[Senate Hearing 112-350]
[From the U.S. Government Publishing Office]

                                                        S. Hrg. 112-350




                               before the

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                              COMMITTEE ON
                          UNITED STATES SENATE

                      ONE HUNDRED TWELFTH CONGRESS

                             FIRST SESSION




                            OCTOBER 20, 2011


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                  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

                     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

            Nathan C. Steinwald, Subcommittee Staff Director

        Sarah Novascone, Republican Subcommittee Staff Director


                            C O N T E N T S


                       THURSDAY, OCTOBER 20, 2011


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

Opening statements, comments, or prepared statements of:
    Senator Johanns..............................................     2


Lael Brainard, Under Secretary for International Affairs, 
  Department of the Treasury.....................................     3
    Prepared statement...........................................    28
Uri Dadush, Ph.D., Director, International Economics Program, 
  Carnegie Endowment for International Peace.....................    13
    Prepared statement...........................................    30
John Makin, Ph.D., Resident Scholar, American Enterprise 
  Institute......................................................    14
    Prepared statement...........................................    36
C. Fred Bergsten, Ph.D., Director, Peterson Institute for 
  International Economics........................................    16
    Prepared statement...........................................    40




                       THURSDAY, OCTOBER 20, 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 3:04 p.m. in room SD-538, Dirksen 
Senate Office Building, Hon. Mark Warner, Chairman of the 
Subcommittee, presiding.


    Senator Warner. I would like to call to order this hearing 
of the Banking Subcommittee on Security and International Trade 
and Finance. This hearing's subject, which is more timely than 
I think when we initially planned it, is the G-20 and global 
economic and financial risks.
    We are fortunate to have on our first panel the Honorable 
Lael Brainard, Under Secretary for International Affairs at 
Treasury, with us today, and since we moved this hearing back 
from 2 o'clock to 3 o'clock because we had votes, I will be 
very brief in my opening comments and try to make sure we take 
advantage of the witnesses' time for questions.
    Obviously, the timing of today I think is particularly 
important in the fact that the G-20 Finance Ministers just met 
this past weekend where they issued a new communique, and we 
have got the European Union summit this weekend, which all the 
eyes of the world will be on. Following these two summits, the 
G-20 will hold a full summit in Cannes, France, November 3rd 
and 4th.
    The single most obvious challenge facing the G-20, at least 
at this moment, is the European Union economic and financial 
crisis. It is not the sole responsibility of the G-20 to fix 
Europe's problems, and obviously this is not the only item on 
the G-20 agenda in early November. But if the G-20 is to prove 
itself useful--useful in the long run--and demonstrate its 
ability to react and at times get in front of the next economic 
or financial crisis, then these next few weeks are going to be 
extraordinarily important.
    The world economy now faces a variety of crises. We still 
have in America an economy that, while technically in recovery, 
a huge number of Americans have not felt that yet. A further 
shock to the system coming about from a non-structured default 
by Greece or any other country or even contagion spreading 
across Europe that could freeze financial markets will have a 
dramatic effect on our economy and an effect that, if not 
appropriately monitored and dealt with, could even rival the 
challenges of 2008. And the challenge right now is we do not 
have all of the same tools available to us that we had in 2008, 
both in terms of monetary policy and fiscal stimulus, as well 
as a growing concern and some level of skepticism amongst the 
American public that some of the actions in 2008 
disproportionately helped financial institutions over many of 
our fellow citizens.
    So we are very, very pleased to have Under Secretary Lael 
Brainard here, somebody whom I have had the opportunity to know 
and work with over the years. She has got an enormous 
challenge, and obviously I will submit my full statement for 
the record.
    Senator Warner. I would like to now turn it over to my good 
friend and colleague, the Ranking Member, Senator Johanns.


    Senator Johanns. Let me just start out and say to my 
colleague, Senator Warner, thanks for your willingness to do 
this. This could not be more timely and could not be more 
    Secretary Brainard, I think you said it well and very 
directly. I was reading through your testimony, and right here 
you say, ``Europe's financial crisis poses the most serious 
risk today to the global recovery.'' And that is what this 
hearing is about. We want to hear about that and what you see 
on the horizon.
    If I might just offer a couple of thoughts about what I 
would see because I would like your reaction to that at some 
point. You know, on the one hand, I think there is consensus 
about the need for action, obviously. You have countries like 
Greece and Portugal that are really struggling and trying to 
figure out how they better position themselves.
    On the other hand, you have political realities, too. How 
far can other leaders move to deal with the crisis that they 
are facing? And every day is a day of concern. Every week is a 
week of concern. And as we continue to move down this pathway, 
if there is not some hint of resolution or some pathway, then 
it appears to me that whatever sense of security the financial 
markets have in the potential for resolution, the underpinning 
for that really gets hit, and they begin to be more and more 
concerned, and it gets tougher and tougher to fashion the 
    So, again, today this could not be more timely. We 
apologize for putting everybody off, but that is the way of the 
Senate. My life is more dictated today by what Mitch McConnell 
and Harry Reid are doing than what my wife is doing, and that 
is a terrible thing to admit in an open hearing, but it is 
true. Some of this is just unavoidable, so we appreciate your 
    With that, I am very anxious to hear from you, Secretary, 
your thoughts on this, and this is informal enough where I 
think we can actually engage in a dialogue about what we see 
and what we need to thinking about in the weeks and months 
ahead. Thank you.
    Senator Warner. Thank you, Senator Johanns. And both of us 
being relatively new here, it is particularly painful for us as 
former Governors when we used to make the agenda to have these 
kind of constraints.
    Senator Warner. Again, with no further ado, Secretary 


