may prevent a triggering of credit
default swaps, that would simultaneously make Eurozone debt
more difficult to insure, not less difficult to insure and
then, of course, Prime Minister Papandreou's announcement of a
referendum on the deal only adds to the perception of risk in
the willingness of the peripheral countries to endure more
austerity.
With the IMF, driven by a U.S. unwillingness to commit
additional resources, unable to dedicate funds beyond its
existing commitments, any new funds for Europe from outside
will have to come exclusively from the BRIC countries, the
Middle East countries and a small handful of G20 members, such
as Japan.
These countries want to keep open the possibility of
participation in an eventual resolution but few relish making
concrete commitments in the near future.
So the most likely scenario here is the continuation with
the muddle-through approach, continued downward pressure on
European economies, and a failure of Europe to make significant
structural moves toward a more integrated fiscal union. All of
this creates important negative strategic implications for the
United States.
It should be said that part of the challenge here is that
the traditional U.S. role in post-war financial crises is not
being seen in this crisis. In the past, the United States would
have used our financial strength or political willingness to
lead, to build multilateral coalitions, to get ahead of and out
in front of the crisis.
Today, we don't possess that same political and economic
influence and what you've seen in the last 6 weeks is the
effort to use heightened market scrutiny by Secretary Geithner
and others to pressure the Europeans into more action. That's
begun to work but I fear the timing here, as the Europeans are
used to working in a slow and deliberate manner.
This crisis is escalating. It's taken a long time to build,
but now that it's building it is likely to speed up beyond
Europe's ability to handle it.
Let me highlight a couple of additional risks other than
the ones that Bruce talked about, which are absolutely on
point. I think the first is that we're really heading toward a
two-track Europe here, with closer coordination among members
of the Eurozone at the expense of broader European unity.
The key element of European integration will no longer be
the 27 members of the Union but 17 or 16, 15, 14 members of the
Eurozone, thus putting the decades-long process of European
integration, a major source of U.S. post-war foreign policy,
into structural reverse.
The Eurozone core is less economically open than are those
European countries that have retained their own currencies, and
across a host of areas including investment, trade, labor and
product markets we could see a greater focus on regulation and
on protection from that European core.
Finally, I think that the weakening of Europe will feed a
soft power deficit for the traditional Western powers and
especially for the United States in the rest of the world as
the liberal Western European model, the alternative Western
model to the United States, which took a big hit in 2008, will
also lose attractiveness to the non-Western world, with
deleterious effects on the international rules and norms.
So the United States, I think, needs to be cognizant of the
fact that, unable to provide the requisite combination of
capacity, funding, and political will to usher through its
preferred solutions here, policymakers must prepare themselves
for less than optimal outcomes, and here the challenge is that
in coming years Europe is likely to be both a seriously less
capable and less willing partner for the United States despite
continued apparent mutuality of interests.
Thank you very, very much for focusing on this important
issue and for offering me the privilege of speaking with you
today.
[The prepared statement of Dr. Gordon follows:]
Prepared Statement of Dr. David F. Gordon
Madame Chairwoman, Ranking Member Barrasso, and distinguished
members of the subcommittee, thank you for inviting me here today. My
name is David F. Gordon and I am Head of Research and Director of
Global Macro Analysis at Eurasia Group, a global political risk
analysis firm. Prior to Eurasia Group, I worked in the U.S. Government
for nearly two decades, culminating in service as Director of Policy
Planning under Secretary of State Condoleezza Rice.
Thank you for your leadership on and attention to the sovereign
debt crisis in the Eurozone. The crisis is very severe, and failure to
resolve or at least mitigate the crisis would have sharply negative
effects on global markets and the fragile U.S. economy. In addition,
should the crisis worsen it will have profound strategic implications
for the United States, Europe, and transatlantic relations.
The timing of today's hearing is especially appropriate, as
continuing efforts to resolve the crisis will dominate the proceedings
at the Group of 20 (G20) meeting that begins in Cannes tomorrow. In
particular, much will rest on key G20 members' response the three-
pronged plan to which Eurozone leaders agreed in their summit last
week. I begin my testimony by looking at this plan.
To begin with the positive, the specific issues that the latest
European response addresses--bank recapitalization, the restructuring
of Greek debt, and an expansion in the size and scope of the European
Financial Stability Facility (EFSF)--are indeed the three key issues in
the almost-2-year-old crisis. European leaders agreed to write down
private sector-held Greek debt by 50 percent, avoiding (for now) the
triggering of a credit event. They announced plans to leverage the EFSF
to insure the first losses if any further bond writedowns occur and to
mobilize external funding through the creation of a set of special
purpose vehicles (SPVs). Finally, leaders mandated that European banks
achieve a core-capital ratio of 9 percent by June of next year. From a
symbolic perspective, Eurozone leaders' ability to arrive at an
agreement does demonstrate a clear commitment to resolve the crisis.
Their capacity to do so, however, remains in question. The latest
agreement is an incremental step forward, not a definitive solution. It
is dominated by half-measures and skeletal proposals with a conspicuous
lack of detail. It will require significant additions and likely some
revisions as the crisis continues. Market sentiment reflects this.
After surging last Thursday following announcement of the deal, markets
were flat on Friday and declined substantially on Monday.
In short, I do not see the latest agreement reached by European
leaders as the beginning of the end of the crisis. Rather, it's more
like the end of the beginning. In fact, we are entering a difficult and
potentially more dangerous phase.
The latest agreement creates additional risk. Each step to which
the Europeans have agreed is necessary, but none (taken singly or
together) are sufficient, even with regard to the issues that they were
designed to address. The call for banks to raise 106.5 billion euros
($150 billion) is almost literally a half-measure, as most private
estimates suggest that about twice that amount will be necessary to
safeguard European financial institutions. European government
involvement in providing capital is unclear, and the banks may reach
the appropriate capital ratio through shrinking their balance sheets,
which could have negative effects on economic growth. As a whole, the
bank recapitalization scheme creates a serious downside risk for the
future operations of European banks and financial institutions.
On Greece, the 50-percent ``haircut'' on private bondholders is
voluntary in name only. While this may effectively prevent a triggering
of credit-default swaps (CDSs) on Greek debt, it will simultaneously
make Eurozone debt more difficult to insure, because private creditors
will doubt that CDSs on Greek or other European peripheral bonds will
offer much protection in the future. The agreement also fails to put
Greece on a sustainable fiscal path. According to the deal struck last
week, Athens will target achieving a sovereign debt-to-GDP ratio of 120
percent by 2020. This is not only a still dangerously high level of
debt, but also is based on implausibly optimistic assumptions about
both economic growth and Greece's ability to narrow its budget gap with
austerity measures and a large-scale privatization program that is
wildly unpopular domestically. Greek Prime Minister George Papandreou's
unexpected announcement on Monday of a referendum on the latest
European aid deal only adds to the risk, and threatens to torpedo the
broader agreement as well.
With regard to the EFSF, significant uncertainty exists both on the
insurance template and the modalities and potential for any SPV for
external financing. The insurance scheme may nurture the seeds of its
own destruction, as the announced extension of its value to 1 trillion
euros ($1.4 trillion) is at best aspirational. Since the EFSF will now
bear first losses in the case of any further writedowns, additional
haircuts could entirely eliminate its capital. As for SPVs, with the
IMF--driven by U.S. inability to commit more resources--unable to
dedicate funds beyond its existing commitments, any new funds will have
to come exclusively from the BRIC countries or a few other G20 members,
notably Japan. Though the BRICs and other countries do want to keep
open the possibility of participation in an eventual resolution, few
relish making concrete commitments to an SPV in the very near term.
The latest European plan thus creates a number of scenarios that
are neither adequate nor sufficient. And neither/nor is a very risky
place to be. What is needed is a set of measures that in toto comprise
a broad and bold enough package to generate confidence that the crisis
is coming to an end. Banks will need to suffer significant writedowns
on debt. Even if, as in the present case, these writedowns were imposed
(regardless of whether they were deemed ``voluntary''), this could
provide stability and a solution to the crisis if European periphery
countries were placed on a growth trajectory, as were debtor nations in
the Brady Plan in the Latin American debt crisis of the 1980s. This
latest response, however, does not follow the Brady template--it
contains little to build broad confidence and does not place the
affected debtors on a sustainable path.
That said, dissolution of the Eurozone remains highly unlikely, nor
is any country likely to leave the euro, at least in the foreseeable
future. By far the most likely scenario--which the latest agreement
only reinforces--is a continuation of the ``muddle through'' approach
that has characterized the European response since the advent of the
crisis. In other words, Europe is unlikely to make significant
structural moves toward a more integrated fiscal union, will suffer
several more years of poor economic performance, and will exhibit an
increasingly inward-looking orientation in global affairs.
Before moving to the strategic implications, I would like to make a
few brief observations on the U.S. response to the crisis. President
Obama and the administration have addressed the crisis in three phases.
First, until early 2011, the United States had virtually no response.
It occasionally offered rhetorical support, but for the most part left
the Europeans to their own devices. Then, through the spring and summer
of this year, the United States increased its engagement but remained
relatively muted publicly. But beginning with the Eurogroup meeting in
Wroclaw in early September, the United States has scolded the Europeans
sharply and publicly, fueling market volatility.
This new U.S. response reflects two factors. The first is U.S.
domestic politics. The administration has preemptively called attention
to the Europeans' failings--which, I should be clear, are serious--to
place public blame elsewhere in case the crisis worsens and induces a
severe downturn in the U.S. economy. As a result, President Obama has
partially inoculated himself publicly if a European crisis spills into
the United States. He also potentially benefits in the unlikely event
that the stridency of the U.S. response spurs a European resolution,
leading to an improving business environment and reduced market
volatility on both sides of the Atlantic.
Second, the U.S. response exemplifies a shift in strategy
necessitated by a change in the U.S.'s international position. In
previous similar crises, such as the Latin America debt crisis of the
1980s, the Mexico peso crisis of 1995, and the Asian financial crisis
of 1997-98, the United States consistently took the lead in generating
the solutions to the crisis (as with the Brady Plan), mustering support
among relevant stakeholders, and building a flying buttress of
financial backing from international organizations.
Today, the United States does not possess the economic or political
influence to force Europe or other actors to accept the U.S.'s
preferred solutions. Instead, the United States has used criticism to
induce scrutiny and market reactions to pressure Europe--speaking
loudly but letting markets carry the stick, if you will. This is the
financial equivalent to the military strategy of ``leading from
behind'' that has governed U.S. involvement in Libya this year, and
will increasingly characterize U.S. engagement with Europe in the
coming years.
In the most likely scenario of muddle through, the debt crisis will
weaken Europe, with negative strategic implications for the United
States and the transatlantic relationship. For one, the need for fiscal
retrenchment will increase pressure on European military budgets and
drive an increasingly inward focus. These two forces will in turn lead
to reduced European willingness to engage militarily beyond Europe.
