[Senate Hearing 112-204]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 112-204
 
THE EUROPEAN DEBT CRISIS: STRATEGIC IMPLICATIONS FOR THE TRANSATLANTIC 
                                ALLIANCE

=======================================================================



                                HEARING

                               BEFORE THE

                    SUBCOMMITTEE ON EUROPEAN AFFAIRS

                                 OF THE

                     COMMITTEE ON FOREIGN RELATIONS

                          UNITED STATES SENATE

                      ONE HUNDRED TWELFTH CONGRESS

                             FIRST SESSION

                               __________

                            NOVEMBER 2, 2011

                               __________

       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        

                         ------------          

                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

                              ----------                              
                                                                   Page

Barrasso, Hon. John, U.S. Senator from Wyoming, opening statement     4
Gordon, David, Head of Research and Director, Global Macro 
  Analysis, Eurasia Group, Washington, DC........................    21
    Prepared statement...........................................    23
Kirkegaard, Jacob Funk, Research Fellow, Peter G. Peterson 
  Institute for International Economics, Washington, DC..........     6
    Prepared statement...........................................     8
    Appendix to prepared statement...............................    44
Lachman, Desmond, Resident Fellow, American Enterprise Institute 
  for Public Policy Research, Washington, DC.....................    12
    Prepared statement...........................................    14
Shaheen, Hon. Jeanne, U.S. Senator from New Hampshire, opening 
  statement......................................................     1
    Prepared statement...........................................     3
Stokes, Bruce, Senior Transatlantic Fellow for Economics, German 
  Marshall Fund of the United States, Washington, DC.............     9
    Prepared statement...........................................    11

                                 (iii)


THE EUROPEAN DEBT CRISIS: STRATEGIC IMPLICATIONS FOR THE TRANSATLANTIC 
                                ALLIANCE

                              ----------                              


                      WEDNESDAY, NOVEMBER 2, 2011

                               U.S. Senate,
                  Subcommittee on European Affairs,
                            Committee on Foreign Relations,
                                                    Washington, DC.
    The subcommittee met, pursuant to notice, at 9:35 a.m., in 
room SD-419, Dirksen Senate Office Building, Hon. Jeanne 
Shaheen, chairman of the subcommittee, presiding.
    Present: Senators Shaheen, Barrasso and Corker.

           OPENING STATEMENT OF HON. JEANNE SHAHEEN,
                U.S. SENATOR FROM NEW HAMPSHIRE

    Senator Shaheen. Good morning, everyone.
    At this point, I would like to call this hearing to order. 
When we scheduled this hearing we thought it would be timely. 
We just didn't realize quite how timely.
    If I were still a teacher I would ask all of you in the 
back to move up but I won't do that. But I am delighted to be 
here with my ranking member, Senator Barrasso. I have a brief 
statement and then I think he probably will have a statement 
before we ask our panelists for their testimony.
    The Foreign Relations Subcommittee on European Affairs 
meets today to discuss the ongoing European debt crisis. This 
crisis presents one of the most complex challenges to European 
stability since the creation of the European Union and the 
outcome will have lasting effects for the United States and our 
transatlantic partnership for decades to come.
    This is a particularly timely hearing, given yesterday's 
surprise announcement by Prime Minister George Papandreou 
calling for a popular referendum in Greece on the recent 
Eurozone agreement and, of course, it's also timely because of 
the G20 meeting which is scheduled to begin tomorrow in France.
    We have a very impressive panel of expert witnesses and we 
look forward to engaging with them on these issues.
    In today's global economy, Europe is by far America's most 
critical ally. Europe is the United States largest trading 
partner and our biggest export market.
    Together, the United States and Europe account for over 
half of the world's gross domestic product, one-third of world 
trade and three-quarters of the global financial services, all 
of which means jobs and economic growth here in the United 
States and in Europe.
    But it also means that what happens in Europe can have 
significant repercussions for the American economy. Our markets 
know this, our businesses know this and we ignore this reality 
at our own peril.
    Negotiations at last week's Eurozone summit produced a 
tentative late-night agreement. The deal included a voluntary 
50-percent cut on Greek bonds, a requirement to raise $148 
billion in new capital for European banks and a significant 
increase in the Eurozone bailout fund.
    Despite the announcement, many of the details of the 
agreement are unresolved and significant questions remain 
unanswered. This agreement is an important first step but 
challenges still lie ahead.
    One of those challenges is the surprise Greek announcement 
that the Papandreou government would seek popular approval of 
the bailout package. That decision, as we all saw, roiled 
markets yesterday and adds new urgency to the G20 meeting this 
week.
    It's critical that the implementation of this agreement 
does not languish and I encourage our partners in Europe to 
continue to act with the urgency this situation requires. It's 
important to recognize that American interests in this crisis 
go far beyond economic and financial implications and will 
affect a broad array of transatlantic issues.
    From a foreign policy standpoint, America needs a strong 
European partner if we're to meet today's challenges, including 
Iran, Afghanistan, and the ongoing ``Arab Spring.'' On the 
security side, a Europe focused solely on budget cuts will make 
it more difficult for European NATO countries to meet their 
resource commitments to this military alliance.
    The United States and the transatlantic community have 
fought two devastating world wars and spent countless resources 
over nearly six decades to bring about a Europe that is whole, 
free, and at peace.
    Today, the forces of European instability are not war and 
fighting but financial uncertainty and the specter of a 
continentwide economic breakdown. How Europe responds to this 
crisis over the next several months will have dramatic 
implications across a broad spectrum of U.S. interests.
    The subcommittee looks forward to engaging on these 
critical questions in the next hour, and to help us sort out 
these issues
we have a very distinguished panel. I just want to take a 
minute to introduce each of you before I turn it over to you 
for your testimony.
    First on our panel today we have Jacob Kirkegaard, a 
research fellow from the Peter G. Peterson Institute for 
International Economics where he has served since 2002. Mr. 
Kirkegaard comes to us from Denmark and is an acclaimed author 
and expert in European economies, reform, and high-skilled 
immigration.
    Next, we have Bruce Stokes, who is currently the senior 
transatlantic fellow for economics at the German Marshall Fund, 
one of the premier transatlantic policy institutions. Mr. 
Stokes is a renowned former international economics columnist 
for the National Journal where he remains a contributing 
editor.
    Next, Dr. Desmond Lachman is a resident fellow at the 
American Enterprise Institute. Dr. Lachman has a Ph.D. in 
economics from Cambridge University and previously served as 
managing director and chief emerging market economic strategist 
at Salomon Smith Barney, also as deputy director at the IMF.
    And finally, we have Dr. David Gordon, the current head of 
research and director of Global Macro Analysis at the Eurasia 
Group. Prior to his current position, Dr. Gordon spent more 
than a decade working on U.S. foreign and economic policy at 
the highest levels of our government including the State 
Department, the CIA, and the National Intelligence Council.
    Thank you all very much for being here. We look forward to 
hearing from each of you, and let me turn it over to Senator 
Barrasso for his comments.
    [The prepared statement of Senator Shaheen follows:]

               Prepared Statement of Hon. Jeanne Shaheen

    The Senate Foreign Relations Subcommittee on European Affairs meets 
today to discuss an issue critical to the global economy and to long 
term U.S. strategic interests. The ongoing European debt crisis 
presents one of the most complex challenges to European stability since 
the creation of the European Union. This is a particularly timely 
hearing today given yesterday's surprise call in Greece for a popular 
referendum on the recent Eurozone agreement, as well as the G20 meeting 
in France, scheduled to begin tomorrow.
    My hope is that we will get a chance today to review some of what 
led us to this crisis, evaluate the Eurozone deal announced last week, 
and consider where Europe goes from here. But more importantly, I also 
wish to discuss some of the broader strategic implications and why a 
resolution in Europe means so much for the United States. We have a 
very impressive panel of expert witnesses, and we look forward to 
engaging with them on these issues.
    In today's global economy, Europe is by far America's most 
important ally. Europe is the United States largest trading partner and 
export market, and together, the United States and Europe account for 
over half of world GDP, one-third of world trade and three-quarters of 
global financial services.
    All of which means jobs and economic growth here in the United 
States and in Europe. But it also means that what happens in Europe can 
have significant repercussions for the American economy, and as we have 
seen over the last year, financial instability and uncertainty in 
Europe can easily spill across the Atlantic. Our markets know this, our 
businesses know this, and we ignore this reality at our own peril.
    As we entered last week's historic Eurozone summit, European 
leaders faced a number of difficult realities. Europe had to deal first 
and foremost with an insolvent Greek Government by significantly 
restructuring its debt. Leaders also needed to recapitalize European 
banks so they could withstand a Greek debt write-down. Finally, they 
needed to create a credible firewall around much larger Eurozone 
countries facing pressures from contagion effects.
    After a long series of negotiations, urgency finally gave way to a 
tentative late night agreement among Eurozone economies on some of 
these critical issues. Leaders announced a voluntary 50-percent cut on 
Greek bonds, a requirement to raise $148 billion in new capital for 
European banks and a significant increase of the Eurozone bailout fund. 
Despite the announcement, many of the details of the agreement remain 
murky and significant questions remain, including the fate of credit 
default swap purchases and the composition of the bailout fund 
increase.
    This agreement was no doubt an important step, but it is just a 
first step. Significant challenges still lie ahead, and it is critical 
that the implementation of this agreement moves forward with the 
urgency it deserves.
    One of those challenges is the surprise Greek announcement this 
week that the government would seek popular approval of the bailout 
package--a decision which roiled markets yesterday and adds new urgency 
to the G20 meetings this week in France. At the very least, a 
referendum would likely set back implementation of the Eurozone plans 
at a time when urgency is needed. At the very worst, as the Chairman of 
the Eurozone Finance Ministers suggested yesterday, Greece could go 
bankrupt if voters rejected the bailout package.
    As German Chancellor Angela Merkel said last week, ``The world 
[was] watching Germany and Europe''--watching to see if Europe was able 
to take on the tough decisions required to address this crisis. The 
world is still watching. I encourage our partners in Europe to continue 
to act with the urgency the situation requires.
    As important as the economic effects of the crisis are for the 
United States, it is this committee's responsibility to also examine 
the broader picture.
    The strategic implications here go well beyond our economic 
interests and can affect all transatlantic issues. From a foreign 
policy standpoint, America needs a strong Europe to partner with on 
issues around the globe. From Iran to Afghanistan to the Arab Spring, 
America needs Europe to play an increasingly active role, and a 
distracted, internally focused Europe will not be able to help us meet 
these difficult challenges.
    A protracted austerity program could also worsen the ongoing 
problem European NATO countries have faced in meeting their security 
commitments to the alliance. As we saw in Libya and in Afghanistan, the 
demand for a strong NATO to meet 21st century challenges is not waning. 
But a Europe focused solely on budget cuts will surely strain those 
already inadequate defense resources.
    The bottom line is America needs a strong and active European 
partner, and we need Europe to do what is necessary to put the 
financial crisis behind them.
    The United States and the transatlantic community have fought two 
devastating world wars and have spent countless resources over nearly 
six decades to help bring about a Europe that is ``whole, free, and at 
peace.'' America has made these sacrifices because a stable, secure, 
and prosperous Europe is in our own vital interests.
    Today, Europe faces a much more complex challenge. The forces of 
European instability are not war and fighting, but financial 
uncertainty and the spectre of a continentwide economic breakdown. The 
future of Europe and the transatlantic alliance is at play.
    How Europe responds to this crisis over the next several months 
will have dramatic implications across the broad spectrum of U.S. 
interests. This subcommittee looks forward to engaging on these 
critical questions in the next hour.
    We have a very distinguished panel today. I will take a moment to 
introduce each of our four witnesses prior to turning it over to them 
for their testimony.
    First on our panel today, we have Jacob Kirkegaard (``KEER-kuh-
guard''), a Research Fellow at the Peter G. Peterson Institute for 
International Economics, where he has served since 2002. Mr. Kirkegaard 
comes to us from Denmark and is a widely acclaimed author and an expert 
in European economies, reform, and high-skilled immigration.
    Next, we have Mr. Bruce Stokes, who is currently the Senior 
Transatlantic Fellow for Economics at the German Marshall Fund--one of 
the premier transatlantic policy institutions in the world today. Mr. 
Stokes is a renowned former international economics columnist for the 
National Journal, where he remains a contributing editor.
    Today, we also have Dr. Desmond Lachman (``Lock-man'')--a Resident 
Fellow at the American Enterprise Institute. Lachman has a Ph.D. in 
Economics from Cambridge University and previously served as managing 
director and chief emerging market economic strategist at Salomon Smith 
Barney and also as Deputy Director at the IMF.
    Finally, we have Dr. David Gordon, the current Head of Research and 
Director of Global Macro Analysis at the Eurasia Group. Prior to his 
current position, David spent more than a decade working on U.S. 
foreign and economic policy at the highest levels of our government, 
including the State Department, the CIA, and at the National 
Intelligence Council.
    Thank you all for being here. We look forward to hearing from each 
of you.

            OPENING STATEMENT OF HON. JOHN BARRASSO,
                   U.S. SENATOR FROM WYOMING

    Senator Barrasso. Thank you very much, Madam Chairman. I'd 
like to just echo your comments and thank you for your 
leadership in arranging for and organizing this important 
hearing today.
    I'd like to also thank and welcome all of our experts for 
being here today to take part in this hearing on the European 
debt crisis. I appreciate you sharing your knowledge, your 
analysis, and your insight with our subcommittee.
    We are meeting today to discuss the European debt crisis 
and to examine the implications for the United States. I'm 
concerned about the escalating economic crisis in Europe, as 
are many Americans. The countries in the Eurozone are committed 
to a common currency and a monetary policy but retain a 
patchwork of fiscal policies.
    Over the past 2 years, there have been a series of 
bailouts, credit rating downgrades, and speculation about 
defaults from countries in the European Union. The fear of 
contagion and euro instability has stifled markets across the 
globe.
    Last week, European leaders announced their newest proposal 
to resolve the debt crisis in the Eurozone. The chairman has 
talked about recent overnight activities and activities 
yesterday, and tomorrow the G20 summit will begin and the 
Eurozone crisis will be a central part of that discussion.
    The United States and Europe have a critically significant 
relationship based on our deep history, our shared values and 
our economic ties.
    The countries in Europe include some of our most important 
allies. Throughout our transatlantic partnership we work 
closely on numerous global issues including international 
security, democracy, human rights, and free markets. It's 
important that we understand the type of impact the current 
crisis in Europe may place on our strategic transatlantic 
partnerships.
    I believe that the problem in Europe could have a 
significant and substantial effect on the United States. The 
United States and Europe have the largest trade and investment 
relationship in the world. The United States exported a total 
of over $170 billion in 2010 to Eurozone countries. An 
estimated 15 million jobs in the United States and Europe are a 
result of the transatlantic economic activity.
    Based on these strong economic ties, the problems facing 
the Eurozone can create significant risks to the United States 
economy, to transatlantic trade and economic growth around the 
world. We must clearly identify these risks and work together 
to limit the fallout from this crisis here at home.
    In addition, the United States should be learning from the 
crisis taking place in Europe. Due to the increasingly 
interconnected nature of the global economy, it is clear that 
unsustainable government debt levels can lead not only to a 
single sovereign default but it can also produce a widespread 
global financial crisis.
    The situation taking place in Europe must serve as a clear 
warning sign to all countries about the dangers of 
irresponsible unsustainable levels of debt.
    So thank you again, Madam Chairman. I look forward to 
hearing the testimony of our witnesses and evaluating the 
complex situation taking place in Europe.
    Senator Shaheen. Thanks very much, Senator Barrasso.
    Would you like to begin, Mr. Kirkegaard?