    Ms. Brainard. Well, thank you, Chairman Warner and Ranking 
Member Johanns. As you said, this hearing is very timely.
    Today Americans are focused on securing good jobs, 
providing for their families, building opportunities for their 
children. That is why it is so important for us to strengthen 
America's recovery, which still remains too vulnerable to 
disruption beyond our shores.
    Europe's financial crisis poses the most serious risk today 
to the global recovery. While the direct exposure of our 
financial system to the most vulnerable countries in Europe is 
moderate, we have very substantial trade and investment ties 
with Europe, and European stability matters greatly for 
consumer and investor confidence.
    Last week at the G-20 meetings in Paris, and on an ongoing 
basis, the Europeans are discussing their efforts to deliver a 
comprehensive plan to address their crisis by the Cannes Summit 
in early November. This plan must have four parts.
    First, Europe needs a powerful firewall to ensure that 
governments can borrow at sustainable interest rates while they 
bring debts and strengthen growth.
    Second, European authorities are taking steps to ensure 
their banks have sufficient liquidity and stronger capital to 
maintain the full confidence of depositors and creditors, and, 
if needed, access to a capital backstop.
    Third, Europe is working to craft a sustainable path 
forward for in Greece as it implements very tough fiscal and 
structural reforms.
    And, finally, European leaders need to tackle the 
governance challenge to get at the root causes of the crisis 
and ensure that every member state is pursuing economic and 
financial policies that support growth and stability.
    For our part here in the United States, pro-growth policies 
in the near term and meaningful deficit reduction in the medium 
term provide the best insurance policy to protect the U.S. 
recovery from further risks from beyond our shores.
    To promote near-term growth and job creation, the President 
has put forward a series of proposals that would put veterans, 
teachers, and construction workers back on the job and put more 
money in the pockets of every American worker.
    President Obama has also proposed importantly a framework 
to put our medium-term public finances on a stronger and more 
sustainable footing, placing the Nation's debt-to-GDP ratio on 
a declining path by the middle of the decade.
    With overall demand in the advanced economies likely to 
remain weak, it is essential for emerging economic powers in 
the G-20, such as China, to move more rapidly to a pro-growth 
strategy that is led by their domestic consumption by allowing 
their exchange rates to adjust. At the G-20 meeting the surplus 
emerging market economies, including China, committed to do 
just that--accelerate the rebalancing of demand toward more 
domestic consumption and to move toward more market-determined 
exchange rates.
    We have made this our top priority with China, and we have 
seen progress with appreciation of over 10 percent real terms 
bilaterally since June 2010 and with exports to China growing 
twice as fast as to other markets. But the exchange rate 
remains substantially undervalued, and we need to see it 
appreciate faster.
    There are two other priorities that I will just touch on 
briefly in the G-20 and in the Financial Stability Board.
    First, we have been working very hard to level up the 
playing field across major and emerging financial centers. In 
the wake of the most globally synchronized financial crisis the 
world has seen, we are working to implementation the most 
globally convergent financial protections the world has 
attempted. And we are trying to do so in lockstep as we 
implement the reforms here under Dodd-Frank.
    The G-20 endorsed new global capital standards in November 
of 2010. It will endorse a new international standard for 
resolution regimes at this summit so that large cross-border 
firms can be resolved without the risk of severe disruption or 
taxpayer exposure to losses. And it is very important that we 
move forward in sync with our G-20 partners on the reforms to 
derivatives markets that were enacted under the Dodd-Frank Act 
and that are extremely important for ensuring that there is 
much greater transparency about where the risks in the system 
lie and efforts to mitigate them.
    Finally, sustained and strong American leadership through 
the international financial institutions is vital to achieving 
our goals in the G-20 and at home. We were instrumental in 2009 
in strengthening the IMF, which helped to strengthen the global 
economy, and our continued leadership is vital in the IMF to 
provide us with outsized influence as the IMF responds to 
challenges, such as the European crisis, which matter greatly 
to American jobs and growth.
    We look forward to continuing to working closely with you 
on these important challenges, and with that let me conclude.
    Senator Warner. Thank you, Secretary Brainard.
    Senator Johanns and I work very well together, and since it 
is just the two of us, rather than putting time on the board, I 
have got a couple questions, and if you want to break in at any 
point, we will go back and forth in a more informal fashion.
    The first question is--and here we are a year-plus after 
Dodd-Frank, 3 years after the 2008 crisis. One of the things we 
saw in 2008--I am not sure we would have predicted that not 
only Lehman but then potentially the counterparty exposure with 
AIG, because we did not have accurate real-time ability to 
figure out counterparty exposure and overall exposure. This is 
not directly your area, but with the FSOC in place at this 
point--the Financial Stability Oversight Council--we have seen 
a lot of published reports about U.S. bank exposure to Greece. 
What level of confidence do you have, at the regulator level, 
at the FSOC level, that we have enough knowledge to know not 
only depository exposure but we have talked a little briefly 
about money market exposure, counterparty exposure? Obviously 
direct and indirect exposure is only one thing. If we have a 
freezing of the credit markets, the percentage of our financial 
exposure to Europe or to Greece in particular all goes out the 
window. But do we have enough current real-time knowledge in 
terms of our financial institutions' exposure both to Greece 
and some of the other countries that are at least talked about 
being in the path of contagion?
    Ms. Brainard. Well, I think as you indicated, some of the 
reforms under Dodd-Frank and some of the confirming reforms in 
the international system under the FSB will help over time, 
although these are in the process of being implemented as we 
speak. The FSOC has spent time on the risks from Europe, and it 
does provide a forum, as was intended, for sharing of 
information among the supervisors and the regulators so that 
they have common assessments of risk.
    As you said, the direct exposures particularly to the most 
vulnerable periphery countries are relatively modest at this 
juncture. There is also----
    Senator Warner. Direct exposures, not just depository 
institutions but----
    Ms. Brainard. Direct exposure from depository institutions 
    Senator Warner. Insurance companies, money market. We do 
not have as much knowledge of hedge funds. What about these 
    Ms. Brainard. So in terms of the information we have on 
some of the other entities in the system, there is much greater 
information, much more detailed information available now on 
money market funds, and that information is publicly available, 
and that was a critical development from the crisis. Insurance 
is still a work in progress, but I think we are going to see 
that moving along at a rapid pace as well. And, of course, the 
reforms that are just in the early stages on derivatives will 
provide extremely important transparency into what was 
previously a very opaque set of markets between central 
clearing, between the information being reported on a real-time 
basis to trade, depositories, those reforms as they move 
forward will make a material difference in terms of our 
regulators' and supervisors' visibility into the system.
    Senator Warner. Well, again, I just hope we recognize that 
we are doing as much as possible we can at this moment in time 
in terms of the counterparty exposure of some of our 
    Let me ask one other question, and, Senator Johanns, please 
jump in.
    We had Chairman Bernanke in around lunch to do a small 
briefing around some of these issues as well. One of the things 
that I think obviously Europe is wrestling with, we have 
focused on Greece, and we are looking at what the Europeans 
directly have done in terms of the European Stabilization Fund 
and potential ways to lever that up. But my understanding--and 
Chairman Bernanke made the point that in the next--if we were 
to see contagion while Greece--a central default on a run on 
Greece would be challenging, if this were to spread to Italy, 
which has got to roll over a trillion euros in debt over the 
next year, and Spain, 500 billion euros in debt over the next 
year to roll over, when you look at the size of the European 
Stabilization Fund, you know, even if you then layer on top of 
that the IMF dollars, our reserves, those reserves are not 
enough to take on the kind of challenges and the firewall you 
mentioned in point number one, the Europeans need to do in 
terms of this firewall, but do they have enough capital at this 
point under the current framework to provide that firewall?
    Ms. Brainard. Well, I think it is very important, as you 
say, to emphasize that in order for Europe's financial 
stability to return, what they categorically need to do is take 
the risk of cascading defaults and bank runs off the table. And 
in order to do that, they need a firewall of sufficient force 
and size to overwhelm the markets. I think that is something 
that we saw in our own financial crisis was critically 
important in helping to restore orderly functioning to our 
financial markets, and it is something that European leaders 
are talking about as they are moving forward on this 
comprehensive plan.
    They have quite substantial resources in the European 
Financial Stability Fund, but they will need to----
    Senator Warner. They have about 440 euros?
    Ms. Brainard. They have 440 billion euros under the 
structure that was just approved by the national parliaments in 
the euro area. And that funding is going to be critically 
important for doing those things that we talked about earlier, 
which is to ensure that large sovereigns with sound policies 
such as Spain and Italy can fund at affordable rates so that 
they can implement those critical reforms that will allow them 
to grow and to bring their debt down. They also need to have 
adequate bank capital backstops so as they move forward with 
their plans to set strong capital buffers in the banking 
system, that where needed they have public capital backstops.
    In order to do that, the EFSF will need to be leveraged up. 
There are a variety ways of doing that. It is achievable. These 
goals are achievable with the capital that they have, but that, 
of course, is one of the key issues that will be part of their 
comprehensive plan.
    Senator Warner. Again, I want to turn to Senator Johanns, 
but you did say you think within that European Stabilization 
Fund it is adequate when we are looking at a trillion dollar 
rollover in Italy and a half trillion dollar rollover just in 
Spain alone, not counting some of the other nations?
    Ms. Brainard. The funding that is available in the European 
Financial Stability Fund can be leveraged up to adequately 
address the needs that we were talking about to ensure that 
Italy and Spain and other large performing sovereigns have 
adequate funding to backstop the banking system and, of course, 
to continue to fund the program countries as they perform. But, 
again, it is vitally important that they leverage up the EFSF.
    Senator Warner. They have not decided how to leverage it up 
    Ms. Brainard. And what is on the table right now is 
precisely what is the form of that leverage. And that leverage 
needs to be credible in the markets, and it needs to give them 
that overwhelming force that takes the threat of defaults and 
bank runs off the table.
    Senator Johanns. There is so much to talk about and ask 
about, but let me, if I might, start with some of the thoughts 
expressed on Dodd-Frank and I think the dilemma that we are 
heading toward. We have put in place with Dodd-Frank an 
enormously complex piece of legislation. I did not support it. 
Now the rules are coming out, and it is just a massive amount 
of injection of new systems, new rules, new requirements for 
the financial system.
    At a Banking hearing some months ago, a concern was 
expressed actually by Senator Johnson, and others actually, and 
the whole issue was how is this going to be harmonized 
internationally. And Deputy Secretary Wolin said, and I am 
quoting, ``We are working closely with our G-20 partners to 
make sure that we get a regime that works worldwide so we do 
not have new opportunities for arbitrage.'' I think, 
translated, what we are all concerned about is you end up with 
this U.S. system and then our capital flees because why deal 
with this if you can find less resistance in Singapore or a G-
20 country?
    Soon after that, I am reading an article, and I probably 
will butcher his last name, and Michel Barnier of the European 
Union said this: ``We don't support the same approach.'' He 
said, ``That is not what we are going to do,'' and really kind 
of put down what we had done in the United States.
    So what assurance can you give me that the G-20 with all of 
these other problems that they have--and they are economy-
threatening problems for that part of the world--that in the 
midst of that they are sitting there trying to figure out how 
to put the Volcker Rule in place and how to put this rule in 
place, et cetera, and following the leadership of the United 
    Ms. Brainard. Well, Senator, let me just say, first of all, 
I could not share more fully your concern and your 
determination to make sure that as we move to put in place new 
mechanisms to ensure the vibrancy and the resilience of our 
system, that we move in lockstep to ensure that other financial 
centers around the world, both established financial centers 
and those that are coming online, move in sync with us so that 
we do not inadvertently undermine the safety and soundness of 
our system by providing regulatory arbitrage opportunities or, 
equally importantly, create a competitive disadvantage for our 
financial institutions.
    I believe we have done more on that than has ever been true 
in the past, and we are having quite a lot of forward momentum 
among the other members of the Financial Stability Board and in 
the G-20.
    Michel Barnier, the Commissioner who has responsibility for 
these issues in the Commission, meets very regularly with 
Secretary Geithner, and they both have repeatedly stated their 
commitment to ensure that as we move to put in place new 
capital liquidity leverage standards, the Europeans do the 
same; that as we move to put in place requirements for 
standardization and central clearing, trade repositories on 
derivatives, they move to do the same.
    I think we have had successes in terms of getting general 
adoption of the principles across all the G-20 and FSB 
membership. I work very hard with my counterparts to make sure 
that not only are they adopting these principles but they are 
implementing them, and our staffs sit with the staffs of 
international financial authorities and go through in fairly 
great detail, as do the staffs of the SEC and the CFTC, and we 
are trying to be as granular as we possibly can to make sure 
that as our implementation proceeds, theirs does as well.
    Obviously, we each have different national legal regulatory 
environments, and so there are going to necessarily be moments 
where, for instance, on Dodd-Frank we move forward with our 
legal framework more quickly than the Europeans did, but we 
have similar implementation deadlines, and we are all working 
extremely hard because they are--similarly, they are as 
committed as we are, and I think they see the same risks to 
their system, which are more evident today perhaps than ever 
before of not moving forward on those key requisites for a 
sound financial system.
    Senator Johanns. Like I said, we could spent hours on this, 
debating this, but here is my impression. My impression in 
having worked with the European Union for many, many years, 
part as Governor, more intensely as Secretary of Agriculture, 
is that this is a very unusual governance system, something we 
are not used to. You have got this umbrella organization out 
there, and it is not really a central government, but it kind 
of tries to act like a central government. You have got all of 
these other countries that are member countries of the European 
Union. They are forever proclaiming their sovereignty because 
it is important that they proclaim their sovereignty to their 
citizens in their country. And, you know, when you talk about 
principles being adopted, it is not very reassuring to me, to 
be honest with you. All that tells me is that we are having a 
lot of meetings. I think you are working hard. But I will bet 
when we look back 12 months from now and 24 months from now and 
36 months from now, we are going to see little activity by the 
member countries to embrace anything near what we did with 
Dodd-Frank, putting our financial structure at a serious 
    Now, I hope you can call me in 12 months and 24 and 36 
months and say, ``Boy, Mike, you were really wrong about that, 
and I am here to call you and tell you you are.'' But I do not 
think I will be wrong about it, unfortunately.
    But if I might move on to, I think, what probably is 
occupying our attention right now, and that is the financial 
crisis that we are all worried about. Here is another 
impression, and I would like your reaction to this. We have a 
handful of countries that really are struggling. Greece would 
lead that. You could probably talk about Portugal, Ireland. I 
hope their Ambassadors do not call me and yell at me, but I 
think, quite honestly, they are really trying to figure out how 
to deal with what is a crisis. There were huge protests in 
Greece yesterday, for example. They are really resisting the 
    You have got a second group of countries--Spain, Italy--
that somebody said to me, and it probably describes it well, 
too big to fail, too big to bail out, large economies. If 
somehow the problems with the other countries cannot be walled 
off, they kind of get tangled up in it, and their cost of 
borrowing goes up, et cetera.
    You have got serious undercapitalization of the banks. You 
have got stress tests that nobody has regarded very seriously. 
I think they made an attempt, but, quite honestly, our 
financial community is not relying on their stress tests. And 
then in the midst of all of this, you have got a European 
system, and you have got people, citizens like mine--it would 
be like--you know, for Germany to embrace the idea of bailing 
out Greece, it would be like Nebraska with a balanced budget 
amendment and an obligation that we cannot borrow any more than 
$100,000 so we have no debt bailing out another State that 
spent wildly and borrowed money. Well, you can only come to 
understand how the Germans are looking at this and going, ``Are 
you kidding me?''
    And then you begin to realize how do you move those 
dynamics with this system to the kind of resolution that is 
necessary, because we are not talking about a few dollars. And 
if the market does not have confidence that this is a big 
enough firewall--and I think guaranteeing 10 or 20 or 30 
percent of the debt is not going to be sufficient--and you 
cannot calm the markets down, then I think this thing really 
has some serious, serious potential.
    Now, boy, I have put a lot out there, but I would love to 
have your reaction. Where am I wrong in this? What have I 
misread about this?
    Ms. Brainard. Well, I think the risks that you point to are 
real. I would say, though, on the other side that Europe has 
the resources, it has the capacity, and we have heard from 
European leaders that they have the will. The things that need 
to be put in place I think are fairly clear, and, of course, as 
you said, I think there is mixed public support. But if you 
look at the vote, for instance, in Germany of the EFSF, 
overwhelming majority in favor of supporting the July 21st 
reforms, which expanded the EFSF and enabled it to do the 
critically important functions of providing precautionary 
financing and backstopping the banks.
    So you are exactly right that Europe will need to muster 
the political will, but everything we have heard is that 
European leaders are determined to do so. And they have the 
capacity, they have the ability to leverage up the EFSF to a 
magnitude that really is commensurate with the size of the 
challenges. They have the ability to take the risk of contagion 
to Italy and Spain off the table entirely, and we will see over 
the next days and weeks how they are going to confront those 
    As you indicate, though, over a slightly longer period of 
time--and they are talking very clearly about this--they will 
need to move forward on putting in place mechanisms that give 
them the fiscal capacity that really matches their monetary 
union, and that is the piece that will take a little longer. 
But they are going to need to have much more fiscal unity and 
much more centralized fiscal governance over time. And I think 
that is something that member states are clear-eyed about in 
the face of this crisis.
    Senator Johanns. If I might, just one more. Does that 
require a treaty change, the last step that you have just 
described? It does, does it not?
    Ms. Brainard. It depends very much, Senator, on how they 
decide to move forward on creating a more unified fiscal 
structure. Some of the ideas that are being discussed would 
require treaty changes. Others might not. They have already put 
forward some very important governance reforms in terms of 
surveillance and penalties for not meeting fiscal targets, for 
instance. So some of these issues have already--we have already 
got a sense of where they are moving. On the broader sense of 
where their fiscal governance is likely to be in several years' 
time, I think they are still working on that, but they are 
committed to it from everything we hear.
    Senator Johanns. I only raise that because changing their 
treaty is akin to amending our Constitution. I mean, this is no 
easy task. A complicated problem, I guess, is what this all 
comes down to, a very complicated problem.
    Senator Warner. I would, first of all, agree with Senator 
Johanns about the complexity of this. I would think, though--I 
think what we have got a little bit, to carry on your analogy, 
is a balanced budget state, as well, with a AAA bond rating----
    Senator Johanns. Yes.
    Senator Warner. I get what you are saying, but it is kind 
of like----
    Senator Johanns. Good governance----
    Senator Warner.----de facto that if the Nebraskan 
government was well run but Nebraskan banks completely financed 
California's budget, you have got a little bit of that problem 
that I think we are looking at in Germany in that, one way or 
the other, Germans are going to have some level of 
responsibility, whether directly through their people or 
indirectly through their banks' exposure.
    I think one of the things--we had a spirited debate about 
Dodd-Frank. I think it is imperfect, but the reaction I heard 
more from our European colleagues was, thank goodness that at 
least America went first, and again, echoing what Senator 
Johanns said, because we have advanced capital standards, move 
further, and we have had more transparent stress tests, for 
example. And the fact that we are intertwined, whether we like 
it or not, if we did not try to have these coordinated 
standards, slipping to lowest common denominator is not going 
to help anyone.
    I believe that, and I share Senator Johanns's concern about 
how we do this in an organized basis. I want to go off subject 
a little bit. I actually think you may see, as we have seen in 
the United Kingdom, they may even be taking an even more 
structured approach than what we took. And when you hear some 
of the leaders in France and Germany in terms of transaction 
tax or other things that would go way beyond even Dodd-Frank in 
terms of financial constraints, and while we may disagree about 
merits or lack of merits around Dodd-Frank, I think we would 
both agree that we need to have not this arbitrage and 
consistently moving forward.
    At the end of the day, I think we and the EU will mesh, 
probably the Japanese and others. But as we get to this G-20 
framework, how do we make sure that, even if all the West moves 
forward in a coordinated fashion, that there is not that kind 
of outlier in this enormously interconnected system that does, 
in effect, become the equivalent of a tax haven but with a low 
standard financial center that does not agree to these 
international standards? What are we doing to grapple with 
    Ms. Brainard. Well, Senator Warner, as you said, I think we 
derived tremendous advantage from moving first and pulling the 
world to our high standards. And what we have seen in the G-20 
and the FSB is that we have succeeded in having all the members 
of the G-20 and the FSB sign up for tougher standards on 
capital liquidity and leverage at banks, sign up for 
resolution, higher prudential standards, greater intensities of 
supervision around systemically important financial 
institutions, and sign up for a host of very profound changes 
that will make our derivatives markets less opaque, more 
transparent, less risky.
    In terms of getting emerging financial centers to come on 
board, that is why we thought it was so important to be working 
through the Financial Stability Board and the G-20 where the 
major financial centers and the emerging financial centers sit 
together, and so we have a variety of standard setting bodies 
now, the Basel Committee, the FSB, where we have emerging 
markets, emerging financial centers represented and taking on 
the same obligations, the same principles, the same 
commitments, the same Basel III standard uniform across all 
members of the FSB. We are intensely engaged with Singapore on 
our derivatives reforms and we have received repeated 
assurances from the Singapore monetary authorities and 
financial supervisory authorities that they will move in 
lockstep as Europe and the United States come together on their 
derivatives regimes.
    So I think that the concerns that you raise are very real. 
We are working very hard on them. We have to stay extremely 
engaged at a level of detail on implementation, which we will 
continue to do. But I think we have a real chance of having a 
system that has far fewer major areas that present regulatory 
arbitrage risks and disadvantage our financial institutions.
    Senator Warner. We will obviously want to monitor that, and 
we need to have--we need to establish what those metrics ought 
to be. I know you have got to leave in a couple minutes. I want 
to ask one more question and make sure my colleague gets 
another crack at you.
    I think we just saw today--you may not have even seen the 
news--that while there was some anticipation that the EU might 
resolve some of these issues this weekend, they are already 
talking about now a second summit, meaning they may not get 
there. A lot of pressure on the meeting in Cannes. How do we 
make sure that this crisis does not just--or what--is there 
anything we can do other than continue to urge you to move 
forward and the Administration and others to move forward to 
make sure this does not just drag itself out? At some point, we 
in this country, right or wrong, stanched some of that with 
dramatic actions in late 2008.
    What is your--I recognize you do not want to make news on 
this, but what is your best guesstimate that we will see 
definitive action within this next 30-day period with this 
summit, Cannes coming, and probably a second summit within the 
next 30 days, or is this going to be an overhang that is going 
to take months and months to work through?
    Ms. Brainard. Let me just say that the European leaders, I 
think, are very intensively engaged on this. I think it is a 
good sign that they are meeting intensively on this. President 
Obama has been on the phone with European leaders and has spent 
a lot of time asking them about the comprehensive plan as they 
are developing it. He is very, very committed to ensuring that 
the U.S. economic recovery is as robust as it can be and as 
insulated as it can be from shocks emanating from abroad, 
recognizing that Europe has--headwinds from Europe have slowed 
our recovery somewhat.
    I think that the set of issues on the table are the right 
set of issues. European leaders are focused on the firewall, 
the bank recapitalization plan, ensuring Greece is sustainable, 
and then that longer-term set of governance reforms. And again, 
I think that they have that capacity. They have stated 
repeatedly that they have the will, they have the resources, 
and I think they know from discussions that we have had among 
finance ministers and central bank Governors at the G-20 last 
weekend that this is an issue that the world cares a great deal 
about, that the emerging markets that are part of the G-20 also 
see European financial stability as central to their own 
economic growth, that this is the most important priority for 
the G-20 meeting, and we see every indication that the 
Europeans are working very hard to come with their plan and to 
have a plan that succeeds on the four dimensions that they are 
talking about.
    Senator Warner. Well, I understand your answer and I 
appreciate your comments and I appreciate your appearing before 
me. I hope, recognizing that we are inexorably tied, that there 
will not be continuing ratcheting back of expectations, which 
seems to be the news of today if the European Union has already 
decided a second summit and is opposed to putting out those at 
least first two steps of the plan in terms of the firewall and 
the bank capitalization in a definitive way this week. We do 
hope that the G-20 will continue to show that these kind of 
large international organizations can be successful, but 
dragging this out is not clearly in Europe's interest nor 
clearly in the United States' interest.
    Senator Johanns did not have any other questions. Again, we 
appreciate your time, Secretary Brainard, and now we will move 
on to the second panel.
    Ms. Brainard. I appreciate the opportunity.
    Senator Warner. Thank you.
    If we could go ahead and move to the second panel, and as 
they get settled, I may go ahead and start to make some 
introductions, recognizing that we will probably have another 
round of votes at some point.
    Senator Johanns. Yes.
    Senator Warner. In our second panel, we are going to 
continue this question of G-20, the European crisis, and 
currency issues, in terms of making the point that all our 
economies are enormously intertwined. So we have three very, 
very distinguished panelists.
    Dr. Uri Dadush serves as the Senior Associate and Director 
for the International Economics Program at the Carnegie 
Endowment for International Peace. His work focuses on trends 
in the global economy and the implications of the increased 
weight of developing countries for the pattern of financial 
flows, trade, and migration, and associated economic policy and 
governance questions. A French citizen, Dr. Dadush has 
previously served as the World Bank's Director of International 
Trade and before that as Director of Economic Policy. He 
directed the Bank's World Economy Group, leading the 
preparation of the Bank's reports on the international economy 
over 11 years. Before that, he was President and CEO of the 
Economic Group's Economist Intelligence Unit and Business 
International. Thank you, sir, for joining us.
    Dr. John Makin is a Resident Scholar at the American 
Enterprise Institute. Dr. Makin is a former consultant to the 
U.S. Treasury Department, the Congressional Budget Office, and 
the IMF. He specializes in international finance and financial 
markets, including stocks, bonds, and currencies. Dr. Makin 
also researches the U.S. economy, including monetary policy and 
tax and budget issues, as well as the Japanese economy and the 
European economy, so we will be anxious to hear your comments 
on some of the EU actions. He is a principal at Caxton 
Associates and is the author of numerous books and articles on 
the financial, monetary, and fiscal policy. Dr. Makin writes 
AEI's Monthly Economic Outlook.
    And, our good friend, Dr. Fred Bergsten, has been Director 
and a widely quoted think-tank economist at the Peterson 
Institute for International Economics since 1981. He has been 
ranked as somebody who can move the markets by Fidelity 
Investment's Worth. Dr. Bergsten was the Assistant Secretary 
for International Affairs at the U.S. Treasury under the Carter 
administration. He also functioned as Under Secretary for 
Monetary Affairs, representing the United States on the G5 
Deputies and in preparing a G7 summit string in 1980 to 1981. 
During 1969 to 1971, Dr. Bergsten coordinated U.S. foreign 
economic policy in the White House as an Assistant for 
International Economic Affairs to Dr. Kissinger at the National 
Security Council. Dr. Bergsten is also a well-published scholar 
and has served in several distinguished institutions on foreign 
policy, economics, and competitiveness matters throughout his 
    I want to thank all of you for being here today. Again, the 
timeliness of this hearing could not be more important. And 
with that, we will get to Dr. Dadush and we will start with 
your testimony. Thank you.


