[Senate Hearing 112-609]
[From the U.S. Government Publishing Office]

                                                        S. Hrg. 112-609



                               BEFORE THE


                                 OF THE

                          UNITED STATES SENATE

                      ONE HUNDRED TWELFTH CONGRESS

                             SECOND SESSION


                             AUGUST 1, 2012


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                COMMITTEE ON FOREIGN RELATIONS         

             JOHN F. KERRY, Massachusetts, Chairman        
BARBARA BOXER, California            RICHARD G. LUGAR, Indiana
ROBERT MENENDEZ, New Jersey          BOB CORKER, Tennessee
BENJAMIN L. CARDIN, Maryland         JAMES E. RISCH, Idaho
ROBERT P. CASEY, Jr., Pennsylvania   MARCO RUBIO, Florida
JIM WEBB, Virginia                   JAMES M. INHOFE, Oklahoma
JEANNE SHAHEEN, New Hampshire        JIM DeMINT, South Carolina
RICHARD J. DURBIN, Illinois          JOHN BARRASSO, Wyoming
TOM UDALL, New Mexico                MIKE LEE, Utah
               William C. Danvers, Staff Director        
        Kenneth A. Myers, Jr., Republican Staff Director        



            JEANNE SHAHEEN, New Hampshire, Chairman        

BENJAMIN L. CARDIN, Maryland         JOHN BARRASSO, Wyoming
ROBERT P. CASEY, Jr., Pennsylvania   JAMES E. RISCH, Idaho
JIM WEBB, Virginia                   BOB CORKER, Tennessee
RICHARD J. DURBIN, Illinois          JIM DeMINT, South Carolina


                            C O N T E N T S


Barrasso, Hon. John, U.S. Senator from Wyoming, opening statement     4
Burwell, Frances G., Ph.D., vice president and director of the 
  Program on Transatlantic Relations, Atlantic Council, 
  Washington, DC.................................................     5
    Prepared statement...........................................     8
    Responses to questions submitted for the record by Senator 
      John F. Kerry..............................................    56
Johnson, Simon, Ph.D., Ronald A. Kurtz Professor of 
  Entrepreneurship and Professor of Global Economics and 
  Management, Mit Sloan School of Management, Cambridge, MA......    25
    Prepared statement...........................................    27
Shaheen, Hon. Jeanne, U.S. Senator from New Hampshire, opening 
  statement......................................................     1
    Prepared statement...........................................     3
Veron, Nicolas, senior fellow, Bruegel, visiting fellow, Peterson 
  Institute for International Economics, Washington, DC..........    11
    Prepared statement...........................................    13
    Responses to questions submitted for the record by Senator 
      John F. Kerry..............................................    55



                      THE FUTURE OF THE EUROZONE:
                          OUTLOOK AND LESSONS


                       WEDNESDAY, AUGUST 1, 2012

                               U.S. Senate,
                  Subcommittee on European Affairs,
                            Committee on Foreign Relations,
                                                    Washington, DC.
    The subcommittee met, pursuant to notice, at 2:30 p.m., in 
room SD-419, Dirksen Senate Office Building, Hon. Jeanne 
Shaheen (chairman of the subcommittee) presiding.
    Present: Senators Shaheen, Barrasso, and Risch.


    Senator Shaheen. Good afternoon, everyone. I think half of 
our audience is out watching the Olympics, so folks should feel 
free to move up if you would like to do that and not worry 
about all of the empty seats. That way you can see and hear a 
little better.
    Let me open this hearing this afternoon of the Senate 
Foreign Relations Subcommittee on European Affairs. We're here 
today to discuss one of the most critical issues that faces the 
global economy and that's the ongoing crisis in the eurozone. 
We're delighted to have our three very experienced and 
knowledgeable panelists with us.
    How Europe responds to this crisis and the lessons we draw 
from these events will have dramatic implications, not only for 
Europe, but also across the broad spectrum of U.S.-Europe 
relations, including political, financial, trade, and security 
issues. In today's global economy, Europe remains by far 
America's biggest and most important ally. Europe is the United 
States largest trading partner and export market. The 
businesses and employers in most of our States rely heavily on 
investment from European companies and purchases by European 
consumers. That's certainly true in my home State of New 
Hampshire, where three of the top six export markets for our 
businesses are in Europe, and cross-border investments mean 
thousands of jobs in my home State.
    If there is one lesson we've learned over the past year, 
it's that Europe continues to matter a great deal to the U.S. 
economic engine and our prospects for growth. We've seen the 
eurozone crisis and economic contraction in Europe drag down 
the American recovery with transatlantic trade and investment 
flows slowing and financial fears in Europe contributing to 
volatility in U.S. capital markets.
    Since 2009, eurozone leaders have undertaken a variety of 
efforts aimed at curbing the negative effects of the crisis and 
stemming possible contagion to larger eurozone countries, 
including Italy and Spain. At the latest round of critical 
summits over the last year, eurozone members agreed to begin 
moving toward a unified banking system and a single bank 
supervisor for the eurozone. Starting with ailing Spanish 
banks, leaders also attempted to break the vicious cycle 
between banks and sovereigns by agreeing to inject cash 
directly into banks, rather than putting governments on the 
hook for bailout funds.
    Despite these efforts, we've not seen any calming of 
European markets for any significant period of time, and the 
euro seems to be entering a new phase of difficulties. Spanish 
and Italian debt is coming under renewed attack by the markets. 
There are rising questions about Greece's ability to meet its 
debt conditions. Europe's banking woes continue to fester. Last 
week Moody's downgraded its outlook from stable to negative for 
Germany, the Netherlands, and Luxembourg.
    It is reassuring that the ECB president last week said that 
the bank will do whatever it takes within its mandate to 
preserve the euro, and in addition Chancellor Merkel's call for 
more Europe and a fiscal and political union indicate German 
interest in moving toward further European integration. These 
important statements have calmed nervous investors and may 
provide some room for governments to take action in the weeks 
and months ahead.
    As Europe struggles to get ahead of this issue, it's 
incumbent on us to draw lessons from the ongoing struggle. 
First, it's important to recognize that this crisis is not the 
result of any single cause. Some continue to argue that Europe 
got here because of runaway spending. Now, that is an easy 
bumper sticker response, but the truth is much more complex, I 
think. The fact is that slow growth, several banking crises, 
real estate bubbles, a lack of competitiveness, institutional 
problems, and a high debt have all contributed to what we face 
    Understanding this fact leads to another lesson. Austerity 
alone can't solve the complex series of problems. Long-term 
growth, competitiveness, and structural reform all need to play 
a role in the solution. Austerity-only will not work and can 
lead to steeper borrowing rates and lower revenues, making the 
longer term challenges even more difficult.
    At the end of the day, the bottom line is that America 
needs a strong Europe and vice versa. After two devastating 
world wars, the United States and the transatlantic community 
have spent countless resources over nearly six decades to help 
bring about a Europe that is whole, free, and at peace. America 
made these commitments because a stable, secure, and prosperous 
Europe is in our own vital interests.
    We need to coordinate where we can to support our European 
partners as they do what's necessary to put these crises behind 
them and resume creating growth and jobs on both sides of the 
    The subcommittee looks forward to engaging on these 
critical questions in the next hour or hour and a half. Before 
I introduce our distinguished panel, I would like to turn to my 
colleague, the ranking member of the subcommittee, Senator 
Barrasso, for his comments.
    [The prepared statement of Senator Shaheen follows:]

