[Senate Hearing 112-609]
[From the U.S. Government Printing Office]
S. Hrg. 112-609
THE FUTURE OF THE EUROZONE: OUTLOOK AND LESSONS
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HEARING
BEFORE THE
SUBCOMMITTEE ON EUROPEAN AFFAIRS
OF THE
COMMITTEE ON FOREIGN RELATIONS
UNITED STATES SENATE
ONE HUNDRED TWELFTH CONGRESS
SECOND SESSION
__________
AUGUST 1, 2012
__________
Printed for the use of the Committee on Foreign Relations
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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
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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
Burwell, Frances G., Ph.D., vice president and director of the
Program on Transatlantic Relations, Atlantic Council,
Washington, DC................................................. 5
Prepared statement........................................... 8
Responses to questions submitted for the record by Senator
John F. Kerry.............................................. 56
Johnson, Simon, Ph.D., Ronald A. Kurtz Professor of
Entrepreneurship and Professor of Global Economics and
Management, Mit Sloan School of Management, Cambridge, MA...... 25
Prepared statement........................................... 27
Shaheen, Hon. Jeanne, U.S. Senator from New Hampshire, opening
statement...................................................... 1
Prepared statement........................................... 3
Veron, Nicolas, senior fellow, Bruegel, visiting fellow, Peterson
Institute for International Economics, Washington, DC.......... 11
Prepared statement........................................... 13
Responses to questions submitted for the record by Senator
John F. Kerry.............................................. 55
(iii)
THE FUTURE OF THE EUROZONE:
OUTLOOK AND LESSONS
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WEDNESDAY, AUGUST 1, 2012
U.S. Senate,
Subcommittee on European Affairs,
Committee on Foreign Relations,
Washington, DC.
The subcommittee met, pursuant to notice, at 2:30 p.m., in
room SD-419, Dirksen Senate Office Building, Hon. Jeanne
Shaheen (chairman of the subcommittee) presiding.
Present: Senators Shaheen, Barrasso, and Risch.
OPENING STATEMENT OF HON. JEANNE SHAHEEN,
U.S. SENATOR FROM NEW HAMPSHIRE
Senator Shaheen. Good afternoon, everyone. I think half of
our audience is out watching the Olympics, so folks should feel
free to move up if you would like to do that and not worry
about all of the empty seats. That way you can see and hear a
little better.
Let me open this hearing this afternoon of the Senate
Foreign Relations Subcommittee on European Affairs. We're here
today to discuss one of the most critical issues that faces the
global economy and that's the ongoing crisis in the eurozone.
We're delighted to have our three very experienced and
knowledgeable panelists with us.
How Europe responds to this crisis and the lessons we draw
from these events will have dramatic implications, not only for
Europe, but also across the broad spectrum of U.S.-Europe
relations, including political, financial, trade, and security
issues. In today's global economy, Europe remains by far
America's biggest and most important ally. Europe is the United
States largest trading partner and export market. The
businesses and employers in most of our States rely heavily on
investment from European companies and purchases by European
consumers. That's certainly true in my home State of New
Hampshire, where three of the top six export markets for our
businesses are in Europe, and cross-border investments mean
thousands of jobs in my home State.
If there is one lesson we've learned over the past year,
it's that Europe continues to matter a great deal to the U.S.
economic engine and our prospects for growth. We've seen the
eurozone crisis and economic contraction in Europe drag down
the American recovery with transatlantic trade and investment
flows slowing and financial fears in Europe contributing to
volatility in U.S. capital markets.
Since 2009, eurozone leaders have undertaken a variety of
efforts aimed at curbing the negative effects of the crisis and
stemming possible contagion to larger eurozone countries,
including Italy and Spain. At the latest round of critical
summits over the last year, eurozone members agreed to begin
moving toward a unified banking system and a single bank
supervisor for the eurozone. Starting with ailing Spanish
banks, leaders also attempted to break the vicious cycle
between banks and sovereigns by agreeing to inject cash
directly into banks, rather than putting governments on the
hook for bailout funds.
Despite these efforts, we've not seen any calming of
European markets for any significant period of time, and the
euro seems to be entering a new phase of difficulties. Spanish
and Italian debt is coming under renewed attack by the markets.
There are rising questions about Greece's ability to meet its
debt conditions. Europe's banking woes continue to fester. Last
week Moody's downgraded its outlook from stable to negative for
Germany, the Netherlands, and Luxembourg.
It is reassuring that the ECB president last week said that
the bank will do whatever it takes within its mandate to
preserve the euro, and in addition Chancellor Merkel's call for
more Europe and a fiscal and political union indicate German
interest in moving toward further European integration. These
important statements have calmed nervous investors and may
provide some room for governments to take action in the weeks
and months ahead.
As Europe struggles to get ahead of this issue, it's
incumbent on us to draw lessons from the ongoing struggle.
First, it's important to recognize that this crisis is not the
result of any single cause. Some continue to argue that Europe
got here because of runaway spending. Now, that is an easy
bumper sticker response, but the truth is much more complex, I
think. The fact is that slow growth, several banking crises,
real estate bubbles, a lack of competitiveness, institutional
problems, and a high debt have all contributed to what we face
today.
Understanding this fact leads to another lesson. Austerity
alone can't solve the complex series of problems. Long-term
growth, competitiveness, and structural reform all need to play
a role in the solution. Austerity-only will not work and can
lead to steeper borrowing rates and lower revenues, making the
longer term challenges even more difficult.
At the end of the day, the bottom line is that America
needs a strong Europe and vice versa. After two devastating
world wars, the United States and the transatlantic community
have spent countless resources over nearly six decades to help
bring about a Europe that is whole, free, and at peace. America
made these commitments because a stable, secure, and prosperous
Europe is in our own vital interests.
We need to coordinate where we can to support our European
partners as they do what's necessary to put these crises behind
them and resume creating growth and jobs on both sides of the
Atlantic.
The subcommittee looks forward to engaging on these
critical questions in the next hour or hour and a half. Before
I introduce our distinguished panel, I would like to turn to my
colleague, the ranking member of the subcommittee, Senator
Barrasso, for his comments.
[The prepared statement of Senator Shaheen follows:]
Prepared Statement of Senator Jeanne Shaheen
The Senate Foreign Relations Subcommittee on European Affairs meets
today to discuss one of the most critical issues facing the global
economy today: the ongoing crisis in the eurozone. How Europe responds
to this crisis and the lessons we draw from these events will have
dramatic implications, not only for the future of Europe, but also
across the broad spectrum of U.S.-Europe relations, including
political, financial, trade, and security issues.
Reflecting the importance of this issue to the United States, this
is the third hearing we have held in this subcommittee on the
transatlantic economic and trade relationship in the wake of this
ongoing crisis. Today, we have an impressive panel of witnesses to
guide us through some of the lessons learned from this continuously
evolving situation and to assess the outlook for Europe as we consider
the near-term future.
In today's global economy, Europe remains by far America's biggest
and most important ally. Europe is the United States largest trading
partner and export market. Together, the transatlantic economy accounts
for over half of world GDP, one-third of world trade and three-quarters
of global financial services. The businesses and employers in most of
our States rely heavily on investment from European companies and
purchases by European consumers. In New Hampshire, three of the top six
export markets for our businesses are in Europe, and cross-border
investments mean thousands of jobs in my State.
If there is one lesson we have learned over the past year, it is
that Europe continues to matter a great deal to the U.S. economic
engine and our prospects for growth. We have seen the eurozone crisis
and economic contraction in Europe drag down the American recovery with
transatlantic trade and investment flows slowing and financial fears in
Europe contributing to volatility in U.S. capital markets. As President
Obama suggested this week, ``Europe is still a challenge'' and as a
result, the United States is ``going to have some continued
headwinds.''
Since 2009, eurozone leaders have undertaken a variety of efforts
aimed at curbing the negative effects of the crisis and stemming
possible contagion to larger eurozone countries, including Italy and
Spain. We have seen financial assistance packages for Greece, Portugal,
and Ireland, a significant restructuring of Greek debt and an increase
in the firepower of a permanent Europewide rescue fund. In addition,
the European Central Bank (ECB) took unprecedented steps over the
winter to increase liquidity, including the offer of unlimited short-
term loans to European banks, which has pumped more than $1 trillion of
capital into the banking system.
At the latest of a round of critical summits over the last year,
eurozone members agreed to begin moving toward a unified banking system
and a single bank supervisor for the eurozone. Starting with ailing
Spanish banks, leaders also attempted to break the ``vicious cycle''
between banks and sovereigns by agreeing to inject cash directly into
banks, rather than putting governments on the hook for bailout funds.
Despite these efforts, we have not seen a calming of European
markets for any significant amount of time, and the euro seems to be
entering a new phase of difficulties.
Spanish and Italian debt is coming under renewed attack by the
markets. There are rising questions about Greece's ability to meet its
debt conditions. Europe's banking woes continue to fester. Last week,
Moody's downgraded its outlook from stable to negative for Germany, the
Netherlands, and Luxembourg.
It is reassuring that the ECB President last week said that the
bank will do ``whatever it takes'' within its mandate to preserve the
euro. In addition, Chancellor Merkel's call for ``more Europe'' and a
fiscal and political union indicate German leadership interest in
moving toward further European integration. These important statements
have calmed nervous investors and may provide some room for governments
to take action in the weeks and months ahead.
As Europe struggles to get ahead of this issue, it is incumbent
upon us to draw lessons from the ongoing struggles.
First, it is important to recognize that this crisis is not the
result of any single cause. Some continue to argue that Europe got here
because of runaway spending. Now, that is an easy bumper sticker
response, but the truth is much more complex. We are witnessing a
multifaceted, interrelated series of crises, including financial,
political and fiscal problems.
There is little doubt that in Greece, profligate spending and a
lack of a mature revenue generating system resulted in unsustainable
debt and sky-rocketing borrowing rates. However, the same cannot be
said for Spain, which was previously running a budget surplus and in
2011, had a manageable public debt total of around 68 percent of GDP.
Despite the relatively solid fiscal situation, Spain now also faces
market pressures. The fact is that slow growth, several banking crises,
real estate bubbles, a lack of competitiveness, institutional problems
and high debt have all contributed to the problems we face today.
Understanding this fact leads to another lesson: austerity alone
cannot solve this complex series of problems. Long-term growth,
competitiveness, and structural reform all need to play a role in the
solution. Austerity-only will not work and can lead to steeper
borrowing rates and lower revenues, making the longer term challenges
even more difficult.
One other important lesson for the United States is that we cannot
wait to tackle our long-term budget challenges. By the time the markets
start raising questions, it becomes much more difficult to restore
credibility. Delay or piecemeal reforms can breed uncertainty and erode
market confidence. Spain, again, is an excellent example where a new
reforming government came to power amid rising costs of borrowing. The
Rajoy administration cut spending, engaged in labor reforms and secured
significant support for its weak banks. Despite the recent impressive
efforts, Spain continues today to face pressure from bond markets,
where on July 25, 10-year bonds reached a euro record of 7.75 percent.
As we move forward, one unanswered question remains for
policymakers here in the U.S.: Considering the importance of Europe to
America's economy, what should we be doing on our side of the Atlantic?
I asked this exact question at our previous hearing. Each one of our
expert witnesses, from across the political spectrum, agreed that the
best action we can take for Europe and for the global economy is to get
our own fiscal house in order. Domestic and international markets
linked closely to the U.S. consumer base would respond positively to a
long-term debt and deficit deal.
It is instructive that markets in Europe reacted quite negatively
to the poor way Congress handled the raising of the debt limit last
summer. In fact, the price of Spanish and Italian borrowing spiked to
well above 6 percent in the leadup to our near-default. Immediately
following the July 31 debt deal in Congress, bond markets throughout
Europe quickly recovered to a much more sustainable 5 percent. This
suggests that a long-term deal in the U.S. would have positive
consequences for Europe, which would lead to even further positive
movement here in America.
This is why we need to continue to work across the aisle and across
the Capitol to get to a balanced, long-term debt deal. As is the case
in Europe, our debt deal last year only bought us a little time. We
need to act.
At the end of the day, the bottom line is that America needs a
strong Europe, and vice versa. After two devastating world wars, the
United States and the transatlantic community have spent countless
resources over nearly six decades to help bring about a Europe that is
``whole, free, and at peace.'' America made these commitments because a
stable, secure, and prosperous Europe is in our own vital interests.
We need to coordinate where we can to support our European partners
as they do what is necessary to put these crises behind them and resume
creating growth and jobs on both sides of the Atlantic. This
subcommittee looks forward to engaging on these critical questions in
the next hour.
OPENING STATEMENT OF HON. JOHN BARRASSO,
U.S. SENATOR FROM WYOMING
Senator Barrasso. Thank you, Madam Chairman. I want to
thank you for your leadership in organizing and holding this
important meeting, and I also want to thank and welcome all of
our experts for being here today to take part in our
subcommittee's second hearing on the Europe debt crisis. Your
experience, your thoughts, your analysis are all very valuable
to us and to these discussions.
The hearing today is meant to further our understanding of
the European debt crisis and to carefully consider its
implications for the United States. Since 2009 European leaders
have been struggling to resolve the financial crisis which is
threatening the economic stability of Europe. There have been
numerous bailouts, credit rating downgrades, speculation
regarding possible defaults by different nations, and the
markets have resulted in and experienced great volatility and
uncertainty as a result.
Despite the efforts and reforms being implemented, Europe
continues to face serious problems. In the month of June, the
Government of Cyprus sought financial assistance and European
leaders needed to bail out Spanish banks. Now there are
concerns that the Governments of Spain and Slovenia will also
be seeking financial assistance.
Like many Americans, I'm concerned about the situation
taking place in the eurozone. The problems facing Europe can
have a significant and a substantial impact on the United
States due to the interconnected nature of our economies.
The United States must take the opportunity to learn from
what is happening in Europe. We must clearly identify the risks
and work together to limit the fallout from the crisis here at
home.
So I look forward to hearing from the witnesses, Madam
Chairman, about the possible risks to the U.S. economy, about
transatlantic trade, and international security. So thank you
again, Madam Chairman.
Senator Shaheen. Thank you, Senator Barrasso. Hopefully,
they will have some good news for us.
First on our panel is Dr. Frances Burwell. She is the vice
president and director of the Program on Transatlantic
Relations at the Atlantic Council here in Washington. Dr.
Burwell is a long-time friend of the subcommittee and she has
an impressive background in U.S.-EU relations and expertise on
political and economic dynamics at play in the eurozone.
Next is Nicolas Veron, a French economist who is currently
a visiting fellow at the Peterson Institute for International
Economics, as well as a senior fellow at the world-renowned
Bruegel, a Brussels-based economic policy think tank. Mr. Veron
has held various positions throughout the public and private
sectors, including as an adviser to the French Labor Minister,
as well as an independent financial services consultant.
Finally today, Professor Simon Johnson is the Ronald A.
Kurtz Professor of Entrepreneurship and a professor of Global
Economics and Management at the MIT Sloan School of Management
in Cambridge, MA. Previously, Professor Johnson served at the
International Monetary Fund as its economic counselor and
director of the IMF Research Department. Professor Johnson is
also a senior fellow at the Peterson Institute.
Thank you all very much for being here. We look forward to
your testimony.
Dr. Burwell, would you like to begin.
STATEMENT OF FRANCES G. BURWELL, PH.D., VICE PRESIDENT AND
DIRECTOR OF THE PROGRAM ON TRANSATLANTIC RELATIONS, ATLANTIC
COUNCIL, WASHINGTON, DC
Dr. Burwell. Thank you very much. Chairwoman Shaheen,
Ranking Member Barrasso, members of the subcommittee, I am
honored to appear before you today to speak about the evolving
crisis in the eurozone. I will focus my remarks on the
political aspects of the crisis, including the lessons learned
and ramifications for Europe and transatlantic relations.
I believe this crisis is as much about politics as it is
about economics. It is the reckoning for Europe's political
failure to establish credible governance for economic and
monetary policy when the euro was created. The crisis will be
resolved only when the governments agree on who has the
political power to set policy in the eurozone.
During the last 2 years, European governments have lacked
the right mechanisms and institutions to respond to the crisis.
They have taken significant strides recently, including
creating the EFSF and ESM, agreeing on the fiscal compact, and
as was mentioned earlier, deciding to undertake European-level
supervision of major banks.
But progress has been slow, incremental, and some would say
tortuous. This is my first lesson of the crisis: EU
decisionmaking is difficult and will remain so. We will not
wake up any day soon and find that the crisis is resolved.
Because of the difficulties in reaching decisions among the 27
members, muddling through is likely to be the optimal policy
choice.
My second lesson is that European leaders are more
concerned with reaching agreement among themselves on internal
reforms than with responding to external pressures. For many
European politicians, getting ahead of the market is not the
objective. Rather, the objective is ensuring structural reforms
in the weaker economies.
My third lesson is that the crisis itself is essential to
reaching decisions. In Europe the 27 leaders only make tough
decisions when standing on the edge of the precipice. When the
German vice chancellor comments that a Greek departure from the
eurozone has lost its horror, we should remember that it may
reflect that person's views, but it also is a very useful
threat as everyone shows up to tell Greece that it's time to
make reforms. Intra-European negotiations are not for the
faint-hearted.
My fourth lesson is that decisionmaking in the EU must
reconcile very different national experiences. Only a few years
ago, Germany had one of the weakest economies in Europe,
something that the German public blamed on the vast financial
transfers given to the new eastern lander. Germany undertook
serious reforms, including raising the pension age, and they
now expect Greece to do the same.
What does all this mean for the future of Europe and the
eurozone? First, we will be dealing with this crisis for some
time to come, probably 2 years more at least, if not longer.
What is likely to emerge very gradually is a much more
integrated eurozone, a core group of countries that has
undergone serious structural reform, but growth will be slow to
return.
This core is likely to be similar to the current eurozone.
I see Greece as the only member seriously at risk of leaving.
The others will not overtly push Greece and the Greek
politician who takes that country out of the eurozone will be
committing political suicide. Most other EU countries are
pledged to join the euro and will work to make it stronger.
Those who've opted out, however, may find themselves on the
periphery. Britain especially seems likely to drift farther
from the EU, with consequences for itself and for Anglo-
American relations.
Some observers have warned of a rise of nationalism as a
consequence of the crisis, but I am actually much more
concerned that weak European economies may become targets for
investors that may erode good business practices and undermine
economic policy. Regional energy firms may be more vulnerable
to investments by Gazprom and others, and we have seen the
Chinese make a significant investment in the Greek port of
Piraeus. The Cypriot Government is using the offer of a Russian
loan to try to secure better terms for an EU bailout.
What are the consequences of this crisis with the United
States and its relationship with Europe? First, there is little
we can do to affect the course or speed of European
decisionmaking. Calls for Europe to lessen the rigors of
austerity or make speedier decisions will be largely ignored,
since the pressure is on them to negotiate among themselves.
Instead, we should focus on the new processes and
institutions in Europe and how they might affect U.S. firms and
regulations. Previous consultations between Congress and the
Europe Parliament on financial services regulation should be
strengthened. We should continue to consult closely about
potential contingency plans.
Second, I also believe that the United States and the
European Union face a significant opportunity in the form of a
bilateral trade and investment initiative, which could
stimulate growth and create jobs on both sides of the Atlantic.
It seems counterintuitive to talk about such an initiative now
with the eurozone in the midst of crisis, but the removal of
tariff and investment barriers and regulatory obstacles should
add to the GDP of both regions at a time when that is much
needed.
Third, we should continue to work with the Europeans to
push forward the agenda of the G20. Many of the emerging
economic powers regard this crisis as a European or North
Atlantic phenomenon. The United States and Europe should work
together to ensure that the commitments made on Los Cabos are
addressed equally among all the G20.
The crisis seems not to have eroded Europe's role as a
foreign policy partner of the United States. On Libya,
Afghanistan, Iran, and Syria, the Europeans continue to be very
active, if not leaders. I would just point to the recent EU
sanctions on Iranian energy exports and, despite the fact that
Iran has supplied several EU countries, including Greece, which
had previously received one-third of its oil from Greece--I
mean from Iran, sorry. These are sanctions that have a real
cost for European countries.
However, the financial crisis has precipitated a crisis in
European defense capabilities. We have heard a steady drumbeat
of budget cuts, forcing the abandonment of real capabilities
among European militaries. It seems likely that our Europe
allies will have limited capabilities for deployment in the
next few years. The impact of a long-term decline in European
defense capabilities as a result of this crisis should be a
priority topic among U.S. and European leaders.
Finally, Europe remains a key partner of the United States.
It is the largest economy in the world and, as Senator Shaheen
mentioned at the beginning, our leading partner in trade and
investment. The eurozone crisis will change the transatlantic
relationship, but it should not define that relationship. With
global wealth and power shifting away from the North Atlantic,
this crisis can either divide the United States and Europe,
leaving us both with reduced influence in the world, or it can
be an opportunity for reforming and strengthening our economies
and our partnership to remain globally competitive.
Madam Chairman, Dr. Barrasso, members of the subcommittee,
thanks for the opportunity to share my views. I look forward to
your questions.
[The prepared statement of Dr. Burwell follows:]
Prepared Statement of Frances G. Burwell
Chairwoman Shaheen, Ranking Member Barrasso, members of the
subcommittee, I am honored to appear before you today to speak about
the evolving crisis in the eurozone. Since both my colleagues are
accomplished economists, I will let them address the economics of the
crisis, and will focus my remarks on the political aspects, including
the lessons learned and the ramifications for the future, both for
Europe and for transatlantic relations.
I believe this crisis is as much about politics as it is about
economics. Its origins are to be found in a political failure to
establish credible governance for economic and monetary policy, and
European leaders have dealt with the crisis through a series of
decisions about political power rather than economic measures. In the
end, the crisis will continue for some time to come--not just months,
but at least a year and probably two--and will be resolved only when
the governments agree on who has the power to set economic and monetary
policy in the eurozone.
The euro, just like the European Union itself, all the way back to
the European Coal and Steel Community, was an economic initiative
designed primarily to achieve a political purpose. It was less about
the creation of a currency based on economic demand, but rather about
taking another step toward ``ever closer Union.'' At the time, many
economists expressed skepticism, especially given the different
approaches to monetary policy within the eurozone, but the politicians
went ahead. And the euro has been a tremendous political success, as an
important symbol of European integration, and rising significantly
against the dollar during its lifetime. The current crisis is the
reckoning, however, for Europe's failure to establish effective
governance when the euro was created.
Throughout the crisis, European governments have been unable to
respond to market pressures because the eurozone has lacked the right
mechanisms and institutions. During the last 2 years, European leaders
have instead focused on creating those mechanisms and institutions.
They have taken significant strides, including: adopting a ``six pack''
of measures establishing European level budget oversight, a fiscal
compact that requires national balanced budget amendments; and most
recently deciding to undertake European level supervision of major
banks, a step which may lead to an eventual banking union. But progress
has been slow and incremental, some would say torturous. This is my
first lesson from the crisis: EU decisionmaking is difficult and will
remain so. We will not wake up any day soon and find the eurozone
crisis solved. Because of the difficulties of reaching decisions among
the 27 members, muddling through is likely to be the optimal policy
choice.