    Mr. Dadush. Thank you very much, Mr. Chairman, Mr. Ranking 
Member, for inviting me here today.
    On the Euro crisis, I think it is apparent from the 
discussion that just preceded that everyone understands that 
sets of sovereign defaults in Europe, possibly leading to a 
collapse of the Eurozone, would have major repercussions in the 
United States and could lead to a Lehman-like event, but in my 
view, one of longer duration.
    What I think, however, is not sufficiently understood is 
that the Eurozone may not be able to handle this crisis on its 
own, and this is because of two dimensions. One is the politics 
and the other is, even more importantly, the economics.
    The politics because Europe remains a half-built structure. 
The Commission is not the Federal Government and the European 
Central Bank is not the Federal Reserve Bank. So, therefore, 
the example of Nebraska bailing out another State, I think, is 
extremely appropriate in terms of understanding the dynamics of 
the current situation, but I would take it one step further, 
which is I do not think there is any question about Nebraska 
and other States considering themselves part of one country, 
America. We are far from that situation in Europe.
    The second aspect is the economics. Whereas the Eurozone, 
as distinct from the European Union, is quite a bit smaller 
economy than the United States, the subprime crisis was between 
one and one-and-a-half trillion dollars, depending what you 
define as subprime. But the sovereign debt of the periphery 
countries is $4.5 trillion. Furthermore, banks are much more 
important in the European Union economies or the Eurozone 
economies than in the United States. They are just a much 
bigger part of the financing. And as you have already 
recognized, policy is largely out of bullets.
    It is also important to realize that the European Financial 
Stability Fund is--there is an element of smoke and mirrors in 
it, because the guarantees come in part from countries that are 
themselves in trouble, and even the countries that were thought 
not to be in trouble, like France, now are confronting a 
billowing cost which has doubled the spread of France vis-a-vis 
Germany in the course of the last several months. It is in 
excess of 100 basis points. That is an indication that the 
market is now calling into question the capacity. And actually, 
referring to the guarantees themselves in the most recent 
Moody's decision to put France on credit watch, referring to 
the guarantees at the current levels, not at the levels that 
are contemplated for the next stage, as being one of the 
reasons that they are considering the downgrade of France.
    So that is why in my written testimony I have proposed that 
there is an emergency, and as a precautionary measure, the 
IMF's resources should be expanded by a trillion dollars. I am 
audacious enough to say, with the United States making a 
contribution to that expense, audacious because I know that the 
previous expansion has not yet been agreed, but, you know, this 
is the situation that I see. I see it as an insurance against a 
very bad event. And I do not think--while I think the emerging 
markets want to contribute, I do not think the emerging markets 
will put all of that amount by themselves, and even if they 
wanted to, the United States would not necessarily want to see 
its interest diluted in the IMF to that extent.
    Thank you.
    Senator Warner. Just one point. The current IMF balance 
sheet is about $300 billion, is it not?
    Mr. Dadush. I think the available forward capacity of the 
IMF, new commitments, according to Managing Director Lagarde, 
is $400 billion. I think the total balance sheet is somewhere 
in the region of $850 billion. So $400 billion is the forward 
    Senator Warner. Thank you, sir.
    Dr. Makin.

                      ENTERPRISE INSTITUTE

    Mr. Makin. Thank you, Chairman Warner and Ranking Member 
Johanns, for the opportunity to testify. I am going to focus my 
comments, as well, on the European situation. It is, I think, 
appropriate to remember that the G-20 was first established in 
1999 after the Asian debt crisis, which was tied to excessive 
rigidity of exchange rates in the region and attempts to avoid 
those adjustments. My contention today is that the European 
crisis will not be contained until some of the problems that 
are inherent in an unstable and nonviable currency regime are 
    And I think if I go a little bit in detail as to how we got 
here, how did we get to a situation where last April we were 
all thinking we were out of the woods, people were starting to 
invest again, the U.S. economy was looking good, to a situation 
where we are looking at a weekend where, once again, Europe is 
delaying needed adjustments, with good reason, because they 
face some very formidable problems.
    Europe's current problems, I would term internal systemic 
driven. That is, they have a flawed currency system. How did 
they get here? When the European monetary system was set up, 
the assertion was made that you became a member, Greek debt was 
the same as German debt. So if you were a bank and German debt 
was commanding an interest rate of 20 or 30 basis points 
above--Greek debt was above German debt, you lent to the Greek 
Government. You then could use that claim on the Greek 
Government to borrow from the European Central Bank and the 
process began. In effect, the European monetary system 
initiated a massive increase in the credit ratings of the 
weaker Southern European economies whose unit labor costs 
suggest that they were in no position to continue to compete 
with Germany.
    And so, over time, the European debt crisis was built on a 
premise, that is, that sovereign governments do not default. 
The U.S. debt crisis, or the systemic financial crisis, was 
built on the premise, the fallacious premise, that house prices 
never go down. Those problems come back to haunt you.
    Why is it so difficult to address this crisis? First of 
all, there are really four ways to address it. One, the one 
that is being contemplated now, is to engineer massive 
transfers from Northern Europe to Southern Europe, and as 
others who have testified have suggested, really, we are down 
to Germany, because even the French have their problems. The 
EFSF with its 440 billion euros is a bit of smoke and mirrors, 
as Uri has suggested. Just the journal today, I think when we 
were discussing that earlier, when you take away the funds that 
are already committed, you are down to 275 billion. And then 
when you look at the commitments from Italy and Spain, which 
are prospectively going to be recipients, you really do not 
have any fund. So the idea that you can leverage that up by 
saying that you will somehow guarantee the first 10 or 20 
percent of the liabilities of the countries involved, I think, 
is perhaps wishful thinking.
    The second way to deal with the problem, aside from massive 
transfers--the resources are not there to make the massive 
transfers, so what else could you do? Well, last year, the idea 
was to say to the Greeks, we will give you money if you will 
blow your brains out, that is, if you will make massive cuts in 
spending, massive increases in taxes, and render the economy or 
push the economy into a tailspin. That means that the debt-to-
GDP ratio will be higher this year than it was last year. That 
is where we are with Greece. That is conceivably where we could 
be headed with some of the other countries.
    A third alternative which, again, is being rejected, is to 
force wages and prices in the Southern European countries to go 
down so rapidly that they are able to compete with Germany. 
That is not going to happen. Greece, Italy, Spain are not going 
to turn into Germany, and so that is just not a realistic 
    The fourth alternative is to allow currency adjustments 
within the Currency Union that would address some of the 
stresses that are there. I think that is probably where we are 
going to end up, although we are certainly going to exhaust a 
lot of pain and suffering before we get there. I do not see a 
way to make Greece a viable member of the European Currency 
Union. Neither do its citizens. The parallels with the 
Argentine debt crisis are there. You go through a long period 
of promise we will do this, we will do that. You have internal 
strife, and the government is left in a very difficult position 
where they are really not prepared to undertake the adjustments 
that are required of them.
    So I think it is probably not wise--I would respectfully 
disagree with my fellow panelist--to put more resources into 
shoring up what probably is not a viable system, and why would 
it be a viable system? To say--to impose a single central bank 
on an area as diverse as Europe, which has 17 treasuries--the 
Nebraska allegory breaks down--is just not a workable system, 
and the sooner we recognize that, the better.
    Thank you.
    Senator Warner. Well, two out of three. So far, this panel 
is not going to lack for some questions.
    Dr. Bergsten.