 STATEMENT OF JACOB FUNK KIRKEGAARD, RESEARCH FELLOW, PETER G. 
 PETERSON INSTITUTE FOR INTERNATIONAL ECONOMICS, WASHINGTON, DC

    Mr. Kirkegaard. Senator Shaheen, Senator Barrasso, members 
of the subcommittee, it is a pleasure to testify before you 
today on the European debt crisis and its strategic 
implications for the transatlantic alliance.
    The European debt crisis is characterized by an extreme 
degree of complexity as the correct diagnosis is not one but at 
least four deep overlapping and mutually reinforcing crises: a 
crisis of institutional design, a fiscal crisis, a crisis of 
competitiveness, and a banking crisis.
    None of these four crises can be solved in isolation and no 
single comprehensive solution to end the crisis promptly is 
consequently available to EU policymakers, indicating that the 
drawn out inconclusive crisis containment effort witnessed in 
Europe since early 2010 will continue.
    At their summit last week, euro area leaders agreed to a 
new set of measures which, while inadequate in scope to end the 
crisis and calm financial market volatility will, in my 
opinion, help militate against a new dramatic economic 
deterioration in Europe. The risk of catastrophic spillovers 
from Europe to the United States and global economy was 
therefore reduced last week, although, of course, Prime 
Minister Papandreou's recent announcement has, to some extent, 
undone this benefit.
    The euro area agreed a voluntary bond swap agreement with 
private holders of Greek Government debt, resulting in a 50-
percent reduction in nominal Greek debt value. This is an 
urgently needed measure which, however, will not independently 
restore Greek fiscal solvency.
    To achieve this goal, substantial financial support will in 
the years ahead have to be made available to Greece as well as 
Portugal and Ireland to avoid a systemic contagion effect in 
the euro area.
    Such resources should overwhelmingly come from the euro 
area itself with a component provided by the International 
Monetary Fund. Ultimately, though, euro area reform will only--
or fiscal stability will only be achieved through the longer 
term domestic consolidation and reform efforts, particularly in 
Italy.
    The Greek debt swap is a voluntary transaction which at 
this moment looks unlikely to trigger sovereign default swaps.
    Apart from the superficial political pride available to 
European leaders from being rhetorically able to deny that a 
euro area default has ever taken place, a potential short-term 
source of dislocation in the financial markets has hereby been 
removed as it is the case, although the net outstanding Greek 
CDS contract value amounts to less than $4 billion, very little 
is known about the extent of individual, including U.S. 
financial institutions, gross exposures to CDS.
    However, the lack of payout after a 50-percent reduction in 
debt may ultimately lead to the demise of the sovereign CDS 
product class for at least industrialized nations.
    Financial markets will be certain to, in the future, doubt 
whether or not any advanced economy sovereign CDS restructuring 
will trigger CDS protection. Given the multiple hedging 
purposes for sovereign CDS this may, ironically, lead to an 
increased financial market volatility in the future including 
here in the United States.
    Euro area leaders, second, agreed to raise the capital 
requirements in euro area or European banks to 9 percent core 
tier one equity and adjust for the effects of market prices of 
sovereign debt. This is a helpful further step which will help 
insulate also U.S. financial institutions against the risk of 
sudden bank collapses in Europe but will not make Europe's 
banking system stable and well capitalized.
    Third, euro area leaders agree to two options to boost the 
financial firepower of the European Financial Stability 
Facility, or EFSF. Both, however, are, in my opinion, almost 
certain to fail.
    Option one, to provide credit enhancement for new debt 
issued by member state, is a meaningless measure from a 
systemic euro area stability point of view. When the overlap 
between the insurer and the insured is as big as in the euro 
area, the beneficial financial effects will be minimal.
    Option two for the EFSF foresees the creation of special 
purpose investment vehicles open to investments from private 
and public financial institutions and investors. However, in my 
opinion, very few if any such investors will exist with the 
willingness and ability to invest the hundreds of billions of 
euros required to make a material difference for European 
financial stability.
    China will certainly not bail out Europe and it would not, 
in my opinion, be prudent use of U.S. taxpayers' money to 
contribute either, just as the statutes of the International 
Monetary Fund will in all probability prevent it from direct 
participation.
    Fortunately, though, this does not really matter, as the 
EFSF's principal purpose is political, not financial. The two 
EFSF options described here are principally, in my opinion, a 
smokescreen created by European leaders to provide political 
cover for the European Central Bank to remain directly involved 
in the European crisis stabilization measures. This is 
critical, as only the European Central Bank in the end commands 
the resources to stabilize the European economy.
    Europe is America's largest trading and investment partner 
and extensive cross-ownership of large financial institutions 
exist. It is consequently inescapable that the U.S. domestic 
economy will experience a further negative external shock from 
any rapid deterioration of the European debt crisis.
    However, the possible direct action by U.S. policymakers 
have been limited by the fact that the European debt crisis is, 
despite increasing global spillover potential, still at heart a 
domestic economic crisis inside another sovereign jurisdiction.
    The ability of U.S. Government to bilaterally affect the 
outcome of the European debt crisis is consequently and, 
indeed, appropriately limited. However, the debt crisis will 
lead to substantial changes in the European political, 
economic, and defense potential.
    The crisis will with certainty lead to a more 
institutionally integrated euro area, potentially enabling a 
more coordinated projection of the continent's remaining 
capabilities, potentially creating an enhanced European 
partnership role for the United States.
    The fact, however, that the United Kingdom is unlikely to 
be a part of such a deeper integration of the euro area will, 
especially from the perspective of the United States, be a 
complicating factor.
    The multifaceted character of the European crisis ensures 
that it will only be solved through a lengthy and, indeed, very 
volatile process. Yet ultimately, in my opinion, the European 
crisis can and will be solved through the use of overwhelmingly 
European financial resources.
    I thank you for the opportunity to appear before the 
subcommittee today and look forward to answering any questions 
you might have.
    [The prepared statement of Mr. Kirkegaard follows:]

              Prepared Statement of Jacob Funk Kirkegaard

    Senator Shaheen, members of the subcommittee, it is a pleasure to 
testify before you today on the European Debt Crisis and its strategic 
implications for the transatlantic alliance.
    The European debt crisis is characterized by an extreme degree of 
complexity, as the correct diagnosis is not one, but at least four 
deep, overlapping and mutually reinforcing crises--a crisis of 
institutional design, a fiscal crisis, a crisis of competitiveness, and 
a banking crisis.
    None of the four crises can be solved in isolation and no single 
comprehensive solution to end the crisis promptly is available to EU 
policymakers, meaning the drawn-out inconclusive crisis containment 
efforts witnessed in Europe since early 2010 will continue.
    At their summit last week, euro area leaders agreed on a new set of 
measures, which while inadequate in scope to end the crisis and calm 
financial market volatility will help militate against a new dramatic 
economic deterioration in Europe. The risk of catastrophic spillovers 
from Europe to the U.S. and global economy has therefore been reduced.
    The euro area has agreed a voluntary bond swap agreement with 
private holders of Greek Government debt resulting in a 50-percent 
reduction in the nominal debt value. This is an urgently needed 
measure, which however will not independently restore Greek fiscal 
solvency. Meanwhile, as concerns over fiscal sustainability in the euro 
area stretches also to Italy, a country ``too big to bail out,'' the 
principal challenge is how to avoid contagion and how to ring-fence 
Greece so as to avoid a generalized undermining of the ``risk free 
status'' of euro area government debt.
    To achieve this goal, substantial financial support will in the 
years ahead have to be made available to Greece, as well as Ireland and 
Portugal. Such resources should overwhelmingly come from the euro area, 
with a component provided by the IMF. Ultimately though euro area 
fiscal stability will only be achieved through the longer term domestic 
consolidation and reform efforts particularly in Italy.
    The Greek debt swap is a voluntary transaction which looks unlikely 
to trigger sovereign default swaps. Apart from the superficial 
political pride available to European leaders from being able 
rhetorically to deny that a euro area default has taken place, a 
potential short-term source of dislocation in the financial markets has 
hereby been removed, as--although the net outstanding Greek CDS 
contract value amount to less than $4bn--little is known about the 
extent of individual, including U.S. financial institutions' gross CDS 
exposures.
    However, the lack of payout after a 50-percent reduction in debt 
may ultimately lead to the demise of the sovereign CDS product class 
for at least industrialized nations. Financial markets will be certain 
to in the future doubt whether any advanced economy sovereign debt 
restructuring will trigger CDS protection. Given the multiple hedging 
purposes for sovereign CDS, this may ironically lead in increased 
financial market volatility in the future, including here in the United 
States.
    Euro area leaders secondly agreed to raise the capital requirements 
in banks to 9 percent core tier 1 equity and adjust for the effects of 
market prices of sovereign debt. This is a helpful further step, which 
will help insulate also U.S. financial institutions against the risk of 
sudden bank collapses in Europe, but will not make Europe's banking 
system ``stable and well capitalized.'' Substantially more new capital 
and an end to the solvency concerns surrounding several euro area 
sovereigns themselves will be required to restore market confidence in 
the stability of the European banking system.
    Third, euro area leaders agreed on two options to boost the 
financial firepower of the European Financial Stability Facility 
(EFSF). Both are, however, are almost certain to fail. Option one, ``to 
provide credit enhancement to new debt issued by Member States \1\'' is 
meaningless from a systemic euro area stability point of view. When the 
overlap between the insurer and the insured is as big as in the euro 
area, the beneficial financial effects will be minimal.
---------------------------------------------------------------------------
    \1\ See Euro Area Summit Statement at http://
www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/
125644.pdf.
---------------------------------------------------------------------------
    Option two foresees the creation of special purpose investment 
vehicles open to investments from ``private and public financial 
institutions and investors.'' However, few if any such investors exist 
with the willingness and ability to invest the hundreds of billions of 
euros required to make a material difference for European financial 
stability. China will not bail Europe out and certainly, it would not 
be prudent use of U.S. taxpayers' money to contribute, just as the 
statutes of the IMF in all probability will prevent it from 
participating.
    Fortunately though this does not matter, as the EFSF's principal 
purpose is political not financial. The two EFSF options described are 
a smokescreen created to provide political cover for the European 
Central Bank (ECB) to remain directly involved in the European crisis 
stabilization measures. This is critical, as only the ECB commands the 
resources to stabilize Europe.
    Europe is America's largest trade and investment partner and 
extensive cross-ownership of large financial institutions exist. It is 
consequently inescapable that the U.S. domestic economy will experience 
a further negative external shock from any rapid deterioration of the 
European debt crisis.
    However, the possible direct actions by U.S. policymakers have been 
limited by the fact that it is, despite increasing global spillover 
potential, still at heart a domestic economic crisis inside another 
sovereign jurisdiction. The ability of the U.S. Government to 
bilaterally affect the outcome of the European debt crisis is 
consequently and appropriately limited.
    Yet, the U.S. Government representatives have since the beginning 
of the euro area crisis exercised important indirect pressure through 
multilateral channels and especially the IMF and the G20 to expedite 
the European crisis resolution process and push it in generally 
beneficial directions.
    The debt crisis will lead to substantial changes in European 
political, economic and defense potential. The crisis will with 
certainty lead to a more institutionally integrated euro area, 
potentially enabling the more coordinated projection of the continent's 
remaining capabilities, potentially creating an enhanced European 
partnership role for the U.S. The fact that the United Kingdom is 
unlikely to be part of a deeper integration of the euro area will 
however especially from the perspective of the United States be a 
complicating factor.
    The multifaceted character of the European crisis ensures that it 
will only be solved through a lengthy and volatile process. Yet 
ultimately Europe's crisis can and will be solved through the use of 
overwhelmingly European financial resources.
    I thank you for the opportunity to appear before the subcommittee 
today and look forward to answering any questions you might have.
    The remainder of my written testimony provides additional 
background information concerning the complex origin of the European 
debt crisis.

[Editor's note.--The above mentioned additional background information 
as an appendix to Mr. Kirkegaard's prepared statement can be found in 
the ``Additional Material Submitted for the Record'' section of this 
hearing.]

    Senator Shaheen. Thanks very much.
    Mr. Stokes.

  STATEMENT OF BRUCE STOKES, SENIOR TRANSATLANTIC FELLOW FOR 
     ECONOMICS, GERMAN MARSHALL FUND OF THE UNITED STATES, 
                         WASHINGTON, DC

    Mr. Stokes. Madam Chairwoman Shaheen, Ranking Member 
Barrasso, and distinguished members of the committee, it's a 
distinct honor and a privilege to appear before you today. My 
remarks here represent my own opinions and are not the views of 
the German Marshall Fund of the United States.
    But I would note that GMF has launched a project on the 
topic of this hearing to look at the foreign and security 
policy implications of the euro crisis for the United States. 
It is particularly timely that we meet a week after another 
European summit about the euro crisis and the announcement of 
the Greek referendum yesterday.
    It is too early to know whether the measures announced last 
week will stem the bleeding and start to heal Europe's wounds 
or how yesterday's events will complicate matters. But 
experience has taught us that at every juncture in this 
unfolding saga European actions have been a day late and a euro 
short. We have every reason to be skeptical and we can only 
hope for the best.
    As you noted, Madam Chairwoman, America has a huge economic 
stake in Europe finally resolving its crisis. A European ``lost 
decade'' would do profound damage to the U.S. economy. But the 
euro crisis is no longer simply an economic problem. It is 
increasingly a foreign and security policy challenge for the 
United States and this crisis has the potential to undermine 
the transatlantic alliance, something, I might note, that the 
Soviets never accomplished during the cold war.
    Default by one or more euro area countries could well lead 
to stagnant economic growth, introspection and self-
preoccupation in Europe. A weakened distracted Europe would 
prove a strategic liability for the United States. It would 
mean a Europe even less able to defend itself, one that cuts 
back on foreign aid, a Europe that falls short in its effort to 
curb greenhouse gases.
    A weakened Europe will become dependent on China to fund 
its debt. It will be less able to stand up to Russian energy 
blackmail or to impose trade sanctions to curb Iran's nuclear 
ambitions. A Europe where the standard of living is declining 
could also face a growing public backlash in the form of rising 
nationalism and populism that could pull Europe apart.
    And a disintegrating Europe would only accelerate America's 
drift toward an Asian-centric foreign policy. That would be a 
development that is neither in Europe's nor America's self-
interest.
    A Europe that is tearing itself apart will be by definition 
less strong, and a Europe that is less strong will be less 
useful for the United States. In this regard, the most 
immediate strategic problem for the United States created by 
the euro crisis will be the coming inevitable budget austerity 
in Europe.
    Belt tightening is already eroding European capacity to 
share the burden of paying for global public goods. Since the 
financial crisis began in 2008, European nations have cut 
military spending by an amount equivalent to the entire annual 
defense budget of Germany, and more cuts are in the works.
    The cost of shortchanging defense was evident in the Libyan 
crisis where Britain and France would not have been able to 
carry out their successful mission without United States 
munitions. Faced with our own budgetary constraints, 
longstanding American resentment about Europe's lack of burden-
sharing in the military area is only likely to grow, poisoning 
future defense collaboration.
    More broadly, the euro crisis is undermining Europe's 
pivotal job as a democratic free market role model for its 
immediate neighbors. The nations of Central and Eastern Europe 
joined the European Union to share its affluence and political 
stability.
    Now the EU looks to be a club of austerity, pain, and 
political impotence. In the future, association with the 
European economy may no longer look so attractive to Turkey, 
accelerating its trajectory as an unpredictable and unhelpful 
free agent in the Middle East.
    Similarly, as the EU looks less stable and successful, the 
former nations of the Soviet Union are likely to slip further 
back into Moscow's orbit. With the stability of North Africa in 
doubt and the Balkans still unsettled, the last thing 
Washington needs is for the European Union to become a 
centrifugal force in the region.
    Finally, European preoccupation with the euro crisis could 
dash all American hope for transatlantic cooperation in coping 
with China. Beijing is flexing its muscles in the South China 
Sea and the Indian Ocean. It is extending its influence in 
Pakistan, in Africa and Latin America. It is developing its own 
brand of Chinese state capitalism that certainly looks more 
attractive today to many around the world than that being 
practiced in Europe or, I dare say, even in the United States.
    Washington will be hard-pressed to counter this Chinese 
influence on its own and we could find ourselves without an 
effective European partner.
    In closing, Madam Chairwoman, the euro crisis is also a 
crisis of Europe's military and diplomatic leadership and 
vision, and, as Europe's strategic partner for the last two 
generations, Europe's problems are now America's headache.
    It is imperative that the United States do whatever it can 
to help Europe resolve its current economic troubles. Most 
important, we need to work together to mitigate the foreign and 
security policy challenges created by this euro crisis.
    Thank you, and I look forward to your questions and 
comments.
    [The prepared statement of Mr. Stokes follows:]

                   Prepared Statement of Bruce Stokes

    Madam Chairwoman Shaheen, Ranking Member Barrasso, and 
distinguished members of the committee, it is a distinct honor and a 
privilege to appear before you.
    My remarks today represent my own opinions and are not the views of 
the German Marshall Fund of the United States. But, I would note, GMF 
has launched a project to look at the foreign and security policy 
implications of the euro crisis for the United States.
    It is particularly timely that we meet a week after another 
European summit about the euro crisis. It is too early to know whether 
the measures announced last week will stem the bleeding and start to 
heal Europe's wounds. But experience has taught us that--at every 
junction in this unfolding saga--European actions have been a day late 
and a euro short. We have every reason to be skeptical. And we can only 
hope for the best.
    As my fellow panelists have noted, America has a huge economic 
stake in Europe finally resolving its crisis. A European ``Lost 
Decade'' would do profound damage to the U.S. economy.
    But the euro crisis is no longer simply an economic problem. It is 
increasingly a foreign and security policy challenge for the United 
States.
    And this crisis has the potential to undermine the transatlantic 
alliance, something the Soviets never accomplished during the cold war.
    Default by one or more euro area countries could well lead to 
stagnant economic growth, introspection and self-preoccupation in 
Europe. A weakened, distracted Europe would prove a strategic liability 
for the United States.
    It would mean a Europe even less able to defend itself. One that 
cuts back on foreign aid. A Europe that falls short in its effort to 
curb greenhouse gases. That becomes dependent on China to fund its 
debt. That is less able to stand up to Russian energy blackmail. Or to 
impose trade sanctions to curb Iran's nuclear ambitions.
    A Europe where the standard of living is declining could also face 
a growing public backlash in the form of rising nationalism and 
populism that could pull Europe apart. And a disintegrating Europe 
would only accelerate America's drift toward an Asian-centric foreign 
policy. A development that is neither in Europe's, nor America's self-
interest.
    A Europe that is tearing itself apart will be, by definition, less 
strong. And a Europe that is less strong will be less useful for the 
United States.
    In this regard, the most immediate strategic problem for the United 
States created by the euro crisis will be the coming, inevitable budget 
austerity in Europe. Belt tightening is already eroding European 
capacity to share the burden of paying for global public goods.
    European defense spending has dropped almost 2 percent annually for 
a decade and more cuts are in the works. The cost of short changing 
defense was evident in the Libyan conflict, where Britain and France 
would not have been able to carry out their successful mission without 
U.S. munitions. Faced with our own budgetary constraints, longstanding 
American resentment about Europe's lack of burden-sharing is only 
likely to grow, poisoning future defense collaboration.
    More broadly, the euro crisis is undermining Europe's pivotal job 
as a democratic, free-market role model for its immediate neighbors. 
The nations of Central and Eastern Europe joined the European Union to 
share in its affluence and political stability. Now the EU looks to be 
a club of austerity, pain, and political impotence.
    In the future, association with the European economy may no longer 
look so attractive to Turkey, accelerating its trajectory as an 
unpredictable and unhelpful free agent in the Middle East. Similarly, 
as the EU looks less stable and successful, the former nations of the 
Soviet Union are likely to slip further back into Moscow's orbit.
    With the stability of North Africa in doubt and the Balkans still 
unsettled, the last thing Washington needs is for the European Union to 
become a centrifugal force in the region.
    Finally, European preoccupation with the euro crisis could dash all 
American hope for transatlantic cooperation in coping with China. 
Beijing is flexing its muscles in the South China Sea and the Indian 
Ocean. It is extending its influence in Pakistan, in Africa and Latin 
America. It is developing its own brand of Chinese state capitalism 
that certainly looks more attractive to many around the world than that 
being practiced in Europe or, I dare say, even in the United States. 
Washington will be hard pressed to counter this Chinese influence on 
its own. And we could find ourselves without an effective European 
partner.
    In closing, Madame Chairwoman, the euro crisis is also a crisis of 
Europe's military and diplomatic leadership and vision. And, as 
Europe's strategic partner for the last two generations, Europe's 
problems are now our headache. It is imperative that the United States 
do whatever it can to help Europe resolve its current economic 
troubles. Most important, we need to work together to mitigate the 
foreign and security policy challenges created by the euro crisis.
    Thank you. I look forward to your questions and comments.