My second lesson is that European decisionmaking is more concerned
with reaching agreement among members on internal reforms than with
responding to external pressures. Not only does the difficulty of the
decisionmaking process make it almost impossible for the eurozone to
``get ahead of the market,'' but I have been struck by the number of
Europeans who have told me that responding to the market is not the
objective. Rather the objective is ensuring structural reforms in the
weaker European economies which will eventually allow for a more
unified economic policy approach, and eventually perhaps mutualization
of debt, which is widely seen as the ultimate solution, but is
currently politically impossible.
My third lesson from the crisis is that the crisis itself is
essential to reaching decisions. We often assume that reaching
decisions is harder during times of stress, but at least in Europe,
that stress forces the 27 leaders to understand that some movement is
required. Jacob Kirkegaard and Fred Bergsten have written about this in
the current crisis, but speaking as someone who has watched the EU for
many years, I can vouch that crisis is often a necessary ingredient to
moving Europe forward across all sorts of issue areas. We should also
remember, when assessing statements from European leaders that seem
extreme--such as the German vice chancellor's comment that a Greek
departure from the eurozone has ``lost its horror''--that while it may
reflect that person's views, it is also a useful threat just before the
``troika'' arrives to tell Greece it must proceed with difficult
reforms. Intra-European negotiations are not for the faint-hearted.
My final lesson is that decisionmaking in the EU must reconcile
very different national domestic situations. Every country brings its
own experiences to the negotiating table. While Greece, Spain,
Portugal, and Italy are genuinely hurting in terms of unemployment and
general economic stress, Germany and others in northern Europe remain
very comfortable. Yet only a few years ago, Germany had one of the
weakest economies in Europe--a situation that the German populace
blamed on the generous economic transfers given to the new, eastern
part of their country after unification. They also experienced
difficult economic reforms, including raising the pension age and
making it easier to fire workers. It is no wonder that the average
German is not willing to transfer financial resources to Greece before
that country has undergone reforms similar to those Germans experienced
themselves. Angela Merkel faces elections in fall 2013, but I for one
am not worried about her chances: her approval rating recently reached
66 percent and only in the last few days has there been much public
criticism of her handling the economic crisis.
What does all this mean for the future of Europe and the eurozone,
and most importantly for this committee, for the United States and its
partnership with Europe? First, we will be dealing with this crisis for
some time to come, probably 2 years at least and perhaps longer. What
is likely to emerge very gradually is a much more integrated eurozone,
providing Europe with a core group of countries that have undergone
serious structural reform. But growth will be slow in returning.
At the end of the crisis, the core group will not be much smaller
than the current eurozone; I see Greece as the only member seriously at
risk of leaving. In that situation, the other members will make sure
that Greece is not pushed but rather that Greek politicians decide to
leave the eurozone. Given the popularity of the euro in Greece, this
would be political suicide. Thus, the EU will effectively become three
clubs: those in the eurozone; those pledged to join at some point in
the future, that is, the ``Euro aspirants''; and those who have opted
out of joining the euro: Britain, Denmark, and Sweden. Most of the Euro
aspirants, largely the new central European members, will stay closely
engaged, seeking to influence the rules of the club they seek to join.
But Britain and Denmark may drift farther from the EU, especially
Britain, which is also not in the Schengen visa regime. That potential
for drift should be taken into account as we look at the future of
U.S.-UK relations.
Some observers have warned of a rise in nationalism as a
consequence of the financial crisis. It is true that any prolonged
economic malaise is likely to lead some in societies to become more
alienated. Europe is also going through a significant change in its
ethnic makeup which is adding additional strains to its social fabric.
However, in Portugal, Spain, Slovakia, and eventually in Greece, the
voters opted primarily for mainstream parties committed to austerity.
Even in France, the vote for M. Hollande seems to have been less
against austerity than against Nicholas Sarkozy. The Front National
received its highest tally ever in the first round this year, but they
did not make it into the second round as they did in 2002, and they
have far fewer seats in the Assemblee Nationale than they did in the
1980s. In the Netherlands, Geert Wilders caused a government crisis by
withdrawing the support of his Freedom Party, but he also made it very
unlikely that he will ever be included in a governing coalition again,
even informally. Currently the left-center Socialist Party is leading
in the polls with the election on September 12.
The outlook for right wing nationalist parties is mixed; indeed, we
may see the rise of more left-wing extremism if austerity policies
continue. One big uncertainty is Greece, which has a long tradition of
anarchism and where Golden Dawn did better than ever in the most recent
elections. But we should remember that in parliamentary systems, with
the government and their parliamentary party unified, there is little
role for parties that are not part of the government. Finally, the
social safety net in most European countries gives the unemployed a
relatively secure existence. Thus, my more serious concern is not with
right-wing extremism, but with new immigrants, especially from the
Muslim world, who are faced with few available jobs and difficulties
integrating into society, and who fall prey to radicalism.
More serious than the prospect of European extremism is the
potential for weak European economies, especially in the south and
east, to become investment targets for companies and countries that may
weaken adherence to good business practices and undermine economic
policy. This is particularly true in the energy sector, where the need
to privatize state energy firms may lead to purchases by Gazprom and
other Russian firms just when Europe is making strides in reducing its
energy dependence. We have also seen the Chinese make a significant
investment in the Greek port of Pireaus, and it is reported that they
are looking for other opportunities as Greece undertakes more
privatization. And most recently, the Cypriot government, while in the
EU Presidency, is using the offer of a Russian loan to try to secure
better terms for an EU bailout of its faltering economy.
What are the consequences of the eurozone crisis for the United
States and its relationship with Europe? First, there is little we can
do to affect the course or speed of European decisionmaking. Calls for
Europe to lessen the rigors of austerity or to make speedier decisions
will be largely ignored as the Europeans negotiate among themselves.
Instead, we should focus on the new processes and institutions in
Europe and how they might affect U.S. firms and U.S. regulations. There
has already been some cooperation between Congress and the European
Parliament on financial services regulation, and this should be
strengthened as Europe now examines the possibility of a banking union,
and possibly other measures such as a financial transactions tax. We
also need to continue the close consultation already developed between
European leaders and the U.S. officials about what is happening in the
crisis--especially concerning large cross-border banks--and potential
contingency plans.
Second, we should avoid making the European financial situation
seem more dire than it actually is. This only stimulates the markets
into erratic behavior, but does not push European leaders toward
finding a resolution. Instead, I believe the United States and European
Union face a significant opportunity in the form of a bilateral trade
and investment initiative, which could stimulate growth and create jobs
on both sides of the Atlantic. It seems counterintuitive to launch such
talks with the eurozone in the midst of crisis, but the removal of
tariff barriers, investment protections, and regulatory obstacles
should add to the GDP of both regions at a time when that is much
needed.
Third, we should continue to work with the Europeans to push
forward the agenda of the G20. Many of the emerging economic powers
regard this crisis as a European or North Atlantic phenomenon. Yet,
taking the lessons of our 2008 crisis and the eurozone crisis and
applying them in a global framework--as outlined in the declaration of
the Los Cabos 2012 summit--is an important task. There are many topics
addressed, but just to mention that they include labor reforms, country
surveillance, enhancing transparency of credit ratings agencies, and
tracking financial sector reforms makes clear that the United States
and Europe should work together to ensure that they are addressed
equally among the G20 membership.
The eurozone crisis affects Europe, not only as an economic
partner, but also as a foreign policy partner of the United States.
There is no doubt that the policymaking bandwidth among European
governments has been overwhelmed by the crisis. When European leaders
meet--as they do very frequently--most of the agenda is focused on
economic issues. Yet, the crisis was already well underway when
European leaders pushed for the NATO operation in Libya and dedicated
significant personnel and armaments to the cause. And Europe has
continued to be an effective foreign policy partner on certain key
policies.
On Iran, the EU Vice President/High Representative Catherine Ashton
continues to lead the efforts of the EU 3 plus U.S., Russia, and China
in negotiating with Tehran. The EU has recently imposed sanctions on
Iranian energy exports, despite the fact that Iran has been a supplier
to several EU countries. The EU had to make compensatory arrangements
for Greece, which had previously received one-third of its oil from
Iran. These are sanctions that have a real cost for European countries.
The EU stopped SWIFT, the Belgian financial transactions clearing
house, from dealing with Iranian banks, a move that may have long-term
consequences for that institution. The EU has also imposed sanctions on
the Assad regime in Syria and with the United States has argued for
more sanctions at the U.N. The EU naval mission ATALANTA continues to
patrol against pirates off the horn of Africa, while a small, new
mission is aimed at training local coast guards to undertake antipirate
patrols. The EU and several of its member states have also reached out
to the countries undergoing transitions in the Arab world. A new trade
agreement has been launched with Morocco, but it remains to be seen if
the EU will lessen barriers sufficiently for Tunisia, Libya, and Egypt.
But if the crisis has not taken much of a toll on these foreign
policy initiatives, it has had an impact on the future of enlargement,
which is the most successful European foreign policy initiative of the
last 20 years. The crisis has lessened European appetites for bringing
in new members and made the EU less attractive to potential members.
Croatia will join next year as the 28th, but it is unclear when the
next country might be ready to accede. Because the Balkan States are
generally small and there is a feeling of obligation after the conflict
of the 1990s, the Balkans are likely to be approved when ready. But the
crisis has reduced the EU's attraction among some Balkan capitals even
while adding more legislative and regulatory requirements for those
seeking to join. The crisis has also diminished the possibility that
any of the Eastern Partnership countries might be given a membership
perspective if they wanted it. Finally, I think the crisis has
significantly lessened any chance that Turkey will eventually join the
EU, both because of EU concerns about the cost of such an accession and
Turkish views of Europe in the wake of the eurozone crisis.
Even more important for the United States, the financial crisis has
precipitated a crisis in European defense capabilities. For the past 18
months, we have heard a steady drumbeat of budget cuts forcing the
abandonment of real capabilities among European militaries. These
include the loss of British capability to launch fixed-wing aircraft
off carriers until at least 2018 and the disbanding of the last two
Dutch tank battalions. Despite NATO's efforts to launch a ``Smart
Defense'' initiative at the Chicago summit, it seems likely that our
European allies will have limited capabilities available for deployment
outside the immediate region for the next few years. The ending of the
ISAF mission in Afghanistan will free up some capabilities, but there
will be much reluctance in Europe to undertake global deployments. The
impact of a long-term decline in European defense capabilities as a
result of the eurozone crisis should be a priority topic among U.S. and
European leaders.
Despite the difficulties of the eurozone crisis, Europe remains a
key foreign policy partner of the United States, as is demonstrated by
Iran, Syria, and Afghanistan, among U.S. foreign policy priorities.
Even with the crisis, Europe remains the largest economy in the world,
and the United States leading partner in trade and investment. The
eurozone crisis will change the transatlantic relationship, and in ways
that we do not yet know or understand. But we should not let the crisis
define the relationship. With wealth and power shifting away from the
North Atlantic, this crisis can either divide the United States and
Europe, leaving us both with reduced influence in the world, or it can
be an opportunity for reforming and strengthening our economies so that
they remain globally competitive.
Senator Shaheen. Thank you very much.
Mr. Veron.
STATEMENT OF NICOLAS VERON, SENIOR FELLOW, BRUEGEL, AND
VISITING FELLOW, PETERSON INSTITUTE FOR INTERNATIONAL
ECONOMICS, WASHINGTON, DC
Mr. Veron. Thank you very much, Chairman Shaheen, Ranking
Member Barrasso, Senator Risch, for the opportunity to appear
at today's hearing.
The eurozone has many problems. You mentioned this, Ms.
Chairman, and there are many causes to the present crisis. I
would argue today that the core--very much like Fran Burwell
just said, that political authority is at the core of what
makes this crisis unique, as opposed to other developments that
we have seen in the past decade.
There's a lot of skepticism in the United States about
Europeans' natural tendency to put the emphasis on
institutional issues. But we've been in this crisis for 5 years
now. The banking crisis in Europe started in late July 2007. So
there is something systemic in the policymaking framework of
Europe that has made it difficult or at some points impossible
to tackle the situations at hand, to react decisively, and to
bring the appropriate action.
I think there is good news. For the first time, in recent
weeks European officialdom has been able, or at least some
parts of it have been able, to articulate a holistic agenda to
react to this crisis that takes into account not only the
short-term aspects, but also the long-term ones. Or I could put
this last sentence actually in reverse: Not only the need for a
consistent permanent solution, but also the need for adequate
immediate action. This is what I would call the European
fourfold union, which includes a banking union, a fiscal union,
a competitiveness union, and a political union that underpins
the first three.
The European Union has suffered from a loss of trust along
many dimensions. There has been a loss of trust in the
interbank market, basically disappearance of entire segments of
the interbank markets in Europe, which underpins the current
banking crisis; loss of trust of investors in government debt
and an increasing number of eurozone states perceived for the
first time in the developed world as carrying a credit risk;
loss of trust in the ability of European economies to grow and
the difficulty of undertaking the structural reforms that would
unleash the growth potential of European entrepreneurs and
economic activity; and I have to say a lot of cynicism about
the lack of accountability of the decisionmakers compared to
the wishes expressed by the general public, what the Europeans
generally refer to as the democratic deficit.
But what is important, I think, to understand is the
combination between the inability to make decisions and this
democratic deficit. So I would call it an executive deficit
combined with a democratic deficit, and the two feed each
other. It might sound paradoxical because one typically
believes that having more democratic checks and balances
hampers the ability to make executive decisions, but in Europe
it has been the contrary. The absence of proper democratic
checks and balances has left executive decisionmakers paralyzed
and unable to make the decisions on short-term actions that
were necessary. And this I think is the starting point of the
crisis, has to be the starting point of our analysis.
So it means creating adequate decisionmaking frameworks,
banking union in banking, fiscal union on government finance,
competitiveness union to coordinate and monitor structural
reforms, and political union, which is a very loosely defined
term, but which I would define as providing democratic
accountability, in which I think the Europe Parliament has to
play a central role, but that requires also reform of the
Europe Parliament itself from its current situation, which is
not sufficiently representative of European citizenry, in order
to provide not only checks and balances, but the legitimacy
that is indispensable to make adequate decisions.
It's very difficult to do this at once. One of the problems
of Europe has been the inability in many circumstances to
distinguish between short-term action and long-term action,
between crisis management and the rebuilding of the post-crisis
order, between firefighting and design and construction of a
new policy framework.
I think this distinction--if you will allow me, I will
focus for a brief moment on the banking aspect of the agenda.
This distinction is crucial to both resolving the banking
crisis and building the banking union that most Europe
policymakers have now agreed that they need to introduce.
In terms of the short-term agenda, leaders need to
establish a temporary bank resolution authority for the
eurozone. It has to be temporary because there is no framework
that establishes permanent institutions, there are no existing
institutions that can do the job, and it will take a lot of
time to establish a permanent institution. So having a
temporary thing, like the U.S. Resolution Trust Corporation in
the early nineties, so it's not an exact parallel, or like the
Auto Industry Task Force in 2009, this is the best way in my
view to tackle the systemic crisis.
It's difficult to do. It will require tough choices, but I
think it's possible, and it's necessary. With a successful bank
crisis resolution process, adequate temporary guarantees,
including on deposits, I think it's possible to achieve bank
crisis resolution. But at the same time, Europeans need to
think about the long term and start establishing the single
supervisory mechanism that they have agreed upon and the other
features of a permanent banking union.
The difficulty of this fourfold union agenda is that none
of the four components can be thought about in isolation from
the others. There is a need to make progress in the banking
union, but for this you need to make progress on fiscal union,
because you need a backstop for anything that looks like
deposit insurance at the European level. You cannot do that if
you don't make progress on political union because you need
legitimacy to make progress.
All these interdependencies make it very difficult to
advance, but I think if European leaders are clear-sighted on
the need to make progress on these four fronts--and it's very
complicated, very difficult--they can overcome the crisis.
The breakup of the eurozone, as has been said by many,
would be absolutely disastrous for Europe, for Europeans, and
for the global economy. The successful resolution, of the
crisis will be very difficult. The slow pace of decisionmaking
has already exacted a very large cost for Europe's economies,
societies, and families, and Greece--I'm sure we'll come back
to this--remains an absolutely burning concern with no obvious
short-term solution.
That said, I would say and believe strongly that it's not
too late yet for Europeans to take the actions that would
ensure the survival, sustainability, and ultimately success of
their monetary and economic union, and I trust and expect that
such decisions can and will be made.
Thank you very much.
[The prepared statement of Mr. Veron follows:]
Prepared Statement of Nicolas Veron
Thank you, Chairman Shaheen, Ranking Member Barrasso, and
distinguished members of the subcommittee for the invitation to appear
at today's hearing.
The Eurozone has many problems. Based on the lessons from the past
5 years, I will argue today that the core of the current crisis, what
makes it unique, is Europe's insufficient ability to make authoritative
policy and political decisions for the region as a whole. To correct
this weakness, Europe must build a fourfold union that would allow such
executive decisions to be made. The four components are: (1) a banking
union, (2) a fiscal union, (3) a competitiveness union, and (4) a
political union, i.e., institutional reform to embed democratic
accountability more solidly in the decisionmaking.
In the second part of my testimony, I will explore a few topical
questions about the first of these four components, namely banking
union.
I work both at Bruegel and the Peterson Institute, on a half-time
basis in each organization, and divide my time between Europe and the
United States. Bruegel is a nonpartisan policy research institution
based in Brussels that aims to contribute to the quality of economic
policymaking in Europe through open, fact-based and policy-relevant
research, analysis, and discussion. The Peter G. Peterson Institute for
International Economics is a private, nonprofit, nonpartisan research
institution devoted to the study of international economic policy. The
views expressed here are my own. I have no financial or commercial
interest that would create a bias or conflict in expressing these
views.
The key points of this statement are as follows:
The deterioration of credit conditions in the eurozone stems
less from inadequate decisions than from an absence of
decisions when they were needed. This ``executive deficit'' is
partly a consequence of the European institutions' lack of
democratic accountability, often referred to in Europe as
democratic deficit. It also contributes to a loss of European
citizens' trust in those same institutions. The European
Central Bank (ECB) is a partial exception to this problem but
cannot make up for the lack of decisiveness of the other
institutions.
Accordingly, profound changes must be made to Europe's
institutional framework to make it effective in resolving the
current crisis and preventing future ones. An authoritative
European-level executive framework must oversee banking,
fiscal, and structural policies. This executive framework must
be made accountable to Europe's citizens, and for this the
European Parliament must become more representative and exert
better control over policymaking. Those four components of
banking, fiscal, competitiveness and political union will take
several years to be completed. They are mutually interdependent
and must be taken together, ideally in parallel increments. In
particular, the completion of a banking union relies on federal
deposit insurance which itself requires a credible
supranational fiscal backstop. And without the democratic
accountability provided by political union, no new integrated
policy framework can be sustainable.
Europe must also overcome its tendency to jump to permanent
solutions, and acknowledge the need for pragmatic short-term
actions that are tailored to the urgency of the crisis.
Europeans have repeatedly tried to resolve long-term issues
before deciding on short-term fixes, but that strategy is a
luxury they no longer have. Specifically regarding banking
issues, a proper crisis management and resolution system must
be put in place before all longer term institutional questions
are answered.
Thus, leaders should establish a temporary eurozone bank
resolution authority, as none of the existing institutions has
the skills and mandate that would allow it to perform the
thankless task of identifying failing financial institutions
and restructure them back to soundness. A successful bank
crisis resolution process will require temporary guarantees,
including a temporary central reinsurance of national deposit
insurance systems by the soon-to-be-created European Stability
Mechanism (ESM) or by a more robust future central financial
instrument.
In the longer term, the eurozone needs not only a single
supervisory mechanism for banks but also a regionally based
deposit insurance system and a central resolution authority for
failing banks. The ECB can play a large role in this future
framework but cannot be its only component. National bank
supervisors will retain many of their attributes but their
governance will need to change. Ultimately the banking union
should cover all banks in the eurozone and possibly in other
European Union (EU) member states, even though it seems likely
that exceptions will be initially negotiated by member states
to exclude some smaller banks from its oversight.
A breakup of the eurozone would be disastrous for Europeans and to
a large extent for the global economy. The choices facing Europe's
leaders and citizens are daunting. Their slow pace of decisionmaking
has exacted a large cost for Europe's economies, societies, and
families. Greece remains a burning concern. No one can be assured that
the eurozone would survive its disorderly exit; but there is still no
clear enforcement framework available if its adjustment trajectory
keeps veering off track, as it has repeatedly over the last 2 years.
Investors have good reasons to be nervous.
Yet I believe it is not too late for Europeans to take actions to
ensure the survival, sustainability, and success of their monetary and
economic union. I trust and expect such decisions will be made.
The rest of this statement expands on these points and provides
additional analysis.
europe's executive and democratic deficit
Europe's systemic financial crisis has been going on for exactly 5
years. Its start can be dated back to German top banking supervisor
Jochen Sanio's reported warning on July 29, 2007, of ``the worst
banking crisis since 1931'' while discussing the public bailout of a
medium-sized lender, IKB.\1\ Since then, European banking policymakers
have been in continuous crisis management mode but have never been able
to bring the interbank market back to its normal state without
exceptional government guarantees. As is well known, from late 2009 the
banking fragility was compounded in the eurozone by growing
unwillingness of market investors to lend to sovereigns, first Greece
and later others, creating a mutually reinforcing ``doom loop'' between
weak sovereigns and banking credit conditions.
Half a decade is a long time in policymaking. In retrospect, the
lack of proactive decisionmaking at the European level is striking.
While the common depiction is of a crisis of the eurozone periphery, it
can equally be described as a failure of the eurozone center, by which
I mean the mechanisms and actors that determine executive policy for
the entire eurozone as opposed to individual member states. Prominent
among these are the European Commission, European Council of EU member
states' heads of state and government, economic and finance affairs
(ECOFIN) council of EU member states' finance ministers, Eurogroup
meeting of eurozone member states' finance ministers, plus multiple ad
hoc subsets of eurozone countries and institutions, such as French-
German and more recently French-German-Italian or French-German-
Italian-Spanish meetings, the ``Frankfurt Group'' in late 2011,\2\ or
the four remaining eurozone triple-A-rated countries in early 2012.\3\
There have been occasional misguided decisions, such as an ill-designed
``bank recapitalization plan'' adopted in late October 2011.\4\ But, on
the whole, such policy errors of commission have been less damaging
than the absence of decisions.
While European institutions have long been criticized for their
democratic deficit, the crisis has thus revealed an equally gaping
executive deficit. Moreover, these two feed each other: the lack of
democratic legitimacy contributes to the paralysis of executive
decisionmaking; and Europe's inability to solve its collective problems
deepens citizens' distrust of its institutions. This is another kind of
``doom loop,'' political rather than financial, but no less damaging
than the one between sovereign and banking credit. To be fair to the
personalities involved, this failure must be seen as a systemic problem
of inadequate incentives and institutions, rather than a shortcoming of
individual leadership.
The insufficiently democratic nature of European decisionmaking has
many aspects. First, European citizens lack equal representation in the
European Parliament, a shortcoming cited in June 2009 by Germany's
federal constitutional court as a key reason for Berlin not to
surrender national fiscal power to Brussels. In addition, the European
Parliament lacks control over financial and other executive decisions.