    Mr. Bergsten. Mr. Chairman, Secretary Johanns, I will make 
a few points that will complement what the earlier panel and my 
colleagues here discussed.
    The most important role for the G-20 summit in Cannes is to 
inject renewed impetus for world economic growth. We are not 
going to solve the European crisis, whatever financial 
engineering is done, unless the Europeans can get more growth 
going. Yet the strong countries in Europe, led by Germany, but 
also Holland, Austria, and the Scandinavians, are 
consolidating. They are tightening budgets, under no pressure 
from the bond market vigilantes. They should stop their 
tightening of policy and instead start expanding.
    Moreover, the European Central Bank should cut interest 
rates substantially. It is the only major central bank that is 
considerably away from the ``zero bound.'' Unless Europe gets 
growth, none of the financing is going to work. Unless the 
United States--the Congress and the Administration--can get 
together and provide some new stimulus to the U.S. economy, the 
world will continue to wallow, as well.
    The good news is that half the world economy is still 
booming. The emerging-market economies, which now make up half 
the world economy, are expanding by an average of more than 6 
percent. Moreover, they have policy space to do even better. 
They have low budget deficits and debt ratios. They still have 
fairly high interest rates. We should now ask the emerging 
markets, which are the leaders of global growth, to do more. 
They can certainly expand further. They have been worried about 
inflation, but now with the rich countries slowing down and 
commodity prices having leveled off, that is no longer of deep 
concern. They have been the beneficiaries of global growth 
strategies led by us and Europe for 30, 40 years. It is time 
for them now to take the lead that their economic capacity and 
achievements permit.
    So this Cannes summit needs to replicate, at least to a 
degree, what the London G-20 summit did in April 2009, namely 
take parallel and to some extent coordinated actions, to get 
the world out of the last economic crisis. We have to do it 
again. Only this time, the effort should be led by the emerging 
markets but with Europe and the United States chiming in as 
    It is critical how that emerging-market growth impetus 
takes place. It has to be done by expanding domestic demand, 
letting their big trade surpluses decline to impart growth to 
the world, not take it away from the rest of the world, which 
higher trade surpluses would do, and that means letting their 
currencies go up much more and much more rapidly.
    On the European crisis, I will make four quick points in 
addition to faster growth. They need to leverage the European 
Financial Stability Facility to create a total resume of two 
trillion to four trillion euros. I disagree with John Makin. I 
do not think the eurozone is a failed experiment. It is a 
halfway house and the other half, the fiscal union, has to be 
completed. The way to do it is to complete the fiscal union, 
not to abolish the monetary union.
    With great respect, I am going to disagree with an 
analytical point made by Secretary Johanns. Nebraska and other 
surplus U.S. States do, to a degree, bail out deficit U.S. 
States, not by direct loans, but through the Federal budget, 
because when they transfer their surpluses to Washington and it 
transfers that to deficit Mississippi, there is some degree of 
bailout. Likewise, when States import citizens from those that 
have had high and rising unemployment, the importing States 
help bail out those losing States. The Europeans do not have 
these two types of mobility. That is why they need fiscal union 
to complement their monetary union.
    I agree with a key point Uri Dadush made, particularly if 
the Europeans do not get their act together quickly, Plan B 
would have to center on the International Monetary Fund, 
because if the Europeans cannot put together an adequate safety 
net, only the IMF can provide it. His trillion dollars may 
actually need to be a little bigger. That money would have to 
be borrowed from the big surplus emerging markets--China, 
Korea, Brazil, India, and others including the oil exporters. 
They should provide the money. They need to pay back.
    Finally, what should the United States contribute to all 
this? I have suggested our Government needs to get its act 
together to get growth on track. We obviously need to move to 
tangible, credible means of bringing our budget deficit down 
over time without interrupting growth in the short run. And I 
think we ought to take on a new commitment to eliminate our 
trade deficit, because that is a way to create three to four 
million U.S. jobs over a 5-year period or so. We have been 
running huge trade deficits for 30 years and facilitating the 
export-led growth of these emerging markets. They have piled up 
huge reserves as a result, partly by manipulating their 
exchange rates. I think we are perfectly justified, and it is 
not protectionist or beggar-thy-neighbor to eliminate our big 
external deficit. We are the world's largest debtor country. 
They all tell us not to keep building it up. The G-20 has 
agreed at every summit on rebalancing of the world economy. 
That means eliminating the U.S. trade deficit, which would 
create three to four million U.S. jobs. If we are serious about 
getting back to full employment, we have to add that. I would 
throw that into the hopper at Cannes as a U.S. commitment to 
implement agreed G-20 strategy, but then we have to do 
something serious about it like reining in the budget deficit 
and getting growth going through domestic demand here.
    Senator Warner. You did not disappoint.
    Let us--there are so many different places to go with this. 
I would like to ask Dr. Makin and Dr. Dadush to respond to at 
least one part of the provocative part that Dr. Bergsten just 
said, was what do you think--is there any realistic chance that 
through the G-20 mechanism we could really see a challenge or a 
coordinated action where the emerging nations would take on 
these kind of growth policies, since it seems to me that there 
has been a, for the most part, an enormous lack of coordination 
amongst the more industrialized nations on issues like 
currency, and then when we try to perhaps ham-handedly deal 
with China on a one-off, always maybe not the most effective 
tool, I will grant, but let us just start with Dr. Bergsten's 
first prescription. What do you think any chance of that could 
happen, either one of you?
    Mr. Makin. Let me just take a--I will just focus on Europe. 
If I am China or India, why would I want to finance this 
European experiment that has been struggling since 2009? Why 
would I want to invest in a system that is just not going to 
    Fred says let us have fiscal union. We are not going to get 
fiscal union in Europe, and we have a monetary union that is 
not viable. Are the Chinese going to invest 500 billion euros 
in trying to turn Greece into Germany? It is just not going to 
    So while the Chinese certainly, in view of their aggressive 
geopolitical ambitions, will want to appear to be stepping in 
here where the United States is unable to do so, I would be 
surprised if they were willing to commit many resources.
    If you look, first of all----
    Senator Warner. Could I just ask one thing here?
    Mr. Makin. Yes.
    Senator Warner. I can----
    Mr. Makin. I mean, it would be nice, but----
    Senator Warner. I understand the point that they are--the 
direct assistance--and I want to come back to your questions 
about Europe. But the kind of more macro agreement that there 
could be coordinated growth policies across emerging nations 
letting their currencies appreciate, I mean, is that even 
realistic? I guess it could happen, but is it really----
    Mr. Makin. Well, what have we been doing since 2008?
    Senator Warner. No, but from the emerging--obviously----
    Mr. Makin. But, remember, in 2008, after the Lehman crisis 
when the Fed cut rates aggressively and we engineered a large 
fiscal stimulus in the United States, China engineered the 
largest stimulus in the world. They engineered a stimulus that 
was worth 15 percent of GDP over 2 years. They got their 
economy going. They have, of course, the fortunate situation 
that they have lots of resources and lots of things that need 
building. So they made a huge contribution to global growth in 
2009 and 2010, although it had its downside in the sense that 
they were--you know, China is such a new force, their 
contribution was so great that they were pushing up commodity 
prices and energy prices and so on.
    I am not quite as sanguine as Fred is about where China is 
headed now, but I think that if I were the Chinese I would say, 
look, we did a lot. We did a lot, it was in our own interest, 
we wanted to stimulate our economy, and the spillover effect 
was very positive.
    So I would think what is realistic now at Cannes, or 
elsewhere, is to see if the Chinese are prepared to back off a 
little bit on tamping down the growth rate because they are 
seeing higher domestic inflation, which some estimates are put 
as high as 10 percent.
    So they are involved in a kind of conflict situation. This 
is a very tough situation. So I would not, let me put it this 
    Senator Warner. Is your prescription in terms of China or 
your expectation in terms of China for other emerging nations 
as well? You know, whether you take India or whether you take 
South Korea----
    Mr. Makin. I think China is so big, the South Koreans are 
certainly--you know, they are in very good fiscal shape. They 
are not in a position to do what the Chinese could do. My 
bottom line is this: I would not bet on a lot of help--if I 
were a realist, I would not bet on a lot of help from emerging 
markets for the European experiment nor for the American 
conundrum as well.
    Senator Warner. Dr. Dadush?
    Mr. Dadush. Yes. First of all, I agree with John Makin that 
the emerging markets played an absolutely instrumental role in 
2009 in particular in supporting global economic activity at a 
very difficult moment, and with China playing a 
disproportionate role. But I think we need to recognize that 
that was a very particular situation, and as the emerging 
markets kind of accelerated extremely rapidly beginning in the 
second and third quarter of 2009, they within about a year, a 
year and a half, were running into what is called a ``supply 
constraint.'' Basically inflation was building up. There is 
also a real concern in asset price bubbles--there was--in a 
number of them. So they were reaching their natural limit.
    Now, again, Fred Bergsten makes a good point. In a scenario 
where global economic activity deteriorates in a rather 
significant way, I think emerging markets can provide a 
cushion, if you see what I mean, because they do have room and 
it will take a while. It is not evident right now, but it might 
take 6 months, 9 months for the inflationary pressures that 
have built up over the last couple of years to abate in the 
emerging markets, and then they can accelerate their growth 
again because they have that capacity.
    But I think it is safe to say that their contribution in 
this kind of scenario will be relatively modest. And as I put 
in my written testimony, I think we should always remember that 
American GDP is, to take one example--I could take other 
examples from advanced countries--is composed of domestic 
demand and net exports. The problem is domestic demand is about 
34 times bigger than net exports. So, you know, even in the 
best of circumstances, just simple arithmetic tells you that 
the real key to American growth--particularly American growth 
because it is a large relatively closed economy. The key to 
American growth is the internal dynamics in the United States, 
and the trade balance will help a little bit at the margin.
    And, by the way, I also would stress the fact that there is 
virtually no conceivable increase in demand from China that 
would have a significant impact on American economic activity, 
very simply just as a result of the fact that China is one-
third the size of the United States and the United States is a 
relatively closed economy. So it is about domestic activity, 
and it is about domestic reforms. It is about domestic 
structural reforms. It is about domestic fiscal reforms. That 
is the essence of what will drive American growth in the long 
    Finally, if I may, I also want to disagree with John Makin 
about not helping Europe, and not because I am a French 
citizen, but because should Europe not be able to get its act 
together--and I fear that it might not, or it could not to a 
sufficient degree--and that led to a collapse of the eurozone 
of this ``half-built failed experiment,'' as John would 
describe it, if that were to lead to a collapse of the 
eurozone, then I assure you we would have a crisis of 
absolutely global proportions that, again, as I said at the 
very beginning, would be of much longer duration than the 
Lehman episode.
    Senator Warner. Senator Johanns.
    Mr. Bergsten. Could I go back on that at some point?
    Senator Johanns. No, go ahead.
    Mr. Bergsten. On this argument about fiscal union in 
Europe, the Europeans are not going to give up. They are not 
going to let the euro collapse. That has been their fundamental 
goal for over 50 years. The history of European integration is 
that when they face crises--and they have faced many before--
out of that and all the uncertainty and the cacophony of the 
different voices comes progress toward greater union. We better 
understand that and support their move toward fiscal union 
because that is the positive outcome for us as well as them 
over time.
    On the debate about emerging-market growth, I absolutely 
agree with my colleagues. China played a decisive role in the 
world recovery from the big crisis in 2008-09. I said that in 
my testimony. I applaud what they did. I draw the opposite 
inference. They did it last time; they can do it again this 
time. And the supply side constraints that John talked about 
have declined sharply as world growth prospects have declined 
and as commodity prices have leveled off. They have huge 
further infrastructure needs and demands. They have those 
programs out there and have plenty of financing for them. The 
issue is when. From their standpoint, as well as the world's 
standpoint, now is the time to do it.
    Some of the other emerging markets have already reversed 
policy. Indonesia just last week--or earlier this week--began 
to cut interest rates. Brazil has begun to cut interest rates. 
Other emerging markets are also already moving in the direction 
I suggest, and I believe China, which is by far the biggest but 
others as well, can do it. I think the G-20 can push that 
    I will reiterate what I said at the outset. These emerging 
markets taken together are half the world economy. They are 
growing 3 times as fast as the rich countries, which means 
their share is rising a couple of percentage points every year. 
A decade from now, they will be two-thirds of the world 
economy. They can be drivers if we can get them to do even a 
fraction of what China did last time around.
    Finally, I want to take up Uri's point that the external 
side is not very important for the United States because we are 
a closed economy. Well, we are looking at 2 percent growth, 
maybe. It is perfectly feasible for us to strengthen our 
external position by one-half to 1 percentage point of GDP per 
year for the next 4 or 5 years. That would take our growth up 
significantly and create a big number of jobs.
    We are a relatively closed economy in the sense that Uri 
mentioned, but at the margin our economy can greatly benefit 
from growth in our external sector. It is absolutely right that 
exports to China alone are not going to do that. But if we can 
get the kind of pickup in world growth that I talked about at 
the outset, with all the emerging markets plus at least a 
little more in Europe, there is no reason why we cannot expand 
our international contribution to GDP growth in a major way. We 
are missing a major bet in not emphasizing that as part of our 
current job strategy.
    Senator Johanns. As I look at these issues, the debt of the 
European Union, its countries, and the United States and slow 
economic growth, just a whole host of things going on, I wonder 
what the potential is that inflation kind of rears its head 
again. How does that fit into the equation here, or does it 
fit? And maybe that is not a question when actually we probably 
worried more about deflation in the last few years. We have 
historically low interest rates, et cetera, et cetera. But it 
just occurs to me that the pressures out there are enormous to 
roll over debt. You have got a situation where countries will 
be struggling to finance that debt. What is the potential that 
inflation becomes a more serious problem as we look 2 years and 
5 years down the road? And I would like everybody's thought on 
that. I am going to work my way across the panel, so everybody 
is going to get a shot at that.
    Mr. Dadush. Well, right now inflationary pressures are 
quite muted. You are seeing some pickup in headline inflation 
in Europe, for example, but a lot of that is a reflection of 
some--you know, the delayed reflection of commodity prices to a 
large degree.
    There is so much unused capacity and so much risk 
aversion--in other words, tendency by people to mask cash and 
banks to mask cash if they possibly can--that even with the 
expansion of the central bank's balance sheets that we have 
seen, the actual expansion of credit remains relatively 
constrained. And that is a general phenomenon in the advanced 
countries. It is rather different in the developing countries. 
In the developing countries, you are seeing, have seen a very 
significant acceleration of inflation.
    I think if you look some years forward, a lot depends on 
what you assume is the capacity of central banks as the economy 
recovers to withdraw the massive amount of liquidity that they 
have injected into the system over the last few years. And 
central bankers will tell you, ``We know how to do that.'' The 
problem I have and the risk that I see is I know they know how 
to do that, that they have the instruments to withdraw the 
liquidity with selling bonds and changing reserve requirements, 
et cetera, et cetera. But the big question is: Will they be 
able to do it elegantly? Will they be able to do it in a way 
that you avoid a very rapid rise in interest rates, as has 
happened many times in the past, against a background of a lot 
of overextended investment and lending that is maybe triggered 
over a period of years by the abundance of liquidity?
    Senator Johanns. Dr. Makin?
    Mr. Makin. I am not concerned about inflation right at this 
point. I would add, however, that if a trillion, 2 trillion 
dollars of additional resources were made available to try to 
shore up a fixed exchange rate regime in Europe, the 
possibility of inflationary risks would rise.
    In the Great Depression in the United States, and usually 
after financial crises, there is a greater risk of deflation 
than inflation. And, second, as we learned in the Great 
Depression, the requisite way out initiated in 1933 by the U.S. 
devaluation of the dollar versus gold, which implied a 
devaluation of the dollar, a sharp exchange rate adjustment, is 
exchange rate adjustment. And our friends in Europe would like 
to maintain a single currency. I understand that. And I 
understand the firmness of their commitment to that. But I 
think the risks of following that path do include some 
inflationary potential.
    Senator Johanns. Dr. Bergsten?
    Mr. Bergsten. I agree with my colleagues, but, again, you 
have to make two key distinctions. You made one, which is 
timing. Over a 2-year horizon, I certainly would not worry 
about inflation. Over a 5-year horizon, I would on the grounds 
John just mentioned, and particularly if we do not get our act 
together here in terms of fiscal policy in a credible way.
    The other distinction is, of course, between groups of 
countries that Uri made. I do not see any inflation risk 
certainly over the near term in the United States or Europe or 
Japan, given slow growth and high unused capacity levels. The 
developing countries and emerging markets have had that risk. 
They are now recognizing the need to pivot their own policies--
I mentioned Brazil and Indonesia already--because of the 
slowdown in world growth. Nevertheless, they are closer to 
capacity margins. Supply constraints there are potentially 
greater, so I would not expect them to do nearly as much as 
China did in 2008-09, but I still think they can change the 
sign of their policy from contraction to expansion. And if they 
do it and the Germans do it and we do it, that could have a 
huge effect on resolving all the problems we are talking about.
    Senator Johanns. I would just ask one more question, and it 
is maybe one of the most complicated things to try to figure 
out. But it is no secret, if you look at the published polling 
numbers in Germany and France, leadership there is really 
struggling. People are looking at what is being asked and 
required and kind of recoiling. And yet----
    Senator Warner. Is it lower than the United States 
    Senator Johanns. Well, I am not sure I can add any thoughts 
on that, but it is a difficult situation, and the political 
issues here are significant.
    What happens if you get a year and a half out there and all 
of a sudden in response to actions that have been taken you 
have governmental change, campaigns that have been run on an 
anti-this or anti-that approach, and all of a sudden you have 
got a whole different set of circumstances from a leadership 
situation? Try to factor that in for me and give your best 
thoughts on that.
    Mr. Bergsten. Certainly, that is a theoretical risk, and I 
have worried for a long time about populist politics in Europe 
that would go in that direction. But I must say there is 
virtually no evidence to support it. The Germans bitch and 
moan--pardon my German--but they vote strongly on every 
occasion in favor of the pro-European policies, the pro-
European parties, including those that have mounted the 
bailouts. The fundamental fact is Germany is a huge beneficiary 
from the euro and the European Union. We know the underlying 
politics going back to the wars and the millennium of 
conflagration in Europe, and the Germans do not forget that. 
But in pure economic terms, for the reasons Makin described, 
the euro is nirvana for the Germans. They are the world's 
largest surplus country, but their currency stays weak. That is 
the dream of Helmut Schmidt and the other German leaders I used 
to work with when I was in government. Every time they would 
run a big surplus, their currency would go up. They would 
complain about the weak dollar, but they were complaining about 
the strong Deutsche Mark. Now they have overcome that.
    Germany is such a massive beneficiary from the economics of 
the eurozone that the business community knows it, the labor 
unions know it. The one party that has opposed the European 
bailouts, the Free Democrats, got thrown out of the government 
in the last election in Berlin. Parties that are in favor of 
continuing the policy are getting 80, 90 percent of the popular 
votes in the Bundestag. The opposition in Germany is even more 
strongly in favor of it than Chancellor Merkel's party.
    So it is a risk that we need to keep our eyes on. It could 
happen. But I would say watch what the Germans do, not what 
they say.
    Senator Johanns. Dr. Makin.
    Mr. Makin. I always know when I am getting to Fred, I am 
demoted from ``Dr. Makin'' to ``John Makin'' or ``Makin.''
    Mr. Bergsten. Just showing you what good friends we are.
    Mr. Makin. You know, I think that, again, looking at 
Germany, Germany has been a great beneficiary of the monetary 
union. But now that the financial complications of the currency 
area have begun to jeopardize the stability of the financial 
system and you have a failure of a major financial institution 
2 weeks ago in Belgium, German economic activity is slowing 
rapidly, partly, I would argue, because things are slowing in 
China, but also partly because European citizens pick up the 
paper every day, and they look at the headlines in Greece, and 
they look at what is going on, and they know that something is 
not working.
    So I understand--and I think if we listen to German 
leadership carefully over the past several weeks, I am sure 
that they are contemplating their options. A German Finance 
Minister said a Greek default may be necessary. That is 
tantamount to suggesting that Greece leave the currency union.
    The German public was never asked--it was never permitted 
to vote on Germany joining the currency union. The German 
elites are powerful, and they manage the system very well--up 
to a point. And I think we may be approaching that point. We 
may see some of the pressure, some of the political pressure, 
which is obviously in Greece which is on the receiving end of 
the adjustment. But the political pressure is rising in Germany 
and could continue to rise. And since they are being asked to 
pay the bills, that would be a destabilizing factor that could 
be preempted, again, by being more realistic about what is a 
viable currency regime for Europe.
    Mr. Dadush. Yes, I tend to agree with Fred that the 
European project goes very deep in Germany, very, very deep, 
and that of all the parties, the least likely to desert the 
euro is Germany, not just because they are the beneficiaries, 
and right now, I mean, I could make a very Machiavellian 
argument that Germany is actually benefiting in some way from 
the crisis because of its low interest rates and because of the 
low euro. But more fundamentally, if Germany, which is actually 
benefiting and not under direct pressure at the moment, were 
itself to say, ``No, I am fed up, I am leaving,'' that really 
would be the end of the European project. That would be--OK. It 
is very different if Greece says, ``I cannot take the pain 
    And, finally, I do not want to--I am not ready to predict 
how things will develop in the European periphery. Let me just 
point to the fact that domestic demand, consumption plus 
investment plus government spending, in Ireland is down 20 
percent compared to 2007. I mean, the magnitude of that number 
should strike one. All right? An indication if Greece were 
already down about 15 percent on 2007.
    What we are witnessing in the periphery countries is the 
equivalent of a Great Depression. It is just not called a 
``Great Depression'' because it happens to occur in some small 
countries that are sort of a little bit outside the news. But 
for all intents and purposes, it is a Great Depression. And in 
Spain, unemployment is now up at 24 or 25 percent.
    So I think it is remarkable, the degree to which this 
structure has held together under enormous economic pressures. 
But if we go--if as I believe, because I believe it is a 
structural crisis more than a fiscal crisis, it is a 
competitiveness crisis, it is a growth crisis that is affecting 
the European periphery, if we are now talking another 5 years 
of adjustment, it is very difficult to say whether the polity 
can actually stay together in these countries. And that is one 
of the arguments why the combination of the commitment to the 
European project and the incredible stress under which the 
system is being put is one of the arguments, I think, to say 
that Europe should be helped in a situation like that.
    Mr. Bergsten. Just if I may, two quick sentences back to 
Dr. Makin. He says the Germans pay the bills. Right, but that 
is a gross payment. Net they are still huge winners from the 
eurozone, and you could view those payments as kind of an 
insurance premium to keep their very big winnings rolling at 
the tables.
    He also suggested that Greek default would equate to exit 
from the euro, and I disagree. Greece may default. They have to 
default. It certainly will have to restructure substantially 
its external debt. But I think both the economics and the 
politics suggest they will do it inside the euro not outside, 
and they will come out better for doing it that way.
    Senator Warner. I have got one last question, but do you 
want to--because I just----
    Mr. Makin. Yes.
    Senator Warner. Could you respond to that? Because one of 
the things in your initial points, you paint, I think, an 
appropriate challenge. And I clearly think the idea of a 
currency union without fiscal union has presented a half-built 
house. I 100 percent agree with you. But I think the 
implications of yours is that if you are going to break up the 
currency union, you are going to have some really short-term 
huge disruption, right?
    Mr. Makin. Yes, so are we going to have----
    Senator Warner. If you could just give a quick response to 
that last question.
    Mr. Makin. Look, we are not in a good situation here, 
right? And so getting out of it is going to be difficult. It 
just seems to me that addressing a reality, which is that 
Greece cannot co-exist in a currency union with Germany without 
massive transfers in their direction and without infecting the 
rest of the system, is probably going to be a positive thing. I 
do not see how it is worse than going from weekend to weekend 
where we keep saying, oh, well, you know, we were going to 
settle it this weekend, but we are going to do it next weekend.
    Remember, the 440 billion euros was agreed to in July and 
was finally largely agreed to over the past several weeks, and 
it is not enough. So how much is enough?
    Again, getting a resolution to this problem containing the 
fallout, it is not going to shock many people in the financial 
markets if Greece either defaults or leaves the union.
    Senator Warner. Well, listen, I know everybody has been 
very generous with their time, and I just want to say I 
really--this has been a fascinating panel, and provocative. I 
hear at least one major consensus point, that whether this 
leads to currency breakup or continuing the European alignment, 
the current resources available to ring-fence or stanch, I 
think everybody--I am hearing everybody would at least concur 
on that. There may be different paths. But----
    Mr. Makin. Well, if we are going to insist on shoring up 
the currency system.
    Senator Warner. Right, agreed. Agreed. Agreed.
    If we each could, please, no more than two or three 
sentences, if possible, but give me your best projection in 
terms of what, if anything, will happen out of the EU 
activities this coming weekend and what should we realistically 
expect coming out of Cannes in a few weeks, either way, any way 
you all want to do it.
    Mr. Bergsten. I will just venture to say what comes out of 
the EU this weekend is further steps toward the ultimate 
objectives that we are all talking about here. They cannot do 
it all in one leap. There are too many players, and too many 
different actors. But they will take some steps forward on a 
path that will eventually lead to the outcomes that I was 
talking about, namely, a highly leveraged EFSF that will 
provide a ring fence around even Spain and Italy and further 
institutional reforms that eventually will lead to fiscal 
    But in the meanwhile, there will be so much cacophony and 
so much uncertainty generated by market pressures that the 
crisis atmosphere will continue. But I think they will move 
    At the G-20 there will be more pressure on the Europeans to 
complete that progress. They may take some steps along the 
growth path, probably not as much as I would like to see, but I 
think there may be some steps. The Finance Ministers last 
weekend actually did reach a fair degree of consensus on the 
direction that is needed, including a stronger Europe, 
certainly in the United States, and encouraging the emerging 
    The IMF portion I think is not as clear, and that will 
depend a lot on how much uncertainty the Europeans leave. If 
they leave a lot, I would not be surprised to see some movement 
toward what I call Plan B and at least putting in train an IMF 
resource expansion effort that would enable it to plug the 
gaps--which, incidentally, I think ought to be pursued anyway 
because in the uncertain world we are facing for several years, 
who knows when and where the IMF will be needed. And I would 
shore it up, in any event, though a European act on its own 
would clearly galvanize that.
    Mr. Makin. This weekend I think we have already heard what 
we will hear, we are going to have another meeting next weekend 
or in the middle of next week, because, again, the problem--the 
alternatives are so unattractive, it is very difficult to step 
up to the plate. What the French will do is put out a number 
that is over $1 trillion that somehow is going to be a shock-
and-awe number, but really nothing much will get done. If 
eventually they do come up with more money and they try to 
shore up the system, 6 months from now we will be back with 
more problems and looking for more resources. That is why I 
think it is a bad idea to go down this road.
    Senator Warner. G-20?
    Mr. Makin. G-20? Well, I was going to say you could just 
read the last G-20 statement that came out in April, but at 
that time they said the global recovery was broadening, so they 
will have to say the global recovery is narrowing and we have 
got problems and we hope everybody gets everything straightened 
out. What else can they do?
    Mr. Dadush. Yes, my projection is, first of all, that the 
crisis will continue to fester for at least another year or 
    The second is with regard to the next 2 months over to the 
G-20, I think you will see a bank recapitalization decision 
in--a significant bank recapitalization decision. You will see 
a structure for the forgiveness of Greek debts that will be 
fleshed out.
    I think you will see a larger and better articulated EFSF, 
and I believe that with all that you will also see some 
significantly greater engagement on the part of the 
International Monetary Fund. I believe you will see that. I do 
not know where exactly how that money will be found or how much 
it will involve the United States. But I believe that that is 
going to be part of the game going forward.
    With all that, the crisis will continue to occasionally 
rear its ugly head over the course of the next several years 
because, again, as I said at the beginning, this is a crisis of 
economic structure, a crisis of competitiveness, a crisis of 
growth. It is not just a fiscal crisis.
    Senator Johanns. Thank you very much.
    Senator Warner. Thank you all. The hearing is adjourned.
    [Whereupon, at 4:43 p.m., the hearing was adjourned.]
    [Prepared statements supplied for the record follow:]

