[Senate Hearing 112-327]
[From the U.S. Government Publishing Office]
S. Hrg. 112-327
THE EUROPEAN DEBT AND FINANCIAL CRISIS: ORIGINS, OPTIONS, AND
IMPLICATIONS FOR THE U.S. AND GLOBAL ECONOMY
=======================================================================
HEARING
before the
SUBCOMMITTEE ON
SECURITY AND INTERNATIONAL TRADE AND FINANCE
of the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED TWELFTH CONGRESS
FIRST SESSION
ON
EXAMINING THE DIMENSIONS OF THE EUROPEAN ECONOMIC CRISIS, INCLUDING
OPTIONS FOR RESOLVING IT, AND IMPLICATIONS FOR THE U.S. AND GLOBAL
ECONOMY
__________
SEPTEMBER 22, 2011
__________
Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
TIM JOHNSON, South Dakota, Chairman
JACK REED, Rhode Island RICHARD C. SHELBY, Alabama
CHARLES E. SCHUMER, New York MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey BOB CORKER, Tennessee
DANIEL K. AKAKA, Hawaii JIM DeMINT, South Carolina
SHERROD BROWN, Ohio DAVID VITTER, Louisiana
JON TESTER, Montana MIKE JOHANNS, Nebraska
HERB KOHL, Wisconsin PATRICK J. TOOMEY, Pennsylvania
MARK R. WARNER, Virginia MARK KIRK, Illinois
JEFF MERKLEY, Oregon JERRY MORAN, Kansas
MICHAEL F. BENNET, Colorado ROGER F. WICKER, Mississippi
KAY HAGAN, North Carolina
Dwight Fettig, Staff Director
William D. Duhnke, Republican Staff Director
Dawn Ratliff, Chief Clerk
Anu Kasarabada, Deputy Clerk
Riker Vermilye, Hearing Clerk
Shelvin Simmons, IT Director
Jim Crowell, Editor
______
Subcommittee on Security and International Trade and Finance
MARK R. WARNER, Virginia, Chairman
MIKE JOHANNS, Nebraska, Ranking Republican Member
SHERROD BROWN, Ohio MARK KIRK, Illinois
MICHAEL F. BENNET, Colorado
TIM JOHNSON, South Dakota
Ellen Chube, Subcommittee Staff Director
Nathan Steinwald, Senior Economic Advisor
Courtney Geduldig, Republican Subcommittee Staff Director
Sarah Novascone, Republican Chief Counsel and Policy Advisor
(ii)
?
C O N T E N T S
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THURSDAY, SEPTEMBER 22, 2011
Page
Opening statement of Chairman Warner............................. 1
Opening statements, comments, or prepared statements of:
Senator Johanns.............................................. 3
Senator Bennet............................................... 3
WITNESSES
Nicolas Veron, Visiting Fellow, Peterson Institute for
International Economics, and Senior Fellow, Bruegel............ 5
Prepared statement........................................... 28
Joachim Fels, Global Head of Economics, Morgan Stanley........... 7
Prepared statement........................................... 37
Domenico Lombardi, President, the Oxford Institute for Economic
Policy and Senior Fellow, the Brookings Institution............ 10
Prepared statement........................................... 39
J.D. Foster, Ph.D., Norman B. Ture Senior Fellow in the Economics
of Fiscal Policy, the Heritage Foundation...................... 12
Prepared statement........................................... 52
(iii)
THE EUROPEAN DEBT AND FINANCIAL CRISIS: ORIGINS, OPTIONS, AND
IMPLICATIONS FOR THE U.S. AND GLOBAL ECONOMY
----------
THURSDAY, SEPTEMBER 22, 2011
U.S. Senate,
Subcommittee on Security and
International Trade and Finance,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Subcommittee met at 2:32 p.m. in room SD-538, Dirksen
Senate Office Building, Hon. Mark Warner, Chairman of the
Subcommittee, presiding.
OPENING STATEMENT OF CHAIRMAN MARK R. WARNER
Senator Warner. Good afternoon, everyone. I would like to
call to order this hearing of the Senate Banking Subcommittee,
which topic today we have entitled ``The European Debt and
Financial Crisis: Origins, Options, and Implications for the
U.S. and Global Economy.''
Now, when we proposed this date with my good friend Senator
Johanns, I am not sure we anticipated that this hearing would
be, unfortunately, quite so timely as it appears to be today
with the U.S. equity markets down, at last glance a moment or
two ago, about 4 percent. With the Fed actions yesterday, with
the continuing fears of what is happening in Europe, it is
very, very appropriate, I believe, to have this hearing and to
make sure that we recognize and fully appreciate how inexorably
linked all of our economies are and how clearly what is
happening in Europe affects the United States and our fiscal
challenges directly.
I want to thank my good friend, Senator Bennet, for
appearing here, and I know that Senator Johanns will be joining
us in a moment, and I again would like to thank all the
witnesses. I will come back to them in a moment.
Watching the markets, again, not only over the last couple
of months but particularly today, it is clear that as U.S.
policymakers I believe we need a greater and better
understanding of both the interconnectedness and the
implications of what is happening throughout the euro zone and,
again, how it affects America. I think it is important, at
least for the record, to restate some of the things that are
obvious but that sometimes we do not focus on. We oftentimes in
the Senate look at our growing challenges and imbalances,
particularly with China and Asia, but, you know, Europe still
remains America's largest trading partner. We exported $398
billion in goods and services to the EU in 2009 and imported
more than $419 billion in goods and services, so while slight
deficit, a relative balance.
In addition to these trade flows, in 2009 a net $114
billion flowed from U.S. residents to EU countries in direct
investments, and on the other side of the ledger, over $82
billion flowed from EU residents into direct investments in the
United States. Our economies, again, are inexorably linked.
On top of these flows, according to the Bank of
International Settlements--we will go ahead and put up the
first of our two slides--while a lot of the attention in the
news has directly focused on Greece, one of the things that is
remarkable to me is we do not really have a full recognition of
how great our American exposure is to the Greek challenges.
U.S. banks have more than $7 billion, which on a relative
basis, compared, obviously, to the United Kingdom, Germany and
France, is not that great a number. But if you look beyond that
in other potential exposures--and these are just from
depository institutions--you have more than $34 billion in
potential exposure.
And, candidly, this does not fully reflect what is our
exposure just to Greece. We do not have information in terms of
our insurance exposure. Hopefully there is not out there the
son, cousin, or nephew of AIG lurking in terms of insurance. We
do not have an understanding of our money market fund
exposures. We do not have an understanding of, you know,
banking, lending to hedge funds that might be also further
invested in Greece.
If we go to the next slide, even assuming on a relative
basis this is manageable, if you then look at our exposures to
other European countries where there have been very real issues
about the potential for contagion, you see this exposure
growing dramatically. It really does reinforce the point that
what is happening real time in Europe has a direct affect on
American jobs, American growth, and, again, I believe that we
are all in this together.
I would point out as well, one of the things that is of
grave concern to me--and I know on this Committee and in the
Senate there remains a great deal of controversy about some of
the things that we did in the so-called Dodd-Frank bill. But
with one of my other colleagues, Senator Corker, we put
together Title I and Title II of that legislation, which
created the Financial Stability Oversight Council and the
Office of Financial Research with the goal of at least making
sure that the regulators could get out of their stovepipes and
see what our exposure in these kinds of circumstances is. And,
unfortunately, I do not believe we have that information. At
least I do not believe the Senate does, and, frankly, I am not
sure that the Administration on both FSOC and the OFR has moved
as quickly as we would have liked to make sure that at least we
have got that information as we try to plan and coordinate
action in terms of taking on this crisis.
So I will now turn to my friend and the Ranking Member,
Senator Johanns, for any opening comments he might have, and
then since we have got a small hearing, I will call on Senator
Bennet. Then it will be my great pleasure to introduce the
witnesses, and I am anxious to hear your testimony. Senator
Johanns.
STATEMENT OF SENATOR MIKE JOHANNS
Senator Johanns. Thank you, Mr. Chairman.
Mr. Chairman, let me just say thank you for bringing us
together today to discuss the economic situation in Greece, and
I guess for that matter the rest of the European Union. I have
to say your timing is remarkable.
Senator Warner. I wish not.
Senator Johanns. I can share that sentiment. But I look at
what is happening today in the markets, what happened last
night, and the timing of this hearing could not be better in
terms of just timeliness in terms of us trying to get an
understanding of what the panel of witnesses thinks about all
this.
I do not think there is any question whatsoever that our
country is facing a fiscal challenge that the current
generation probably could have never imagined, and we have to
start making decisions to correct our fiscal ship.
As a Nation, we are borrowing about 42 cents of every
dollar. I know of no economist anywhere in the world, whether
they are considered a liberal or a conservative, who would put
forward the argument to anyone that that is a sustainable
course. It just simply is not.
Austerity measures in Greece have not calmed the panic, and
the contagion around Europe continues to impact other
countries. Certainly more fiscally responsible countries are
beginning to wonder where this is going to lead and how far do
they get entangled in this, although obviously they already
are.
Widespread uncertainty over what is happening in Greece and
countries around it is directly affecting the United States,
and it is not just a big bank and a downgrade that they may be
enduring. It is the teachers' retirement, it is the 401(k), it
is all of those things that are real in the lives of our
citizens.
This uncertainty only adds to the uncertainty of our
domestic policies, many of which, I believe, are only stifling
economic growth in the United States. Until nations such as
Greece and the United States, for that matter, can provide
confidence in our ability to control runaway debt and to deal
with our fiscal houses, I believe we are going to continue to
struggle.
This hearing, I hope, will enlighten us on maybe some
mistakes that have been made and enlighten us on the
interrelationship between our country and what is happening in
the European Union. My hope is that we will have an opportunity
to not only hear from you but to ask questions and try to get
to the bottom of what is happening and get a better
understanding today.
Thank you, Mr. Chairman.
Senator Warner. Thank you, Senator Johanns.
Senator Bennet.
STATEMENT OF SENATOR MICHAEL F. BENNET
Senator Bennet. Thank you, Mr. Chairman, and I will be very
brief because I want to hear the witnesses' testimony. But I
also want to thank you for holding this hearing. It is very
timely, and it is very important. This may surprise our
witnesses, but there are people in this town that will say that
things have to get worse before we can construct the politics
that will actually solve the problem that we are facing. They
will say, you know, not until it gets worse can we have a
conversation with our constituents about what is needed to fix
this problem. And I think that is a very tragic way of looking
at it.
My hope is that this hearing, among other work that is
being done on the Hill, will show how perilous the position we
are in is today, how perilous the global economy is today, and
the reason we care about that is, I think, for two reasons:
One, the folks in our States that are suffering through the
residue of the worst recession since the Great Depression. You
know, we find ourselves at a place where our productivity is
very high, actually; our GDP has grown somewhat. But we have
got 14 million people that are unemployed that we have not been
able to figure out how to put back to work. We were at the end
of--not the end, but at the end of about 15 years of median
family income falling in this country. And those things are
only going to get worse if we do not deal with these challenges
that we face.
The other issue that we have is the fiscal condition that
the country is in, which is threatening to constrain the
choices that our kids and grandkids will make. But it also is
having a profound effect on our economic activity in this
country, I think. People are unwilling to invest when they have
no idea what interest rate environment they are going to be in.
And, you know, when you have got $1.5 trillion of deficit and
$15 trillion of debt, and it is unclear to everybody that
watches what is going on in Washington, the conversation that
we are having here, whether we have the political capacity to
actually get ahead of this, there is a lot of reason for
concern.
So the first thing I would say is that it is not a
sufficient answer to the people we represent that things have
to get worse before we fix this problem. And, second, if we
really are accepting as a Congress a standard of outcomes of
success that is just keeping the lights flickering with
temporary transportation bills and temporary FEMA bills and
temporary continuing resolutions and all this kind of stuff,
without doing the hard work that is necessary to deal with a
crisis it is inevitably going to become, we are all going to
rue the day that we did not have a more meaningful conversation
about it.
So, Mr. Chairman, thanks for having the hearing, and I look
forward to hearing the testimony.
Senator Warner. Thank you, Senator Bennet. I again want to
thank both my colleagues. They have been part of the group that
has been trying to reach that common ground.
We have got a very distinguished panel. Let me very briefly
introduce each of the panel members, and then we will take each
of your opening statements. And we have got your statements. We
have reviewed them. If you want to amend off of those,
particularly in light of some of the immediate circumstances,
please feel free to.
Nicolas Veron is a Senior Fellow at Bruegel, a Brussels-
based economic policy think tank, and has served as a Visiting
Fellow at the Peterson Institute for International Economics
since October 2009. A French citizen, he has held various
positions in the public and private sectors, including as
corporate adviser to France's Labor Minister, as chief
financial officer of the publicly listed Internet company
MultiMania/Lycos France, and as an independent financial
services consultant. Since 2008 he has been a member of the CFA
Institute's Corporate Disclosure Policy Council. He also
recently co-authored ``Smoke and Mirrors, Inc.: Accounting for
Capitalism.'' Mr. Veron, thank you for being here.
Joachim Fels co-heads Morgan Stanley's global economics
team and is the firm's Chief Global Fixed-Income Economist.
Based in London, Joachim edits the Global Monetary Analyst, a
weekly Morgan Stanley research publication. Mr. Fels joined
Morgan Stanley in 1996 to cover the German economy; later he
co-headed the currency economics team and the European
economics team, where he won several number one ratings in the
institutional investor poll over a number of years. Mr. Fels
was also the firm's ECB watcher from the institution's birth in
1995 until 2005. He is a member of the Germany Banking
Association's Economic and Monetary Committee and Volkswagen
Foundation's Asset Allocation Advisory Board from 1999 to 2008.
He has advised the German Finance Minister on international
economic policy and financial market issues, and since it seems
so much of what is going on in the EU now is dependent upon
what Germany decides, we are particularly looking forward to
your comments, sir.
Dr. Domenico Lombardi is a Senior Fellow for Global Economy
and Development at the Brookings Institution. As an expert on
G-20 and G-8 summits, international monetary relations, global
currencies, his current projects focus on the recent and
ongoing international financial crisis, the ongoing European
crisis, and reform of the IMF and World Bank. He is also
president of the Oxford Institute for Economic Policy. He is a
member of a whole series of committees and associations, and we
are grateful to have Dr. Lombardi here.
Dr. J.D. Foster, this is the second time we have had a
chance to hear Dr. Foster--I at least--this week. He is the
Norman B. Ture Senior Fellow in Economics and Fiscal Policy at
the Heritage Foundation. His primary focus is studying long-
term changes in tax policy to ensure a strong economy. He also
examines changes in Medicare, Medicaid, and Social Security so
they are both affordable and more efficient. Dr. Foster came to
Heritage in 2007 after serving many years at the White House,
the executive branch, Capitol Hill, and private policy
institutions. His last job before joining Heritage was the
White House Office of Management and Budget where he was
Associate Director for Economic Policy.
Again, we have got four very distinguished panelists. We
are anxious for your analysis of not only origins but kind of
next steps, particularly in Europe. And, again, since many of
you know who work in this town or here in America we still have
this American bias, so if you could also help make clear how
much real time going on in Europe both directly and indirectly
affects some of the challenges we have in this country, that
will be helpful as well.
Mr. Veron.
STATEMENT OF NICOLAS VERON, VISITING FELLOW, PETERSON INSTITUTE
FOR INTERNATIONAL ECONOMICS, AND SENIOR FELLOW, BRUEGEL
Mr. Veron. Thank you very much, Chairman Warner, thank you,
Ranking Member Johanns, thank you, Senator Bennet, for giving
me the opportunity to testify today. It is a great honor. It is
also the first time, as far as I am aware of, that Bruegel,
which is a young organization, has one of its fellows giving
testimony on this Hill. So it is a moment of pride also for
this organization and for the Peterson Institute. My views are
very informed by conversations with my colleagues, which is why
I mention many of them in my written testimony. My main focus
in research is on financial regulation, and this also informs
the emphasis of my remarks.
I also call for forgiveness for my imperfect English. I
will probably make mistakes in expressing myself, so I call for
your understanding.
Senator Warner. You heard how badly I did some of my
introductory comments in English, so you are doing quite well,
sir.
Mr. Veron. The roots of the crisis, I believe, are very
much to do with the European banking system and European
banking system fragilities. Subprime, Lehman Brothers collapse,
shock was exogenous to Europe. It came from the United States,
but it revealed very significant weaknesses in the European
banking system. One big difference between Europe and the
United States is that the United States by comparison addressed
its banking crisis more decisively and more quickly than the
European Union, which did not have an equivalent to the sort of
aggressive stress testing and recapitalizations that was
endeavored in 2008 and 2009. Why? Because of a number of
factors of political economy. But the fact is that the European
Union has been in almost continuous stage of systemic banking
fragility--you may call it systemic banking crisis--basically
since 2007-08, so there has been a continuity on this.
And now we have--and this is my second point--a sovereign
crisis which is really a combination between sovereign fiscal
crisis and banking crisis. So the title of this session is well
taken. It is really a financial and debt crisis, the two
feeding each other. Of course, it started in Greece with the
statistics manipulation of the Greek Government. The contagion
went to other countries. In some countries, the banking system
has had a negative impact on the fiscal dynamics, like Spain
and Ireland. In other countries it has been the other way
around, fiscal dynamics having a negative impact on the banking
system, like Greece and Italy. But we have had very significant
contagion.
Now, this could perhaps have been better resolved if we did
not have also weaknesses in the EU institutional framework, and
this is my third point. This is becoming basically a European
institutional crisis because the inability of our
institutions--and I say our institutions not our leaders,
because I think institutions are more to blame than individual
leaders. So their inability to provide the right solutions in a
timely fashion has been a very significant factor in the
crisis, especially at this point. I think when you discuss with
investors these days, they really express very vividly the
feelings that the political systems or policymaking system are
not delivering, and this is their major focus on concern, even
as much or in some cases even more than the bad debt dynamics
or the bad economic situation.
My fourth point is that the resolution of this crisis,
because of all the time lost and because of all these
components, will need basically four planks. We need to put in
place a credible system of fiscal federalism in Europe, and
there are many ways to do that, but it is something new
compared to the current situation where monetary policy is
being done in a federal framework but not fiscal policy.
Then I think we also need banking federalism, which is
perhaps less discussed but, in my view, as important. We need a
truly European banking system. At this point we have an
unstable hybrid between national banking systems and European
banking integration. It is not sustainable. And to enable this,
we need a significant overhaul of EU institutions to make them
more accountable, more accountable to EU citizens, and giving
them a better executive decisionmaking capability. So this
implies treaty changes. It is very complicated. In the
meantime, we need gap financing for those countries which need
it, probably some debt restructuring--I am sure we will come
back to this--and also some bank restructuring which goes with
the sovereign restructuring under the current institutional
framework.