              Prepared Statement of Senator Jeanne Shaheen

    The Senate Foreign Relations Subcommittee on European Affairs meets 
today to discuss one of the most critical issues facing the global 
economy today: the ongoing crisis in the eurozone. How Europe responds 
to this crisis and the lessons we draw from these events will have 
dramatic implications, not only for the future of Europe, but also 
across the broad spectrum of U.S.-Europe relations, including 
political, financial, trade, and security issues.
    Reflecting the importance of this issue to the United States, this 
is the third hearing we have held in this subcommittee on the 
transatlantic economic and trade relationship in the wake of this 
ongoing crisis. Today, we have an impressive panel of witnesses to 
guide us through some of the lessons learned from this continuously 
evolving situation and to assess the outlook for Europe as we consider 
the near-term future.
    In today's global economy, Europe remains by far America's biggest 
and most important ally. Europe is the United States largest trading 
partner and export market. Together, the transatlantic economy accounts 
for over half of world GDP, one-third of world trade and three-quarters 
of global financial services. The businesses and employers in most of 
our States rely heavily on investment from European companies and 
purchases by European consumers. In New Hampshire, three of the top six 
export markets for our businesses are in Europe, and cross-border 
investments mean thousands of jobs in my State.
    If there is one lesson we have learned over the past year, it is 
that Europe continues to matter a great deal to the U.S. economic 
engine and our prospects for growth. We have seen the eurozone crisis 
and economic contraction in Europe drag down the American recovery with 
transatlantic trade and investment flows slowing and financial fears in 
Europe contributing to volatility in U.S. capital markets. As President 
Obama suggested this week, ``Europe is still a challenge'' and as a 
result, the United States is ``going to have some continued 
    Since 2009, eurozone leaders have undertaken a variety of efforts 
aimed at curbing the negative effects of the crisis and stemming 
possible contagion to larger eurozone countries, including Italy and 
Spain. We have seen financial assistance packages for Greece, Portugal, 
and Ireland, a significant restructuring of Greek debt and an increase 
in the firepower of a permanent Europewide rescue fund. In addition, 
the European Central Bank (ECB) took unprecedented steps over the 
winter to increase liquidity, including the offer of unlimited short-
term loans to European banks, which has pumped more than $1 trillion of 
capital into the banking system.
    At the latest of a round of critical summits over the last year, 
eurozone members agreed to begin moving toward a unified banking system 
and a single bank supervisor for the eurozone. Starting with ailing 
Spanish banks, leaders also attempted to break the ``vicious cycle'' 
between banks and sovereigns by agreeing to inject cash directly into 
banks, rather than putting governments on the hook for bailout funds.
    Despite these efforts, we have not seen a calming of European 
markets for any significant amount of time, and the euro seems to be 
entering a new phase of difficulties.
    Spanish and Italian debt is coming under renewed attack by the 
markets. There are rising questions about Greece's ability to meet its 
debt conditions. Europe's banking woes continue to fester. Last week, 
Moody's downgraded its outlook from stable to negative for Germany, the 
Netherlands, and Luxembourg.
    It is reassuring that the ECB President last week said that the 
bank will do ``whatever it takes'' within its mandate to preserve the 
euro. In addition, Chancellor Merkel's call for ``more Europe'' and a 
fiscal and political union indicate German leadership interest in 
moving toward further European integration. These important statements 
have calmed nervous investors and may provide some room for governments 
to take action in the weeks and months ahead.
    As Europe struggles to get ahead of this issue, it is incumbent 
upon us to draw lessons from the ongoing struggles.
    First, it is important to recognize that this crisis is not the 
result of any single cause. Some continue to argue that Europe got here 
because of runaway spending. Now, that is an easy bumper sticker 
response, but the truth is much more complex. We are witnessing a 
multifaceted, interrelated series of crises, including financial, 
political and fiscal problems.
    There is little doubt that in Greece, profligate spending and a 
lack of a mature revenue generating system resulted in unsustainable 
debt and sky-rocketing borrowing rates. However, the same cannot be 
said for Spain, which was previously running a budget surplus and in 
2011, had a manageable public debt total of around 68 percent of GDP. 
Despite the relatively solid fiscal situation, Spain now also faces 
market pressures. The fact is that slow growth, several banking crises, 
real estate bubbles, a lack of competitiveness, institutional problems 
and high debt have all contributed to the problems we face today.
    Understanding this fact leads to another lesson: austerity alone 
cannot solve this complex series of problems. Long-term growth, 
competitiveness, and structural reform all need to play a role in the 
solution. Austerity-only will not work and can lead to steeper 
borrowing rates and lower revenues, making the longer term challenges 
even more difficult.
    One other important lesson for the United States is that we cannot 
wait to tackle our long-term budget challenges. By the time the markets 
start raising questions, it becomes much more difficult to restore 
credibility. Delay or piecemeal reforms can breed uncertainty and erode 
market confidence. Spain, again, is an excellent example where a new 
reforming government came to power amid rising costs of borrowing. The 
Rajoy administration cut spending, engaged in labor reforms and secured 
significant support for its weak banks. Despite the recent impressive 
efforts, Spain continues today to face pressure from bond markets, 
where on July 25, 10-year bonds reached a euro record of 7.75 percent.
    As we move forward, one unanswered question remains for 
policymakers here in the U.S.: Considering the importance of Europe to 
America's economy, what should we be doing on our side of the Atlantic? 
I asked this exact question at our previous hearing. Each one of our 
expert witnesses, from across the political spectrum, agreed that the 
best action we can take for Europe and for the global economy is to get 
our own fiscal house in order. Domestic and international markets 
linked closely to the U.S. consumer base would respond positively to a 
long-term debt and deficit deal.
    It is instructive that markets in Europe reacted quite negatively 
to the poor way Congress handled the raising of the debt limit last 
summer. In fact, the price of Spanish and Italian borrowing spiked to 
well above 6 percent in the leadup to our near-default. Immediately 
following the July 31 debt deal in Congress, bond markets throughout 
Europe quickly recovered to a much more sustainable 5 percent. This 
suggests that a long-term deal in the U.S. would have positive 
consequences for Europe, which would lead to even further positive 
movement here in America.
    This is why we need to continue to work across the aisle and across 
the Capitol to get to a balanced, long-term debt deal. As is the case 
in Europe, our debt deal last year only bought us a little time. We 
need to act.
    At the end of the day, the bottom line is that America needs a 
strong Europe, and vice versa. After two devastating world wars, the 
United States and the transatlantic community have spent countless 
resources over nearly six decades to help bring about a Europe that is 
``whole, free, and at peace.'' America made these commitments because a 
stable, secure, and prosperous Europe is in our own vital interests.
    We need to coordinate where we can to support our European partners 
as they do what is necessary to put these crises behind them and resume 
creating growth and jobs on both sides of the Atlantic. This 
subcommittee looks forward to engaging on these critical questions in 
the next hour.