               Under Secretary for International Affairs
                       Department of the Treasury
                            October 20, 2011

    Chairman Warner, Ranking Member Johanns, and distinguished Members 
of the Committee, thank you for the opportunity to discuss how we are 
working with our G-20 partners to advance America's economic interests.
    There is no stronger economic imperative today than to strengthen 
our economic recovery, create jobs, fuel growth, and build a stronger 
fiscal and economic foundation for our children and grandchildren. That 
is the prism that shapes our engagement in the Group of 20 (G-20) and 
with our international partners more broadly.

Safeguarding and Strengthening the Recovery
    At the Pittsburgh Summit in 2009, the G-20 adopted as its core 
mandate achieving strong, sustainable, and balanced global growth. In 
the G-20 and in our bilateral engagements, we press vigorously for 
substantive economic, financial, and exchange rate reforms that will 
help achieve stronger and more balanced global growth in order to 
strengthen economic opportunities and growth for American families and 
workers. Our recovery in the United States remains fragile and all too 
vulnerable to disruption beyond our shores. Earlier this year, high oil 
prices and the tragic earthquake and tsunami in Japan led to a sharp 
economic slowdown. Consumer and business confidence was shaken in the 
summer in part because of the debt limit debate in the United States 
but increasingly because of the intensification of the European crisis.
    Europe's financial crisis poses the most serious risk today to the 
global recovery. While the direct exposure of the United States' 
financial system to the most vulnerable countries in Europe is 
moderate, we have substantial trade and investment ties to Europe, and 
European financial stability matters greatly for consumer and investor 
confidence. That is why we have been working closely with our partners 
to support their efforts to resolve the crisis swiftly and resolutely.
    Last week at the G-20 meetings in Paris, the Europeans committed to 
delivering a comprehensive plan to address their crisis by the Cannes 
Summit in early November. There are four key elements. First, Europe 
needs a more substantial financial firewall to ensure that governments 
can borrow at sustainable interest rates while they implement policies 
to bring down their debts and strengthen the foundations for growth. 
Second, European authorities are taking steps to ensure that their 
banks have sufficient liquidity and build capital cushions to maintain 
the full confidence of depositors and creditors, and to ensure that 
banks have access to a capital backstop where needed. Third, Europe is 
working to craft a sustainable program in Greece as it implements its 
fiscal and structural reforms. Finally, European leaders must tackle 
governance changes to address the root causes of the crisis, and ensure 
that every member state pursues sound economic and financial policies.
    The United States must also do our part, and as the world's largest 
and most vibrant economy, we recognize that we have a global leadership 
role to play in strengthening the recovery. To promote near-term growth 
and job creation, the Obama administration has put forward a series of 
proposals in the American Jobs Act that would put veterans, teachers, 
and construction workers back on the job while rebuilding and 
modernizing America's schools and neighborhoods, and put more money in 
the pockets of every American worker by cutting their payroll taxes in 
    President Obama has also proposed a framework to put our medium-
term public finances on a stronger and more sustainable footing. The 
President's proposal to the Fiscal Commission would place the Nation's 
debt-to-GDP ratio on a declining path no later than the middle of the 
decade through a balanced plan to reduce deficits by $4 trillion over 
10 years when combined with the $1 trillion in savings enacted in the 
Budget Control Act of 2011.
    Together, pro-growth policies in the near term and meaningful 
deficit-reduction in the medium term represent our best insurance 
policy to protect the U.S. economy from further risks from global 
markets. We must work together to safeguard America's economic 
resilience and strength from further stress.
    Emerging markets must also do their part to strengthen global 
growth through rebalancing. With demand in the advanced economies 
likely to remain weak, it is essential for emerging economic powers, 
such as China, to play a bigger role in bolstering and sustaining 
global growth. These emerging markets with large current account 
surpluses have substantial capacity to pivot more rapidly to a pro-
growth strategy led by domestic consumption.
    At last week's G-20 meeting, the surplus emerging market countries 
such as China committed to accelerate the rebalancing of demand toward 
more domestic consumption and to move toward more market-determined 
exchange rates and achieve greater exchange rate flexibility to reflect 
economic fundamentals. By allowing its exchange rate to appreciate more 
rapidly in line with market forces, China could boost consumption, 
strengthen domestic demand, and help curb inflationary pressures. We 
have worked aggressively to pressure China in particular to move much 
faster in allowing the value of its currency to appreciate. We have 
seen some progress on this front, with appreciation of over 10 percent 
in real terms bilaterally since June 2010 and 38 percent since 2005, 
but more is needed.
    We will continue to urge the IMF to use the considerable scope it 
already has to identify risks to the international monetary system--
particularly external ones such as exchange rates--and ensure that IMF 
members are meeting their international obligations.

Strengthening the Global Financial Sector
    The second focus of our work in the G-20 and the Financial 
Stability Board (FSB) has been leading a ``race to the top,'' leveling 
up the playing field across major and emerging financial centers. In 
the wake of the financial crisis, and with the leadership of this 
Committee, the United States moved quickly with the passage of the 
Dodd-Frank Act to undertake financial reform. We have moved in lockstep 
on our international financial reform agenda, securing adoption of key 
conforming reform commitments in the FSB and G-20.
    With financial markets that are globally integrated, we need 
financial reforms that are globally convergent. This is particularly 
important in areas with the greatest potential for small discrepancies 
in national regulations to create disproportionate dislocations in 
global markets that could negatively impact our economy and our firms. 
Accordingly, we have focused on three key areas: stronger global 
standards for bank capital and liquidity; heightened prudential 
standards and orderly resolution processes for large, complex financial 
institutions; and aligning global derivatives markets.
    First, following international negotiations that were concluded in 
record time, G-20 Leaders endorsed new global capital standards in 
November 2010. These standards will raise the quality and quantity of 
capital so that banks can withstand losses of the magnitude seen in the 
crisis, strengthen liquidity standards, and limit leverage. 
Implementation of these reforms will proceed at a pace that reduces 
risks to the economic recovery and ensures a level playing field around 
the world.
    Furthermore, we have successfully called on the Basel Committee to 
ensure that risk-weighted assets are measured similarly across the 
world. This is essential to maintain a level playing field and to 
ensure consistency across borders.
    Second, for the largest, most complex firms, whose failure could 
cause the greatest damage to the economy, we are establishing a new 
international standard for resolution regimes, so that large cross-
border firms can be resolved without the risk of severe disruption or 
taxpayer exposure to loss; more intensive and effective supervisory 
regimes; and a capital surcharge. The G-20 Leaders in Cannes will 
endorse this set of reforms for these global systemic financial 
institutions (G-SIFIs).
    Third, G-20 Leaders adopted new principles for the first time to 
promote international convergence across derivatives markets, which are 
fully aligned with the Dodd-Frank Act. In the run-up to the financial 
crisis, few understood the magnitude of aggregate derivatives exposures 
in the system and the risks embedded in these exposures as derivatives, 
such as credit default swaps (CDS), were traded over the counter on a 
bilateral basis and without transparency. Moving derivatives trading 
onto exchanges and requiring trades to be centrally cleared increases 
transparency and reduces systemic risk. Central clearing will greatly 
reduce risk by requiring a central clearinghouse to guarantee the 
transaction and help market participants better monitor their risk. 
Mandatory trading on exchanges or trading platforms will improve price 
discovery and greatly enhance transparency, and reporting to trade 
repositories will shed light on what was once an opaque market. New 
work is beginning on our call to establish global standards for margins 
on un-cleared derivatives trades that will incentivize central 
    We are working with our G-20 counterparts to synchronize the 
implementation of these derivatives principles, and the United States 
is providing leadership by meeting the end-2012 deadline for 
implementing new rules consistent with these commitments. When taken 
together, these reforms will provide policymakers and investors a 
clearer picture of the true exposures and interconnectedness among and 
across financial institutions.
    The examples above highlight areas where international convergence 
is imperative to preserve global financial stability. In other areas, 
the international regulatory system has long recognized differences in 
the institutional structure of national financial systems, reflecting 
different laws and histories. For example, the Volcker Rule in the 
United States and the Independent Banking Commission recommendations in 
the UK, though taking different approaches, are taking more restrictive 
positions on the permitted activities of banks than are some other 
countries which still use the universal banking model.

Retaining U.S. Leadership in the International Financial Institutions
    Across all of these economic priorities, sustained and strong 
American leadership through the international financial institutions 
helps to facilitate solutions, advance growth, and build a better 
    In 2009, the United States was instrumental in supporting an 
expansion in the emergency financing of the International Monetary 
Fund. Rapid Congressional passage of legislation enabling U.S. 
participation helped stabilize financial markets at home and around the 
world during the peak of the crisis, paving a pathway for renewed 
global confidence and growth. Our continued leadership role at the Fund 
provides us with outsized influence to shape the IMF's responses to 
economic challenges, such as the European crisis, which matter to 
American jobs and growth.
    Our leadership at the multilateral development banks (MDBs) has 
likewise offered us immense leverage and influence to shape development 
around the world, and thereby strengthen our own security and economic 
growth, while advancing American principles and ideals.
    Yet today our leadership at the international financial 
institutions could be at risk if Congress does not act to support our 
commitments to these institutions. For example, at the World Bank, we 
currently have a veto over changes to the Articles of Agreement, which 
govern Bank membership and leadership, among other issues. At the 
African Development Bank, we have our own board seat, and can influence 
regional development to ensure that there are strict environmental and 
procurement standards. Other nations, particularly China, are eager to 
take up our shares in these institutions if we do not meet our 
    We must continue to work together in a bipartisan manner to renew 
U.S. leadership at these institutions, just as at the end of the cold 
war, when President Reagan advocated for the last general capital 
increase for the World Bank and a Democratic Congress approved it. 
These institutions provide immense leverage of our scarce resources, 
with every dollar the United States contributes to the MDBs generating 
$25 of investments.
    It was through the power of our ideas and our values that we became 
leaders. With the emergence of new powers and new challenges, we will 
remain leaders by expressing that same commitment and vision through 
our evolving global partnerships in the 21st century. Our leadership in 
the international financial institutions, the G-20, and the FSB will be 
essential to securing the future we want for our children and for their 
    Our leadership in the G-20 helped to avert a much deeper recession 
after the crisis and to forge a common effort to strengthen the 
recovery and the financial system. The U.S. will continue to emphasize 
the critical role of the G-20 in developing a strong, collective 
response to overcome near-term vulnerabilities, and put in place the 
building blocks for more balanced and durable growth going forward.
    We appreciate the leadership and support of this Committee on these 
key challenges, and we look forward to working with Congress as we 
engage with our international partners, and encourage robust policy 
responses to today's global challenges.
               Director, International Economics Program
               Carnegie Endowment for International Peace
                            October 20, 2011

    Mr. Chairman, Mr. Ranking Member, distinguished Members of the 
Subcommittee, thank you for inviting me here today. In my testimony, I 
will address three issues: the G20's role in the Euro crisis, its role 
in restarting sustainable economic growth, and the G20's own 