    Senator Shaheen. Thanks very much.
    Dr. Lachman.

    STATEMENT OF DESMOND LACHMAN, RESIDENT FELLOW, AMERICAN 
ENTERPRISE INSTITUTE FOR PUBLIC POLICY RESEARCH, WASHINGTON, DC

    Dr. Lachman. Thank you, Madam Chairman and Ranking Member 
Barrasso, for affording me the honor to testify before this 
committee.
    As you've mentioned, these hearings are occurring at a most 
timely moment in the sense that what we're getting is very 
clear indications that Greece is now bordering on 
ungovernability that is very likely to lead to a disorderly 
default on its debt within the next few months.
    What is also of significance are developments in the 
Italian bond market where the markets are giving you the 
clearest of indications that they're not at all assured by the 
efforts that the European summit took to try to stabilize the 
situation. Italian bond interest rates are now at the highest 
level that they've been in the past 10 years.
    In my remarks this morning, what I'd like to do is 
emphasize the seriousness of the European crisis, to indicate 
why I believe that this crisis is going to materially intensify 
in the months ahead and why I think that a worsening of the 
European situation is going to have a major impact on the 
United States economy.
    I think a good place to start is looking at the origins of 
the crisis. While there are many explanations, I think that the 
most basic explanation is that the countries in Europe's 
periphery did not play by the rules of a currency union for 
many years.
    As a result, they developed severe imbalances, both with 
respect to their public finances where we had budget deficits 
routinely over 10 percent of GDP when the rules required that 
they be 3 percent of GDP, and we had a material deterioration 
in the countries' external balances. These countries lost like 
20 percent competitiveness to Germany, which resulted in very 
large external current account deficits.
    The essence of the problem in Europe's periphery is that 
those imbalances are very difficult to correct without having 
the advantage of a currency to depreciate that boost exports.
    Following the IMF prescription of fiscal austerity of a 
hair-shirt variety in those circumstances leads to very deep 
recessions that undermine the willingness of the population to 
stay the course and impair the public finances.
    I should also mention that the seriousness of the present 
Eurozone debt crisis extends far beyond the periphery in the 
sense that while the countries in the periphery might be small 
they are hugely indebted. Countries Portugal, Greece, Ireland, 
Spain between them have 2 trillion dollars' worth of sovereign 
debt and too much of that debt sits uncomfortably on the 
balance sheets of the French and the German banks.
    So if we do get defaults in the periphery, what we should 
expect is a major European banking crisis. The ECB itself talks 
about the possibility of Europe having its ``Lehman moment.''
    The crisis has, clearly, intensified. Greece, as I've 
mentioned, looks as it's on the cusp of default. Contagion has 
spread to Portugal and Ireland, and now we're having, more 
worryingly, Italy and Spain being very impacted. Those 
countries in the markets are described as too big to fail but 
too big to bail, and we're finding that out.
    The European banking system itself is showing signs very 
reminiscent of what we saw in the United States in 2008, 2009. 
They're at the beginning of a credit crunch that is going to 
have a deep impact on the growth prospects of most countries in 
Europe.
    And finally, I'd say that France and Germany--the high-
frequency data coming out of those countries are suggesting 
that those countries are approaching a recession, which is 
going to make it all the more difficult for the countries in 
the periphery to grow out of their problems.
    The European summit at last, at least, moved out of denial 
and addressed what were the fundamental problems that we now 
have. They tried to do something to stabilize the Greek 
situation. They tried to ensure that banks were properly 
capitalized and they tried to erect a firewall around Italy and 
Spain.
    The market reaction to this summit has been lukewarm at 
best. Markets sold off in the bond markets on that 
announcement, which is hardly an encouraging sign and that was 
before the announced referendum in Greece yesterday.
    Looking at this package, it's not clear that the haircut 
for Greece is nearly large enough. It's not clear that the 
Europeans will come up with 1 trillion euros in money for the 
firewall. That money will be conditional and it's likely that 
the manner in which they're going about bank restructuring is 
going to lead to an intensification of the credit crunch.
    This all is going to have an impact on the United States 
economy. In your opening remark you mentioned the trade 
relation with the United States and the investment relation 
with the United States. I would emphasize the financial 
interconnectivity between Europe and the United States.
    It disturbs me that money market funds--the United States 
have over $1 trillion in money parked with European banks, that 
you've got large exposure to banks, to Germany and France, and 
there's unknown amount of credit derivatives written. So if we 
do get a series of defaults, as I expect we will in Europe, we 
should really be bracing ourselves for an impact in the United 
States.
    Finally, I have to just say that it's very limited what the 
United States can do rather than exhort the Europeans to try to 
be more bold and serious in addressing this crisis.
    We've extended to them money through the Federal Reserve, 
through credit--through dollar swaps and we're doing our part 
through the International Monetary Fund. But I think beyond 
that there's really very little we can do.
    We should only take into account when we formulate our own 
budget policies, when we formulate our own economic policies, 
that we've got a sense of realism as to what is going to be 
occurring in Europe and not be Pollyannaish about how this is 
going to turn out.
    Thank you, Ms. Chairman.
    [The prepared statement of Dr. Lachman follows:]

               Prepared Statement of Dr. Desmond Lachman

    Thank you, Chairman Shaheen, Ranking Member Barrasso, and members 
of the subcommittee for affording me the great honor of testifying 
before you today. My name is Desmond Lachman and I am a Resident Fellow 
at the American Enterprise Institute. I am here in my personal capacity 
and I am not here to represent the AEI's view.
    In the testimony that follows I set out the reasons why I think 
that there will be a further significant intensification of the 
Eurozone debt crisis in the months immediately ahead. I also lay out 
the reasons why I think that the efforts currently underway by European 
policymakers to address this crisis will fall short of what might be 
needed to resolve this crisis in an orderly fashion. Finally, I attempt 
to draw out the serious risks that the Eurozone crisis poses to the 
U.S. economic recovery.
                         origins of the crisis
    1. The main underlying cause of the Eurozone debt crisis is that 
countries in the Eurozone's periphery persistently did not play by the 
currency union's rules. In particular, whereas the Maastricht Treaty 
had proscribed member countries from running budget deficits in excess 
of 3 percent of GDP, Greece, Ireland, and Portugal all ran budget 
deficits well above 10 percent of GDP. Similarly whereas the Maastricht 
Treaty had required that member countries keep their public debt below 
60 percent of GDP, the Eurozone's peripheral countries have seen their 
public debt levels rise to well above 100 percent of GDP.
    In addition to compromising their public finances, the peripheral 
countries have lost a great degree of external competitiveness as a 
result of relatively high domestic inflation. This has contributed to 
very large external current account deficits in the periphery and very 
high external debt to GDP ratios.




    2. The essence of the peripheral countries' problem is that stuck 
within the Euro they are not able to devalue their currencies as a 
means of boosting their exports. Attempting to comply with the IMF-EU 
programs of massive fiscal austerity without the benefit of devaluation 
to redress their internal and external imbalances is producing very 
deep recessions in these countries. That in turn is eroding these 
countries' tax bases and is sapping those countries' political 
willingness to stay the IMF course. It is also not helping these 
countries reduce their very high public debt to GDP levels.




    3. The seriousness of the present Eurozone debt crisis is that it 
has the potential for causing a full-blown banking crisis in Europe's 
core countries. While the Eurozone periphery might not constitute a 
large part of the overall European economy, the peripheral countries 
are highly indebted. The total sovereign debt of Greece, Ireland, 
Portugal, and Spain is around US$2 trillion. A large part of that debt 
sits uncomfortably on the balance sheets of the French and the German 
banks.
                    the euro crisis is intensifying
    4. Over the past few months, there has been a marked 
intensification of the Eurozone debt crisis that could have major 
implications for the United States economy in 2012.




    Among the signs of intensification are the following:

          a. The Greek economy now appears to be in virtual freefall as 
        indicated by a 12-percent contraction in real GDP over the past 
        2 years and an increase in the unemployment rate to over 15 
        percent. This makes a substantial write-down of Greece's US$450 
        billion sovereign debt highly probable within the next few 
        months. Such a default would constitute the largest sovereign 
        debt default on record.
          b. Contagion from the Greek debt crisis is affecting not 
        simply the smaller economies of Ireland and Portugal, which too 
        have solvency problems. It is now also impacting Italy and 
        Spain, Europe's third- and fourth-largest economies, 
        respectively. This poses a real threat to the euro's survival 
        in its present form.
          c. The Eurozone debt crisis is having a material impact on 
        the European banking system. This is being reflected in an 
        approximate halving in European bank share prices and an 
        increase in European banks' funding costs. French banks in 
        particular are having trouble funding themselves in the 
        wholesale bank market.
          d. There are very clear indications of an appreciable slowing 
        in German and French economic growth. It is all too likely that 
        the overall European economy could soon be tipped into a 
        meaningful economic recession should there be a worsening in 
        Europe's banking crisis. A worsening in the growth prospects of 
        Europe's core countries reduces the chances that the countries 
        in the European periphery can grow themselves out of their 
        present debt crisis.

    5. The IMF now acknowledges that Greece's economic and budget 
performance has been very much worse than anticipated and that the 
Greek economy is basically insolvent. The IMF estimates that Greece's 
public debt to GDP ratio will rise to at least 180 percent or to a 
level that is clearly unsustainable. The IMF is proposing that the 
European banks accept a 50-60 cent on the dollar write-down on their 
Greek sovereign debt holding. This would have a material impact on the 
European banks' capital reserve positions.




    6. The European Central Bank (ECB) is correctly warning that a 
Greek default would have a devastating effect on the Greek banking 
system, which has very large holdings of Greek sovereign debt. This 
could necessitate the imposition of capital controls or the 
nationalization of the Greek banking system. The ECB is also rightly 
fearful that a Greek default will soon trigger similar debt defaults in 
Portugal and Ireland since depositors in those countries might take 
fright following a Greek default. This has to be a matter of major 
concern since the combined sovereign debt of Greece, Portugal, and 
Ireland is around US$1 trillion.
    7. Since July 2011, the Italian and Spanish bond markets have been 
under substantial market pressure. This has necessitated more than 
US$100 billion in ECB purchases of these countries' bonds in the 
secondary market. An intensification of contagion to Italy and Spain 
would pose an existential threat to the euro in its present form given 
that the combined public debt of these two countries is currently 
around US$4 trillion.
    8. While to a large degree European policymakers are right in 
portraying Italy and Spain as innocent bystanders to the Greek debt 
crisis, Italy and Spain both have pronounced economic vulnerabilities. 
Italy's public debt to GDP ratio is presently at an uncomfortably high 
120 percent, while it suffers from both very sclerotic economic growth 
and a dysfunctional political system. For its part, Spain is presently 
saddled with a net external debt of around 100 percent of GDP, it still 
has a sizeable external current account deficit, and it is still in the 
process of adjusting to the bursting of a housing market bubble that 
was a multiple the size of that in the United States.




    9. Sovereign debt defaults in the European periphery would have a 
major impact on the balance sheet position of the European banking 
system. The IMF estimates that the European banks are presently 
undercapitalized by around US$300 billion, while some private estimates 
consider that the banks are undercapitalized by more than US$400 
billion. It is of concern to the European economic outlook that there 
are already signs of the European banks selling assets and constraining 
their lending to improve their capital ratios.




               implications for the united states economy
    10. Considering that the European economy accounts for over 30 
percent of global economic output, a deepening of the European crisis 
could very well derail the U.S. economic recovery. In principle, a 
deepening in the European economic crisis could impact the U.S. economy 
through three distinct channels:

          a. A renewed European economic recession would diminish U.S. 
        export prospects to an important market for U.S. goods.
          b. A weakening in the euro against the dollar, which would 
        very likely flow from a European banking crisis and from 
        questions about the euro's survival in its present form, would 
        put United States companies at a marked disadvantage with 
        respect to European companies in third markets.
          c. In much the same way as the U.S. Lehman crisis of 2008-09 
        severely impacted the European economy through financial market 
        dislocation, a European banking crisis would materially impact 
        the U.S. economy both through the financial market channel and 
        through a generalized increase in global economic risk 
        aversion.

    11. Secretary of the Treasury Geithner has correctly asserted that 
the United States financial system has relatively limited direct 
exposure to the Greek, Irish, Portuguese, or Spanish economies. 
However, this assertion overlooks the fact that the U.S. financial 
system is hugely exposed to the European banking system, which in turn 
is directly exposed to the European periphery. Among the indicators of 
this heavy exposure are the following:

          a. According to the Fitch rating agency, short-term loans by 
        U.S. money market funds to the European banking system still 
        total over US$1 trillion or more than 40 percent of their total 
        overall assets.
          b. According to the Bank for International Settlements, the 
        U.S. banks have exposure to the German and French economies in 
        excess of US$1.2 trillion.
          c. According to BIS estimates, U.S. banks have written 
        derivative contracts on the sovereign debt of the European 
        periphery in excess of US$400 billion.
          d. The recent Dexia bank failure in Belgium has revealed 
        close interconnections between European and U.S. banks.
                          what is to be done?
    12. European policymakers are presently engaged in an effort to put 
forward a comprehensive plan to address the crisis ahead of the 
forthcoming G20 summit on November 3-4, 2011. After many months of 
denial, they now recognize the severity of Greece's solvency problem 
and the serious risks that a disorderly Greek default would pose to the 
European economy. The plan that the Europeans announced on October 26, 
2011, comprised the following three pillars:

          a. A revision to the IMF-EU program aimed at putting Greece's 
        public finances on a sustainable path. The proposed revision 
        would include the requirement that Greece's bank creditors 
        accept a 50-percent write-down on their Greek loans than the 
        21-percent haircut that was earlier agreed upon in July 2011.
          b. The erection of a credible firewall around Italy and 
        Spain. By substantially leveraging up the European Financial 
        Stability Facility (EFSF), European policymakers hope to have 
        at their disposal around US$1.4 trillion that could be used to 
        purchase Italian and Spanish bonds.
          c. The recapitalization of the European banking system with a 
        view to creating an adequate cushion for the European banks to 
        absorb the losses from a Greek default.

    13. Over the past 18 months, the European policymakers' response to 
the Eurozone debt crisis has been one of ``too little, too late'' to 
get ahead of the crisis. There is the real risk that the efforts 
presently underway will also fall short of what is needed to finally 
defuse this crisis. Among the areas of concern are the following:

          a. It remains to be seen whether Greece's bank creditors will 
        voluntarily accept the large debt write-downs that are now 
        being proposed by European policymakers. It is also concerning 
        that even after the proposed debt write-down Greece's public 
        debt to GDP ratio would remain as high as 120 percent.
          b. It is not clear whether European policymakers will succeed 
        in leveraging up the EFSF by a sufficient amount to reassure 
        investors in Italian and Spanish bonds. Nor is it clear whether 
        they will be able to do so in a manner that allows those 
        resources to be readily used to effectively prop up the Italian 
        and Spanish bond markets without excessive interference by the 
        German Bundestag or without IMF conditionality.
          c. There is the danger that leaving it up to the banks to 
        improve their capital over the next 9 months will result in 
        increased bank asset sales and credit restrictions. This could 
        result in an intensification of Europe's incipient credit 
        crunch that would increase the odds that the European economy 
        experiences a meaningful double dip recession.
                 the u.s. role in resolving the crisis
    14. To date, the United States has supported the Europeans through 
the IMF, in which the U.S. has a 17-percent stake, and the through the 
Federal Reserve. Over the past 18 months, in each of the massive IMF-EU 
bailout programs for Greece, Ireland, and Portugal, the IMF has 
provided around one-third of the total funding. Meanwhile, the U.S. 
Federal Reserve has made amply available to the European Central Bank 
large amounts of U.S. dollar funding through enhanced U.S. dollar swap 
lines.
    15. A number of considerations would suggest that beyond exhorting 
European policymakers to be more decisive of their handling of the 
crisis there is little more that the United States should be doing to 
support the Europeans in resolving their crisis. Among these 
considerations are the following:

          a. The essence of the problem confronting Greece, Ireland, 
        and Portugal is one of solvency rather than one of liquidity. 
        Providing additional funding to these countries to essentially 
        help them kick the can down the road does little to resolve 
        these countries' solvency problems.
          b. Providing funding to help prop up the Italian and Spanish 
        sovereign bond markets would be putting U.S. taxpayers' money 
        at risk given the troubled economic fundamentals of these two 
        countries.
          c. In light of the United States own budgetary problems, it 
        is not clear why additional U.S. taxpayers' money should be 
        used to either bail out countries in the European periphery or 
        to support European banks. It would seem that much in the same 
        way as the United States did not seek European support to help 
        it resolve the 2009 U.S. banking sector crisis, the Europeans 
        should now use their own budget resources to resolve their own 
        sovereign debt and banking crises.

    Senator Shaheen. Thank you, Dr. Lachman.
    Dr. Gordon.