Consequently, it cannot act ``in such a way that a decision on
political direction taken by the European electorate could have a
politically decisive effect,'' and this constitutes a ``structural
democratic deficit.'' \5\ Second, the European Council, a key actor in
Europe's collective executive decisionmaking, does not have a framework
to ensure collective accountability. Its members, heads of state and/or
of government, are exclusively accountable to their respective national
citizens, but the Council as a whole is accountable to no one. The same
shortcoming hampers the summit meetings of the eurozone, as well as
other intergovernmental formations such as the ECOFIN Council and
Eurogroup. The European Commission has a stronger accountability to the
European Parliament, but it has often been sidelined in the past 5
years (with important exceptions such as on competition policy). Third,
when electorates in individual member states were consulted on
successive treaty revisions by referendum, negative responses have not
been answered by a change of orientation. The French and Dutch
rejection of the 2004 constitutional treaty were followed by the
reintroduction of a near-identical text as the Lisbon Treaty in 2007;
the Irish were asked to vote again on the Lisbon Treaty in 2009 after
first rejecting it in 2008. The democratic shortfall has been widely
cited as a factor in the rise of populist anti-European parties in
recent elections in several member states.
It might sound paradoxical to advocate stronger democratic
accountability as a means to reinforce Europe's ability to make
executive decisions. Democratic checks and balances, including
parliamentary control mechanisms, are constraints on executive
discretion. But the lesson of the past 5 years in Europe is that, in a
region like Europe where the commitment to democracy runs deep, the
absence of such checks and balances cripplingly inhibits decisionmaking
as leaders don't feel empowered to take bold action for the region as a
whole. Alternative history is always a perilous exercise, but it is
likely that if proper European executive decisionmaking and oversight
processes had existed in the banking, fiscal, and structural policy
areas during the past decade, the European systemic banking fragility
could have been resolved as early as 2009 (as it was in the United
States); a special resolution regime for all European banks could have
been introduced early in the crisis, instead of a legislative
discussion about it being started only in June 2012; Greece's sovereign
debt could have been effectively contained in early 2010; and the
growth potential of Europe, especially of its southern member states,
could have been bolstered. In other words, Europe's executive and
democratic deficit has mattered hugely for economic outcomes and the
inability to tackle the crisis, and will continue to do so.
It must be noted that the ECB is an outlier in this context.
Central bankers are inherently less dependent than other policymakers
on democratic accountability mechanisms to legitimize their decisions.
Therefore, the ECB has been less paralyzed than other actors by the
weaknesses of democratic representation at the European level, and it
has exercised its authority forcefully. But the ECB must be careful not
to act much beyond the treaty-defined limits of its mandate. Its
ability to fill Europe's executive deficit is thus limited.\6\
the need for fourfold union
A resolution of the current crisis must address these mutually
reinforcing deficits of executive decisionmaking capability and of
democratic representation and empowerment. The key executive functions
that need strengthening are financial sector oversight, government
financing, and structural reforms, which is why there is a need for a
banking union, a fiscal union, and a competitiveness union. In
parallel, a transformed European institutional framework must provide
democratic accountability, the political backbone of European
integration, and address the concerns expressed in the above mentioned
2009 ruling of the German federal constitutional court. This
institutional transformation can be called a political union as it
would entail the recognition of a political space at the European level
and not only in individual member states. Such a fourfold union is
needed to resolve the eurozone crisis over the medium term.
These labels, which echo the four ``building blocks'' proposed by
the President of the European Council in a landmark report published on
June 26,\7\ are certainly formulaic and they can encompass many
possible options. Yet they are used here as a useful way to discuss the
preconditions for crisis resolution.
Each component union can be seen as a response to lost trust in
Europe's collective future--respectively, the evaporation of the
interbank market and especially of cross-border interbank lending
(banking union); the erosion of market demand for eurozone national
sovereign debt, which is increasingly perceived as carrying a credit
risk (fiscal union); the doubts about eurozone countries' ability to
generate dynamic economic growth (competitiveness union); and the
growing cynicism about the undemocratic nature of European
decisionmaking (political union).
In practice, a banking union--as further developed in the latter
section of this statement--would entail a common framework for banking
supervision, crisis resolution, and deposit insurance.\8\ A fiscal
union would include the creation of a commonly issued debt instrument
to meet investors' demand for a credit-risk-free asset (or
``Eurobonds,'' but actually there are many possible designs for such an
instrument), accompanied by adequate central controls on national
budgetary choices.\9\ A competitiveness union would monitor, assess,
and coordinate structural reform policies at the national and European
levels, including on areas that have high impact on the potential
development of high-growth firms in Europe such as insolvency
legislation, financial regulation, service sector regulation, and labor
law. A political union would make the European Parliament genuinely
representative and able to exert due democratic control of relevant
executive functions.\10\
All these steps are necessary to sustain the eurozone's monetary
union and to prevent the dissolution of the eurozone, which, as Anders
Aslund at the Peterson Institute among others has convincingly argued,
is likely to be disastrous for all parties.\11\ A fourfold union would
not by itself resolve the crisis. But it would effectively address the
obstacles that have impeded progress in the past 5 years, and thus make
crisis resolution a possibility that is not currently at hand.
Progress toward a fourfold union requires thinking about political
obstacles, interdependencies, and sequencing. National resistances vary
depending on the component and the country. For example, banking union
and fiscal union tend to be supported by troubled countries as a way to
share their liabilities with stronger countries. Conversely, fiscally
stronger member states tend to emphasize central control over banking,
fiscal, and competitiveness decisions as a precondition for liability-
sharing. Political union tends to be more easily envisaged by countries
with a strong federal tradition, such as Belgium, Italy, or Germany,
than by those with a more centralized state, including France. Another
impediment to establishing such a union stems from the fact that the
European Union possesses a supranational legal and political framework
that covers 27 member states,\12\ but the eurozone remains only a
subset of countries.
Six non-eurozone member states (Bulgaria, Denmark, Latvia,
Lithuania, Poland, and Romania) are members of the Euro Plus Pact, a
2011 policy framework that can be seen as the existing basis for a
competitiveness union. The European Fiscal Compact, which provides a
possible basis for further fiscal union, includes all EU member states
except for the Czech Republic and the United Kingdom. All EU member
states participate in the London-based European Banking Authority (EBA)
which would have a role to play in a future banking union. Most
significantly perhaps, the European Parliament is an EU institution, as
is the European Commission. One can imagine restricted formations in
which only members of the European Parliament (MEPs) from eurozone
countries would have a right to vote, somewhat akin to the Scottish,
Welsh, and Northern Ireland Grand Committees in the U.K. House of
Commons, with possible observer status for MEPs from non-eurozone
countries. For all its importance, the eurozone is embedded in the
European Union and cannot envisage its institutional future
independently from the Union as a whole.
The components of the fourfold union agenda are mutually
interdependent. Because executive capability must be seen as
legitimate, banking, fiscal, or competitiveness union will not be
sustainable without political union. Fiscal union is also necessary for
a stable banking union, because a common deposit insurance system, even
one funded by levies on the financial sector, must ultimately rely on a
common and credible fiscal backstop. There is also a direct
relationship between banking union and competitiveness union, as
financial system policy is one of the key areas in which Europe must
introduce structural reforms to enhance its growth potential. These
observations mean that none of the component of the fourfold union can
be seen as a substitute for the others.
In terms of sequencing, progress of all four must occur in
lockstep, or at least in parallel. For example, an incremental advance
on banking union, such as that achieved at the eurozone countries'
summit on June 29, requires further incremental steps forward on fiscal
union to pave the way for a common deposit insurance system. Advances
toward political union are needed to buttress the pooling of
sovereignty entailed by a single supervisory and resolution authority,
or by joint issuance of bonds by all eurozone countries. European
leaders cannot afford to neglect any of these four components in the
difficult steps ahead.
short-term and long-term responses
Europe must pay equal attention to short-term crisis management
actions and longer term initiatives to build a more sustainable system.
An exclusive short-term focus may worsen future problems. But a focus
only on the long term, ignoring the most urgent challenges, is no less
dangerous.
This may sound self-evident, but is worth emphasizing in the
eurozone crisis context. Eurozone leaders have often given the
impression of focusing exclusively on long-term legislative and
institutional reforms while neglecting more short-term aspects of the
crisis. When they did take short-term action, they often sounded as if
the result was final and there would be no further steps needed after
the one just announced. Yet institutions take time and deliberation to
change, while the crisis has a pace of its own, requiring an immediate
policy response. Short-term responses must be undertaken despite the
absence of a specific legal framework. Pragmatic adaptation is often
required. By contrast, post-crisis reconstruction can be carried out
after time is devoted to higher standards of consistency and
accountability. Short-term emergency legislation is different from
permanent legislative reform.
From this standpoint, the U.S. and European responses to the 2008
crisis stand in striking contrast. A high point of financial turmoil
was reached in the early fall of 2008, following the bankruptcy of
Lehman Brothers. Broadly speaking, the financial shock was of similar
magnitude on both sides of the Atlantic, even though the initial
apparent trigger had been the subprime crisis in the United States. In
America, the sequence included a highly visible piece of emergency
legislation (the Emergency Economic Stabilization Act, enacted October
3, 2008), which allowed the banking situation to be temporarily
stabilized in mid-October through bank recapitalizations using the so-
called Troubled Asset Relief Program (TARP). The next major step was a
comprehensive program of capital assessment and recapitalization of the
19 largest banks (the Supervisory Capital Assessment Program, known as
``stress tests'' and conducted from February to May 2009). Its
completion resulted in a rapid return of the interbank market to normal
conditions. Then, in mid-June 2009 the U.S. Government published a
blueprint for long-term financial reform, which opened a phase of
legislative deliberation concluding with enactment of the Dodd-Frank
Wall Street Reform and Consumer Protection Act in July 2010. The
implementation of Dodd-Frank through rulemaking by various federal
agencies then started and continues, though with some significant
delays. Several issues remain unresolved, including U.S. housing market
reform, but it appears fair to say that the United States first adopted
short-term crisis management and resolution measures from October 2008
to mid-2009, and then followed by another sequence of long-term
reforms.
By contrast, the European Union has persistently focused on long-
term initiatives first, and to concede short-term action only under the
irresistible pressure of events. This tendency results from the
executive deficit described above, and the fact that long-term actions
lend themselves to a protracted legislative process that European
Institutions favor. To be fair, individual member states have carried
out significant short-term actions, but their effectiveness has been
diminished by the lack of adequate European-level coordination. For
example, the summit of heads of state and government of eurozone
members and the U.K. in Paris on October 12, 2008, initially helped
stabilize markets, along with the near-simultaneous use of TARP in the
United States for bank recapitalizations. But this initial success was
not followed by systemwide monitoring and capital assessment in Europe,
in spite of successive rounds of ``stress tests'' in 2009, 2010, and
2011, leaving the European banking sector fragile. A more recent case
is the Euro Area Summit Statement of June 29, 2012, which contemplated
the direct intervention of the European Stability Mechanism (ESM) to
recapitalize banks in certain eurozone countries. It proclaimed the aim
``to break the vicious circle between banks and sovereigns,'' but only
``when an effective single supervisory mechanism is established.'' \13\
Taken literally, this is somewhat akin to deciding that firefighters
can intervene to put out a fire only after architects and builders have
completed their work of design and reconstruction of the firehouse.
To be more effective in the next phases of the crisis, the eurozone
should adopt more explicit short-term crisis management contingency
measures, even if they are designed as temporary steps to be superseded
by future permanent arrangements. This is particularly the case in
managing the banking crisis and making progress toward the creation of
a banking union.
banking union: short-term aspects
Several analysts, including myself, have urged adoption of a
federal framework for banking policy with centralized functions of
supervision, crisis resolution and deposit insurance as essential to
the stability of the European banking system and to the sustainability
of eurozone monetary union.\14\ Similar views have been advocated by
the International Monetary Fund (IMF).\15\ Yet such analysis has long
remained controversial inside the European Union. As recently as early
June 2012, the European Commission proposed draft legislation on long-
term reform of bank crisis management and resolution that envisaged no
central deposit insurance, supervisory, or resolution authority.\16\
However, the vision of banking union as an indispensable component of a
sustainable economic and monetary union has gathered a remarkable
momentum in the spring of 2012. It was forcefully advocated by IMF
Managing Director Christine Lagarde in mid-April,\17\ backed by ECB
President Mario Draghi in late April,\18\ promoted by newly elected
French President Francois Hollande in what can be seen as a significant
inflection from previous French policy in late May,\19\ and more
cautiously yet unambiguously endorsed by German Chancellor Angela
Merkel in early June.\20\
This momentum created the context for the previously mentioned Euro
Area Summit Statement of June 29, which asked the European Commission
to present proposals (now expected in September) for a ``single
supervisory mechanism'' to be established under Article 127(6) of the
Treaty, implying an anchoring role for the ECB. The statement further
creates the possibility for the ESM ``to recapitalize banks directly.
This would rely on appropriate conditionality [for each relevant member
state], including compliance with state aid rules, which should be
institution-specific, sector-specific or economywide and would be
formalized in a Memorandum of Understanding [between European-level
authorities and the member state concerned].'' This declaration has
been rightly hailed as a policy breakthrough, but it also raises far
more questions than it answers. As previously argued, the next steps
will require careful thinking about the sequence and articulation of
short-term and long-term initiatives, as well as about the
interdependencies between action on the banking system and the other
components of Europe's ``fourfold union.''
In the short term, policymakers need to think in terms of systemic
bank crisis resolution. They could gain precious insight from
consideration of the lessons from previous episodes of systemic crises
in developed countries, particularly the U.S. savings & loan crisis of
the late 1980s, the Scandinavian crises of the early 1990s, the
Japanese crisis until 2002-03, and the U.S. financial crisis of 2007-
09. The aim is to restore trust in the banking system, starting with
the more systemically important banks. This necessarily involves
willingness to acknowledge and share losses; a strong and well-
empowered resolution authority; significant financial risk-taking by
public authorities; and several phases, from the emergency prevention
of contagion to the restoration of individual banks' safety and
soundness.
The starting point is that there are probably vast unrecognized
losses in Europe's banking sector and that the resolution framework
must allow an adequate sharing of these losses among all relevant
stakeholders, including private sector creditors. At the same time,
ordinary bankruptcy procedures are notoriously unsuitable to
systemically important financial institutions. Some European member
states, including some but not all in the eurozone, have adopted
special resolution regimes for banks. But so far, almost no senior
unsecured creditors have been forced to take losses on financial
institutions found insolvent in the European Union. Leaving aside a
handful of tiny bank bankruptcies in Northern Europe, the only
exceptions have been two medium-sized banks in Denmark (Amargebanken in
February 2011, and Fjordbank Mors in June 2011) but under a policy
framework that was later amended so that subsequent situations would be
treated differently. In most cases, even subordinated unsecured
creditors of failed banks have been fully repaid, at great cost to the
respective countries' taxpayers. This stands in stark contrast with the
United States, where a handful of high-profile federal bailouts (most
notably Bear Stearns, Fannie Mae, Freddie Mac and AIG) have rightly
caused much public controversy, but senior unsecured creditors have
been forced to take major losses on their exposures to dozens of
depositary institutions, including large ones such as Washington
Mutual, and medium-sized nonbanks such as CIT and MF Global, not to
mention Lehman Brothers.\21\
The European practice of fully bailing out all senior creditors,
even of smaller banks, and many junior ones is clearly unsustainable.
The aim to have adequate participation of senior creditors in the
sharing of losses should become the driving objective of Europe's
crisis management and resolution approach. The ECB has recently
signaled its acknowledgement of this reality, in a significant shift
from its earlier policy positions.\22\ However, most member states and
the European Commission, ostensibly motivated by contagion concerns,
still appear to defend the view that no losses should be imposed on any
senior creditors even of failed banks.\23\
The best way to address the fear of contagion is to conduct the
assessment of bank solvency on a systemwide basis, i.e. by including
all systemically important banks throughout the eurozone in a
comprehensive, rigorous, and consistent review of balance sheets and
capital strength. This was the key to past successful systemic crisis
resolutions, including in Sweden in 1992-93, in Japan (belatedly) in
2002-03, and in the United States with the Supervisory Capital
Assessment Program in 2009. Conversely, the fact that in the eurozone,
capital assessment and restructuring has been left to national
authorities in spite of the high degree of cross-border market
integration is a major reason why Europe's banking fragility remains
unresolved after half a decade of turmoil, three rounds of ``stress
tests'' (2009, 2010, 2011), and the ill-fated ``recapitalization plan''
of October 2011. There is considerable political resistance against a
genuine systemwide approach to banks' capital assessment, particularly
in countries such as France and Germany whose official position is that
their respective banking systems have been kept sound (notwithstanding
past problems at banks such as IKB, Hypo Real Estate, WestLB, and
Dexia). But it might be the only possible approach that allows
significant burden-sharing with senior creditors, an increasingly
evident financial and political imperative, not to mention the moral
hazard implications of open-ended taxpayer-supported bailouts.
Even if it remains impossible to approach resolution synchronously
across the eurozone, it is a clear lesson of the past few years that
the resolution authority must be centralized. The most evident reason
is that national authorities have failed on their supervisory duties in
several member states, and have lost too much credibility to remain the
main decisionmaker on future restructuring, as in the case of Spain.
Moreover, it is difficult to see how to build a perception of fairness
in the treatment of controversial situations across several countries
without having a single authority in charge for the entire eurozone (or
possibly beyond, assuming other member states would want to
participate). Furthermore, bank resolution is an extremely time-
consuming, skill-intensive, and sensitive process that cannot possibly
be coordinated across borders without an unambiguous centralization of
information and authority. Many of Europe's larger banks have
significant cross-border operations within the European Union, and a
centralized resolution process is the only practical way to balance the
interest of home and host countries, as national authorities have
powerful incentives not to cooperate in such cases. In addition, as
some banking operations and assets are likely to be brought under
temporary public ownership as a result of the resolution process,
centralization of their management and/or disposal would prevent
ineffective competition among different national authorities to the
collective detriment of taxpayers, and would help an orderly process of
price discovery as assets are eventually sold back to the private
sector. Finally, it makes operational sense to have expertise and
skills concentrated in one central team rather than having it spread
thin across various member states, both in terms of cost-effectiveness
and more importantly of ability to attract talent and learn from
experience.
No existing institution is well equipped to assume this role of
eurozone resolution authority. The ECB, in addition to not having the
relevant skills directly at hand, cannot assume the politically
contentious responsibility of bank resolution in a manner compatible
with its jealously safeguarded monetary policy independence. The
European Banking Authority, in addition to not having the relevant
skills directly at hand either, is ruled out given its governance
structure that makes it too dependent from member states and by its
location in the U.K., a country that has unambiguously refused to
participate in any effort toward banking union. The European Financial
Stability Facility (EFSF) and soon-to-be-established ESM are small
structures with no expert staff with a specialization in banking, and
even more than in the case of the EBA may lack the independence from
member states to ensure the impartiality of the resolution process. The
European Commission has built valuable experience through the
implication of its directorate-general for competition (DG COMP) in
most bank restructurings over the past years under the European Union's
state aid control policy, and its involvement in the ``troika'' that
negotiates conditionality with countries under assistance programs,
including in the recent case of Spain. But it is questionable whether
the task of restructuring may conflict with the Commission's many
institutional constraints, and whether its staffing by general-purpose
civil servants is compatible with the need for specialized skills in
the resolution and restructuring task.
This suggests that in the short term the best way to achieve a
resolution authority at the eurozone level might be to create a
temporary, dedicated structure with wide latitude to recruit
specialized staff, both from the private sector and through temporary
leaves from national or European public authorities. In addition, bank
restructuring and resolution is a thankless task, and those who will
perform it will gain few friends, an observation which also favors a
temporary structure that can ensure maximum independence and
impartiality. Precedents suggest this can be an effective approach to
systemic crisis resolution, including the U.S. Resolution Trust
Corporation (1989-1995), the Swedish Bank Support Authority (1993-96),
or in the case of systemic issues beyond the financial system, the
Treuhandanstalt that restructured and sold the former German Democratic
Republic's state-owned enterprises in 1990-94, or the U.S. Presidential
Task Force on the Auto Industry that coordinated government policy on
Chrysler and GM in 2009. While none of these experiences was without
its blemishes, they all suggest that a temporary, well-empowered task
force structure, obviously with adequate provisions for accountability
and transparency, would represent a credible and well-suited response
to the short-term challenge of European bank crisis resolution.
This leaves open the question of future ownership of those
institutions that the temporary resolution authority would find
insolvent following in-depth balance sheet assessment. In legal terms,
those countries that do not currently have a special resolution regime
for banks should pass emergency legislation to create one, and those
that have one might also need emergency legislation to empower the
temporary resolution authority at the eurozone level. Failed banks will
generally need to be taken over by public authorities, but there might
be no uniform framework as to which public authorities will become
equity owners. One can imagine a combination of national government
ownership and ownership at the European level (specifically by the ESM
as suggested by the eurozone summit statement of June 29), depending on
countries and individual bank situations. This should logically be
negotiated by the temporary resolution authority together with the
imposition of losses on relevant categories of creditors (excluding, of
course, those which are covered by explicit guarantees). While these
negotiations should be conducted with a sense of impartiality and
evenhandedness across the eurozone, differences in legal environments,
banking structures and fiscal positions make it unadvisable, and
arguably impossible, to adopt a one-size-fits-all approach.
Beyond this, crisis resolution and restructuring will necessarily
involve significant financial risk-taking by public authorities--but
these have to be compared to the current open-ended explicit and
implicit commitments of support to the financial sector that exist at
the level of individual member states. Here again, banking policy
cannot be considered in isolation from the other components of fourfold
union.
This is most obvious as regards the protection of retail deposits,
and more generally the prevention of further capital flight,
particularly in the more fragile countries. As previously argued,
European policymakers should refrain from a blanket and permanent
guarantee of all bank liabilities, but they could and should do more to
reassure depositors. Deposit data in Europe tend to be only disclosed
with a lag, and are far from complete, but the available evidence
suggests that deposit flight is occurring, at various paces in several
eurozone member states. This is very dangerous for financial stability
and should be addressed decisively. It would be irresponsible for
policymakers to delay their action until it is forced by a fully
fledged retail bank run.
Three main factors appear to motivate deposit flight: a fear of
currency redenomination and devaluation in case of eurozone exit; a
fear of inability of the government to fulfill its deposit insurance
commitments; and for larger depositors, concerns about their deposits
above the insured threshold in case of failure of the bank where they
are held. Addressing the first concern involves reassuring eurozone
citizens that there will be no forced or disorderly exit from the
currency union: the crucial case here, in the next few months as in the
recent past, is obviously Greece, and to say the least, eurozone
leaders have not done enough to remove uncertainties about its future
status. To address the second concern, the ESM, when it is in place,
should provide a temporary and unconditional guarantee of national
deposit insurance systems across the eurozone, at least until progress
has been made toward comprehensive bank crisis resolution and possibly
until a federal eurozone deposit insurance system is in place. Such
``deposit reinsurance'' should be temporary as it creates questionable
incentives for member states, but might be a necessary step to achieve
the eurozone leaders' ``imperative to break the vicious circle between
banks and sovereigns.'' The third concern could be addressed by
targeted temporary guarantees until the completion of a credible,
systemwide process of bank assessment as earlier described.