Can the G20 help coordinate a response to the Euro crisis, and what 
        should that look like?
    As it did last weekend, the G20 can exercise moral suasion on the 
eurozone countries to act more forcefully. More important, in the event 
that Spain and Italy are unable to raise money at reasonable interest 
rates--as happened to Greece, Ireland and Portugal--the fallout on the 
global and European economy would be so severe that it is doubtful in 
my view that the Europeans could handle the crisis on their own. In 
this case, the G20 would then have to coordinate a response.
    Bailing out Spain and Italy would entail, as in the case of the 
other peripheral countries, covering their public financing 
requirements for 3 years. The associated loans would amount to about 
$2.1 trillion. This large sum poses two separate problems. First, if 
the IMF were to fund one-third of the total, as it did in the case of 
the other countries, its share would amount to about $700 billion, 
exceeding its current $400 billion new lending capacity--recently 
indicated by Managing Director Christine Lagarde. The eurozone 
countries, for their part, would have to find $1.4 trillion, which 
exceeds the available capacity of the rescue fund, the European 
Financial Stability Facility (EFSF), by over $1 trillion, not counting 
any draw on the fund that may be needed to recapitalize European banks.
    Though the eurozone economy is large enough to theoretically cover 
such an outlay, in practice it remains a half-built economic and 
political union and each individual member would be hard-pressed. 
Eurozone member nations manage their own fiscal and financial 
operations as do U.S. states, but there is no Federal Government of 
anywhere near corresponding size or clout that can spend--and just as 
importantly, borrow--like the U.S. Government can. Moreover, the 
European Central Bank (ECB) lacks the Fed's political legitimacy to 
intervene in support of member nations, and is, in fact, explicitly 
forbidden by treaty from doing so. The resignation of two German ECB 
board members over its emergency purchases of the periphery's 
government bonds is a clear signal of the profound opposition to such a 
    The institutional deficit of the European monetary union explains 
why marshaling an appropriate and timely response to the Greek crisis, 
whose debt is less than 15 percent of that of Spain and Italy combined, 
has been so extraordinarily difficult. But the political dimension is 
only one aspect of the problem should the crisis spread to the larger 
countries. Markets are very well aware that a bailout of Italy and 
Spain may fail, as it has in the case of Greece, and that the ability 
of the European core countries to cover these losses is limited. The 
spread on France's Government bonds relative to Germany's has doubled 
in recent weeks and is now well in excess of 100 basis points. In 
motivating its recent decision to place France's AAA credit rating on 
downgrade watch, Moody's pointed to France's share of the EFSF 
guarantees, which already amounts to 8 percent of its GDP, not counting 
new commitments to recapitalize its banks. According to the IMF, 
Germany's debt-to-GDP level is projected at 77 percent and France's at 
90 percent by 2015, and it is clear that other large expansions of the 
EFSF would place France, and perhaps Germany in dangerous territory.
    But these calculations greatly understate the problem. Even with a 
bailout, a sudden halt of financing to Spain and Italy would be 
accompanied by a severe recession in those countries which would have a 
major spillover on the rest of Europe. (Real domestic demand in Ireland 
and Greece, for example, is down 20 percent and 15 percent, 
respectively, compared to 2007, and is expected to continue to fall in 
    Were, on the other hand, Italy and Spain forced to fend for 
themselves, in the event of a sudden stop in financing, an extremely 
dangerous European and global banking and economic crisis comparable in 
size and virulence to the Lehman episode, further undermining the 
public finances of all European countries, could erupt. Bearing in mind 
the disproportionate role that banks play in the European economy, 
Europe's political divisions, and the European governments' limited 
ability to respond now compared to 2008, it is easy to envision a 
scenario in which the acute phase of such a Lehman repeat would last 
not 6 months, but many years. Some may think that this scenario is 
alarmist, but I think it is important to bear in mind that, whereas the 
U.S. subprime mortgage market totaled between $1 and $1.5 trillion at 
its peak (depending on how subprime is defined), the outstanding debt 
of the European periphery now totals $4.6 trillion.
    The global implications of such a scenario are dire. The United 
States would be affected, through trade and foreign investment (profits 
from its international companies and returns on the equity and bond 
portfolios of U.S. residents), but most importantly through the banking 
system. U.S. banks have $850 billion in direct exposure to the 
eurozone, including nearly $400 billion in exposure to eurozone banks. 
Moreover, they have an additional $1.8 trillion in indirect exposure, 
through instruments such as derivative contracts and guarantees. These 
numbers do not include U.S. exposures to banks in the UK and other 
European countries outside the Euro zone which are themselves exposed.
    The emerging markets of the G20 would also be affected through the 
trade and banking channels as well as through ownership of European 
government bonds. But they are more exposed to a European crisis than 
the United States in two main ways: Europe attracts exports equivalent 
to 5.4 percent of its GDP (compared to 1.7 percent of GDP for the 
United States) and they are more likely to suffer a contagious 
withdrawal of external financing, as is already happening, while the 
United States is protected by its safe haven status.
    Were this risk to materialize, it would be entirely appropriate for 
the G20, operating through the IMF, to seek to support the European 
adjustment. In order to cover, say, half of the cost of the bailout of 
Spain and Italy and retain the firepower to deal with the fallout on 
other countries, the IMF's resources would have to be expanded by about 
$1 trillion, of which the U.S. share would be $177 billion. It is 
important to bear in mind that IMF resources represent contingencies, 
not actual outlays, part of a ``bazooka''--to use former Treasury 
Secretary Paulson's term--that may not need to be used. Such IMF loans 
have historically been paid back.
    In the event of an expanded eurozone commitment, the G20 should 
insist that the IMF impose demanding conditions not only on the 
recipient countries, as it does at present, but also on Germany and the 
other core countries, as well as on the ECB. These conditions would be 
designed to ensure both that the program is well funded and designed, 
but also to promote the establishment of the institutional framework 
needed for the currency union to be sustained in the very long run. 
Such steps would include new fiscal and monetary arrangements capable 
of dealing with the diversity of European situations, a powerful 
European Banking Authority, mechanisms for managing default and exit 
from the eurozone, as well as structural reforms that increase the 
flexibility of the markets for goods and services inside the union.
    The suggestion that the United States may need to provide 
additional IMF resources while it has not yet ratified the previously 
agreed-on expansion will appear audacious to some. But this is, in my 
view, the situation we may soon have to confront. Against the risk of a 
eurozone collapse, the G20, including the United States, should see 
expansion of IMF resources as a relatively cheap form of insurance. 
Even if it remains unused by the eurozone this time around, it may well 
come in handy in the not too distant future as the fallout from the 
financial crisis and the Euro zone crisis continues to reverberate.
Can the G20 help restart sustainable economic growth?
    Yes, by appropriately mandating the main specialized economic 
agencies--the IMF, OECD, World Bank, and WTO--and by monitoring their 
work. This is already happening to a degree, but here, I would like to 
highlight two areas where a shift of focus is warranted and where 
leadership from the United States is badly needed. The first relates to 
the appropriate focus of global growth policies, while the second 
relates to restarting the world trade system as a driver of reforms.

Global Growth Policy
    Policies for restarting sustainable economic growth as managed, for 
example, through the Mutual Assessment Process of the G20/IMF, suffer 
from two deficiencies in my view. First, they do not place sufficient 
emphasis on domestic policies and instead overstate the importance of 
global rebalancing. Second, domestic policies are not paying sufficient 
attention to structural reforms as distinct from macroeconomic 
    It should be obvious that domestic policies, and not those of other 
countries as reflected in trade balances, are the overwhelmingly 
important drivers of economic growth. After all, in the United States, 
for example, domestic demand is 34 times larger in absolute terms than 
(negative) net exports. And any single trading partner has only a very 
limited impact on the United States' GDP through net exports. For 
example, I have made the following calculation.
    Assume that, in response to U.S. pressure, Chinese leaders could 
dictate that their country's savings be reduced immediately by 10 
percent of GDP--approximately $500 billion. Even more implausibly, 
assume further that none of this additional spending could go toward 
domestic products, and that all of it instead went to imports, 
immediately making China a larger external deficit nation proportional 
to its GDP than the United States. If the increase were allocated 
geographically in proportion to China's recent import spending, the 
direct effect on U.S. exports and demand would be only $40 billion--or 
0.3 percent of U.S. GDP--equivalent to about one-ninth of U.S. Fiscal 
stimulus measures in 2010.
    This type of calculation actually overstates the importance of 
policy changes in other countries on the United States, since imported 
components and raw materials account for a significant part of the 
total value of U.S. exports. So the demand impulse from exports is less 
than it appears. On the other hand, the importance of imports in 
assuring the efficiency of U.S. producers and exporters, not to mention 
living standards, tends to be overlooked.
    More generally, while demand stimulus is sometimes needed in 
emergencies, its importance--whether it occurs through fiscal and 
monetary policy in the United States or in its trading partners--in 
assuring sustainable long-term growth is almost insignificant. 
Structural reforms, such as privatization and liberalization of product 
and factor markets and encouragement of research and development, are a 
much more important driver of long-term growth. Under a broad 
definition of structural reforms, I would also include tax and 
expenditure reforms that modify incentives, reduce waste, and assure 
that a nation's fiscal situation remains on a sustainable path.
    A good example of inadequate attention to structural reforms comes 
from Japan, which has been mired in slow growth and deflation for close 
to two decades. Japan has tried every trick in the macroeconomic policy 
book--repeated fiscal stimulus, zero interest rates, and quantitative 
easing--without any notable success in breaking out of its rut, and its 
public debt has exploded. The fact that it has systematically run a 
current account surplus has not helped. But observers of the Japanese 
economy long ago identified a number of structural weaknesses on which 
little or no action has been taken--for example, the nation's 
demographic decline combined with extremely restrictive immigration 
policies; an inefficient, overregulated, and protected service sector; 
super-protected agriculture; overbuilt and corrupt infrastructure 
sectors; and a state-owned post office and savings bank that 
artificially channels a huge part of the nation's savings to the 
purchase of government bonds instead of to more productive activities.
    Similar structural weaknesses help explain the dire growth and 
competitiveness problems in countries such as Greece, Italy and Spain, 
which in addition suffer from extremely inflexible labor markets, where 
``insiders'' enjoy job security and extensive benefits while an army of 
outsiders remain in precarious occupations or are unemployed.
    Instead of insisting that the G20 pay so much attention to trade 
imbalances, which are a minor part of the problem and largely reflect a 
needed adjustment to domestic imbalances, the United States would be 
well served to place a greater focus on the latter, and especially on 
how structural distortions, including misguided tax and expenditure 
policies are hobbling the G20 economies. The OECD and World Bank are 
especially well-placed to support this work.
    There is also a very rich reform agenda here on which the United 
States and China, the two largest economies, could lead the G20 by 
example. Detailing the needed structural reforms in the United States 
and China would take us beyond the current topic, but one structural 
reform area of great importance--in which the United States has just 
taken a notable step forward through ratification of agreements with 
Korea, Colombia, and Panama--is trade.

Trade Policy
    WTO disciplines, reinforced by the G20's standstill agreement on 
new trade restrictions in November 2008, helped contain protectionism 
during the height of the crisis and avoid a repeat of the disastrous 
experience of the 1930s. That is the good news.
    The bad news is that the failure to conclude the Doha Round of 
multilateral trade negotiations 10 years after they began shows that 
the WTO is broken as a liberalizing force. This means that huge parts 
of global economic activity, including large segments of services, 
foreign investment, manufactures imports in developing countries, and 
agriculture--all areas of vital interest to the United States--may 
remain essentially exempt from effective WTO disciplines. The world 
economy is still being propelled by the great opening up that occurred 
in the 1980s and 1990s as country after country embraced more market-
friendly policies, but the inability to move forward on deeper global 
trade reforms will, in my view, increasingly constrain sustainable 
growth in years to come.
    Just as it has done with the IMF and the World Bank, the G20 should 
now focus its attention on how the WTO can be reformed. How can the WTO 
regain the effectiveness of its predecessor, the GATT system?
    Drawing on work carried out by the trade council of the World 
Economic Forum, of which I am a member, I would recommend that 
agreement to the current Doha draft be linked with establishment of a 
forward agenda of ``plurilateral'' negotiations. Plurilateral 
negotiations are negotiations among a critical mass of countries on a 
specific issue, such as trade in environmental goods, for example. 
Unlike multilateral rounds, they do not require that all members agree 
on every single agenda item before a deal can be struck. Examples of 
successful prior plurilateral negotiations include the Government 
Procurement Agreement and the Information Technology Agreement. 
Examples of plurilateral agreements that could be of great interest to 
the United States and to many other countries would include many areas 
in services and trade in high-technology products.
    By supporting such a course, the United States would accept an 
admittedly low-ambition Doha deal, but, in the process, capitalize on a 
few aspects of the Doha draft that are of interest (such as trade 
facilitation), break the impasse in the WTO, and establish a new, much 
more flexible negotiating framework capable of yielding gains in a wide 
range of sectors in the decades to come. Though I believe there is 
interest in adopting a plurilateral approach to negotiations among the 
WTO membership, progress is only possible if the United States actively 
supports it and works through the G20 to promote it. As the next step, 
the G20 meeting should mandate trade ministers to meet to: a) link a 
Doha conclusion to plurilaterals, b) reach agreement on such a deal, 
and c) establish an agenda for reforming the WTO. The G20 trade 
ministers would then promote this approach among the entire WTO 

What should the G20's role be in the long run, and what would make it 
        more or less likely to succeed?
    The G20 heads of state summit was born of the financial crisis, was 
sponsored by the United States for its first meeting in Washington in 
November 2008, and was charged to be the preeminent forum for global 
economic policymaking at the Pittsburgh summit in September 2009. 
Comprising 10 emerging markets, 9 advanced economies, and the EU, the 
G20 has the potential to fill a large gap in global economic governance 
that its predecessors, such as the G7 and G8, were not able to bridge. 
It reflects the reality of a global economy where emerging countries 
are headed toward representing well over half of global GDP and trade.
    In a forthcoming paper co-authored with Kati Suominen of the German 
Marshall Fund, I argue that, to succeed in global economic governance 
as well as crisis-fighting, the G20 needs to confront four major 
challenges: sticking to its comparative advantage, being realistic in 
what it can achieve, effectively integrating emerging economies in 
decisionmaking, and clarifying its own structure and composition. It 
will also need leadership from its largest members, beginning with the 
United States but supported by China.

Comparative Advantage
    The G20 is not designed to be a decisionmaking body: it is not 
universally representative and its deliberations are not ratified by 
parliaments. It is also not well-suited to engaging at the granular 
level, which would risk encroaching on the territory of established 
multilateral institutions, such as the IMF, World Bank, or WTO, whose 
technical competence is far greater.
    The G20 is very well-positioned, however, to function like a 
steering committee. It is flexible enough to react quickly to events 
and, therefore, manage crises, but also to provide general guidance for 
how the international institutional architecture should evolve.
    The G20 countries, which together account for the vast majority of 
the ownership and voting power in the major global institutions, should 
focus on the big picture and look to these institutions to translate 
the G20-designed strategy into explicit decisions.

    The G20 has unique strengths as a coordinating forum, but it also 
has limitations that should inform its agenda. Expectations of what it 
can accomplish must be tempered.
    While the G20 economies were able to deliver on most of the 
commitments they made during the peak of the crisis, including fiscal 
stimulus, they have had much less success in dealing with longer-term 
issues, for example, restarting the trade agenda.
    For one, the G20 and its watchers need to differentiate between the 
issues that multilateral institutions can genuinely make progress on 
and those--for example, taming global imbalances--that depend instead 
on domestic political processes in the largest economies and their 
willingness to engage.
    One has to distinguish, in other words, between the need to improve 
the rules of the game and the need for key players to raise their game. 
Lacking enforcement tools, the G20 cannot induce action. But, over 
time, it can aim to develop broad consensus on the approach to take on 
global issues, nudge the executives in member states in new directions, 
and provide political cover for policy change at home. Such an approach 
is not always given to dramatic successes or flashy announcements.