My fifth and final point is about the outlook. There is no
sufficient political willingness at this point to provide what
I have identified as conditions for crisis resolution. So,
unfortunately, in the case of Europe, I am afraid it will get
worse before it gets better. And this will have an impact in
the United States, the same way the U.S. crisis had an impact
on the EU in 2008.
I think there are encouraging recent signs of the debate
moving forward in Germany and other countries, but we are not
yet there.
Will this lead to a break-up of the euro area? I do not
believe so. I do not even believe that Greece will leave the
euro zone because I think this is a case of united we stand
together or we fall, and that the alternative of break-up or
some countries leaving the euro zone will be really very
negative in their consequences, so leaders will not go for it.
The EU framework may be strengthened in the end by the
results of the crisis, but in the meantime, the road will be
very bumpy, and I think Europeans will pay a high price for it.
Thank you very much.
Senator Warner. Thank you, sir.
Mr. Fels.
STATEMENT OF JOACHIM FELS, GLOBAL HEAD OF ECONOMICS, MORGAN
STANLEY
Mr. Fels. Thank you, Mr. Chairman. Thank you, Senators. It
is a pleasure and an honor to be here today.
I will focus on three issues: first, the origins of the
crisis; second, the options to resolve it; and, third, the
implications, the macro implications for the United States and
for the global economy.
Now, starting with the origins of the crisis, I think there
are three key factors at the root of the current crisis:
First--and it was already mentioned by Mr. Veron--the very
peculiar institutional framework of the euro area because we
have a single monetary policy conducted by a central bank with
a very narrow inflation focus; then we have a decentralized
fiscal policy, and we have a decentralized banking supervision
in the 17 members states. So a very unique set-up.
Second, we have an oversized and undercapitalized and
fragmented banking sector in the euro area, so that is very
different from the U.S. situation.
And, third, we have diverging trends in growth and price
competitiveness between the member states, and this has led to
very large current account imbalances within the euro area, and
it has led to a buildup of debt in the deficit countries.
Now, I think that the most important of these three factors
is the institutional set-up, and one distinctive feature of
this framework is that monetary policy is centralized, but
individual member states have retained their fiscal
sovereignty.
Now, we put rules in place to avoid irresponsible fiscal
behavior--that was the so-called Stability and Growth Pact--but
as we found out, it did not work and many member states have
been running excessive fiscal deficits because we did not have
well-designed rules.
Moreover, the European Treaty contains a ``no bailout''
clause. I think that is well know. It states that no member
country can be forced to stand in for the debts of other member
countries. And at the same time, the treaty lacks a mechanism
for orderly sovereign debt restructuring, and it does not
provide for a mechanism to exit the euro zone. So, in summary,
the euro area's fiscal framework has neither been able to
prevent irresponsible fiscal behavior, nor does it provide a
mechanism for an orderly resolution once a fiscal position has
become unsustainable.
Now, to make matters worse, we have a European Central Bank
that is constitutionally banned from financing governments
directly. You may say that is a good thing. However, as a
consequence, European governments no longer have a lender of
last resort that they can resort to in times of crisis. And
without access to the printing press in extreme circumstances,
there is a risk--and this is what we have learned over the past
year--of self-fulfilling runs on otherwise solvent governments.
Now, I think this lack of access to a lender of last resort
helps to explain why investors treat countries in the euro area
as credits. So these government bonds are seen as credits. That
is different from countries which have similarly high debt
levels, like Japan or the United States or the United Kingdom,
but in these countries where governments have access to the
central bank as a last resort, investors see them as true
sovereigns.
So these are the factors at the origin of the crisis. There
have been a number of exacerbating factors, namely, a series of
policy mistakes that have been made ever since the Greek crisis
broke out, but I would refer to my written statement on the
details here.
Now, briefly on the second point, what is required to
resolve the crisis, I think to get a lasting solution we need
three things:
First, very bold reforms of the fiscal framework. This
involves two elements: first, a fiscal transfer mechanism or an
insurance scheme on the European level--so that is the fiscal
federalism that was already referred to--and this would provide
a backstop for governments unable to fund in the market; and,
second, as a compensation, we need a partial transfer of member
states' fiscal sovereignty to the European level in order to
avoid irresponsible fiscal behavior at the national level.
The second thing we need is a central bank able and willing
to serve as a lender of last resort, as I just explained. To
some extent, the ECB has assumed this role during the crisis.
They have started to buy government bonds. They have bought
Greek bonds, Portuguese bonds, Irish bonds. They have started
to buy Spanish and Italian bonds. However, the amounts they
have purchased have been relatively small, and the ECB is
constitutionally barred from buying bonds directly at auction.
Then the third thing we need is a large-scale bank
recapitalization, and I think this would break the negative
feedback loop between the sovereign crisis and the banking
crisis that we have already seen. U.S. banks are much better
capitalized than European banks, and I think this is what needs
to happen.
The problem here is that all these reforms require changes
in the European Treaty which would have to be ratified in all
national parliaments, and it would require popular votes. And
to be honest, I think this is a process that could take years.
I am not talking months. I am talking years here. So,
therefore, I think it is fair to assume that the crisis will
continue in the foreseeable future, and it will probably deepen
further.
My final point, the last point, what are the implications
for the United States and the global economy? Mr. Chairman, you
have already referred to them. The first thing that we need to
look at here is that the euro economy will probably stagnate in
a broad sense over the next couple of years. We think that
southern member states like Italy and Spain will experience a
renewed recession next year, and this means that European
import demand looks set to slow, and as a consequence, U.S.
exports to Europe will also slow further.
Second, the European crisis deepening means that the euro
will weaken further. We are seeing this as we speak in the
markets, so this means a stronger dollar, and, again, this will
hurt U.S. exports.
Then the third and last consequence is the financial market
linkages. U.S. banks are stronger in terms of capital,
liquidity, and asset quality than their European peers, but the
European crisis has already contributed to higher funding rates
also for U.S. banks and to a higher cost of capital in the
United States and elsewhere.
So I conclude by saying that just as Europe and the rest of
the world were severely impacted by the subprime crisis several
years ago, I think it is very fair to assume that the United
States is now very severely impacted by the European crisis,
which is very unlikely to end soon.
Thank you.
Senator Warner. Mr. Fels, thank you for that very
uplifting----
Mr. Fels. I did my best.
Senator Warner. I am anxious to get to the questions, but a
very good presentation.
Dr. Lombardi.
STATEMENT OF DOMENICO LOMBARDI, PRESIDENT, THE OXFORD INSTITUTE
FOR ECONOMIC POLICY AND SENIOR FELLOW, THE BROOKINGS
INSTITUTION
Mr. Lombardi. Chairman Warner, Ranking Member Johanns,
Senator Bennet, thank you for this opportunity to share my
views with you today.
The crisis of the euro area has entered a new stage. What
was initially a fiscal crisis of relatively smaller peripheral
economies has now turned into something that is very close to a
systemic crisis of the euro area itself with large sovereigns
like Italy, Spain, even France coming increasingly under
strains, and not only the sovereigns but also their respective
financial sectors, as we have seen through a number of
downgrades of several Italian banking and financial
institutions and also French financial institutions days ago.
While European governments, of course, are obviously
primarily responsible for the unfolding of the current events--
and Nicolas Veron was reminding us that the Greek Government
was fudging statistics, and this prompted what we are now going
through--the incomplete architecture of the euro area also
created unprecedented scope for contagion by exposing each
member of the union--albeit to varying degrees--to the
vulnerabilities of the other members. And coupled with the
inexistence of a lender of last resort, this means, as Mr. Fels
has reminded us, market expectations can rapidly become self-
fulfilling in the context of the euro area.
In terms of the policy options--of course, I would refer
you to my written statement for a fuller elaboration. In terms
of the policy options, I think the euro area governments ought
to implement a multi-pronged approach consisting of immediate,
short-term, and medium-term options. And on the immediate
measures, certainly the EFSF--that is, the European rescue
funds--we should not that the euro area leaders already agreed
to a number of amendments to strengthen the European rescue
fund on July 21st, and yet those amendments have still not been
ratified by the member countries. I believe the German
parliament is expected to review the amendments sometime in
October, as other euro area parliaments will.
It is important to further strengthen the EFSF, however,
perhaps by providing a line of credit to the European Central
Bank and, therefore, turn the EFSF into an effective crisis
manager and relieve the ECB from duties that are technically
outside of its own mandate, like, you know, in some ways the
role of a lender of last resort that the ECB to some extent has
been performing in the current crisis, or certainly that of a
crisis manager.
It is important to ring-fence the Greek crisis because
right now there is no program of assistance that can work in
Greece as long as its debt-to-GDP ratio is projected to reach
140 percent. And Senator Johanns was reminding us that whether
you are a liberal or a conservative economist, having a high
burden given by the debt of country and economy is--it makes it
really impossible for the economy to grow, and this is
certainly much more true in the case of Greece.
Of course, the fiscal surrounding needs to pooled. There
will be also a need for medium-term measures like coordinating
macroeconomic and structural policies. Of course, if Germany
has a current account surplus, it cannot expect to continue to
have that surplus if the other euro area countries where it was
exporting its own goods and services are in retrenchment.
In terms of, you know, the levers that the United States
can leverage on, I think given where we are, this is perhaps by
far more relevant. I think there are five levers that the
United States can use. No one of them is--of course, the
responsibility still lies with the European governments in the
first place.
First, there is, of course, the worldwide bilateral
relationships between the United States and the single European
countries. The Administration has been engaging bilaterally
with the various European countries. Perhaps it is not a
coincidence that German Chancellor Merkel declared her public
support to the first rescue package in Greece on the very same
day she had a conference call with the U.S. President.
There is the G-20, and there is a framework that was
proposed by the United States in 2009, the Framework for
Strong, Sustainable, and Balanced Growth. It is very important
that we do not lose momentum on that, that there are still--
there should still be progress in terms of rebalancing of
global demand in China to try to positively contribute to
flagging European and possibly U.S. demand. So it is very
important this euro area crisis does not sort of make these
talks lose momentum.
There is the G-7, and there has been actually a revival in
the G-7 countries to what many had expected, because I believe
continental European countries are more attuned in discussing
about their issues with G-7 countries. And the United States,
of course, is a leading member in this forum.
There is certainly the International Monetary Fund. Of
course, the United States is represented by one of the
executive directors. The first deputy managing director has
also been an American citizen since the position was
established.
Here I would like to draw your attention to the confidence-
building effect that enhancing the IMF war chest would have in
terms of stabilizing expectations. And the Board of Governors
had already approved a doubling of the quotas, and, again,
national legislatures would need to approve--to ratify that
agreement. So far only a few countries have done so.
The IMF can rely on the NAB, which is a contingent credit
line that it can activate should there be any need. Again, it
is not about enhancing the IMF financial capability to imply
that the IMF will be spending more money, but just to emphasize
the confidence-building effect that enhancing the IMF war chest
could have.
And then, of course, there is the U.S. Federal Reserve that
has been very cooperative with the European Central Bank. There
has been a number of bilateral currency swaps through which the
ECB, thanks to the Fed, has been able to ease pressure on the
European banks so far.
Mr. Chairman, I am sorry for taking too much time, and I
will stop here and await questions from the Committee. Thank
you.
Senator Warner. Thank you, Dr. Lombardi. I would say on the
EFSF, to my understanding the French Foreign Minister today has
made some proposal, and we are anxious to hear from you all on
that.
Dr. Foster.
STATEMENT OF J.D. FOSTER, Ph.D., NORMAN B. TURE SENIOR FELLOW
IN THE ECONOMICS OF FISCAL POLICY, THE HERITAGE FOUNDATION
Mr. Foster. Chairman Warner, Ranking Member Johanns,
Senator Bennet, thank you for the opportunity to testify today.
I am J.D. Foster, a senior fellow at the Heritage Foundation.
The views I express in this testimony are my own and not the
official position of the Heritage Foundation.
The European economic crisis is no accident. It is entirely
self-inflicted, resulting from two fundamental economic policy
mistakes begun long ago and since magnified and papered over
repeatedly.
The first mistake was adopting a single currency without
the economic policy infrastructure necessary to sustain it. As
a matter of economics, the euro could have succeeded as
envisioned, but Europe largely ignored the prerequisites of
harmonizing labor, commercial, environment, labor, and fiscal
policy.
The second great mistake was adopting a generous social
welfare state without attending to the pro-growth policies
necessary to sustain such a state in light of an increasingly
competitive global economy.
But that is past. What is next?
Europe's immediate problem is a budding liquidity crisis.
European financial institutions are struggling to access short-
term dollar credit markets, and depositors are getting very
nervous. Confidence, the lifeblood of financial markets, is
failing fast.
The reason? The banks hold vast quantities of dodgy
government debt. Many have serious solvency problems. Joaquin
Alumnia, the European Union's competition commissioner, noted
recently that, ``Sadly, as the sovereign debt crisis worsens,
more banks may need to be recapitalized.''
Mr. Alumnia has a knack for understatement. An IMF study
out yesterday puts the shortfall at about 300 billion euros.
The solvency problem, in turn, traces to the sovereign debt
problem--unsustainable debt and deficits--unsustainable because
of their magnitudes and because these countries also suffer
from an ongoing growth problem. The problem is not enough
growth. Now they are contracting, in some cases rapidly. So
while their debt is high and rising, the economy on which the
debt rests is flat or contracting.
Worse yet, the cost structures in many of these countries
render them highly uncompetitive, even within Europe. This
means they cannot run the trade surpluses necessary to generate
the earnings with which to pay their foreign creditors.
Liquidity problem to solvency problem to sovereign debt
problem to growth problem to competitive problem.
The painful immediate policy conundrum is that addressing
excessive sovereign debt and deficits through tax hikes, for
example, weakens their economies further, thus making current
debt levels even less sustainable. Meanwhile, issuing even more
debt to buy time for fiscal consolidation to take hold worsens
the bank solvency problem by depressing the value of the dodgy
debt held by the banks. And it gets worse. Drawing attention to
the need for more bank capital, the financial market solvency
problem, brings the liquidity crisis to a fevered pitch. This
is a Gordian knot of enormous complexity, and I think we have
to have a little grudging admiration for the European
leadership for at least managing to get this far.
The fundamental transmission mechanisms of the European
economic crisis for the United States economy are as
straightforward in outline as they are murky in detail. There
are two such mechanisms, one through financial markets and the
second through trade flows.
Five years ago, the European financial crisis might have
appeared to us as a European affair that would stop at water's
edge. Five years ago, the Europeans thought the same about the
then-rumored U.S. subprime mortgage fiasco. The fact is, Mr.
Chairman, as you noted, the issue is financial global
interconnectedness. No one, including the participants and
regulators, really understands all the connections or all the
weaknesses. A financial crisis in Europe will spread to the
United States Will the shock to the United States be great or
small? No one knows. And it is this uncertainty more than
anything else that is rattling markets today.
European leaders will not be able to kick the can down the
road indefinitely. At some point this house of cards will come
tumbling down, taking much of the European financial system
with it. That is the bad news.
The good news is, I believe, this part of Europe's problems
will be halted in its tracks fairly quickly by recapitalizing
the banks and other financial institutions. Done quickly and
decisively, this is a light switch for the liquidity and
solvency problems. The questions for the Europeans will be
whose capital and how much. For the United States, too, the
immediate threat will then pass. Europe will then be left with
a dysfunctional monetary union, uncompetitive economies in many
cases, and excessive debt burdens in others, and a deep
recession. Even after the financial crisis passes, Europe will
still face grave difficulties. Most immediately, Europe, a
major U.S. trading partner, will be in a deep slump, which can
only mean U.S. exports to Europe will suffer badly, and the
effects will not be fleeting--again, Mr. Chairman, a point you
emphasized yourself.
Our focus today should be in preparing for the immediate
threat of financial contagion. Above all, the key to preparing
for the financial threat is capital. Capital reserves act like
levees in the face of a flood, protecting financial
institutions from the onrushing river of failing confidence.
Presumably, America's financial regulators and supervisors, and
this Committee, are keeping a close eye on bank capital
reserves and adequacy.
The American economist Joseph Schumpeter once observed,
``The problem that is usually being visualized is how
capitalism administers existing structures, whereas the
relevant problem is how it creates and destroys them.'' The
next few years are very likely, and painfully, to bear this
out.
Thank you, Mr. Chairman.
Senator Warner. Thank you, Dr. Foster.
I think I made one comment in private to the panel before
we got started. You know, I hope the kind of American political
rallying cry does not become, ``Well, at least we are not as
bad as the euro zone,'' which should not be--oh, boy. Normally,
Mr. Veron, what we do is we take 5 minutes each and we rotate
around, but I am going to try to be brief so that we can try to
get a more active discussion since we have got a smaller group
here. And we will all have a chance to ask a series of
questions.
I guess politicians, rightfully, always are accused of
short-termism, and that is true. It is interesting that you
have got, I think, a variety of economic philosophies along the
panel, but we all see the institutional challenges that were
set up in the euro zone. And while we need to come back to the
time that it will take to make those changes, as Senator Bennet
has pointed out, we have got to work on some of these things in
our own country as well.
I guess what I am looking at is, recognizing the first
round of kind of short-termism, do you believe the ECB or the
European regulators even have the appropriate level of data to
know how deep not only their banking crisis is but other
financial instruments, for example, exposure to Greece? So, you
know, if you think about ring-fencing, do they even know the
size of the problem? One of the challenges I think we have
still got in this country, number one.
Number two, what will be some of the markers that we should
look at? I know the Germans are now grappling with the decision
on what will be the trigger mechanism to make the next round of
emergency relief--I think it is mid-October, I believe, in
terms of the next payment, and will the Greeks meet those
preconditions? And are the Finns, by saying they want
collateral--if they suddenly take a Greek island or two as
collateral, will everybody else kind of get in line as well on
that?
Then, three, I would just like a quick comment on some of
these immediate actions today in terms of what I think Dr.
Lombardi was referring to, trying to kind of lever up this
emergency fund that the French Foreign Minister mentioned. So,
you know, do they have the data? What are the metrics in terms
of what we should be watching for as the triggering events?
And, you know, will there be anything we will see even in
advance of the middle of October of actions being taken? In
whatever order.
Mr. Veron. Maybe I will start very briefly on the
question----
Senator Warner. If I could just again, because I want to
make sure all my colleagues get time, if you could answer
relatively briefly to all these. I have got a lot more
questions, but I want to make sure they get a chance.
Mr. Veron. Very briefly on the data, of course, there is
never enough data, and there has been some improvement with the
latest round of stress tests where the disclosure part of the
stress testing was a much better quality than the previous
round, so the latest round was July 2011, the previous in 2009
and 2010. The stress testing itself was not very harsh, but
disclosure was valuable.
I think, however, the contagion we are witnessing is not
reducible to something we can analyze, that we can model with,
you know, equations. If you look at the contagion patterns to
Italy in July, to French banks in August, which are the two
latest dramatic developments of the euro zone crisis, I do not
think they can be well captured by an analysis of the direct
exposures, of the direct financial interdependence. Even so, it
is important to know them, the sort of numbers you showed on
the two slides. There are many other things at play, including
the political factors. In a way it is what makes the situation
so difficult right now.