                   U.S. SENATOR FROM WYOMING

    Senator Barrasso. Thank you, Madam Chairman. I want to 
thank you for your leadership in organizing and holding this 
important meeting, and I also want to thank and welcome all of 
our experts for being here today to take part in our 
subcommittee's second hearing on the Europe debt crisis. Your 
experience, your thoughts, your analysis are all very valuable 
to us and to these discussions.
    The hearing today is meant to further our understanding of 
the European debt crisis and to carefully consider its 
implications for the United States. Since 2009 European leaders 
have been struggling to resolve the financial crisis which is 
threatening the economic stability of Europe. There have been 
numerous bailouts, credit rating downgrades, speculation 
regarding possible defaults by different nations, and the 
markets have resulted in and experienced great volatility and 
uncertainty as a result.
    Despite the efforts and reforms being implemented, Europe 
continues to face serious problems. In the month of June, the 
Government of Cyprus sought financial assistance and European 
leaders needed to bail out Spanish banks. Now there are 
concerns that the Governments of Spain and Slovenia will also 
be seeking financial assistance.
    Like many Americans, I'm concerned about the situation 
taking place in the eurozone. The problems facing Europe can 
have a significant and a substantial impact on the United 
States due to the interconnected nature of our economies.
    The United States must take the opportunity to learn from 
what is happening in Europe. We must clearly identify the risks 
and work together to limit the fallout from the crisis here at 
    So I look forward to hearing from the witnesses, Madam 
Chairman, about the possible risks to the U.S. economy, about 
transatlantic trade, and international security. So thank you 
again, Madam Chairman.
    Senator Shaheen. Thank you, Senator Barrasso. Hopefully, 
they will have some good news for us.
    First on our panel is Dr. Frances Burwell. She is the vice 
president and director of the Program on Transatlantic 
Relations at the Atlantic Council here in Washington. Dr. 
Burwell is a long-time friend of the subcommittee and she has 
an impressive background in U.S.-EU relations and expertise on 
political and economic dynamics at play in the eurozone.
    Next is Nicolas Veron, a French economist who is currently 
a visiting fellow at the Peterson Institute for International 
Economics, as well as a senior fellow at the world-renowned 
Bruegel, a Brussels-based economic policy think tank. Mr. Veron 
has held various positions throughout the public and private 
sectors, including as an adviser to the French Labor Minister, 
as well as an independent financial services consultant.
    Finally today, Professor Simon Johnson is the Ronald A. 
Kurtz Professor of Entrepreneurship and a professor of Global 
Economics and Management at the MIT Sloan School of Management 
in Cambridge, MA. Previously, Professor Johnson served at the 
International Monetary Fund as its economic counselor and 
director of the IMF Research Department. Professor Johnson is 
also a senior fellow at the Peterson Institute.
    Thank you all very much for being here. We look forward to 
your testimony.
    Dr. Burwell, would you like to begin.

                    COUNCIL, WASHINGTON, DC

    Dr. Burwell. Thank you very much. Chairwoman Shaheen, 
Ranking Member Barrasso, members of the subcommittee, I am 
honored to appear before you today to speak about the evolving 
crisis in the eurozone. I will focus my remarks on the 
political aspects of the crisis, including the lessons learned 
and ramifications for Europe and transatlantic relations.
    I believe this crisis is as much about politics as it is 
about economics. It is the reckoning for Europe's political 
failure to establish credible governance for economic and 
monetary policy when the euro was created. The crisis will be 
resolved only when the governments agree on who has the 
political power to set policy in the eurozone.
    During the last 2 years, European governments have lacked 
the right mechanisms and institutions to respond to the crisis. 
They have taken significant strides recently, including 
creating the EFSF and ESM, agreeing on the fiscal compact, and 
as was mentioned earlier, deciding to undertake European-level 
supervision of major banks.
    But progress has been slow, incremental, and some would say 
tortuous. This is my first lesson of the crisis: EU 
decisionmaking is difficult and will remain so. We will not 
wake up any day soon and find that the crisis is resolved. 
Because of the difficulties in reaching decisions among the 27 
members, muddling through is likely to be the optimal policy 
    My second lesson is that European leaders are more 
concerned with reaching agreement among themselves on internal 
reforms than with responding to external pressures. For many 
European politicians, getting ahead of the market is not the 
objective. Rather, the objective is ensuring structural reforms 
in the weaker economies.
    My third lesson is that the crisis itself is essential to 
reaching decisions. In Europe the 27 leaders only make tough 
decisions when standing on the edge of the precipice. When the 
German vice chancellor comments that a Greek departure from the 
eurozone has lost its horror, we should remember that it may 
reflect that person's views, but it also is a very useful 
threat as everyone shows up to tell Greece that it's time to 
make reforms. Intra-European negotiations are not for the 
    My fourth lesson is that decisionmaking in the EU must 
reconcile very different national experiences. Only a few years 
ago, Germany had one of the weakest economies in Europe, 
something that the German public blamed on the vast financial 
transfers given to the new eastern lander. Germany undertook 
serious reforms, including raising the pension age, and they 
now expect Greece to do the same.
    What does all this mean for the future of Europe and the 
eurozone? First, we will be dealing with this crisis for some 
time to come, probably 2 years more at least, if not longer. 
What is likely to emerge very gradually is a much more 
integrated eurozone, a core group of countries that has 
undergone serious structural reform, but growth will be slow to 
    This core is likely to be similar to the current eurozone. 
I see Greece as the only member seriously at risk of leaving. 
The others will not overtly push Greece and the Greek 
politician who takes that country out of the eurozone will be 
committing political suicide. Most other EU countries are 
pledged to join the euro and will work to make it stronger. 
Those who've opted out, however, may find themselves on the 
periphery. Britain especially seems likely to drift farther 
from the EU, with consequences for itself and for Anglo-
American relations.
    Some observers have warned of a rise of nationalism as a 
consequence of the crisis, but I am actually much more 
concerned that weak European economies may become targets for 
investors that may erode good business practices and undermine 
economic policy. Regional energy firms may be more vulnerable 
to investments by Gazprom and others, and we have seen the 
Chinese make a significant investment in the Greek port of 
Piraeus. The Cypriot Government is using the offer of a Russian 
loan to try to secure better terms for an EU bailout.
    What are the consequences of this crisis with the United 
States and its relationship with Europe? First, there is little 
we can do to affect the course or speed of European 
decisionmaking. Calls for Europe to lessen the rigors of 
austerity or make speedier decisions will be largely ignored, 
since the pressure is on them to negotiate among themselves.
    Instead, we should focus on the new processes and 
institutions in Europe and how they might affect U.S. firms and 
regulations. Previous consultations between Congress and the 
Europe Parliament on financial services regulation should be 
strengthened. We should continue to consult closely about 
potential contingency plans.
    Second, I also believe that the United States and the 
European Union face a significant opportunity in the form of a 
bilateral trade and investment initiative, which could 
stimulate growth and create jobs on both sides of the Atlantic. 
It seems counterintuitive to talk about such an initiative now 
with the eurozone in the midst of crisis, but the removal of 
tariff and investment barriers and regulatory obstacles should 
add to the GDP of both regions at a time when that is much 
    Third, we should continue to work with the Europeans to 
push forward the agenda of the G20. Many of the emerging 
economic powers regard this crisis as a European or North 
Atlantic phenomenon. The United States and Europe should work 
together to ensure that the commitments made on Los Cabos are 
addressed equally among all the G20.
    The crisis seems not to have eroded Europe's role as a 
foreign policy partner of the United States. On Libya, 
Afghanistan, Iran, and Syria, the Europeans continue to be very 
active, if not leaders. I would just point to the recent EU 
sanctions on Iranian energy exports and, despite the fact that 
Iran has supplied several EU countries, including Greece, which 
had previously received one-third of its oil from Greece--I 
mean from Iran, sorry. These are sanctions that have a real 
cost for European countries.
    However, the financial crisis has precipitated a crisis in 
European defense capabilities. We have heard a steady drumbeat 
of budget cuts, forcing the abandonment of real capabilities 
among European militaries. It seems likely that our Europe 
allies will have limited capabilities for deployment in the 
next few years. The impact of a long-term decline in European 
defense capabilities as a result of this crisis should be a 
priority topic among U.S. and European leaders.
    Finally, Europe remains a key partner of the United States. 
It is the largest economy in the world and, as Senator Shaheen 
mentioned at the beginning, our leading partner in trade and 
investment. The eurozone crisis will change the transatlantic 
relationship, but it should not define that relationship. With 
global wealth and power shifting away from the North Atlantic, 
this crisis can either divide the United States and Europe, 
leaving us both with reduced influence in the world, or it can 
be an opportunity for reforming and strengthening our economies 
and our partnership to remain globally competitive.
    Madam Chairman, Dr. Barrasso, members of the subcommittee, 
thanks for the opportunity to share my views. I look forward to 
your questions.
    [The prepared statement of Dr. Burwell follows:]