Military interoperability between the United States and its European
allies will decrease, and NATO's New Strategic Concept, adopted with
much fanfare less than a year ago, will become irrelevant. Former
Defense Secretary Gates's warnings of a two-tiered alliance, with a few
countries providing nearly all of the military resources, will prove
prescient.
As a result, leading from behind will be a problematic strategy.
The Libya operation will prove to be the exception, not the rule. And
even that operation, in which the United States did effectively
maintain a supporting rather than leading role, underscored the
decreasing European capability to project force. NATO shortages in
intelligence-gathering aircraft, precision-guidance systems for
ordnance, and in-air refueling equipment necessitated U.S. involvement.
The Eurozone crisis will only exacerbate this situation in future
alliance interventions.
The crisis will also foster closer ties within the Eurozone itself,
but at the expense of broader European unity. The key element of
European integration will no longer be the 27 members of the European
Union proper, but instead the 17 countries of the European Monetary
Union. The crisis has, in other words, put the decades-long process of
European integration--one of the most significant geopolitical
developments since World War II--into structural reverse.
The Eurozone core is in general less economically liberal than are
those European Union countries that have retained their own currencies.
Across a host of areas, including investment, trade, and labor and
product markets, Eurozone countries are inclined toward regulation on
all dimensions. The core's assumption of a more dominant role in the
Eurozone and the Eurozone's supplanting of the European Union as the
locus of European integration creates the risk of a decreasing openness
in the European economy and investment environment and an increasing
inward focus in European trade.
Strategically, Europe's increasing inward orientation--as
exemplified by the trends in defense, investment, and trade noted
above--will make transatlantic cooperation vis-a-vis China and other
emerging powers much less likely. Nowhere is this better illustrated
than in the ongoing speculation about a Chinese financial contribution
to Europe. Fundamentally, this story is much more about the paradigm
shift underway globally than about the solvency of European banks.
The shift is not about a revisionist China pushing to change all
the rules of the international order in 1 week--and certainly not this
week. This crisis will not be a game-changing event for China on the
international stage, and Beijing is neither inclined nor in a position
to take on the mantle of global leadership. China does not want the
responsibility or the risk required to save Europe, and China's
proclivity to free ride on the existing international system will hold
true in this case as well.
Beijing will make some contribution, but will be more focused on
getting the maximum benefit for the minimum amount: providing enough
funding to be constructive without risking a domestic backlash or
assuming ownership over Europe's problems. Especially because the
Europeans (and the United States as well) are reluctant to grant the
concessions, such as market economy status or significant revisions to
the IMF voting structure, that Beijing might demand in return for
backstopping Europe, I expect that China will offer limited assistance
either bilaterally or through a multilateral approach centered around
the BRICs or the G20.
A bilateral deal would be less risky and more typical for Beijing,
and less useful for Europe. A multilateral approach, by contrast, would
pay strategic benefits to China by allowing Beijing to partner with
other countries that share similar goals about (eventually) changing
the international economic order. These alliances could pay dividends
in the future as China and other developing markets bargain for more
representation in international economic institutions.
This possibility is a further component of the challenge of a
financially weakened Europe and will have negative ramifications for
U.S. efforts to incorporate developing economies into the political,
economic, and security architecture that has underpinned the
international system since World War II. European insularity and
economic weakness will feed a soft-power deficit for the traditional
Western powers in the rest of the world, and the liberal European model
will lose attractiveness to the non-Western world, with deleterious
effects on international rules and norms.
I want to emphasize once more that the foregoing implications all
result from the most likely, not the worst case, scenario. The United
States is no longer able to provide the requisite combination of
capacity, funding, and political will to usher through its preferred
solutions to global fiscal crises. Accordingly, policymakers must
prepare themselves for less than optimal outcomes. And here the
challenge is that in the coming years Europe is likely to be both a
less capable and less willing partner for the United States, despite
continued mutuality of interests.
I wish to thank the subcommittee for its focus on this very
important issue, and for offering me the privilege of testifying today.
Senator Shaheen. Well, thank you very much, Dr. Gordon, and
thank you all. It is not an optimistic picture that you all
paint, sadly.
I would actually like to begin with yesterday's events in
terms of the crisis and that is the surprise announcement by
Prime Minister Papandreou that he would seek a public
referendum on the Eurozone deal with respect to Greece.
I think that decision caught everyone off guard and had an
impact, as was pointed out on the markets in Europe, here in
the United States and erased many of the gains from the deal's
announcement last week although, Dr. Lachman, as you pointed
out, that seemed like it might be likely anyway.
So I would like to begin with your assessment of what
happens as the result of that announcement and, Dr. Lachman,
I'll begin with you.
If the referendum goes forward as planned, what are the
likely repercussions and how will that affect the wider
Eurozone crisis, and if the Greeks do not support the deal, if
they reject the Eurozone bailout package, what does that mean?
Dr. Lachman. I think the referendum is clearly--the
referendum is, clearly, of vital importance to where this
crisis is going but I think it's important that when you look
at the referendum you should be looking at it against the
background of an economy that is virtually in freefall, that
the Greek economy has contracted by 7 percent over the last
year. It's down 12 percent from its peak.
Unemployment is up 15 percent because of IMF-imposed
austerity within a fixed exchange rate system, and what's also
occurring is that the country has become virtually
ungovernable--that you've got strikes, you've got protests
against paying taxes, you've got garbage piling up in the
streets of Athens, you've got real anger on the public side.
Papandreou had to do this referendum if he was to regain
any authority. So this is a long shot, that apparently as much
as 60 percent of the population will vote ``No'' on the basis
of polls right now if the question is formulated do you like
the deal that we're doing with the IMF.
So it's all too likely that the Papandreou government is
going to fall. If the Papandreou government falls, it's going
to be very difficult for them to continue with the IMF program,
and this is basically the way in which you get a disorderly
default.
To me, the events in Greece the last week or so, the
referendum being part of that, is all too reminiscent of the
last days of the Argentine Convertibility Plan where you had a
political vacuum, that the people had lost the political
willingness to stay with the austerity. And if they don't stay
with the austerity and they don't get the foreign funding then
the logical conclusion of that is they default on the debt, and
I don't think that we can be very far from that so if
Papandreou loses.
The last thing I would say is that the opposition is not
being too responsible. The opposition are indicating that they
don't like austerity. They want to go a tax-cut route--that
they really are not offering the hope that if the opposition
comes in they're going to be following very sensible policies.
So I fear that we're on the way to default and that if we
do get a hard default the ECB has--over the past year they've
repeatedly said that if you get a hard default you're going to
get contagion to Portugal and Ireland but, more importantly,
you're going to get contagion to Spain and Italy and that would
really put the whole euro experiment at risk.
Senator Shaheen. Mr. Kirkegaard, do you agree with that
analysis?
Mr. Kirkegaard. Yes and no. I have to say I am very
skeptical that this referendum will go ahead as planned. I view
it as----
Senator Shaheen. Why do you say that?
Mr. Kirkegaard. Because, first of all, I don't think that
Prime Minister Papandreou actually has the majority of the
Greek Parliament behind this plan. I think his own party will
fracture over this, and I think it's important to realize that
this call for the referendum is really, in my opinion, a
strategic move or attempt by Prime Minister Papandreou to
essentially force the main opposition party of Greece into
declaring its political support for the IMF program.
And the way that that's going to happen is that so far the
Greek opposition, the New Democracy Party, has, as Desmond
said, essentially been playing, in my opinion, a deceitful
political game where they have been refusing to take political
responsibility for implementing the IMF program while telling
the Greek population that we are going to renegotiate this
program and get a better deal.
What this referendum call is going to do and in fact
already has done is it's going to make it very clear. I mean,
the other European leaders in particular have already made it
very clear that this referendum is not going to be about
whether or not Greece is going to get a new IMF program or not.
It's going to be whether or not Greece is in the EU and the
euro area as a whole or not. You're either in or you're out. I
mean, beggars can't be choosers, so to speak. And viewed in
that light, I, first of all, don't think that the Greek
population, even if the referendum went ahead, would actually
vote to leave the euro because there seems to be conflicting
sentiments here that they're opposed to the current IMF program
but they're also heavily in favor of remaining in the euro
because I think at the end the Greek population knows the
alternative of leaving the euro area which, in my opinion,
would be a graduate slide into de facto third-world status for
Greece, and that's not something that the population would,
frankly, vote for voluntarily.
But as I said, I think the much more likely scenario to
come out of this crisis or this referendum call is either a
unity government, which will be joined by the main opposition
party which has already said that they will do everything to
avoid the referendum to take place, or early elections fought
on a sort of electoral platform that shows that both the
Socialist PASOK Party as well as the main opposition, New
Democracy Party, are fundamentally pro-European pro-euro
parties and therefore I think, as I said, ultimately while this
will create a new political strategy for implementing the IMF
program for which there is no alternative in Greece, I think
the main problem is that it risks delaying the entire effort.
The timetable is pushed further into the future. We have
all the risks of contagion and financial market mayhem and
volatility in the time delay and that's what I think is going
to be the main focus of the meeting tonight or the dinner
tonight between the European leaders and Prime Minister
Papandreou is essentially to make sure that whatever happens in
Greece happens quickly.
Senator Shaheen. Thank you. I am out of time.
Senator Barrasso.
Senator Barrasso. Thank you very much, Madam Chair.
You know, it just seems that, you know, people say well,
over there and over here. There doesn't seem to me, at least,
there is no more over there and over here. We're all
interwound, interlinked and it's of great concern.
I hear that the European problem is real, that it is not
going away and the question is where do we--where do we go from
here and how much impact can the United States and our own
economic situation have to have an impact.
Mr. Lachman, I was listening closely to your comments and
you said that what they are trying to do now is too little too
late. Mr. Gordon talked about the 17 countries that may be then
16, 15, 14.
What scenarios are you seeing? Maybe the two of you want to
comment on that in terms of the--and a timeline on how this all
unfolds.
Dr. Lachman. Well, the first thing I'd say is that what is
of the greatest concern is if we do get a series of disorderly
defaults because if you do get disorderly defaults what that
means is you have big hits on the French and the German banks.
You have an intensification of a credit crunch and then
you're in what the ECB would call Europe's ``Lehman moment''
where the whole European economy goes into big contraction. I
don't see how that at this point is avoidable, what's left it
far too late. These countries are in deep recession.
There's huge political resentment on continuing that
course. I think that the debt is going to have to be written
down. We're dealing with solvency problems in these countries,
you know, and that's really how I see that playing out. Whether
or not the countries leave the euro is debatable.