Take a country like Italy. You look at it objectively,
frankly, it has a primary surplus. It has a fiscal situation
which is characterized by high debt but also quite sound in
terms of fiscal management. But because of all the uncertainty
in surrounding factors, nobody can be sure that this is enough.
Senator Warner. Thank you.
Mr. Fels. All right, Mr. Chairman. Well, on your first
question, I think that, you know, does the ECB--do the
regulators know enough? I think the good news is that Europe is
still a largely bank-financed system, so about 80 percent of
all the loans to the private sector come from the banks rather
than from the capital market or the shadow banking system. So
in that sense--and the regulators and the ECB know a lot about
what is going on in the banks due to the stress tests. So I
think they have a very good grasp of how deep the problem in
the banking sector is. And, again, this is what really matters
for the euro area economy.
The bad news is, Where does the capital come from to
recapitalize the banks? I think we all agree with need bank
recapitalization. The problem is in many of these countries,
where the capital would have to come from the sovereign, from
the national government, these governments do not have access
to the capital markets anymore, so they do not have the money.
And so far it is very difficult to explain to the taxpayers in
the stronger countries, Germany and others, that they should
put capital into the peripheral banks. There is strong
resistance in those countries to recapitalize their own banks
because, obviously, people are angry with the banks, given that
we had a major and still have a major crisis. It is even more
difficult for them to explain that they should put capital into
peripheral banks.
Then your question on Greece, will they get the next
tranche, and, you know, will the EFSF changes, the rescue fund
changes go through parliaments? My answer to both questions is
yes. Greece has come up with additional measures. I think it is
very unlikely that Greece will be allowed to fail in the near
term. Nobody has an interest in that. So it looks as if Greece
will get its next tranche in October.
On the EFSF changes that have to go through national
parliaments, I am also quite confident that these changes will
go through by the beginning or the middle of October, and then
I think the real problems only start then, because then when
the EFSF will be able to put money--or to lend to governments
so they can recapitalize their banks. When the EFSF will be
allowed to buy government bonds in the secondary market, there
may be a bigger incentive among some politicians to let Greece
go bankrupt because the view would be that we will be able to
ring-fence this.
I do not believe that the ring-fencing will be possible. I
think the EFSF is not big enough to do that, and I think it
would be a major mistake if we would allow Greece to go
bankrupt over the next couple of years. But the thinking may be
very different in some political circles, so this is a key risk
to watch, once the enhanced EFSF has come into action in mid-
October or early November.
Senator Warner. Thank you.
Mr. Lombardi?
Mr. Lombardi. Thank you, Mr. Chairman.
In terms of the data, I would say that in continental
Europe there is a good wealth of data. The Bank of Italy has a
credit registry, so we know perfectly well, almost perfectly,
how the banks have allocated their portfolios. I think the same
is true in France with the Banc de France, and these systems
are very much relying on banks rather than intermediaries
outside of the banking system. So data-wise, I think the ECB
more or less, you know, is in good shape.
Turning to your other points, Mr. Chairman, the EFSF has a
potential capability of 440 billion euros because roughly 175
of them have already been committed in some way or another. The
residual will not be able to even fund a program for Italy
should, you know, Italy for some reason be unable to borrow
from the financial markets. And for that matter, 1 year of the
Italian funding needs currently standing at roughly 235 billion
a year would also deplete the IMF capabilities.
So this is why it is important that the EFSF is able to
exceed an ECB credit line, so just--line of credit, sorry, so
just, you know, enhancing the EFSF but without enabling the
EFSF with the needed financial capability would essentially be
almost unhelpful.
The EFSF could be used as a device to recapitalize the
European banking system so to make banks to be in a better
position once a substantial part of the Greek debt will have to
be written off in terms of--in order for the Greek economy, you
know, to rebound, of course, in exchange of strict conditions
and in exchange of some commitments from the Greek authorities.
But certainly the EFSF could be used well beyond its current
capabilities if, you know, the euro area parliaments were to
act in that direction.
Senator Warner. Dr. Foster?
Mr. Foster. Yes, Senator. In terms of the exposures, I am
reasonably confident the ECB and the IMF have very good data as
to the exposures of the banks to the direct threats. But, as
you alluded to in your remarks, sir, it is the indirect
exposures that are the risk. You may think you are holding a
perfectly good asset, but it turns out the company you own
through asset is itself in trouble because it holds too much
bad debt. We have read a lot over the years about how much of
this risk has been hedged through use of credit default swaps.
CDS does not eliminate risk. They shift it. To whom? We do not
know. That is the issue.
The issue is also only contextualized by the numbers. The
real driving force is confidence. That is the lifeblood of
financial markets, people trusting each other and what is going
to happen.
Remember back in 2008 in the peak of our crisis, fully
solvent large banks stopped talking to one another. Markets
broke down because of a lack of confidence in basic business
arrangements. It is a psychological matter, and it could be
triggered by anything--a bad soccer match. It could be
triggered by an event where some politician makes an
unfortunate statement. But whatever it is, it is a question of
psychology. Greece primarily, but other nations in the
periphery as well, are hanging by a thread, and that thread is
being eroded as the confidence erodes. When it goes it is hard
to say.
One last note about Greece. I think there is no question
that if Greece were to default or spin out of the euro, the
consequences for Greece would be terrible. The consequences for
Europe would be terrible. It does not change the fact, in my
opinion, that this is inevitable. It is only a question of
time. And the reason for that is very simple. It is not a
question of fiscal matters. It is not really a question of
finance. It is a question of the fact that Greece's cost
structure, wages and prices, are grossly out of line with their
productivity. They cannot possibly produce the trade surpluses
with their current cost structure necessary to pay off their
foreign creditors. That is not a question of financing.
There is one way it could occur, and that is if the German
people were willing indefinitely and with unknown amounts to
bankroll the Greeks. I do not see that happening.
Senator Warner. With that, I am going to turn to Senator
Johanns, recognizing that Dr. Foster said, you know, this issue
about confidence. And I was a bit taken aback when he said that
occasionally a politician might make an ill-suited comment.
Senator Johanns. Be careful.
Mr. Foster. Not the Members of this Committee, sir.
Senator Johanns. I remember during the height of the
financial crisis of a few years ago in the United States, I was
visiting with a president of one of the major banks, and the
bank is still operating today. I was probing as to the
condition of the bank, you know, the capital and a whole host
of things, you know, what is the loan portfolio like, et
cetera. And kind of at the end of it, I said, ``So how do you
feel about your current situation? How do you feel about the
security of the bank?'' And he said, ``You know, Senator, when
a run starts, it is very hard to stop.'' And it was to me a
very telling comment that you could have a secure financial
institution that seemed to be doing all the right things, and I
believe today they were. But what he was saying is when things
start going downhill, they really can go downhill very quickly.
I saw that because I would like to offer a perspective, and
then I would like your reaction to it. Certainly we go to
Greece and we see the challenges there, and, Dr. Foster, I
found your comments to be very interesting. Something bad is
going to happen. We just do not know how bad and to what
extent. But we know something bad is going to happen. But to
have Greece out there that, I agree, how you get this country
competitive is a significant issue. But it does not stop with
Greece. It is Spain and Portugal and potentially Italy and
potentially France. And once the run starts, where do you stop
it?
Now, my experience with the European Union is that it is
even hard to define the structure. Those who work there and are
experienced in it could probably give us 2 hours of what the
structure is. But what is it? It is a governing body that, by
and large, operates on consensus, and when they want to change
the treaty, they have this very cumbersome process.
So you lay out the pathway, and then you say, ``But they
have got to change the treaty, and here is what they have to
do.'' And I am thinking, holy smokes, that is like amending the
Constitution of the United States. This does not happen anytime
soon. That is why we do not do it very much.
And so I look at all of these things that are happening,
and then I add in this factor--and, again, this comes from our
own experience in the United States. There is a point at which
you are asking your strong countries to bail out weak countries
who maybe have better social benefits, better whatever, and
those strong countries with their citizens are saying, ``Excuse
me? Why? Why would I, who worked so hard, be forced to do
that?''
And then the final thing I wanted to mention--and then I
will ask for your reaction to what I have said--is it just
occurs to me that if part of the key here is to recapitalize
the banks, where do you find the capital, number one? And,
number two, how do you muster up the willingness of the
citizens to tolerate that? Much like we ran into here in the
United States, there is a point at which the population, our
constituents just say no, enough is enough, no matter what the
consequences are.
Adding those factors in, where am I missing the point here?
What about my analysis of this is not accurate or misses the
mark here? Dr. Foster, I will start with you.
Mr. Foster. Thank you, sir. I do not think your analysis
misses the mark hardly at all. The question ultimately will be,
as I noted, the recapitalization of the banks. When that
occurs--likely not 1 minute before it has to. When that will be
we do not know. Where the capital will come from is the big
question, but the European tradition and, in fact, our own in
the recent crisis, says it is going to come from the
governments. Simply put, the governments are going to own the
banks. Germany can do that. France can do that. They have
access to capital markets. I suspect Italy will be able to.
What Greece is going to do, and some of the peripheral
countries, is another matter. But one way or another, that is
how you address the financial system. You had insolvent banks.
Now you have solvent banks. They are owned by the government.
Why would Europeans tolerate this? Well, the Europeans,
frankly, are more tolerate of governments owning financial
institutions than we are. When we do it, the expectation is
that the banks will pay back the money and so will get rid of
the public ownership. AIG is trying very hard to become a
private institution again. The banks that received TARP funds
tried very hard to give the money back, and that was our policy
as well as a Nation.
The Europeans--I am not sure how anxious they are going to
be to resell those financial institutions. But that is where
the capital is going to come from; ultimately it is going to be
from the governments.
Why would the strong continue to bail out the weak? They
would do so as long as they think they are sustaining a
sustainable system. There is something to the European vision
that is widely shared across the continent. It may not be
always comprehensible to Americans, but we have to acknowledge
its existence, and they will defend it, to a point. I think it
is pretty clear that point has been reached in Germany, in
Finland, and some of the other countries. And so I do not
expect this to continue. They are going to have to find a
resolution pretty quick.
Senator Johanns. Mr. Lombardi?
Mr. Lombardi. Thank you, Senator Johanns, for your
question. I would say I think in the current context of the
euro area crisis, there has not been an even perception of the
benefits of the single currency. So in a way it is the
politicians' jobs, I would say, to highlight to their own
national electorates what the benefits of the current European
projects have been and are and can be in the future. I mean, it
is a very hard job to do, but it really hinges on the European
senior political leadership.
I think if Chancellor Kohl had called a referendum on the
euro or on the European single market, I doubt that the
national electorates of the various euro area countries would
have ever voted yes. And yet, you know, over several decades of
sustained economic, financial, and political integration, I
think that there have been substantial benefits overall that
this crisis should not obscurate.
Clearly there is more than a perception, the reality that
the peripheral economies, including even Spain, you know, other
economies like Ireland, have benefited from low interest rate
policies that they were able to access thanks to the single
European currency. But I think also Germany--and I am referring
to Germany because it is always the strong country that is very
competitive, of course, with a very sound fiscal stance. So
this is why I am referring to Germany. Even Germany has
benefited from the single currency. Germany has been able to
run current account surpluses in proportion of GDP even higher
than those of China but, however, without the compensating
mechanism given by the appreciation of the currency, because
being part of a monetary union, of course, the euro did not
rise as it should have if Germany had its own currency. So, in
a way, Germany has benefited from a sort of hidden subside
through the single currency as much as, you know, other
countries have also benefited from some other forms, perhaps
not so hidden, of subsidies.
In a way this is the benefit of creating a single market,
so there are benefits for all in different forms. Some are more
evident, other times less evidence. But there are for all.
In terms of the other levers that politicians could
leverage in Europe, I have here the projections that the IMF
has released a day ago, and, again, Germany last year grew at
3.6 percent, which is a rate of growth that, I would say, used
to be pretty normal in the United States, maybe even low-ish,
but it was really extremely high compared to European
standards. This year Germany will grow at 2.7 percent. Next
year and the next again, it is going to grow at 1.3 percent.
So, of course, Germany is being affected by the crisis.
German consumers will have, of course, less resources to spend
compared to what they would have had otherwise. But in the end,
again, everything, you know, hinges on the political leadership
sort of explaining very difficult things to their own national
electorates.
Just one more quick point on Greece, if I may. I understand
the reasoning made by Dr. Foster, and, you know, as an
economist, there is certainly substance to it, I have to
acknowledge. But at this moment I think entertaining the idea
that Greece could be exiting the euro area would just be
destabilizing because it is going to be impossible really to
draw the line. You know, after Greece, is there going to be any
other country that will leave the euro area? And where are you
going to put Italy or Spain?
So I think the emphasis should be in stabilizing the Greek
situation by perhaps leveraging on the EFSF to strengthen the
balance sheet of the banks, and then perhaps in the medium term
certainly there should be at least an institutional framework
allowing the orderly exit of some countries who voluntarily
want to leave the euro area. But right now I think it would
just be destabilizing and would just trigger contagion and
further destabilize the prospect for exiting from this crisis.
Thank you.
Senator Warner. I am going to go to Senator Bennet, and
maybe he can start with Mr. Fels or Mr. Veron.
Senator Bennet. Sure. Thank you, Mr. Chairman.
I have two questions I will get out here. Mr. Fels, when
you had your list of the things that would be required for--in
order to accomplish them would require treaty changes, was the
bank recapitalization on that list? Or it would require treaty
changes to do the----
Mr. Fels. No. Bank recapitalization does not require treaty
changes.
Senator Bennet. OK, so it was my----
Mr. Fels. The other changes do, but bank recapitalization
should be relatively easy to do.
Senator Bennet. OK. And the other smaller question I had
was on Italy, Mr. Veron or Mr. Fels. In trying to understand
the domestic politics of the countries there, when you think
about Italy and who holds the Italian debt, I gather 50 percent
of it is held by Italians and the rest by others, but the first
question is: Do you know, do we know? And the second is: If
banks like the large German banks own a lot of that paper, how
does that inform the decisions about recapitalizations and the
politics of the work going forward?
Mr. Fels. Senator Bennet, if I may start on the Italian
question, slightly more than half of the Italian debt is held
abroad. We pretty much know where it is. It sits largely with
banks in the rest of the euro area, but also in large
portfolios here in the United States. and the rest of it is
owned by Italian banks and Italian citizens. The Italians have
a very high savings ratio, so Italy is country that has, you
know--it is a poor state or a poor government, but rich
citizens with a savings rate of around 20 percent of disposable
income year after year. The comparable number here in the
United States is now 5 percent, and that has gone up a lot over
the last----
Senator Bennet. It was zero. It was zero.
Mr. Fels. It was zero before the crisis, correct. So I
think we know where the debt sits, and the issue with Italy is
that, as I am sure you are all aware, Italy is the third
largest bond market in the world, and it is the largest bond
market in terms of bonds outstanding in the euro area. It is
larger than Germany. It is a smaller economy, but they have a
higher debt ratio. So Italy is too big to fail. If Italy fails,
then I think it is game over, and that would be a major
financial crisis. I think Lehman would pale in comparison.
Everybody knows that.
The other problem is Italy is not only too large to fail,
it is also too big to rescue because there is nobody around in
the euro area who could, you know, bring up the money to bail
Italy out. This is why it is absolutely crucial to follow what
is happening in Italy. To me, Greece has become a sideshow.
Senator Bennet. Exactly.
Mr. Fels. This is really about Italy.
The encouraging thing--now, I said a lot of things that,
you know, may have depressed you, but the encouraging thing is
we have seen considerable responses in Italy. This Italian
Government has responded. They have come up with additional
fiscal savings. They have agreed to put a balanced budget
amendment into their constitution. Now, that has not happened
yet, and they are still debating how. But this is something
that has happened. And I am actually quite confident that Italy
can get through this for a simple reason: they have done it
before. Italy managed in the 1990s, before the euro started, to
push through very significant pension reforms that put the
country's debt on a sustainable level, and this will play out
over the next 10 to 20 years. And so Italy has a high inherited
debt-to-GDP, but its long-term trajectory is much better than
that of most other countries of--and that is a big ``if''--they
can continue to fund at reasonable interest rates. That is the
big question, and this is why this contagion has to be stopped,
and this is why the ECB buying is playing a very important role
here.
Mr. Veron. I think what Mr. Fels just said is very
important. European countries have shown a significant ability
to reform, including to accept painful reforms, with different
levels in different countries, but if you look at certainly the
most graphical examples--Latvia, Ireland, they have taken
exactly painful economic medicine and with a very stoic
population not only the decisionmakers.
I think Portugal and Spain also have very much owned up to
their crisis. They have gone way past the stage where they
blame it on foreigners or outsiders. They really, you know,
understand that they have to take the bitter medicine, and they
are taking it.
I agree with a lot of things that Dr. Foster said, but I do
not think there is anything mechanistic or deterministic in
these dynamics. If you look back a decade, many people were
saying Turkey and Brazil are basket cases, there is no way they
can get out of their predicament, and they did. So I am not
saying that--I mean, of course, the question is: Can Greece
avoid debt restructuring? I am not sure I can answer yes to
this. But to the more general question of ability to reform and
take painful measures, I think it is higher than how it is
sometimes depicted both in Europe and outside Europe.
Regarding Greece, they announced yesterday some very, very
significant measures of adjustment, which will be painful,
which will be depressing on growth, but I think were necessary.
I would also say on this account that the electoral
dynamics are not as dire as perhaps sometimes they are
described. There has been a lot of press coverage, rightly so,
of populist parties gaining ground in Europe, but they remain
very much in the minority. If you look at the German
opposition, they are more pushy on EU integration and
solidarity with the Greeks than the ruling coalition. So it is
not the case--even when the coalition has a problem in
parliament, it is not the case that that means there is just a
minority willing to go further with EU joint action in Germany.
Of course, this is one political cycle. The next political
cycle might be different, and I think we have to be very
cautious on medium-term political assessment, but I think it is
important to mention these facts.
As regards recapitalization, I think we all see the
paradox--it is a Catch-22, right? The big risk right now for
the banks is the solvency risk for euro zone countries. So the
bank capital assessment is dependent on the solvency assessment
of these countries. So the two are completely linked, and there
are banks which say, well, Italy is solvent so why should I
mark-to-market Italian debt? There is no point of doing that.
And it is a very difficult cycle to break.
I will only say that, yes, there will be probably some need
for public capital eventually for the recapitalization of the
European banking sector, but I think there are two crucial
questions which will vastly affect the shape of the outcome.
One is, are cross-border acquisitions possible in Europe in the
banking system? There is a lot of economic nationalism,
especially in the banking system in many European countries,
including, I must say, my own. If politicians in those
countries realize that they have to deliver on the vision of an
integrated banking market and that, say, the acquirer of an
ailing French bank may be a Spanish bank or a German bank or a
U.K. bank or a U.S. bank, then we have a very different picture
than the picture we have if there is the constraints that any
merger and acquisition have to be inside individual countries.