Include the Emerging Economies
    The G20 has created the possibility of shifting coalitions that cut 
across developing and advanced country lines. But including emerging 
countries as full participants could also limit the G20's 
effectiveness. The argument is often made that even as the emerging 
powers demand a larger voice in international organizations, they 
resist taking on the associated responsibilities and are reluctant to 
yield sovereignty, even at the cost of torpedoing international 
consensus. There is some truth to this argument and, in my view, 
examples of it can be found in the Doha trade negotiations and in aid 
policy. But equally clearly, developing countries are not the only ones 
that have failed to live up to their international responsibilities, in 
areas ranging from agricultural trade policies to control of carbon 
emissions, not to mention taking adequate precautions to avoid 
financial booms and busts.
    So while both the emerging and advanced economies need to learn 
from their mistakes, emerging economies need to be given time to get 
the hang of international negotiations, to articulate a clear vision of 
the specific policies they want to drive on the global stage, and to 
establish a clearer ordering of their various preferences and 

    To play a strategic role in global economic policy, the G20 must 
strike a balance between bringing too many countries and institutions 
around the table and being too small to be representative. Thoughtful 
leaders in such nonmember nations as Denmark or Chile have questioned 
the legitimacy of the self-appointed G20, even though its members 
account for some 80 percent of world GDP.
    But catering to these concerns would only lead to ineffectiveness. 
The G20 already borders on being too unwieldy and is also taking on too 
many issues at once, which risks diluting its focus. At the same time, 
power on the international stage, rather than numbers, ultimately 
determines who will call the shots. In the final analysis, the five or 
six largest G20 members are in charge and including another economy the 
size of Argentina will not change that fact.
    To improve continuity and build institutional memory and capacity, 
proposals have also been aired to establish a G20 permanent secretariat 
and a more durable presidency. The current set-up is not ideal, but it 
is not clear that any alternative, such as the IMF model of national 
groupings headed by rotating chairs, would be preferable. A longer 
Presidential term would also give one nation too much weight, as the 19 
others would have to wait for their turn for years. And while a 
permanent secretariat would lead to more continuity, it would also, 
once established, increase the risks of bureaucratization, mission 
creep, and competition with other institutions.

The U.S. Role
    As the crisis began spreading across the globe in 2008, the G20, 
led by the United States, which was at the epicenter of the crisis, 
helped avoid descent into a second Great Depression. Since then, it has 
also shown glimpses of its longer-term potential--beginning the hard 
work of revising the roles and structures of major institutions and 
setting the long-term global economic agenda.
    Above all, the G20 needs to avoid the temptation to be all things 
to all nations and instead keep its eye on the ball--the systemic 
short- and long-term global policy issues that affect all nations and 
require major coordinated reforms. It also needs to know how to pick 
its fights and focus on those issues where there is a genuine emerging 
consensus about what to do.
    The key factor between success and failure will be leadership. As 
in the past, there are only a handful of members that can swing the big 
decisions. Of these, the United States is still by far the most 
important and the only plausible leader--and will, in my view, remain 
so in coming decades. No relationship is more crucial for the United 
States in leading the G20 than that with China, a developing economy 
that is also the world's second-largest and fastest-growing economy. As 
in the past, the United States will lead best by example.
     * The views expressed in this testimony are those of the author 
alone and do not necessarily represent those of the American Enterprise 
            Resident Scholar, American Enterprise Institute
                            October 20, 2011
    Thank you, Chairman Warner, Ranking Member Johanns, and Members of 
the Committee for the opportunity to testify.
    The first paragraph of an article on how to save the euro in a 
recent issue of the Economist captures a significant part of what has 
gone wrong with the European economy.
    So grave, so menacing, so unstoppable has the euro crisis become 
that even rescue talk only fuels ever-rising panic. Investors have 
sniffed out that Europe's leaders seem unwilling ever to do enough. Yet 
unless politicians act fast to persuade the world that their desire to 
preserve the euro is greater than the markets' ability to bet against 
it, the single currency faces ruin. As credit lines gum up and 
outsiders plead for action, it is not just the euro that is at risk, 
but the future of the European Union and the health of the world 
    \1\ ``How to Save the Euro,'' The Economist, September 17, 2011, 
www.economist.com/node/21529049 (accessed September 20, 2011).
    As we enter the fall of 2011 , 3 years after the Lehman Brothers 
crisis, Europe and the United States are teetering on the brink of 
another, potentially more serious, systemic crisis. It is surely fair 
to ask how we got to this point just a few months after the U.S. 
recovery had been declared well-established and European leaders had 
created a fund with resources that were supposed to be sufficient to 
ensure that Greece, the fulcrum of Europe's debt crisis, would not 
default on its debt. Figure 1 shows the sharp rise in interest rates on 
some European governments' debt--especially Greece, Ireland, and 
Portugal--and a recent jump in Spanish and Italian yields that is 
emblematic of Europe's intensifying debt crisis.

    The crisis in Europe is somewhat mirrored and amplified by a 
parallel sharp growth slowdown in the United States. After last year's 
second round of quantitative easing (QE2) and extra fiscal stimulus 
spawned expectations of 3.5 percent growth, actual U.S. first-half 
growth of only 0.7 percent has changed everything. During the spring, 
the Federal Reserve began talking about detailed strategy for exiting 
high levels of monetary accommodation, while during July's debt ceiling 
fiasco, U.S. policymakers wrestled with the need to reduce deficits and 
debt accumulation. In the end, they left the heavy lifting to a 
congressional ``super committee'' that is to report back to President 
Obama by Thanksgiving. But before the super committee could even meet, 
the President reversed course in the face of the threat of a double-dip 
recession and proposed nearly a half trillion dollars in additional 
fiscal stimulus for 2012 that repeated and expanded measures the last 
Congress passed in December 2010.
    Americans who follow deliberations in Washington, especially about 
taxes and Government spending, can be forgiven some confusion. During 
much of the second quarter in the lead-up to the July debt-ceiling 
debate, which was punctuated by threats of America's default on its 
debt, politicians loudly touted the benefits of living within our 
means, which meant cutting the deficit, which in turn meant cutting 
Government spending, raising taxes, or both. As Congress returned from 
vacation, the President offered up a jobs program costing nearly half a 
trillion dollars that involves cutting taxes and increasing Government 
    Of course, the President followed up his jobs plan with proposals 
for future tax increases and spending cuts he claimed would provide 
more than $4 trillion in deficit reduction over the 10 years after 2013 
``as the economy grows stronger.''\2\ It seems unlikely, though, that 
the tax cuts and higher spending that are supposed to make the economy 
stronger in 2012 will, when reversed in 2013, somehow not cause it to 
grow weaker.
    \2\ White House Office of the Press Secretary, ``Fact Sheet: Living 
Within Our Means and Investing in the Future: The President's Plan for 
Economic Growth and Deficit Reduction,'' September 19, 2011, 
within-our-means-and-investing-future-president-s-plan (accessed 
September 22, 2011).
    We, and many in Europe, are left to wonder whether it is deficit 
reduction that is good for the economy or euphemistically named things 
like ``jobs programs'' that increase the deficit. It is important to 
ask how, at the time of this writing in September 2011, Europe has 
reached an acute sovereign-debt crisis while the U.S. economy 
simultaneously threatens to contract, exacerbating both its own 
budgetary problems and Europe's sovereign-debt crisis.

What Happened in Europe?
    Europe's problems, which are probably more acute than America's, 
spring from a simple cause: an attempt to forge and maintain an 
impossible currency union. The European Monetary Union, which includes 
such disparate economies as Germany on the strong side and Greece, 
Ireland, Portugal, Spain, and Italy on the weak side, requires the 
assumption that monetary policy that is appropriate for Germany is also 
appropriate for Greece. Europe's adoption of monetary union enabled 
less credit-worthy countries such as Greece to borrow on virtually the 
same terms as Germany because both were issuing debt denominated in 
euros and the European Central Bank (ECB) was treating those debts as 
being of identical quality.
    The European Monetary Union was, at first, attractive for all of 
its members, including Germany. European banks were happy to make euro-
denominated loans to government and private borrowers in southern 
Europe who could suddenly borrow for less, given that the loans were 
denominated in euros. If a bank lent money to, for example, the Greek 
Government, it acquired a claim on Greece that it could take to the ECB 
and use as collateral for further borrowing. The terms for that 
transaction were virtually identical to the terms available if claims 
on the German Government were used as collateral. Easy credit 
accelerated European growth, not to mention German exports. As 
inflation and growth surged in southern Europe, so too did borrowing in 
those countries.
    Adoption of the euro by countries like Greece and Spain meant that 
they got a German credit rating that enabled them to purchase more 
Mercedes--on credit. At first, German exporters were pleased. But now, 
Germans are being asked to help borrowers in these southern European 
countries repay these loans.
    By 2009, some lenders began to notice that Greek budget deficits 
and government debt were rising rapidly. When Greece revealed late in 
2009 that its deficits and debt were substantially larger than 
previously reported, the first phase of the European debt crisis began. 
However, the ECB continued to allow banks to use Greek, Italian, 
Spanish, and any other sovereign debt from the European Monetary Union 
as collateral for loans. Banks were also not required to hold reserves 
against their sovereign-debt loans because it was effectively assumed 
that sovereigns do not default.
    The solution to the Greek crisis that emerged in the spring of 2010 
was essentially perverse. In exchange for additional loans so that 
Greece could roll over its debts and pay its debt service, the 
International Monetary Fund (IMF) and the European Union imposed strict 
conditions on Greece in the form of higher taxes and sharply 
contractionary cuts in government spending that caused the economy to 
slow further, undercutting its ability to service outstanding debt and 
additional debt.
    By the second quarter of 2011, it was clear that Greece would 
require additional funding to meet its debt service obligations, while 
similar problems arose for Portugal, Spain, and Italy. Ten years of 
pretending that loans to southern European governments carried as 
little risk as loans to the German Government left Europe's banks with 
nearly $2 trillion worth of claims on those riskier borrowers. For the 
purpose of ``stress tests,'' it was assumed that these claims were 
worth 100 cents on the dollar when the marketplace implies 
substantially lower values. The large sovereign-debt holdings by 
European banks pose a threat to the solvency of many of those banks 
that rises in proportion to doubts about governments' ability to 
service those loans. Given these conditions, if Greece, for example, 
defaults on its debts, the possibility of defaults by other sovereign 
governments in Europe may rise, triggering solvency problems for most 
of Europe's private banks.
    Many hope to preempt this disaster scenario by recommending 
aggressive steps to prevent a Greek default. The problem is that 
Germany, the country that would have to foot most of the bill, is 
insisting that Greece adopt additional austerity conditions in exchange 
for the loan. The austerity conditions, in turn, imply that Greece will 
be less able to service its debts a year from now, given that the 
economy is expected to contract at a 5 percent rate if these austerity 
conditions are imposed.

Impact of Europe's Debt Crisis on the United States
    Americans are exposed to the European debt crisis through money 
market funds, among other channels. The rapid slowdown of U.S. economic 
growth, along with the elevated uncertainty tied to July's debt-ceiling 
fiasco, caused many households to sell stocks during August. Typically, 
investors move such funds into ``cash equivalents'' or money market 
funds, which pay virtually no interest but are meant to be highly 
liquid should households need to reinvest the funds or to purchase 
goods and services. As Europe's debt crisis intensified during the 
summer, U.S. money market funds were, in effect, lending heavily to 
European banks that in turn were significantly exposed to shaky 
sovereign-debt issuers like Greece, Portugal, Spain, and Italy. The 
result was that Americans who wanted to avoid more risk by exiting 
stocks and entering money market funds were effectively lending to 
Greece and Portugal. This discovery led money market funds to sharply 
reduce their exposure to European sovereign debt as depositors began to 
exit for fear that the funds would be vulnerable to a Greek default and 
other European sovereign-debt problems.
    The search for safety outside money market funds drove risk-averse 
American investors into U.S. Treasury bills, bonds, and notes. As a 
result, the yield on 4-week and 3-month Treasury bills was driven to 
zero or below by late August, while the yield on 1-year Treasury bills 
was driven to an incredibly low six basis points. So desperate were 
American households, and undoubtedly some firms, for a risk-free cash 
repository that in some cases they were willing to pay the U.S. 
Government one or two basis points for the privilege of lending to the 
Government for a short period. Those who wanted more yield bought 10-
year notes and 30-year bonds, pushing yields on 10-year notes below 2 
percent, even lower than they had been after the Lehman crisis, and 
yields on 30-year bonds down to 3.25 percent or below. Other investors 
seeking safety and expecting higher inflation bought gold, pushing its 
price over $1,900 per ounce at some points.
    It is worth commenting on the simultaneous increase in the price of 
gold and the drop in interest rates on 30-year bonds. Because gold pays 
no return, buyers are essentially betting on an increasing price of 
gold to reward them. If inflation continues to rise, as gold buyers 
expect, purchasers of 30-year bonds will be at risk since they will be 
paid back in dollars with less purchasing power. As a result, the most 
popular fixed-income instrument, whose returns rival that of gold 
during 2011, have been U.S. Treasury inflation-protected securities 
(TIPS). So eager are investors for a safe haven that the real yield on 
TIPS has been driven well below -1 percent. That means buyers of TIPS 
are willing to pay the U.S. Government more than a percentage point for 
the privilege of owning a long-term, inflation-protected asset.
    But why are some investors betting on inflation by purchasing gold 
while others are willing to bid up prices on long-term Treasuries that 
would be harmed by higher inflation? The answer may be that the 
extremely high level of uncertainty in financial markets implies a wide 
range of possible outcomes, including both higher inflation and 
deflation. Gold is a somewhat illiquid way to play the inflation 
scenario, while longer-term Treasuries are a bet on the deflation 
outcome. Investors who remember Japan's deflationary experience after 
1998 and the resulting drop in long-term interest rates to below 1 
percent may buy Treasury bonds, while those who fear debasement of 
paper money may buy gold. Gold buyers are also concentrated in 
countries like China and India where local-currency, long-term 
government securities are not available and gold is the preferred safe-
haven asset.

No Place to Hide
    The systemic mess the United States and Europe--and eventually, the 
rest of the world--are facing in the fall of 2011 is greater than the 
sum of its parts. The U.S. economy slowed down even after substantial 
monetary and fiscal stimulus had been applied. The slowdown was 
surprising and also disconcerting to policymakers who had to entertain 
the notion that the policy levers they were pulling were no longer 
effective. Just as these disquieting realizations were arising in the 
United States, the European debt crisis reintensified as Greece 
teetered on the edge of default and the crisis environment spread to 
the rest of southern Europe. These conditions raise some serious 

Why Isn't the United States Stimulus Working?
    The short answer is this: monetary policy is not stimulating the 
economy because the United States is in a liquidity trap. At first, the 
Fed's QE2 was followed by higher interest rates as markets expected 
further growth. But as growth failed to materialize, interest rates 
came back down, stock markets weakened, and funds went back into cash. 
Viewed another way, the Fed's QE2 initially induced investors to put 
more money into riskier assets like stocks, but when growth failed to 
materialize, the funds left those riskier assets for cash. It was 
additionally disconcerting that one of the first cash destinations, 
money market funds turned out to be essentially lending to European 
borrowers who were even riskier than U.S. borrowers. As a result, funds 
flowed into the Treasury markets, pushing short-term Treasury yields to 
zero or below. Those fearing eventual currency debasement and inflation 
bought gold.
    The Fed's latest attempt to offer additional stimulus is somewhat 
bizarre. After its August meeting, the Fed indicated strongly that it 
would hold short-term interest rates at zero for another 2 years. That 
amounts to promising that the economy will not recover for 2 years 
because if it did, short-term interest rates would rise as cash 
balances sought higher returns on investments in the equity markets, 
which would improve as the economy improves. Those seeking a positive 
return on investments must bet either on higher inflation and buy gold 
or on higher growth and buy stocks.
    The Fed has sought to push down immediate and longer-term interest 
rates with Operation Twist, whereby it is concentrating its purchases 
in the Treasury market on 10-year notes and 30-year bonds at the 
expense of shorter-term bills and notes for which interest rates are 
already virtually zero. Lower interest rates--even lower longer-term 
ones--are not likely to produce much growth in an economy with 
virtually no demand for credit from qualified borrowers.
    Fiscal stimulus is not working because the constraints of rising 
deficits and resulting debt mean that it is by definition temporary and 
must be reversed after implementation. Last December, the Obama 
administration announced temporary tax cuts. Enactment boosted incomes, 
but termination a year later will slow their growth. Obama's early 
September 2011 proposal for a $450 billion stimulus package for 2012 
was followed in mid-September by another package proposal that promised 
more than $4 trillion in deficit reduction--nearly 10 times the 
stimulus proposal--over the next decade. The impetus for Obama's 2012 
stimulus was the end of the 2011 stimulus, which not only did not work 
to boost the economy but also will cause a slower economy once it ends. 
In other words, because the 2011 stimulus did not work, the President 
is claiming that we need another one in 2012 that will be reversed in 

Why Doesn't Europe Either Let Greece Default or Bail It Out?
    The question of Greek debt has to be addressed very soon. If Greece 
unilaterally defaults, fears of defaults elsewhere in southern Europe 
may produce a run on European banks that hold claims on those 
countries, leading to a full-blown financial crisis in Europe. It 
probably would be better for the ECB--or the ECB, European Union, and 
IMF, collectively--to offer unconditional guarantees on sovereign 
European debt. This would mean the euro would likely end up as a 
relatively soft currency, so the German Government, which would have to 
fund much of the sovereign-debt bailout, has so far refused to agree to 
this plan. Given the cumbersome nature of the European Monetary Union 
and its institutions, it appears likely that an agreement will not be 
reached and that some kind of Greek default, probably preceded by 
capital controls, will occur before the end of this year. The fallout, 
sharply lower European growth and sharply elevated financial turmoil, 
will be negative for the United States and the rest of the world.