   STATEMENT OF DAVID GORDON, HEAD OF RESEARCH AND DIRECTOR, 
      GLOBAL MACRO ANALYSIS, EURASIA GROUP, WASHINGTON, DC

    Dr. Gordon. Thank you, Madam Chair, and I want to thank 
other members of the committee, Ranking Member Barrasso, 
Senator Corker, for inviting me here today, and I want to 
commend you on your leadership and the attention that you're 
drawing to the sovereign debt crisis in the Eurozone.
    As my copanelists have emphasized, the failure to resolve 
or at least mitigate the crisis will have sharply negative 
effects on global markets and on the fragile U.S. economy and 
will have negative strategic implications for the United 
States, for Europe itself, and for transatlantic relations.
    The timing of the hearing, obviously, is very appropriate, 
given the meeting in Cannes tomorrow, the European Council 
agreements of last week and the political turmoil in Greece.
    Let me start my testimony by looking at the three-pronged 
plan to which Eurozone leaders agreed in their summit last week 
and then move on to U.S. policy and the strategic implications.
    To begin with the positive, the specific issues at the 
latest European response addresses--bank-recapitalization, 
restructuring of Greek debt, expansion of the size and scope of 
the EFSF--are, indeed, the three key issues in the almost 2-
year-old crisis.
    From a symbolic perspective, then, the Eurozone leaders' 
ability to arrive at agreements on these three issues is 
definitely a step in the right direction and shows increasing 
awareness really for the first time of the scope of the crisis.
    Their capacity to act on this in a decisive way, however, 
remains very much in question. The latest agreement is an 
incremental step forward, not a definitive solution. It's 
dominated by half measures and skeletal proposals with little 
detail attached to them.
    Market sentiment, as Desmond said, reflects this. Following 
the announcement of the deal and a lot of enthusiasm last 
Thursday, markets have tanked this week. I think that this 
latest agreement is not the beginning of the end of the crisis 
but rather the end of the beginning, and in fact, I think we're 
entering into a potentially more dangerous phase.
    The latest agreement creates additional risk. Each step 
that the Europeans have highlighted is necessary but none are 
sufficient. For instance, the bank recapitalization scheme 
creates a very serious downside risk for future operations of 
European banks and financial institutions.
    The 50-percent haircut on private bondholders is voluntary 
in name only. While it may prevent a triggering of credit 
default swaps, that would simultaneously make Eurozone debt 
more difficult to insure, not less difficult to insure and 
then, of course, Prime Minister Papandreou's announcement of a 
referendum on the deal only adds to the perception of risk in 
the willingness of the peripheral countries to endure more 
austerity.
    With the IMF, driven by a U.S. unwillingness to commit 
additional resources, unable to dedicate funds beyond its 
existing commitments, any new funds for Europe from outside 
will have to come exclusively from the BRIC countries, the 
Middle East countries and a small handful of G20 members, such 
as Japan.
    These countries want to keep open the possibility of 
participation in an eventual resolution but few relish making 
concrete commitments in the near future.
    So the most likely scenario here is the continuation with 
the muddle-through approach, continued downward pressure on 
European economies, and a failure of Europe to make significant 
structural moves toward a more integrated fiscal union. All of 
this creates important negative strategic implications for the 
United States.
    It should be said that part of the challenge here is that 
the traditional U.S. role in post-war financial crises is not 
being seen in this crisis. In the past, the United States would 
have used our financial strength or political willingness to 
lead, to build multilateral coalitions, to get ahead of and out 
in front of the crisis.
    Today, we don't possess that same political and economic 
influence and what you've seen in the last 6 weeks is the 
effort to use heightened market scrutiny by Secretary Geithner 
and others to pressure the Europeans into more action. That's 
begun to work but I fear the timing here, as the Europeans are 
used to working in a slow and deliberate manner.
    This crisis is escalating. It's taken a long time to build, 
but now that it's building it is likely to speed up beyond 
Europe's ability to handle it.
    Let me highlight a couple of additional risks other than 
the ones that Bruce talked about, which are absolutely on 
point. I think the first is that we're really heading toward a 
two-track Europe here, with closer coordination among members 
of the Eurozone at the expense of broader European unity.
    The key element of European integration will no longer be 
the 27 members of the Union but 17 or 16, 15, 14 members of the 
Eurozone, thus putting the decades-long process of European 
integration, a major source of U.S. post-war foreign policy, 
into structural reverse.
    The Eurozone core is less economically open than are those 
European countries that have retained their own currencies, and 
across a host of areas including investment, trade, labor and 
product markets we could see a greater focus on regulation and 
on protection from that European core.
    Finally, I think that the weakening of Europe will feed a 
soft power deficit for the traditional Western powers and 
especially for the United States in the rest of the world as 
the liberal Western European model, the alternative Western 
model to the United States, which took a big hit in 2008, will 
also lose attractiveness to the non-Western world, with 
deleterious effects on the international rules and norms.
    So the United States, I think, needs to be cognizant of the 
fact that, unable to provide the requisite combination of 
capacity, funding, and political will to usher through its 
preferred solutions here, policymakers must prepare themselves 
for less than optimal outcomes, and here the challenge is that 
in coming years Europe is likely to be both a seriously less 
capable and less willing partner for the United States despite 
continued apparent mutuality of interests.
    Thank you very, very much for focusing on this important 
issue and for offering me the privilege of speaking with you 
today.
    [The prepared statement of Dr. Gordon follows:]

               Prepared Statement of Dr. David F. Gordon

    Madame Chairwoman, Ranking Member Barrasso, and distinguished 
members of the subcommittee, thank you for inviting me here today. My 
name is David F. Gordon and I am Head of Research and Director of 
Global Macro Analysis at Eurasia Group, a global political risk 
analysis firm. Prior to Eurasia Group, I worked in the U.S. Government 
for nearly two decades, culminating in service as Director of Policy 
Planning under Secretary of State Condoleezza Rice.
    Thank you for your leadership on and attention to the sovereign 
debt crisis in the Eurozone. The crisis is very severe, and failure to 
resolve or at least mitigate the crisis would have sharply negative 
effects on global markets and the fragile U.S. economy. In addition, 
should the crisis worsen it will have profound strategic implications 
for the United States, Europe, and transatlantic relations.
    The timing of today's hearing is especially appropriate, as 
continuing efforts to resolve the crisis will dominate the proceedings 
at the Group of 20 (G20) meeting that begins in Cannes tomorrow. In 
particular, much will rest on key G20 members' response the three-
pronged plan to which Eurozone leaders agreed in their summit last 
week. I begin my testimony by looking at this plan.
    To begin with the positive, the specific issues that the latest 
European response addresses--bank recapitalization, the restructuring 
of Greek debt, and an expansion in the size and scope of the European 
Financial Stability Facility (EFSF)--are indeed the three key issues in 
the almost-2-year-old crisis. European leaders agreed to write down 
private sector-held Greek debt by 50 percent, avoiding (for now) the 
triggering of a credit event. They announced plans to leverage the EFSF 
to insure the first losses if any further bond writedowns occur and to 
mobilize external funding through the creation of a set of special 
purpose vehicles (SPVs). Finally, leaders mandated that European banks 
achieve a core-capital ratio of 9 percent by June of next year. From a 
symbolic perspective, Eurozone leaders' ability to arrive at an 
agreement does demonstrate a clear commitment to resolve the crisis.
    Their capacity to do so, however, remains in question. The latest 
agreement is an incremental step forward, not a definitive solution. It 
is dominated by half-measures and skeletal proposals with a conspicuous 
lack of detail. It will require significant additions and likely some 
revisions as the crisis continues. Market sentiment reflects this. 
After surging last Thursday following announcement of the deal, markets 
were flat on Friday and declined substantially on Monday.
    In short, I do not see the latest agreement reached by European 
leaders as the beginning of the end of the crisis. Rather, it's more 
like the end of the beginning. In fact, we are entering a difficult and 
potentially more dangerous phase.
    The latest agreement creates additional risk. Each step to which 
the Europeans have agreed is necessary, but none (taken singly or 
together) are sufficient, even with regard to the issues that they were 
designed to address. The call for banks to raise 106.5 billion euros 
($150 billion) is almost literally a half-measure, as most private 
estimates suggest that about twice that amount will be necessary to 
safeguard European financial institutions. European government 
involvement in providing capital is unclear, and the banks may reach 
the appropriate capital ratio through shrinking their balance sheets, 
which could have negative effects on economic growth. As a whole, the 
bank recapitalization scheme creates a serious downside risk for the 
future operations of European banks and financial institutions.
    On Greece, the 50-percent ``haircut'' on private bondholders is 
voluntary in name only. While this may effectively prevent a triggering 
of credit-default swaps (CDSs) on Greek debt, it will simultaneously 
make Eurozone debt more difficult to insure, because private creditors 
will doubt that CDSs on Greek or other European peripheral bonds will 
offer much protection in the future. The agreement also fails to put 
Greece on a sustainable fiscal path. According to the deal struck last 
week, Athens will target achieving a sovereign debt-to-GDP ratio of 120 
percent by 2020. This is not only a still dangerously high level of 
debt, but also is based on implausibly optimistic assumptions about 
both economic growth and Greece's ability to narrow its budget gap with 
austerity measures and a large-scale privatization program that is 
wildly unpopular domestically. Greek Prime Minister George Papandreou's 
unexpected announcement on Monday of a referendum on the latest 
European aid deal only adds to the risk, and threatens to torpedo the 
broader agreement as well.
    With regard to the EFSF, significant uncertainty exists both on the 
insurance template and the modalities and potential for any SPV for 
external financing. The insurance scheme may nurture the seeds of its 
own destruction, as the announced extension of its value to 1 trillion 
euros ($1.4 trillion) is at best aspirational. Since the EFSF will now 
bear first losses in the case of any further writedowns, additional 
haircuts could entirely eliminate its capital. As for SPVs, with the 
IMF--driven by U.S. inability to commit more resources--unable to 
dedicate funds beyond its existing commitments, any new funds will have 
to come exclusively from the BRIC countries or a few other G20 members, 
notably Japan. Though the BRICs and other countries do want to keep 
open the possibility of participation in an eventual resolution, few 
relish making concrete commitments to an SPV in the very near term.
    The latest European plan thus creates a number of scenarios that 
are neither adequate nor sufficient. And neither/nor is a very risky 
place to be. What is needed is a set of measures that in toto comprise 
a broad and bold enough package to generate confidence that the crisis 
is coming to an end. Banks will need to suffer significant writedowns 
on debt. Even if, as in the present case, these writedowns were imposed 
(regardless of whether they were deemed ``voluntary''), this could 
provide stability and a solution to the crisis if European periphery 
countries were placed on a growth trajectory, as were debtor nations in 
the Brady Plan in the Latin American debt crisis of the 1980s. This 
latest response, however, does not follow the Brady template--it 
contains little to build broad confidence and does not place the 
affected debtors on a sustainable path.
    That said, dissolution of the Eurozone remains highly unlikely, nor 
is any country likely to leave the euro, at least in the foreseeable 
future. By far the most likely scenario--which the latest agreement 
only reinforces--is a continuation of the ``muddle through'' approach 
that has characterized the European response since the advent of the 
crisis. In other words, Europe is unlikely to make significant 
structural moves toward a more integrated fiscal union, will suffer 
several more years of poor economic performance, and will exhibit an 
increasingly inward-looking orientation in global affairs.
    Before moving to the strategic implications, I would like to make a 
few brief observations on the U.S. response to the crisis. President 
Obama and the administration have addressed the crisis in three phases. 
First, until early 2011, the United States had virtually no response. 
It occasionally offered rhetorical support, but for the most part left 
the Europeans to their own devices. Then, through the spring and summer 
of this year, the United States increased its engagement but remained 
relatively muted publicly. But beginning with the Eurogroup meeting in 
Wroclaw in early September, the United States has scolded the Europeans 
sharply and publicly, fueling market volatility.
    This new U.S. response reflects two factors. The first is U.S. 
domestic politics. The administration has preemptively called attention 
to the Europeans' failings--which, I should be clear, are serious--to 
place public blame elsewhere in case the crisis worsens and induces a 
severe downturn in the U.S. economy. As a result, President Obama has 
partially inoculated himself publicly if a European crisis spills into 
the United States. He also potentially benefits in the unlikely event 
that the stridency of the U.S. response spurs a European resolution, 
leading to an improving business environment and reduced market 
volatility on both sides of the Atlantic.
    Second, the U.S. response exemplifies a shift in strategy 
necessitated by a change in the U.S.'s international position. In 
previous similar crises, such as the Latin America debt crisis of the 
1980s, the Mexico peso crisis of 1995, and the Asian financial crisis 
of 1997-98, the United States consistently took the lead in generating 
the solutions to the crisis (as with the Brady Plan), mustering support 
among relevant stakeholders, and building a flying buttress of 
financial backing from international organizations.
    Today, the United States does not possess the economic or political 
influence to force Europe or other actors to accept the U.S.'s 
preferred solutions. Instead, the United States has used criticism to 
induce scrutiny and market reactions to pressure Europe--speaking 
loudly but letting markets carry the stick, if you will. This is the 
financial equivalent to the military strategy of ``leading from 
behind'' that has governed U.S. involvement in Libya this year, and 
will increasingly characterize U.S. engagement with Europe in the 
coming years.
    In the most likely scenario of muddle through, the debt crisis will 
weaken Europe, with negative strategic implications for the United 
States and the transatlantic relationship. For one, the need for fiscal 
retrenchment will increase pressure on European military budgets and 
drive an increasingly inward focus. These two forces will in turn lead 
to reduced European willingness to engage militarily beyond Europe. 
Military interoperability between the United States and its European 
allies will decrease, and NATO's New Strategic Concept, adopted with 
much fanfare less than a year ago, will become irrelevant. Former 
Defense Secretary Gates's warnings of a two-tiered alliance, with a few 
countries providing nearly all of the military resources, will prove 
prescient.
    As a result, leading from behind will be a problematic strategy. 
The Libya operation will prove to be the exception, not the rule. And 
even that operation, in which the United States did effectively 
maintain a supporting rather than leading role, underscored the 
decreasing European capability to project force. NATO shortages in 
intelligence-gathering aircraft, precision-guidance systems for 
ordnance, and in-air refueling equipment necessitated U.S. involvement. 
The Eurozone crisis will only exacerbate this situation in future 
alliance interventions.
    The crisis will also foster closer ties within the Eurozone itself, 
but at the expense of broader European unity. The key element of 
European integration will no longer be the 27 members of the European 
Union proper, but instead the 17 countries of the European Monetary 
Union. The crisis has, in other words, put the decades-long process of 
European integration--one of the most significant geopolitical 
developments since World War II--into structural reverse.
    The Eurozone core is in general less economically liberal than are 
those European Union countries that have retained their own currencies. 
Across a host of areas, including investment, trade, and labor and 
product markets, Eurozone countries are inclined toward regulation on 
all dimensions. The core's assumption of a more dominant role in the 
Eurozone and the Eurozone's supplanting of the European Union as the 
locus of European integration creates the risk of a decreasing openness 
in the European economy and investment environment and an increasing 
inward focus in European trade.
    Strategically, Europe's increasing inward orientation--as 
exemplified by the trends in defense, investment, and trade noted 
above--will make transatlantic cooperation vis-a-vis China and other 
emerging powers much less likely. Nowhere is this better illustrated 
than in the ongoing speculation about a Chinese financial contribution 
to Europe. Fundamentally, this story is much more about the paradigm 
shift underway globally than about the solvency of European banks.
    The shift is not about a revisionist China pushing to change all 
the rules of the international order in 1 week--and certainly not this 
week. This crisis will not be a game-changing event for China on the 
international stage, and Beijing is neither inclined nor in a position 
to take on the mantle of global leadership. China does not want the 
responsibility or the risk required to save Europe, and China's 
proclivity to free ride on the existing international system will hold 
true in this case as well.
    Beijing will make some contribution, but will be more focused on 
getting the maximum benefit for the minimum amount: providing enough 
funding to be constructive without risking a domestic backlash or 
assuming ownership over Europe's problems. Especially because the 
Europeans (and the United States as well) are reluctant to grant the 
concessions, such as market economy status or significant revisions to 
the IMF voting structure, that Beijing might demand in return for 
backstopping Europe, I expect that China will offer limited assistance 
either bilaterally or through a multilateral approach centered around 
the BRICs or the G20.
    A bilateral deal would be less risky and more typical for Beijing, 
and less useful for Europe. A multilateral approach, by contrast, would 
pay strategic benefits to China by allowing Beijing to partner with 
other countries that share similar goals about (eventually) changing 
the international economic order. These alliances could pay dividends 
in the future as China and other developing markets bargain for more 
representation in international economic institutions.
    This possibility is a further component of the challenge of a 
financially weakened Europe and will have negative ramifications for 
U.S. efforts to incorporate developing economies into the political, 
economic, and security architecture that has underpinned the 
international system since World War II. European insularity and 
economic weakness will feed a soft-power deficit for the traditional 
Western powers in the rest of the world, and the liberal European model 
will lose attractiveness to the non-Western world, with deleterious 
effects on international rules and norms.
    I want to emphasize once more that the foregoing implications all 
result from the most likely, not the worst case, scenario. The United 
States is no longer able to provide the requisite combination of 
capacity, funding, and political will to usher through its preferred 
solutions to global fiscal crises. Accordingly, policymakers must 
prepare themselves for less than optimal outcomes. And here the 
challenge is that in the coming years Europe is likely to be both a 
less capable and less willing partner for the United States, despite 
continued mutuality of interests.
    I wish to thank the subcommittee for its focus on this very 
important issue, and for offering me the privilege of testifying today.