Defaulting on the debt seems to be more or less a certainty
that you're going to get a hard default in Greece in the sense
that the debt will be written down by 60, 70 cents on the
dollar. Leaving the euro would be a very big choice for any of
these countries because, as Jacob has pointed out, that the
rules of the game are if you leave the euro you're also obliged
to leave the European Union.
I've observed over the past 2 years that the Europeans
waive the rules when you get to the crunch--that we were having
no bailout clauses and then we find that we have bailouts or
the ECB doesn't buy bonds in the secondary market, then it buys
bonds in the secondary market.
I think the same will occur here is that they'd make
allowances for Greece if Greece were to leave. The essence of
the problem though is that what Greece is being offered by the
Europeans they're already--I wouldn't say that they're deep in
recession. They're in depression, and what they're being
offered is more IMF austerity to hold their exchange rate,
which means that they're going to have a ``lost decade.''
When that is the case, it is very tempting to try something
different even with all of the risks and I think that this is--
basically, my experience with fixed exchange rates is that
that's basically where we're headed.
Senator Barrasso. And Mr. Gordon, did you want to----
Dr. Gordon. Yes. I agree with both Jacob's political
analysis and with Desmond's economic and financial analysis
here. I think the purpose of what Papandreou was trying to do
is to draw in the opposition. I think he's likely to fail.
I think there's likely to be new elections in Greece and
then the opposition will likely be the predominant actor in a
post-election coalition. But I think that you then are very
much in Desmond's dynamics--this will lead to a disorderly
resolution of the debt crisis until or unless Europe is willing
to put a better deal on the table for Greece.
I think that could very well happen. I think these events
are probably 4 to 6 months away. The big challenge for the
United States is that, is this going to end with a bang or with
a whimper. If it ends with a bang, we get hurt very, very, very
badly. If it ends with a whimper, it's bad for Europe. It's not
great for us but I think our exposure to it still is
containable. But that will depend on what the outcome of this
political event in Greece is and then I believe very much that
there will be another round of negotiations with the European
authorities, particularly the EU and the ECB.
Senator Barrasso. Mr. Lachman, could you talk a little bit
more about the potential credit crunch that you see coming? I
think you had described it as the ``Lehman moment.''
Dr. Lachman. Well, you've already got signs that there are
real strains in the European credit markets, you know, if you
look at the credit default swaps on banks or you look at
interest rates or you look at banks cutting back on lending.
One of the key mistakes that the Europeans made at the
summit was to identify that the banks are short on their
capital ratios, that they need to raise additional capital, but
then allowing them 9 months to meet those capital ratios. What
one would expect is that the banks aren't going to raise
capital. With their share prices so depressed they're not going
to want to dilute shareholders' capital.
What they're going to do is they're going to shrink their
balance sheets. They're either going to sell assets or they're
going to restrict credit and that is the last thing that I
think a weak Germany and France right now needs is the banks to
pull back.
If we get the disorderly default that I think that we're
going to get, and I don't think that we're more than a few
months away from that, then that just means that the hit to the
banks, their capital ratios, are even more impaired.
So this process of getting a credit crunch is very real and
that is going to affect not simply Europeans. You've got to
take into account that the European banks are very large.
They've got enormous international reach, that there are
already reports that Asian companies are having difficulty
raising capital from the banks. So that is the way I think this
gets transmitted globally.
Senator Barrasso. And then the question that follows is
with the trillion dollars of U.S. dollars in money market funds
that are in Europe, how do you see that then playing and what
the impact is in terms of the value of those dollars, which
people in America think are very safe?
Dr. Lachman. Well, hopefully, the Europeans won't let any
banks fail on their obligations but nonetheless this is a risk
that we're exposed and markets will see this.
We've already seen this in terms of you've just got to look
at the share prices of Morgan Stanley or JP Morgan or any of
these banks that have got exposure in Europe. You know, the
markets are making those connections.
But the exposure that we've got is a trillion dollars'
worth of money market funds, over a trillion dollars with the
banks. This is not insignificant and I think that the lesson
that we've learned from the U.S. experience with our financial
crisis is the same way as our financial crisis was propagated
throughout the globe what we're now going to have is a similar
banking crisis in Europe.
Hopefully, we've learned lessons that they won't make the
mistakes of letting banks fold. But, nonetheless, if you've got
those tensions that is going to have repercussions through the
global economy.
Senator Barrasso. Thank you, Madame Chairman.
Senator Shaheen. Thank you.
Senator Corker.
Senator Corker. Well, thank you both. I think this is a
great hearing. I thank you for having it and certainly the
witnesses, I think, have been excellent.
Let me--you know, it's kind of interesting to listen to you
and, of course, read everything that's happening around the
world. But the fact that Western democracies as a whole--I know
Germany and others maybe have handled themselves well but we
are in a period of decline because we have not handled our
fiscal matters appropriately and therefore our ability to
affect the world is lessened, and what we're seeing is that
those countries that have the courage and the will to get their
balance sheets in order and to get their fiscal house in order
are going to be projecting greater strength and leadership
around the world.
And so we're witnessing something right now that I think is
going to be looked back upon in the future as a real moment in
time where world balances are changing and I think that's, for
those of us here in this country and certainly in Europe, one
of our greatest allies, this is a problem and hopefully a wake-
up call even for what we're doing right now this very moment in
Congress as it relates to dealing with deficits.
But on that note, and moving back to Europe and some of the
things that have taken place, when we had our financial crisis
and I know it's been highly--you know, it's been highly
criticized by many but we had the ability at that moment in
time, obviously, being only one country, a huge advantage, but
to really come in with force and to stop it.
It does appear that everything that's happening in Europe
right now comes at the last minute and not quite enough and so
resources are wasted, effort is wasted. In other words, you're
using things up that might actually end the crisis. You're
using those resources up. You're still not going to end it. It
goes over another hoop.
Is there anything right now, that in spite of all the
difficulties of having differing countries with differing
interests is there any bazooka, if you will, that Europe has
that it could use to actually cause this to end at this moment?
Yes, sir.
Mr. Kirkegaard. There is only one bazooka in Europe, in my
opinion, is the European Central Bank. But they have
essentially put themselves under--I think that it's also
important to understand that this is a truly independent
central bank. You can't tell it what to do. It's
constitutionally----
Senator Corker. Are you saying that unlike the Fed or what
are you--I'm going----
Mr. Kirkegaard. No, no. [Laughter.]
Not at all. What I'm saying is that it has chosen to not go
big or use its bazooka, which it had. It could go big, if you
like, and guarantee all the sovereign debt of Italy, for
instance.
Senator Corker. But the European Central Bank, excuse me,
is not the lender of last resort. Is that not correct? I mean,
its----
Mr. Kirkegaard. It hasn't----
Senator Corker [continuing]. Mandate is very different than
the Fed's mandate.
Mr. Kirkegaard. It has chosen to--it has essentially chosen
its own mandate to not be or act as a lender of last resort.
But if it changed that it could, in fact, act as a lender of
last resort. What it essentially is trying to do is, in my
opinion, to carefully construct financial pressure, as Desmond
said, in the financial markets. Now we have Italian interest
rates over 6 percent.
Well, that is having a very significant effect and putting
pressure on Silvio Berlusconi to do the kind of structural
reforms that the European Central Bank has very clearly, in
fact, written letters to Silvio Berlusconi instructing him to
do.
So what it is trying to do, in my opinion, by not--
deliberately not ending the crisis is to get the kind of
response from politicians in the euro area and in Italy
particularly that it wants. And it actually has the
institutional power in Europe to do this because it is, as I
said in my testimony, the only credible bazooka in Europe.
So it is ironic that if you wanted to end a financial
crisis you would normally go big and a credible commitment--a
big number. But Europe actually goes exactly the other way.
They deliberately prolong the crisis to build up market
pressure to essentially force politicians and policymakers to
do these kinds of reforms.
Dr. Gordon. Senator, I think the good news here on the
timing is that I think that the move by Prime Minister
Papandreou will basically mean that we won't be spending weeks
talking about the European plan that was constructed last week
as a potential solution.
I think actually that's a positive. We will quickly go
beyond that and I think the timing of the G20 will allow
leaders to have a chance to get together and think about next
steps. Do I think that anything systemic will come out of the
G20 meeting? Absolutely not.
But I think where the G20 meeting was headed before this
was this endorsement of what the Europeans had been doing, some
financial support, particularly from BRIC countries and the
Gulf States.
I think none of that is going to happen. I think that's a
positive thing because it will bring a greater sense of crisis
and an ability to move forward as we iterate toward a solution.
Senator Corker. Yes, sir?
Dr. Lachman. I certainly agree with Jacob that the ECB
could be a bazooka that, from a technical point of view, they
clearly can expand their balance sheet at will. But the reason
that I think that they're not is that their major shareholder,
namely Germany, is not too keen about the ECB using its
printing press.
What we've seen is over the past year we've seen Axel
Weber, a governor on the ECB board from Germany, leaving in
protest. We saw Jurgen Stark leaving in protest. We've seen the
president of Bundesbank thinking that what the ECB is doing is
wrong.
We've seen the President of Germany indicating that he
thinks that what the ECB is doing goes beyond legality. So I
don't think it's an accident that the ECB doesn't go into the
market in this degree.
The ECB has to be very concerned about losing the support
of the German people, which would then take away their
independence. So I would see the ECB as being politically
constrained in dealing with the situation.
Senator Corker. Yes. Go ahead, Bruce.
Mr. Stokes. If I could tie together a couple of remarks
here, I think that--I don't know if I agree or disagree with
some of my fellow panelists. I think the problem with the
announcement of the referendum, and even if we don't actually
have a referendum, is that time is not on our side. The markets
are moving already.
We have every reason to believe they will continue to
move--that if this takes days or even weeks to sort out that
events could get rapidly out of control. I do think the ECB
will do what it can, but I don't think there's a lot of
evidence that they're willing to take the steps that we would
all say the United States took and that they should emulate.
And so to get back to your point, Senator Corker, I think
that what we're going to need in the weeks ahead is market-
stabilizing initiatives.
We can't necessarily expect those to come out of Europe,
which puts new pressure on the United States and the Super
Committee. If the Super Committee can come up with a credible
plan, this will help stabilize global markets in a way that is
not totally sufficient, but it can be our contribution, that,
as David said, we're not about to write a check to Europe but
just make it our contribution to helping stabilize markets.
If, on the other hand, we have a train wreck on November
the 23rd, we'll only be throwing gasoline on the fire of the
markets and I think that would be unfortunate.
Senator Shaheen. I just want to follow up on that real
quickly, Mr. Stokes, because does the Super Committee just need
to fulfill its mandate or are you suggesting that it needs to
come up with a broader response to the current situation, that
grand bargain that was talked about earlier in the discussions
about this country's debt and deficits?