Finally on the sequencing, several successive steps will be needed
and policymakers should preserve as much flexibility as possible in
their intervention framework. Even under the most optimistic
assumptions, it would take at least 2-3 months to build a temporary
European resolution authority; 3-4 further months to reach a
comprehensive systemwide assessment of the balance sheet and capital
positions of the most important banks (which would represent a sample
comparable to that of the 2011 stress tests, say between 60 and 90
banks); and one or two additional months to negotiate the outline of
restructuring packages for those banks found insolvent, which might
number in the double rather than single digits. As a consequence, the
disclosure of capital assessments, which can only be made once adequate
backstop plans have been defined for failed institutions, could hardly
happen before February or March 2013, and possibly not before the late
spring of 2013 at the earliest, with a long period of prolonged
uncertainty in the meantime. Even after that, it will take many months
if not years to complete the restructurings. As illustrated by multiple
recent cases including WestLB, Fortis, Dexia, RBS, and others,
resolving or restructuring problem banks in Europe is almost always a
protracted and legal-risk-ridden process. This long sequence will be
difficult to manage, and will require very careful and professional
communication towards the financial community and the wider public.
banking union: longer term aspects
In accordance with the June 29 eurozone summit statement, eurozone
policymakers have started discussing the long-term design of their
future banking union even before having set the key parameters of
short-term crisis management and resolution. In this context, essential
choices will have to be made shortly about the future institutional
framework. The only indication so far is an anchoring role to be played
by the ECB, consistent with the statement's reference to article 127(6)
of the Treaty on the Functioning of the European Union, which states
that ``The Council, acting by means of regulations in accordance with a
special legislative procedure, may unanimously, and after consulting
the European Parliament and the European Central Bank, confer specific
tasks upon the European Central Bank concerning policies relating to
the prudential supervision of credit institutions and other financial
institutions with the exception of insurance undertakings.''
A proper banking policy framework includes several dimensions,
including regulation, supervision, resolution, deposit insurance,
competition, and consumer protection. In the European Union, regulation
is mostly defined at the EU level, through legislation (directives and
regulations) and ``binding technical rules'' which are increasingly
prepared by the EBA and other European Supervisory Authorities, even
though the European Commission retains decisionmaking authority in the
current framework.\24\ While this framework is somewhat clumsy, its
reform is not a necessary condition for the establishment of a banking
union. Competition policy is conducted under a time-tested integrated
policy framework, in which the European Commission's DG COMP plays a
pivotal role together with national competition authorities. Consumer
protection might require further convergence, including as part of a
future economic competitiveness union, even though this has not yet
been considered an urgent concern by most European policymakers. This
leaves supervision, resolution, and deposit insurance as the key areas
on which leaders need to start designing a viable future framework now.
As previously observed, the inherent political nature of bank
resolution authority makes it unlikely that such authority could be
temporarily or permanently granted to the ECB, even assuming a
separation of teams and a dedicated governance framework within the
institution. This is especially true in the European context of a weak
central executive and problematic democratic accountability, which
advises against delegating excessive discretionary power to the ECB.
The ECB itself has signaled that it had no appetite to assume the
inherently controversial task of bank resolution, including by
stressing that the future banking union framework should allow the ECB
to act ``without risks to its reputation.'' \25\ Thus, it appears
inevitable that the long-term framework will include a European
resolution authority separate from the ECB, and also most likely
separate from all other currently existing institutions for the reasons
developed in the previous section. However, it is desirable that the
resolution authority should be able to have close interaction with the
ECB, particularly in times of crisis. For this reason it should
preferably be located in Frankfurt, as geographical proximity would
help in this respect even as the two institutions would remain
separate.
The supervisory function has synergies both with the lender-of-
last-resort role of the ECB, and with resolution authority. If the June
29 decision is to be implemented, the ECB will develop supervisory
functions of its own in any case. It is likely that the resolution
authority will require a supervisory mandate as well, as is the case
with the Federal Deposit Insurance Corporation (FDIC) in the United
States;\26\ as in the United States, it could be coupled with the
deposit insurance function, even though a formally separate deposit
insurance fund could be envisaged as well. Some overlapping of
supervisory functions across two or more European institutions should
of course be kept to a minimum as it involves duplication of some costs
and complexity, but its existence should not necessarily be seen as a
problem in itself: situations of overlap exist in several jurisdictions
including the United States (Federal Reserve/FDIC/Office of the
Comptroller of the Currency) but also Japan (Bank of Japan/Financial
Services Agency) and Germany (Bundesbank/BAFin). If the eurozone is to
avoid such overlap, its leaders may need to envisage a change from the
June 29 decision and a buildup of the supervisory function entirely
outside of the ECB even though adequate operational links with the
Central Bank should be established, as is the case in Australia,
Canada, China, Sweden, and Switzerland among others.
National supervisors would continue to exist in a future banking
union, at least in a first phase. The European principle of
subsidiarity, according to which a European authority should perform
only those tasks which cannot be performed effectively at the national
level, suggests in particular that the supervision of most local banks
should remain in their scope, and they could be delegated other tasks
by the European supervisor(s). However, their mandate and governance
will need to be adapted to the new, more integrated approach. To be
consistent with the eurozone's claimed ``imperative to break the
vicious circle between banks and sovereigns,'' at least some of their
functions should be placed under the authority of the European
supervisor(s) rather than of the respective national government as is
currently the case, with possible corresponding changes in terms of
their accountability framework. Conversely, one can imagine a role for
national supervisors in the governance of the new European-level
authorities, including possibly of the new supervisory function within
the ECB, a possibility made arguably easier by the fact that many of
these supervisors are part of the National Central Banks that
participate in the eurosystem together with the ECB itself. However,
appropriate lessons should be drawn from the experience of the EBA and
other European Supervisory Authorities, suggesting that such role
should not be exclusive. Officials with a European as opposed to
national mandate and accountability, as is the case of members of the
ECB's executive board, should be prominent in the key decisionmaking
bodies, unlike the situation of the EBA where the so-called supervisory
board, which in spite of its name is in charge of most key executive
decisions, is composed exclusively of national representatives. In line
with previous arguments about political union, strong channels of
accountability should be built vis-a-vis the European Parliament.
In relation with the above arguments about the role of national
supervisory authorities, the European supervisory, resolution, and
deposit insurance authorities should have competence not only over
those financial institutions that are systemically important at the
European level (or E-SIFIs, to mimic the current jargon of the
Financial Stability Board and Basel Committee on Banking Supervision,
which identifies G-SIFIs as financial institutions that are
systemically important at the global level, and D-SIFIs as those that
are systemically important at the domestic level). It should also cover
smaller banks, even though most operational duties related to these
could and should be devolved to national supervisors. This would also
help maintain, or rather establish, a competitive level playing field
across the banking union. It is likely however that some member states
will try, at least in a first phase, to negotiate exceptions for
sections of their respective banking systems with particularly strong
links with local and regional environments. Such exceptions from the
general framework of banking union, which would also encompass separate
deposit insurance systems, appear unadvisable from the standpoint of
policy consistency and effectiveness, but may be inevitable to reach a
political consensus at least in an initial phase. They may concern the
German Sparkassen-Finanzgruppe, with the possible exception of the
Landesbanken within it, and perhaps also Germany's cooperative bank
system (Volksbanks and Raiffeisenbanks, and DZ-Bank). Whether other
exceptions will be sought by member states other than Germany remains
to be seen.
In terms of geographical scope, the generally adopted working
assumption is that the banking union would be identical in perimeter to
the eurozone. However, it can also be envisaged that its perimeter
would be wider and include some EU member states that may not join the
eurozone in the short term, say Poland or Denmark. This would create
additional complexity and potential risks, but it is technically
conceivable and may be ultimately determined by political
considerations. Under this scenario, common supervisory and resolution
authorities might span different currency areas (the eurozone being by
far the largest among them) and be linked to different deposit
insurance funds, as it appears difficult to envisage how a single
deposit insurance fund could span multiple currency areas. The opposite
option, of a banking union that would include some eurozone countries
but not all, is harder to imagine.
This brief and incomplete enumeration shows that many different
parameters remain to be discussed in order to put in place a consistent
permanent institutional framework for the future banking union. In this
context, it is to be hoped that pragmatism will prevail and that direct
financial intervention by the ESM in individual banks will be unlocked
before all these parameters are set, in order to allow swift and
effective crisis management and resolution. However, it is also
desirable that eurozone leaders achieve consistency between their
short-term and long-term planning, and that an early version of a
future European supervisor can be set up rapidly and provide continuity
of approach beyond the short-term phase and beyond the possible
lifetime of a temporary resolution authority, if such an option is
indeed chosen.
outlook
Even under optimistic assumptions, the situation in the eurozone
will remain affected by high levels of market volatility. Many
observers and investors have gradually lost hope in the eurozone's
ability to resolve its problems. They are not encouraged by what they
perceive as a state of denial affecting several senior European
policymakers, about both the severity of the region's problems, and the
need to maintain or regain investors' trust to resolve them. In their
narrative, the eurozone is too diverse to survive as a monetary union,
and centrifugal forces are too strong to be contained.
I share the view that Europe's current institutions are not strong
enough to contain such forces indefinitely, but the European Union is
and remains a work in progress and is capable of change. The completion
of a fourfold union as advocated in this testimony would create a much
more robust and resilient framework that could enable decisions to
repair investors' trust and keep centrifugal forces in check. Arguments
that Europe is too diverse for stronger central institutions to exist
do not hold up to scrutiny. India is one example of a fairly stable
democratic polity whose internal historical, social, economic,
religious, ethnic and linguistic diversity is greater than in the
European Union, let alone the eurozone. Among more advanced economies,
Canada and Switzerland are other examples of stable, yet diverse and
multilingual democracies. Many pessimistic observers underestimate the
extent to which well-designed political institutions can tie different
communities, provided there is a desire to hold together.
European integration has been a process of political innovation
from the start. There is no precedent, and still no equivalent
elsewhere in the world, for the kind of supranational institution-
building that has been going on in Europe since 1950. Even though
parallels might be drawn with some cases of constitution of
federations, particularly the United States in the 1780s and Canada in
the 1860s, these cases are too different from Europe to have any
predictive relevance. As with all innovation, success can neither be
taken as given nor considered impossible.
In the specific case of the eurozone, powerful ``de facto
solidarities'' exist and make the bloc more resilient than superficial
observation might suggest. These solidarities are of a different nature
from those involved in earlier steps of European integration, and are
often ill-understood including in the European economic policy and
research community itself, as the rambunctious debate about so-called
Target2 imbalances among Eurosystem Central Banks, among others, has
illustrated.\27\ They are particularly strong in the case of Germany,
the eurozone's pivotal member state.
Nonetheless, Greece remains the litmus test of whether the eurozone
will hold together, and the outcome there is hard to predict. Eurozone
leaders, including Greek ones, might come to the conclusion that
further transfer of economic sovereignty by Greece to the eurozone
level is the only way to prevent a disorderly dislocation. If this
happens, the issue of European institutions' democratic accountability,
in other terms the political union agenda, will gain even more urgency
than is currently the case. Similarly, if a legal impasse is reached as
the consequence of future rulings of Germany's constitutional court
about crisis management initiatives, a major strengthening of the
democratic underpinnings of EU institutions might be the only way to
overcome the court's reservations against more transfer of
decisionmaking toward the supranational level.
There is no easy, simple or painless way to resolve the eurozone
crisis successfully. An enormous effort of adjustment and
transformation lies ahead, in addition to the substantial sacrifices
already incurred by Europe's member states and citizens. In my opinion,
achieving a fourfold union as described here is indispensable to avoid
a disorderly and disastrous eurozone breakup. Time and stamina will be
needed. The changes involved are significant, but not impossible. The
European does not have to become a ``superstate'' to overcome the
crisis, and will remain a hybrid in which component nation-states play
an irreducible role. The fragmentation of Europe's financial, economic
and social space that has occurred since the crisis started is damaging
and worrying, but has not reached a point of no-return beyond which it
could not be reversed. The eurozone faces daunting challenges, but is
far from condemned to failure yet.\28\
----------------
End Notes
\1\ Financial Times, ``Germany Rescues Subprime Lender,'' August 2,
2007.
\2\ This informal group included, in alphabetical order: European
Commission President Jose Manuel Barroso; European Central Bank
President Mario Draghi; Eurogroup Chairman Jean-Claude Juncker;
International Monetary Fund Managing Director Christine Lagarde; German
Chancellor Angela Merkel; European Commissioner Olli Rehn; French
President Nicolas Sarkozy; and European Council President Herman Van
Rompuy. See for example Peter Spiegel, ``EU Presses Rome and Athens,''
Financial Times, November 14, 2011.
\3\ Finance ministers of Finland, Germany, Luxembourg, and the
Netherlands held joint meetings in the context of the Greek debt
restructuring negotiations. See for example Associated Press, ``Greek
Debt Talks to Stretch Into Weekend,'' February 3, 2012.
\4\ See for example Nicolas Veron, ``Banking Federalism is Key to
the Eurozone's Survival,'' Emerging Markets G20 Edition, November 3,
2011.
\5\ Press release No. 72/2009 of 30 June 2009, ``Act Approving the
Treaty of Lisbon compatible with the Basic Law; accompanying law
unconstitutional to the extent that legislative bodies have not been
accorded sufficient rights of participation,'' Federal Constitutional
Court of Germany.
\6\ It may be noted that an early call for a stronger European
executive policymaking capacity in the context of the eurozone crisis
came from then-President of the ECB Jean-Claude Trichet, ``Building
Europe, Building Institutions,'' speech on receiving the Charlemagne
Prize 2011 in Aachen, June 2, 2011.
\7\ ``Towards a Genuine Economic and Monetary Union,'' Report by
President of the European Council Herman Van Rompuy, Brussels, EUCO
120/12 .
\8\ A possible blueprint was outlined before the last European
Council meeting by Jean Pisani-Ferry, Andre Sapir, Nicolas Veron and
Guntram Wolff, ``What Kind of European Banking Union?'' Bruegel Policy
Contribution 2012/12, June 2012.
\9\ One exploration of the policy options is in Benedicta
Marzinotto, Andre Sapir and Guntram Wolff, ``What Kind of Fiscal
Union?'' Bruegel Policy Brief 2011/06, November 2011.
\10\ National Parliaments may also play a role in strengthening
democratic accountability, but cannot replace the European Parliament
as the only assembly where all EU citizens are represented together.
\11\ Anders Aslund, ``Why a Breakup of the Euro Area Must be
Avoided: Lessons from Previous Breakups,'' Peterson Institute Policy
Brief, August 2012.
\12\ This number will grow to 28 in mid-2013 with the planned
enlargement of the European Union to Croatia.
\13\ Euro Area Summit Statement, Brussels, 29 June 2012.
\14\ In my case, relevant references include ``Is Europe Ready for
a Major Banking Crisis?,'' Bruegel Policy Brief 2007/03, August 2007;
``A Solution for Europe's Banking Problem,'' with Adam Posen, PIIE
Policy Brief PB09-13 and Bruegel Policy Brief 2009/03, June 2009;
prepared statement on ``The European Debt and Financial Crisis:
Origins, Options and Implications for the US and Global Economy,'' U.S.
Senate Committee on Banking, Housing and Urban Affairs, Subcommittee on
Security and International Trade and Finance, hearing on September 22,
2011.
\15\ See in particular Dominique Strauss-Kahn, ``Crisis Management
Arrangements for a European Banking System,'' keynote speech at the
European Commission conference ``Building a Crisis Management Framework
for the Internal Market,'' Brussels, March 19, 2010.
\16\ European Commission Press Release IP/12/570, ``New crisis
management measures to avoid future bank bail-outs,'' Brussels, June 6,
2012.
\17\ Christine Lagarde, opening remarks at the IMF/CFP Policy
Roundtable on the future of
financial regulation, Washington DC, April 17, 2012, available on
www.imf.org .
\18\ Mario Draghi, introductory statement before the Committee on
Economic and Monetary
Affairs of the European Parliament, Brussels, April 25, 2012.
\19\ Transcript of the President of the French Republic's press
conference in Brussels, May 23, 2012, available in French on http://
www.elysee.fr/president/les-actualites/conferences-de-presse/2012/
conference-de-presse-de-m-le-president-de-la.13289.html.
\20\ Reuters, ``Merkel calls for body to supervise major EU
banks,'' June 4, 2012.
\21\ For a discussion of this contrast see Morris Goldstein and
Nicolas Veron, ``Too Big to Fail: The Transatlantic Debate'' in J.F.
Kirkegaard, N. Veron and G.B. Wolff (editors), Transatlantic Economic
Challenges in an Era of Growing Multipolarity, Peterson Institute/
Bruegel Special Report 22, July 2012.
\22\ Interview of Mario Draghi in Le Monde, July 21, 2012.
\23\ Gabriele Steinhauser and Brian Blackstone, ``Europe's Bank
Shifts View on Bond Losses,'' Wall Street Journal, July 16, 2012.
\24\ There are however multiple exceptions to the principle of a
``single European rulebook'' for banking regulation, as illustrated
among others by the U.K. debate over implementation of the
recommendations of the Independent Commission on Banking, or Vickers
Commission. Moreover, corporate law applicable to banks remains
exclusively national, a situation which may require modification with
the creation of a permanent European resolution authority. Banks across
the European Union will also need to continue to adapt to different
national tax systems for the foreseeable future.
\25\ Jorg Asmussen, ``Building deeper economic union: what to do
and what to avoid,'' speech at the European Policy Centre, Brussels,
July 17, 2012.
\26\ The FDIC is the primary supervisor of only a subset of
depositary financial institutions in the U.S., but has backup
supervisory authority over all others and is a prominent member of the
U.S. supervisory community.
\27\ See for example Isabelle Kaminska, ``*That* Target2
presentation,'' FT Alphaville, June 27, 2012.
\28\ Insightful comments on an early draft of this statement by my
colleagues Andre Sapir, Shahin Vallee and Guntram Wolff at Bruegel, and
Martin Kessler, Ted Truman, Steve Weisman and John Williamson at the
Peterson Institute are most gratefully acknowledged.
Senator Shaheen. Thank you.
Dr. Johnson.
STATEMENT OF SIMON JOHNSON, PH.D., RONALD A. KURTZ PROFESSOR OF
ENTREPRENEURSHIP AND PROFESSOR OF GLOBAL ECONOMICS AND
MANAGEMENT, MIT SLOAN SCHOOL OF MANAGEMENT, CAMBRIDGE, MA
Dr. Johnson. Thank you very much, particularly for holding
this hearing on such an important and timely topic.
I would describe myself as much more pessimistic about the
European situation than either Dr. Burwell or Mr. Veron. I
think I would try to communicate this pessimism in the
following way. Senator Shaheen, you said in the beginning that
this crisis has many causes, and of course you're right in some
sense. But I think also that there is an overarching
explanation or driving force behind what we're now seeing,
which is the end of a very large credit boom.
Now, we had a credit boom, obviously, in the United States
and we're familiar with the devastating consequences across
mortgages and across many parts of the economy that are still
with us 5 years after our crisis, and I think we'll struggle
for another 5 years to get out from that. The Europeans didn't
just go crazy on real estate. That was the situation in Ireland
and Spain. They also went crazy on government spending,
including most spectacularly in Greece, and their banks became
very highly leveraged, speculative operations. The notion of
``too big to fail,'' which is obviously a problem still with
us, the Europeans have that and more. Their banks became much
bigger relative to their economies. In Ireland three banks were
two times the size of the Irish economy. Switzerland, two banks
eight times the size of the Swiss economy. Not a member of the
eurozone, but the same general phenomenon.
The crisis, as Mr. Veron said, absolutely began in the
summer of 2007. We are 5 years into a financial crisis that
continues to drag out and a crisis within which the Europeans
have made many awful mistakes, including introducing or, let's
say, communicating with some clarity that sovereign debt is not
necessarily backed by the Central Bank in the European context.
They have in a sense recreated on the fly a version of the
gold standard, in which you're not going to get bailed out, but
they're doing it in a situation where people have already
borrowed massively assuming that there were Central-Bank-type
bailouts of the kind to which people have become accustomed in
recent decades in this country and in Europe.
This is a really toxic and dangerous combination. I think
that when people say, as they are now saying, that Mario
Draghi, the president of the European Central Bank, can solve
the crisis, he can do whatever it takes, they're kidding
themselves. The European Central Bank cannot issue credit to
any degree in any form that will deal with the underlying
problems, some of which my colleagues have absolutely nailed
and I would just add on top of that and emphasize the
competitiveness problem, the intra-European problem that the
Greeks' real wages relative to the Germans are too high
relative to their productivity. Either you devalue in that kind
of situation or you lower your wages and prices, and we know
that lowering wages and prices is extremely difficult.
These serious, deep-rooted problems all exacerbated, pushed
further than would otherwise have been possible by the credit
boom, all of these problems now need to be dealt with. The
European Central Bank can't do that.
In fact, as the Central Bank now moves to provide more
credit, more so-called liquidity to this situation, I fear we
move into the most dangerous phase of the eurozone crisis, the
one in which people seriously begin to question whether or not
the euro will break up, this dissolution risk. If you have a
contract with a German bank, for example, you may feel
comfortable with the creditworthiness of that bank. You may
even like the creditworthiness of the German state, which you
might presume stands behind their largest banks. But how
certain are you that when this contract comes due, for example
in a year, there will be such a thing as a euro?
Or perhaps the euro will exist in parallel with other
currencies. In what currency will you be paid? Does it matter
whether or not that contract was in Frankfort, London, New
York, or the Cayman Islands?
All of these questions become enormously important. And
remember, we are sitting on a powder keg of opaque, over the
counter, derivative transactions. The amount of derivatives
notionally linked to Euribor, the European version of Libor, or
to the London Interbank Offered Rate, a rate which is already
called into question by the apparently fraudulent activities of
the big banks engaged in reporting information used for the
construction of those interest rates, the notional value of
these contracts is in the hundreds of trillions of euros.
Nobody can tell you what is the true exposure of American
banks to these problems. No one can tell you if Greece exits
the euro in the coming months, which is my expectation, what
will be the knock-on effect on the balance sheet of French
banks? How will that affect the largest U.S. banks?
I think as a matter of pressing policy in this country the
Federal Reserve should suspend the payment of dividends and
suspend share buybacks for all systemically important financial
institutions. Those funds still belong to the shareholders.
They remain on the balance sheet of the bank as a buffer
against the losses they are likely to incur as the European
situation worsens and as a protection against the taxpayer
being dragged into another round of expensive and damaging
bailouts in the United States.
Thank you very much.
[The prepared statement of Dr. Johnson follows:]
Prepared Statement of Simon Johnson\1\
summary
(1) Successive plans to restore confidence in the euro area have
failed. The market cost of borrowing is at unsustainable levels for
euro banks and a significant number of governments.
(2) Two major problems loom over the euro area. First, the
introduction of sovereign credit risk has made nations and subsequently
banks effectively insolvent unless they receive large-scale bailouts.
Second, the ensuing credit crunch has exacerbated difficulties in the
real economy, causing Europe's periphery to plunge into recession. This
has increased the financing needs of troubled nations well into the
future.