                Prepared Statement of Frances G. Burwell

    Chairwoman Shaheen, Ranking Member Barrasso, members of the 
subcommittee, I am honored to appear before you today to speak about 
the evolving crisis in the eurozone. Since both my colleagues are 
accomplished economists, I will let them address the economics of the 
crisis, and will focus my remarks on the political aspects, including 
the lessons learned and the ramifications for the future, both for 
Europe and for transatlantic relations.
    I believe this crisis is as much about politics as it is about 
economics. Its origins are to be found in a political failure to 
establish credible governance for economic and monetary policy, and 
European leaders have dealt with the crisis through a series of 
decisions about political power rather than economic measures. In the 
end, the crisis will continue for some time to come--not just months, 
but at least a year and probably two--and will be resolved only when 
the governments agree on who has the power to set economic and monetary 
policy in the eurozone.
    The euro, just like the European Union itself, all the way back to 
the European Coal and Steel Community, was an economic initiative 
designed primarily to achieve a political purpose. It was less about 
the creation of a currency based on economic demand, but rather about 
taking another step toward ``ever closer Union.'' At the time, many 
economists expressed skepticism, especially given the different 
approaches to monetary policy within the eurozone, but the politicians 
went ahead. And the euro has been a tremendous political success, as an 
important symbol of European integration, and rising significantly 
against the dollar during its lifetime. The current crisis is the 
reckoning, however, for Europe's failure to establish effective 
governance when the euro was created.
    Throughout the crisis, European governments have been unable to 
respond to market pressures because the eurozone has lacked the right 
mechanisms and institutions. During the last 2 years, European leaders 
have instead focused on creating those mechanisms and institutions. 
They have taken significant strides, including: adopting a ``six pack'' 
of measures establishing European level budget oversight, a fiscal 
compact that requires national balanced budget amendments; and most 
recently deciding to undertake European level supervision of major 
banks, a step which may lead to an eventual banking union. But progress 
has been slow and incremental, some would say torturous. This is my 
first lesson from the crisis: EU decisionmaking is difficult and will 
remain so. We will not wake up any day soon and find the eurozone 
crisis solved. Because of the difficulties of reaching decisions among 
the 27 members, muddling through is likely to be the optimal policy 
    My second lesson is that European decisionmaking is more concerned 
with reaching agreement among members on internal reforms than with 
responding to external pressures. Not only does the difficulty of the 
decisionmaking process make it almost impossible for the eurozone to 
``get ahead of the market,'' but I have been struck by the number of 
Europeans who have told me that responding to the market is not the 
objective. Rather the objective is ensuring structural reforms in the 
weaker European economies which will eventually allow for a more 
unified economic policy approach, and eventually perhaps mutualization 
of debt, which is widely seen as the ultimate solution, but is 
currently politically impossible.
    My third lesson from the crisis is that the crisis itself is 
essential to reaching decisions. We often assume that reaching 
decisions is harder during times of stress, but at least in Europe, 
that stress forces the 27 leaders to understand that some movement is 
required. Jacob Kirkegaard and Fred Bergsten have written about this in 
the current crisis, but speaking as someone who has watched the EU for 
many years, I can vouch that crisis is often a necessary ingredient to 
moving Europe forward across all sorts of issue areas. We should also 
remember, when assessing statements from European leaders that seem 
extreme--such as the German vice chancellor's comment that a Greek 
departure from the eurozone has ``lost its horror''--that while it may 
reflect that person's views, it is also a useful threat just before the 
``troika'' arrives to tell Greece it must proceed with difficult 
reforms. Intra-European negotiations are not for the faint-hearted.
    My final lesson is that decisionmaking in the EU must reconcile 
very different national domestic situations. Every country brings its 
own experiences to the negotiating table. While Greece, Spain, 
Portugal, and Italy are genuinely hurting in terms of unemployment and 
general economic stress, Germany and others in northern Europe remain 
very comfortable. Yet only a few years ago, Germany had one of the 
weakest economies in Europe--a situation that the German populace 
blamed on the generous economic transfers given to the new, eastern 
part of their country after unification. They also experienced 
difficult economic reforms, including raising the pension age and 
making it easier to fire workers. It is no wonder that the average 
German is not willing to transfer financial resources to Greece before 
that country has undergone reforms similar to those Germans experienced 
themselves. Angela Merkel faces elections in fall 2013, but I for one 
am not worried about her chances: her approval rating recently reached 
66 percent and only in the last few days has there been much public 
criticism of her handling the economic crisis.
    What does all this mean for the future of Europe and the eurozone, 
and most importantly for this committee, for the United States and its 
partnership with Europe? First, we will be dealing with this crisis for 
some time to come, probably 2 years at least and perhaps longer. What 
is likely to emerge very gradually is a much more integrated eurozone, 
providing Europe with a core group of countries that have undergone 
serious structural reform. But growth will be slow in returning.
    At the end of the crisis, the core group will not be much smaller 
than the current eurozone; I see Greece as the only member seriously at 
risk of leaving. In that situation, the other members will make sure 
that Greece is not pushed but rather that Greek politicians decide to 
leave the eurozone. Given the popularity of the euro in Greece, this 
would be political suicide. Thus, the EU will effectively become three 
clubs: those in the eurozone; those pledged to join at some point in 
the future, that is, the ``Euro aspirants''; and those who have opted 
out of joining the euro: Britain, Denmark, and Sweden. Most of the Euro 
aspirants, largely the new central European members, will stay closely 
engaged, seeking to influence the rules of the club they seek to join. 
But Britain and Denmark may drift farther from the EU, especially 
Britain, which is also not in the Schengen visa regime. That potential 
for drift should be taken into account as we look at the future of 
U.S.-UK relations.
    Some observers have warned of a rise in nationalism as a 
consequence of the financial crisis. It is true that any prolonged 
economic malaise is likely to lead some in societies to become more 
alienated. Europe is also going through a significant change in its 
ethnic makeup which is adding additional strains to its social fabric. 
However, in Portugal, Spain, Slovakia, and eventually in Greece, the 
voters opted primarily for mainstream parties committed to austerity. 
Even in France, the vote for M. Hollande seems to have been less 
against austerity than against Nicholas Sarkozy. The Front National 
received its highest tally ever in the first round this year, but they 
did not make it into the second round as they did in 2002, and they 
have far fewer seats in the Assemblee Nationale than they did in the 
1980s. In the Netherlands, Geert Wilders caused a government crisis by 
withdrawing the support of his Freedom Party, but he also made it very 
unlikely that he will ever be included in a governing coalition again, 
even informally. Currently the left-center Socialist Party is leading 
in the polls with the election on September 12.
    The outlook for right wing nationalist parties is mixed; indeed, we 
may see the rise of more left-wing extremism if austerity policies 
continue. One big uncertainty is Greece, which has a long tradition of 
anarchism and where Golden Dawn did better than ever in the most recent 
elections. But we should remember that in parliamentary systems, with 