Mr. Stokes. At the risk of being Pollyannaish, I think we
should have a broader grand bargain. I think that would be the
bazooka that we could bring to the table in this timeframe to
try to help calm markets and also it would be good for
ourselves in the process, because at the end of the day we have
to deal with our own problems.
Europeans have to deal with their problems. But markets are
going to be worried about instability. Even if we could get a
deal, a smaller deal, to fulfill the Super Committee's mandate
I think that would send the right signals.
I think what would not send the right signals is if the
Super Committee gets to the 23rd of November and kicks the ball
down the road. Then we have to worry about the interaction of
concern about the European crisis with what might be perceived
as a new crisis in the United States.
Whether it is or it is not a crisis is a different issue.
And then we would, I think, risk what we had in 2008, which was
that credit markets on both sides of the Atlantic would begin
to dry up--that people just say, I don't trust things, I will
just sit on my money, and that would not be good for the global
economy given the fact that we're slowing down already.
Senator Shaheen. Mr. Gordon, I'm going to ask you to
respond but I want to do another followup with you, Mr. Stokes,
first, what should the G20 summit do in response to the euro
crisis and what do you think they will do?
So if you could say these are the perfect steps you should
take in order to respond in a way that would reassure the
markets, that would reassure Europe and the rest of the world
that you're addressing this problem and then what do you think
they have the political will to do?
Mr. Stokes. Well, I would second Jacob's statement that
probably the most important thing that's going to happen in
Cannes is this dinner between Sarkozy and Merkel and the Greek
Prime Minister because out of that meeting, their dinner, there
has to come some strong signal that we're on top of this, we're
together on this, we are in accord.
I'm not quite sure how they do that, how they come out with
that kind of message, because if it comes out that people are
pointing fingers and are not cooperating, I think that would
send a very dangerous signal to the markets.
I would have said before the announcement of the referendum
that what one could have hoped for at the summit vis-a-vis this
crisis is that there would be some agreement that the BRIC
countries would in some way be willing to pony up some money to
help backstop Europe, and the details could be worked out
whether it's a euro bond or other things, that would be left to
the technicians, but that there was a commitment and that it be
done not through the Chinese investing in Greek port
facilities, but through some kind of centralized mechanism that
would reduce the concerns about BRIC political influence.
I think now, after the Greek decision, it's inconceivable
to me. I think it was already hard to believe that the Chinese
would be willing to risk their money and now it seems to me the
Greek decision has given the Chinese an excuse to say--you sort
this out and come back to us later. My guess is the Japanese
might feel the same way. So that's an added complication. But
at the very least, it seems to me that the leaders have to have
some very reassuring statements in Cannes because markets will
be moved by what they do.
Senator Shaheen. Mr. Gordon, I know you wanted to respond
earlier but can I also ask you as part of that, you pointed out
that you thought it was positive that we have jumped ahead in a
way that I don't want to say cancels out but looks at what the
alternative to last week's Eurozone deal is. So what is the
deal that should be put on the table that could reassure
markets?
Dr. Gordon. I don't think that we get to grand deal here
and this is a connection back to the Super Committee. I think
that the best is often the enemy of the good so I think the
good for the Super Committee, which is doable--absolutely
doable--is meeting its mandate.
A grand bargain is not doable. In our system elections
determine the political context. We're very close to a
Presidential election. That's when following that election is
the time for grand bargains. But the Super Committee has a
doable mandate. That's what it should do and that would
definitely calm markets.
We're still at a moment of iteration here and I think,
importantly, you throw the ball back into the court of the
Europeans to say put some real detail on these steps. Move to
turn these half measures into whole measures.
Give a pathway here for Greece to see itself being able to
grow out of the economic freefall it now finds itself in and I
think that that would be a step forward. But there's not going
to be resolution coming out of this G20. The basis for it
doesn't exist.
Senator Sheehan. So you're not suggesting that it's the
parameters of the deal, the broad outline, that's the issue.
It's that they don't have enough detail to what's being
proposed.
Dr. Gordon. Well, and the parameters as announced are
insufficient. I think the themes are the right themes. The
parameters are half measures and----
Senator Shaheen. OK. Let me just, if I could, poll
everybody else.
Does everyone else agree with that? Mr. Lachman? No. I'm
just going to ask you to do yes or no because I'm about to run
out of time but we'll be back to you. Do you agree or not?
Dr. Lachman. Partly, but I would just emphasize that you're
dealing with solvency problems in a number of the countries--
dealing with solvency problems in Greece, Portugal and Ireland
to get additional money, to throw additional money at these
countries. All you're doing is you're kicking the can down the
road. You're not resolving their solvency problem.
Senator Shaheen. See, it's not only politicians who have
trouble answering yes or no. [Laughter.]
Mr. Stokes.
Mr. Stokes. I would say yes, you need more money for the
bank bailout. You need more money for the bailout of the
countries.
Senator Shaheen. Mr. Kirkegaard.
Mr. Kirkegaard. I would say yes but I think we have to
recognize that the biggest impact the G20 has had is having the
Cannes summit because it has forced the Europeans to move
further than they otherwise would, as indicated by tonight's
dinner.
Senator Shaheen. Thank you. Thank you all.
Senator Barrasso. Well, I think this follows up, Madam
Chairman, the things that Mr. Stokes was talking about. He said
it's not just an economic crisis or a global realignment
crisis, a security crisis with regard to NATO. And so I do
wonder about leverage used by other foreign governments.
We talked about--I think we mentioned China. I think, Mr.
Gordon, you mentioned all of the BRIC countries and then what
the implications of that are. So just I'd like to ask each of
the four of you to just kind of take a look at that globally,
if you would.
But also the other question that I'd ask you quickly is on
the referendum issue in Greece. Does that mean then that the
Germans may say, we want a referendum as well, and if they're
going to take the haircut, which is at 50 percent but I think
Mr. Lachman said it may have to get to 70 percent.
So I don't know, if we could just go down the panel and if
you want to start, Mr. Gordon, we can just ask everyone's
opinions.
Dr. Gordon. I mean, on the realignment I think that China
is unable to act strategically here because of domestic
politics and the power of nationalism. I think that this crisis
offers a major potential opportunity for China but there's not
going to be an immediate quid pro quo.
Without an immediate quid pro quo, the Chinese are going to
be too hesitant because of the potential political backlash at
home.
Dr. Lachman. Yes, I'd agree that it's going to be difficult
to get China and the other BRICs to contribute. But I think
that there's a more basic question is whether a 1 trillion euro
firewall is big enough and whether it is unconditional enough
to do the job that really what you need to contain this crisis
is you do need a bazooka and the ECB is the only institution
that's got the bazooka but for reason I said it is constrained.
Mr. Stokes. I think that China in particular will probably
not pony up as much money as some people might have speculated.
In part because, I think, of David's reasons. But we should
understand that China is already having an influence.
If you talk to EU officials in their private discussions
among themselves, when they're sitting down to talk about
should we bring an antidumping case or an antisubsidy case
against the Chinese, there will be people from countries in
that room, EU member countries, who say, we can't do this--
we're looking for money from Beijing. And it's not just that
we're worried about this. They've actually called us and
threatened us that we won't get the money because they know
we're about to make a decision on these dumping cases.
So that kind of influence, which I must admit we probably
have also exercised ourselves in the past, is something we both
have to worry about as we think about working with the
Europeans going forward in dealing with China.
Your other point about does the Greek referendum lead to a
German demand for a referendum, it's interesting, there's a
piece in a German paper today arguing just the opposite that
said, we've already said that any deal has to be passed by our
Bundestag--why shouldn't the Greeks have the same democratic
option.
Of course, the problem with that is that it slows down
these processes even more and one of the needs of a crisis like
this is the ability to move fast and that balance between
democracy, which we obviously believe in and think is
absolutely necessary to bring along the public, and the need to
move rapidly to send messages to markets is a tension that the
Europeans are trying to balance and I fear may not get the
balance right.
Mr. Kirkegaard. No, I agree completely with Bruce's
comments about that China is already exercising soft leverage
on some of the European countries. There's no doubt about that.
Even if they don't for domestic political reasons, as David
said, are going to be able to pony up any kind of money that
will make a credible bazooka they're not, nor will anybody
else, as I said in my testimony.
Quickly, on the referendum, I also agree with what Bruce
said there. I think the Europeans will be very, very adamant.
I mean, this will be one of the things that they will say
to Papandreou tonight is that we don't want a precedent for
referendums on IMF programs because we know that even if, as I
said, ultimately I believe that a referendum will probably be
won by Papandreou it will be hugely destabilizing and it would
work the same way as referendas has worked in terms of getting
new European treaties approved.
It basically slows everything down, you know, by several
years potentially and that has, obviously, very destabilizing
effects.
Senator Barrasso. Thank you, Madam Chair.
Senator Shaheen. Senator Corker.
Senator Corker. Thank you. I think, again, this has been
very interesting. You know, so you see the ECB with German
leadership in essence putting sanctions on countries.
I mean, that's what's really happening here and the
question is will the length of time intersect properly where
you actually end this crisis. And I agree with you. Having this
referendum in January means that basically nothing else can
happen and so you basically have no real progress underway
except for, I guess, at the end of this month hearing more
details about the three steps that European Union has taken.
So to me it's pretty--it's not heartening to see that
there's not a real step taken. My guess is by the time it's all
said and done the European Central Bank will play a different
role than it is now playing and it's just a matter of time.
Let me ask you this. On the credit default swaps, I mean,
it seems to me that, No. 1, we're in this era where even in a
more exaggerated way he who has the gold rules.
I mean, we're seeing that play out very strongly. Those
countries, again, that had their fiscal house in order are
going to be the dominant players in the world.
We're diminishing in that regard right now because of our
own ability. We still have major economy but our resources and
our ability to act are diminishing. The credit default, the
other piece it seems to me that's really illuminated right now,
is this whole CDS--I mean, now sovereign entities issuing debt.
If all of a sudden you can just change the rules on the credit
default swaps sovereign debt is now in a very different place,
is it not?
I mean, you literally cannot buy--well, you will not be
able to buy insurance for sovereign debt and feel good about it
if all of a sudden you can say well, you know, your living room
burnt down, your kitchen burnt down, you know, your bedroom has
burnt down but your garage is still standing so we owe nothing.
It'd be like this--that would be the relevant place for home
insurance.
So tell me the effect that this is going to have on lesser
countries, if you will, as it relates to issuing sovereign
debt.
Dr. Gordon. I think the European plan is that you have the
50-percent haircut, no CDS and then you have some European
insurance on this and I think that you're right.
I think that basically this whole thing makes the efforts
to hedge sovereign debt much more challenging but, and again,
it gets back to your point that it reinforces the position of
those countries that don't have to go there, basically, in the
world and makes it tougher for those that do.
I think the other thing that it does here is that it will
create incentives if we do get a disorderly default here. It
will create incentives for others to follow and that's the
challenge of putting the ring fence here around Greece that's
going to be very difficult to do.