(3) With governments reaching their presumed debt limits, the
European Central Bank (ECB) is now treading a dangerous path. It feels
compelled to provide adequate ``liquidity'' to avert systemic financial
collapse, yet must presumably limit its activities in order to prevent
a loss of confidence in the euro--i.e., a change in market and
political sentiment that could lead to a rapid breakup of the euro
area.
(4) Five measures are needed to enable the euro area to survive:
(1) an immediate program to deal with excessive sovereign debt, (2) far
more aggressive plans to reduce budget deficits and make peripheral
nations ``hypercompetitive'' in the near future, (3) supportive
monetary policy from the ECB, (4) the introduction of mechanisms that
credibly achieve medium-term fiscal sustainability, and (5)
institutional change that reduces the scope for excessive leverage and
consequent instability in the financial sector.
(5) Europe's leaders have mainly focused on a potential long-term
fiscal agreement, and the ECB under Mario Draghi is setting a more
relaxed credit policy; however, the other elements are essentially
ignored.
This crisis is unique due to its size and the need to coordinate 17
disparate nations. I suggest four examples of economic, social, and
political events that could lead to more sovereign defaults and serious
danger of systemic collapse.
Each trigger has some risk of occurring in the next weeks, months,
or years, and these risks will not disappear quickly.
1. The Euro Area's Last Stand
For over 2 years Europe's political leaders have promised to do
whatever it takes to save the euro area. Yet problems are growing and
solutions still seem far off.
The October 27 and December 9, 2011, agreements of European leaders
failed to change the dangerous trends in Europe's economies or markets.
The implicit risk of default priced in sovereign bond markets reached
all-time highs in the last 3 months. The trend is similar with bank
default risk. The crisis is continuing to get deeper, broader, and more
dangerous.
A combination of misdiagnosis, lack of political will, and
dysfunctional politics across 17 nations have all contributed to the
failure so far to stem Europe's growing crisis. I begin with our view
on the main problems that are pushing the euro area toward collapse. I
then turn to potential solutions (although we are very aware that the
complexity of the problems in Europe renders any solution
questionable), and finally I outline several factors that could trigger
rapid financial collapse in the euro area.
2. Key Systemic Problems in the Euro Area
Within the complex sphere of Europe's crisis, if we had to pick one
issue that turns this crisis from a tough economic adjustment into a
potentially calamitous collapse, we would argue it is the
transformation of Europe's sovereign debt market. We outline this in
section 2.1 and then discuss the economic ramifications in sections 2.2
and 2.3.
2.1. European Sovereign Bonds Are Now Deeply Subordinated
Claims on
Recessionary Economies
In July 2011, Peter Boone and I laid out the case that the euro
area's immediate problems, in large part, reflect transition from a
regime where sovereign debts were perceived to be sacrosanct (``risk-
free'') to one in which investors perceived that sovereign defaults
were possible.\2\ Neither investors nor Europe's politicians understood
the full ramifications of no bailout clauses in the Maastricht treaty
until recently. With the new risk premium needed to compensate for
default risk, some European nations will need to radically reduce their
debt levels and change its maturity structure.
The treatment of private investors in the upcoming Greek debt
restructuring has made it ever clearer that Europe's sovereign bonds
bear substantial risk. On July 27, 2011, the EU Council of Ministers
finally admitted that a Greek default was needed--although to date they
prefer to describe this default as voluntary, referring to it as
private sector involvement (PSI).\3\ By choosing a default over
bailouts, it is as if the politicians have inserted a new clause into
all European sovereign bonds:
In the event that the issuing sovereign cannot adequately
finance itself in markets at reasonable interest rates, and if
a sufficient plurality of the EU Council of Ministers/Euro
group/ECB/IMF/the Issuer determine it is economically or
politically expedient, then this bond may be restructured.
Soon after this announcement it was apparent Greece could not
afford the proposed deal, and more funds would be needed. At the summit
on October 27, 2011, Europe's leaders announced that for Greek debt the
PSI ``haircut'' would rise from 21 to 50 percent in order to provide
these funds, while the official creditors promised no additional funds
specifically for Greece.\4\
Those nonofficial creditors holding Greek bonds learned a new
lesson: They are the residual financiers to European issuers when the
troika's programs fail.\5\ The Greek press reported that the government
was prepared to change laws governing its bonds in order to force
nonofficial creditors to bear these losses. For nonofficial creditors,
a further clause has thus been effectively and implicitly inserted into
European sovereign bonds:
In the event of default (i) any non-official bond holder is
junior to all official creditors and (ii) the issuer reserves
the right to change law as needed to negate any rights of the
non-official bond holder.\6\
We should not underestimate the damage these steps have inflicted
on Europe's =8.4 trillion sovereign bond markets. For example, the
Italian government has issued bonds with a face value of over =1.8
trillion. The groups holding these bonds are banks, pension funds,
insurance companies, and Italian households. These investors bought
them as safe, low-return instruments that could be used to hedge
liabilities and provide for future income needs. It was once hard to
imagine these could ever be restructured or default.
Now, however, it is clear they are not safe. They have default
risk, and their ultimate value is subject to the political constraint
and subjective decisions by a collective of individuals in the Italian
Government and society, the ECB, the European Union, and the
International Monetary Fund (IMF). An investor buying an Italian bond
today needs to forecast an immediate, complex process that has been
evolving in unpredictable ways. Investors naturally want a high return
in order to bear these risks.
Investors must also weigh carefully the costs and benefits to them
of official intervention. Each time official creditors provide loans or
buy bonds, the nonofficial holders become more subordinated, because
official creditors including the IMF, ECB, and now the European Union
continue to claim preferential status. Despite large bailout programs
in Greece, Portugal, and Ireland, the market yield on their bonds
remains well above levels where they are solvent. This is partly due to
the subordinated nature of these obligations. De facto, if not de jure,
Europe's actions have turned these bonds into junior claims on troubled
economies.
Once risk premiums are incorporated in debt, Greece, Ireland,
Portugal, and Italy do not appear solvent. For example, with a debt/GDP
ratio of 120 percent and a 500-basis-point risk premium, Italy would
need to maintain a 6 percent of GDP larger primary surplus to keep its
debt stock stable relative to the size of its economy.\7\ This is
unlikely to be politically sustainable.
2.2. Crisis Spreads Into Europe's Core Banks and Incites
Capital Flight From the Periphery
On August 27, 2011, Christine Lagarde, the managing director of the
IMF, shocked European officialdom with a speech decrying inadequate
capital levels in European banks.\8\ She referred to analysis by IMF
staff showing that, if European banks were stressed for market-implied
sovereign default risks, they were =200 billion to =300 billion short
of capital. Lagarde's speech was courageous and the logic of her
analysis raised deep concerns.\9\ This was the first time the IMF
admitted that sovereign default risk needed to be taken into account
for the largest banks in Europe. Europe's regulatory regime does not
require banks to have equity capital funding for sovereign debt--there
is no capital requirement, in banking jargon--so banks accumulated
these debts over many years under the assumption no additional capital
would be needed. They must now revisit those portfolios to take account
for capital needs on risky sovereign debt. However, the IMF analysis of
the capital needs to offset this risk was odd. Markets price in a small
risk of sovereign default, yet a major sovereign default would be a
large, discrete event. Regulators need to decide: Sovereigns are safe,
in which case banks need little capital protection against sovereign
default, or they are not safe. If they are not safe, then banks need to
accumulate adequate capital--raising their equity relative to total
assets--to survive plausible sovereign defaults. For example, Bank for
International Settlements (BIS) data show French banks in June 2011 had
claims worth $109 billion (on an ultimate risk basis) on Greece,
Ireland, Italy, Portugal, and Spain (GIIPS); if these nations were to
default on their sovereign claims, then French banks would surely
experience large losses on the entirety of this portfolio while the
repercussions for France's own economy would add further domestic
losses.\10\
If sovereign default risk is not removed, then banks need nearly
full equity funding to cover plausible states of nature where
disorderly defaults do happen. The lesson for banks is clear: They need
to reduce exposures to troubled nations and batten down the hatches.
In addition, Europe's peripheral banks are suffering large funding
losses as capital moves to safer nations--most notably Germany.
2.3 Macroeconomic Programs: Too Timid To Restore Confidence
or Growth
While it may already be too late to avoid extensive defaults, we
can still consider what needs to be done to reduce the risk of default.
To avoid defaults and restructurings, Europe needs to introduce
policies that bring market risk premiums on sovereign (and hence bank)
debts down. Investors need to feel confident that, with a 2- to 3-
percent risk premium, it is worth the risk to hold onto several
trillion euros worth of troubled nations' sovereign debts, as well as
the much larger nonsovereign debts.
In a nation with a flexible exchange rate, adjustment is usually
achieved with budget cuts and a sharp devaluation. Since euro area
nations have forgone their right to devalue, they need to regain
competitiveness through price and wage cuts, while even more sharply
cutting budget spending. In essence, they need to increase volatility
of their wages, prices, and budgets if they are prepared to forgo
similar changes that could be achieved through the exchange rate.
The available evidence from the outcomes of the troika programs in
Portugal, Ireland, and Greece, as well as the recently announced budget
plans in Italy and Spain, suggests current policies will fail at this
task. These programs all plan for gradual reductions in budget
deficits, implying continued buildup of total government debts, while
partially substituting private debt for official debt. In Portugal and
Ireland the programs rely on external financing until 2013 when it is
anticipated the program countries will reenter markets to finance
ongoing budget deficits and ever higher debt stocks at modest interest
rates. In Italy, optimistic growth assumptions help bring the budget to
balance in 2013, but debt stocks remain far too high. Spain announced
it would miss its 2011 budget deficit target of 6 percent, raising it
to 8 percent. In Greece, budget revenue and GDP growth forecasts are
again proving too optimistic.
Any successful program must recognize the fact that appetite for
periphery debt amongst investors will not recover to ``pre-crisis''
levels, because default risk is now a reality that was not foreseen
prior to 2009 and because debt stocks are now higher in the periphery.
For example, Ireland is currently running a budget deficit measured at
12.5 percent of GNP.\11\ The troika program calls for that budget
deficit to fall to 10.6 percent of GNP in 2012. Ireland's stock of
official debt will reach 145 percent of GNP in 2013, while it also has
contingent liabilities to its banking sector that amount to over 100
percent of GNP. An investor looking at these numbers must recognize
there is serious risk of default. Since market access is highly
unlikely, who will finance Ireland from 2013 onward?
A successful program must also take steps to quickly improve
competitiveness.\12\ The only nation that shows moderate improvement in
relative unit labor costs is Ireland, but this is largely a statistical
artifact driven by the decline of unproductive industry in the
weighting.\13\ Italian Prime Minister Mario Monti's program includes no
general wage cuts.\14\ In Portugal, the government abandoned attempts
to engineer unit labor cost reductions through ``internal devaluation''
after meeting political opposition. In Ireland, the Croke Park accord
prevents the government from further reducing public sector wages.\15\
Despite nearly 2 years of troika programs, Greek unit labor costs have
hardly budged.
With sovereign risk premiums rising, and capital flowing out of the
periphery from banks while deficits and competiveness improve little,
it is not surprising that peripheral economies are in trouble. The
Purchasing Managers' Index (PMI) indicates a bleak picture. It is no
coincidence that a new major ``downturn'' started soon after German
politicians made clear they were planning to let Greece default. It is
also clear that the troika programs are failing to restore growth.
The stark contrast between unemployment in Germany and the
periphery reflects the dynamics of the crisis. The strong core is
becoming stronger--German unemployment is lower than it was in 2008--
while Greece, Ireland, Portugal, and Spain have high unemployment that
continues to rise.\16\ Italy's troubles are recent, so with a sharp
recession beginning, we anticipate Italian unemployment will soon rise
sharply also.
3. Solutions
Europe may continue to veer toward a major financial collapse.
European economies are in decline due to capital outflows from fear of
sovereign and bank defaults. Recessions and continued budget deficits
only raise the risk of default. Macroeconomic adjustment programs are
not strong enough and do not reflect the large measures needed given
the lack of exchange rate devaluation. As the GIIPS decline, there is
serious risk that other indebted and heavily banked nations in the euro
area, such as France, Belgium, and Austria, could be pulled into
trouble themselves.
3.1. The Big Bazooka
Some analysts are now calling for a massive ECB-led bailout to
arrest sovereign risk and stop this dangerous trend. The general hope
is that, if the ECB offered to massively finance the periphery,
investors would return to buying those sovereign and bank bonds. Lower
interest rates would give breathing space for sovereigns to correct
budget deficits and banks to build capital.
To see how feasible this is, first consider the sums required. Any
bailout would need to unequivocally convince investors that for several
years these nations will simply not see serious financial problems.
This means the bailout would need to have enough funds to buy up a
large portion of the existing stock of ``risky sovereign debts'' plus
finance those nations for, say, 5 years. The bailout must buy the debt,
rather than simply refinance debt rollovers, since otherwise secondary
market interest rates would stay high. The secondary market rates will
determine the lending capacity of local banks and their
creditworthiness.
We have calculated the sums required to purchase 75 percent of the
outstanding government debts of the troubled nations (leaving aside
debt owed to official lenders), plus finance their deficits over 5
years. In this base case we assume troika programs are implemented and
deficits decline gradually over 5 years. The total adds to =2.8
trillion, or 29 percent of euro area GDP.
We can then contrast this with alternative assumptions.\17\ The
most dangerous risk facing the euro area is if a ``bazooka'' is
employed and yet the troika programs fail to restore growth and improve
budgets. We assume budget deficits decline only modestly, and we
calculate the financing needed to cover deficits until 2020. Our
negative outcome implies nearly =5 trillion would be needed just for
GIIPS, something the IMF implicitly flagged when they reported recently
that Greece alone may need =500 billion (\1/2\ trillion) by 2020.\18\
Successful ``bazooka'' interventions often occur when the extra
financing is no longer needed, so that the financing acts as a backstop
but is hardly used. For example, when Poland launched its stabilization
program in early 1990, the $1 billion stabilization fund was never
spent. The U.S. Troubled Asset Relief Program (TARP) was quickly repaid
by almost all banks. This is not possible for the euro area. Some euro
area nations have too much debt in the new regime with default risk. In
the early days of such a program we expect large purchases would be
needed. The ECB would have to drive market interest rates down to
levels where private creditors would not be well rewarded to hold the
debts. As the ECB purchased the debts, private creditors would be
further subordinated, and this would add to their desire to sell their
bonds.
There are many reasons we believe such ECB ``bazooka'' programs
won't occur and are potentially dangerous to euro area survival. First,
while using the ECB balance sheet may make such risks more opaque, any
large bailout still poses potential heavy losses for Germany and other
healthy members of the euro area. In the event there is default in the
GIIPS, Germany would be responsible for 43 percent of the capital needs
of the ECB. Hence with a bailout fund of =2.8 trillion, Germany would
be assuming =1.2 trillion, or 45 percent of German GDP, in credit risk.
The Bundesbank and other National Central Banks are likely to refuse.
Second, this measure on its own does not resolve competitiveness
problems or large budget deficits in the periphery. It would
undoubtedly cause the euro to fall but the benefits of euro
depreciation are somewhat muted since Germany would remain relatively
competitive compared with the periphery. The periphery will still need
aggressive fiscal and wage cuts to improve their deficits and
competitiveness relative to Germany.
Third, it would place the unelected ECB governors in a political
role they were never destined to play and were legally forbidden to
play according to the Maastricht treaty. The ECB could quickly become
the largest creditor to peripheral nations, and as their financier it
would ultimately need to negotiate budget programs, wage cuts, and
structural change. It may choose to relinquish those powers to the IMF,
but it would be the true power behind all these negotiations.
Finally, the bazooka could well incite an eventual crash of the
euro area. If the ECB embarked on a program to backstop troubled
nations, observers would quickly recognize that the potential sums
needed to maintain stability could be large. Our bad case scenario
implies over 341 percent of the ECB monetary base and 46 percent of
euro area GDP might be needed.
For markets, what matters are the perceived future bailout costs.
Hence, an announcement of a ``bazooka'' will lead to varying reactions
in markets as the perceived bailout needs rise and fall. Investors
could become very afraid if peripheral adjustment programs appear to
fail or bailout needs spread to more nations. Such concerns could
rapidly cause financial-market turmoil and euro area collapse (see
section 4).
3.2 A More Comprehensive Solution
If the bazooka is unlikely and probably won't work, while the
status quo is failing, what is an alternative? The focus needs to be on
returning the relevant sovereigns to solvency. Once the sovereigns are
solvent, most commercial banks will have breathing space to rebuild
capital through operating profits and retained earnings.
However, there is no easy means to achieve this. In our assessment,
the GIIPS will need to restructure their debts by extending maturities
and reducing coupons to levels that they can afford. There is some
scope for official assistance to offset the total costs of such
restructuring by subsidizing debt swaps. However, the Greek example
suggests Europe's politicians have little appetite to provide more
taxpayer funds for this purpose.
While preemptive restructuring seems attractive, the needed extent
and scope is unclear. Carmen Reinhart and Kenneth Rogoff argue that
countries with no lenders of last resort typically run into problems
when debt levels reach 60 percent of GDP. Even if we assume advanced
European economies could manage more debt, it would not be higher than
the 90 percent that Reinhart and Rogoff flag as a threshold for
developed markets. Such figures imply that greater than 50 percent
writedowns of nonofficial debt in Portugal and Ireland may be needed,
while Italian debt writedowns might be close to 50 percent.
If the GIIPS followed preemptive restructurings, Europe's core
banks, insurance companies, and pensions funds would need substantial
recapitalizations, and the costs of this could draw France and other
core nations into debt crises of their own. Hence, any plan to
preemptively restructure debts would need to be applied carefully
across Europe.
The second ingredient is a far more aggressive program to reduce
budget deficits and improve competitiveness in the periphery. These
nations need to be highly competitive if they are to generate growth
soon given the large risks overhanging their economies. This requires
large wage cuts, public sector spending cuts, changes in tax policy to
attract investment and business, and stable politics.
If these two steps were implemented, then a bailout program from
the ECB would pose lower risks. The debt restructuring and measures to
improve competitiveness would mean far less funds were needed. The
ECB's role could be to provide confidence that stability would be
maintained--a sensible central bank role--rather than to refinance
large amounts of debt and deficits.
While these steps would be a major improvement on current programs,
they are hardly likely to be implemented. As discussed in section 2,
the troubled nations have declined to implement large budget and wage
cuts. Political conditions have prevented them. Meanwhile, creditor
nations are claiming there will be no more debt restructurings beyond
Greece, and at the same time the creditors are refusing to
substantially raise bailout funds needed to prevent high interest rates
and default. None of this leads to a credible path out of crisis.
4. Playing With Fire: Ways the Euro Area Could Come to an End
Policymakers often have trouble grasping the danger that small tail
risks pose to leveraged systems. As we discussed above, a mere 10
percent annual risk of an Italian crisis is already inconsistent with
Italian long-term solvency. If Italy has a disorderly crisis, how safe
are French banks? And if those banks aren't safe, how safe is France's
sovereign debt? Low-probability bad events can very quickly generate a
wave of collapse through leveraged systems.
Our concern is that, when compared with financial crises elsewhere,
the potential triggers for a euro area collapse are numerous.
4.1 A Unilateral Exit, or the Credible Threat of One
At a midnight press conference on November 2, 2011, in southern
France, German Chancellor Angela Merkel and French President Nicolas
Sarkozy for the first time entertained the idea that a nation could
leave the euro area. Merkel and Sarkozy chose to take a hard line with
Greek politicians and their electorate: either complete the existing
agreement or leave. The background to this threat was the tough
politics in Greece. After 18 months of large budget cuts and some
structural reforms, Greece's economy remained in decline. Prime
Minister George Papandreou's government was weak, and in a last
desperate gesture he attempted to force further reforms through by
offering Greek citizens a referendum with an implicit choice of
``reform or exit.''
An exit from the euro area can be forced in minutes. The Eurosystem
only needs to cut off a National Central Bank from the payments system
and prevent that nation from printing new cash euros. Once this is
achieved, a bank deposit in Greece would no longer be the same as a
deposit in Germany, because one would not be able to get cash for a
Greek deposit and one would not be able to transfer it to a non-Greek
bank. Of course, the moment people understand such a change could be
imminent in their nation, they would run to their banks and attempt to
withdraw cash or transfer funds. This is what is now happening in
Greece. The country is losing 2.5 percent of GDP monthly in deposits
from banks.\19\
There would be enormous, painful ramifications for all of Europe if
Greece or another nation made a disorderly exit. Since there is no
legal basis for exit, all financial contracts and indebtedness between
Greek and non-Greek entities would have uncertain value as the parties
could dispute whether these are to be paid in drachmas or euros. Trade
between the exiting nation and the rest of the euro area would dry up.
The mere fact that a country did exit would have ramifications for the
other troubled nations, most likely inciting further capital flight
from those nations and producing sharp economic downturns. This in turn
would question the viability of Europe's core banks and some of the
core sovereigns. The euro itself would probably weaken sharply, and
``currency risk'' would be added into the euro.
4.2 The Weak Periphery Lashes Out Against Germany, While
Germany Fights Back
The political dynamics of crisis invariably pit creditors against
debtors, potentially leading to flareups that cause creditors to give
up. In Ireland, against strong popular opposition, the ECB is forcing
Irish citizens to take on further debt in order to bail out creditors
of bankrupt banks. In Greece, Prime Minister Papandreou was essentially
ordered to revoke his planned referendum, while Greece's opposition
leader was ordered to write a letter promising he supported Greece's
troika program, despite the fact that he clearly did not support it nor
did he participate actively in any negotiations to agree to it. French
and German politicians are also playing an instrumental role in
supporting Italy's new technocratic Prime Minister, while they eschewed
former Prime Minister Silvio Berlusconi toward the end of his term.
Meanwhile in Germany, ``bailout fatigue'' has set in as electorates and
politicians turn against more funds to nations that, they perceive, are
failing to reform sufficiently quickly.
While there are many outcomes of such discord, one possibility is
that it leads to a messy grab for power. The troubled nations already
have the power to take over decisionmaking at the ECB. They may well
usurp control in order to provide much larger ECB bailouts. This would
raise concerns in financial markets and could lead to rising long-term
yields on all euro-denominated debts. Germany would be forced to pay
more to finance itself, and German savers would ultimately be paying
for the periphery bailouts through inflation and a weak euro. In
Germany this would lead to rising calls to leave the euro area.
Once there is a small risk that Germany could leave, market prices
for euro-denominated assets would again change sharply. New risk
premiums would need to be added to national debts where nations are
expected to have weak currencies, while Germany and other strong
nations might see their risk premiums fall even further. Such changes
would reinforce the recent trends in which the core nations continue to
strengthen relative to the periphery, but those changes would also be
highly destabilizing for financial markets.
4.3 Economics of Austerity May Fail
The third risk for the euro area is that economic, political, and
social realities eventually prove that the system simply cannot work.
After all, the euro area is a dream of political leaders that has been
imposed on disparate economies. Few nations sought popular support to
create the euro. The German leadership avoided a referendum, and in
France the Maastricht treaty was passed with a thin majority of 51
percent. Even though most European leaders are highly committed to
maintaining this dream, no one can be sure what the costs are in order
to keep it.