the government and their parliamentary party unified, there is little 
role for parties that are not part of the government. Finally, the 
social safety net in most European countries gives the unemployed a 
relatively secure existence. Thus, my more serious concern is not with 
right-wing extremism, but with new immigrants, especially from the 
Muslim world, who are faced with few available jobs and difficulties 
integrating into society, and who fall prey to radicalism.
    More serious than the prospect of European extremism is the 
potential for weak European economies, especially in the south and 
east, to become investment targets for companies and countries that may 
weaken adherence to good business practices and undermine economic 
policy. This is particularly true in the energy sector, where the need 
to privatize state energy firms may lead to purchases by Gazprom and 
other Russian firms just when Europe is making strides in reducing its 
energy dependence. We have also seen the Chinese make a significant 
investment in the Greek port of Pireaus, and it is reported that they 
are looking for other opportunities as Greece undertakes more 
privatization. And most recently, the Cypriot government, while in the 
EU Presidency, is using the offer of a Russian loan to try to secure 
better terms for an EU bailout of its faltering economy.
    What are the consequences of the eurozone crisis for the United 
States and its relationship with Europe? First, there is little we can 
do to affect the course or speed of European decisionmaking. Calls for 
Europe to lessen the rigors of austerity or to make speedier decisions 
will be largely ignored as the Europeans negotiate among themselves. 
Instead, we should focus on the new processes and institutions in 
Europe and how they might affect U.S. firms and U.S. regulations. There 
has already been some cooperation between Congress and the European 
Parliament on financial services regulation, and this should be 
strengthened as Europe now examines the possibility of a banking union, 
and possibly other measures such as a financial transactions tax. We 
also need to continue the close consultation already developed between 
European leaders and the U.S. officials about what is happening in the 
crisis--especially concerning large cross-border banks--and potential 
contingency plans.
    Second, we should avoid making the European financial situation 
seem more dire than it actually is. This only stimulates the markets 
into erratic behavior, but does not push European leaders toward 
finding a resolution. Instead, I believe the United States and European 
Union face a significant opportunity in the form of a bilateral trade 
and investment initiative, which could stimulate growth and create jobs 
on both sides of the Atlantic. It seems counterintuitive to launch such 
talks with the eurozone in the midst of crisis, but the removal of 
tariff barriers, investment protections, and regulatory obstacles 
should add to the GDP of both regions at a time when that is much 
    Third, we should continue to work with the Europeans to push 
forward the agenda of the G20. Many of the emerging economic powers 
regard this crisis as a European or North Atlantic phenomenon. Yet, 
taking the lessons of our 2008 crisis and the eurozone crisis and 
applying them in a global framework--as outlined in the declaration of 
the Los Cabos 2012 summit--is an important task. There are many topics 
addressed, but just to mention that they include labor reforms, country 
surveillance, enhancing transparency of credit ratings agencies, and 
tracking financial sector reforms makes clear that the United States 
and Europe should work together to ensure that they are addressed 
equally among the G20 membership.
    The eurozone crisis affects Europe, not only as an economic 
partner, but also as a foreign policy partner of the United States. 
There is no doubt that the policymaking bandwidth among European 
governments has been overwhelmed by the crisis. When European leaders 
meet--as they do very frequently--most of the agenda is focused on 
economic issues. Yet, the crisis was already well underway when 
European leaders pushed for the NATO operation in Libya and dedicated 
significant personnel and armaments to the cause. And Europe has 
continued to be an effective foreign policy partner on certain key 
    On Iran, the EU Vice President/High Representative Catherine Ashton 
continues to lead the efforts of the EU 3 plus U.S., Russia, and China 
in negotiating with Tehran. The EU has recently imposed sanctions on 
Iranian energy exports, despite the fact that Iran has been a supplier 
to several EU countries. The EU had to make compensatory arrangements 
for Greece, which had previously received one-third of its oil from 
Iran. These are sanctions that have a real cost for European countries. 
The EU stopped SWIFT, the Belgian financial transactions clearing 
house, from dealing with Iranian banks, a move that may have long-term 
consequences for that institution. The EU has also imposed sanctions on 
the Assad regime in Syria and with the United States has argued for 
more sanctions at the U.N. The EU naval mission ATALANTA continues to 
patrol against pirates off the horn of Africa, while a small, new 
mission is aimed at training local coast guards to undertake antipirate 
patrols. The EU and several of its member states have also reached out 
to the countries undergoing transitions in the Arab world. A new trade 
agreement has been launched with Morocco, but it remains to be seen if 
the EU will lessen barriers sufficiently for Tunisia, Libya, and Egypt.
    But if the crisis has not taken much of a toll on these foreign 
policy initiatives, it has had an impact on the future of enlargement, 
which is the most successful European foreign policy initiative of the 
last 20 years. The crisis has lessened European appetites for bringing 
in new members and made the EU less attractive to potential members. 
Croatia will join next year as the 28th, but it is unclear when the 
next country might be ready to accede. Because the Balkan States are 
generally small and there is a feeling of obligation after the conflict 
of the 1990s, the Balkans are likely to be approved when ready. But the 
crisis has reduced the EU's attraction among some Balkan capitals even 
while adding more legislative and regulatory requirements for those 
seeking to join. The crisis has also diminished the possibility that 
any of the Eastern Partnership countries might be given a membership 
perspective if they wanted it. Finally, I think the crisis has 
significantly lessened any chance that Turkey will eventually join the 
EU, both because of EU concerns about the cost of such an accession and 
Turkish views of Europe in the wake of the eurozone crisis.
    Even more important for the United States, the financial crisis has 
precipitated a crisis in European defense capabilities. For the past 18 
months, we have heard a steady drumbeat of budget cuts forcing the 
abandonment of real capabilities among European militaries. These 
include the loss of British capability to launch fixed-wing aircraft 
off carriers until at least 2018 and the disbanding of the last two 
Dutch tank battalions. Despite NATO's efforts to launch a ``Smart 
Defense'' initiative at the Chicago summit, it seems likely that our 
European allies will have limited capabilities available for deployment 
outside the immediate region for the next few years. The ending of the 
ISAF mission in Afghanistan will free up some capabilities, but there 
will be much reluctance in Europe to undertake global deployments. The 
impact of a long-term decline in European defense capabilities as a 
result of the eurozone crisis should be a priority topic among U.S. and 
European leaders.
    Despite the difficulties of the eurozone crisis, Europe remains a 
key foreign policy partner of the United States, as is demonstrated by 
Iran, Syria, and Afghanistan, among U.S. foreign policy priorities. 
Even with the crisis, Europe remains the largest economy in the world, 
and the United States leading partner in trade and investment. The 
eurozone crisis will change the transatlantic relationship, and in ways 
that we do not yet know or understand. But we should not let the crisis 
define the relationship. With wealth and power shifting away from the 
North Atlantic, this crisis can either divide the United States and 
Europe, leaving us both with reduced influence in the world, or it can 
be an opportunity for reforming and strengthening our economies so that 
they remain globally competitive.