And also in terms of the public capital, we said, national
governments, now that the EFSF has been explicitly also raised
to intervene in the banking sector, at this point indirectly
through loans to individual member states for them to
restructure their banks, I think at some point we will start
discussing the injection of EU money as opposed to national
government money, and this will also bring to it a different
picture, of course, with a lot of difficult political issues
involved.
My last point on this is on Greece. There are scenarios in
which a disorderly Greek debt restructuring would force an exit
from the euro zone, and this cannot be ruled out because some
of these scenarios are very serious.
Now, I think the trick with Greece will have to be how to
restructure the sovereign debt without Greece exiting the euro
zone, in spite of the temptation, of course, as an economic
boost of devaluation in the short term and so on. But I think
my hunch and my expectation is that the contagion from a euro
exit would be so impossible to manage that leaders in the end
will do their best and may succeed in having a Greek debt
restructuring, if this is really necessary--which it may be--
while keeping Greece inside the euro zone. This requires very
hands-on extraterritorial, I mean supranational instruments on
the Greek banking system. It is an absolutely necessary
condition. But it may happen.
Senator Bennet. Thank you, and I appreciate the answer. I
am going to ask a question with the Chairman's indulgence, and
then we will answer it.
One of the things that I am worried about in our country is
that we have seen periods of growth in the 1980s and the 1990s
where there was a relationship between the growing GDP and
growing wages and growing jobs. And we saw a decoupling of that
during the decade before this recession happened, and we are
seeing in this recession here a deepening of that disconnect
between growth and job creation and income.
I wonder, in thinking about the political cycles that Mr.
Veron was talking about, whether you could give us a picture of
what that looks like in Europe. There was a lot of discussion
here about the program that Germany had in place to keep people
employed during this downturn about a year or two ago. Is there
any insight you can give us on what that looks like? Is the
cycle we are seeing here repeating itself there? Mr. Lombardi,
do you have----
Mr. Lombardi. Thank you. Yes, this is indeed a very crucial
issue because right now the Europeans, of course, the
peripheral economies under stress, but also all the other
economies have embarked on fiscal retrenchment programs just
fearing what may be happening to them if they would not do so.
Clearly, this implies, you know, lagging demand with
effects on jobs, and in a way the euro area has always focused
on, you know, fiscal stability. But there has never been enough
emphasis on structural policies, on, you know, enabling the
euro area economies to grow more. And now we are in a way--you
know, they are paying the price.
Just to give you a more concrete example, there is now in
Italy a lot of emphasis on achieving this balanced budget
objective. Of course, this is certainly something that the
Italian authorities would need to embark on. But yet if the
public debt sustainability is the main issue, that does not
come from a balanced budget because the Italian public finances
have been run in a pretty conservative way over the latest
decade. The crucial issue is the very low rate of growth.
Clearly, if the economy grows at a very low rate and you have a
high and increasing public debt stock, there is no way the
economy in the very long run can be solvent.
And at the European euro area level, there have been a lot
of discussions on keeping the fiscal deficits shrinking, but
there has never really been enough emphasis on these other
crucial aspects, also important for the fiscal sustainability
in the long run. And, clearly, this has alienated a lot of
consensus, and I have to say that right now there has been no
lesson learned in a way because what euro area governments have
committed to, in a way well before that we would achieve this
kind of escalation of the prices, was fiscal retrenchment
across the board. So even countries in a better position, they
have focused on fiscal retrenchment, and, again, there has not
really been enough emphasis on creating jobs, and this is why
the euro area economy as a whole is performing very poorly in
terms of its own potential rate of growth.
Senator Bennet. Thank you. Thank you very much for your
excellent testimony.
Thank you, Mr. Chairman.
Senator Warner. Thank you all. Let me just as a brief
question, and then if any of my colleagues would like to ask
another brief question. I think Senator Johanns made an
interesting comment earlier when even those of us who take an
interest in trying to understand, you know, all the EU
mechanisms, it sometimes seems probably as challenging as
understanding the American congressional processes.
We do have another chance in the United States now before
the end of the year through this so-called Super Committee to
set a process in place. And I agree with Dr. Foster so much
about the issue of confidence. We do not know what will spark
something that could lead to this contagion.
What should we be--between just now and the end of the
year--we have not even got to long-term structural, but what
are the events or things that as American policymakers we
should be watching for to see if progress is being made?
Obviously, the next tranche of the Greek relief, but are there
other events or markers that we should either say, Aha, we are
moving in the right direction, oh, my gosh, or should further
evidence be on the 486-point drop we just had today of, oh, my
gosh, this may be getting worse?
Mr. Veron. I think there is a temptation to put Germany in
an even more central position than it is, but actually it is
central right now. It is a pivotal country. So I would suggest
watching very closely the German internal debate, including
perhaps spending a bit on translation, to understand what are
the currents and undercurrents in the German debate. I think it
is moving perhaps too slowly, but it is moving in directions
which are encouraging, with a lot of uncertainties, and
ultimately the German debate will have a huge impact on what
gets done or does not get done.
Senator Warner. And when will that conclude?
Mr. Veron. There is a bunch of parliamentary votes that are
planned. There is obviously at each time that the German
constitutional court has to give a ruling, it is important. But
I would also watch indicators like, you know, what do senior
figures in the German business community say, how do, of
course, parties, change their stance or not change their
stance. So it is a lot of moving elements, and I acknowledge
that it is very complex to watch from outside. But I think it
is crucial.
Senator Warner. Just very briefly, any other markers we
should look--because I want to make Senator Johanns gets
another round, and we are going to have to conclude around 4.
Mr. Fels. Just one thing. The crucial vote in Germany on
the EFSF, the changes, is on the 29th of September, and I agree
we need to watch that very closely. And then after that, after
the EFSF is--the reforms are in place, I would really watch the
bank, how we are progressing on bank recapitalization because I
think that is at the core.
If the new EFSF will be used to recapitalize some of those
banks in the weak countries through their governments, I think
that would be a very, very positive sign.
Senator Warner. And you think that process can start before
the end of the year?
Mr. Fels. It can start before the end of the year. I think
the regulators will be pushing it as soon as the reformed EFSF
is in place, which should be around mid-October.
Mr. Lombardi. Mr. Chairman, I would say in the immediate I
will be looking at, of course, Germany, would also be looking
at Italy for the simple reason that the government has issued
to us budget supplementary plans in less than 2 months. But now
they are working on a third supplementary plan just because the
previous one, which was approved by the parliament days ago,
and then, you know, the following day Italy was downgraded by
Standard & Poor's, of course, relying on growth projections
that were in a way exceedingly overoptimistic. Now these growth
projections have almost been cut in half, and, of course, the
plan that the government was confident would allow it to
achieve a balanced budget in 2013 does not any longer have a
basis.
So there is already a shortfall which has already been
assessed by the IMF, and the authorities are working on a third
supplementary plan.
However, this also highlighted the lack of a comprehensive
strategy, at the European level but also in Italy, because you
cannot clearly tackle the crisis from month to month issuing a
budget supplementary plan each month.
In the more medium term, again, by the end of the year,
which was your timeframe, I would also look in Germany at the
German parliamentary discussion on the European Stability
Mechanism that is the mechanism which will succeed to the EFSF
for the simple reason that there was a few days ago a decision
by the German constitutional court that would prevent Germany
from joining any permanent rescue mechanism. And the EFSF is a
temporary mechanism and will be replaced by this ESM, European
Stability Mechanism, which is permanent in nature. And,
therefore, as currently we think, the German participation to
this new mechanism--the German constitutional court has decreed
that would be unconstitutional.
Senator Warner. Dr. Foster, and then Senator Johanns will
get the last questions.
Mr. Foster. Yes, sir. Very quickly, following up on this
last point, the issue really is Germany. The real issue is the
constitutional court decision. What they decided almost looked
like it was written by Angela Merkel herself, because what it
said was that the budget committee of the Bundestag must be
consulted if there is any more German funds to be used. Well,
basically what that is saying is this is a way for Germany to
say no without the problem landing in Angela Merkel's lap. They
now have the ability to say no, and she will not be blamed.
Senator Johanns. This is going to be a bit of a general
question, so I will just warn you of that as I think about all
these moving parts and pieces and what has to happen and trying
in my mind to prioritize what is absolutely critical from
something that maybe is not.
Can you describe for me what I would say would be a tipping
point? Is there an event out there that you are anticipating
must, must happen to set up the line of defense, and if it does
not happen, all of a sudden it is the catalyst that things
really start unraveling and will be very hard to corral, if you
know what I am saying? Maybe I will start at this end.
Mr. Veron. Well, I would say two things. One is something
that would look like what Secretary Geithner suggested
apparently in his discussions with the European Finance
Ministers last weekend, which has been mentioned in this panel,
i.e., access to ECB liquidity for the EFSF. I think this could
be really something that would stabilize the market situation
enormously.
And on the banking side, a clear signal by euro zone
governments that they are ready for a truly European banking
system, for decoupling their national banking system from the
national sovereign. And this takes various dimensions. Some of
them are mentioned in my written statement, but I think it is
basically a political statement that the era of national
banking systems within the euro zone is over.
Mr. Fels. My answer is very similar. The EFSF changes have
to come through over the next 4 weeks. The EFSF has to be
leveraged up, so to increase its size by access to ECB funding.
And my last point is bank recapitalization has to happen. I
think that is crucial, and it can happen once the EFSF is
reformed and is larger. And as I said earlier, the bank
recapitalization, that is what I am watching.
Mr. Lombardi. I would say that over the next few weeks we
will be watching a possible escalation of the crisis in the
Italian bond markets, and this will come with an increasing
weakening of the several large financial institutions, European
financial institutions. And that could provide a tipping point
for really a quantum leap in the political debate that we have
been watching in Europe.
I think we have not reached that tipping point, and I think
once a systemic economy of the euro area comes under hit, this
will generate--this hopefully will generate a new perspective
in the political debate at the euro area level, and this
trigger, this tipping point, I think will come from
intensification and escalation of the crisis in Italy.
Mr. Foster. Senator, I think all of what my co-panelists
said I would agree with. I would only add that if Greece were
somehow denied its next tranche of help, that would certainly
be a major event. I do not expect that to happen. Europe will
find a way to rewrite its rules to make sure Greece gets the
money.
While I cannot tell you the date, I can give you a bit of
the timing--24 to 48 hours after we have an unpleasant,
unexpected event from some direction we were not anticipating,
something nobody was looking for that will so unsettle the
markets, that will trigger the contagion. I cannot tell you
what it would be. It could be a financial institution suddenly
finding that one of their traders committed $2 billion of bad
trades--UBS, for example. It may not be Greece. A Spanish
provincial government that suddenly decides, oh, we have been
running much larger deficits than we were telling the central
government, as we saw a few days ago.
Any one of these kind of events--a shock from an unexpected
direction--24 to 48 hours later the balloon is up.
Senator Johanns. Let me just say that was very, very
helpful testimony, and I really appreciate you taking time this
afternoon to work with us and give us your best thoughts on
this.
Senator Warner. Let me just add as well, this has been
sobering, but I think you have given us some of the markers. I
would love to--I am going to look through your testimony. Maybe
we can continue this conversation as we think as well about--we
have focused on the immediate, the intermediate, and longer-
term structural changes and how--not to be answered because we
have to break now--but how we in the United States can be
helpful to our European friends and allies in that process,
but, boy, oh, boy, anyone that denies the interconnectedness
that we are all in this together, I think that would--I would
hope they would listen to this presentation today. It has been
excellent testimony, and again, I thank my colleagues for
joining me in this.
Thank you, gentlemen, and with that the hearing is
adjourned.
[Whereupon, at 4:04 p.m., the hearing was adjourned.]
[Prepared statements and responses to written questions
supplied for the record follow:]
PREPARED STATEMENT OF NICOLAS VERON
Visiting Fellow, Peterson Institute for International Economics, and
Senior Fellow, Bruegel
September 22, 2011
Thank you Chairman Warner, Ranking Member Johanns, and
distinguished Members of the Subcommittee for the invitation to appear
at today's hearing. The European crisis is entering a critical phase as
policy initiatives undertaken so far have not prevented systemic
contagion. I will concentrate my remarks on the role of Europe's
banking system in the crisis, the steps needed at the European level
for the crisis to be resolved, and the short-term outlook.
I currently work both at Bruegel and the Peterson Institute, on a
half-time basis in each organization, and divide my working time
between Europe and the United States. Bruegel is a nonpartisan policy
research institution that started operations in Brussels in 2005 and
aims to contribute to the quality of economic policymaking in Europe
through open, fact-based and policy-relevant research, analysis and
discussion. The Peter G. Peterson Institute for International Economics
is a private, nonprofit, nonpartisan research institution devoted to
the study of international economic policy. The views expressed here
are my own and not those of the Peterson Institute or Bruegel. I have
no financial or commercial interest that would create a bias or
conflict in expressing these views.
The key points of my statement are the following:
First, Europe's banking system has been in a continuous
stage of systemic fragility since 2007-08, in contrast with the
United States where banking crisis resolution was swifter and
was essentially completed in 2009. The inability of European
policymakers to resolve their banking crisis so far can be
explained by deeply embedded features of their respective
countries' financial systems and political economy structures.
Second, the current phase, which is often described as a
sovereign debt crisis, is really a sequence of interactions
between sovereign problems and banking problems. Had Western
Europe's banks been in a better shape a year and a half ago,
the policy approach to the Greek debt crisis would have been
entirely different, possibly allowing for a much earlier
sovereign debt restructuring. So the situation is best
described as twin sovereign and banking crises that mutually
feed each other. The result of this interaction is a gradual
contagion to more countries and more asset classes.
Third, the crisis has exposed a major deficit of executive
decisionmaking capability in the EU and Eurozone institutional
framework, which helps to explain the insufficient policy
response. It can thus be said that the banking and sovereign
crises are compounded by a crisis of the EU institutions
themselves. Specialized European bodies, primarily the European
Central Bank (ECB), have partly bridged this gap with policy
initiatives that go beyond a narrow reading of their mandate,
but they could do so only to a limited extent that has not been
sufficient to stop the contagion.
Fourth, a successful crisis resolution will need to include
at least four components at the European level, in addition to
steps to be taken by individual countries: (a) fiscal
federalism, i.e., mechanisms that ensure that fiscal policies
in the Eurozone are partly centralized with shared backing
across countries so as to meet the requirements of monetary
union; (b) banking federalism, i.e., a framework for banking
policy at the European level that credibly supports the vision
of a single European market for financial services; (c) an
overhaul of EU/Eurozone institutions that would enable fiscal
and banking federalism to be sustainable, by allowing
centralized executive decisionmaking to the extent necessary
and by guaranteeing democratic accountability; and (d) short-
term arrangements that chart a path toward the completion of
the previous three points, which is bound to take some time.
These should involve expanded instruments to intervene in the
banking sector and to provide interim funding to struggling
Eurozone governments, taking into account the possibility of
insolvent member states having to undergo debt restructuring.
Fifth, these requirements for crisis resolution cannot be
met unless political conditions change sharply in their favor.
This leaves the United States exposed to a risk of financial
contagion, which it can partly mitigate with adequate
contingency planning and proportionate precautionary measures.
The United States can and should also continue to play a
constructive role by providing advice to its European partners,
and thus helping them rise to the momentous challenges they
face. However, only the Europeans themselves can solve their
current predicament.
I would not want these remarks to sound unduly pessimistic. In the
U.S. public debate, one frequently hears the Eurozone described as an
inherently unsustainable experiment, and European nations as incapable
of reform. Such dark depictions of the European situation are unhelpful
and misleading. European monetary union is certainly an experiment, but
it is not doomed to fail: Eurozone countries have shown and are showing
an extraordinary degree of political commitment to perpetuate their
currency union. They have already taken very significant institutional
steps toward more centralized economic and financial management since
the beginning of the crisis, and are gradually accepting the need for
further steps, even though the process is not as swift as external
observers might wish it to be. Most Eurozone periphery countries have
taken very serious and painful initiatives to reform and place
themselves back on a sustainable economic track. And elections in many
European countries since the start of the crisis have shown that the
vast majority of citizens resist the temptation of populism and are
willing to embrace the needed adjustment policies.
I personally believe that the integrity of the Eurozone will be
defended in this crisis and that the EU will eventually emerge from it
with a stronger, more resilient economic and financial policy
framework. But I also expect the road to be very bumpy, and that the
Europeans will pay a high economic price for the inadequacies of their
collective decisionmaking processes.
The rest of this statement expands on these points and provides
additional background.
Europe's banking crisis
Europe has been in a continuous state of systemic banking fragility
since August 2007. This puts it in contrast with the United States
where the phase of systemic banking crisis ended in 2009, even though
the broader economic crisis has proved difficult to address and casts a
shadow on America's long-term fiscal outlook. One indication of
Europe's prolonged state of fragility is that the ECB's extraordinary
liquidity support to Eurozone banks (in the ECB's parlance, fixed-rate
full allotment in refinancing operations), introduced in October 2008,
remains in place to this day. By contrast, the closest comparable
program on the U.S. side, the Federal Reserve's Term Auction Facility,
was gradually phased out and expired in March 2010. Similarly, in
October 2008 the European Commission's Directorate-General for
Competition Policy (DG COMP) made its enforcement practices on the
control of State Aid to the banking sector more flexible on the basis
of Article 87.3b of the European Community Treaty, which allows for aid
``to remedy a serious disturbance in the economy of a member state.''
This adaptation of competition policy to crisis times has been
continuously in place since then, and European Commissioner for
Competition Policy Joaquin Almunia recently announced that it would
remain so until early 2012 at least.
In comparison with the United States, the European banking sector
has until now gone only through modest restructuring as a consequence
of the crisis, particularly in the Eurozone. Among major European
financial institutions, only Halifax Bank of Scotland (HBOS) in the
United Kingdom (U.K.) and Fortis in the Benelux countries were
dismantled or forcibly merged into competitors at the height of the
crisis, in comparison to Countrywide Financial, Bear Stearns, Lehman
Brothers, American International Group, Washington Mutual, Wachovia and
Merrill Lynch which were merged or restructured in the United States.
Moreover, the U.S. bank receivership process administered by the
Federal Deposit Insurance Corporation meant that a significant number
of small- and medium-sized banks (and some large ones, such as
Washington Mutual) were allowed to fail. In Europe, where most
countries did not have an orderly resolution process for depository
institutions in 2008-09, senior creditors were made whole in almost all
cases of individual bank problems, and so were junior creditors in the
vast majority of cases.