Dr. Lachman. The point that you raise about credit default
swaps is a lot more serious because it's affecting not the
smaller countries but it's affecting a country like Italy where
the bond holders now feel that they don't have the insurance,
and Italy's got something like 1.9 trillion of sovereign debt
outstanding and if people begin selling that really could tip
Italy into a bad equilibrium and that is really what we're
fearing.
Senator Corker. Yes.
Dr. Lachman. You know, your second point about the emerging
market finances versus the developed countries' finances
couldn't be more true. These countries--whereas most G7
countries have now got debt to GDP ratios with a 90-percent-
plus handle or that they're running very large budget deficits,
if you look at countries like Brazil, Russia, China, all of
these countries have got public debt levels that are half the
levels of ours and their budget deficits are half the levels of
ours.
So they're really in very much stronger position to weather
these kind of storms than we are.
Mr. Kirkegaard. If I could just say quickly, I actually
think that it's an even bigger issue with respect to the CDS
because what does it actually signal? Why do we need CDS on
sovereign debt is because there is a fundamental impairment of
the risk-free status in financial markets of government debt.
The full faith and credit of Country X is, clearly, not
what it used to be and I think that has very tremendous or very
large implications for how governments more broadly, and this
includes, I believe, the United States as well as large--other
G7 countries, how are they going to be able to act going
forward in future crises in a countercyclical manner.
One of the ways that we traditionally have fought large,
you know, cyclical swings in the economy is that the government
in a crisis acts. Because it has the capacity to borrow at the
risk-free rate, it can expand expenditure in a countercyclical
way.
Well, if government credit as is now happening and,
clearly, in the Eurozone begins to be swinging procyclically so
that it goes up with--in a downturn just like the riskiness of
all other types, that will essentially impair the ability of
government to act in this way, which I think will ultimately
lead to much more volatile, you know, advanced economies.
Senator Corker. OK. So you have a--so speaking of Italy,
you have a situation where now credit default swap is
worthless--maybe not worthless but certainly its credibility is
damaged. Their interest rates when we walked in the room were
at 6.22, which is, you know, a multidecade high, not just a 10-
year high.
At what level do interest rates in Italy get to a point
where it's absolutely a downward spiral? I mean, have you all
looked at what that level is?
Mr. Stokes. Well, they already are at levels where Portugal
and Ireland had to get a bailout. I know Italy is a different
country. The debt of Italy is held more by its own people than
some of these other countries. But it is a danger.
One thing I wanted just to jump in on is the CDS issue to
highlight something that Jacob said in his testimony. We aren't
sure we know the data on CDS and at least this summer both the
Fed and the IMF claimed they weren't really sure who held
this--who had written this.
Now, it may well be they know and they just don't want to
talk about it because that would move markets. But I think that
it is the kind of thing that Congress needs to get on top of.
We at least need to know what the exposure is even if it's
not public information so that we can begin to plan for worst
case scenarios.
Senator Corker. May I ask one more question?
Senator Shaheen. Sure.
Senator Corker. And by the way, we have been pursuing that.
Is there any discussion at any level that makes any sense?
I know in a crisis mode it's hard to focus on anything
other than the crisis at hand and I think, again, the
multicountries involved we know that's difficult and, you know,
it creates lots of frustrations by us as onlookers.
But is there any discussion about the growths out of this?
I mean, at the end of the day there's a downward spiral that's
being exacerbated by all of these actions. Has anybody over
there articulated any thought about how growth resumes?
Obviously, that's the easiest solution to this but or any
prospects of something that would generate growth.
Mr. Kirkegaard. Well, I think it's fair to say that the
short-term growth outlook for Europe is bleak. I don't think
there's any doubt about that. I think we will possibly have a
short technical recession in one of the quarters, either the
fourth quarter of this year or the first quarter of 2012.
But there is some movement toward a growth strategy in the
periphery by basically through the traditional European
Commission budget where investment funds are being now made
available to Greece, Portugal, and Ireland without the
traditional need for national copayments.
So it essentially becomes investments fully funded by the
European Union. And there was actually in the leaders'
communique--the euro group communique--last week a reference to
this project. It's called Project Helios and it's essentially a
50 billion euro solar panel investment project in Greece that
obviously has the potential to create some kind of growth in
the short term.
But having said that, growth agendas are not central to the
European debate and to the degree that it should be, given the
growth outlook.
Mr. Stokes. Senator, one thing that it seems to me that we
can do at the margin but I think would be a terribly useful
thing to do is to begin to talk to Europe about how we remove
all tariffs on goods traded across the Atlantic, how we
encourage investment across the Atlantic.
We can make a contribution that both helps Europe and helps
us by deepening and broadening the transatlantic market, which
right now is the world's largest market. But it won't be that
forever.
So we have something we can contribute. There's a EU-U.S.
summit coming up November 28. It's my understanding that
they're at least considering the possibility of trying to make
some statement along these lines, not a commitment but at least
a commitment to look into it.
Certainly, the U.S. Chamber of Commerce supports this. The
National Association of Manufacturers is looking at it. So I do
think there is a potential there for us to make some small
contribution which will both help them and help us.
Senator Corker. Madam Chairman, thank you and thank each of
you. You all were great.
Senator Shaheen. Thank you. I want to follow up on the line
of discussion that Senator Corker has opened because as has
been pointed out from the beginning of this crisis the focus in
Europe has been on austerity measures and cutting budgets, and
yet as you pointed out, Mr. Kirkegaard, there have been a
number of factors and I think probably you said this too, Mr.
Lachman, that have contributed to the crisis.
So should the focus have only been on austerity measures?
Has that been the correct response? Should there have been a
kind of one-size-fits-all? I mean, you've all talked about how
difficult the measures have been on Greece in terms of the
tightening of their economy.
So should they be looking at efforts that emphasize more
than just austerity? And Mr. Kirkegaard, do you want to respond
first?
Mr. Kirkegaard. I have to say that I believe that for the
peripheral countries and those would be, of course, Greece,
Portugal, and Ireland, I believe austerity to the extent that
it has been imposed by the IMF programs was indeed appropriate
because what we saw during the crisis and was in fact that it
turned out that these countries, apart from having a
significant structural budget, they also had very procyclical
government revenues.
So the crisis itself creates this negative spiral to a
certain extent that Desmond has talked about. But when you have
the kind of debt levels and the kind of structural deficits
that these countries have, yes, then I believe austerity was
appropriate.
It doesn't mean that you should not try to have outside
capital brought in from the European level for investment
growth-stimulating purposes. But I believe austerity was the
appropriate measure.
Senator Shaheen. Yes.
Dr. Lachman. I guess I draw different lessons from the
experience of Greece. You know, I think that the degree of
austerity imposed on a country in a fixed exchange rate system
the IMF should have known that that was going to fail and,
indeed, events have borne that out. When the IMF started these
programs they thought that Greece's debt to GDP level was going
to peak at 130.
Now they're talking about it peaking at 180, maybe going to
200, and the reason that that is occurring is because the
economy has contracted at a very much faster rate, deeper rate
than they anticipated.
But that should have come as no surprise to anybody because
if you tighten budget by 5, 6, 7 percentage points of GDP in a
single year and you're in a fixed exchange rate, it's difficult
to see where the growth comes from.
Looking forward, I think we're in an even worse situation
because what the IMF is doing is they're continuing to impose a
lot of austerity but now they're going to be doing it in the
context of a credit crunch developing so monetary policy is
effectively tightening and a global environment that is a lot
less benign than before.
So I don't think one should be surprised to see if we stick
with these policies, no restructuring of the debt, no
devaluation of the currency, really then what you must expect
is very deep recessions and you must expect the kind of
political situation you get in Greece and I'll tell you that
Portugal is the country that is the next in line.
Senator Shaheen. Mr. Gordon.
Dr. Gordon. I think the IMF--the striking thing to me is
that the IMF learned all of these lessons from dealing with
similar crises in the developing world over a long period of
time and got increasingly, I think, sophisticated about the
need to balance austerity programs with growth programs and the
need for local political ownership. All of these have sort of
gone out the window in dealing with Europe and I think it's
really unfortunate.
Mr. Stokes. But to answer your question, Madam Chairwoman,
I think that there are things that they could have done; they
could have lowered interest rates. The ECB could have lowered
interest rates. It did not.
There are things now that they are doing they could have
done earlier. Jacob mentioned the EU funds that are being
transferred to the periphery. There were proposals from the
very beginning that said look, these funds are supposed to be
appropriated over 5 years--why don't you frontload them, just
do it all at once.
They didn't initially do that. So I think there are things
that--lessons we could learn hopefully for the next crisis that
we should have known to do from the beginning.
Senator Shaheen. Well, given those lessons for this crisis,
is there a way to reset any of the efforts that are under way
that would provide a more positive outcome than what we're
currently seeing? You're shaking your head, no, Mr. Lachman.
Dr. Lachman. I think that there were reasons that the IMF
imposed those kind of policies on these countries. They didn't
want the defaults because they were concerned about what that
would do to the French and the German banking system, which are
holding the debt.
So I think that Greece was used--that Greece was--they
weren't particularly concerned what would be the outcome in
Greece. They were concerned should the banks take the hit. I
think that the mistake that was made is that strategy made
sense if you used the time to strengthen the position of the
banks so that when the inevitable default occurred the banks
would be in a better position to do it.
Sadly, that hasn't occurred. All they've done is they've
kicked the can down the road, they've made the problem bigger
and if we throw more money at it all we'll be doing is
postponing it a little bit further.
But eventually this debt has to be written down big time
and that is going to be a big hit to the European banks.
Senator Shaheen. Well, so just to sum up, at this point it
sounds to me like what everyone is suggesting is that there is
no reason to be optimistic that the efforts undertaken will
have a real impact on the European financial crisis and
therefore we are going to see further impacts on not only the
European countries but on the United States and other parts of
our global markets.
Is that the conclusion that everybody has come to?
Dr. Gordon. I don't think we're at a denouement here. I
think that this is getting sped up. As I said, I think that the
silver lining here is that we aren't going to spend a month
talking about this plan from Europe next week.
But several of us talked about the changing potential role
of the ECB here. Germany would have to give a mandate to that
but the question is, when push comes to shove, will Germany
enable the ECB to play a different role here? Because I think
that in the first half of next year we really are likely to
come to a denouement.
Mr. Kirkegaard. If I can just say, too, quickly, I think we
will certainly not see an end to the kind of volatility that
we've seen in the markets in the last couple of days.
Because of the structural nature of this crisis in Europe
it is going to take several years to work it out. But I think
you will--I think the Europeans does, on the other hand, and
through principally the ECB have the capacity to avoid a
disastrous outcome like another ``Lehman moment,'' as Desmond
has talked about several times.