    Senator Shaheen. Thank you very much.
    Mr. Veron.

                   ECONOMICS, WASHINGTON, DC

    Mr. Veron. Thank you very much, Chairman Shaheen, Ranking 
Member Barrasso, Senator Risch, for the opportunity to appear 
at today's hearing.
    The eurozone has many problems. You mentioned this, Ms. 
Chairman, and there are many causes to the present crisis. I 
would argue today that the core--very much like Fran Burwell 
just said, that political authority is at the core of what 
makes this crisis unique, as opposed to other developments that 
we have seen in the past decade.
    There's a lot of skepticism in the United States about 
Europeans' natural tendency to put the emphasis on 
institutional issues. But we've been in this crisis for 5 years 
now. The banking crisis in Europe started in late July 2007. So 
there is something systemic in the policymaking framework of 
Europe that has made it difficult or at some points impossible 
to tackle the situations at hand, to react decisively, and to 
bring the appropriate action.
    I think there is good news. For the first time, in recent 
weeks European officialdom has been able, or at least some 
parts of it have been able, to articulate a holistic agenda to 
react to this crisis that takes into account not only the 
short-term aspects, but also the long-term ones. Or I could put 
this last sentence actually in reverse: Not only the need for a 
consistent permanent solution, but also the need for adequate 
immediate action. This is what I would call the European 
fourfold union, which includes a banking union, a fiscal union, 
a competitiveness union, and a political union that underpins 
the first three.
    The European Union has suffered from a loss of trust along 
many dimensions. There has been a loss of trust in the 
interbank market, basically disappearance of entire segments of 
the interbank markets in Europe, which underpins the current 
banking crisis; loss of trust of investors in government debt 
and an increasing number of eurozone states perceived for the 
first time in the developed world as carrying a credit risk; 
loss of trust in the ability of European economies to grow and 
the difficulty of undertaking the structural reforms that would 
unleash the growth potential of European entrepreneurs and 
economic activity; and I have to say a lot of cynicism about 
the lack of accountability of the decisionmakers compared to 
the wishes expressed by the general public, what the Europeans 
generally refer to as the democratic deficit.
    But what is important, I think, to understand is the 
combination between the inability to make decisions and this 
democratic deficit. So I would call it an executive deficit 
combined with a democratic deficit, and the two feed each 
other. It might sound paradoxical because one typically 
believes that having more democratic checks and balances 
hampers the ability to make executive decisions, but in Europe 
it has been the contrary. The absence of proper democratic 
checks and balances has left executive decisionmakers paralyzed 
and unable to make the decisions on short-term actions that 
were necessary. And this I think is the starting point of the 
crisis, has to be the starting point of our analysis.
    So it means creating adequate decisionmaking frameworks, 
banking union in banking, fiscal union on government finance, 
competitiveness union to coordinate and monitor structural 
reforms, and political union, which is a very loosely defined 
term, but which I would define as providing democratic 
accountability, in which I think the Europe Parliament has to 
play a central role, but that requires also reform of the 
Europe Parliament itself from its current situation, which is 
not sufficiently representative of European citizenry, in order 
to provide not only checks and balances, but the legitimacy 
that is indispensable to make adequate decisions.
    It's very difficult to do this at once. One of the problems 
of Europe has been the inability in many circumstances to 
distinguish between short-term action and long-term action, 
between crisis management and the rebuilding of the post-crisis 
order, between firefighting and design and construction of a 
new policy framework.
    I think this distinction--if you will allow me, I will 
focus for a brief moment on the banking aspect of the agenda. 
This distinction is crucial to both resolving the banking 
crisis and building the banking union that most Europe 
policymakers have now agreed that they need to introduce.
    In terms of the short-term agenda, leaders need to 
establish a temporary bank resolution authority for the 
eurozone. It has to be temporary because there is no framework 
that establishes permanent institutions, there are no existing 
institutions that can do the job, and it will take a lot of 
time to establish a permanent institution. So having a 
temporary thing, like the U.S. Resolution Trust Corporation in 
the early nineties, so it's not an exact parallel, or like the 
Auto Industry Task Force in 2009, this is the best way in my 
view to tackle the systemic crisis.
    It's difficult to do. It will require tough choices, but I 
think it's possible, and it's necessary. With a successful bank 
crisis resolution process, adequate temporary guarantees, 
including on deposits, I think it's possible to achieve bank 
crisis resolution. But at the same time, Europeans need to 
think about the long term and start establishing the single 
supervisory mechanism that they have agreed upon and the other 
features of a permanent banking union.
    The difficulty of this fourfold union agenda is that none 
of the four components can be thought about in isolation from 
the others. There is a need to make progress in the banking 
union, but for this you need to make progress on fiscal union, 
because you need a backstop for anything that looks like 
deposit insurance at the European level. You cannot do that if 
you don't make progress on political union because you need 
legitimacy to make progress.
    All these interdependencies make it very difficult to 
advance, but I think if European leaders are clear-sighted on 
the need to make progress on these four fronts--and it's very 
complicated, very difficult--they can overcome the crisis.
    The breakup of the eurozone, as has been said by many, 
would be absolutely disastrous for Europe, for Europeans, and 
for the global economy. The successful resolution, of the 
crisis will be very difficult. The slow pace of decisionmaking 
has already exacted a very large cost for Europe's economies, 
societies, and families, and Greece--I'm sure we'll come back 
to this--remains an absolutely burning concern with no obvious 
short-term solution.
    That said, I would say and believe strongly that it's not 
too late yet for Europeans to take the actions that would 
ensure the survival, sustainability, and ultimately success of 
their monetary and economic union, and I trust and expect that 
such decisions can and will be made.
    Thank you very much.
    [The prepared statement of Mr. Veron follows:]

                  Prepared Statement of Nicolas Veron

    Thank you, Chairman Shaheen, Ranking Member Barrasso, and 
distinguished members of the subcommittee for the invitation to appear 
at today's hearing.
    The Eurozone has many problems. Based on the lessons from the past 
5 years, I will argue today that the core of the current crisis, what 
makes it unique, is Europe's insufficient ability to make authoritative 
policy and political decisions for the region as a whole. To correct 
this weakness, Europe must build a fourfold union that would allow such 
executive decisions to be made. The four components are: (1) a banking 
union, (2) a fiscal union, (3) a competitiveness union, and (4) a 
political union, i.e., institutional reform to embed democratic 
accountability more solidly in the decisionmaking.
    In the second part of my testimony, I will explore a few topical 
questions about the first of these four components, namely banking 
    I work both at Bruegel and the Peterson Institute, on a half-time 
basis in each organization, and divide my time between Europe and the 
United States. Bruegel is a nonpartisan policy research institution 
based in Brussels that aims to contribute to the quality of economic 
policymaking in Europe through open, fact-based and policy-relevant 
research, analysis, and discussion. The Peter G. Peterson Institute for 
International Economics is a private, nonprofit, nonpartisan research 
institution devoted to the study of international economic policy. The 
views expressed here are my own. I have no financial or commercial 
interest that would create a bias or conflict in expressing these 
    The key points of this statement are as follows:

   The deterioration of credit conditions in the eurozone stems 
        less from inadequate decisions than from an absence of 
        decisions when they were needed. This ``executive deficit'' is 
        partly a consequence of the European institutions' lack of 
        democratic accountability, often referred to in Europe as 
        democratic deficit. It also contributes to a loss of European 
        citizens' trust in those same institutions. The European 
        Central Bank (ECB) is a partial exception to this problem but 
        cannot make up for the lack of decisiveness of the other 
   Accordingly, profound changes must be made to Europe's 
        institutional framework to make it effective in resolving the 
        current crisis and preventing future ones. An authoritative 
        European-level executive framework must oversee banking, 
        fiscal, and structural policies. This executive framework must 
        be made accountable to Europe's citizens, and for this the 
        European Parliament must become more representative and exert 
        better control over policymaking. Those four components of 
        banking, fiscal, competitiveness and political union will take 
        several years to be completed. They are mutually interdependent 
        and must be taken together, ideally in parallel increments. In 
        particular, the completion of a banking union relies on federal 
        deposit insurance which itself requires a credible 
        supranational fiscal backstop. And without the democratic 
        accountability provided by political union, no new integrated 
        policy framework can be sustainable.
   Europe must also overcome its tendency to jump to permanent 
        solutions, and acknowledge the need for pragmatic short-term 
        actions that are tailored to the urgency of the crisis. 
        Europeans have repeatedly tried to resolve long-term issues 
        before deciding on short-term fixes, but that strategy is a 
        luxury they no longer have. Specifically regarding banking 
        issues, a proper crisis management and resolution system must 
        be put in place before all longer term institutional questions 
        are answered.
   Thus, leaders should establish a temporary eurozone bank 
        resolution authority, as none of the existing institutions has 
        the skills and mandate that would allow it to perform the 
        thankless task of identifying failing financial institutions 
        and restructure them back to soundness. A successful bank 
        crisis resolution process will require temporary guarantees, 
        including a temporary central reinsurance of national deposit 
        insurance systems by the soon-to-be-created European Stability 
        Mechanism (ESM) or by a more robust future central financial 
   In the longer term, the eurozone needs not only a single 
        supervisory mechanism for banks but also a regionally based 
        deposit insurance system and a central resolution authority for 
        failing banks. The ECB can play a large role in this future 
        framework but cannot be its only component. National bank 
        supervisors will retain many of their attributes but their 
        governance will need to change. Ultimately the banking union 
        should cover all banks in the eurozone and possibly in other 
        European Union (EU) member states, even though it seems likely 
        that exceptions will be initially negotiated by member states 
        to exclude some smaller banks from its oversight.