    Senator Shaheen. Well, thank you very much, Dr. Gordon, and 
thank you all. It is not an optimistic picture that you all 
paint, sadly.
    I would actually like to begin with yesterday's events in 
terms of the crisis and that is the surprise announcement by 
Prime Minister Papandreou that he would seek a public 
referendum on the Eurozone deal with respect to Greece.
    I think that decision caught everyone off guard and had an 
impact, as was pointed out on the markets in Europe, here in 
the United States and erased many of the gains from the deal's 
announcement last week although, Dr. Lachman, as you pointed 
out, that seemed like it might be likely anyway.
    So I would like to begin with your assessment of what 
happens as the result of that announcement and, Dr. Lachman, 
I'll begin with you.
    If the referendum goes forward as planned, what are the 
likely repercussions and how will that affect the wider 
Eurozone crisis, and if the Greeks do not support the deal, if 
they reject the Eurozone bailout package, what does that mean?
    Dr. Lachman. I think the referendum is clearly--the 
referendum is, clearly, of vital importance to where this 
crisis is going but I think it's important that when you look 
at the referendum you should be looking at it against the 
background of an economy that is virtually in freefall, that 
the Greek economy has contracted by 7 percent over the last 
year. It's down 12 percent from its peak.
    Unemployment is up 15 percent because of IMF-imposed 
austerity within a fixed exchange rate system, and what's also 
occurring is that the country has become virtually 
ungovernable--that you've got strikes, you've got protests 
against paying taxes, you've got garbage piling up in the 
streets of Athens, you've got real anger on the public side.
    Papandreou had to do this referendum if he was to regain 
any authority. So this is a long shot, that apparently as much 
as 60 percent of the population will vote ``No'' on the basis 
of polls right now if the question is formulated do you like 
the deal that we're doing with the IMF.
    So it's all too likely that the Papandreou government is 
going to fall. If the Papandreou government falls, it's going 
to be very difficult for them to continue with the IMF program, 
and this is basically the way in which you get a disorderly 
default.
    To me, the events in Greece the last week or so, the 
referendum being part of that, is all too reminiscent of the 
last days of the Argentine Convertibility Plan where you had a 
political vacuum, that the people had lost the political 
willingness to stay with the austerity. And if they don't stay 
with the austerity and they don't get the foreign funding then 
the logical conclusion of that is they default on the debt, and 
I don't think that we can be very far from that so if 
Papandreou loses.
    The last thing I would say is that the opposition is not 
being too responsible. The opposition are indicating that they 
don't like austerity. They want to go a tax-cut route--that 
they really are not offering the hope that if the opposition 
comes in they're going to be following very sensible policies.
    So I fear that we're on the way to default and that if we 
do get a hard default the ECB has--over the past year they've 
repeatedly said that if you get a hard default you're going to 
get contagion to Portugal and Ireland but, more importantly, 
you're going to get contagion to Spain and Italy and that would 
really put the whole euro experiment at risk.
    Senator Shaheen. Mr. Kirkegaard, do you agree with that 
analysis?
    Mr. Kirkegaard. Yes and no. I have to say I am very 
skeptical that this referendum will go ahead as planned. I view 
it as----
    Senator Shaheen. Why do you say that?
    Mr. Kirkegaard. Because, first of all, I don't think that 
Prime Minister Papandreou actually has the majority of the 
Greek Parliament behind this plan. I think his own party will 
fracture over this, and I think it's important to realize that 
this call for the referendum is really, in my opinion, a 
strategic move or attempt by Prime Minister Papandreou to 
essentially force the main opposition party of Greece into 
declaring its political support for the IMF program.
    And the way that that's going to happen is that so far the 
Greek opposition, the New Democracy Party, has, as Desmond 
said, essentially been playing, in my opinion, a deceitful 
political game where they have been refusing to take political 
responsibility for implementing the IMF program while telling 
the Greek population that we are going to renegotiate this 
program and get a better deal.
    What this referendum call is going to do and in fact 
already has done is it's going to make it very clear. I mean, 
the other European leaders in particular have already made it 
very clear that this referendum is not going to be about 
whether or not Greece is going to get a new IMF program or not.
    It's going to be whether or not Greece is in the EU and the 
euro area as a whole or not. You're either in or you're out. I 
mean, beggars can't be choosers, so to speak. And viewed in 
that light, I, first of all, don't think that the Greek 
population, even if the referendum went ahead, would actually 
vote to leave the euro because there seems to be conflicting 
sentiments here that they're opposed to the current IMF program 
but they're also heavily in favor of remaining in the euro 
because I think at the end the Greek population knows the 
alternative of leaving the euro area which, in my opinion, 
would be a graduate slide into de facto third-world status for 
Greece, and that's not something that the population would, 
frankly, vote for voluntarily.
    But as I said, I think the much more likely scenario to 
come out of this crisis or this referendum call is either a 
unity government, which will be joined by the main opposition 
party which has already said that they will do everything to 
avoid the referendum to take place, or early elections fought 
on a sort of electoral platform that shows that both the 
Socialist PASOK Party as well as the main opposition, New 
Democracy Party, are fundamentally pro-European pro-euro 
parties and therefore I think, as I said, ultimately while this 
will create a new political strategy for implementing the IMF 
program for which there is no alternative in Greece, I think 
the main problem is that it risks delaying the entire effort.
    The timetable is pushed further into the future. We have 
all the risks of contagion and financial market mayhem and 
volatility in the time delay and that's what I think is going 
to be the main focus of the meeting tonight or the dinner 
tonight between the European leaders and Prime Minister 
Papandreou is essentially to make sure that whatever happens in 
Greece happens quickly.
    Senator Shaheen. Thank you. I am out of time.
    Senator Barrasso.
    Senator Barrasso. Thank you very much, Madam Chair.
    You know, it just seems that, you know, people say well, 
over there and over here. There doesn't seem to me, at least, 
there is no more over there and over here. We're all 
interwound, interlinked and it's of great concern.
    I hear that the European problem is real, that it is not 
going away and the question is where do we--where do we go from 
here and how much impact can the United States and our own 
economic situation have to have an impact.
    Mr. Lachman, I was listening closely to your comments and 
you said that what they are trying to do now is too little too 
late. Mr. Gordon talked about the 17 countries that may be then 
16, 15, 14.
    What scenarios are you seeing? Maybe the two of you want to 
comment on that in terms of the--and a timeline on how this all 
unfolds.
    Dr. Lachman. Well, the first thing I'd say is that what is 
of the greatest concern is if we do get a series of disorderly 
defaults because if you do get disorderly defaults what that 
means is you have big hits on the French and the German banks.
    You have an intensification of a credit crunch and then 
you're in what the ECB would call Europe's ``Lehman moment'' 
where the whole European economy goes into big contraction. I 
don't see how that at this point is avoidable, what's left it 
far too late. These countries are in deep recession.
    There's huge political resentment on continuing that 
course. I think that the debt is going to have to be written 
down. We're dealing with solvency problems in these countries, 
you know, and that's really how I see that playing out. Whether 
or not the countries leave the euro is debatable.
    Defaulting on the debt seems to be more or less a certainty 
that you're going to get a hard default in Greece in the sense 
that the debt will be written down by 60, 70 cents on the 
dollar. Leaving the euro would be a very big choice for any of 
these countries because, as Jacob has pointed out, that the 
rules of the game are if you leave the euro you're also obliged 
to leave the European Union.
    I've observed over the past 2 years that the Europeans 
waive the rules when you get to the crunch--that we were having 
no bailout clauses and then we find that we have bailouts or 
the ECB doesn't buy bonds in the secondary market, then it buys 
bonds in the secondary market.
    I think the same will occur here is that they'd make 
allowances for Greece if Greece were to leave. The essence of 
the problem though is that what Greece is being offered by the 
Europeans they're already--I wouldn't say that they're deep in 
recession. They're in depression, and what they're being 
offered is more IMF austerity to hold their exchange rate, 
which means that they're going to have a ``lost decade.''
    When that is the case, it is very tempting to try something 
different even with all of the risks and I think that this is--
basically, my experience with fixed exchange rates is that 
that's basically where we're headed.
    Senator Barrasso. And Mr. Gordon, did you want to----
    Dr. Gordon. Yes. I agree with both Jacob's political 
analysis and with Desmond's economic and financial analysis 
here. I think the purpose of what Papandreou was trying to do 
is to draw in the opposition. I think he's likely to fail.
    I think there's likely to be new elections in Greece and 
then the opposition will likely be the predominant actor in a 
post-election coalition. But I think that you then are very 
much in Desmond's dynamics--this will lead to a disorderly 
resolution of the debt crisis until or unless Europe is willing 
to put a better deal on the table for Greece.
    I think that could very well happen. I think these events 
are probably 4 to 6 months away. The big challenge for the 
United States is that, is this going to end with a bang or with 
a whimper. If it ends with a bang, we get hurt very, very, very 
badly. If it ends with a whimper, it's bad for Europe. It's not 
great for us but I think our exposure to it still is 
containable. But that will depend on what the outcome of this 
political event in Greece is and then I believe very much that 
there will be another round of negotiations with the European 
authorities, particularly the EU and the ECB.
    Senator Barrasso. Mr. Lachman, could you talk a little bit 
more about the potential credit crunch that you see coming? I 
think you had described it as the ``Lehman moment.''
    Dr. Lachman. Well, you've already got signs that there are 
real strains in the European credit markets, you know, if you 
look at the credit default swaps on banks or you look at 
interest rates or you look at banks cutting back on lending.
    One of the key mistakes that the Europeans made at the 
summit was to identify that the banks are short on their 
capital ratios, that they need to raise additional capital, but 
then allowing them 9 months to meet those capital ratios. What 
one would expect is that the banks aren't going to raise 
capital. With their share prices so depressed they're not going 
to want to dilute shareholders' capital.
    What they're going to do is they're going to shrink their 
balance sheets. They're either going to sell assets or they're 
going to restrict credit and that is the last thing that I 
think a weak Germany and France right now needs is the banks to 
pull back.
    If we get the disorderly default that I think that we're 
going to get, and I don't think that we're more than a few 
months away from that, then that just means that the hit to the 
banks, their capital ratios, are even more impaired.
    So this process of getting a credit crunch is very real and 
that is going to affect not simply Europeans. You've got to 
take into account that the European banks are very large. 
They've got enormous international reach, that there are 
already reports that Asian companies are having difficulty 
raising capital from the banks. So that is the way I think this 
gets transmitted globally.
    Senator Barrasso. And then the question that follows is 
with the trillion dollars of U.S. dollars in money market funds 
that are in Europe, how do you see that then playing and what 
the impact is in terms of the value of those dollars, which 
people in America think are very safe?
    Dr. Lachman. Well, hopefully, the Europeans won't let any 
banks fail on their obligations but nonetheless this is a risk 
that we're exposed and markets will see this.
    We've already seen this in terms of you've just got to look 
at the share prices of Morgan Stanley or JP Morgan or any of 
these banks that have got exposure in Europe. You know, the 
markets are making those connections.
    But the exposure that we've got is a trillion dollars' 
worth of money market funds, over a trillion dollars with the 
banks. This is not insignificant and I think that the lesson 
that we've learned from the U.S. experience with our financial 
crisis is the same way as our financial crisis was propagated 
throughout the globe what we're now going to have is a similar 
banking crisis in Europe.
    Hopefully, we've learned lessons that they won't make the 
mistakes of letting banks fold. But, nonetheless, if you've got 
those tensions that is going to have repercussions through the 
global economy.
    Senator Barrasso. Thank you, Madame Chairman.
    Senator Shaheen. Thank you.
    Senator Corker.
    Senator Corker. Well, thank you both. I think this is a 
great hearing. I thank you for having it and certainly the 
witnesses, I think, have been excellent.
    Let me--you know, it's kind of interesting to listen to you 
and, of course, read everything that's happening around the 
world. But the fact that Western democracies as a whole--I know 
Germany and others maybe have handled themselves well but we 
are in a period of decline because we have not handled our 
fiscal matters appropriately and therefore our ability to 
affect the world is lessened, and what we're seeing is that 
those countries that have the courage and the will to get their 
balance sheets in order and to get their fiscal house in order 
are going to be projecting greater strength and leadership 
around the world.
    And so we're witnessing something right now that I think is 
going to be looked back upon in the future as a real moment in 
time where world balances are changing and I think that's, for 
those of us here in this country and certainly in Europe, one 
of our greatest allies, this is a problem and hopefully a wake-
up call even for what we're doing right now this very moment in 
Congress as it relates to dealing with deficits.
    But on that note, and moving back to Europe and some of the 
things that have taken place, when we had our financial crisis 
and I know it's been highly--you know, it's been highly 
criticized by many but we had the ability at that moment in 
time, obviously, being only one country, a huge advantage, but 
to really come in with force and to stop it.
    It does appear that everything that's happening in Europe 
right now comes at the last minute and not quite enough and so 
resources are wasted, effort is wasted. In other words, you're 
using things up that might actually end the crisis. You're 
using those resources up. You're still not going to end it. It 
goes over another hoop.
    Is there anything right now, that in spite of all the 
difficulties of having differing countries with differing 
interests is there any bazooka, if you will, that Europe has 
that it could use to actually cause this to end at this moment? 
Yes, sir.
    Mr. Kirkegaard. There is only one bazooka in Europe, in my 
opinion, is the European Central Bank. But they have 
essentially put themselves under--I think that it's also 
important to understand that this is a truly independent 
central bank. You can't tell it what to do. It's 
constitutionally----
    Senator Corker. Are you saying that unlike the Fed or what 
are you--I'm going----
    Mr. Kirkegaard. No, no. [Laughter.]
    Not at all. What I'm saying is that it has chosen to not go 
big or use its bazooka, which it had. It could go big, if you 
like, and guarantee all the sovereign debt of Italy, for 
instance.
    Senator Corker. But the European Central Bank, excuse me, 
is not the lender of last resort. Is that not correct? I mean, 
its----
    Mr. Kirkegaard. It hasn't----
    Senator Corker [continuing]. Mandate is very different than 
the Fed's mandate.
    Mr. Kirkegaard. It has chosen to--it has essentially chosen 
its own mandate to not be or act as a lender of last resort. 
But if it changed that it could, in fact, act as a lender of 
last resort. What it essentially is trying to do is, in my 
opinion, to carefully construct financial pressure, as Desmond 
said, in the financial markets. Now we have Italian interest 
rates over 6 percent.
    Well, that is having a very significant effect and putting 
pressure on Silvio Berlusconi to do the kind of structural 
reforms that the European Central Bank has very clearly, in 
fact, written letters to Silvio Berlusconi instructing him to 
do.
    So what it is trying to do, in my opinion, by not--
deliberately not ending the crisis is to get the kind of 
response from politicians in the euro area and in Italy 
particularly that it wants. And it actually has the 
institutional power in Europe to do this because it is, as I 
said in my testimony, the only credible bazooka in Europe.
    So it is ironic that if you wanted to end a financial 
crisis you would normally go big and a credible commitment--a 
big number. But Europe actually goes exactly the other way. 
They deliberately prolong the crisis to build up market 
pressure to essentially force politicians and policymakers to 
do these kinds of reforms.
    Dr. Gordon. Senator, I think the good news here on the 
timing is that I think that the move by Prime Minister 
Papandreou will basically mean that we won't be spending weeks 
talking about the European plan that was constructed last week 
as a potential solution.
    I think actually that's a positive. We will quickly go 
beyond that and I think the timing of the G20 will allow 
leaders to have a chance to get together and think about next 
steps. Do I think that anything systemic will come out of the 
G20 meeting? Absolutely not.
    But I think where the G20 meeting was headed before this 
was this endorsement of what the Europeans had been doing, some 
financial support, particularly from BRIC countries and the 
Gulf States.
    I think none of that is going to happen. I think that's a 
positive thing because it will bring a greater sense of crisis 
and an ability to move forward as we iterate toward a solution.
    Senator Corker. Yes, sir?
    Dr. Lachman. I certainly agree with Jacob that the ECB 
could be a bazooka that, from a technical point of view, they 
clearly can expand their balance sheet at will. But the reason 
that I think that they're not is that their major shareholder, 
namely Germany, is not too keen about the ECB using its 
printing press.
    What we've seen is over the past year we've seen Axel 
Weber, a governor on the ECB board from Germany, leaving in 
protest. We saw Jurgen Stark leaving in protest. We've seen the 
president of Bundesbank thinking that what the ECB is doing is 
wrong.
    We've seen the President of Germany indicating that he 
thinks that what the ECB is doing goes beyond legality. So I 
don't think it's an accident that the ECB doesn't go into the 
market in this degree.
    The ECB has to be very concerned about losing the support 
of the German people, which would then take away their 
independence. So I would see the ECB as being politically 
constrained in dealing with the situation.
    Senator Corker. Yes. Go ahead, Bruce.
    Mr. Stokes. If I could tie together a couple of remarks 
here, I think that--I don't know if I agree or disagree with 
some of my fellow panelists. I think the problem with the 
announcement of the referendum, and even if we don't actually 
have a referendum, is that time is not on our side. The markets 
are moving already.
    We have every reason to believe they will continue to 
move--that if this takes days or even weeks to sort out that 
events could get rapidly out of control. I do think the ECB 
will do what it can, but I don't think there's a lot of 
evidence that they're willing to take the steps that we would 
all say the United States took and that they should emulate.
    And so to get back to your point, Senator Corker, I think 
that what we're going to need in the weeks ahead is market-
stabilizing initiatives.
    We can't necessarily expect those to come out of Europe, 
which puts new pressure on the United States and the Super 
Committee. If the Super Committee can come up with a credible 
plan, this will help stabilize global markets in a way that is 
not totally sufficient, but it can be our contribution, that, 
as David said, we're not about to write a check to Europe but 
just make it our contribution to helping stabilize markets.
    If, on the other hand, we have a train wreck on November 
the 23rd, we'll only be throwing gasoline on the fire of the 
markets and I think that would be unfortunate.
    Senator Shaheen. I just want to follow up on that real 
quickly, Mr. Stokes, because does the Super Committee just need 
to fulfill its mandate or are you suggesting that it needs to 
come up with a broader response to the current situation, that 
grand bargain that was talked about earlier in the discussions 
about this country's debt and deficits?
    Mr. Stokes. At the risk of being Pollyannaish, I think we 
should have a broader grand bargain. I think that would be the 
bazooka that we could bring to the table in this timeframe to 
try to help calm markets and also it would be good for 
ourselves in the process, because at the end of the day we have 
to deal with our own problems.
    Europeans have to deal with their problems. But markets are 
going to be worried about instability. Even if we could get a 
deal, a smaller deal, to fulfill the Super Committee's mandate 
I think that would send the right signals.
    I think what would not send the right signals is if the 
Super Committee gets to the 23rd of November and kicks the ball 
down the road. Then we have to worry about the interaction of 
concern about the European crisis with what might be perceived 
as a new crisis in the United States.
    Whether it is or it is not a crisis is a different issue. 
And then we would, I think, risk what we had in 2008, which was 
that credit markets on both sides of the Atlantic would begin 
to dry up--that people just say, I don't trust things, I will 
just sit on my money, and that would not be good for the global 
economy given the fact that we're slowing down already.
    Senator Shaheen. Mr. Gordon, I'm going to ask you to 
respond but I want to do another followup with you, Mr. Stokes, 
first, what should the G20 summit do in response to the euro 
crisis and what do you think they will do?
    So if you could say these are the perfect steps you should 
take in order to respond in a way that would reassure the 
markets, that would reassure Europe and the rest of the world 
that you're addressing this problem and then what do you think 
they have the political will to do?
    Mr. Stokes. Well, I would second Jacob's statement that 
probably the most important thing that's going to happen in 
Cannes is this dinner between Sarkozy and Merkel and the Greek 
Prime Minister because out of that meeting, their dinner, there 
has to come some strong signal that we're on top of this, we're 
together on this, we are in accord.
    I'm not quite sure how they do that, how they come out with 
that kind of message, because if it comes out that people are 
pointing fingers and are not cooperating, I think that would 
send a very dangerous signal to the markets.
    I would have said before the announcement of the referendum 
that what one could have hoped for at the summit vis-a-vis this 
crisis is that there would be some agreement that the BRIC 
countries would in some way be willing to pony up some money to 
help backstop Europe, and the details could be worked out 
whether it's a euro bond or other things, that would be left to 
the technicians, but that there was a commitment and that it be 
done not through the Chinese investing in Greek port 
facilities, but through some kind of centralized mechanism that 
would reduce the concerns about BRIC political influence.
    I think now, after the Greek decision, it's inconceivable 
to me. I think it was already hard to believe that the Chinese 
would be willing to risk their money and now it seems to me the 
Greek decision has given the Chinese an excuse to say--you sort 
this out and come back to us later. My guess is the Japanese 
might feel the same way. So that's an added complication. But 
at the very least, it seems to me that the leaders have to have 
some very reassuring statements in Cannes because markets will 
be moved by what they do.
    Senator Shaheen. Mr. Gordon, I know you wanted to respond 
earlier but can I also ask you as part of that, you pointed out 
that you thought it was positive that we have jumped ahead in a 
way that I don't want to say cancels out but looks at what the 
alternative to last week's Eurozone deal is. So what is the 
deal that should be put on the table that could reassure 
markets?
    Dr. Gordon. I don't think that we get to grand deal here 
and this is a connection back to the Super Committee. I think 
that the best is often the enemy of the good so I think the 
good for the Super Committee, which is doable--absolutely 
doable--is meeting its mandate.
    A grand bargain is not doable. In our system elections 
determine the political context. We're very close to a 
Presidential election. That's when following that election is 
the time for grand bargains. But the Super Committee has a 
doable mandate. That's what it should do and that would 
definitely calm markets.
    We're still at a moment of iteration here and I think, 
importantly, you throw the ball back into the court of the 
Europeans to say put some real detail on these steps. Move to 
turn these half measures into whole measures.
    Give a pathway here for Greece to see itself being able to 
grow out of the economic freefall it now finds itself in and I 
think that that would be a step forward. But there's not going 
to be resolution coming out of this G20. The basis for it 
doesn't exist.
    Senator Sheehan. So you're not suggesting that it's the 
parameters of the deal, the broad outline, that's the issue. 
It's that they don't have enough detail to what's being 
proposed.
    Dr. Gordon. Well, and the parameters as announced are 
insufficient. I think the themes are the right themes. The 
parameters are half measures and----
    Senator Shaheen. OK. Let me just, if I could, poll 
everybody else.
    Does everyone else agree with that? Mr. Lachman? No. I'm 
just going to ask you to do yes or no because I'm about to run 
out of time but we'll be back to you. Do you agree or not?
    Dr. Lachman. Partly, but I would just emphasize that you're 
dealing with solvency problems in a number of the countries--
dealing with solvency problems in Greece, Portugal and Ireland 
to get additional money, to throw additional money at these 
countries. All you're doing is you're kicking the can down the 
road. You're not resolving their solvency problem.
    Senator Shaheen. See, it's not only politicians who have 
trouble answering yes or no. [Laughter.]
    Mr. Stokes.
    Mr. Stokes. I would say yes, you need more money for the 
bank bailout. You need more money for the bailout of the 
countries.
    Senator Shaheen. Mr. Kirkegaard.
    Mr. Kirkegaard. I would say yes but I think we have to 