A plausible negative scenario is that those costs, in the eyes of
the electorate, eventually appear too high. The evidence to date
suggests Europe's periphery, even in a fairly benign outcome, will be
condemned to many years or even a decade of tough austerity, high
unemployment, and little hope for future growth. A good comparison is
the ``lost decade'' of the 1980s in Latin America when nations hardly
grew due to the large debt overhangs from unaffordable debts. However,
those nations had the benefit of flexible exchange rates, while
Europe's periphery faces a more difficult period with uncompetitive
economies. Latin America's problems ended only when the creditor
nations accepted large writedowns and debt restructuring.
Another comparison would be the heavily indebted United Kingdom
during the 1920s when the government managed policies to restore
currency convertibility after the war. Britain suffered with a weak
economy for a decade, before ending in the Great Depression, despite a
booming global economy throughout the 1920s. However, this too is not a
good comparison since Britain had far more flexible wages and prices
than Europe's periphery, with nominal wages falling 28 percent during
the 1920-21 recession.
4.4 Markets Lose Patience
Our final scenario is the most likely. Faced with the reality of
failing adjustment programs, difficult politics, and rising risks that
one or more peripheral nations may rebel, or Germany may rescind its
support, investors may simply decide that the cumulative risks mean the
euro area has a moderate risk of failing.
If investors decide there is a low but significant probability that
the euro area might fail, we would encounter another version of Rudi
Dornbusch's astute observation: ``The crisis takes a much longer time
coming than you think, and then it happens much faster than you would
have thought.'' Here's why: The failure of the euro area will be a
calamitous financial event. As Dornbusch famously remarked of the
Mexican 1994-95 crisis, ``It took forever and then it took a night.''
If one believes the euro might fail, one should avoid being
invested in European financial institutions, and in euro-denominated
assets, until the outcome of the new pattern of currencies is clearer.
As a result, a large swathe of euro-denominated assets would quickly
fall in value. The euro itself would cheapen sharply, but so would the
value of European bank debt and European shares, and most sovereigns
would see their bonds trade off sharply. This in turn would make it
expensive for even the Germans to raise finance in euros. Despite their
impeccable credit record, they would be attempting to issue bonds in
what is perceived as a flawed currency.
A small risk of the euro ``breaking up'' would have great
importance for the euro swap market. This market is used by Europe's
insurance companies, banks, and pension funds to hedge their interest
rate risk. A swap contract allows, for example, a pension fund to lock
in a long-term interest rate for their investments, in return for
promising to pay short-term interest rates to their contract
counterparty. It is an important market that underlies the ability of
insurance companies, pension funds, and others to make long-term
commitments to provide society with annuities, pensions, and savings
from insurance policies. The notional value of these swaps is many
times euro area GDP.
The euro swap market could quickly collapse if markets begin to
question the survival of the euro. Euro swap rates are calculated as
the average interest rate paid on euro-denominated interbank loans for
44 of Europe's banks. Approximately half of these banks are in
``troubled nations.'' So the interest rate will reflect both inflation
risk and credit risk of the participating banks. If investors decided
that the euro may not exist in several years' time, swap interest rates
would naturally rise because people would be concerned that banks could
fail and that the ``euro'' interest rate could turn into something
else--for example, the average of a basket of new currencies with some,
such as the Greek drachma, likely to be highly inflationary.
If euro swap interest rates start to reflect bank credit risk and
inflation risk from a euro breakup, then the market would no longer
function. A pension fund could no longer use it to lock in an interest
rate on German pensions since it would not reflect the new German
currency rates. The holders of these contracts would, effectively, have
little idea what they would be in a few years' time. Hence, investors
would try to unwind their swap contracts, while the turmoil from
dislocations in this massive market would cause disruptive and rapid
wealth transfers as some holders made gains while others lost. If the
euro swap market ran into trouble, Europe's financial system would
undoubtedly face risk of rapid systemic collapse.
This example illustrates why a small perceived risk of a euro area
breakup could rapidly cause systemic financial collapse. The swap
market is only one mechanism through which collapse could ensue.
On November 23, 2011, Germany was unable to sell as many bonds as
it wished.\20\ The auction failure caused an immediate steepening in
the German sovereign bond yield curve. Some German officials argued
this failure was due to ``volatile markets,'' but there is a more
fundamental concern. Germany's ability to pay low interest rates in
euro-denominated assets requires the euro area be a financially stable
region. Today, German yields remain very low and are not at worrying
levels. However, if these rates were to rise due to fears of currency
breakup risk, then the euro area would quickly enter deep crisis as
even Germany would have trouble financing itself.
5. Dreams Versus Reality
There is no doubt that European political leaders are highly
committed to keeping the euro area together, and so far, there is
widespread support from business leaders and the population to maintain
it. There is also, rightly, great fear that disorderly collapse of the
euro area would impose untold costs on the global economy. All these
factors suggest the euro area will hold together.
However, many financial collapses started this way. A far more
dramatic creation and collapse was the downfall of the ruble zone when
the Soviet Union collapsed in 1991. Argentina's attempt to peg its
currency to the dollar in the 1990s was initially highly successful but
ended when its politicians and society could not make the adjustments
needed to hold the structure together. The Baltic nations--Estonia,
Latvia, and Lithuania--have managed to maintain their pegs but only
after dramatic wage adjustments and recessions.
More relevant, the various exchange rate arrangements that Europe
created prior to the euro all failed. With the creation of the euro,
Europe's leaders raised the stakes by ensuring the costs of a new round
of failures would be far greater than those of the past, but otherwise
arguably little has changed to make this attempt more likely to succeed
than the previous one. Small probabilities of very negative events can
be destabilizing. A lot of things can go wrong at the level of
individual countries within the euro area--and one country's debacle
can easily spill over to affect default risk and interest rates in the
other 16 countries. The euro swap market is based, in part, on interest
rates charged by 44 banks in a range of countries; about half of these
banks may be considered to be located in troubled or potentially
troubled countries. If the euro swap market comes under pressure or
ceases to function, this would have major implications for the funding
of all European sovereigns--including those that are a relatively good
credit risk.
At the least, we expect several more sovereign defaults and
multiple further crises to plague Europe in the next several years.
There is simply too much debt, and adjustment programs are too slow to
prevent it. But this prediction implies that the long-term social
costs, including unemployment and recessions rather than growth,
attributable to this currency union are serious. Sometimes it is easier
to make these adjustments through flexible exchange rates, and we
certainly would have seen more rapid recovery if peripheral nations had
the leeway to use exchange rates.
When we combine multiple years of stagnation with leveraged
financial institutions and nervous financial markets, a rapid shift
from low-level crisis to collapse is very plausible. European leaders
could take measures to reduce this risk (through further actions on
sovereign debt restructurings, more aggressive economic adjustment, and
increased bailout funds). However, so far, there is little political
will to take these necessary measures. Europe's economy remains,
therefore, in a dangerous state.
----------------
End Notes
\1\ This testimony draws on heavily on joint work with Peter Boone,
particularly ``The European Crisis Deepens,'' Policy Briefs in
International Economics 12-4, January 2012; Peterson Institute for
International Economics, and ``Europe on the Brink,'' Policy Briefs in
International Economics 11-13, July 2011; Peterson Institute for
International Economics. For more background, please see also our paper
``Will the Politics of Moral Hazard Sink Us Again'' (Chapter 10, in the
LSE volume on ``The Future of Finance,'' July 2010). I also draw on
joint work with James Kwak, including ``13 Bankers: The Wall Street
Takeover and The Next Financial Meltdown'' (Pantheon, 2010) and, on the
U.S. fiscal outlook, ``White House Burning: The Founding Fathers, The
National Debt, And Why It Matters To You'' (Pantheon, April 2012).
Underlined text indicates links to supplementary material; to see this,
please access an electronic version of this document, e.g., at http://
BaselineScenario.com, where we also provide daily updates and detailed
policy assessments for the global economy. For important disclosures
relative to affiliations, activities, and potential conflicts of
interest, please see my bio on BaselineScenario.
\2\ Peter Boone and Simon Johnson, ``Europe on the Brink,'' Policy
Briefs in International Economics 11-13, July 2011, Peterson Institute
for International Economics, available at www.piie.com.
\3\ For the definition of PSI in the euro area context, see page18
in ``European Financial Stability Facility (EFSF),'' available at
www.efsf.europa.eu/attachments/faq_en.pdf.
\4\ At the July 21, 2011, summit euro area leaders called for =109
billion of official assistance. On October 26 they committed to =100
billion of official assistance. The IMF did not provide any additional
commitment in October.
\5\ The troika is the informal name given to the European Union,
ECB, and the IMF, which negotiates the terms of external assistance to
Greece and other troubled peripheral countries.
\6\ To be clear, this ``clause'' and the preceding clause are just
our interpretations--such clauses are nowhere written down, which
greatly adds to the prevailing uncertainty.
\7\ A 500-basis-point risk premium is consistent with an annual 10-
percent risk that something will trigger a decision to restructure and
that there would be a 50-percent mark-to-market loss on bonds under
such an event.
\8\ Christine Lagarde, speech at Kansas City Federal Reserve
conference, Jackson Hole, August 27, 2011, available at www.imf.org.
\9\ European politicians first dismissed Lagarde's analysis and
later the European Banking Authority revised down the needs to =114
billion. They argued that the IMF failed to take into account a
potential rally in the price of safe haven bonds, such as France and
Germany, which banks hold on their balance sheets. We believe the
analysis far underestimates the potential capital needs since it does
not take into account the full macroeconomic ramifications of sovereign
default.
\10\ Bank for International Settlements, Table 9D: Consolidated
foreign claims of reporting banks--Ultimate risk basis, BIS Quarterly
Review, December 2011, available at www.bis.org/publ/qtrpdf/
r_qa1112_anx9d_u.pdf.
\11\ Ireland's GNP is substantially smaller than its GDP. Due to
its role as a tax haven, many foreign companies have set up operations
in Ireland, with a controlling shell company located in a tax-free
nation, in order to take advantage of Ireland's regulations that
specify that the controlling owner, rather than the resident company,
is subject to tax. For this reason companies such as Google, Yahoo,
Microsoft, Forest Labs, and many others channel license revenues and
royalties through Irish subsidiaries. These royalties and revenues are
in large part excluded from the tax base in Ireland. These companies
would move if Ireland changed rules and made such revenues taxable.
Since the relevant concept for fiscal sustainability is the taxable
base, it makes sense that this should be used to measure Ireland's
indicators. No other nation in Europe has a large difference between
GNP and GDP. The IMF regularly reported Irish GNP in its staff reports
but recently removed all reference to GNP. This raises concerns that
the IMF is attempting to mask fiscal sustainability problems by not
reporting these data.
\12\ Unit labor costs are the best measure of competitiveness in
this context. These also include nontraded goods and are not a perfect
measure of competitiveness, but the general pattern is clear--over the
past decade Germany has really diverged from its European trading
partners by becoming more competitive.
\13\ Ireland's nontraded goods sector is less productive than its
traded goods sector (which includes companies such as Google that
choose to report earnings in this low corporate tax environment.) As
part of the Irish recession, the nontraded goods sector has contracted
while ``exports'' from large multinationals have remained relatively
robust.
\14\ See, for example, Alex Roe, ``Monti's Measures for Italy,''
Italy Chronicles, December 5, 2011, available at http://
italychronicles.com.
\15\ See Harry McGee, ``Freeze on Cuts After Croke Park Accord,''
Irish Times, July 21, 2011, available at www.irishtimes.com.
\16\ The latest unemployment numbers are bad, including 22 percent
in Spain and 14 percent in Ireland.
\17\ For more detail, please see Peter Boone and Simon Johnson,
``The European Crisis Deepens,'' referenced in footnote 1 above.
\18\ This is a stress scenario in the IMF's debt sustainability
analysis for Greece. In our view, this scenario could reasonably be
regarded as something closer to a baseline forecast.
\19\ Deposits have declined by =61 billion, or 24 percent of GDP,
since spring 2009. See Bank of Greece, ``Aggregated balance sheets of
monetary financial institutions (MFIs),'' available at
www.bankofgreece.gr.
\20\ Paul Dobson, ``German Auction `Disaster' Stirs Crisis
Concern,'' Bloomberg News, November 23, 2011, available at
www.bloomberg.com.
Senator Shaheen. Well, where to begin? That made me feel so
much better, Dr. Johnson, about our prospects.
I actually am going to start. We did another hearing on the
eurozone crisis before this subcommittee last November, and I'm
going to start with the last question that I asked that panel.
That was what the United States could do to help address the
situation in Europe. I will tell you that to a person the
members of that panel said the most important thing we could do
is to get our own fiscal house in order here.
I want to ask each of you to start, if you agree with that
assessment? Dr. Burwell, you actually mentioned some other
things in your testimony, but how do you assess what we heard
from that other panel?
Dr. Burwell. I do agree with that, if for nothing else than
it gives us more credibility when we talk to the Europeans
about their crisis. I also think, though, that one of the other
things that we can do is to try and keep the temperature low.
The European situation is often made worse by the market. As I
pointed out, I think European leaders do not see it as a
priority to respond to the market in the way that perhaps some
of our leaders do. We could talk more about why that is. But I
do think that it's in our own interest not to spur the market
into going after certain currencies.
But yes, first we have to get our own house in order in
order to be credible in this discussion.
Senator Shaheen. Thank you.
Mr. Veron.
Mr. Veron. In a way, it's frustrating, but my impression is
that there is relatively little that the United States can do
on top of what it already does, which is provide discreet and
sometimes public advice to European leaders and play its role
in the International Monetary Fund, which is one of the members
of the European troika.
Beyond this, it's my impression that the European crisis
can only be solved by the Europeans themselves. And one reason
for this is that Europe is a rich continent. The problem is not
that Europe needs external financial assistance. Actually there
is enough wealth and money inside Europe to resolve this crisis
by a margin. So the roadblock is internal in Europe. It is
political inside Europe. There is little that the United States
can do except leading by example, as you have suggested.
Senator Shaheen. Thank you.
Dr. Johnson.
Dr. Johnson. I would make three suggestions. The first is
to strengthen the capital basis, increase the capital funding,
the equity funding of our largest financial institutions.
That's tremendously important, both for our own financial
stability and for global financial stability because we're the
heart of the world's financial markets.
The second point would be clearly to at least avoid another
debilitating fight over the fiscal cliff or over the debt
ceiling. Remember that, while the GAO has recently, their study
recently said that the last fight we had in the summer of last
year did push up U.S. borrowing costs by a little, an
insignificant amount, the big impact was on other countries.
When you scare the world and investors become frightened,
actually the larger effect is that capital comes into the
United States, which, other things equal, would tend to push
down our interest rates. But that will make it harder for
countries that are viewed by the market as potentially in
trouble, harder for them to fund themselves.
If you want to cause a sovereign debt crisis for France,
the best thing you can do is have an enormous fiscal fight on
Capitol Hill in January and February of next year. I don't
think you really want to go there.
The third point is with regard to the IMF. I completely
agree with what Mr. Veron said. The eurozone can, should, and
must, and ultimately will solve this problem by itself. The
IMF's involvement in the eurozone and intra-European support I
think should be wound down. The IMF played a useful role
initially in Greece. I'm not supportive of the IMF being
dragged into and being used as a scapegoat, for example, in a
program for Spain or Italy, wherever this goes.
However, in terms of potential knock-on effects, if you
take the downside scenario seriously, as I'm urging you to do
today, you should worry about lots of other countries that are
not in the eurozone, that don't issue a reserve currency, that
are also important to us for trading reasons, financial sector
reasons, or security reasons. Those countries could well suffer
a huge hit, and we are not good and we're not organized in such
a way as we can provide bilateral support quickly and
effectively. We always work through the IMF in these kinds of
settings. We need to look at whether the IMF has the resources,
the people, and the right mindset, given that it is excessively
dominated by Europeans, to handle the potential knock-on
effects of the European crisis really does get out of control
quickly.
Senator Shaheen. So let me just ask you, when you talk
about the potential impacts on other countries outside the
eurozone, you're not talking about other countries that might
be members of the EU. You're talking about a much more
extensive global impact.
Dr. Johnson. Yes. Certainly the impact could be completely
global. I would worry about some parts of Eastern Europe, by
the way. East European countries that are not members of the
eurozone, it's not clear, if the pressure is really on, how
much support they could count on purely within that European
context. They don't have the euro as their currency. They're
not issuing a reserve currency. They're much more likely to be
pressed hard by the markets, and we could go country by country
or talk about it with your staff afterward.
So I would not rule out some dangerous developments within
Europe, and I think we have serious security interests there
that need to be--on which we've done very well over the past 20
years. Those need to be safeguarded, because you can throw away
a lot of progress very quickly in this kind of crisis.
Senator Shaheen. Sure. No, I was just trying to get some
sense of, when you said the other countries that would be
affected, where your focus was, whether it was on the rest of
Europe or whether you were thinking in particular some other
region of the world.
Dr. Johnson. Well, anyone who's a commodity exporter is
typically vulnerable when you have a dramatic slowdown, and
there are many countries which really have made progress with
democratization and with opening themselves up in a responsible
way to global trade, in Africa, in Latin America, in some parts
of Asia. All of this could take a big step back if the European
crisis causes big disruptions and if nobody is there to help.
Who is there to help? We're not going to do it ourselves.
You're not going to put that in next year's budget, I'm sure,
under any circumstances. It falls on the IMF. Is the IMF
prepared to do this? I worry because we've allowed the IMF to
become excessively dominated by the Europeans, who are largely
in denial about the scope of their own problems and the way in
which those can damage the world.
Senator Shaheen. Thank you.
My time is up. Senator Barrasso.
Senator Barrasso. Thank you, Madam Chairman.
I want to follow up, as we had been doing from the hearing
from last November, and specifically with the implications for
the U.S. economy, for our financial system. Perhaps we could
just start in the order in which our guests have testified. So
could you talk about some of the implications to the U.S.
economy, financial systems, transatlantic relations, should the
current crisis lead to a breakup of the eurozone or specific
countries leaving, as Dr. Johnson has suggested that may be
occurring within the next 6 months, and how would that
specifically impact us as well as U.S. exports?
Dr. Burwell. Let me first say that I think the breakup of
the eurozone and certainly the breakup of the European Union is
a very unlikely event. I think that we often in this country
underestimate how closely tied these countries are, how
integrated they are.
It is true that over the last 18 months many of the non-
Greek countries have been pulling their assets away to protect
themselves should something happen in Greece. But what we need
to think about in terms of the implications for the United
States, even if the crisis goes forward as I would predict for
2 more years with European summit after European summit that
incrementally puts in place the minimal decisions that they
need to make to keep their heads above water, I think we're
looking at a couple of consequences and then I think my
colleagues who are real economists are much more capable of
talking about some of the specifics.
But two that I see on the economic side are: first off, the
impact on the stock market, and for many middle-class Americans
and others who have their retirement in 401(k) plans.
The other consequence is the lack of business confidence.
You have many companies in this country who have funds to hire
or expand or invest, but who are being conservative, little
``c'' conservative, about that, and it's probably prudent
business practice, because they don't know what markets will be
like in the future.
So I think that those are things that we will have to deal
with in terms of the U.S. economy not growing as fast because
the overall pressures are to be very guarded about what you do
in terms of investment and expansion. So I'll leave it at that.
Senator Barrasso. Thank you.
Mr. Veron. First, I think it's striking to see the contrast
between the seriousness with which the breakup scenario is
taken on this side of the Atlantic and the denial of the
possibility of breakup that you often sense in Europe and
particularly in Brussels. I would inevitably sit a little bit
in the middle of this. Personally, I think that a breakup is
seen as more likely than it really is in many American circles,
but I would also accept the proposition that many Europeans are
in denial and that actually this denial is very harmful in
terms of crisis management, where those who would need to be
most paranoid, those who would need to take the downside
scenario most seriously, should be the European policymakers,
and I often have the impression that they're not doing that
enough.
That said, on Greece particularly, which is a flashpoint
and will remain one I think for some time, I don't share Dr.
Johnson's prediction. I think that many observers, including
many market participants, are considering the possibility of a
Greek exit more likely than I would. The reason that I consider
it less likely is not that I see Greece doing well or being on
track in its adjustment program, which it is not, but just the
fact that I think the contagion of a Greek exit to other member
states would be absolutely impossible or at least could be
absolutely impossible to manage. I think there is an awareness
of this situation in European policy circles.
Now, that doesn't get us to a clear view of what to do with
Greece if it continues to veer off track, and I think here
we'll have very difficult decisions to make in Europe in the
next few months, including some that could go further than what
the troika has already done in terms of temporarily depriving
the Greek Republic from some attributes of sovereignty.
For the United States, the United States has to cope right
now with a European recession. I think in any scenario Europe
will remain in recession in the near future. I don't see a
scenario of a strong European rebound. Maybe I'm not optimistic
enough on this one, but I really don't see it as possible under
the present circumstances.
However, a breakup of the euro would plunge Europe into a
deep depression, and I think this would create shock waves that
the United States would not be able to escape, even though, as
Dr. Johnson mentioned, it's very difficult to model this. It's
very difficult to know where exactly the exposures are because
the system is so complex. The interactions are everywhere.
There are linkages all over the place.
As regards financial institutions, I'm less sure than Dr.
Johnson about the need for radical measures in terms of capital
strength. My impression is that many U.S. banks, including
large U.S. banks, have rebuilt capital in a fairly strong
manner in the past few years. Maybe I should take a closer look
at them, but my impression is that the Federal Reserve and
other members of the U.S. supervisory community have been very
careful in watching the interconnectedness of the U.S.
financial system with the European financial system and in
nudging the financial institutions into adequate contingency
planning.
But I think there's no denying that shock waves from a
eurozone breakup and depression would affect the United States.
I think in terms of the rest of the world, the point that was
discussed just before, we already have seen a lot of European
bank deleveraging, particularly in Asia, also in Latin America
and other parts of the world. So this has already started, and
I think this has strategic consequences, including for the
United States, because what we have seen is that a lot of the
credit that was provided by European banks to Asian or Latin
American economic agents has been replaced fairly effectively
by credit from other players, including U.S. or Canadian banks,
but including also Chinese or Japanese or other Asian banks. So
there is a redrawing of the global financial map which has
already started, has actually gone very rapidly in the past 2,
3 years, and I think this has strategic consequences as well.
It's already happening. It has already happened to a large
extent.
Senator Barrasso. Thank you.
Dr. Johnson.
Dr. Johnson. It's all about the financial sector, Senator,
and the transmission of shocks, I believe, through opaque
derivative transactions. To give you one specific example, not
to single someone out, but to give you an example. J.P. Morgan
Chase has a published balance sheet under U.S. GAAP of $2.3
trillion. U.S. GAAP allows a very generous netting of
derivative transactions. If you use international accounting
standards, as they use in Europe, with a less generous netting
of derivatives and one that is considered by many authorities
on resolution to be more appropriate when thinking about the
potential losses, then J.P. Morgan Chase's balance sheet is not
$2.3 trillion, it's $3.9 trillion.
They have shareholder equity around $180 billion capital.
In their own living will that they have presented, they model
the scenario in which losses of $20 to $30 billion trigger a
collapse of J.P. Morgan Chase and therefore a systemic crisis.
Now, that living will was put together before they lost $6
billion on those trades in London, which happened in a
relatively benign period for the world economy.