    A breakup of the eurozone would be disastrous for Europeans and to 
a large extent for the global economy. The choices facing Europe's 
leaders and citizens are daunting. Their slow pace of decisionmaking 
has exacted a large cost for Europe's economies, societies, and 
families. Greece remains a burning concern. No one can be assured that 
the eurozone would survive its disorderly exit; but there is still no 
clear enforcement framework available if its adjustment trajectory 
keeps veering off track, as it has repeatedly over the last 2 years. 
Investors have good reasons to be nervous.
    Yet I believe it is not too late for Europeans to take actions to 
ensure the survival, sustainability, and success of their monetary and 
economic union. I trust and expect such decisions will be made.
    The rest of this statement expands on these points and provides 
additional analysis.
               europe's executive and democratic deficit
    Europe's systemic financial crisis has been going on for exactly 5 
years. Its start can be dated back to German top banking supervisor 
Jochen Sanio's reported warning on July 29, 2007, of ``the worst 
banking crisis since 1931'' while discussing the public bailout of a 
medium-sized lender, IKB.\1\ Since then, European banking policymakers 
have been in continuous crisis management mode but have never been able 
to bring the interbank market back to its normal state without 
exceptional government guarantees. As is well known, from late 2009 the 
banking fragility was compounded in the eurozone by growing 
unwillingness of market investors to lend to sovereigns, first Greece 
and later others, creating a mutually reinforcing ``doom loop'' between 
weak sovereigns and banking credit conditions.
    Half a decade is a long time in policymaking. In retrospect, the 
lack of proactive decisionmaking at the European level is striking. 
While the common depiction is of a crisis of the eurozone periphery, it 
can equally be described as a failure of the eurozone center, by which 
I mean the mechanisms and actors that determine executive policy for 
the entire eurozone as opposed to individual member states. Prominent 
among these are the European Commission, European Council of EU member 
states' heads of state and government, economic and finance affairs 
(ECOFIN) council of EU member states' finance ministers, Eurogroup 
meeting of eurozone member states' finance ministers, plus multiple ad 
hoc subsets of eurozone countries and institutions, such as French-
German and more recently French-German-Italian or French-German-
Italian-Spanish meetings, the ``Frankfurt Group'' in late 2011,\2\ or 
the four remaining eurozone triple-A-rated countries in early 2012.\3\ 
There have been occasional misguided decisions, such as an ill-designed 
``bank recapitalization plan'' adopted in late October 2011.\4\ But, on 
the whole, such policy errors of commission have been less damaging 
than the absence of decisions.
    While European institutions have long been criticized for their 
democratic deficit, the crisis has thus revealed an equally gaping 
executive deficit. Moreover, these two feed each other: the lack of 
democratic legitimacy contributes to the paralysis of executive 
decisionmaking; and Europe's inability to solve its collective problems 
deepens citizens' distrust of its institutions. This is another kind of 
``doom loop,'' political rather than financial, but no less damaging 
than the one between sovereign and banking credit. To be fair to the 
personalities involved, this failure must be seen as a systemic problem 
of inadequate incentives and institutions, rather than a shortcoming of 
individual leadership.
    The insufficiently democratic nature of European decisionmaking has 
many aspects. First, European citizens lack equal representation in the 
European Parliament, a shortcoming cited in June 2009 by Germany's 
federal constitutional court as a key reason for Berlin not to 
surrender national fiscal power to Brussels. In addition, the European 
Parliament lacks control over financial and other executive decisions. 
Consequently, it cannot act ``in such a way that a decision on 
political direction taken by the European electorate could have a 
politically decisive effect,'' and this constitutes a ``structural 
democratic deficit.'' \5\ Second, the European Council, a key actor in 
Europe's collective executive decisionmaking, does not have a framework 
to ensure collective accountability. Its members, heads of state and/or 
of government, are exclusively accountable to their respective national 
citizens, but the Council as a whole is accountable to no one. The same 
shortcoming hampers the summit meetings of the eurozone, as well as 
other intergovernmental formations such as the ECOFIN Council and 
Eurogroup. The European Commission has a stronger accountability to the 
European Parliament, but it has often been sidelined in the past 5 
years (with important exceptions such as on competition policy). Third, 
when electorates in individual member states were consulted on 
successive treaty revisions by referendum, negative responses have not 
been answered by a change of orientation. The French and Dutch 
rejection of the 2004 constitutional treaty were followed by the 
reintroduction of a near-identical text as the Lisbon Treaty in 2007; 
the Irish were asked to vote again on the Lisbon Treaty in 2009 after 
first rejecting it in 2008. The democratic shortfall has been widely 
cited as a factor in the rise of populist anti-European parties in 
recent elections in several member states.
    It might sound paradoxical to advocate stronger democratic 
accountability as a means to reinforce Europe's ability to make 
executive decisions. Democratic checks and balances, including 
parliamentary control mechanisms, are constraints on executive 
discretion. But the lesson of the past 5 years in Europe is that, in a 
region like Europe where the commitment to democracy runs deep, the 
absence of such checks and balances cripplingly inhibits decisionmaking 
as leaders don't feel empowered to take bold action for the region as a 
whole. Alternative history is always a perilous exercise, but it is 
likely that if proper European executive decisionmaking and oversight 
processes had existed in the banking, fiscal, and structural policy 
areas during the past decade, the European systemic banking fragility 
could have been resolved as early as 2009 (as it was in the United 
States); a special resolution regime for all European banks could have 
been introduced early in the crisis, instead of a legislative 
discussion about it being started only in June 2012; Greece's sovereign 
debt could have been effectively contained in early 2010; and the 
growth potential of Europe, especially of its southern member states, 
could have been bolstered. In other words, Europe's executive and 
democratic deficit has mattered hugely for economic outcomes and the 
inability to tackle the crisis, and will continue to do so.
    It must be noted that the ECB is an outlier in this context. 
Central bankers are inherently less dependent than other policymakers 
on democratic accountability mechanisms to legitimize their decisions. 
Therefore, the ECB has been less paralyzed than other actors by the 
weaknesses of democratic representation at the European level, and it 
has exercised its authority forcefully. But the ECB must be careful not 
to act much beyond the treaty-defined limits of its mandate. Its 
ability to fill Europe's executive deficit is thus limited.\6\
                      the need for fourfold union
    A resolution of the current crisis must address these mutually 
reinforcing deficits of executive decisionmaking capability and of 
democratic representation and empowerment. The key executive functions 
that need strengthening are financial sector oversight, government 
financing, and structural reforms, which is why there is a need for a 
banking union, a fiscal union, and a competitiveness union. In 
parallel, a transformed European institutional framework must provide 
democratic accountability, the political backbone of European 
integration, and address the concerns expressed in the above mentioned 
2009 ruling of the German federal constitutional court. This 
institutional transformation can be called a political union as it 
would entail the recognition of a political space at the European level 
and not only in individual member states. Such a fourfold union is 
needed to resolve the eurozone crisis over the medium term.
    These labels, which echo the four ``building blocks'' proposed by 
the President of the European Council in a landmark report published on 
June 26,\7\ are certainly formulaic and they can encompass many 
possible options. Yet they are used here as a useful way to discuss the 
preconditions for crisis resolution.
    Each component union can be seen as a response to lost trust in 
Europe's collective future--respectively, the evaporation of the 
interbank market and especially of cross-border interbank lending 
(banking union); the erosion of market demand for eurozone national 
sovereign debt, which is increasingly perceived as carrying a credit 
