[Senate Hearing 112-327]
[From the U.S. Government Publishing Office]

                                                        S. Hrg. 112-327




                               before the

                            SUBCOMMITTEE ON

                                 of the

                              COMMITTEE ON
                          UNITED STATES SENATE

                      ONE HUNDRED TWELFTH CONGRESS

                             FIRST SESSION




                           SEPTEMBER 22, 2011


  Printed for the use of the Committee on Banking, Housing, and Urban 

                 Available at: http: //www.fdsys.gov /

73-404                    WASHINGTON : 2012
For sale by the Superintendent of Documents, U.S. Government Printing Office, 
http://bookstore.gpo.gov. For more information, contact the GPO Customer Contact Center, U.S. Government Printing Office. Phone 202�09512�091800, or 866�09512�091800 (toll-free). E-mail, [email protected].  


                  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
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


                            C O N T E N T S


                      THURSDAY, SEPTEMBER 22, 2011


Opening statement of Chairman Warner.............................     1

Opening statements, comments, or prepared statements of:
    Senator Johanns..............................................     3
    Senator Bennet...............................................     3


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




                      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.


    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 


    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 
    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 
    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 
    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 
    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.


    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 
    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.


    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, 
    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 
    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 
    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.


    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 
    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 
    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 
    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 
    Mr. Fels. I did my best.
    Senator Warner. I am anxious to get to the questions, but a 
very good presentation.
    Dr. Lombardi.


    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 
    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 
    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 
    Dr. Foster.


    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    [Whereupon, at 4:04 p.m., the hearing was adjourned.]
    [Prepared statements and responses to written questions 
supplied for the record follow:]

 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 
    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 

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 
    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 
    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 

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 

    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, 
    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 
    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 
    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 

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 
                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 

  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 

      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 

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.
    \1\ I am grateful to, but do not wish to implicate, Karim Foda and 
Sarah Milsom for excellent research assistance.
 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.

    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.


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 
    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 
    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 
    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 
    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 
    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 

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 
    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 
    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.
    \2\ See, for instance, the Dow Jones wire available at: http://
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.

     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 

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 
    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 
    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.
    The Heritage Foundation is a public policy, research, and 
educational organization recognized as exempt under section 501(c)(3) 
of the Internal Revenue Code. It is privately supported and receives no 
funds from any government at any level, nor does it perform any 
government or other contract work.
    The Heritage Foundation is the most broadly supported think tank in 
the United States. During 2010, it had 710,000 individual, foundation, 
and corporate supporters representing every state in the United States. 
Its 2010 income came from the following sources:

    The top five corporate givers provided The Heritage Foundation with 
2 percent of its 2010 income. The Heritage Foundation's books are 
audited annually by the national accounting firm of McGladrey & Pullen. 
A list of major donors is available from The Heritage Foundation upon 
    Members of The Heritage Foundation staff testify as individuals 
discussing their own independent research. The views expressed are 
their own and do not reflect an institutional position for The Heritage 
Foundation or its board of trustees.