We need to worry a great deal about the vulnerability of
the systemically important institutions. Unfortunately, with
all due respect, I disagree very strongly with Mr. Veron. I
spend a lot of time with regulators. I'm on the FDIC Systemic
Resolution Advisory Panel. I do not believe that our
authorities, including specifically the Federal Reserve, both
the Board of Governors and the New York Fed, have pushed hard
enough to strengthen the capital base.
The stress tests that were run repeatedly, including most
recently this year, did not model any of the events that we are
now all regarding as part of our baseline scenario.
Senator Barrasso. Thank you.
Thank you, Madam Chairman.
Senator Shaheen. Senator Risch.
Senator Risch. Thank you very much.
For those of us I think that are unschooled to the extent
that you are in economics, it was fascinating to watch the
eurozone first of all be created. I just kind of shook my head
and I didn't understand how this could work, where you had
sovereigns who had not given up sovereignty, but yet decided to
combine their currencies.
I suppose it's not dissimilar to what happened at the
Constitutional Convention when the States got together and did
this. They created a constitution and probably had a lot of the
same questions that were presented to the eurozone, and they
left the Constitutional Convention without resolving those.
Indeed, a lot of them walked away with different ideas about
the sovereignty versus the strength of the central government.
However, fortunately they lived in a lot simpler times than
we live in today. You don't have the complexity of the
institutions or the interrelation of the institutions that you
have today or, for that matter, the Internet and communications
that tie us together. So as the country went along, they had
serious problems, but I guess they had the luxury of the train
wreck was slow instead of a fast-moving train wreck, which we
don't have the luxury of today.
So as these issues come up and as the EU continues to
wrestle with them, but not seem to be able to resolve them, I
think I worry about how quickly the house of cards could come
down. So I guess I'd like all of your thoughts about how--I
mean, this is going to end sooner or later. You have to think
it's going to end sooner or later, one way or another.
So the question I guess I have for each of you is your
predictions as to how this--what does this look like on the
other side?
Dr. Burwell.
Dr. Burwell. Well, I think it will be very messy getting to
the other side. I think that no matter--I consider myself an
optimist on this and my prediction is still that we have a few
years to go. I believe that if we come to the point where it
looks like Italy or Spain will fall out of the eurozone that
the Germans at that time will lift their political objection to
mutualization of debt. As Mr. Veron said, there are the
resources in Europe to solve this problem.
The scenario that Dr. Johnson has painted of what happens
at the end of the breakup of the eurozone I think is something
that everyone keeps in mind, and precisely for that reason
they're unwilling to go there, because it is so horrible. The
estimates that I have seen for even Greece leaving the eurozone
are 30 to 50 billion euros in costs for Greece. That doesn't
say anything about the costs outside Greece for that. You can
imagine what that would be if we actually had 17 countries who
were all using one currency suddenly decide not to use that
currency any more.
Germany, which is leading a very comfortable economic
existence right now, would suddenly find that its exports were
priced much more highly if it went back to its own, the
deutschemark.
Senator Risch. You're convinced, though, that there will be
mutualization of debt at some point in the future?
Dr. Burwell. At some point in the future. If we take the
nonemergency scenario, then I think that we will see over the
next 2 to 5 years--they will bring the fiscal compact into the
European institutions, which means having another round of
referendums, which will be difficult, but I think will happen.
You will see more and more of the countries actually bring
their economies closer together through these structural
reforms that are being pushed on Spain and the others at this
point.
Only once that has been in practice for some time, so
perhaps 10 years from now, will you see a formal eurobond
issuance or something of that sort.
Senator Risch. And of course there's huge political
problems in places like Germany before that gets done.
Dr. Burwell. The problem actually is that Germany is doing
well right now. I mean, there are little issues and we've seen
business confidence decline in the last couple of months. There
are little indications in Germany, for example, that their
exports are slowing because of the slowing of economic action
in the rest of Europe.
But Angela Merkel will face election in fall 2013. Her
approval ratings now are at 66 percent. Most of the Germans
believe that she's doing pretty well handling this.
Senator Risch. Those of us in politics know that there is a
short, very short shelf life on your ratings.
Dr. Burwell. Yes.
Senator Risch. Mr. Veron, could you give us your view on
how this unwinds, what this looks like after it's resolved?
Mr. Veron. I think it looks different. In other terms, I
certainly don't believe and have never believed that the
eurozone and the European Union could come out of this crisis
with a return to something that would look like what they had
before. This crisis is transformational and there is no middle
ground, and I would argue has never been, between resolution by
failure, which is the breakup of the eurozone and the dire
consequences that we've already talked about, and what I would
consider a successful resolution, even though it will carry a
cost and it will not be a cakewalk, which is deeper
integration.
In a very remarkable speech in Berlin a couple of months
ago, Radek Sikorski, the Foreign Minister of Poland, expressed
it that way: ``If we are not willing to risk a partial
dismantling of the EU, then the choice becomes as stark as can
be in the lives of federations: deeper integration or
collapse.'' And this is a noneurozone country which was
considered by a former Secretary of Defense here as part of so-
called ``New Europe.''
Senator Risch. Mr. Veron, do you agree that eventually
there's going to be mutualization of debt?
Mr. Veron. Yes.
Senator Risch. Dr. Johnson, how about you?
Dr. Johnson. Well, Senator, I wrote a book recently on U.S.
fiscal history and I think we share the same perspective on
what happened at the Constitutional Convention in 1787. The key
issue coming out of that, as you know, was exactly the
assumption of State debts by the new Federal Government.
I think that will be the sticking point for the Europeans.
There was a legitimacy to those debts in the United States
because of the joint effort of the War of Independence. There's
no legitimacy behind the fact the Greeks had a great party and
the Spanish went crazy with their real estate, and so did the
Irish, and that banks are going to be failing left, right, and
center. That's going to be the problem.
So that mutualization of debt on an ongoing basis, perhaps
that could be one thing that gets put on the table. But what
are you doing about this overhang of debts? After Hamilton
restructured the debt in 1789, 1790, the United States had a
debt-to-GDP of around 40 percent. That was high for the day.
The Europeans, the eurozone, are at 90 percent average if you
take all of their debts and divide by eurozone GDP. There's not
a lot of room to play with there, and I think ultimately it's
going to come back to the political legitimacy. Ultimately, why
should the Germans pay for what their euro partners did over
the past 10 years, the counterpart of the massive credit boom
that led them into this.
Senator Risch. That's a good point. There's a little bit of
that debate going on up here because some of the States have,
although not directly, at least obliquely, looked to the
Federal Government, saying: Look, we've got serious problems
here.
Dr. Johnson. But the problem we haven't had in the United
States, at least not since the 1840s, is the expectation that
the Federal Government is going to be bailing out the States.
And that's clearly an expectation that----
Senator Risch. But some do.
Dr. Johnson. Agreed. But that was an expectation that was
more generally shared in Europe recently, and that's now been
withdrawn, or maybe it's not. Or maybe Mr. Draghi will provide
it, or maybe they don't know what they're doing.
That I think goes directly to the issues that were salient
in 1787 and unresolved, I would argue, until after the War of
1812.
Senator Risch. Thank you, Dr. Johnson.
Thank you for being generous with the time.
Senator Shaheen. Thank you, Senator.
I want to go back to Greece because it's come up both from
all of your testimonies. Dr. Burwell, let me start with you
because I think you pointed out in your testimony that
Germany's vice chancellor, it was reported, said that a Greek
exit from the eurozone had ``lost its horror,'' quoting.
So what do you think would be the actual impact of Greece
leaving the eurozone? First, if you will, talk about what the
prospects of that are if you had to weigh the percentages, and
then what you think the impacts of that would be?
Mr. Veron. Frankly, I'm reluctant to give a percentage. I
think it's a very difficult question to answer. I would say
that the only way I find to escape the burden of your question
is to say something like 50-50. It's very undecided.
I think many investors think the likelihood is more than
that, but I would submit that the marketplace is overestimating
the chances.
Senator Shaheen. Let me then get to Dr. Burwell and then
Dr. Johnson on that question. I won't ask you to give me a
percentage. Everybody can assess it at 50-50. But what would be
the real impact of Greece's leaving?
Mr. Veron. I think investors----
Senator Shaheen. Mr. Veron, can I get Dr. Burwell to answer
that first?
Mr. Veron. Sorry.
Dr. Burwell. I think Nicolas can talk more on the actual
economic consequences. I do think that the biggest risk
probably is contagion. Greece is something like 2 percent of
the European economy. I think politically, internally in
Greece, it would be a huge blow to the country's confidence and
perhaps to its democratic institutions.
I would say that we currently face a situation in Greece
where many in the public blame their political leaders for the
situation which they are now in and there is some justice in
that, given that some of this crisis comes out of the fact that
no one quite knew how big the Greek deficit was.
And I fear that if Greece leaves the euro, which has been a
very popular symbol among the Greek people of their acceptance
as one of the mature European countries, even though we all
know that when Greece got into the euro, was accepted, there
were some, shall we say, financial tricks that were accepted.
But if that is taken away, I fear that there would be a real
loss of legitimacy of the government among the Greek people and
a much more serious rise of nationalism in Greece than we face
today even with the struggles to try and restructure their
economy.
As long as they are in the EU, one of the safety valves
they have is that Greeks can leave Greece easily and go work
and make money elsewhere in the Union. If they leave the Union,
they lose that opportunity and they remain stuck in Greece with
very few jobs.
Senator Shaheen. Mr. Veron, I'll ask you to answer this.
Haven't we seen, though, opposition on the part of the Greek
public to be willing to accept the reforms that their leaders
have negotiated? Then, recognizing what Dr. Burwell said about
how Greeks feel about themselves and their involvement in the
euro, isn't there a contradiction here, and can we expect that
the reforms that are being required of Greece will actually
have public support to be completed?
Mr. Veron. There's a massive contradiction, but I would
argue that Greece, the Greek public opinion's, willingness to
stay in the euro is even greater than their reluctance to face
the reforms that are needed. So obviously the message of the
two rounds of elections this year was that they would like to
have both, not do the reforms and stay in the euro.
But ultimately my understanding of the current state of
Greek public opinion--and who knows about the future, but my
understanding of the current state is that they prefer to stay
in the euro, even though that means very bitter medicine. Of
course, the question is will this be delivered by the Greek
political system. I think this is the most difficult question,
because so far the Greek political system has displayed a
systemic difficulty to deliver.
Senator Shaheen. Dr. Johnson, do you think that the
eurozone could survive a Greek exit?
Dr. Johnson. Well, Senator, I think the probability of
Greece leaving the euro by the end of this year is about 90
percent. This would do without question significant damage to
the eurozone and how far that would go depends on how they
handle it. If they decide to form a more unified core
completely and unambiguously backed by the European Central
Bank and they put in place the fiscal unification measures, for
example, to make that meaningful, that will be one thing. If
they leave Portugal, Spain, Italy out in the wind to be beaten
by financial markets, that's obviously a very different and
much more scary scenario.
On the dynamics of Greece, I would just point out that the
measures currently under way call for the banks to be taken
over by the government and brought closer to the government
apparatus. This government is the same government that managed
Greece--is led by the same people who managed Greece into the
crisis prior to 2008, 2009. The level of corruption, for want
of a better word, throughout Greek political life is profound.
I'm not sure if you remember, but when the United States
and the IMF tried to help Indonesia in the fall of 1997 a key
issue that emerged was the corruption of the Suharto regime as
manifest in how the banking system behaved and in who did and
did not get a banking license, including in one notable example
Mr. Suharto's son. I think the same kind of collapse of the
legitimacy of the bailout effort as seen from the outside, as
seen by people who feel they've been trying honestly to help
over the past 3 or 4 years, that is exactly where this is
heading.
Senator Shaheen. So you're not optimistic, not only that
the leadership in Greece will deliver the correct message to
the public, but that they will actually be willing to undertake
the reforms, and haven't been to date, that are going to be
necessary in order to stay in the eurozone?
Dr. Johnson. I think they're in an end game within which
elites typically grab what they can, take the resources, move
them offshore, get ready for being wealthy after the collapse;
you can come back and buy assets. This is what you saw at the
end of the Soviet Union, for example. This is what you see at
the end of other kinds of regimes. That is the moment at which
I believe Greece now finds itself.
Senator Shaheen. Thank you.
Senator Barrasso.
Senator Barrasso. Dr. Johnson, I know you spent time at the
IMF as the chief economist there. I'm just curious about the
role of economic growth in a time of austerity and how to
balance that out and what sort of economic growth potential you
see in it. Perhaps you can give just a little discussion on the
role there, given the IMF has requirements of significant
austerity currently combined with the monetary policy
constraints.
Dr. Johnson. So the thinking at the IMF and the experience
in recent decades has exactly been that, while some situations
call for and require austerity, and the Greek public finance
would be one of them, in other situations it can be quite
counterproductive to press your foot too firmly on the fiscal
brakes. Spain today would be one example. Italy would be
another example.
The question is always one of financing. Do you have the
ability to finance yourself in markets or is someone else
willing to lend to you so you can have a larger deficit on a
temporary basis to help buffer your way through your troubles
and aim for--the IMF will always tell you--aim for a
sustainable medium-term fiscal outcome.
Now, I think that that can be done in some parts of Europe.
That is where the IMF has urged the Europeans to go at some
moments in the past. It's obviously not the trajectory right
now in Greece.
Senator Barrasso. Just to kind of follow up, I'm looking
at, there was a column in The Economist this past week. You're
familiar with the Big Mac Index, relative value of Big Mac
hamburgers around the world. I think they mentioned that a
couple years ago the euro was about 18 percent overvalued
relative to the dollar, now it's about 4 percent undervalued
relative to the dollar.
So I just look in terms of the implications for a long-term
continued weakening of the euro versus the dollar and the
impact of that on U.S. businesses and consumers as we get back
to the question of how does this all impact the United States
and our own economy. I would like you to comment on that.
Dr. Johnson. Well, it's very hard, as you know, to forecast
where exchange rates are going to move. But I agree with the
logic of your question, which is that the European situation,
whether I'm right on the more negative side or whether my
colleagues are right on a more positive side, this would seem
to push the euro to becoming more undervalued and therefore at
least some parts of Europe become more competitive relative to
U.S. industry.
Now, remember, though, that credit is becoming extremely
disrupted in many parts of Europe. In Germany, however, it's
not. In Germany credit is pretty easy, partly because the
capital flight from southern Europe or peripheral Europe is
going toward, at this stage still going toward, Germany.
So competition between German firms and United States
firms, yes, I would expect that to be heightened. Will other
parts of Europe be stronger as a result of this? No, probably
not. And overall I would expect the euro to weaken
significantly, which is not going to help our economic
recovery.
Senator Barrasso. Thank you.
Thank you, Madam Chairman.
Senator Shaheen. I'd like to pursue that a little more,
because, Dr. Johnson, I think you talked about the extent of
exposure, that we're not even sure--let me rephrase that. We're
not sure about the extent of the exposure on U.S. banks because
of the opaque instruments that exist.
Secretary Geithner has consistently stressed that direct
U.S financial exposure to the European crisis is modest. So I
wonder if you can elaborate a little bit, Dr. Johnson, on the
reasons that you draw the conclusions that you do about the
extent of the exposure and whether you have any assessment as
to how great that exposure is for U.S. banks?
Dr. Johnson. Well, Senator, I would remind you of the
complexity of these derivative markets and the difficulty even
of the organizations themselves, the institutions, to
understand their true exposure. So again just as an example,
J.P. Morgan Chase's trading losses in London were not known to
Jamie Dimon and other senior executives in New York until they
read about it on the front page of the Wall Street Journal.
So it is actually not possible for Mr. Geithner or any
other official to know more than the banks know about their
true exposures, and the banks do not know to what extent severe
movements in security prices, which is what's implied in the
scenarios I'm talking about, would impact their counterparty
risk.
For example, if you come to believe, just as a
hypothetical, that the French Government will not stand fully
behind all of the obligations of large French banks--I'm not
saying they'll default, but I'm saying they could selectively
choose to pay out on a different basis to different kinds of
creditors--how would that impact the position of J.P. Morgan
Chase or Bank of America or Citigroup? We don't know. We do
know that they have very large derivative books. We know that
their net exposure measured properly, I would suggest, under
international accounting standards is very large relative to
their capital base, and according to the modeling that they
present in the public domain--for example, I recommend to you
the living will discussion that J.P. Morgan Chase executives
have made publicly available--the dynamics there are
potentially devastating.
I don't know how much capital would be necessary to
safeguard the American financial system. I'm not comfortable
we've got there and I don't believe, or I know for a fact, the
stress tests run by the Federal Reserve did not take into
account any of these scenarios, any of these massive losses
that we're now discussing.
Senator Shaheen. So are there other measures that you would
suggest that we as Members of Congress ought to be thinking
about in terms of how we could better assess the extent to
which our financial system is exposed to what's happening in
Europe?
Dr. Johnson. This is a hard thing to do from where you sit,
but I think a key point on which to press is the Office of
Financial Research, OFR, which was created by the Dodd-Frank
legislation to support the Financial Stability Oversight
Council, needs to work on exactly this and needs to be in here
on a very frequent basis presenting to all relevant committees,
including your committee.
I don't know if you and your staff had a chance to review
their latest report that just appeared yesterday. It's about
400 pages long, so I understand it may take some time. There's
nothing in it with regard to the issues that we're discussing,
nothing that would significantly inform or reassure you that
I'm wrong or my concerns are exaggerated, nothing in it.
OFR, I'm afraid to say, has not done a good job. The
Financial Stability Oversight Council is generally considered
to be moving slowly. I belong to a new private sector Systemic
Risk Council founded and chaired by Sheila Bair and we have
released some public statements about specific pressing
measures that could be taken now and should be taken to
safeguard the system. I'm not saying that Ms. Bair or the rest
of the council shares my view on the dangers that could come
from Europe. So whether or not I'm right, we're arguing that
these changes should be pressed forward, and it's not
happening. This administration is not pushing to make our
financial system safe enough soon enough.
Senator Shaheen. Do either of you want to comment on that?
Mr. Veron. I would absolutely agree with what Dr. Johnson
just said about the need to have a well-resourced, competent,
and reactive Office of Financial Research. That said, it is
also my impression that a purely American such organization
cannot really do the job that you have outlined, because we are
talking here about a very integrated global financial system on
which many of the information points are outside of the United
States. So of course, the United States can do what it does at
its own scale, which is building an Office of Financial
Research, and more should be done in that direction. But I
think there is also a need to scale up global initiatives to
collect data and analyze them in a way that would provide more
insight on the very complex, very difficult issues that we are
talking about here.
I would argue in the same logic that what Dr. Johnson said
about the need to have a better understanding of big banks'
balance sheets in the United States is an argument for more
decisive adoption of international financial reporting
standards or at least some moves in that direction, which this
administration unfortunately has not made. It doesn't have to
be quick, it doesn't have to be radical, but I think this would
be very constructive on the global stage, even though it's a
slightly different consideration from the main focus of this
hearing.
Senator Shaheen. So should the ECB be taking measures that
it isn't currently, recognizing that there has to be agreement
from a lot of places in order for that to happen? But are you
also advocating that they take different measures?
Mr. Veron. I think the ECB has signaled in the past few
days that they will do more to stabilize the situation in the
marketplace even than the significant actions that they have
undertaken so far. This goes back to the executive deficit at
the core of the eurozone problem, because the ECB has been
forced to take action in place of the political authorities,
and I think we'll continue to see that because ultimately the
ECB is the only institution which is able to act in the short
term. And I think they are taking this responsibility very
seriously.
I also believe that, compared to some of the criticisms
that are placed on the ECB, especially from here in the United
States, that it doesn't do enough, the ECB cannot act as if it
was the Federal Government of the eurozone. So it has to
acknowledge that its scope for action is limited and that
elected governments, elected institutions, political
institutions, have to do a bigger part of the heavy lifting.
So I would submit that the ECB has a very difficult balance
to keep here, but I think they have kept it fairly skillfully
in the past few months at least.
Senator Shaheen. I know Dr. Johnson wants to comment, but,
Dr. Burwell, did you want to comment on the original question
before we go back to him?
Dr. Burwell. Yes, just two comments. Dr. Johnson pointed
out, brought to the fore a very good question, I think, which
is: Greece didn't undertake reforms before; these are the same
people or the same political elite that got Greece into so much
trouble; so why should we believe anything will change? I think
in point of fact, because there are so many EU supervisors in
the Greek Government at this point. They have extensive
supervision on the ground, to the point where I've had Greek
officials certainly tell me that there is no sovereignty left
in Greece as far as economic policymaking goes.
And of course, they are being held with their backs to the
wall if they want to get any more money from the EU. And if
they don't get money from the EU, if they don't get the tranche
that is now overdue because of the elections, I've heard some
estimates that they will have to start issuing script in about
2 months to be paying government employees, of which there are
quite a few in Greece.
So the government is in a position where it will have to
make some very difficult decisions, but it will be forced to
make them.
I also think that Dr. Johnson was right in pointing out
that we don't really know what's going on in terms of the
banks' balance sheets. The conversation that I'm hearing from
Europe is about too big to supervise and too big to fail, and
the idea that these banks are now simply too large. I would
expect that we will see some legislative movements in the
European Parliament to explore whether there are ways of making
the banks more supervisable, more susceptible to adequate
supervision.
In a way, the LIBOR scandal and HBSC has kind of morphed
together with this eurozone crisis in a way in Europe which has
become much more susceptible to strong banking regulation than
we have heard discussed in the United States, and that's
something that I think the U.S. Congress should be aware of and
be watching in terms of its own agenda in the future.
Senator Shaheen. So you think there will be a move to set
limits on size?
Dr. Burwell. I don't know quite how it would be done,
because, as Mr. Veron pointed out, these are global entities in
many regards. So I'm not quite sure how you would be able to do
it. But I have--when Sharon Bowles was here, the head of the
Econ Committee in the European Parliament, which is the
legislature now for doing this, addressing this question, she
was quite concerned about this in a public forum. So I would
expect that there will be some serious thinking about how one
does this.
Senator Shaheen. Thank you.
Dr. Johnson, I think you wanted to respond to the ECB
question.
Dr. Johnson. Yes. The problem is that if you ask the ECB to
do more, you're asking it to provide more credit to the system,
which will weaken the euro, create the prospect of inflation,
and further undermine the legitimacy of the monetary union for
key countries, including Germany. So it's not clear at all that
doing, ``whatever it takes'' has any meaning when providing
more credit actually undermines the political legitimacy of the
very arrangement that you're trying to protect.
If I could just add a point to what Dr. Burwell said about
the extensive supervision on the ground of the Europeans, the
experience of the IMF quite clearly is that when you're on the
ground doing someone else's reforms for them it doesn't work.
There has to be local ownership. The politicians have to want
it. There has to be a mandate. It has to be in this kind of
context--it has to have sufficient democratic support. That
support has to be sustainable.
That's where all these programs fail, not because they're
poorly designed. Typically you can always adjust the design.
And not just because of creditor fatigue. Creditors get
fatigued because you don't deliver things on the ground because
there's no ownership. I think that's exactly where the European
situation is going.
On the bank size, I think this is a very important point
that again will become increasingly salient. Too big to manage.
The banks don't know what's going on. The bank executives have
no idea of the exposure. As banks collapse or come under
pressure and have to be rescued, you will see more and more of
these stories in the European context, just as we're seeing
more of them now in the American context.