recognize that the biggest impact the G20 has had is having the 
Cannes summit because it has forced the Europeans to move 
further than they otherwise would, as indicated by tonight's 
dinner.
    Senator Shaheen. Thank you. Thank you all.
    Senator Barrasso. Well, I think this follows up, Madam 
Chairman, the things that Mr. Stokes was talking about. He said 
it's not just an economic crisis or a global realignment 
crisis, a security crisis with regard to NATO. And so I do 
wonder about leverage used by other foreign governments.
    We talked about--I think we mentioned China. I think, Mr. 
Gordon, you mentioned all of the BRIC countries and then what 
the implications of that are. So just I'd like to ask each of 
the four of you to just kind of take a look at that globally, 
if you would.
    But also the other question that I'd ask you quickly is on 
the referendum issue in Greece. Does that mean then that the 
Germans may say, we want a referendum as well, and if they're 
going to take the haircut, which is at 50 percent but I think 
Mr. Lachman said it may have to get to 70 percent.
    So I don't know, if we could just go down the panel and if 
you want to start, Mr. Gordon, we can just ask everyone's 
opinions.
    Dr. Gordon. I mean, on the realignment I think that China 
is unable to act strategically here because of domestic 
politics and the power of nationalism. I think that this crisis 
offers a major potential opportunity for China but there's not 
going to be an immediate quid pro quo.
    Without an immediate quid pro quo, the Chinese are going to 
be too hesitant because of the potential political backlash at 
home.
    Dr. Lachman. Yes, I'd agree that it's going to be difficult 
to get China and the other BRICs to contribute. But I think 
that there's a more basic question is whether a 1 trillion euro 
firewall is big enough and whether it is unconditional enough 
to do the job that really what you need to contain this crisis 
is you do need a bazooka and the ECB is the only institution 
that's got the bazooka but for reason I said it is constrained.
    Mr. Stokes. I think that China in particular will probably 
not pony up as much money as some people might have speculated. 
In part because, I think, of David's reasons. But we should 
understand that China is already having an influence.
    If you talk to EU officials in their private discussions 
among themselves, when they're sitting down to talk about 
should we bring an antidumping case or an antisubsidy case 
against the Chinese, there will be people from countries in 
that room, EU member countries, who say, we can't do this--
we're looking for money from Beijing. And it's not just that 
we're worried about this. They've actually called us and 
threatened us that we won't get the money because they know 
we're about to make a decision on these dumping cases.
    So that kind of influence, which I must admit we probably 
have also exercised ourselves in the past, is something we both 
have to worry about as we think about working with the 
Europeans going forward in dealing with China.
    Your other point about does the Greek referendum lead to a 
German demand for a referendum, it's interesting, there's a 
piece in a German paper today arguing just the opposite that 
said, we've already said that any deal has to be passed by our 
Bundestag--why shouldn't the Greeks have the same democratic 
option.
    Of course, the problem with that is that it slows down 
these processes even more and one of the needs of a crisis like 
this is the ability to move fast and that balance between 
democracy, which we obviously believe in and think is 
absolutely necessary to bring along the public, and the need to 
move rapidly to send messages to markets is a tension that the 
Europeans are trying to balance and I fear may not get the 
balance right.
    Mr. Kirkegaard. No, I agree completely with Bruce's 
comments about that China is already exercising soft leverage 
on some of the European countries. There's no doubt about that.
    Even if they don't for domestic political reasons, as David 
said, are going to be able to pony up any kind of money that 
will make a credible bazooka they're not, nor will anybody 
else, as I said in my testimony.
    Quickly, on the referendum, I also agree with what Bruce 
said there. I think the Europeans will be very, very adamant.
    I mean, this will be one of the things that they will say 
to Papandreou tonight is that we don't want a precedent for 
referendums on IMF programs because we know that even if, as I 
said, ultimately I believe that a referendum will probably be 
won by Papandreou it will be hugely destabilizing and it would 
work the same way as referendas has worked in terms of getting 
new European treaties approved.
    It basically slows everything down, you know, by several 
years potentially and that has, obviously, very destabilizing 
effects.
    Senator Barrasso. Thank you, Madam Chair.
    Senator Shaheen. Senator Corker.
    Senator Corker. Thank you. I think, again, this has been 
very interesting. You know, so you see the ECB with German 
leadership in essence putting sanctions on countries.
    I mean, that's what's really happening here and the 
question is will the length of time intersect properly where 
you actually end this crisis. And I agree with you. Having this 
referendum in January means that basically nothing else can 
happen and so you basically have no real progress underway 
except for, I guess, at the end of this month hearing more 
details about the three steps that European Union has taken.
    So to me it's pretty--it's not heartening to see that 
there's not a real step taken. My guess is by the time it's all 
said and done the European Central Bank will play a different 
role than it is now playing and it's just a matter of time.
    Let me ask you this. On the credit default swaps, I mean, 
it seems to me that, No. 1, we're in this era where even in a 
more exaggerated way he who has the gold rules.
    I mean, we're seeing that play out very strongly. Those 
countries, again, that had their fiscal house in order are 
going to be the dominant players in the world.
    We're diminishing in that regard right now because of our 
own ability. We still have major economy but our resources and 
our ability to act are diminishing. The credit default, the 
other piece it seems to me that's really illuminated right now, 
is this whole CDS--I mean, now sovereign entities issuing debt. 
If all of a sudden you can just change the rules on the credit 
default swaps sovereign debt is now in a very different place, 
is it not?
    I mean, you literally cannot buy--well, you will not be 
able to buy insurance for sovereign debt and feel good about it 
if all of a sudden you can say well, you know, your living room 
burnt down, your kitchen burnt down, you know, your bedroom has 
burnt down but your garage is still standing so we owe nothing. 
It'd be like this--that would be the relevant place for home 
insurance.
    So tell me the effect that this is going to have on lesser 
countries, if you will, as it relates to issuing sovereign 
debt.
    Dr. Gordon. I think the European plan is that you have the 
50-percent haircut, no CDS and then you have some European 
insurance on this and I think that you're right.
    I think that basically this whole thing makes the efforts 
to hedge sovereign debt much more challenging but, and again, 
it gets back to your point that it reinforces the position of 
those countries that don't have to go there, basically, in the 
world and makes it tougher for those that do.
    I think the other thing that it does here is that it will 
create incentives if we do get a disorderly default here. It 
will create incentives for others to follow and that's the 
challenge of putting the ring fence here around Greece that's 
going to be very difficult to do.
    Dr. Lachman. The point that you raise about credit default 
swaps is a lot more serious because it's affecting not the 
smaller countries but it's affecting a country like Italy where 
the bond holders now feel that they don't have the insurance, 
and Italy's got something like 1.9 trillion of sovereign debt 
outstanding and if people begin selling that really could tip 
Italy into a bad equilibrium and that is really what we're 
fearing.
    Senator Corker. Yes.
    Dr. Lachman. You know, your second point about the emerging 
market finances versus the developed countries' finances 
couldn't be more true. These countries--whereas most G7 
countries have now got debt to GDP ratios with a 90-percent-
plus handle or that they're running very large budget deficits, 
if you look at countries like Brazil, Russia, China, all of 
these countries have got public debt levels that are half the 
levels of ours and their budget deficits are half the levels of 
ours.
    So they're really in very much stronger position to weather 
these kind of storms than we are.
    Mr. Kirkegaard. If I could just say quickly, I actually 
think that it's an even bigger issue with respect to the CDS 
because what does it actually signal? Why do we need CDS on 
sovereign debt is because there is a fundamental impairment of 
the risk-free status in financial markets of government debt.
    The full faith and credit of Country X is, clearly, not 
what it used to be and I think that has very tremendous or very 
large implications for how governments more broadly, and this 
includes, I believe, the United States as well as large--other 
G7 countries, how are they going to be able to act going 
forward in future crises in a countercyclical manner.
    One of the ways that we traditionally have fought large, 
you know, cyclical swings in the economy is that the government 
in a crisis acts. Because it has the capacity to borrow at the 
risk-free rate, it can expand expenditure in a countercyclical 
way.
    Well, if government credit as is now happening and, 
clearly, in the Eurozone begins to be swinging procyclically so 
that it goes up with--in a downturn just like the riskiness of 
all other types, that will essentially impair the ability of 
government to act in this way, which I think will ultimately 
lead to much more volatile, you know, advanced economies.
    Senator Corker. OK. So you have a--so speaking of Italy, 
you have a situation where now credit default swap is 
worthless--maybe not worthless but certainly its credibility is 
damaged. Their interest rates when we walked in the room were 
at 6.22, which is, you know, a multidecade high, not just a 10-
year high.
    At what level do interest rates in Italy get to a point 
where it's absolutely a downward spiral? I mean, have you all 
looked at what that level is?
    Mr. Stokes. Well, they already are at levels where Portugal 
and Ireland had to get a bailout. I know Italy is a different 
country. The debt of Italy is held more by its own people than 
some of these other countries. But it is a danger.
    One thing I wanted just to jump in on is the CDS issue to 
highlight something that Jacob said in his testimony. We aren't 
sure we know the data on CDS and at least this summer both the 
Fed and the IMF claimed they weren't really sure who held 
this--who had written this.
    Now, it may well be they know and they just don't want to 
talk about it because that would move markets. But I think that 
it is the kind of thing that Congress needs to get on top of.
    We at least need to know what the exposure is even if it's 
not public information so that we can begin to plan for worst 
case scenarios.
    Senator Corker. May I ask one more question?
    Senator Shaheen. Sure.
    Senator Corker. And by the way, we have been pursuing that. 
Is there any discussion at any level that makes any sense?
    I know in a crisis mode it's hard to focus on anything 
other than the crisis at hand and I think, again, the 
multicountries involved we know that's difficult and, you know, 
it creates lots of frustrations by us as onlookers.
    But is there any discussion about the growths out of this? 
I mean, at the end of the day there's a downward spiral that's 
being exacerbated by all of these actions. Has anybody over 
there articulated any thought about how growth resumes?
    Obviously, that's the easiest solution to this but or any 
prospects of something that would generate growth.
    Mr. Kirkegaard. Well, I think it's fair to say that the 
short-term growth outlook for Europe is bleak. I don't think 
there's any doubt about that. I think we will possibly have a 
short technical recession in one of the quarters, either the 
fourth quarter of this year or the first quarter of 2012.
    But there is some movement toward a growth strategy in the 
periphery by basically through the traditional European 
Commission budget where investment funds are being now made 
available to Greece, Portugal, and Ireland without the 
traditional need for national copayments.
    So it essentially becomes investments fully funded by the 
European Union. And there was actually in the leaders' 
communique--the euro group communique--last week a reference to 
this project. It's called Project Helios and it's essentially a 
50 billion euro solar panel investment project in Greece that 
obviously has the potential to create some kind of growth in 
the short term.
    But having said that, growth agendas are not central to the 
European debate and to the degree that it should be, given the 
growth outlook.
    Mr. Stokes. Senator, one thing that it seems to me that we 
can do at the margin but I think would be a terribly useful 
thing to do is to begin to talk to Europe about how we remove 
all tariffs on goods traded across the Atlantic, how we 
encourage investment across the Atlantic.
    We can make a contribution that both helps Europe and helps 
us by deepening and broadening the transatlantic market, which 
right now is the world's largest market. But it won't be that 
forever.
    So we have something we can contribute. There's a EU-U.S. 
summit coming up November 28. It's my understanding that 
they're at least considering the possibility of trying to make 
some statement along these lines, not a commitment but at least 
a commitment to look into it.
    Certainly, the U.S. Chamber of Commerce supports this. The 
National Association of Manufacturers is looking at it. So I do 
think there is a potential there for us to make some small 
contribution which will both help them and help us.
    Senator Corker. Madam Chairman, thank you and thank each of 
you. You all were great.
    Senator Shaheen. Thank you. I want to follow up on the line 
of discussion that Senator Corker has opened because as has 
been pointed out from the beginning of this crisis the focus in 
Europe has been on austerity measures and cutting budgets, and 
yet as you pointed out, Mr. Kirkegaard, there have been a 
number of factors and I think probably you said this too, Mr. 
Lachman, that have contributed to the crisis.
    So should the focus have only been on austerity measures? 
Has that been the correct response? Should there have been a 
kind of one-size-fits-all? I mean, you've all talked about how 
difficult the measures have been on Greece in terms of the 
tightening of their economy.
    So should they be looking at efforts that emphasize more 
than just austerity? And Mr. Kirkegaard, do you want to respond 
first?
    Mr. Kirkegaard. I have to say that I believe that for the 
peripheral countries and those would be, of course, Greece, 
Portugal, and Ireland, I believe austerity to the extent that 
it has been imposed by the IMF programs was indeed appropriate 
because what we saw during the crisis and was in fact that it 
turned out that these countries, apart from having a 
significant structural budget, they also had very procyclical 
government revenues.
    So the crisis itself creates this negative spiral to a 
certain extent that Desmond has talked about. But when you have 
the kind of debt levels and the kind of structural deficits 
that these countries have, yes, then I believe austerity was 
appropriate.
    It doesn't mean that you should not try to have outside 
capital brought in from the European level for investment 
growth-stimulating purposes. But I believe austerity was the 
appropriate measure.
    Senator Shaheen. Yes.
    Dr. Lachman. I guess I draw different lessons from the 
experience of Greece. You know, I think that the degree of 
austerity imposed on a country in a fixed exchange rate system 
the IMF should have known that that was going to fail and, 
indeed, events have borne that out. When the IMF started these 
programs they thought that Greece's debt to GDP level was going 
to peak at 130.
    Now they're talking about it peaking at 180, maybe going to 
200, and the reason that that is occurring is because the 
economy has contracted at a very much faster rate, deeper rate 
than they anticipated.
    But that should have come as no surprise to anybody because 
if you tighten budget by 5, 6, 7 percentage points of GDP in a 
single year and you're in a fixed exchange rate, it's difficult 
to see where the growth comes from.
    Looking forward, I think we're in an even worse situation 
because what the IMF is doing is they're continuing to impose a 
lot of austerity but now they're going to be doing it in the 
context of a credit crunch developing so monetary policy is 
effectively tightening and a global environment that is a lot 
less benign than before.
    So I don't think one should be surprised to see if we stick 
with these policies, no restructuring of the debt, no 
devaluation of the currency, really then what you must expect 
is very deep recessions and you must expect the kind of 
political situation you get in Greece and I'll tell you that 
Portugal is the country that is the next in line.
    Senator Shaheen. Mr. Gordon.
    Dr. Gordon. I think the IMF--the striking thing to me is 
that the IMF learned all of these lessons from dealing with 
similar crises in the developing world over a long period of 
time and got increasingly, I think, sophisticated about the 
need to balance austerity programs with growth programs and the 
need for local political ownership. All of these have sort of 
gone out the window in dealing with Europe and I think it's 
really unfortunate.
    Mr. Stokes. But to answer your question, Madam Chairwoman, 
I think that there are things that they could have done; they 
could have lowered interest rates. The ECB could have lowered 
interest rates. It did not.
    There are things now that they are doing they could have 
done earlier. Jacob mentioned the EU funds that are being 
transferred to the periphery. There were proposals from the 
very beginning that said look, these funds are supposed to be 
appropriated over 5 years--why don't you frontload them, just 
do it all at once.
    They didn't initially do that. So I think there are things 
that--lessons we could learn hopefully for the next crisis that 
we should have known to do from the beginning.
    Senator Shaheen. Well, given those lessons for this crisis, 
is there a way to reset any of the efforts that are under way 
that would provide a more positive outcome than what we're 
currently seeing? You're shaking your head, no, Mr. Lachman.
    Dr. Lachman. I think that there were reasons that the IMF 
imposed those kind of policies on these countries. They didn't 
want the defaults because they were concerned about what that 
would do to the French and the German banking system, which are 
holding the debt.
    So I think that Greece was used--that Greece was--they 
weren't particularly concerned what would be the outcome in 
Greece. They were concerned should the banks take the hit. I 
think that the mistake that was made is that strategy made 
sense if you used the time to strengthen the position of the 
banks so that when the inevitable default occurred the banks 
would be in a better position to do it.
    Sadly, that hasn't occurred. All they've done is they've 
kicked the can down the road, they've made the problem bigger 
and if we throw more money at it all we'll be doing is 
postponing it a little bit further.
    But eventually this debt has to be written down big time 
and that is going to be a big hit to the European banks.
    Senator Shaheen. Well, so just to sum up, at this point it 
sounds to me like what everyone is suggesting is that there is 
no reason to be optimistic that the efforts undertaken will 
have a real impact on the European financial crisis and 
therefore we are going to see further impacts on not only the 
European countries but on the United States and other parts of 
our global markets.
    Is that the conclusion that everybody has come to?
    Dr. Gordon. I don't think we're at a denouement here. I 
think that this is getting sped up. As I said, I think that the 
silver lining here is that we aren't going to spend a month 
talking about this plan from Europe next week.
    But several of us talked about the changing potential role 
of the ECB here. Germany would have to give a mandate to that 
but the question is, when push comes to shove, will Germany 
enable the ECB to play a different role here? Because I think 
that in the first half of next year we really are likely to 
come to a denouement.
    Mr. Kirkegaard. If I can just say, too, quickly, I think we 
will certainly not see an end to the kind of volatility that 
we've seen in the markets in the last couple of days.
    Because of the structural nature of this crisis in Europe 
it is going to take several years to work it out. But I think 
you will--I think the Europeans does, on the other hand, and 
through principally the ECB have the capacity to avoid a 
disastrous outcome like another ``Lehman moment,'' as Desmond 
has talked about several times.
    And on that point I think I will disagree slightly with the 
emphasis that a lot of people put on Germany at the ECB because 
it is true that Germany may have the biggest shareholding at 
the ECB at about 27 percent. But we have to recall that the ECB 
uniquely in the European Union actually works like the U.S. 
Senate. Germany only has one vote. Germany has the vote----
    Senator Shaheen. That doesn't make me feel better. 
[Laughter.]
    Mr. Kirkegaard. Well, the ability for Germany to actually 
block these things in the short term is essentially, in my 
opinion, not there. They can't do it, and the Germans on the 
governing council represent--there's 23 members on that council 
and there's a--you know, the Germans are a very small minority.
    Senator Shaheen. Thank you.
    Mr. Stokes.
    Mr. Stokes. I think I agree here. I think that there is 
nothing that is likely to transpire in Europe in the next few 
days or even weeks that is going to defuse this crisis. It's 
going to continue to build. That's the challenge we face.
    I think from an American point of view, there are three 
things we need to think about. One is to send as positive of 
signals as we can to the markets that we are getting our house 
in order. Two, I think we do need to consider what we can do at 
the margins to improve trade and investment across the Atlantic 
to at least contribute to helping getting them and us out of 
the problems we're in.
    And then I would raise an issue that no one on Capitol Hill 
wants to talk about and that is what are we prepared to do to 
help the IMF if things really go badly. Congress has already 
spoken already to a certain extent on this and I think it's not 
a sign that we want to send to the markets in a crisis.
    Senator Shaheen. Thank you. I would--I have just one final 
question and I would be remiss as the chair of this 
subcommittee and given the conversations that I've had with 
representatives from a number of the other European countries 
that are still looking to get into the EU.
    Do you have any view of what the prospects are for those 
continuing discussions and whether the financial crisis will 
have a dampening effect on the interest that some of those 
countries have in getting into the EU?
    Mr. Kirkegaard.
    Mr. Kirkegaard. I think it will clearly have a dampening 
effect on people or countries wanting to get into the euro 
area. I think that's already happening.
    But I have to say that in the 10-year time horizon I think 
we will see a euro area of 26 countries. The only country that 
will not join is the U.K. and the reason is that for the other 
smaller Eastern European countries in particular but also 
Denmark and Sweden, as the euro area begins to integrate 
institutionally and becomes the forum in which major decisions 
are taken in the EU, the political costs for these small 
countries to remain outside becomes prohibitive.
    I think that they would--they will probably want to wait to 
see what happens and what kind of euro area they join and they 
would probably also prefer for some of the bills to be paid 
before they join. But as I said, in the 10-year time horizon I 
think they all will.
    Moving to the issue of expanding the EU beyond the 27, I 
think that'll be very difficult. I believe that the chances of 
Turkey of ever joining the European Union are zero, and the 
main reason for that is that you have in the European Council 
right now a dual-majority rule which means that it weighs the 
influence of a country both by GDP and by population.
    So if Turkey ever joined, Turkey would quickly become the 
most powerful country in the EU and Germany and France will 
never accept that. But I would also say that I think the 
process of prospective Turkish membership has actually already 
worked the way it should.
    I think the process, if you like, has been the goal here 
because I think without the potential for, even if never 
materialized actually, for Turkish EU membership you would not 
have seen the reduction in the role of the Turkish military and 
a whole host of other very positive developments in Turkey.
    So I think both countries, both the EU and Turkey, has 
actually had great benefits from this ultimately, you know, 
futile effort and I think with respect to the Ukraine, it all 
depends on internal Ukrainian politics. What has happened in 
the last couple of weeks in Ukraine will certainly not make 
them a prospective EU member.
    Senator Shaheen. What about some of the other Balkan 
countries and----
    Mr. Kirkegaard. Oh, sorry. Yes. I think ultimately all of 
the Western Balkans will become members including Albania, and 
obviously, I also forgot to mention that Iceland has recently 
opened up and they will also join relatively quickly.
    Senator Shaheen. Thank you.
    Mr. Stokes.
    Mr. Stokes. I think the issue may be that up to this point 
it was the internal debates inside these applicant countries 
that slowed down or complicated their joining.
    I think increasingly there will be reluctance among the 
existing members of the EU to move for membership very rapidly 
because of the impending recession in Europe, because of the 
fears that we wouldn't want to admit a country that would 
somehow turn out to be another Greece.
    And I agree with Jacob. I think if there was any chance 
that Turkey joined the EU, which I think was probably zero 
before this crisis, the crisis has really put a nail in that 
coffin.
    Senator Shaheen. Certainly, I appreciate what you're saying 
about internal disagreements within many of those potential 
member countries, although I think their perception, at least 
among some of them, is that there has been more of a reluctance 
as time has gone on to allow for increased EU expansion and 
that that has hurt their chances.
    So hopefully that is not the case. Mr. Lachman, did you 
want to weigh in on that?
    Dr. Lachman. No, I just have a different view that----
    Senator Shaheen. OK. Good.
    Dr. Lachman. I just think that we're going to see--within 
the next year or 18 months we're going to see countries leaving 
the euro.
    I don't see how Greece and Portugal and probably Ireland 
remain within the euro and I think I would agree with Bruce 
that it's very difficult if Europe's in recession. Countries 
are leaving. You've got all these crises. To then be expanding 
the euro would just make no sense.
    Senator Shaheen. Mr. Gordon.
    Dr. Gordon. I think that if we are in Jacob's world that 
would be a huge success. I suspect we're going to be in Desmond 
and Bruce's world.
    Senator Shaheen. Well, we'll give you the last word. Thank 
you all very much. It's been a fascinating discussion.
    The hearing is closed.
    [Whereupon, at 11:18 a.m., the hearing was adjourned.]
                              ----------                              