In the spring of 2009, the U.S. Supervisory Capital Assessment
Program (commonly known as ``stress tests'') identified 10 of the
country's 19 largest financial institutions as undercapitalized, and
the subsequent wave of capital strengthening helped investors regain
trust in the institutions at the core of the U.S. financial system,
even as smaller banks continued to fail in large numbers in 2009 and
2010. In the EU, no similar process of triage and recapitalization was
conducted in time to restore confidence. A first round of European
``stress tests'' in September 2009 had negligible market impact as only
aggregate numbers, not bank-by-bank results, were published. A second
round of stress tests led to the publication of bank-by-bank results
for 91 financial institutions across the EU in July 2010, but the
disclosures lacked specificity and comparability, and some institutions
that had passed the tests, such as Allied Irish Banks, were exposed as
severely undercapitalized shortly afterwards. A third round of stress
tests led to better disclosures in July 2011, but identified only
limited recapitalization needs.
The European reluctance to accept bank failures and banking sector
restructuring can be traced to various factors. To start with, banks
are comparatively much larger in Europe than they are in America,
compared with the size of national economies and even after the
consolidation that the crisis has induced on the U.S. side. According
to the Bank for International Settlements, in 2009, the aggregated
assets of the top three banks represented 406 percent of GDP in the
Netherlands, 336 percent in the U.K., 334 percent in Sweden, 250
percent in France, 189 percent in Spain, 121 percent in Italy, and 118
percent in Germany, compared with 92 percent in Japan and ``only'' 43
percent in the United States. This is due to a combination of two main
factors. First, banks generally play a larger role of financial
intermediation in Europe than in the United States, where nonbank
financial intermediaries and capital markets provide a larger share of
total capital and credit. And second, many European banks have
aggressively expanded internationally, thus increasing the scope of
activities that, to the extent that these banks aren't allowed to fail,
are implicitly supported by taxpayers in the home country. On average,
the largest European banks have 57 percent of their activity outside of
their home country (in the rest of Europe and in the rest of the world
in about equal proportions), while the average ratio is only 22 percent
among a comparable sample of the largest U.S. banks.
Moreover, there is a high degree of interdependence between banking
systems and policymaking systems in most Western European countries.
This interdependence also exists in the United States, as my Peterson
Institute colleague Simon Johnson has repeatedly argued, and its
specific forms vary widely from one country to another. In Germany,
many locally elected officials sit on the boards of local public banks,
an activity from which they typically derive a not insignificant part
of their personal income; publicly owned banks at regional (Land) and
sub-regional levels are often used as tools for local economic
development policy. In Spain, a similar situation used to exist with
the local savings banks (Cajas), even though this is now changing as
many Cajas are being merged and restructured under compulsion from the
central government. In Italy, non-profit foundations with strong links
with local political establishments are key shareholders in most
prominent financial institutions. In France, the regional component is
perhaps less strong but at the national level, financial policymakers
and bank executives tend to come from the same small pool of senior
civil servants, and it is common practice for the former to switch to a
high-level bank position at mid-career. In all these countries and
elsewhere in Europe, this interdependence is a significant factor in
the national political economy.
Moreover, the protection granted by national governments to their
``home'' banks does not have to be a function of cozy links between
public and private-sector elites, as there is also a strong component
of economic nationalism at play. In most Eurozone countries, banks are
frequently seen as national or local ``champions'' whose prosperity is
presumed to be broadly aligned with the national interest--even where
this presumption does not rest on specific, compelling evidence.
Resistance to cross-border bank takeovers remains deeply entrenched
particularly in France, Italy and Spain but also in parts of Northern
Europe--even though the ongoing restructuring of the Spanish banking
sector might eventually result in a change in attitudes there. The same
factors help explain why national policymaking communities are often in
collective denial of the moral hazard created by the too-big-to-fail
problem, as well as in denial of the conflicts of interest that are
potentially embedded in the universal bank model which combines retail
banking, investment banking, plus in many cases asset management,
insurance activities, and proprietary investment within diversified
financial conglomerates. In many Continental European countries,
supervisory authorities harbor a culture that favors keeping sensitive
information tight between themselves and the supervised entities, and
are thus inclined to resist calls for public disclosures about
financial risks and exposures, as was illustrated by controversies
around the successive rounds of European stress tests.
Banking crisis and sovereign crisis
The financial crisis spilled over into a sovereign crisis in the
Eurozone in early 2010. A year before, in the first months of 2009, the
tense situation of several Central and Eastern European countries had
raised widespread market concerns, but was subsequently stabilized
thanks to energetic efforts of economic reform and budget tightening,
most remarkably in the Baltic countries, and to successful
international coordination in the form of the so-called Vienna
Initiative to maintain liquidity to local banking systems. The Eurozone
sovereign crisis started when the Government of Greece, freshly elected
in October 2009, revealed that its predecessor had misled its Eurozone
neighbors and the public about the true state of the country's public
finances. The ensuing deterioration of Greece's access to capital
markets led it to seek help from fellow Eurozone countries and the
International Monetary Fund (IMF), resulting in the May 2010
announcement of a first conditional assistance package of EUR110bn,
quickly followed by the decision to set up a European Financial
Stabilisation Facility (EFSF) with EUR440bn financial firepower to
intervene in similar situations. Simultaneously, the ECB initiated a
``Securities Markets Programme'' under which it buys sovereign debt of
troubled countries in secondary markets. Subsequently, the EFSF and IMF
jointly agreed to provide conditional assistance packages to Ireland
(November 2010) and Portugal (April 2011), and in July 2011, further
assistance to Greece was decided by the Eurozone heads of state and
government.
The interdependence between sovereign credit and banking systems
has been a running theme of this sequence of events. Eurozone sovereign
debt assets are held in large amounts by Eurozone banks, with a
significant bias for the bonds of the country in which the bank is
headquartered but also significant cross-border exposures to other
Eurozone countries' sovereign debt. This is partly due to policy
choices before the crisis which in retrospect appear questionable,
particularly the risk-weighting at zero of Eurozone sovereign bonds in
regulatory capital calculations, the longstanding acceptance of such
bonds with no haircut by the ECB as collateral in its liquidity
policies, and possible instances of moral suasion by home-country
public authorities that resulted in large holdings of the home
country's sovereign debt. In early 2010, the concern about the possible
financial stability consequences for banks in France, Germany and other
countries of having to book losses in the event of a Greek debt
restructuring was a significant motivation for the decision to provide
financial assistance to Athens. Even though it is impossible to know
counterfactuals, had the Western European banking sector been less
fragile at that time, it is very possible that a different course would
have been taken involving Greek debt restructuring as early as 2010,
and everything afterwards would have developed very differently. Put
bluntly, the moral hazard created by the Greek package is largely a
consequence of the failure or unwillingness of European policymakers to
resolve the European banking crisis in 2009.
Similarly, the perceived fragility of Continental European banks is
the main reason why the Irish Government was not allowed to impose
losses on holders of senior bonds issued by the country's banks,
including the collapsed Anglo Irish Bank, in the discussion of the
November 2010 assistance package provided by the IMF and the EFSF, with
a strong involvement of the ECB in the negotiation of that package.
This condition correspondingly increased the burden of fiscal
adjustment for Ireland and remains to this day a matter of controversy
in the Irish political environment. Conversely, deterioration of
sovereign debt prospects in Greece, Portugal, and Italy has had a
knock-on negative effect on their domestic banking systems, given local
banks' high levels of home-country sovereign debt exposure, as well as
on French banks which hold large portfolios of sovereign debt from the
Eurozone's periphery countries.
In the latest step to date, a relatively mild debt restructuring
scheme euphemistically known as ``private sector involvement'' (PSI)
was made a condition for the new assistance package to Greece whose
outline was announced on July 21st, 2011, largely because of domestic
political factors in countries including Germany and the Netherlands.
However, the continued banking fragility led leaders to go for a
``voluntary'' form of PSI that would only entail moderate impairment of
the affected assets. This arguably results in the worst of both worlds
for Greece and the Eurozone: a further deterioration of Greece
creditworthiness (PSI being considered ``selective default'' by the
main credit rating agencies) and contagion to other Eurozone countries,
in spite of solemn declarations that the Greek case is unique and would
not be used as a template for other country situations; and
simultaneously, a reduction of the Greek debt burden that is too
limited to significantly improve its debt dynamics.
The interconnectedness between the banking and the sovereign crises
helps to explain the lack of consensus about the current capital
strength of Europe's banks. The official position of EU authorities and
all Eurozone governments remains that, with the possible exception of
Greece, Eurozone countries are not going to default on their sovereign
obligations. Under this assumption, the current depressed market prices
of periphery countries' debt need not be reflected on the balance
sheets of banks with large held-to-maturity portfolios of such debt,
and the European banking sector would appear adequately capitalized as
a whole. If, however, market signals are taken at face value, or simply
if a prudential approach is applied that compels banks with high
exposures to periphery sovereigns to hold sizable additional capital
buffers, the average level of capital strength appears seriously
insufficient. Thus, the solvency assessment of Europe's banks crucially
depends on the view one has of the seriousness of the sovereign crisis.
The rapidity of contagion, which extended to Italy in July and to
French banks in August, suggests a conservative attitude is warranted,
as the IMF is also arguing in its latest Global Financial Stability
Report.
A crisis of EU institutions
This sequence of events highlights that European policymakers
missed an important opportunity when they neglected to address their
banking sector's fragility decisively when market conditions were
relatively favorable in 2009, especially after the success of the U.S.
Supervisory Capital Assessment Program. This failure is not for lack of
good advice: the IMF, among others, had emphasized this challenge in
its policy recommendations to European leaders. Had this advice been
taken, and had Greek debt been adequately restructured in the first
half of 2010, we would probably not have a major systemic crisis in
Europe.
In decisions taken after May 2010, and until now, European leaders
have often appeared to be behind the curve, and to react to the
crisis's previous stage rather than to the current one. The European
Commission, with the significant exception of DG COMP (the European
Commission's Directorate-General for Competition Policy), has not been
able to make executive decisions that it could impose on individual
market participants. Its Directorate-General for the Internal Market
and Services (DG MARKT) has focused on drafting new financial
legislation but has devoted limited resources to its core mission of
enforcing the integrity of the single market for financial services.
Its Directorate-General for Economic and Financial Affairs (DG ECFIN)
has provided valuable economic analysis, but so far has not presented a
blueprint for crisis management instruments that would bring the
situation under control. The Commission's President, Jose Manuel
Barroso, has been very successful and proactive on one important
occasion, when he commissioned a report from a blue-ribbon group led by
former French central banker Jacques de Larosiere, which resulted in a
major overhaul of the EU's supervisory architecture (see below). But in
terms of crisis management, the Commission has generally not been able
to get ahead of events, partly because of its limited de facto
decisionmaking autonomy vis-a-vis member states (apart from DG COMP,
which enjoys special status). This has left much of the action in the
hands of the Council, i.e., the group formed by relevant
representatives of the individual member states' governments, who,
being accountable as they are to their respective national
constituencies, have found it difficult to overcome their differences.
This is better analyzed as a failure of institutions than of
individual leaders. A different set of political leaders might have
done better, but the core problem has been the insufficient political
mandate of the Commission (and of the permanent president of the
Council since the entry into force of the Lisbon Treaty in January
2010, Herman Van Rompuy), combined with the misalignment between the
incentives of individual countries' leaders and the collective European
interest. This combination works more or less satisfactorily in
ordinary times, but its shortcomings become much more apparent in a
crisis environment as it does not allow for effective executive
decisionmaking at the EU level. The ``French-German couple'' is
occasionally presented as a pragmatic option to bridge the executive
leadership gap, but its accountability and legitimacy have been
insufficient to provide the required impetus.
In the course of the crisis, individual EU bodies have occasionally
found it possible to bridge part of the executive leadership gap. This
has been most obviously the case of the ECB, particularly since May
2010 with the Securities Markets Programme of buying sovereign bonds
from selected Eurozone countries on the secondary markets. However, the
extent to which the ECB can go further on this path is not
unconstrained, because it is seen by a number of constituents (notably
in Germany) as a dangerous intrusion into fiscal policy that is bound
to compromise the ECB's independence and its integrity in delivering on
its core mission of ensuring price stability. Similarly though less
prominently, since 2008 DG COMP has leveraged its authority to examine
state aid by individual member states to individual financial
institutions to press for more aggressive recapitalization of the
weaker links in Europe's banking system, but its mandate has not
allowed it to embark on a system-wide approach.
As mentioned above, a high-level group led by Jacques de Larosiere
was formed in late 2008 at the initiative of the European Commission's
President, and in February 2009 this group recommended the creation of
three European Supervisory Authorities to help oversee Europe's
financial sector from a pan-European perspective--respectively, the
European Banking Authority (EBA) based in London, the European
Securities and Markets Authority (ESMA) based in Paris, and the
European Insurance and Occupational Pensions Authority (EIOPA) based in
Frankfurt. These supervisory authorities were complemented by the
creation of a European Systemic Risk Board (ESRB) to coordinate
macroprudential policy. The corresponding EU legislation was (by EU
standards) swiftly approved and the new institutions officially started
operations on January 1, 2011. Even though it is still early to form a
judgment, the EBA has had a material impact in making the disclosures
accompanying the July 2011 stress tests markedly more reliable than had
been the case in the previous round a year earlier. Thus, it can be
hoped that these new agencies can bridge part of the leadership gap in
the future as they gather institutional strength. However, as with the
ECB and DG COMP, their mandate is limited and cannot be overextended to
matters that entail major dimensions of political legitimacy and
accountability.
The European Parliament has been gaining competencies in successive
revisions of the European treaties, and is now an important player in
shaping legislation. However, its oversight powers on the EU
institutions, especially the Council, remain restricted in comparison
to most national parliaments. Moreover, the European Parliament, unlike
lower houses in democratic regimes, is not elected on the basis of
electoral constituencies of about-equal demographic weight, as smaller
EU member states elect more Members of the European Parliament (MEPs)
than larger ones in proportion to their population. These shortcomings
have led Germany's Federal Constitutional Court, in a landmark ruling
in June 2009, to find the EU institutions not democratic enough to be
granted powers in key areas of sovereignty, including fiscal policy.
In the words of the Court, ``With the present status of
integration, the European Union does, even upon the entry into force of
the Treaty of Lisbon, not yet attain a shape that corresponds to the
level of legitimisation of a democracy constituted as a state. ( . . .
) Neither as regards its composition nor its position in the European
competence structure is the European Parliament sufficiently prepared
to take representative and assignable majority decisions as uniform
decisions on political direction. Measured against requirements placed
on democracy in states, its election does not take due account of
equality, and it is not competent to take authoritative decisions on
political direction in the context of the supranational balancing of
interest between the states. It therefore cannot support a
parliamentary government and organise itself with regard to party
politics in the system of government and opposition in such a way that
a decision on political direction taken by the European electorate
could have a politically decisive effect.'' This ``structural
democratic deficit'' (also in the words of the Court) is a fundamental
impediment to building up an effective executive capability at the EU
level.
Conditions for crisis resolution
The design flaws of the Eurozone, including the lack of a federal
fiscal and banking policy framework and the democratic deficit of EU
institutions, had been well identified by analysts at the time the
Maastricht Treaty was signed in 1991. However, this did not prevent the
euro from being introduced in 1999 and from having what can fairly be
described as a highly successful first decade, ostensibly disproving
its doubters' warnings. Similarly, the same shortcomings need not be
fatal now if individual member states succeed in bringing their
sovereign finances, their banking systems and their economies back on a
sustainable track. However, the unfavorable global economic environment
and loss of investor confidence during the sequence of events so far
make it unlikely that the crisis can be overcome without meaningful
progress in addressing fundamental weaknesses in the European
institutional framework.
Structural reforms that favor entrepreneurship and enhance the
economy's growth potential, fiscal adjustment, and bank restructuring
are required at the level of individual member states. They are an
indispensable dimension of any successful crisis resolution. They vary
from one country to another and their elaboration would require detail
beyond the scope of this testimony. At the European level, the
necessary steps can be (rather simplistically) summarized into four
components: (a) a consistent federal Eurozone framework for fiscal
policy (fiscal federalism); (b) a consistent federal Eurozone/EU
framework for banking policy (banking federalism); (c) a general
overhaul of the EU's political institutions that would upgrade their
executive decisionmaking capability; and (d) adequate short-term crisis
management arrangements to bridge the time gap between the present
turmoil and an ultimate crisis resolution that would include the
previous three components.
The first component, fiscal federalism, already exists in Europe in
indirect forms, including the borrowing capacity of the European
Commission and the European Investment Bank (which are however tightly
limited) and the collateral policy of the ECB, which allows it to take
risks with an ultimate guarantee from member states. A further
tentative step was taken in the direction of building a Eurozone fiscal
federation with the creation of the EFSF, even though its design is
strictly intergovernmental, and the decision to provide loans to
struggling Eurozone countries at below-market rates. However, none of
this prevents the possibility of fiscal or economic mismanagement or
financial shocks in individual member states putting the stability of
the entire monetary union at risk, as is now the case.
A vivid debate in Europe centers on the possible practical form of
such fiscal federalism. One much-discussed proposal, by my Bruegel
colleagues Jacques Delpla and Jakob von Weizsacker, would have Eurozone
members pool debt issuance up to 60 percent of their respective GDP in
the form of Eurozone-wide ``blue bonds,'' and meet any additional
funding needs through higher-yielding ``red bonds'' that would instill
market discipline at the level of individual countries. Another option,
typically referred to as ``Eurobonds,'' would be to federalize all
sovereign borrowing in the Eurozone under a joint and several guarantee
from all Eurozone countries. A more limited approach, first suggested
by Daniel Gros at the Centre for European Policy Studies and Thomas
Mayer at Deutsche Bank, would be to allow the EFSF to leverage its
current resources and vastly expand its lending capacity by allowing it
to borrow from the ECB. All these proposals imply new mechanisms to
discipline the economic policy behavior of individual member states and
mitigate the moral hazard inherent in any pooled borrowing scheme.
In a landmark speech in Aachen on June 2, 2011, ECB President Jean-
Claude Trichet has outlined what he sees as the necessary next steps:
in a first step ``in the medium term,'' giving the European Council, on
the basis of a proposal by the European Commission and in liaison with
the ECB, the right to veto national economic policy decisions that may
be harmful to Eurozone stability; and in a second step, ``in the
historical long term,'' establishing a European ``ministry of finance''
that would exert ongoing surveillance of both fiscal policies and
competitiveness policies, that could take over direct responsibility
for economic policy in failing countries, and that would also exert
responsibilities in financial sector policy and external
representation. Even though he did not specify how this intrusive
authority could be legitimized from a political standpoint, this vision
emphasizes the need for executive decisionmaking capacity at the core
of the future fiscal federal framework, as not all future policy
challenges can be captured in a set of ex ante rules and automatic
sanctions, no matter how well designed.