What Should the United States Do?
    This fall, while Europe is awaiting Greece's impending default, it 
appears that American policymakers will repeat July's debt-ceiling 
fiasco: ambivalence about whether tighter or easier fiscal policy is 
better for the United States (that is, are we supposed to raise 
deficits or reduce them?) will be rendered moot by the super 
committee's likely inability to find an additional $1.5 trillion (or 
more, if any stimulus measures are enacted) in deficit cuts over the 
next 10 years. If that is the case and U.S. fiscal policy essentially 
continues on its current path through the end of the year, while Europe 
is in a default mess the United States will be experiencing fiscal drag 
equal to about 2 percentage points of gross domestic product, 
exacerbating any global slowdown caused by a failure to resolve 
Europe's debt mess.
    No easy or obvious ways exist to bypass this bad outlook that has 
grown out of the inability of European and U.S. economic policymakers 
to make hard decisions over the last several years. The signs that such 
an outcome is becoming more likely include a slowdown in inflation and 
a threat of deflation as more households and businesses seek the 
relative safety of cash equivalents like Treasury bills and rein in 
their spending in anticipation of substantial financial turbulence and 
slower growth. That development, coupled with the surge in demand for 
liquid assets that usually accompanies an acute financial crisis, will 
require central banks to print a lot more money to avoid a self-
reinforcing deflationary disaster that raises the real debt burden at 
the root of the problem faced by banks and governments in Europe and 
banks and households in the United States.
    One encouraging sign is that we may already have seen an initial 
step toward preempting deflation. On September 15, the Fed, in 
conjunction with the central banks of Europe, Great Britain, 
Switzerland, and Japan, arranged to supply dollars to Europe's banking 
system. The flow of dollars to Europe's banks has dried up as other 
banks and U.S. money market funds feared their exposure to large 
quantities of sovereign debt issued by southern European countries. The 
swap lines, as they are called, will be available to help with year-end 
funding needs by supplying the dollars European banks need to finance 
their dollar loans and other dollar liabilities. At the least, this 
step represents a solid move toward financial coordination among 
central banks that may help ease what appears to be an upcoming global 
financial mess.
      Director, Peterson Institute for International Economics \1\
    \1\ And formerly Assistant Secretary of the Treasury for 
International Affairs and Assistant for International Economic Affairs 
to the National Security Council. His 40 books on global economic 
issues include Global Economic Leadership and the Group of Seven in 
1996 and he chaired a ``shadow G7'' during 2000-2005.
                            October 20, 2011

    The world economy obviously faces major risks. There are three 
separate though related problems: the possibility of renewed recession 
in the three large high-income areas (United States, Europe Union, 
Japan), the continued fragility of the global financial system and most 
immediately the threat of renewed crisis in Europe.
    At the same time, the global economy does exhibit several 
significant strengths. The emerging markets and developing countries, 
which now account for half of all global output, continue to grow 
rapidly. Many of the design shortcomings and implementation failures of 
the previous financial regulatory regime have been reduced by the Basel 
III agreement and by regulatory reform at the national level, including 
importantly the Dodd-Frank law in the United States. World trade has 
continued to expand and the feared outbreak of protectionism has failed 
to materialize.
    In this mixed setting, what should the G-20 do at its upcoming 
summit in Cannes on November 4-5? I recommend a three-part initiative.

Promoting Global Growth
    The most critical task is restoring economic growth throughout the 
world and the G-20 should act to do so at Cannes as it did at London in 
April 2009. The group should postpone its 2010 pledge ``to cut budget 
deficits in half by 2013.'' There is no problem in the emerging 
markets: they continue to expand at an average rate of 6 percent and 
some, including China and India, are doing much better. Such growth is 
pervasive across all groups of these countries, including Latin America 
and sub-Saharan Africa as well as East Asia.
    All three of the traditional global economic leaders, however, are 
struggling to reach even 2 percent growth. All are experiencing high 
and persistent unemployment. Compounding their policy problems, all 
simultaneously face large budget deficits and rapidly growing debt 
burdens that require fiscal corrections rather than the expansions that 
would normally be adopted in such circumstances.\2\ Nor can monetary 
policy do very much since all three central banks are at or not far 
from the ``zero bound'' of interest rates.
    \2\ See Joseph Gagnon, The Global Outlook for Government Debt over 
the Next 25 Years: Implications for the Economy and Public Policy, 
Policy Analyses in International Economics 94, Peterson Institute for 
International Economics, Washington, June 2011.
    The world will thus have to continue to rely--increasingly so--on 
the emerging and developing economies led by China, which alone 
accounts for one quarter of all global growth.\3\ These countries 
should adopt new stimulus programs to strengthen the global prospect. 
Some, notably Brazil and Indonesia, have already begun to do so. 
Fortunately, almost all of them have fiscal and/or monetary policy 
space to deploy expansionary policies. Moreover, they are already 
planning to spend trillions of dollars on new infrastructure projects 
over the coming decade and acceleration of these efforts should be 
feasible as well as desirable. Their recent concerns over inflation, 
which justifiably have deterred some of them from shifting their policy 
gears heretofore, should be mitigated by the weakened prospects in the 
high-income countries and the leveling off of most commodity process.
    \3\ China accounts for about 10 percent of global output (at 
purchasing power parity exchange rates) and has been growing at about 
10 percent per year for over three decades. Hence it contributes 1 
percent to global growth, about 25 percent of the current total and 20 
percent even in the boom years of 2003-07.
    In short, it is time for the emerging economies to assert the 
leadership of the global economic system for which their dramatic 
progress of the last decade or so has prepared them. China already did 
so to an important extent in 2008 when it acted most quickly and most 
decisively of any major economy to promote recovery from the Great 
Recession. This time the emerging markets as a group need to move with 
equal vigor to prevent another Great Recession.
    It is also essential that the emerging markets promote global 
growth through the shape of their expansion strategies. China and the 
other countries with large reserves must provide stimulus through 
domestic demand and reductions, rather than renewed increases as 
forecast by the International Monetary Fund, in their external 
surpluses. This is the only way they can help the world as a whole, 
including a number of poorer countries as well as the high-income trio, 
attain renewed growth--which is of course critical to them as well.
    China continues to buy $1-2 billion every day to keep the exchange 
rate of its renminbi 20-30 percent below equilibrium levels. It and 
other emerging and developing countries spent $1.5 trillion in 2011 
alone to hold their currencies down, substantially increasing the trade 
and current account deficits of the United States (and Europe and a few 
others). These countries achieved much of their rapid development by 
exploiting demand in the rich countries and it is time for them to 
promote domestic consumption and social infrastructure spending and to 
let their exchange rates appreciate much more rapidly (which will also 
help counter any inflationary pressures from their new stimulus 

The European Crisis
    The most immediate problem is of course the European crisis, and 
the G-20 should be in a position by Cannes to endorse a comprehensive 
action plan.
    Here too, however, renewed growth is essential. Austerity alone 
cannot restore economic viability in Greece, Italy or the eurozone as a 
whole. Two steps are required on this aspect of the European problem:

    Germany, the Netherlands and the other strong countries of 
        the European ``core'' should, at a minimum, postpone the 
        further tightening of their fiscal policies that is now planned 
        and let their automatic stabilizers play through, and 
        preferably adopt temporary stimulus measures for the next 
        couple of years;

    The European Central Bank, which alone in the high-income 
        world has tightened monetary policy this year and is some 
        distance from the ``zero bound,'' should reduce its interest 
        rates by at least 100 basis points.

    In addition, the eurozone must deal decisively with its financial 
perils. The only way to do so is by leveraging the European Financial 
Stability Facility (EFSF), through the European Central Bank (which 
will remain the ultimate source of eurozone bailouts) or whatever 
techniques prove to be most feasible politically, to create a total 
reserve of 2-4 trillion euros. Such a war chest would assure markets 
that the zone itself could handle any conceivable contingencies, 
including defaults by Italy and Spain, as well as provide the financing 
necessary to provide the essential recapitalization of European banks 
and enable Greece to buy back large portions of its existing debt and 
thus restore national solvency.
    For the longer run, the Europeans must continue with the steps 
toward completing their Economic and Monetary Union that have already 
been galvanized by the crisis. These will include a fiscal union, a 
European Monetary Fund to systematize their rescue capabilities (and 
the accompanying conditionalities) and a comprehensive mechanism for 
regional economic governance. Such evolution will almost certainly 
require changes in the EU treaty and national constitutions. It will 
obviously take time, perhaps 5-10 years, but is an essential complement 
to the current crisis management to prevent replication of the present 
difficulties and restore assured stability to the European Union as the 
single largest component of the global economy.
    If the Europeans fail to get their act together sufficiently to 
deal with their crisis themselves, which we should know by Cannes, it 
will be necessary to move to Plan B: mobilization of global resources 
to do so through the International Monetary Fund. The Fund is the only 
alternative through which such financing, along with the requisite 
adjustment programs, could be obtained.
    The G-20 would have to play a crucial role in any such process, as 
it did in raising $750 billion for the Fund in 2009, because the IMF 
would have to raise several trillion dollars to enable it to deal 
effectively with the European difficulties. Such funds could only be 
borrowed from the emerging market economies that have built huge 
reserves of foreign exchange: China, Russia, Brazil, Korea, India, 
Mexico, Singapore, Hong Kong and several others including a number of 
large oil exporters.
    Such investments would be attractive for these countries because 
almost all of them would like to diversify their reserves out of 
dollars. A claim on the IMF would provide them with an asset that was 
both diversified in terms of currency risk and paid a higher interest 
rate. They might also, quite legitimately, link their provision of such 
funds to the IMF to further substantial increases in their quotas, and 
thus voting rights, at that institution.
    I believe that the IMF should seek to avail itself of such 
additional resources, with or without an immediate need in Europe, due 
to the ongoing fragility of the global economy and its uncertain 
prospects for at least the next several years. But Europe's 
requirements could provide a compelling case for urgent action and this 
issue could in fact leap to the top of the G-20 agenda in Cannes.

Global Financial Regulation
    It would clearly be desirable to implement a common financial 
regulatory regime that encompassed all major parts of the world and all 
classes of financial institutions. We are still far from being able to 
achieve such a regime, however, as indicated by the fierce battles over 
key components such as capital requirements and resolution mechanisms.
    The G-20 should thus agree to implement on schedule--and sooner 
where feasible--the minimum bank capital and liquidity requirements 
under Basel III including the capital surcharge for global systemically 
important banks. In view of the market funding strains and contagion 
risks facing banking systems in some important economies, this is 
decidedly not the time to be heeding pleas to weaken and/or postpone 
these key reforms. This is of course especially the case in the Euro 
area, where large holdings of beleaguered sovereign bonds by banks and 
credibility problems with previous bank ``stress'' tests have increased 
the risk of significant spillovers from the smaller periphery countries 
to larger ones at the center (particularly Spain and Italy).
    In this connection, it is instructive to note that, in the latest 
(September 2011) IMF Global Financial Stability Report, bank leverage 
(defined as the ratio of tangible assets to tangible common equity) in 
the Euro area is over twice as high as in the United States (26 versus 
12) with particularly high leverage for German, Belgian, and French 
banks (32, 30, and 26, respectively). Concerns that efforts to increase 
bank capital ratios will result in a fire sale of bank assets (by 
lowering the denominator of the bank capital ratio) can be countered 
either by requiring banks to meet the higher capital requirements in 
absolute terms (that is, by raising a specific amount of capital 
without regard to risk-weighted assets) or by picking a benchmark for 
the capital ratio that uses a level of (risk-weighted) bank assets 
prior to the required increase.
    The G-20 should also redouble its efforts in two other reform 
areas. First, it should underline further the importance of the FSB and 
national authorities monitoring carefully the buildup of risks in the 
``shadow banking system'' so that tougher capital and liquidity 
standards in the banking system do not merely result in a shifting of 
risk to less regulated but increasingly systemically important nonbank 
entities. Second, it should press the FSB to make further and faster 
progress in securing G-20-wide agreement on a cross-border resolution 
regime--especially for the 28 globally active banks that have been 
identified as global systemically important institutions. This should 
be a priority since such global institutions typically have hundreds or 
even thousands of majority-owned subsidiaries in other countries and 
resolution cannot take place effectively without such a cross-border 

What Role for the United States?
    The United States must obviously play a central role in galvanizing 
such a G-20 program at Cannes if it is to eventuate. It can make five 
major contributions:

    agreement between the President and Congress to adopt a new 
        stimulus program to enhance U.S. economic growth for 2012; we 
        can hardly expect China and Germany to take responsibility for 
        maintaining global expansion if we continue to be paralyzed in 
        moving similarly;

    tangible progress toward credibly reining in the U.S. 
        budget deficit over the remainder of this decade, going far 
        beyond the procedural legislation passed on August 2, to 
        stabilize our debt buildup and thus restore global confidence 
        in our economy and the dollar;

    a commitment to eliminate our current account deficit, 
        which would create 3-4 million new U.S. jobs and carry out 
        previous G-20 pledges to correct the large global imbalances in 
        order to achieve sustainable world growth;\4\
    \4\ C. Fred Bergsten, ``An Overlooked Way to Create Jobs,'' The New 
York Times, September 29, 2011. Copy attached.

    House passage and Presidential signature of the China 
        currency bill recently passed by the Senate, to emphasize our 
        seriousness concerning the rebalancing issue and thus increase 
        the incentives for China to both stimulate world growth via 
        domestic demand and let its exchange rate strengthen more 
        rapidly; alternatively, or in addition, the numerous G-20 
        countries concerned by China's currency manipulation could file 
        a joint case against it in the World Trade Organization; and

    support for augmenting the reserves of the IMF as suggested 
        above, including a commitment by the Senate and House 
        leadership to enact the pending IMF reform legislation once it 
        is sent to the Congress by the Administration and an expression 
        of U.S. willingness to increase the weight of the emerging 
        markets at the Fund (primarily at the expense of the Europeans, 
        who would be gaining directly--indeed rescued--from the new 
        funds provided by those countries).

    The United States has a massive national interest in successful 
revival of the world economy, especially as a large part of our own 
recovery will depend on our success in expanding sales to external 
markets. We must exercise a new style of leadership to catalyze action 
by the still-new, and diverse, G-20 but a good start has been made over 
the past 3 years and the stakes are so high that we must place the 
highest priority on utilizing the institution effectively over the 
coming months and years.