              Additional Material Submitted for the Record


           Appendix to Jacob Kirkegaard's Prepared Statement

          the origin of the euro area's four different crises,
                their overlaps and mutual reinforcement
    The euro area crisis has gradually since May 2010 taken center-
place in an increasingly volatile global economy. It has become evident 
that the crisis consists of four distinct, though frequently 
overlapping and mutually reinforcing crises; (1) A design crisis, as 
the euro area from its creation in the 1990s has lacked crucial 
institutions to ensure financial stability during a crisis; (2) a 
fiscal crisis centered in Greece, but present across the southern euro 
area and Ireland; (3) a competitiveness crisis manifest in large and 
persistent precrisis current account deficits in the euro area 
periphery and even larger intraeuro area current account imbalances; 
and (4) a banking crisis first visible in Ireland, but spreading 
throughout euro area via accelerating concerns over sovereign 
solvencies.
The Euro Area Design Challenge
    The concrete thinking about an economic and monetary union (EMU) in 
Europe goes back to 1970, when the Werner Report \1\ laid out a 
detailed three-stage plan for the establishment of EMU in Europe by 
1980. Members of the European Community would gradually increase 
coordination of economic and fiscal policies, while reducing exchange 
rate fluctuations and finally fixing these irrevocably. The collapse of 
the Bretton Woods system and the first oil crisis in the early 1970s 
caused the Werner Report proposals to be abandoned.
    By the mid-1980s, following the 1979 creation of the European 
Monetary System and the initiation of Europe's internal market, 
European policymakers again took up the idea of EMU. The Delors Report 
\2\ from 1989 envisioned the achievement of EMU by 1999, moving 
gradually (again in three stages) towards closer economic coordination 
among the EU members, with binding constraints on member states' 
national budgets, and a single currency with an independent European 
Central Bank (ECB).
    While Europe's currency union therefore has lengthy historical 
roots, it was an unforeseen shock--German reunification in October 
1990--that provided the political impetus for the creation of the 
Maastricht Treaty,\3\ which in 1992 provided the legal foundation and 
detailed design for today's euro area. With the historical parity in 
Europe between (West) Germany and France no longer a political and 
economic reality, French President Francois Mitterrand and German 
Chancellor Helmut Kohl launched the EMU process as a principally 
political project to irrevocably join the French, German and other 
European economies together in an economic and monetary union and 
cement European unity.
    This political imperative for launching the euro by 1999, however, 
frequently facilitated that politically necessary compromises, rather 
than theoretically sound and rigorous rules and regulations made up the 
institutional framework for the euro.
    While the earlier Werner and Delors reports discussing the design 
of EMU had been explicit about the requirement to compliment a European 
monetary union (e.g., the common currency) with a European economic 
union complete with binding constraints on member states' behavior, 
political realities in Europe made this goal unattainable within the 
timeframe dictated by political leaders following German reunification.
    The continued principal self-identification among Europeans as 
first and foremost residents of their home country,\4\ i.e., Belgians, 
Germans, Poles, Italians, etc., made the collection of direct taxes to 
fund a large centralized European budget implausible. The frequently 
discussed relatively high willingness of Europeans to pay taxes does 
not ``extend to Brussels.'' The designers of the euro area was 
consequently compelled to create the common currency area without a 
sizable central fiscal authority with the ability to counter regional 
specific (asymmetric) economic shocks or reinstill confidence in 
private market participants in the midst of a crisis--like the one the 
euro area is currently experiencing.
    Similarly, the divergence in the economic starting points among the 
politically prerequisite ``founding members'' of the euro area moreover 
made the imposition of firm, objective fiscal criteria for membership 
in the euro area politically impossible. The Maastricht Treaty in 
principle included at least two hard ``convergence criteria'' for euro 
area membership--the so-called ``reference values'' of 3 percent 
general government annual deficit limit and 60 percent general 
government gross debt limit.\5\ However, in reality these threshold 
values were anything but fixed, as the Maastricht Treaty Article 104c 
stated that countries could exceed the 3 percent deficit target, if 
``the ratio has declined substantially and continuously and reached a 
level that comes close to the reference value,'' or ``excess over the 
reference value is only exceptional and temporary and the ratio remains 
close to the reference value.'' Euro area countries could similarly 
exceed the 60-percent gross debt target, provided that ``the ratio is 
sufficiently diminishing and approaching the reference value at a 
satisfactory pace.''
    In other words, it was a wholly political decision whether a 
country could become a member of the euro area or not, and had 
relatively less to do with the fundamental economic strengths and 
weaknesses of the country in question. As it was politically 
inconceivable to launch the euro without Italy, the third-largest 
economy in continental Europe, or Belgium, home of the European capital 
Brussels, both countries became members despite in 1997-98 having gross 
debt levels of almost twice the reference value of 60 percent (Figure 
1).




    As a result, Europe's monetary union was launched in 1999 
comprising of a set of countries that were far more diverse in their 
economic fundamentals and far less economically integrated than had 
been envisioned in the earlier Werner and Delors reports. Yet, not only 
did European political leaders proceed with the launch of the euro with 
far more dissimilar countries than what economic theory would have 
predicted feasible, shortly after the launch of the euro, they went 
further and undermined the remaining credibility of the rules-based 
framework for the coordination of national fiscal policies in the euro 
area.
    Building on the euro area convergence criteria, the Stability and 
Growth Pact (SGP) was intended to safeguard sound public finances, 
prevent individual euro area members from running unsustainable fiscal 
policies and thus guard against moral hazard by enforcing budget 
discipline. However, faced themselves with breaching the 3-percent 
deficit limit in 2002-2004, France and Germany pushed through a 
watering down of the SGP rules in March 2005\6\ that, as in the 
Maastricht Treaty itself, introduced sufficient flexibility into the 
interpretation of SGP that its enforcement became wholly political and 
with only limited reference to objective economic facts. Individual 
euro members subsequently failed to restore the long-term 
sustainability of their finances during the growth years before the 
global financial crisis began.
    By 2005 the euro area was as a result of numerous shortcuts taken 
to achieve and sustain a political goal, a common currency area 
consisting of a very dissimilar set of countries, without a central 
fiscal agent, without any credible enforcement of budget discipline or 
real deepening economic convergence. Initially, however, none of these 
danger signs mattered, as the financing costs in private financial 
markets of all euro area members quickly fell towards the traditionally 
low interest rates of Germany (Figure 2).




    It is beyond this testimony to speculate about the causes of this 
lasting colossal mispricing of credit risk in the euro area sovereign 
debt markets by private investors in the first years after the 
introduction of the euro. The financial effects of this failure on the 
other hand were obvious, as euro area governments and private investors 
were able to finance themselves at historically low (often 
significantly negative real) interest rates seemingly irrespective of 
their economic fundamentals. Large public and private debt overhangs 
were correspondingly built up in the euro area during the first years 
of the euro area and in the run up to the global financial crisis in 
2008. Financial markets' failure to properly assess the riskiness of 
different euro area countries papered over these issues until the 
global financial crisis finally struck.
    The euro area institutional design has in essence been that of a 
``fair weather currency,'' with no central institutions capable of 
compelling the member states to act in unison. As a new, untested and 
severely under-institutionalized entity, the euro area has had no 
capacity to act forcefully during the current crisis or restore 
confidence among private businesses and consumers. Unless that changes, 
the euro area will be unable to exit the current crisis.
    European policymakers therefore today are faced with the acute 
challenge of correcting the design flaws in the euro area institutions 
that their predecessors in their quest to quickly realize a political 
vision for Europe helped create. The euro area needs a new rule book. 
Leaders must in the midst of this crisis craft a new set of euro area 
institutions that for the first time provide the common currency with 
binding fiscal rules for its member states, and a centralized fiscal 
entity capable of acting in a crisis on behalf of the euro area as a 
whole. This will require the transfer of sovereignty from individual 
member states to the supra-national euro area level considerably beyond 
what has previously occurred in the EU.
The Euro Area Fiscal Challenge
    The euro area fiscal crisis is concentrated in Greece, which 
according to the latest IMF/EC/ECB estimates will have a general 
government debt surpassing 180 percent of GDP by 2012. Despite Greece's 
IMF program and associated financial support from the EU and IMF since 
May 2010, the country is at this point clearly not able to repay all 
its creditors in full and has to restructure its government debt. 
Greece will consequently be the first ever euro area country and first 
OECD member since shortly after World War II forced to restructure its 
sovereign debt.
    Portugal and Ireland are currently subject to IMF programs, too, 
but in contrast to Greece have successfully implemented their program 
commitments to this date.\7\ Through continued strong reform 
implementation and access to financial assistance from the EU and IMF 
in the years ahead, it looks still potentially feasible for Portugal 
and Ireland to in the medium-term restore their access to private 
financial markets at sustainable interest rates.
    However, as illustrated in figure 3, the cost of financing for 
Spain and Italy has also risen substantially in recent month with 
secondary 10y bond market yields currently between 5.5 and 6 percent. 
Unlike, however, the three smaller euro area countries with IMF 
programs, Spain and Italy are economies of a size that makes them ``too 
big to bail out'' for the euro area, even with IMF help. The fact that 
financial markets have begun to doubt the fiscal sustainability of 
``too big to bail out'' members of the euro area is at the heart of the 
euro area policymakers' fiscal challenge.