And on that point I think I will disagree slightly with the
emphasis that a lot of people put on Germany at the ECB because
it is true that Germany may have the biggest shareholding at
the ECB at about 27 percent. But we have to recall that the ECB
uniquely in the European Union actually works like the U.S.
Senate. Germany only has one vote. Germany has the vote----
Senator Shaheen. That doesn't make me feel better.
[Laughter.]
Mr. Kirkegaard. Well, the ability for Germany to actually
block these things in the short term is essentially, in my
opinion, not there. They can't do it, and the Germans on the
governing council represent--there's 23 members on that council
and there's a--you know, the Germans are a very small minority.
Senator Shaheen. Thank you.
Mr. Stokes.
Mr. Stokes. I think I agree here. I think that there is
nothing that is likely to transpire in Europe in the next few
days or even weeks that is going to defuse this crisis. It's
going to continue to build. That's the challenge we face.
I think from an American point of view, there are three
things we need to think about. One is to send as positive of
signals as we can to the markets that we are getting our house
in order. Two, I think we do need to consider what we can do at
the margins to improve trade and investment across the Atlantic
to at least contribute to helping getting them and us out of
the problems we're in.
And then I would raise an issue that no one on Capitol Hill
wants to talk about and that is what are we prepared to do to
help the IMF if things really go badly. Congress has already
spoken already to a certain extent on this and I think it's not
a sign that we want to send to the markets in a crisis.
Senator Shaheen. Thank you. I would--I have just one final
question and I would be remiss as the chair of this
subcommittee and given the conversations that I've had with
representatives from a number of the other European countries
that are still looking to get into the EU.
Do you have any view of what the prospects are for those
continuing discussions and whether the financial crisis will
have a dampening effect on the interest that some of those
countries have in getting into the EU?
Mr. Kirkegaard.
Mr. Kirkegaard. I think it will clearly have a dampening
effect on people or countries wanting to get into the euro
area. I think that's already happening.
But I have to say that in the 10-year time horizon I think
we will see a euro area of 26 countries. The only country that
will not join is the U.K. and the reason is that for the other
smaller Eastern European countries in particular but also
Denmark and Sweden, as the euro area begins to integrate
institutionally and becomes the forum in which major decisions
are taken in the EU, the political costs for these small
countries to remain outside becomes prohibitive.
I think that they would--they will probably want to wait to
see what happens and what kind of euro area they join and they
would probably also prefer for some of the bills to be paid
before they join. But as I said, in the 10-year time horizon I
think they all will.
Moving to the issue of expanding the EU beyond the 27, I
think that'll be very difficult. I believe that the chances of
Turkey of ever joining the European Union are zero, and the
main reason for that is that you have in the European Council
right now a dual-majority rule which means that it weighs the
influence of a country both by GDP and by population.
So if Turkey ever joined, Turkey would quickly become the
most powerful country in the EU and Germany and France will
never accept that. But I would also say that I think the
process of prospective Turkish membership has actually already
worked the way it should.
I think the process, if you like, has been the goal here
because I think without the potential for, even if never
materialized actually, for Turkish EU membership you would not
have seen the reduction in the role of the Turkish military and
a whole host of other very positive developments in Turkey.
So I think both countries, both the EU and Turkey, has
actually had great benefits from this ultimately, you know,
futile effort and I think with respect to the Ukraine, it all
depends on internal Ukrainian politics. What has happened in
the last couple of weeks in Ukraine will certainly not make
them a prospective EU member.
Senator Shaheen. What about some of the other Balkan
countries and----
Mr. Kirkegaard. Oh, sorry. Yes. I think ultimately all of
the Western Balkans will become members including Albania, and
obviously, I also forgot to mention that Iceland has recently
opened up and they will also join relatively quickly.
Senator Shaheen. Thank you.
Mr. Stokes.
Mr. Stokes. I think the issue may be that up to this point
it was the internal debates inside these applicant countries
that slowed down or complicated their joining.
I think increasingly there will be reluctance among the
existing members of the EU to move for membership very rapidly
because of the impending recession in Europe, because of the
fears that we wouldn't want to admit a country that would
somehow turn out to be another Greece.
And I agree with Jacob. I think if there was any chance
that Turkey joined the EU, which I think was probably zero
before this crisis, the crisis has really put a nail in that
coffin.
Senator Shaheen. Certainly, I appreciate what you're saying
about internal disagreements within many of those potential
member countries, although I think their perception, at least
among some of them, is that there has been more of a reluctance
as time has gone on to allow for increased EU expansion and
that that has hurt their chances.
So hopefully that is not the case. Mr. Lachman, did you
want to weigh in on that?
Dr. Lachman. No, I just have a different view that----
Senator Shaheen. OK. Good.
Dr. Lachman. I just think that we're going to see--within
the next year or 18 months we're going to see countries leaving
the euro.
I don't see how Greece and Portugal and probably Ireland
remain within the euro and I think I would agree with Bruce
that it's very difficult if Europe's in recession. Countries
are leaving. You've got all these crises. To then be expanding
the euro would just make no sense.
Senator Shaheen. Mr. Gordon.
Dr. Gordon. I think that if we are in Jacob's world that
would be a huge success. I suspect we're going to be in Desmond
and Bruce's world.
Senator Shaheen. Well, we'll give you the last word. Thank
you all very much. It's been a fascinating discussion.
The hearing is closed.
[Whereupon, at 11:18 a.m., the hearing was adjourned.]
----------
Additional Material Submitted for the Record
Appendix to Jacob Kirkegaard's Prepared Statement
the origin of the euro area's four different crises,
their overlaps and mutual reinforcement
The euro area crisis has gradually since May 2010 taken center-
place in an increasingly volatile global economy. It has become evident
that the crisis consists of four distinct, though frequently
overlapping and mutually reinforcing crises; (1) A design crisis, as
the euro area from its creation in the 1990s has lacked crucial
institutions to ensure financial stability during a crisis; (2) a
fiscal crisis centered in Greece, but present across the southern euro
area and Ireland; (3) a competitiveness crisis manifest in large and
persistent precrisis current account deficits in the euro area
periphery and even larger intraeuro area current account imbalances;
and (4) a banking crisis first visible in Ireland, but spreading
throughout euro area via accelerating concerns over sovereign
solvencies.
The Euro Area Design Challenge
The concrete thinking about an economic and monetary union (EMU) in
Europe goes back to 1970, when the Werner Report \1\ laid out a
detailed three-stage plan for the establishment of EMU in Europe by
1980. Members of the European Community would gradually increase
coordination of economic and fiscal policies, while reducing exchange
rate fluctuations and finally fixing these irrevocably. The collapse of
the Bretton Woods system and the first oil crisis in the early 1970s
caused the Werner Report proposals to be abandoned.
By the mid-1980s, following the 1979 creation of the European
Monetary System and the initiation of Europe's internal market,
European policymakers again took up the idea of EMU. The Delors Report
\2\ from 1989 envisioned the achievement of EMU by 1999, moving
gradually (again in three stages) towards closer economic coordination
among the EU members, with binding constraints on member states'
national budgets, and a single currency with an independent European
Central Bank (ECB).
While Europe's currency union therefore has lengthy historical
roots, it was an unforeseen shock--German reunification in October
1990--that provided the political impetus for the creation of the
Maastricht Treaty,\3\ which in 1992 provided the legal foundation and
detailed design for today's euro area. With the historical parity in
Europe between (West) Germany and France no longer a political and
economic reality, French President Francois Mitterrand and German
Chancellor Helmut Kohl launched the EMU process as a principally
political project to irrevocably join the French, German and other
European economies together in an economic and monetary union and
cement European unity.
This political imperative for launching the euro by 1999, however,
frequently facilitated that politically necessary compromises, rather
than theoretically sound and rigorous rules and regulations made up the
institutional framework for the euro.
While the earlier Werner and Delors reports discussing the design
of EMU had been explicit about the requirement to compliment a European
monetary union (e.g., the common currency) with a European economic
union complete with binding constraints on member states' behavior,
political realities in Europe made this goal unattainable within the
timeframe dictated by political leaders following German reunification.
The continued principal self-identification among Europeans as
first and foremost residents of their home country,\4\ i.e., Belgians,
Germans, Poles, Italians, etc., made the collection of direct taxes to
fund a large centralized European budget implausible. The frequently
discussed relatively high willingness of Europeans to pay taxes does
not ``extend to Brussels.'' The designers of the euro area was
consequently compelled to create the common currency area without a
sizable central fiscal authority with the ability to counter regional
specific (asymmetric) economic shocks or reinstill confidence in
private market participants in the midst of a crisis--like the one the
euro area is currently experiencing.
Similarly, the divergence in the economic starting points among the
politically prerequisite ``founding members'' of the euro area moreover
made the imposition of firm, objective fiscal criteria for membership
in the euro area politically impossible. The Maastricht Treaty in
principle included at least two hard ``convergence criteria'' for euro
area membership--the so-called ``reference values'' of 3 percent
general government annual deficit limit and 60 percent general
government gross debt limit.\5\ However, in reality these threshold
values were anything but fixed, as the Maastricht Treaty Article 104c
stated that countries could exceed the 3 percent deficit target, if
``the ratio has declined substantially and continuously and reached a
level that comes close to the reference value,'' or ``excess over the
reference value is only exceptional and temporary and the ratio remains
close to the reference value.'' Euro area countries could similarly
exceed the 60-percent gross debt target, provided that ``the ratio is
sufficiently diminishing and approaching the reference value at a
satisfactory pace.''
In other words, it was a wholly political decision whether a
country could become a member of the euro area or not, and had
relatively less to do with the fundamental economic strengths and
weaknesses of the country in question. As it was politically
inconceivable to launch the euro without Italy, the third-largest
economy in continental Europe, or Belgium, home of the European capital
Brussels, both countries became members despite in 1997-98 having gross
debt levels of almost twice the reference value of 60 percent (Figure
1).
[GRAPHIC(S)] [NOT AVAILABLE IN TIFF FORMAT]
As a result, Europe's monetary union was launched in 1999
comprising of a set of countries that were far more diverse in their
economic fundamentals and far less economically integrated than had
been envisioned in the earlier Werner and Delors reports. Yet, not only
did European political leaders proceed with the launch of the euro with
far more dissimilar countries than what economic theory would have
predicted feasible, shortly after the launch of the euro, they went
further and undermined the remaining credibility of the rules-based
framework for the coordination of national fiscal policies in the euro
area.
Building on the euro area convergence criteria, the Stability and
Growth Pact (SGP) was intended to safeguard sound public finances,
prevent individual euro area members from running unsustainable fiscal
policies and thus guard against moral hazard by enforcing budget
discipline. However, faced themselves with breaching the 3-percent
deficit limit in 2002-2004, France and Germany pushed through a
watering down of the SGP rules in March 2005\6\ that, as in the
Maastricht Treaty itself, introduced sufficient flexibility into the
interpretation of SGP that its enforcement became wholly political and
with only limited reference to objective economic facts. Individual
euro members subsequently failed to restore the long-term
sustainability of their finances during the growth years before the
global financial crisis began.