The second component of eventual crisis resolution, banking
federalism, also exists in embryonic form in the EU, with a largely
though not completely harmonized banking regulatory framework in the
form of EU financial legislation, and the recently created EBA which
was endowed with limited supervisory and crisis management
competencies. Even so, however, most supervisory and resolution
authority still rests with member states, and so does a still
significant amount of rulemaking that affects financial institutions,
on conduct of business and consumer protection but also on prudential
aspects as is illustrated by the current debate about the
recommendations of the Independent Commission on Banking (or Vickers
Commission) in the U.K.. Member states provide the guarantee for
deposits, even though the modalities are harmonized under EU
legislation, and only the member states have the fiscal capacity to
intervene with equity or capital-like instruments in a crisis situation
(even though liquidity policy in the Eurozone is mainly conducted by
the ECB, and the ECB also has a say over additional liquidity
assistance that may be provided by the Eurozone's national central
banks beyond its own operations).
A European banking policy framework would imply the consistent
formulation and implementation of regulatory, supervisory, resolution,
deposit guarantee, and competition policies with regard to the banking
industry throughout the EU. Compared with the present situation, this
would entail at least four steps:
The EBA should be granted supervisory authority over all
credit institutions in the Union, which it would exercise
either directly (specifically, over the central operations of
banks with a pan-European scope) or indirectly (by delegating
it back to national agencies, over banks that are only active
in one country, or over local operations of pan-European
banks);
The EBA's own governance should be overhauled so as to
ensure its decisionmaking is better aligned with the European
public interest (the current decision framework involves
single-majority voting by representatives of the 27 EU member
states, which can lead to massively skewed outcomes because of
the disproportionate influence of smaller countries);
The EFSF should provide an explicit guarantee of national
deposit guarantee schemes in all countries in the Eurozone, in
order to prevent bank runs in the event of national sovereign-
debt difficulties;
Existing processes that allow member states to block cross-
border acquisitions of ``their'' banks should be dismantled or
brought under the control of European authorities.
The combination of these measures would have the effect of
``decoupling'' the banks from their national governments, putting an
end to the single major impediment to the formation of a genuine
European banking system, as opposed to a collection of national ones,
as an indispensable complement to monetary unification. These proposals
are broadly similar to the ones outlined by the IMF's then Managing
Director Dominique Strauss-Kahn in a speech in Brussels on March 19,
2010.
The third component of crisis resolution is the upgrading of EU
institutions, to enable them to support the federal frameworks for
fiscal policy and banking policy in a politically sustainable manner.
Essentially, this means bridging the current democratic deficit to a
sufficient extent that executive decisions can be legitimately taken in
these policy areas at the European level and not only at the national
one. This cannot be achieved without significant changes in the EU
treaties. One aspect has to be the correction of the design flaws
identified by Germany's Federal Constitutional Court in its above-
quoted 2009 ruling, namely the redefinition of the European
Parliament's electoral constituencies in order to ensure equal
representation of EU citizens, and enhanced oversight powers for the
European Parliament over the executive and budget functions of EU
institutions. Whether these measures would be sufficient to close the
democratic gap is debatable, and would obviously warrant further public
deliberation.
One additional layer of complexity is the tension between the
Eurozone perimeter and that of the EU as a whole. At this point, the
Eurozone comprises 17 of the EU's 27 member states, the outliers being
the U.K., Sweden, Denmark, and seven Central and Eastern European
countries (Bulgaria, Czech Republic, Hungary, Latvia, Lithuania,
Poland, and Romania). Some of these countries may move toward joining
the Eurozone assuming that the current phase of turmoil is overcome,
but this does not seem to be a likely prospect for the U.K., and
perhaps others. How the EU institutional framework can cohabit with
what U.K. Chancellor of the Exchequer George Osborne has memorably
termed ``the remorseless logic of monetary union that leads from a
single currency to greater fiscal integration'' among Eurozone
countries remains an open question. This is particularly true in the
area of banking policy, which is currently set at the EU rather than
Eurozone level, a fact that is reflected in the location of the
European Banking Authority in London. This tension may become
increasingly prominent in the years ahead.
Finally, the fourth necessary component of crisis resolution is to
manage the transition from now to the completion of a federal fiscal
and banking policy framework under reformed EU institutions, which,
even under extreme assumptions, is bound to take an extended period of
time, measured in years rather than months, to achieve. By definition,
these transition arrangements represent a more short-term concern that
needs to be addressed within the existing Treaty framework. Here too,
in addition to action at the level of individual member states, the
twin issues of banking crisis and sovereign crisis need to be
addressed.
A central role could be played by an instrument to be created on an
explicitly temporary basis, analogous to the Resolution Trust
Corporation (RTC) that brought about the resolution of the U.S. savings
and loan crisis in 1989-90. More than 2 years ago, in June 2009,
Bruegel and the Peterson Institute published an analysis in which Adam
Posen, now on the Monetary Policy Committee of the Bank of England, and
I suggested a blueprint for such a European RTC, or as we termed it
with reference to a German precedent a ``European Banking Treuhand.''
The role of this ad hoc entity would be to catalyze and steer the
necessary restructuring and cross-border consolidation of Europe's
banking sector, by identifying which institutions are undercapitalized
on a consistent basis across national borders, by taking over and
restructuring those that cannot find enough capital from arm's-length
sources, and by managing the corresponding assets and reselling them
when market conditions allow. In the context of the sovereign crisis,
this trust corporation could play an additional stabilizing role by
ensuring the orderly functioning of the banking system in countries
which undergo a sovereign debt restructuring. To fulfill its role, it
would require enabling legislation passed in emergency by all relevant
member states.
With a proper framework in place to manage banking emergencies on a
consistent, system-wide basis, the Eurozone could envisage energetic
debt restructuring in member states that cannot meet their obligations,
which I believe to be the case for Greece alone at this point. This
would send shock waves through the system but would also contribute to
a reduction of uncertainty. It would need to be backed by enhanced
liquidity assistance to other member states. The most likely option for
this in the short term is expanded intervention by the ECB, possibly
through the agency of a leveraged EFSF that would be granted access to
ECB liquidity. This appears to be what was recommended by U.S. Treasury
Secretary Timothy Geithner in his conversations with his European
colleagues last week. It is also the short-term solution that emerged
from a collective simulation exercise jointly hosted by the Peterson
Institute and Bruegel last week, on which my colleagues Guntram Wolff
at Bruegel and Ted Truman at the Peterson Institute have reported on
the two organization's respective Web sites. Our simulation suggests
that this could be compatible with the ECB's mandate under the existing
Treaty and that it could have a material impact in addressing market
contagion.
Short-term outlook and policy options for the United States
Spelling out these conditions for crisis resolutions underlines the
Herculean political challenges of their implementation. Treaty changes
that involve multiple referendums and also likely amendments to
national constitutions, including in Germany; the shift of core areas
of sovereignty from the national to the EU level; the definition of a
modus vivendi with non-Eurozone members within EU institutions whose
functioning would become dominated by Eurozone-only processes; and,
inevitably, the public acknowledgement of major policy failures in the
treatment of the crisis so far.
At this point, it appears very difficult to identify a reliable
path from here to there, and the short-term outlook is not the most
encouraging. Things are likely to get worse in Europe before they can
get better. In the current circumstances too many European citizens,
and too many of their leaders, remain in denial of their collective
predicament, which prevents necessary initiatives from being
undertaken. This means that contagion may spread further in the very
short term.
This, however, remains a crisis for the Europeans to resolve.
Europe's international partners can help, but cannot take their place
to fix the situation. The Eurozone as a whole is not in a state of
financial distress. Its aggregate debt and deficit metrics compare
favorably to the United States, U.K., or Japan.
The IMF has played a very constructive role since the beginning of
the crisis. Beyond the financial assistance it has provided to Greece,
Ireland and Portugal, it has brought invaluable experience and
technical input to the discussion among Europeans. The U.S. Government,
together with other non-European countries, has provided pointed advice
at critical moments. But none of these external partners of Europe can
unlock the key bottlenecks in the current phase, which are primarily
political in nature.
Financial contagion to the United States from further deterioration
in the Eurozone cannot be ruled out. In spite of the recent downgrading
by Standard and Poor's, U.S. sovereign debt retains safe haven status
and I do not expect this to change in the short term, including in the
case that things would take a sharp negative turn in Europe. However,
because of multiple financial interdependencies across the Atlantic,
deterioration in Europe could have financial impact in the United
States. These transatlantic contagion risks can be mitigated to an
extent by appropriate contingency planning and enhanced dialog between
financial supervisory authorities in the United States, on the one
hand, and the U.S. arms of European financial firms, as well as U.S.
financial firms with financial exposure to Europe, on the other hand.
Under the current circumstances, the United States should not overreact
and financially ring-fence itself from the rest of the world to an
extent that would compromise global financial integration from which
the United States is one of the key beneficiaries. Thus, precautionary
measures are warranted but should remain proportionate. This seems to
be the current mindset of U.S. financial authorities.
The Federal Reserve is also participating, together with others of
the world's prominent central banks, in a network of currency swaps
with the ECB that facilitates the access of Eurozone banks to liquidity
in dollars and other non-euro currencies. The benefits of this
initiative in terms of financial stability, at the global level and
also from the strict domestic point of view of the United States,
appear to vastly exceed the risks involved to the Federal Reserve.
The United States, the IMF and others global partners have an
important role to play by providing advice and what John Maynard Keynes
called ruthless truth-telling to their European partners. Many
Europeans still find it difficult to acknowledge the extreme
seriousness of the current conditions in the Eurozone. Expressing
concern in constructive but frank terms can help, as Secretary Geithner
apparently did last weekend in Poland. But, once again, only the
Europeans themselves can meaningfully address their current, dangerous
situation.
______
PREPARED STATEMENT OF JOACHIM FELS
Global Head of Economics, Morgan Stanley
September 22, 2011
Introduction and Summary
1. The origins of the euro area's twin sovereign debt and banking
crisis include (i) a weak institutional framework with one
money but many nations; (ii) an oversized and undercapitalized
banking sector with high exposure to sovereign debt; and (iii)
diverging growth and competitiveness trends between euro member
countries, leading to large current account imbalances and a
buildup of debt in the deficit countries. The crisis was
exacerbated over the past eighteen months by a slow and
inadequate response to the Greek and the banking sector
problems, and more recently by the decision to involve the
private sector in the latest Greek bail-out package. A lasting
solution of the crisis requires bold reforms of the euro area's
institutional framework, including (i) a big step toward closer
fiscal union between member states with a (partial) loss of
fiscal sovereignty to avoid moral hazard, (ii) large-scale
recapitalization and restructuring of the banking sector, and
(iii) a central bank able and willing to serve as a lender of
last resort to member states in order to prevent self-
fulfilling `runs' on otherwise solvent sovereigns. Major
political and legal obstacles to such reforms imply that a
quick resolution of the crisis is unlikely. A deepening crisis
potentially involving a default by one or several members
states and, as a worst case, a break-up of the euro would have
severe adverse consequences for the U.S. and global financial
sector and economy.
The Origins of the Crisis
2. There are three key factors at the root of the current sovereign
debt and banking sector crisis in the euro area. First, a
unique institutional framework combining a single monetary
policy conducted by a central bank constrained by a narrow
inflation mandate with decentralized fiscal policy and
decentralized banking supervision in the 17 member states.
Second, an oversized, undercapitalized and fragmented banking
sector highly dependent on wholesale funding. Third, divergent
trends in growth and price competitiveness between member
states' economies, which led to large current imbalances within
the union and a buildup of debt in the deficit countries.
3. The most important of these three factors is the euro area's
peculiar institutional framework. One distinctive feature of
this framework is that while monetary policy is centralized,
individual member states have retained their fiscal
sovereignty. To prevent countries from running excessive fiscal
deficits, the Stability and Growth Pact (SGP), an inter-
governmental agreement that accompanied the move to a single
currency, set limits for individual countries' debts and
deficits and envisaged fiscal sanctions for fiscal sinners.
However, the SGP lacked teeth because the imposition of
sanctions always required a qualified majority vote by all
finance ministers (`sinners watching over sinners'), and
because the criteria were watered down further in 2003, when
the two largest countries, Germany and France, missed the
fiscal criteria and coalesced to change the goal posts.
Moreover, the Treaty regulating monetary union contains a `no
bail-out' clause, stating that no member country can be forced
to stand in for the debts of other members. At the same time,
the Treaty lacks a mechanism for orderly sovereign debt
restructurings and it does not provide for a mechanism to exit
the euro area. In fact, while a country may chose to exit the
euro, there is no provision for excluding a non-compliant
member state. In summary, the euro area's institutional
framework has neither been able to prevent irresponsible fiscal
behaviour, nor does it provide a mechanism for an orderly
resolution once a fiscal position has become unsustainable--
either in the form of fiscal transfers or an orderly
insolvency.
4. To make matters worse, another distinctive feature of the euro
area's institutional framework is that the European Central
Bank is constitutionally banned from financing governments
directly, be it through direct loans or purchases of government
bonds at auction. This provision was enshrined in the Treaty
establishing monetary union to enhance the ECB's credibility as
an inflation fighter--the Treaty states price stability as the
ECB's primary mandate--and, in particular, to placate Germany's
fears of financing governments through the printing press,
which are rooted in the experience with hyperinflation in the
Weimar Republic of the 1920s and the experience of financing
two wars through the printing press. However, an important
consequence of this provision is that governments no longer
have a lender of last resort to turn to in case creditors
refuse to fund them at reasonable interest rates. Without
access to the printing press in extreme circumstances, there is
a risk of self-fulfilling `runs' on otherwise solvent
governments.
True, access to the printing press, if overused, can be
inflationary. But investors typically fear default more than
inflation, which is usually much slower to materialize and less
disruptive for the financial system than a default. The lack of
access to the central bank as a lender of last resort helps to
explain why investors treat countries with high debt in the
euro area as `credits' and thus differently from countries with
similarly high debt levels (Japan, U.K., U.S.) who, in
principle, have access to their central bank and are thus `true
sovereigns'.
Exacerbating Factors
5. While the three key factors above--a weak institutional
framework, an oversized and undercapitalized banking system,
and growing imbalances within and between euro area member
countries--have been at the root of the crisis, it was
exacerbated by a slow and inadequate policy response ever since
the Greek problems became apparent in late 2009. Delaying the
initial aid package for Greece until May of last year helped
spark contagion into Portugal and Ireland. Making the rescue
fund (the European Financial Stability Facility EFSF) a
temporary institution scheduled to expire in 2013 fueled fears
that default would become likely after the fund's expiration.
Including the principle of private sector participation in
post-2013 bail-outs into the blueprint for the post-2013
permanent rescue fund (the European Stability Mechanism ESM)
confirmed those fears. Failure to force banks to recapitalize
faster and more aggressively undermined both investor
confidence in the financial system and companies' and private
households' access to bank credit. Moreover, by breaking an
earlier promise and involving private investors in the latest
Greek bail-out package decided on 21 July 2011 through a
`voluntary' debt exchange, euro area governments sparked the
latest round of contagion into the Spanish and Italian bond
markets as the promise that `Greece is an exception' was not
deemed credible. In all these cases, domestic political
considerations in the face of widespread public opposition to
further bail-outs especially in Germany, the Netherlands and
Finland, prevented bolder and more timely steps. Rather than
blaming governments in these countries for delayed or misguided
decisions at the European level as many commentators do, we
view this outcome as the logical consequence of what we
identified as the most important underlying cause of the
crisis--the euro area's inadequate institutional economic
governance framework.
Options to Resolve the Crisis
6. A lasting solution of the crisis requires bold reforms of the
euro area's institutional framework--fiscal and monetary--as
well as banking sector recapitalization and restructuring.
Fiscal reform should include two elements. First, a fiscal
transfer mechanism or insurance scheme that provides a backstop
for governments unable to fund in the market at reasonable
interest rates. Second, a (partial) transfer of member states'
fiscal sovereignty to a European authority to avoid
irresponsible fiscal behaviour.
7. Second, to prevent self-fulfilling runs on otherwise solvent
sovereigns, the euro area needs a central bank able and willing
to serve as a lender of last resort to member states in
exceptional circumstances. To some extent, the ECB has assumed
this role in the current crisis by buying government bonds of
Greece, Portugal, Ireland and, more recently, Spain and Italy
in the secondary market. However, the amounts purchased have
been relatively small and the ECB is constitutionally barred
from buying bonds directly at auction.
8. Third, to break the negative feedback loop between the sovereign
crisis and the banking sector crisis, banking regulators should
push for a large-scale recapitalization program including both
private sector and EFSF involvement.
9. There are major legal and political obstacles to bold and far-
reaching reforms of the euro area's fiscal and monetary
framework. These reforms would require a change in the Treaty
of Europe, which would have to be ratified in all national
parliaments and would, in several countries require popular
votes. Past experience with Treaty changes suggests that this
could take several years. Yet, without such reforms, the euro
area's sovereign debt crisis is unlikely to be solved. As a
consequence, it is safe to assume that the crisis will continue
in the foreseeable future and probably deepen further.
Implications for the U.S. and Global Financial Sector and Economy
10. A deepening crisis potentially involving a default by one or
several members states and, as a worst case, a break-up of the
euro would have severe adverse consequences for the U.S. and
global financial sector and economy. First, higher funding
costs for the public and private sector, fiscal austerity
measures and banking sector stress suggest that the euro area
economy will broadly stagnate in the foreseeable future, with
many Southern member countries including Italy and Spain
experiencing a renewed recession. Thus, European import demand
looks set to slow, which will dampen U.S. and other regions'
export growth. Second, a deepening European crisis is likely to
push the euro exchange rate lower versus the dollar and other
currencies, which will also hurt U.S. and other exports to
Europe. Third, while U.S. banks, in general, are viewed as
stronger in terms of capital, liquidity and asset quality than
their European peers, the European crisis has contributed,
alongside global growth concerns, to higher funding stress and
a higher cost of capital in the United States and elsewhere.
______
PREPARED STATEMENT OF DOMENICO LOMBARDI \1\
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\1\ I am grateful to, but do not wish to implicate, Karim Foda and
Sarah Milsom for excellent research assistance.
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President, the Oxford Institute for Economic Policy and Senior Fellow,
the Brookings Institution
September 22, 2011
Chairman Warner, Ranking Member Johanns, honorable Members of the
Subcommittee, thank you for this opportunity to share my views with you
on the euro-area crisis and its implications for the United States.
I have organized my remarks as follows: in the first section I
elaborate on the origin of the crisis and provide a basic chronology of
the main events until the downgrade by Standard & Poor's of Italy's
sovereign bonds on Monday. In the following section, I focus on the
policy response, highlighting the many gaps that still persist and
proposing a multi-pronged strategy consisting of immediate as well as
short- and medium-term measures. Finally, in the last section, I focus
on the implications for the U.S. economy and elaborate on the
diplomatic and institutional levers that the United States can mobilize
to affect current developments in Europe.
Origins
What started in the fall of 2009 as a fiscal crisis in a smaller
European economy--Greece, accounting for just 2 percent of the total
area's GDP--has evolved into a systemic crisis of the euro-area itself.