    The key link between Greece and Spain and Italy is the issue of 
``contagion'' \8\, i.e., a situation in which instability in a specific 
asset markets or institutions is transmitted to one or more other 
specific such asset markets or institutions. Inside a currency union 
like the euro area, where the central bank is legally barred from 
guaranteeing all the sovereign debts of individual member states \9\ 
and for political reasons each sovereign members' debts remains 
distinct,\10\ yet the debt is denominated in the same currency and 
governed by at least some common institutions, the phenomenon of 
contagion has particular force. If private investors begin to fear that 
a precedent will be set inside the euro area with the imposition of 
haircuts on Greek sovereign debt, they will assess the riskiness of 
other euro area members' sovereign debt differently once the ``risk 
free status'' of euro area sovereign debt has been impaired. The large 
increases in the interest rates on Italian and Spanish Government debt 
seen immediately following the July 21, 2011 EU Council decision to 
first introduce haircuts on Greek Government debt looks, in the absence 
of simultaneous new bad economic news released from the two countries, 
to be largely due to contagion.
    Given the high public and private debt levels built up before the 
global financial crisis in Spain and Italy, the sudden emergence of 
contagion and associated reprising by private investors of the 
riskiness of these two countries has the potential initiate 
destabilizing self-fulfilling interest rate-solvency spirals. Contagion 
from Greece causes Italian interest rates to go up, which given Italy's 
high existing debt levels adds materially to the interest burden, 
necessitating further austerity measures, further reducing economic 
growth in the short-term, leading to lower government revenues and 
increased financial market concerns, again increasing both the Italian 
Government deficit and interest burden. The presence of contagion 
inside a currency union, where many individual members have high debt 
levels consequently have to potential of turning what might previously 
have been stable and sustainable high debt burdens into unstable 
unsustainable debt burdens.
    The unique degree of independence of the ECB adds a further 
complication to such contagion inside the euro area. Its independence 
derives from Article 282 of the EU Treaty,\11\ which states that the 
central bank ``shall be independent in the exercise of its powers and 
in the management of its finances. Union institutions, bodies, offices 
and agencies, and the governments of the member states shall respect 
that independence.'' With Treaty-defined independence, the ECB is more 
akin to a Supreme Court than a central bank in the mold of the U.S. 
Federal Reserve, whose independence is derived from the Federal Reserve 
Act passed by Congress (which Congress expressly reserves the right to 
amend, alter, or repeal).\12\ The ECB has no political masters and the 
EU Treaty moreover bars bar elected officials from criticizing its 
decisions.
    In a sovereign and financial crisis, such total central bank 
independence might actually hinder the restoration of market 
confidence, because it might further undermine investors' trust in the 
solvency of a government that does not ultimately control its own 
central bank, lacks its own currency, and thus has no ultimate lender 
of last resort. The European Treaty's Article 123 forbids the ECB to 
extend credit to member states, preventing it from issuing any blanket 
guarantees for their sovereign debt. Due to the complete independence 
of the ECB and the restrictions the EU Treaty places on it, the euro 
area thus lacks an important confidence boosting measure in the face of 
contagion.
    On the other hand, the ECB's independence and status as the only 
pan-euro area institution capable of direct forceful action to calm 
global financial markets bestows upon the ECB's governing council a 
degree of leverage over elected officials in this crisis not seen 
elsewhere in the world. This gives the ECB leadership the ability to 
engage in horse-trading with democratically elected governments behind 
closed doors, where it can quietly demand that government leaders 
implement far-reaching reforms. A clear example of this came in August 
2011 just ahead of the ECB's initiation of emergency support purchases 
of Italian Government debt. The sitting and incoming presidents of the 
ECB wrote bluntly to Italian Prime Minister Silvio Berlusconi, stating 
that ``the [ECB] Governing Council considers that pressing action by 
the Italian authorities is essential to restore the confidence of 
investors\13\'' followed by a list of more than 10 specific required 
reforms to be implemented by the Italian Government.
    The degree of independence and influence of the ECB matters for the 
attempts to find an expeditions solution to the euro area fiscal 
crisis, as it is actually not in the ECB's interest to act too 
decisively to immediately try to end any contagion or the crisis more 
broadly. It is not that the ECB cannot step in. There is no asset it 
cannot buy, if the governing council agrees. The strategy of allowing 
financial market mayhem to pressure European governments is therefore 
less risky than it seems. Ultimately, the ECB has the means to calm 
markets down but its intention is to do so only to avoid absolute 
disaster.
    A sweeping preemptive ``helping hand to euro area governments'' 
under speculative attack would from the perspective of the ECB be 
counterproductive, as it would relieve pressure on governments to 
reform. The ECB's game is thus not to end the crisis at all costs as 
soon as possible, but to act deliberatively to cajole governments into 
implementing the crisis solutions it wants. The market volatility seen 
accelerating in recent months becomes something not to be avoided, but 
to use as a club against recalcitrant and reform-resistant euro area 
leaders.
    European policymakers therefore today are faced with the acute 
challenge of enabling Greece to restructure its unsustainable sovereign 
debt, while at the same time ensuring that such an event has no 
precedent-setting effects inside the euro area and that contagion among 
sovereign debt markets consequently is contained. Ring-fencing Greece 
geographically and in the time dimension (i.e., assuring that Greece 
will only ever go through a single one-off sovereign debt 
restructuring) will require further financial assistance in the coming 
years be provided to Greece itself, as well as Portugal and Ireland. 
The sizable majority of this support must sensible come from the rest 
of the euro area, with some continued financial participation also of 
the IMF.
    In addition to further restrict contagion, euro area leaders must 
device a method which can provide a degree of preemptive financial 
support to ``too big to bail out'' euro area members and potentially 
lower their primary bond market cost of finance. This is the key aspect 
of the current debate surrounding how to utilize the =440bn European 
Financial Stability Facility (EFSF) most effectively. However, given 
the constraints on and reluctance of the ECB to participate directly in 
any such financial support (though for instance providing leverage to 
the EFSF) to large non-IMF program countries, the resources available 
to euro area leaders will be constrained. Any financial benefits to 
large beneficiary countries like Spain and Italy from new euro area 
measures will moreover be relatively limited, due to the large weight 
inside the euro area itself of the beneficiary countries themselves. 
Irrespective of the ultimate format chosen by euro area leaders, the 
``correlation between benefactors and beneficiaries'' will be so large 
that the financial advantage will be relatively modest. There will be 
no euro area ``bazooka'' created from the EFSF.
    Ultimately, the euro area will have to rely on its large members to 
``bail themselves out'' through a lengthy period of fiscal 
consolidation. Financial markets are unlikely to be satisfied with this 
outcome, and while the ECB will continue to act as a conditional final 
defender of financial stability in the euro area, heightened levels of 
uncertainty and volatility will remain a feature of the euro area 
sovereign debt and other asset markets several years ahead.
The Euro Area Competitiveness Challenge
    The euro area was wrought by merging together in a single currency 
a number of highly divergent European economies, and for reasons of 
political expediency any binding political euro area rules and 
intrusive regulations that could during the euro's first decade have 
forced a real economic convergence to occur among divergent euro area 
members were abandoned. Cushioned by the seemingly secure access to 
cheap financing once inside the euro area, most member states moreover 
scaled back the implementation of structural reforms of their national 
economies.\14\
    The principal exception was Germany, which in the years immediately 
after the euro introduction implemented a series of far reaching 
reforms of especially its labor markets and pension system. 
Consequently, Europe's traditionally strongest and most competitive 
economy during the first decade of the euro area gradually pulled 
itself even further ahead of most of the other members of the common 
currency. A persistent pattern inside the euro area consequently became 
the widening current account imbalances with Germany and other Northern 
members running surpluses and especially the Southern peripheral 
members running deficits (figure 4).




    Financing their large external deficits posed few obstacles for 
peripheral countries prior to the global financial crisis, even as it 
became clearer that the inflows of foreign capital were increasingly 
channeled towards financing speculative real estate investments, rather 
than adding to new productive asset investments. With the disappearance 
of foreign private capital following the onslaught of the global 
financial crisis, peripheral euro area deficit countries and their 
banks suddenly found themselves instead overwhelmingly dependent on 
financial support from the ECB. However, while such central support 
will be continuous inside any functioning currency union, a longer term 
requirement for peripheral euro area nations to regain competitiveness 
and restore external balance (or surplus) remains.\15\ Without 
improving external competitiveness and increasing exports/reducing 
imports, the euro area periphery will not during their current 
prolonged period of fiscal consolidation be able to restore domestic 
economic growth.
    Inside a currency union without the ability to devalue their 
currency against major trading partners, peripheral euro area members, 
however, do not have access to the traditionally fastest and most 
effective way through which a country can regain external 
competitiveness.\16\ Consequently, the euro area peripheral countries 
only have means at their disposal to increase the competitiveness that 
might be effective in a longer term framework. Such measures include 
numerous traditional ``supply-side structural reforms'' of especially 
peripheral euro area labor markets, where the often legally sanctioned 
coercive power of labor unions, the rigidity of collective bargaining 
agreements and automatic wage indexation to the public sector must be 
curtailed. Nominal wage levels at the firm level must be brought into 
line with productivity, an effort which in numerous instances will lead 
to nominal wage cuts.
    European policymakers face a competitiveness challenge today in 
which the precise requirements of the euro area periphery to regain 
their external competitiveness and for the euro area as a whole to 
limit intra-euro area imbalances will vary depending on individual 
country circumstances and require additional measures in surplus 
countries (such as Germany), too. It is furthermore evident that 
available policy options inside a currency union are of a structural 
reform character. Such reforms can only hope to be effective in raising 
competitiveness and potential economic growth rates in the medium term, 
and will indeed in the short term, though for instance required nominal 
wage declines, hurt economic growth.
The Euro Area Banking Crisis
    The first manifestations of a banking crisis in the euro area in 
Ireland in 2008 had relatively few pan-euro area elements about it. The 
Irish real estate boom was clearly supported by the record low negative 
real interest rates in the country following the introduction of the 
euro (figure 5), but the 2008 collapse of the Irish banking sector and 
subsequent required rescue of the Irish Government by the EU and IMF 
was overwhelmingly due to domestic Irish domestic factors and 
failures.\17\ That on the other hand is not true of the most recent 
volatility to affect the euro area banking system.




    Several systematic ailments that plaque the euro area banking 
system are illustrated in table 1; First of all, the euro area's 
banking system is very large relative to the size of the overall home 
economies with average euro area financial institutions' gross debt 
equal to 143 percent of GDP (U.S. equal 94 percent). Second, euro area 
bank leverage is very high at tangible assets at 26 times common equity 
(U.S. level is at 12 times); and third, euro area banks tend to own a 
lot of the debt issued by their own governments (something U.S. banks 
do to a much smaller degree).




    The sheer size of the euro area banking system makes it--as 
illustrated in Ireland in 2008-10--problematic for individual already 
indebted euro area governments to credibly issue guarantees to stand 
behind their domestic banks in a crisis. This issue is aggravated by 
the low level of common equity (core tier 1) capital in the euro area 
banks. With low private shareholder risk capital levels in euro area 
banks, euro area governments risks being frequently called upon to 
rescue domestic banks as only a thin layer of private equity capital is 
available as first-loss risk capital. Disproportionally large capital 
injection requirements are another risk to euro area tax payers in 
rescues of thinly capitalized banks. There is consequently across the 
euro area a large degree of interdependence between the financial 
solidity of large domestic banking systems and national government 
solvency.
    The bank large ownership of government debt in the euro area 
presents a particularly intractable concern. Euro area (and other) 
banks are under the Basle Agreements not required to set aside any risk 
capital to offset any future losses on government bond holdings. 
Sovereign bonds have by definition been deemed ``risk free.'' 
Consequently, when Greek Government debt must be restructured, it will 
impose upon the euro area banks credit losses for which they have 
previously not set aside capital, and given the scale of ownership of 
such debt among domestic Greek banks will require that these be 
recapitalized with money from international donors. The same dynamic is 
inevitable across essentially all euro area members, as the domestic 
banking system will face ruinous capital losses if national sovereign 
debt is restructured, due to the high domestic government debt 
ownership.
    Fearful that banks would require very large amounts of new equity 
capital, which would in many instances have to come from governments 
themselves and might therefore pose a challenge to some governments' 
own solvency, European banking regulators have been reluctant to 
include any potential impairment of banks' sovereign debt holdings in 
EU bank stress tests in 2010 and 2011. Given, however, the justified 
market concerns about the solvency of at least one euro area sovereign 
(Greece) and the potential for contagion to other euro area sovereign 
bond markets, stress tests that do not include the potential for losses 
on sovereign bonds cannot provide a credible measure of the riskiness 
of any euro area banking system. As long as solvency concerns exists 
about euro area governments, a high degree of volatility will surround 
the euro area banking system, which again provide a powerful feedback 
loop to increased investor fears about the financial stability of 
governments in the first place.
    Last, in addition to low capital levels and associated concerns, 
many euro area banks also suffer from substantial liquidity risks with 
high degrees of dependence on short-term wholesale funding from markets 
where access may prove ephemeral and subject to rapid changes.
    Euro area governments face the challenge of rapidly having to 
stabilize their oversized and in the aggregate undercapitalized banking 
systems without having to dispend large amounts of capital themselves, 
as this could further jeopardize their own solvency. Further 
postponement today of forceful measures to stabilize the euro area 
banking system with new outside capital risks throwing the euro area 
into an accelerating credit crunch as banks de-lever and conserve their 
scarce capital. This would rapidly have a strongly detrimental effect 
on the broader growth prospects of the euro area.
    Not all euro area governments are in the same situation though, as 
for instance the German Government would quite easily be able to manage 
an even very large government-led recapitalization of its national 
banking system. However, due to the close linkages among sovereigns 
(and consequently their banking systems) inside the euro area and the 
observable presence of contagion between them, a key challenge for 
European policymakers will be to move expeditiously to a new system of 
tougher pan-European banking support, regulation and supervision. The 
establishment of a new set of common regulatory institutions for the 
European banking system will, however, due to the obvious implications 
potential government financial crisis support for banks have for 
governments' own solvency require a new level of fiscal integration in 
the euro area and the commensurate loss of national fiscal sovereignty. 
The fact that the city of London, the EU and euro area financial 
center, is located in the U.K., which can safely be assumed to remain 
outside the euro area itself for the foreseeable future, further 
complicates this type of banking sector integration initiatives.

----------------
End Notes

    1. Available at http://aei.pitt.edu/1002/1/
monetary_werner_final.pdf.
    2. Available at http://aei.pitt.edu/1007/1/monetary_delors.pdf.
    3. Available at http://www.eurotreaties.com/maastrichtec.pdf.
    4. See Kirkegaard (2010) at http://www.piie.com/publications/pb/
pb10-25.pdf.
    5. The actual numerical reference values to article 104c of the 
Maastricht Treaty are in a Protocol on the Excessive Deficit Procedure 
to the Treaty. Available at http://www.eurotreaties.com/
maastrichtprotocols.pdf. The Maastricht Convergence Criteria for euro 
area membership eligibility include three additional metrics; inflation 
(within 1.5 percent of the three EU countries with the lowest inflation 
rate); long-term interest rates (within 2 percent of the three lowest 
interest rates in the EU); and exchange rate fluctuations 
(participation for two years in the ERM II narrow band of exchange rate 
fluctuations).
    6. See EU Council Conclusions March 23rd 2005 at http://
www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/84335.pdf.
    7. See IMF press release 11/374 at http://www.imf.org/external/np/
sec/pr/2011/pr11374.htm and IMF press release 11/330 at http://
www.imf.org/external/np/sec/pr/2011/pr11330.htm.
    8. See speech by ECB Vice President Vitor Constancio for a precise 
definition and discussion at http://www.ecb.int/press/key/date/2011/
html/sp111010.en.html.
    9. Article 123 in the EU Treaty states ``Overdraft facilities or 
any other type of credit facility with the European Central Bank or 
with the central banks of the Member States (hereinafter referred to as 
`national central banks') in favour of Union institutions, bodies, 
offices or agencies, central governments, regional, local or other 
public authorities, other bodies governed by public law, or public 
undertakings of Member States shall be prohibited, as shall the 
purchase directly from them by the European Central Bank or national 
central banks of debt instruments.''
    10. As discussed above, with the vast majority of European citizens 
still self-identifying as citizens of their respective countries 
(rather than the euro area), a pooling of all the national sovereign 
debts of the euro area into a single debt instruments--similar to what 
Alexander Hamilton achieved for the U.S. States war debts in 1790--is 
not a realistic political option in Europe at this point. Another 
critical political difference is that unlike the war debts incurred by 
U.S. States during the Revolutionary War, the outstanding debts of 
individual euro area members have not been incurred in order to achieve 
a ``common cause.'' The political narrative of seeing such debts 
``honored in common'' by all euro area members consequently does not 
exist.
    11. http://www.ecb.int/ecb/legal/pdf/fxac08115enc_002.pdf.
    12. http://www.federalreserve.gov/aboutthefed/section31.htm.
    13. Full text of ECB letter to Silvio Berlusconi at http://
www.corriere.it/economia/11_
settembre_29/trichet_draghi_inglese_304a5f1e-ea59-11e0-ae06-
4da866778017.shtml?fr=
correlati.
    14. See Duval and Elmeskov (2005) for an in-depth analysis at 
http://www.ecb.int/pub/pdf/scpwps/ecbwp596.pdf.
    15. It can be seen in figure 4 how peripheral deficits have 
declined substantially since 2008. This, however, can be mostly related 
to the severe economic contractions experienced in the euro area 
periphery, which has temporarily caused import levels to collapse.
    16. I shall in this testimony not discuss the option of member 
leaving the euro area. I will refrain from this for three main reasons; 
first of all, I consider the costs of any country leaving the euro area 
as catastrophically high for the country in question, irrespective of 
whether it is Greece or Germany. Secondly, it is clear from the 
political announcements of all EU leaders that the departure of any 
country from the euro area will not be tolerated (such a departure 
could prove to have a very serious contagion effect). And thirdly, as 
under the current EU Treaty, the departure from the euro area is 
legally undefined and thus presumed impossible.
    17. See the Nyberg Report at http://www.bankinginquiry.gov.ie/
Documents/Misjuding%20
Risk%20-
%20Causes%20of%20the%20Systemic%20Banking%20Crisis%20in%20Ireland.pdf.

                                  
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