By 2005 the euro area was as a result of numerous shortcuts taken
to achieve and sustain a political goal, a common currency area
consisting of a very dissimilar set of countries, without a central
fiscal agent, without any credible enforcement of budget discipline or
real deepening economic convergence. Initially, however, none of these
danger signs mattered, as the financing costs in private financial
markets of all euro area members quickly fell towards the traditionally
low interest rates of Germany (Figure 2).
[GRAPHIC(S)] [NOT AVAILABLE IN TIFF FORMAT]
It is beyond this testimony to speculate about the causes of this
lasting colossal mispricing of credit risk in the euro area sovereign
debt markets by private investors in the first years after the
introduction of the euro. The financial effects of this failure on the
other hand were obvious, as euro area governments and private investors
were able to finance themselves at historically low (often
significantly negative real) interest rates seemingly irrespective of
their economic fundamentals. Large public and private debt overhangs
were correspondingly built up in the euro area during the first years
of the euro area and in the run up to the global financial crisis in
2008. Financial markets' failure to properly assess the riskiness of
different euro area countries papered over these issues until the
global financial crisis finally struck.
The euro area institutional design has in essence been that of a
``fair weather currency,'' with no central institutions capable of
compelling the member states to act in unison. As a new, untested and
severely under-institutionalized entity, the euro area has had no
capacity to act forcefully during the current crisis or restore
confidence among private businesses and consumers. Unless that changes,
the euro area will be unable to exit the current crisis.
European policymakers therefore today are faced with the acute
challenge of correcting the design flaws in the euro area institutions
that their predecessors in their quest to quickly realize a political
vision for Europe helped create. The euro area needs a new rule book.
Leaders must in the midst of this crisis craft a new set of euro area
institutions that for the first time provide the common currency with
binding fiscal rules for its member states, and a centralized fiscal
entity capable of acting in a crisis on behalf of the euro area as a
whole. This will require the transfer of sovereignty from individual
member states to the supra-national euro area level considerably beyond
what has previously occurred in the EU.
The Euro Area Fiscal Challenge
The euro area fiscal crisis is concentrated in Greece, which
according to the latest IMF/EC/ECB estimates will have a general
government debt surpassing 180 percent of GDP by 2012. Despite Greece's
IMF program and associated financial support from the EU and IMF since
May 2010, the country is at this point clearly not able to repay all
its creditors in full and has to restructure its government debt.
Greece will consequently be the first ever euro area country and first
OECD member since shortly after World War II forced to restructure its
sovereign debt.
Portugal and Ireland are currently subject to IMF programs, too,
but in contrast to Greece have successfully implemented their program
commitments to this date.\7\ Through continued strong reform
implementation and access to financial assistance from the EU and IMF
in the years ahead, it looks still potentially feasible for Portugal
and Ireland to in the medium-term restore their access to private
financial markets at sustainable interest rates.
However, as illustrated in figure 3, the cost of financing for
Spain and Italy has also risen substantially in recent month with
secondary 10y bond market yields currently between 5.5 and 6 percent.
Unlike, however, the three smaller euro area countries with IMF
programs, Spain and Italy are economies of a size that makes them ``too
big to bail out'' for the euro area, even with IMF help. The fact that
financial markets have begun to doubt the fiscal sustainability of
``too big to bail out'' members of the euro area is at the heart of the
euro area policymakers' fiscal challenge.
[GRAPHIC(S)] [NOT AVAILABLE IN TIFF FORMAT]
The key link between Greece and Spain and Italy is the issue of
``contagion'' \8\, i.e., a situation in which instability in a specific
asset markets or institutions is transmitted to one or more other
specific such asset markets or institutions. Inside a currency union
like the euro area, where the central bank is legally barred from
guaranteeing all the sovereign debts of individual member states \9\
and for political reasons each sovereign members' debts remains
distinct,\10\ yet the debt is denominated in the same currency and
governed by at least some common institutions, the phenomenon of
contagion has particular force. If private investors begin to fear that
a precedent will be set inside the euro area with the imposition of
haircuts on Greek sovereign debt, they will assess the riskiness of
other euro area members' sovereign debt differently once the ``risk
free status'' of euro area sovereign debt has been impaired. The large
increases in the interest rates on Italian and Spanish Government debt
seen immediately following the July 21, 2011 EU Council decision to
first introduce haircuts on Greek Government debt looks, in the absence
of simultaneous new bad economic news released from the two countries,
to be largely due to contagion.
Given the high public and private debt levels built up before the
global financial crisis in Spain and Italy, the sudden emergence of
contagion and associated reprising by private investors of the
riskiness of these two countries has the potential initiate
destabilizing self-fulfilling interest rate-solvency spirals. Contagion
from Greece causes Italian interest rates to go up, which given Italy's
high existing debt levels adds materially to the interest burden,
necessitating further austerity measures, further reducing economic
growth in the short-term, leading to lower government revenues and
increased financial market concerns, again increasing both the Italian
Government deficit and interest burden. The presence of contagion
inside a currency union, where many individual members have high debt
levels consequently have to potential of turning what might previously
have been stable and sustainable high debt burdens into unstable
unsustainable debt burdens.
The unique degree of independence of the ECB adds a further
complication to such contagion inside the euro area. Its independence
derives from Article 282 of the EU Treaty,\11\ which states that the
central bank ``shall be independent in the exercise of its powers and
in the management of its finances. Union institutions, bodies, offices
and agencies, and the governments of the member states shall respect
that independence.'' With Treaty-defined independence, the ECB is more
akin to a Supreme Court than a central bank in the mold of the U.S.
Federal Reserve, whose independence is derived from the Federal Reserve
Act passed by Congress (which Congress expressly reserves the right to
amend, alter, or repeal).\12\ The ECB has no political masters and the
EU Treaty moreover bars bar elected officials from criticizing its
decisions.
In a sovereign and financial crisis, such total central bank
independence might actually hinder the restoration of market
confidence, because it might further undermine investors' trust in the
solvency of a government that does not ultimately control its own
central bank, lacks its own currency, and thus has no ultimate lender
of last resort. The European Treaty's Article 123 forbids the ECB to
extend credit to member states, preventing it from issuing any blanket
guarantees for their sovereign debt. Due to the complete independence
of the ECB and the restrictions the EU Treaty places on it, the euro
area thus lacks an important confidence boosting measure in the face of
contagion.
On the other hand, the ECB's independence and status as the only
pan-euro area institution capable of direct forceful action to calm
global financial markets bestows upon the ECB's governing council a
degree of leverage over elected officials in this crisis not seen
elsewhere in the world. This gives the ECB leadership the ability to
engage in horse-trading with democratically elected governments behind
closed doors, where it can quietly demand that government leaders
implement far-reaching reforms. A clear example of this came in August
2011 just ahead of the ECB's initiation of emergency support purchases
of Italian Government debt. The sitting and incoming presidents of the
ECB wrote bluntly to Italian Prime Minister Silvio Berlusconi, stating
that ``the [ECB] Governing Council considers that pressing action by
the Italian authorities is essential to restore the confidence of
investors\13\'' followed by a list of more than 10 specific required
reforms to be implemented by the Italian Government.
The degree of independence and influence of the ECB matters for the
attempts to find an expeditions solution to the euro area fiscal
crisis, as it is actually not in the ECB's interest to act too
decisively to immediately try to end any contagion or the crisis more
broadly. It is not that the ECB cannot step in. There is no asset it
cannot buy, if the governing council agrees. The strategy of allowing
financial market mayhem to pressure European governments is therefore
less risky than it seems. Ultimately, the ECB has the means to calm
markets down but its intention is to do so only to avoid absolute
disaster.
A sweeping preemptive ``helping hand to euro area governments''
under speculative attack would from the perspective of the ECB be
counterproductive, as it would relieve pressure on governments to
reform. The ECB's game is thus not to end the crisis at all costs as
soon as possible, but to act deliberatively to cajole governments into
implementing the crisis solutions it wants. The market volatility seen
accelerating in recent months becomes something not to be avoided, but
to use as a club against recalcitrant and reform-resistant euro area
leaders.
European policymakers therefore today are faced with the acute
challenge of enabling Greece to restructure its unsustainable sovereign
debt, while at the same time ensuring that such an event has no
precedent-setting effects inside the euro area and that contagion among
sovereign debt markets consequently is contained. Ring-fencing Greece
geographically and in the time dimension (i.e., assuring that Greece
will only ever go through a single one-off sovereign debt
restructuring) will require further financial assistance in the coming
years be provided to Greece itself, as well as Portugal and Ireland.
The sizable majority of this support must sensible come from the rest
of the euro area, with some continued financial participation also of
the IMF.
In addition to further restrict contagion, euro area leaders must
device a method which can provide a degree of preemptive financial
support to ``too big to bail out'' euro area members and potentially
lower their primary bond market cost of finance. This is the key aspect
of the current debate surrounding how to utilize the =440bn European
Financial Stability Facility (EFSF) most effectively. However, given
the constraints on and reluctance of the ECB to participate directly in
any such financial support (though for instance providing leverage to
the EFSF) to large non-IMF program countries, the resources available
to euro area leaders will be constrained. Any financial benefits to
large beneficiary countries like Spain and Italy from new euro area
measures will moreover be relatively limited, due to the large weight
inside the euro area itself of the beneficiary countries themselves.
Irrespective of the ultimate format chosen by euro area leaders, the
``correlation between benefactors and beneficiaries'' will be so large
that the financial advantage will be relatively modest. There will be
no euro area ``bazooka'' created from the EFSF.
Ultimately, the euro area will have to rely on its large members to
``bail themselves out'' through a lengthy period of fiscal
consolidation. Financial markets are unlikely to be satisfied with this
outcome, and while the ECB will continue to act as a conditional final
defender of financial stability in the euro area, heightened levels of
uncertainty and volatility will remain a feature of the euro area
sovereign debt and other asset markets several years ahead.
The Euro Area Competitiveness Challenge
The euro area was wrought by merging together in a single currency
a number of highly divergent European economies, and for reasons of
political expediency any binding political euro area rules and
intrusive regulations that could during the euro's first decade have
forced a real economic convergence to occur among divergent euro area
members were abandoned. Cushioned by the seemingly secure access to
cheap financing once inside the euro area, most member states moreover
scaled back the implementation of structural reforms of their national
economies.\14\
The principal exception was Germany, which in the years immediately
after the euro introduction implemented a series of far reaching
reforms of especially its labor markets and pension system.