This crisis now threatens not just to melt down one of the world's
major economies, but to destroy the social and political fabric that
several generations of European political leaders have laid down with
the unwavering friendship of the United States since the end of WW II.
In October 2009, when Greece's newly elected Socialist government
revised the estimate for that year's budget deficit from 6.7 percent of
GDP up to a whopping 12.7 percent of GDP, and then further revised to
above 15 percent, credit-rating agencies began downgrading Greek bonds
while investors faced increasing concerns about the country's high debt
and about allegations that the Greek government had altered official
statistics so as to enable spending beyond the country's means (Tables
1 and 2).
In May 2010, a loan agreement between the euro-area countries, the
IMF, and the Greek government was announced in the amount of EUR110
billion, of which EUR80 billion would be financed by the euro-area
countries and EUR30 billion by the IMF.
The inertia from the euro area in assembling a stabilization
program for Greece until almost the middle of the following year
focused market investors and analysts on the vulnerabilities of other
countries sharing the single European currency. A few months later,
Portugal and Ireland had to request a stabilization program from the
IMF and the EU.
Following intense economic and financial pressures, triggered by a
critically weakened banking sector in Ireland, public finances were
weighed down by a deep fiscal deficit as a result of commitments to
bank support. In late November 2010, an agreement was reached between
the IMF, the EU, and the Irish authorities on a policy package of EUR85
billion for the period 2010-2013, of which EUR22.5 billion would be
funded by the IMF.
Portugal was the third member of the euro area to seek assistance
from the IMF and the EU. Its long-standing structural problems--
including low productivity, lack of competitiveness, and high
unemployment--had severely undermined its growth, which averaged only 1
percent during the previous 10 years. The lack of growth, combined with
the impact of the global financial crisis, had resulted in a large
fiscal deficit and high levels of debt (Tables 1 and 2). The joint EU-
IMF financial package agreed for the period 2011-2014 was for EUR 78
billion, of which one third committed by the IMF.
Late this summer, market pressure on Italy escalated and the
spreads of its government bonds vis-a-vis the German Bund widened to
over 400 basis points--levels not seen since the introduction of the
euro (Table 13). As a result, the Italian authorities put forward two
supplementary budget plans in less than 2 months--the latter having
been approved by the Parliament only days ago. Soon afterwards, just
this Monday in fact, Standard & Poor's downgraded the country's
sovereign rating, keeping it on a ``negative outlook,'' which may
prompt a further downgrade over the coming weeks.
Other large sovereigns have also been affected. French government
bond spreads have risen vis-a-vis the Bund, albeit by far less than
Italy's. Last week, two large French banks were also downgraded on
account of their exposure to the distressed peripheral economies of the
euro area.
While interest rates on German government bonds have been
decreasing, it would be inaccurate to say that Germany has not been
affected by the euro-area turmoil. Following a strong rebound of 3.6
percent last year in the aftermath of the international financial
crisis, Germany's GDP growth will be subdued this year at an estimated
2.7 percent, and will further decline to 1.3 percent next year,
according to the data released by the IMF on Tuesday (Table 8).
The stabilization programs pursued by the economies in distress and
the fiscal retrenchment enacted by the rest of the euro area will,
moreover, increasingly affect the ability of German manufacturers to
export their products in the area. Compounded with increasing
uncertainty, this is likely to result, at the very least, in a slowing
down of the German GDP growth for the next few years--as a best-case
scenario and barring significant repercussions in its financial sector.
While the national governments are obviously primarily responsible
for the unfolding of the current events in Europe, the incomplete
architecture of the euro area has created unprecedented scope for
contagion by exposing each member of the monetary union--albeit to
varying degrees--to the vulnerabilities of the other members.
Italy is a case in point. While the sluggish growth of its economy
and the high-level (and increasing) public debt are not new phenomena,
the crisis of the peripheral economies has provided the trigger for
market investors to focus on the Italian economy's long-run ability to
service an increasing stock of public debt.
Coupled with the inexistence of a lender of last resort, market
expectations can rapidly become self-fulfilling in the euro area.
Options
The Policy Response So Far
As the Greek crisis reached its peak, the EU, concerned about
contagion risks within euro zone countries, came forward in May 2010
with a broad package of measures worth EUR500 billion to preserve
financial stability in the region. In addition, the IMF expressed its
aim to support such financing arrangements with an additional EUR250
billion, bringing the total amount of the ``safety net'' to EUR750
billion.
The European Council also established a special-purpose vehicle,
the European Financial Stability Facility (EFSF), which was
incorporated weeks later in Luxembourg, with the objective to provide
temporary financial assistance to euro-area partners. The EFSF became
fully operational on August 4, 2010, and is designed to operate for 3
years.
It is authorized to issue bonds and/or other debt instruments on
the market, with the support of the German Debt Management Office
(DMO). Issues are to be backed by guarantees from euro-area countries,
for a total amount not to exceed EUR440 billion. In September 2010,
EFSF bonds were assigned the top credit rating (AAA) by rating
agencies. EFSF debt instruments can be used as collateral in
refinancing operations through the European Central Bank.
The EFSF is not a preferred creditor along the lines of the IMF.
Its claims on a particular country have the same standing as any other
sovereign claim. If too many creditors were granted preferred status,
private investors would be reluctant to offer loans to the country
concerned.
The EFSF has a very lean structure, with a staff of only about a
dozen people, made possible because the German DMO and the European
Investment Bank both provide the EFSF support. The board of the EFSF is
made up of high-level representatives-Deputy Ministers or Secretaries
of State or director generals of national treasuries-from the 16 euro-
area Member States. Observers from both the European Commission and the
ECB also sit on the EFSF board, which is chaired by the EU's Economic
and Financial Committee Chairman.
The euro zone summit held on July 21, 2011 widened the EFSF's scope
of activity by allowing it to: i) act on the basis of a precautionary
program; ii) finance recapitalization of financial institutions through
loans to governments, including in non-program countries; and iii)
intervene in the secondary markets on the basis of exceptional
financial market circumstances and risks to financial stability, or on
the basis of a mutual decision by the EFSF Member States, to avoid
contagion.
Earlier on, at their summit on June 24, 2011, EU Heads of State and
Government had also decided that the EFSF may intervene in exceptional
circumstances in the debt primary market, in the context of a program
with strict conditionality. These amendments are still not operational
as they await approval by national legislatures. It is expected that
they may enter into effect sometime in October, at the earliest.
Meanwhile, a recent decision by the German Constitutional Court appears
to preclude the possibility that Germany will join the new permanent
crisis mechanism, the European Stability Mechanism, which EU Heads of
State and Government decided to establish on June 24 as a successor to
the temporary EFSF.
Moreover, earlier in the summer, euro-area leaders had agreed to a
follow-up program for Greece on the order of EUR100 billion, which also
awaits parliamentary approval. The German Parliament is expected the
program sometime in October. Uncertainty exists as to whether, under
what terms, and in what proportion the IMF might join such a program.
The European Central Bank Governing Council has taken extraordinary
measures in filling a political and institutional vacuum. In the period
from May 2010 to April 2011, the Eurosystem--the ECB and the euro-
area's national central banks--conducted open market purchases of
Greek, Irish, and Portuguese bonds for EUR78 billion through the
Securities Market Program (SMP).
Following escalating market pressures on Italy and Spain over the
summer, the Eurosystem reactivated the SMP by intervening for EUR80
billion as of September 16, 2011. Unofficial reports from trading desks
suggest that approximately 65 percent has been spent to buy Italian
government bonds, 30 percent to buy Spanish bonds, and the remaining 5
percent for Ireland and Portugal bonds. While the ECB has not disclosed
for how long it intends to continue the SMP, it is reasonable to assume
that it may plan to do so until the EFSF will be able to step in,
following ratifications of recent amendments noted above.
The ECB has also intervened to ease pressures on European banks in
the U.S. dollar funding market. At the end of June, the ECB extended
the liquidity swap arrangement with the U.S. Federal Reserve to provide
U.S. dollar liquidity to those banks unable to access the interbank
dollar market. Research conducted by Barclays Capital (Euro Money
Markets Weekly) reports that some European banks have recently been
using ECB dollar facilities.
Assessing the Policy Response
Admittedly, the institutional framework established at the outset
for the single European currency did not include a safety pillar such
as an EFSF-type mechanism. This is mainly a reflection of the
assumption, not fulfilled ex post, that subsequent to the introduction
of the euro, the overall stability of the euro zone would be
underpinned by a sustained convergence toward a unique policy process--
one that would go well beyond monetary policy and would be geared
toward macroeconomic stability. This expectation has not materialized,
as economic policies have diverged.
More than a year after the establishment of the EFSF, there are
still no emergency instruments for intervening in support of large
sovereigns, like Italy, should market pressure significantly escalate
in the coming weeks or months. Given that the EFSF has currently
committed some EUR175 billion--based on estimates from Barclays Capital
Research--of its EUR440 billion potential endowment, the remaining
EUR265 billion would be insufficient to ring-fence Italy, should it be
cutoff from markets.
In 2012 alone, the Italian Treasury will need to provision an
amount of, at least, EUR235 billion, excluding T-bills (Buoni Ordinari
del Tesoro). Assuming an approximately similar amount for 2013, this
implies that a hypothetical joint 2-year EU-IMF program would deplete
both the EFSF and the IMF. The resources of the latter were, as of
September 15, SDR246 billion (or about EUR290 billion) in terms of its
forward commitment capacity.
Oddly enough, if euro-area countries were to step up their
guarantees in any substantial way to make the EFSF a viable financing
instrument for large sovereigns, the contingent fiscal liabilities that
would arise for each euro-area member would increase proportionally by
a few percentage points of GDP. For France, this could entail losing
the AAA status.
In other words, in an attempt to stabilize Italy, France could make
itself more vulnerable. As a result, Italy, and other large sovereigns,
is currently exposed to self-fulfilling market runs against which there
are no safety net, unless the ECB were to monetize public debt, which
it is prevented from doing.
Against this background, an effective, credible, and comprehensive
response would need to rely on three pillars of emergency, short- and
medium-term measures.
i) First Pillar
In the immediate, the EFSF should be strengthened by implementing
the decisions already agreed upon by euro-area leaders during the
summer. Further reforms should also be introduced to step up the
decisionmaking, operational, and financial capabilities of the EFSF so
as to stabilize market expectations about the euro-area's immediate-
response firepower.
The EFSF suffers, in fact, from a number of limitations. Its
governance is symptomatic of a purely intergovernmental approach to the
management of the euro-area crisis, with lending decisions requiring
the unanimous approval of all the euro-area countries. Yet, one of the
key reasons for the current crisis is precisely the fact that markets
have very deep reservations about the credibility of a monetary union
run on the basis of an intergovernmental approach rather than a
federalist one.
As for its financial capability, the EFSF funds its lending
programs by issuing bonds guaranteed by its euro-area shareholders. As
a result, subscriptions to the EFSF's bond issuances cannot be taken
for granted in the case of a systemic crisis, where contagion to
otherwise healthy national financial markets is a serious possibility.
Even when the EFSF can borrow from markets, its financial capability is
severely constrained by the time lag needed to provision resources from
the markets.
As has been suggested, the possibility of acceding to a credit line
by the ECB would, instead, confer easy and timely access to funding,
would enable the EFSF to amplify its financial capacity by leveraging
on that funding, and would relieve the ECB of the role of crisis
lender, which is outside its mandate. Admittedly, uncertainty would
still persist against the lack of a lender of last resort, which would
be needed to stabilize large sovereigns with substantial refinancing
needs, should they be hit by a severe liquidity crisis.
Moreover, euro-area leaders and the Greek authorities would need to
establish the sustainability of any new follow-up program. The Greek
debt-to-GDP ratio is currently projected to reach over 140 percent;
under these conditions, it is simply impossible for the Greek economy
to return to a sound footing--all the more so given that monetary and
exchange rate policies are outside the control of the authorities.
A more extensive engagement by the private sector (i.e., ``orderly
default'') is required to decrease the ratio to a lower, sustainable
level. The enhanced EFSF could provide the resources to strengthen the
European banks that will have to write off part of the Greek debt.
As long as the Greek crisis is not credibly reigned in, uncertainty
will persist as to whether other euro-area economies may be stabilized,
regardless of the required efforts that their national authorities have
to implement.
ii) Second Pillar
In the short-term, the euro area would need to establish a
framework for pooling the fiscal sovereignty of euro-area members. This
would not need to result in a euro-area-wide finance ministry. Rather,
a centralized entity such as the European Commission should be allowed
to vet national fiscal policies or strategies on behalf of the euro
area as a whole and on the basis of commonly agreed-upon and binding
criteria.
In return, member countries could issue eurobonds, that is,
government bonds backed by a common, euro-area-wide guarantee, up to a
certain threshold, such as, for instance, 60 percent of GDP, as has
been suggested. Admittedly, the issuance of eurobonds alone, without
the safeguards afforded by the centralized vetting, would not stabilize
all euro-area countries.
For instance, with a debt-to-GDP ratio of 120 percent or EUR1.9
trillion in absolute value, Italy would still need to issue the upper
60 percent tranche of its debt under the current framework of
nationally guaranteed bonds. In other words, from Italy alone, there
would be almost EUR1 trillion in bonds floating with no euro-area
guarantee.
iii) Third Pillar
In the medium term, euro-area countries should establish a
coordinating framework that would go beyond fiscal policies by
encompassing macroeconomic and structural policies. In fact, this is
required to ensure that aggregate demand is sustained over time and
that national economies do not pursue policies that are inconsistent at
the euro-area level.
Along those lines, for instance, some euro-area economies like
Germany cannot expect to run a persistent surplus in their current
accounts while other economies of the area have to reduce their
aggregate demand and, therefore, their imports from Germany as well.
Accordingly, the latter could balance the reduced demand from the rest
of the euro area by expanding its own domestic demand. This would have
the advantage of supporting the rest of the euro-area economies that
would otherwise be facing substantial retrenchment for years to come.
Up to now, there has been no mechanism to balance current accounts
within the euro area. Germany has been able to accumulate consistent
surpluses, even greater than those of China in proportion to GDP,
without the restrictions of a compensatory mechanism provided by
exchange-rate appreciation, such as that in play during the 1970s and
1990s with the German mark. Because of this asymmetry, Germany
multiplied the benefits for its economy after the introduction of the
single currency, with current account balances consistently in surplus
and for the most part on the rise, reaching about 6 percent of GDP in
2010 (Table 9). During the 3-year period 2006-2008, the balance was
even greater, representing a historical high for Germany, at least with
respect to the last 40 years.
On the other hand, the current account balance with respect to GDP
of the euro area in general has hovered, on average, around zero over
the course of the past decade, without therefore generating any direct
pressure for a compensatory adjustment in the exchange rate of the
single currency. Never has this asymmetry been more evident than at the
height of the international financial crisis, when the German economy
benefited from a considerable increase in exports outside the euro
area. Over the course of 2010, taking advantage of a relatively weaker
euro--by 9 percent compared to the year before, in real terms--
manufacturing orders from beyond the euro area for German firms reached
their highest in a decade.
Implications for the United States
The U.S. exports goods to the euro area for approximately US$100
billion (Table 3) or a bit less than 10 percent of its total goods
exports (Table 6). They are mostly skewed toward Germany, France, and,
also, Italy. Flagging demand in Europe due to a gloomy outlook and
increasing uncertainty is likely to result in fewer exports, thus
increasing the fragility of the U.S. economic recovery.
From a financial standpoint, U.S. banks are exposed to the euro
area for US$2.7 trillion, largely reflecting claims toward France
(US$643 billion) and Germany (US$623 billion) (see Table 10). These
claims account for 29 percent of the United States total exposure to
foreign counterparts (Table 11). Exposure to France and Germany
accounts for 14 percent altogether of total foreign exposure (Table
11).
U.S. banks are also exposed to the U.K. for some US$2 trillion or
23 percent of their total foreign exposure (Tables 10 and 11). Exposure
to the peripheral economies under stress is modest--claims on Greece,
Ireland, and Portugal account for 3 percent of total foreign exposure
(Table 11).
Therefore, any significant impact to the U.S. banking system would
accrue through the largest euro-area sovereigns, once or if the crisis
becomes a fully blown systemic one. Accordingly, there is still an
important window of opportunity that the United States may use in
trying to stabilize the euro-area crisis.
While, of course, any resolution of the euro-area crisis ultimately
hinges on the European countries themselves, the United States can rely
on the following levers to affect the current developments.
i) Bilateral Relationships
Euro-area countries are traditional allies to the United States,
with whom the United States has developed longstanding diplomatic and
working relationships. The press has reported regular conference calls
and meetings between senior officials of the current administration and
their respective European counterparts.
The President has reportedly engaged European political leaders on
a regular basis. Perhaps it is not a coincidence that German Chancellor
Merkel publicly announced support for the first rescue program for
Greece in the spring of last year, following a conference call with the
U.S. president the very same day.
ii) The G-20
The G-20 played a pivotal role in the 2007-09 international
financial crisis. The Bush administration convened the first Leaders'
Summit in Washington in November 2008 (``Washington Summit'').
Subsequently, President Obama and other world leaders from the G-20
decided to hold regular summits and ``designated the G-20 to be the
premier forum for.[their] international economic cooperation''
(Pittsburgh Summit, September 2009). Yet, the G-20 has kept a
remarkably low profile in the wake of current developments in Europe,
mainly as a reflection of the hesitation of its continental European
members to involve the global G-20 forum on issues they consider
``internal.''
Regardless of whether the G-20 gets formally involved in the
European crisis, it could still fulfill a very important coordinating
role. In September 2009, the United States launched the Framework for a
Strong, Sustainable, and Balanced Growth. The rebalancing of global
demand through some large emerging economies' switching to a greater
extent to domestic sources for their economic growth becomes a more
urgent issue against flagging demand in Europe and the increasing
fragility of the U.S. economic rebound.
Today and in the next few days, the G-20 will meet at the margins
of the IMF and World Bank Annual Meetings. It is important that the G-
20 makes tangible progress on global rebalancing by the time of the
forthcoming summit in Cannes in early November. There is, however, a
sense that expectations should be low as progress may not materialize.
iii) The G-7
The G-7 has been increasingly active in the context of the European
crisis and has represented the international forum where Continental
European countries have exchanged views with other nations on the
developments unfolding in Europe. The longstanding, small network of G-
7 officials provides a more intimate forum in contrast with the G-20,
and the Europeans themselves regard this forum as better suited to have
internationally broad discussions with traditional allies.
The United States has used this forum to persuade the Europeans and
to prod them to a credible and urgent course of action.\2\ Following
the latest recent financial summit in France, the G-7 will meet again
at the margins of this week's IMF and World Bank Annual Meetings.
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\2\ See, for instance, the Dow Jones wire available at: http://
www.foxbusiness.com/industries/2011/07/19/in-flurry-calls-g7-
governments-signal-eu-meeting-critical/.