Senator Shaheen. Well, so that really leads back to the
question about to what extent is public opinion behind the
efforts to address the eurozone crisis. Dr. Burwell, you talked
about Chancellor Merkel's continued popularity among the German
public, but in fact somebody just pointed out to me this week
that there is a recent poll that was published that showed that
33 percent of Germans believe that she's making the right
decisions on the eurozone crisis, down from 63 percent back in
earlier in July.
So how much is public resistance going to impede the
ability to really address the crisis in Germany? I guess we
could ask the same thing about France. Obviously, we've already
seen the change in government in France as the result of
concern among the electorate about whether they were headed in
the right direction. Obviously, Spain is an ongoing issue.
Can we expect that public interest--it goes back to the
Greek question: Can we expect that public interest in staying
in the eurozone is ultimately going to outweigh frustration
with the impact of austerity measures on people's own personal
prosperity and thinking about their futures?
Dr. Burwell. I believe that the public's commitment to the
eurozone and to the EU particularly is strong enough so that it
will get through this point. However, I would say that the
decline in Chancellor Merkel, public opinion is not because
Germans believe she is being too tough and not making the right
decisions as we would see them, but because they think she's
being too soft.
Senator Shaheen. Right. No, I understand that.
Dr. Burwell. So, if anything, you do have diametrically
opposed public opinions. But the one thing they're all united
on is they want to stay, not necessarily together, Greeks and
Germans, but they all want to stay in the European Union, with
one exception, and that one exception is the U.K. And here I
think what we are seeing is a combination of, shall we say,
longstanding British skepticism coupled with the eurozone
crisis, which I think is on the verge of leading to a very real
change in Britain's position within the EU. That is something
that as we think about Anglo-American relations we should think
about very seriously.
But on the whole----
Senator Shaheen. Can you elaborate on that a little bit in
terms of what you think the effect will be on Britain's
position in the EU?
Dr. Burwell. The December decisions on the fiscal compact,
when Britain decided not only not to be in the fiscal compact,
but prevented the others from making this intra-EU, and now
they had to do this outside, was kind of a final straw for many
in Europe about the British, what they see as the British lack
of commitment to the European Union.
What I have been hearing since then is that if the British
want to go, that's OK; we'd like for them to stay, but it's
their decision. Whereas before there was much more of a desire
to have the British engaged.
I do think that the Cameron government until very recently
has managed their euroskeptic constituents skillfully. However,
they have I think--recently this has been something that has
threatened to get a little out of control. There are increasing
calls for a referendum and if we see the fiscal compact
eventually being put into a treaty and the need for referenda
in some countries and probably in the U.K., then I think you
have a crisis point about 3 to 5 years away where this question
will be asked.
So I think there is more talk now in the U.K. about halfway
arrangements. The problem is that most of those halfway
arrangements, the one that Norway has, for example, where it's
part of the Europe economic space, they have to agree to
everything but they don't get to sit at the table, and I think
that would be unacceptable.
So we are a long way from any decisions, but I think the
temperature has changed, if I can put it that way. It's subtle.
It could change back. The city of London has a lot to gain or
lose through Britain's participation in designing the rules for
financial services within the EU, and I think that will be the
thing that will keep Britain in if it decides to stay that way.
Senator Shaheen. Thank you.
Mr. Veron, did you want to add to that?
Mr. Veron. I totally share the concern about the position
of the U.K. I think it's a strategic worry and challenge for
the U.K., for the rest of Europe, and also for the United
States. I think that the U.K. has gone very far already on a
slippery slope that could bring it outside of the European
Union and I personally believe this would be to the advantage
of precisely no one.
So I think there's a big concern. It was a big change a
year ago when Chancellor Osborne spoke about the remorseless
logic of political integration inside the eurozone that is
reversing almost three decades or four decades almost of U.K.
policy, where the stance had always been having a seat at the
table. So I was surprised by this change of tack and I think it
will have consequences.
In Spain, Greece, Italy, I think we're seeing serious
indications of deep problems in the political system, to say
the least. But I'd like to comment on Germany and France
because that was your initial question. In Germany, we've seen
time and again that the commitment of the main parties
ultimately was for more Europe, and this has been most
obviously the case when the liberal party, the LDP, started to
consider a different strategy. This led it nowhere and that
reversed to a large extent this stance.
It's notable in Germany, it has been--I'm sure you're aware
of this and it has been commented many times, but it has to be
reaffirmed, that in Germany the opposition is criticizing the
government for not going far enough in terms of European
integration, in spite of the difficult situation of public
opinion that you have referred to.
If I get back to the question which was asked by Dr.
Johnson, why would Germany accept debt mutualization, given the
difference in historical circumstances with, say, the
assumption of States debt by the federation in the early
history of the United States, I think there is a very deep
sense of responsibility in Germany, that Germany has a stake
and has a burden to carry in terms of the future of Europe, the
future of the eurozone.
So my response to this question, which is a very relevant
question on why would Germany accept mutualization, is that
there is an awareness that the consequences of not accepting it
is something that Germany doesn't want, the German elites don't
want it, but more importantly the German public doesn't want
it, and that would be the breakup of the euro.
As regards France, I would not see the recent change in
government as a direct consequence of the European saga. It had
been driven--first, it was a very close result, and I would
argue as a French voter that it has been driven predominantly
by domestic issues and individual issues that had little to do
with European policy.
Now, in terms of European policy there is a lot of
continuity between the previous administration and the current
one. I will note that the one point on which there is a change
of direction, which is the push toward banking union, which was
not there under the previous administration, the inflection has
been in the direction of more integration, not less. Of course,
this is not a judgment on what the future steps will be, and I
think when we are talking about political union and empowering
the European Parliament and basically having some more
political features of a federation in the European
institutional framework, this is something that will be more
difficult possibly in France than in any other eurozone member
state. So I am not underestimating the future challenge and I
think the current administration is very aware of it. But I
would argue that there is no indication that France is becoming
more euroskeptic, particularly in the recent political
transition.
Senator Shaheen. Thank you.
Dr. Johnson.
Dr. Johnson. Well, I hate to sound more optimistic than my
colleagues, but I will on this point. I think the eurozone is
going to go into a deep crisis. It will break up. A core will
be reconstituted and work together very closely. The big
question is whether or not France is in that core, and related
whether or not Italy is in that core.
The British like to complain and certainly have not been
always constructive. But in this crisis type situation, I think
that they will be helpful and I think Europe will pull
together. I don't think the European Union will disintegrate. I
don't think we're going to have a war in Europe. They have far
too much history. And I think the British will negotiate some
complicated arrangement where the big question is to what
extent you can do that and have a proper seat at the table and
get to have some say with regard to regulations, including
around finance. That's hard to predict. But I think the British
will stay engaged and I think that ultimately Europe will come
out of this. Ultimately there will be a shared currency, a more
Germanic eurozone, and a rival reserve currency to the U.S.
dollar. Of course, at that time we should worry about how
international investors see the United States. If and when
there's a viable reserve currency to the dollar, the pressure
on us potentially becomes much greater. And if we don't have
our fiscal house in order by that time, there will be trouble.
Senator Shaheen. Listen. If we don't have our fiscal house
in order by that time, we've got a lot more things to worry
about than just how the dollar's going to compare against the
euro, at least by my assessment.
Dr. Johnson. I agree, Senator. But in terms of interest
rates and in terms of pressure on short- and long-term interest
rates, those presumably would be much more severe if
international investors already could shift out of the dollar
into some other asset.
Senator Shaheen I know we're about to wind down, but I did
want to ask before we close about the potential for growth in
Europe because, as several of you have mentioned, one of the
debates that's gone on has been austerity versus growth, and at
what point do you need to include some growth measures along
with austerity in order to provide hope. And Europe's back in,
at least I think everybody agrees that Europe is now in a
double-dip recession, so to what extent do measures need to be
taken that can help speed growth in Europe in order to improve
prospects for economic prosperity there.
I don't know who wants to address that first. Dr. Burwell?
Dr. Burwell. Let me take a noneconomic stab at it and say
that I think sometimes on this side of the Atlantic and on the
other side, when we talk about growth versus austerity we're
actually talking past each other and talking about different
things. The countries that are in difficulty right now often
have large public sectors, where getting a job in the
government is the best thing and you should be there for all of
your career. The universities have not learned how to educate
people for jobs. It is very difficult to start a new business,
so they don't have the small business sector that has been the
engine of employment in this country.
I'm not saying necessarily that they should come to
duplicate our economy. There will always be differences. But
when Americans go over and talk about growth, Europeans are
often leery about a stimulus from the government because they
fear that it will only lead to the hiring of more government
workers, which then exacerbates the problem and how they got
there.
So hence the very strong emphasis on austerity, which is
really code for structural reforms. And the German experience
is that if you do these reforms then you will see growth. We
can ask whether the German model is the only one suitable in
Europe, but right now Germany is the predominant country
calling the shots in this economic crisis.
We have seen some moderation of the emphasis on austerity
and I think, in fact, that President Hollande's election has
allowed more discussion of the need for growth and, as one of
my Spanish colleagues put it to me once: We can do the
austerity, but we need to have a glimmer of hope at the end of
that. So I think the conversations we have seen between Mr.
Monte and Mr. Hollande about this, it's not necessarily that
they're setting up an opposition to Germany, but they're
setting up a moderation of the debate.
There are some infrastructure funds that are now going to
be disbursed. Infrastructure is something the EU has always
used to boost economies. It's one of the reasons for the
success of the Polish economy right now. So I think you will
see more along those lines, more moderation. But the trick in
Europe is to do it without necessarily funding the public
deficit.
Senator Shaheen. Am I correct that one of the other
successes of the Polish economy has been that their banking
system was not affected by the fiscal crisis that we
experienced here and in Europe?
Mr. Veron. The Polish banking system had been very
conservatively supervised in the years before the crisis. It's
also a relatively unsophisticated banking system, so fewer of
the big derivatives exposures that Dr. Johnson talked about.
Senator Shaheen. That may be a good thing, though.
Mr. Veron. In the circumstances, it has been a good thing.
There is a wider debate which goes beyond this hearing whether
it's always a good thing. But in the circumstances it has
certainly been, as in a number of emerging economies, by the
way.
I completely agree that the terms of the debate on
austerity versus growth are very different in Europe and the
eurozone from what they are in this country. One simple
difference is that this is one single currency zone, with no
risk of fragmentation, and where, at least since the middle of
2009, in spite of possible problems in the banking system,
credit is flowing relatively normally in the U.S. economy, more
in some segments than others, but generally normally.
In Europe, credit is a major factor and the threat of
fragmentation is a major factor. So basically you have a
situation where in countries like Greece, but also in Spain or
Italy or others, one of the main impediments to growth is that
many people are concerned about investing in a currency area
where there could be a depreciation risk. You see that in terms
of capital flight, but you also see this in terms of paucity of
investment.
So the risk of breakup to me is the No. 1 factor that
inhibits growth in the eurozone. The second most important
factor is the lack of credit because of the dire condition of
the banking system, which goes back to the debate on banking
union. These factors to me are bigger factors than the fine-
tuning of the fiscal stance or of what the European Investment
Bank can do.
Obviously very important is the question of structural
reforms in order to boost the potential of high-growth firms,
which is what Europe needs most, not just new firms but new
firms that grow fast from small to large. This is the biggest
challenge I think in almost all of the European Union,
particularly in the periphery.
Part of this is state reform. I think there is no denying
that the state needs to be reformed for growth to come back,
for both economic and political reasons, in countries like
Greece, but also some other eurozone countries.
So I would see all these factors as really center stage. So
yes, Europe needs more growth, but the determining conditions
in the near future will be about the perception of breakup risk
and credit conditions.
Senator Shaheen. Thank you.
Dr. Johnson, final word?
Dr. Johnson. If these countries did have flexible exchange
rates with their major trading partners, so if Spain had an
exchange rate that could depreciate, then the way that you
would square the circle and have austerity but also get growth
is the kind of way that Korea did it, for example, in 1997-
1998, which is you'd have some tightening on the fiscal side,
you would have a big depreciation, you'd have an export boom.
You can't do that as long as you remain within the currency
union. You would therefore have to get something similar
through a fall in your nominal wages and your nominal prices.
That's incredibly difficult. The history of modern economics--
go back to the 1920s, go back to the gold standard. It broke
down in part because our societies don't tolerate that kind of
nominal flexibility.
The Governor of the Central Bank of Mexico, Agustin
Carstens, likes to say it: There's two ways to paint a house;
either that the house stays where it is and the person with the
paintbrush moves around it, or the painter stays where he is
and you move the house. That's what you're asking the Europeans
to do within this fixed exchange rate system, this ultra-gold
standard arrangement that they have between the major trading
partners. It is incredibly difficult to do that. The Central
Bank can't wave some magic wand and make it happen. The result
is going to be, I think, exactly what I guess that you fear,
which is austerity on top of austerity, loss of growth
prospects. Then everybody's debts look much worse because
there's no private sector growth and there's no growth to
sustain the public finances, and then you go into some even
deeper crisis from which it's harder to extricate yourself.
Senator Shaheen. Well, thank you all very much. You've
given us a lot to think about. I appreciate your insights.
I will submit all of your testimony for the record, and I
also had a longer statement that I will submit for the record.
We will leave the record open for 48 hours in case there are
other questions that are submitted.
At this time, again I want to thank you, and declare the
hearing closed.
[Whereupon, at 4:08 p.m., the hearing was adjourned.]
----------
Additional Material Submitted for the Record
Responses of Nicolas Veron to Questions Submitted
by Senator John F. Kerry
Question. Business groups on both sides of the Atlantic are
advocating a U.S.-EU agreement to further reduce barriers to trade and
investment. Would such an agreement help with the eurozone crisis, and
if yes, what should the scope of such an agreement be?
Answer. A substantial transatlantic trade and investment agreement
would be a welcome signal of economic cooperation and openness and a
positive factor for Europe's overall economic outlook. However, it
cannot be seen as central in terms of crisis resolution given the
nature and magnitude of the eurozone crisis.
Question. Despite the effects of the crisis, Europe remains a
wealthy continent, with ample resources to address the crisis. If a
solution were to be found that required greater financing than has been
marshaled to date within Europe: (i) what would be the most efficient
way to raise these resources; (ii) how would the burden be distributed
across euro area countries; and (iii) on whom is the burden likely to
fall the hardest?
Answer. Indeed, the eurozone crisis differs from many crises of the
past, especially in developing and emerging countries, in that external
financial assistance is not indispensable to resolve it successfully
given the high level of wealth of the eurozone as a whole. The
roadblocks are about economic and political decisionmaking arrangements
inside Europe. Even though individual member states' fiscal discipline
is necessary for the future robustness of Europe's monetary union, I
also believe that a degree of debt mutualization will have to be part
of a successful crisis resolution strategy. In my opinion, this
requires significant changes in the EU institutions which might need to
go as far as the creation of a European framework for taxation, and
granting powers to the European Parliament to exert adequate control
over revenue and expense decisions at the European level.
______
Responses of Dr. Frances Burwell to Questions Submitted
by Senator John F. Kerry
Question. In your testimony and responses to questions, you
suggested that some degree of increased integration was required to
resolve the current crisis. You also noted the risk that, through that
process, the U.K. would become increasingly estranged from the rest of
the EU. To play devil's advocate, in light of the disparate views on
political integration and economic policy within the euro area and the
broader EU, should the resolution of the crisis be sought, instead, in
a smaller, tighter euro area, and less centralization of authority
among other countries and in other policy areas?
Answer. The crisis has made clear that the European Union is now at
a transition point. Greater integration--at least in financial policy--
will be required to resolve the current situation, but for a few EU
members, the further transfer of sovereignty in such a core area is
unacceptable. Currently, it is estimated that between 60-70 percent of
national legislation is actually determined by the Brussels
institutions, and then ``transposed'' by national parliaments. Although
the EU has brought many benefits to Europeans (and we should not forget
the anniversary of the outbreak of World War II in September), there is
no doubt that it also constrains national policy options. The fiscal
compact will certainly add to that constraint. In this environment,
some governments accept that their small countries can only be secure
and influential as part of a larger group. Others, like Germany, find
some constraints acceptable for historic reasons. Others (France,
Poland) believe they can lead the EU and thus have greater global
impact than on their own. But some, particularly the U.K., but perhaps
also Denmark, do not relish giving up so much sovereignty to Brussels.
There has long been talk of a multispeed Europe or ``Europe a la
carte'' and we already see this in the eurozone, Schengen arrangements,
and even the Common European Security and Defense Policy (Denmark has
an ``opt out), where the memberships can vary from that of the EU. But
we are now at a fundamental division: those who remain in the eurozone
can only keep the currency healthy by embarking on a much more unified
set of economic policies. They now realize that they cannot be held
back by the objections of those outside the eurozone who wish to move
more slowly. As we see the eurozone government seek to resolve the
crisis, we will see the emergence of a two-tier Europe. Most of the
current eurozone will remain, and those new countries pledged to join
the eurozone will eventually come in (there may be some delays, as
these countries will have to meet tighter requirements and will also be
reluctant until the eurozone has recovered).
But beyond the core and the ``core aspirants,'' there will be an
outer ring of the U.K., perhaps Denmark and Sweden, but also Norway,
Liechtenstein, and others in the European Economic Area may reconsider
whether they wish to join this ``outer EU.'' As for Turkey, whether
Ankara would find being in such an outer ring acceptable is uncertain.
The evolution of such an EU, may well lead the Turkish Government to
rethink the desirability of EU membership. The main challenge of such a
structure will be defining the rights and responsibilities of those in
the outer ring so that it does not become just a way station on the
path to exiting the EU. In sum, whether one favors it or not, the most
likely future of the EU is along the lines of the bifurcated two-tier
organization suggested by the question.
Question. Business groups on both sides of the Atlantic are
advocating a U.S.-EU agreement to further reduce barriers to trade and
investment. Would such an agreement help with the eurozone crisis, and
if yes, what should the scope of such an agreement be?
Answer. A U.S.-EU ``jobs and growth initiative'' would not help
directly to resolve the eurozone crisis, but it could have some
important and positive indirect consequences. The announcement of such
an initiative could signal U.S. confidence in the long-term health of
the European economy, and perhaps encourage the markets to be a bit
more patient, thus lowering the costs and risks associated with the
current sovereign debt and banking crises in Europe. The markets may
even realize that such an accord would have significant economic
effects for both the United States and EU, and inspire a greater sense
of business confidence. [Figures range from $180 billion added to GDP
over 5 years from an agreement that only eliminated tariffs on goods (A
Transatlantic Zero Agreement, ECIPE Occasional Paper #4, 2010) to
significantly higher (but less certain) gains from an agreement also
erasing barriers on services and investment.]
Once the launch of negotiations is announced, most policymakers
anticipate that it would be 2 years at least before an agreement is
signed and accepted by the U.S. Congress and European Parliament. Only
then would the economic effects be felt directly. However, even before
the final agreement, companies may start to anticipate the impact of
the accord, especially as they make decisions about establishing or
enhancing investments (including factories). One peculiarity of the
transatlantic economy is that at least 30 percent of trade is intra-
firm; that is, companies such as Ford or Unilever shipping parts from
one factory to another. In these cases, tariff reductions free up funds
that could be used for greater investments--and job creation--on both
sides of the Atlantic. Tariffs also affect decisions on where to put
manufacturing facilities. If it looked, for example, as though U.S.
tariffs on the export of fully assembled cars to the EU would be
reduced to the level charged by Mexico, some companies may think about
building more facilities in the United States. Because such decisions
are normally made with a long lead time, we may see some developments
before the final conclusion of an accord.
As for the scope of such an agreement, most experts agree that it
should be comprehensive, going beyond elimination of tariffs and quotas
(including on agricultural goods) to include services, investment, and
regulatory measures, as well as some specific areas such as trade
facilitation and government procurement. Some analysts (including this
one) look forward and think that privacy/data protection issues might
also be important, as they are likely to become a significant factor in
future transatlantic commerce and investment. Similarly, the issue of
visas, especially for highly skilled workers, is likely to grow in
importance as companies become more ``transatlantic'' and need a mobile
workforce. These last two issues, however, are not on the current
mainstream agenda, but rather identified as challenges that will
increasingly confront an integrated transatlantic economy.
The main question about negotiating such an agreement is whether it
is a ``single undertaking''; that is, follows the normal practice of
trade negotiations that ``nothing is agreed until everything is
agreed.'' This strategy does allow tradeoffs between the parties across
different issues. In the current political climate, however, it is
worth considering whether certain elements of such a comprehensive
accord should be separated out when agreed and thus allow for some
early victories, while preserving a comprehensive accord as the end
goal. A trade facilitation package (supposedly largely agreed already
under the Doha Round) might be a good example of an accord that can be
relatively quickly concluded, or even the elimination of manufacturing
and agricultural tariffs and quotas. A public victory or two might
invigorate negotiations as they reach the difficult and opaque areas of
trade in services and regulatory mutual recognition. In the end,
however, this distinction between a single undertaking or separate
packages leading to a comprehensive accord is less important than
simply getting this initiative underway.
Question. Despite the effects of the crisis, Europe remains a
wealthy continent, with ample resources to address the crisis. If a
solution were to be found that required greater financing than has been
marshaled to date within Europe: (i) what would be the most efficient
way to raise these resources; (ii) how would the burden be distributed
across euro area countries; and (iii) on whom is the burden likely to
fall the hardest?
Answer. I will let my two economist colleagues comment more
specifically on the technical aspects of such financing, and will focus
on the political. It is certainly possible that greater resources will
be required, especially as the eurozone crisis is likely to persist for
a few years. That funding can come from three basic sources: private
sector, ECB, and governments (via the EFSF and ESM). I believe that we
will see greater use of all of these. First, except for the Greek case,
the private sector has not taken large, official losses (in Greece, the
``haircut'' was about 70 percent). Especially as the banking crisis in
Spain must now be faced squarely--a crisis that results at least in
part from speculative real estate investments--more private sector
investors will be forced to write off debt. Second, the ECB will also
be forced to intervene more frequently and in more direct ways. This
will only happen gradually, and there will be much uncertainty largely
because of German criticism of such actions. At times, Mario Draghi
will have to be very imaginative in finding a way forward that works
but also keeps German pressure at an acceptable level. Third, during
this crisis, we have seen an accumulation of capital in Germany as
investors seek a safe harbor (even though German bond yields have
sometimes been negative). Some countries, such as France, will be
limited in contributing further to financing arrangements as their own
debt level is now affected by their earlier contributions. In this
situation, it will be Germany that will bear the primary burden of
future financing (although it will insist on other countries continuing
to pay into the ESM, perhaps at lower percentages).
Although Germany might seem reluctant to provide more funds, based
on the public debate in that country, there are two countervailing
factors. First, the Chancellor has made clear that she will do what is
necessary to save the euro, and her dominance of the German political
scene is still strong. Second, there seems to be a distinction among
German policymakers between making an additional, but finite
contribution to the ESM, and making an open ended commitment to support
pan-European financing through a eurobond. Thus, particularly in a
crisis, and confronted with a possible default by a eurozone country,
Germany is likely to step forward and provide an agreed amount of
additional funds, even while it continues to object to any open-ended
commitment.
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