Consequently, Europe's traditionally strongest and most competitive
economy during the first decade of the euro area gradually pulled
itself even further ahead of most of the other members of the common
currency. A persistent pattern inside the euro area consequently became
the widening current account imbalances with Germany and other Northern
members running surpluses and especially the Southern peripheral
members running deficits (figure 4).
[GRAPHIC(S)] [NOT AVAILABLE IN TIFF FORMAT]
Financing their large external deficits posed few obstacles for
peripheral countries prior to the global financial crisis, even as it
became clearer that the inflows of foreign capital were increasingly
channeled towards financing speculative real estate investments, rather
than adding to new productive asset investments. With the disappearance
of foreign private capital following the onslaught of the global
financial crisis, peripheral euro area deficit countries and their
banks suddenly found themselves instead overwhelmingly dependent on
financial support from the ECB. However, while such central support
will be continuous inside any functioning currency union, a longer term
requirement for peripheral euro area nations to regain competitiveness
and restore external balance (or surplus) remains.\15\ Without
improving external competitiveness and increasing exports/reducing
imports, the euro area periphery will not during their current
prolonged period of fiscal consolidation be able to restore domestic
economic growth.
Inside a currency union without the ability to devalue their
currency against major trading partners, peripheral euro area members,
however, do not have access to the traditionally fastest and most
effective way through which a country can regain external
competitiveness.\16\ Consequently, the euro area peripheral countries
only have means at their disposal to increase the competitiveness that
might be effective in a longer term framework. Such measures include
numerous traditional ``supply-side structural reforms'' of especially
peripheral euro area labor markets, where the often legally sanctioned
coercive power of labor unions, the rigidity of collective bargaining
agreements and automatic wage indexation to the public sector must be
curtailed. Nominal wage levels at the firm level must be brought into
line with productivity, an effort which in numerous instances will lead
to nominal wage cuts.
European policymakers face a competitiveness challenge today in
which the precise requirements of the euro area periphery to regain
their external competitiveness and for the euro area as a whole to
limit intra-euro area imbalances will vary depending on individual
country circumstances and require additional measures in surplus
countries (such as Germany), too. It is furthermore evident that
available policy options inside a currency union are of a structural
reform character. Such reforms can only hope to be effective in raising
competitiveness and potential economic growth rates in the medium term,
and will indeed in the short term, though for instance required nominal
wage declines, hurt economic growth.
The Euro Area Banking Crisis
The first manifestations of a banking crisis in the euro area in
Ireland in 2008 had relatively few pan-euro area elements about it. The
Irish real estate boom was clearly supported by the record low negative
real interest rates in the country following the introduction of the
euro (figure 5), but the 2008 collapse of the Irish banking sector and
subsequent required rescue of the Irish Government by the EU and IMF
was overwhelmingly due to domestic Irish domestic factors and
failures.\17\ That on the other hand is not true of the most recent
volatility to affect the euro area banking system.
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Several systematic ailments that plaque the euro area banking
system are illustrated in table 1; First of all, the euro area's
banking system is very large relative to the size of the overall home
economies with average euro area financial institutions' gross debt
equal to 143 percent of GDP (U.S. equal 94 percent). Second, euro area
bank leverage is very high at tangible assets at 26 times common equity
(U.S. level is at 12 times); and third, euro area banks tend to own a
lot of the debt issued by their own governments (something U.S. banks
do to a much smaller degree).
[GRAPHIC(S)] [NOT AVAILABLE IN TIFF FORMAT]
The sheer size of the euro area banking system makes it--as
illustrated in Ireland in 2008-10--problematic for individual already
indebted euro area governments to credibly issue guarantees to stand
behind their domestic banks in a crisis. This issue is aggravated by
the low level of common equity (core tier 1) capital in the euro area
banks. With low private shareholder risk capital levels in euro area
banks, euro area governments risks being frequently called upon to
rescue domestic banks as only a thin layer of private equity capital is
available as first-loss risk capital. Disproportionally large capital
injection requirements are another risk to euro area tax payers in
rescues of thinly capitalized banks. There is consequently across the
euro area a large degree of interdependence between the financial
solidity of large domestic banking systems and national government
solvency.
The bank large ownership of government debt in the euro area
presents a particularly intractable concern. Euro area (and other)
banks are under the Basle Agreements not required to set aside any risk
capital to offset any future losses on government bond holdings.
Sovereign bonds have by definition been deemed ``risk free.''
Consequently, when Greek Government debt must be restructured, it will
impose upon the euro area banks credit losses for which they have
previously not set aside capital, and given the scale of ownership of
such debt among domestic Greek banks will require that these be
recapitalized with money from international donors. The same dynamic is
inevitable across essentially all euro area members, as the domestic
banking system will face ruinous capital losses if national sovereign
debt is restructured, due to the high domestic government debt
ownership.
Fearful that banks would require very large amounts of new equity
capital, which would in many instances have to come from governments
themselves and might therefore pose a challenge to some governments'
own solvency, European banking regulators have been reluctant to
include any potential impairment of banks' sovereign debt holdings in
EU bank stress tests in 2010 and 2011. Given, however, the justified
market concerns about the solvency of at least one euro area sovereign
(Greece) and the potential for contagion to other euro area sovereign
bond markets, stress tests that do not include the potential for losses
on sovereign bonds cannot provide a credible measure of the riskiness
of any euro area banking system. As long as solvency concerns exists
about euro area governments, a high degree of volatility will surround
the euro area banking system, which again provide a powerful feedback
loop to increased investor fears about the financial stability of
governments in the first place.
Last, in addition to low capital levels and associated concerns,
many euro area banks also suffer from substantial liquidity risks with
high degrees of dependence on short-term wholesale funding from markets
where access may prove ephemeral and subject to rapid changes.
Euro area governments face the challenge of rapidly having to
stabilize their oversized and in the aggregate undercapitalized banking
systems without having to dispend large amounts of capital themselves,
as this could further jeopardize their own solvency. Further
postponement today of forceful measures to stabilize the euro area
banking system with new outside capital risks throwing the euro area
into an accelerating credit crunch as banks de-lever and conserve their
scarce capital. This would rapidly have a strongly detrimental effect
on the broader growth prospects of the euro area.
Not all euro area governments are in the same situation though, as
for instance the German Government would quite easily be able to manage
an even very large government-led recapitalization of its national
banking system. However, due to the close linkages among sovereigns
(and consequently their banking systems) inside the euro area and the
observable presence of contagion between them, a key challenge for
European policymakers will be to move expeditiously to a new system of
tougher pan-European banking support, regulation and supervision. The
establishment of a new set of common regulatory institutions for the
European banking system will, however, due to the obvious implications
potential government financial crisis support for banks have for
governments' own solvency require a new level of fiscal integration in
the euro area and the commensurate loss of national fiscal sovereignty.
The fact that the city of London, the EU and euro area financial
center, is located in the U.K., which can safely be assumed to remain
outside the euro area itself for the foreseeable future, further
complicates this type of banking sector integration initiatives.
----------------
End Notes
1. Available at http://aei.pitt.edu/1002/1/
monetary_werner_final.pdf.
2. Available at http://aei.pitt.edu/1007/1/monetary_delors.pdf.
3. Available at http://www.eurotreaties.com/maastrichtec.pdf.
4. See Kirkegaard (2010) at http://www.piie.com/publications/pb/
pb10-25.pdf.
5. The actual numerical reference values to article 104c of the
Maastricht Treaty are in a Protocol on the Excessive Deficit Procedure
to the Treaty. Available at http://www.eurotreaties.com/
maastrichtprotocols.pdf. The Maastricht Convergence Criteria for euro
area membership eligibility include three additional metrics; inflation
(within 1.5 percent of the three EU countries with the lowest inflation
rate); long-term interest rates (within 2 percent of the three lowest
interest rates in the EU); and exchange rate fluctuations
(participation for two years in the ERM II narrow band of exchange rate
fluctuations).
6. See EU Council Conclusions March 23rd 2005 at http://
www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/84335.pdf.
7. See IMF press release 11/374 at http://www.imf.org/external/np/
sec/pr/2011/pr11374.htm and IMF press release 11/330 at http://
www.imf.org/external/np/sec/pr/2011/pr11330.htm.
8. See speech by ECB Vice President Vitor Constancio for a precise
definition and discussion at http://www.ecb.int/press/key/date/2011/
html/sp111010.en.html.
9. Article 123 in the EU Treaty states ``Overdraft facilities or
any other type of credit facility with the European Central Bank or
with the central banks of the Member States (hereinafter referred to as
`national central banks') in favour of Union institutions, bodies,
offices or agencies, central governments, regional, local or other
public authorities, other bodies governed by public law, or public
undertakings of Member States shall be prohibited, as shall the
purchase directly from them by the European Central Bank or national
central banks of debt instruments.''
10. As discussed above, with the vast majority of European citizens
still self-identifying as citizens of their respective countries
(rather than the euro area), a pooling of all the national sovereign
debts of the euro area into a single debt instruments--similar to what
Alexander Hamilton achieved for the U.S. States war debts in 1790--is
not a realistic political option in Europe at this point. Another
critical political difference is that unlike the war debts incurred by
U.S. States during the Revolutionary War, the outstanding debts of
individual euro area members have not been incurred in order to achieve
a ``common cause.'' The political narrative of seeing such debts
``honored in common'' by all euro area members consequently does not
exist.
11. http://www.ecb.int/ecb/legal/pdf/fxac08115enc_002.pdf.
12. http://www.federalreserve.gov/aboutthefed/section31.htm.
13. Full text of ECB letter to Silvio Berlusconi at http://
www.corriere.it/economia/11_
settembre_29/trichet_draghi_inglese_304a5f1e-ea59-11e0-ae06-
4da866778017.shtml?fr=
correlati.
14. See Duval and Elmeskov (2005) for an in-depth analysis at
http://www.ecb.int/pub/pdf/scpwps/ecbwp596.pdf.
15. It can be seen in figure 4 how peripheral deficits have
declined substantially since 2008. This, however, can be mostly related
to the severe economic contractions experienced in the euro area
periphery, which has temporarily caused import levels to collapse.
16. I shall in this testimony not discuss the option of member
leaving the euro area. I will refrain from this for three main reasons;
first of all, I consider the costs of any country leaving the euro area
as catastrophically high for the country in question, irrespective of
whether it is Greece or Germany. Secondly, it is clear from the
political announcements of all EU leaders that the departure of any
country from the euro area will not be tolerated (such a departure
could prove to have a very serious contagion effect). And thirdly, as
under the current EU Treaty, the departure from the euro area is
legally undefined and thus presumed impossible.
17. See the Nyberg Report at http://www.bankinginquiry.gov.ie/
Documents/Misjuding%20
Risk%20-
%20Causes%20of%20the%20Systemic%20Banking%20Crisis%20in%20Ireland.pdf.
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