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iv) The IMF
The IMF represents an important source of leverage for the United
States, given its status as the largest shareholder. The U.S. appoints
an Executive Director in the Executive Board. Moreover, the post of
First Deputy Managing Directorship has always been filled by an
American citizen, since the position was established in the 1990s.
Given its role of overseer of the stability of the global financial
and monetary system, the IMF has not just the right, but the duty, to
intervene--on its own terms--in the current developments. Its role goes
well beyond lending and falls under its original surveillance mandate.
The IMF has jointly funded, with the EU, all the programs in the
distressed euro-area economies. Whether or not it will join future
programs is a matter the Executive Board will have to decide on.
Regardless of future lending commitments, however, the confidence-
building effect from a step up in the Fund's financial capacity should
be seriously considered.
Just as the G-20 leaders fortified the IMF's financial position
with an extraordinary injection of capital following the London Summit
in April 2009, the membership of the IMF should, at the very least,
implement the reform package already agreed on by the IMF Board of
Governors in December 2010 and previously endorsed by the G-20 leaders
in Seoul the month before. Once approved, IMF resources will increase
from SDR238.4 billion to approximately SDR476.8 billion (about US$750
billion). As part of the agreement, moreover, Western European
countries will release two seats on the Executive Board in favor of
emerging and developing countries.
The United States has not yet ratified this agreement.
The IMF also relies on contingent credit lines through the New
Arrangements to Borrow. In the event the Fund needs to readily
supplement its permanent resources, the NAB is a first-recourse
facility. Once activated, it can provide supplementary resources of up
to SDR367.5 billion (about US$580 billion) to the IMF. The NAB was
activated last spring for a period of 6 months, in the amount of SDR
211 billion (about US$333 billion). The United States contributes with
SDR69 billion (approximately US$100 billion).
Given the prospect of a meltdown of the euro-area, the NAB provides
a fundamental backstop to the IMF's lending capacity, even more so as
the final ratification of the doubling in IMF quotas will inevitably
require several more months, at least.
v) The U.S. Federal Reserve
The Fed has provided the ECB with dollar funding through currency
swap operations since the outbreak of the international financial
crisis, to enable the ECB to provide U.S. dollar funding to euro-area
banks. In May 2010, the ECB reintroduced this form of transaction, as
the Greek crisis led to tensions in the U.S. dollar liquidity market
for European banks. In January 2011, the ECB then dropped the facility
to reintroduce it again this summer. Accordingly, at the end of June
2011, the liquidity-swap arrangements between the ECB and the Fed were
extended to August of next year.
Notably, the Federal Reserve's cooperation lent to the ECB allows
European financial institutions to meet their counterparty or loan
obligations in U.S. dollars thus minimizing the risk of contagion in
U.S. markets. The extension of these credit lines does not expose the
Federal Reserve to foreign exchange or private bank risk. When the
Federal Reserve provides dollars through the reciprocal currency swaps,
they provide them to the ECB, not to the institutions obtaining funding
through the liquidity operations tendered by the ECB. Nor does the
Federal Reserve assume any exchange-rate risk, because the supplying of
dollars in exchange for foreign currency, and the subsequent receipt of
dollars in exchange for foreign currency at the swap's maturity date,
take place at the same rate of foreign exchange.
______
PREPARED STATEMENT OF J.D. FOSTER, Ph.D.
Norman B. Ture Senior Fellow in the Economics of Fiscal Policy
The Heritage Foundation
September 22, 2011
Chairman Warner, Ranking Member Johanns, thank you for the
opportunity to testify today. My name is J.D. Foster. I am the Norman
B. Ture Senior Fellow at The Heritage Foundation. The views I express
in this testimony are my own, and should not be construed as
representing any official position of The Heritage Foundation.
The European Economic Crisis is no accident. It is entirely the
product of fundamental policy mistakes begun long ago and since
magnified and papered over time and again. I believe there are two root
mistakes that have produced this outcome.
The first is the relatively recent mistake of adopting a single
currency without the economic policy infrastructure necessary to
protect it. Without arguing the wisdom of the Euro one way or the
other, the fact is that if it were purely a matter of economic policy
the Euro could have succeeded as envisioned. But there were
prerequisites relating to harmonization of labor policy, commercial
policy, environmental policy, and so forth, and absent these it was
imperative to harmonize fiscal policies. Europe made some progress in
some areas and little in others. It was undeniably woefully inadequate.
The second great mistake was the adoption of a generous social
welfare state without attending to the pro-growth policies necessary to
sustain such a state in light on an increasingly competitive global
economy. In the absence of increasing global competition a slow-growth
big government economic model is viable; not, in my view, preferable by
any means, but viable. In the face of fierce and rising competitive
pressures from outside Europe, economic growth through rising
productivity and improved economic competitiveness is not merely
beneficial, it is essential to national survival.
The Europeans have long been aware of this tension, hence their
efforts to cajole, coerce, or otherwise convince the rest of the world
to adopt their economic model. An obvious example is their efforts to
force Ireland to adopt a higher corporate income tax rate. Rather than
adopt the policies necessary to speed their own economies to match
those of the competition, Europe tried to slow the economies of the
competition. It didn't work.
I very much regret what our friends across the pond must now
endure, and what awaits them in the days, months, and years ahead. For
them, there are no easy answers. For us, there is little we can do to
help, but there are preparations we can make and lessons we can learn.
These causal questions are important and interesting, but the issue
of the day is what is happening today, and what effect it will have on
the United States. In the testimony that follows, I will attempt to
describe briefly the basic dimensions of what continental Europe now
faces, and then the transmission mechanisms by which the United States
may be affected, and conclude with what the United States can do to
prepare.
Europe's Many Layered Problems
Europe's immediate problem is a pending and building liquidity
crisis. European banks and other financial institutions are
experiencing increasing difficulty accessing short-term credit markets,
and depositors are getting very nervous. According to reports, for
example, Siemens recently withdrew 500 million Euros from a French
bank. Greek banks have been on life support from the European Central
Bank for months, and central banks have just recently pumped more
billions of dollars into the continental-wide banking system.
Confidence, the life blood of financial markets, is failing fast.
The reason, of course, is that these banks hold vast quantities of
dubious assets--dodgy government debt. Some, perhaps many or even most,
European banks have a solvency problem. As Josef Ackerman, Chief
Executive Office of Deutsche Bank recently explained, ``Numerous
European banks would not survive having to revalue sovereign debt held
on the banking book at market levels''. This view was reinforced on
September 20 by Joaquin Alumnia, the European Union's competition
commissioner, who noted that ``Sadly, as the sovereign debt crisis
worsens, more banks may need to be recapitalized''.
In this Alumnia was restating a view presented recently by
Christine Lagarde, managing director of the International Monetary Fund
(IMF) from which she subsequently beat a hasty retreat under withering
fire from the EU establishment. Madam Lagarde had committed the
unpardonable sin of speaking the obvious truth, a truth that is likely
to be laid bare by an IMF report expected to be out at the end of
September reportedly showing banks need a ``whopping 273.2 billion
(euros)'' in recapitalization. A big problem in this regard for credit
markets is nobody really knows which bank would and which would not
survive today.
The solvency problem, in turn, traces to the sovereign debt
problem--some governments have issued debt and run budget deficits to
unsustainable levels. And a big reason these debt levels are
unsustainable is not merely their sheer magnitudes, but that these
countries also suffer from an ongoing growth problem. The growth
problem--even in good times they experienced little growth. Now they
are contracting, in some cases rapidly. So while their debt is high and
rising, the economy on which the debt rests is flat or contracting.
But growth rates tell only a part of the story. The larger story is
that the cost structures in many of these countries render them highly
uncompetitive economically, even within Europe and certainly outside of
Europe. This means they cannot hope to run the trade surpluses
necessary to generate the earnings with which to pay their foreign
creditors.
The painful immediate conundrum Europe faces is that attempts to
address the sovereign debt problem, through tax hikes for example, make
the economic growth problem worse thus making current debt levels less
sustainable. At the same time, issuing even more debt in an attempt to
buy time to deal with the sovereign debt problem typically make the
bank solvency problem worse by driving down the value of the
outstanding dodgy debt.
And it gets worse. Attempts to address the financial market
solvency problem by drawing attention to the need for more bank capital
often bring the liquidity crisis to a fevered pitch. This is a Gordian
know of enormous proportion and complexity, and one must express a
grudging admiration for the European leaders in having managed so well
for so long, all the while knowing they could not do so indefinitely.
Taking a step back for perspective, the long-run implications of
being highly uncompetitive are catastrophic. Europe will, at some point
and in some fashion, overcome the liquidity problem, and the solvency
problem, and even the sovereign debt problem. These can be overcome in
a variety of ways, all of which are painful to someone and all of which
will cause hardship for years to come. But I am confident they can and
will be overcome.
In contrast, the inability to compete globally presents problems of
an entirely different nature. Greece is, unfortunately, an excellent
example. Greece achieved an artificially high standard of living
largely by borrowing from abroad. This also led to increases in wages
and prices that far outstripped productivity growth, leaving Greek
producers uncompetitive within and without Europe. However, in the good
old days being able to borrow from abroad made up the difference in
terms of income. Greek borrowing is today on a very short leash, the
economy is contracting rapidly, and with their artificially elevated
wage and price structures Greece cannot hope to generate the net
exports and earnings needed to service its existing debt.
This leaves Greece with two very unpalatable options. One option is
to let a deep, prolonged depression drive down wages and prices to the
point where Greece's workers and companies can generate a trade
surplus. Greece would quite possibly look enviously at Japan's lost
decade.
The other option is to make the adjustment the old fashioned way--
to devalue. And there's the rub--as a member of the monetary union,
Greece lacks a currency to devalue; which is why the arguments about
how difficult or painful it would be for Greece to break out of the
Euro are irrelevant. There is no less painful alternative as long as
Germany refuses to work so Greece can enjoy the fruits of German labor.
As Financial Times columnist James Mackintosh wrote in Wednesday's
paper, ``Fixed exchange rates force economic adjustment via wages and
prices; Greece needs dramatic wage deflation to regain competitiveness
against Germany. The political impossibility of slashing pay packets
enough is a reason it may have to leave the Euro, even though living
standards will fall either way.''
The Implications for the United States
With this as overview, the fundamental transmission mechanisms of
the European Economic Crisis for the United States economy are as
straightforward in outline as they are murky in detail. There are two
such mechanisms, one through financial markets and a second through
trade flows.
Five years ago, one might have viewed the European financial
crisis, that is, the existential threat to European financial
institutions and markets, as mostly a European affaire. To be sure,
American financial institutions hold some of this dodgy European debt,
as well. There have even been stories that super-safe money market
funds have loaded up on scary levels of high-yielding Greek debt. But,
on balance, one would have thought a financial contagion in Europe
would be stopped at water's edge. Five years ago, the Europeans thought
the same thing about the then-rumored U.S. subprime mortgage fiasco
about to unfold.
The issue is global financial interconnectedness. This is where
matters get murky. No one, including the participants and including the
financial regulators, really knows or understands all the connections,
or all the weaknesses. We know in great detail, for example, how much
foreign debt by country each of our banks own. But for years the
Europeans have assured the world their true exposure to sovereign debt
risk was limited because they had hedged their positions with credit
default swaps (CDS). Note, however, that CDS do not eliminate risk but
merely shift it. To whom? No one really knows.
Suppose, for example, you are the CEO of a well-run U.S. bank. You
have carefully assessed your exposures to the European sovereign debt
crisis and have built up a proper capital cushion. Your exposures to
Europe all appear to be through credible institutions which themselves
appear to have adequate capital. But what are their other assets? How
much of these CDS do they own? How much capital do they have when they
have to make good on their CDS exposure? They may not really know. You
don't know. And so you as CEO don't really know how safe your bank
really is.
European leaders will not be able to kick the can down the road
indefinitely. Matters worsen almost daily. Italy's debt was recently
downgraded. Economies are contracting. Greece is fighting for one more
breathe in the form of the next tranche of oxygen from the IMF.
As these events unfold, the essential consequence for the United
States economy is a large dose of bad uncertainty. Bad uncertainty is
analogous to bad cholesterol. It builds up and creates economic
blockages. In the economic sphere, this shows up as decisions delayed
or downscaled, decisions that under normal times would produce the
actions that produce growth. Europe is clearly adding to the headwinds
facing the economy today.
At some point, this house of cards will come tumbling down, taking
much of the European financial system with it. Fortunately, this part
of Europe's problem can and I believe will be halted in its tracks
fairly quickly by recapitalizing the banks. The questions for the
Europeans will be--whose capital and how much? For the United States,
too, the immediate threat will then pass.
As the financial crisis fades, as it will, Europe will be left with
the remaining fundamental economic problems of a dysfunctional monetary
union, uncompetitive economies in many cases, and recession. This,
again, is where matters get murky. The monetary union may evolve in any
one of a number of paths, none of which appear particularly germane to
the U.S. situation; likewise the policies necessary to restore all the
nations of Europe to a state of international competitiveness.
The depth and length of the recession in each country will vary,
but none will be immune. Many of these countries suffered poorly
performing economies before the crisis. For the United States the
implications if not the magnitudes are clear--a major U.S. trading
partner will be in a slump, and so U.S. exports to Europe will suffer.
If the U.S. economy were in good shape, a drop in exports would
simply be another headwind to be overcome. In 1997, during the Asian
economic crisis, the U.S. experienced an event similar in nature if not
magnitude, but the U.S. economy was reasonably strong and accelerating
and so the headwinds from the Asian crisis were essentially
imperceptible in the aggregate.
Unfortunately, rather than strengthening, the U.S. economy today is
flat on its back, and facing the very real possibility of yet another
recession even without the headwinds of Europe. President Obama's
economic policies have failed utterly and completely. Mounting a
sustained, robust, job-creating U.S. recovery under the circumstances
will prove very difficult.
What the United States Can Do to Prepare
There is very little the United States can do to help the Europeans
through their troubles. There is, perhaps, some harm the U.S.
Government can inflict, and Treasury Secretary Geithner appears to have
done his best to inflict some in his recent lectures to the European
leadership at their recent finance meetings in Poland. No doubt his
counterparts are wondering to themselves the old refrain, ``with
friends like this, who needs enemies.''
One rather nebulous issue for the United States arising from
Europe's troubles is that once again the United States, despite all its
troubles, is perceived as a safe haven for capital. Thus enormous
capital inflows from abroad have propped up the dollar exchange rate to
an extent, and driven down domestic interest rates. Given the current
weakness in the U.S. economy and the Federal Reserve's current policy
of maintaining very low interest rates and its expected attempts at
driving down long-term rates in particular, these interest rate
pressures may actually be benefiting the U.S. economy today. On the
other hand, there will be a flip side--at some point these capital
inflows will become outflows, pushing up interest rates at an
inopportune time.
As there are two definable threats to the United States economy,
preparations should focus on dealing with those two threats. Above all,
the key to preparing for the financial threat is capital. Capital
reserves act like levees in the face of a flood, protecting financial
institutions from the onrushing river of failing confidence.
Presumably, America's financial regulators and supervisors are keeping
a close eye on bank capital reserves. However, in light of what may be
in the offing, it is reasonable to question the prudence of banks and
other financial institutions paying out dividends at this time,
dividends that if retained would add a few sandbags to the levees.
The second threat is from the expected drop in exports to Europe
and the effects this will have on the U.S. economy. Little or nothing
can be done about the drop in exports, but much could be done to
strengthen the economy to absorb the blow better. All of these actions
fall under the guiding principle of ``do less harm''.
To Grow, or Not to Grow, That is the Question
The fundamentals of our economy remain sound. The natural
productive tendencies of America's workers, investors, and
entrepreneurs remain undiminished. The economy is poised to grow.
Why, then, does it hold back?
There are, of course, the unusual headwinds, such as the follow-on
effects of Japan's devastating earthquake and tsunami. But the economy
faces and overcomes such headwinds even in the best of times. Headwinds
there are, to be sure, but they do not explain the economy's lethargy.
The economy suffers from two categories of troubles. The first are
structural troubles, which today primarily reflect a housing sector
still in deep disequilibrium in many areas of the country.
There is very little substantively that government can do to return
housing markets to normal, and heaven knows Congress and the President
have tried just about everything. And that is part of the problem.
Government's well-intentioned meddling has delayed and distorted the
essential requirement for normalization--price discovery. On balance,
these policies have set back the housing recovery by months, perhaps a
year or more. There is an important lesson here.
The second category of trouble is what might be termed
environmental--not the natural environment, but the economic
environment. Most relevant for our discussion is alternatively a
shortage of confidence or an excess of bad uncertainty. Those who could
make the decisions and take the actions that would grow the economy
lack the confidence to do so. Even today, the economy abounds in
opportunities for growth. But turning potential into reality requires
action, and action requires confidence--confidence in the future,
confidence in the specific effects in government policy, and confidence
that government can properly carry out its basic functions, like
agreeing to a budget.
America suffers a confidence shortage, and Washington is
overwhelmingly the cause.
Confidence, in turn, is lacking because of an excess of
uncertainty: Uncertainty about the future, but also uncertainty about
the effects of government policies--tax, regulatory, monetary, trade.
Uncertainty is natural, of course. The future is always uncertain. But
there is good uncertainty and bad uncertainty, much as there is good
cholesterol and bad cholesterol. Good uncertainty, for example,
presents opportunities for profit. Bad uncertainty arises largely when
investors and entrepreneurs have very real questions about the
consequences of government policy.
Tax policy provides a good example of bad uncertainty. The
President's repeated insistence on raising taxes on high-income workers
and investors slows the economy even without the policy being enacted.
It does so by raising the uncertainty about the tax consequences of
various actions. It does not stop all such actions, but it stops some,
and therein lies the difference between growth and stagnation.
The President's insistence is a twofer in terms of bad uncertainty.
The specific is that taxpayers don't know what their tax liability will
be. The general is that suggesting raising taxes on anyone in the face
of high and possibly rising unemployment suggests a gross lack of
understanding about how an economy works. That's a source of bad
uncertainty that afflicts the entire economy, not just those threatened
with higher taxes.
In this environment, Congress need not enact bad policy to weaken
the economy. Threats suffice to do real damage.
Unfortunately, President Obama's recent and urgent deficit-building
jobs plan was so weak Senate Majority Leader Harry Reid (D-NV) refused
even to attempt to bring it to the Senate floor. And his subsequent
deficit reduction plan was so full of gimmicks and misrepresentations
even his allies on the left had to stifle their reactions. Clearly,
President Obama has chosen to campaign for re-election on a far left
populist message that sacrifices economic strength and job growth for
ideology, leaving the U.S. economy to fend for itself as events in
Europe unfold.
The American economist Joseph Schumpeter once observed, ``the
problem that is usually being visualized is how capitalism administers
existing structures, whereas the relevant problem is how it creates and
destroys them.'' The next few years are very likely to bear this out.
______
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