risk (fiscal union); the doubts about eurozone countries' ability to 
generate dynamic economic growth (competitiveness union); and the 
growing cynicism about the undemocratic nature of European 
decisionmaking (political union).
    In practice, a banking union--as further developed in the latter 
section of this statement--would entail a common framework for banking 
supervision, crisis resolution, and deposit insurance.\8\ A fiscal 
union would include the creation of a commonly issued debt instrument 
to meet investors' demand for a credit-risk-free asset (or 
``Eurobonds,'' but actually there are many possible designs for such an 
instrument), accompanied by adequate central controls on national 
budgetary choices.\9\ A competitiveness union would monitor, assess, 
and coordinate structural reform policies at the national and European 
levels, including on areas that have high impact on the potential 
development of high-growth firms in Europe such as insolvency 
legislation, financial regulation, service sector regulation, and labor 
law. A political union would make the European Parliament genuinely 
representative and able to exert due democratic control of relevant 
executive functions.\10\
    All these steps are necessary to sustain the eurozone's monetary 
union and to prevent the dissolution of the eurozone, which, as Anders 
Aslund at the Peterson Institute among others has convincingly argued, 
is likely to be disastrous for all parties.\11\ A fourfold union would 
not by itself resolve the crisis. But it would effectively address the 
obstacles that have impeded progress in the past 5 years, and thus make 
crisis resolution a possibility that is not currently at hand.
    Progress toward a fourfold union requires thinking about political 
obstacles, interdependencies, and sequencing. National resistances vary 
depending on the component and the country. For example, banking union 
and fiscal union tend to be supported by troubled countries as a way to 
share their liabilities with stronger countries. Conversely, fiscally 
stronger member states tend to emphasize central control over banking, 
fiscal, and competitiveness decisions as a precondition for liability-
sharing. Political union tends to be more easily envisaged by countries 
with a strong federal tradition, such as Belgium, Italy, or Germany, 
than by those with a more centralized state, including France. Another 
impediment to establishing such a union stems from the fact that the 
European Union possesses a supranational legal and political framework 
that covers 27 member states,\12\ but the eurozone remains only a 
subset of countries.
    Six non-eurozone member states (Bulgaria, Denmark, Latvia, 
Lithuania, Poland, and Romania) are members of the Euro Plus Pact, a 
2011 policy framework that can be seen as the existing basis for a 
competitiveness union. The European Fiscal Compact, which provides a 
possible basis for further fiscal union, includes all EU member states 
except for the Czech Republic and the United Kingdom. All EU member 
states participate in the London-based European Banking Authority (EBA) 
which would have a role to play in a future banking union. Most 
significantly perhaps, the European Parliament is an EU institution, as 
is the European Commission. One can imagine restricted formations in 
which only members of the European Parliament (MEPs) from eurozone 
countries would have a right to vote, somewhat akin to the Scottish, 
Welsh, and Northern Ireland Grand Committees in the U.K. House of 
Commons, with possible observer status for MEPs from non-eurozone 
countries. For all its importance, the eurozone is embedded in the 
European Union and cannot envisage its institutional future 
independently from the Union as a whole.
    The components of the fourfold union agenda are mutually 
interdependent. Because executive capability must be seen as 
legitimate, banking, fiscal, or competitiveness union will not be 
sustainable without political union. Fiscal union is also necessary for 
a stable banking union, because a common deposit insurance system, even 
one funded by levies on the financial sector, must ultimately rely on a 
common and credible fiscal backstop. There is also a direct 
relationship between banking union and competitiveness union, as 
financial system policy is one of the key areas in which Europe must 
introduce structural reforms to enhance its growth potential. These 
observations mean that none of the component of the fourfold union can 
be seen as a substitute for the others.
    In terms of sequencing, progress of all four must occur in 
lockstep, or at least in parallel. For example, an incremental advance 
on banking union, such as that achieved at the eurozone countries' 
summit on June 29, requires further incremental steps forward on fiscal 
union to pave the way for a common deposit insurance system. Advances 
toward political union are needed to buttress the pooling of 
sovereignty entailed by a single supervisory and resolution authority, 
or by joint issuance of bonds by all eurozone countries. European 
leaders cannot afford to neglect any of these four components in the 
difficult steps ahead.
                   short-term and long-term responses
    Europe must pay equal attention to short-term crisis management 
actions and longer term initiatives to build a more sustainable system. 
An exclusive short-term focus may worsen future problems. But a focus 
only on the long term, ignoring the most urgent challenges, is no less 
    This may sound self-evident, but is worth emphasizing in the 
eurozone crisis context. Eurozone leaders have often given the 
impression of focusing exclusively on long-term legislative and 
institutional reforms while neglecting more short-term aspects of the 
crisis. When they did take short-term action, they often sounded as if 
the result was final and there would be no further steps needed after 
the one just announced. Yet institutions take time and deliberation to 
change, while the crisis has a pace of its own, requiring an immediate 
policy response. Short-term responses must be undertaken despite the 
absence of a specific legal framework. Pragmatic adaptation is often 
required. By contrast, post-crisis reconstruction can be carried out 
after time is devoted to higher standards of consistency and 
accountability. Short-term emergency legislation is different from 
permanent legislative reform.
    From this standpoint, the U.S. and European responses to the 2008 
crisis stand in striking contrast. A high point of financial turmoil 
was reached in the early fall of 2008, following the bankruptcy of 
Lehman Brothers. Broadly speaking, the financial shock was of similar 
magnitude on both sides of the Atlantic, even though the initial 
apparent trigger had been the subprime crisis in the United States. In 
America, the sequence included a highly visible piece of emergency 
legislation (the Emergency Economic Stabilization Act, enacted October 
3, 2008), which allowed the banking situation to be temporarily 
stabilized in mid-October through bank recapitalizations using the so-
called Troubled Asset Relief Program (TARP). The next major step was a 
comprehensive program of capital assessment and recapitalization of the 
19 largest banks (the Supervisory Capital Assessment Program, known as 
``stress tests'' and conducted from February to May 2009). Its 
completion resulted in a rapid return of the interbank market to normal 
conditions. Then, in mid-June 2009 the U.S. Government published a 
blueprint for long-term financial reform, which opened a phase of 
legislative deliberation concluding with enactment of the Dodd-Frank 
Wall Street Reform and Consumer Protection Act in July 2010. The 
implementation of Dodd-Frank through rulemaking by various federal 
agencies then started and continues, though with some significant 
delays. Several issues remain unresolved, including U.S. housing market 
reform, but it appears fair to say that the United States first adopted 
short-term crisis management and resolution measures from October 2008 
to mid-2009, and then followed by another sequence of long-term 
    By contrast, the European Union has persistently focused on long-
term initiatives first, and to concede short-term action only under the 
irresistible pressure of events. This tendency results from the 
executive deficit described above, and the fact that long-term actions 
lend themselves to a protracted legislative process that European 
Institutions favor. To be fair, individual member states have carried 
out significant short-term actions, but their effectiveness has been 
diminished by the lack of adequate European-level coordination. For 
example, the summit of heads of state and government of eurozone 
members and the U.K. in Paris on October 12, 2008, initially helped 
stabilize markets, along with the near-simultaneous use of TARP in the 
United States for bank recapitalizations. But this initial success was 
not followed by systemwide monitoring and capital assessment in Europe, 
in spite of successive rounds of ``stress tests'' in 2009, 2010, and 
2011, leaving the European banking sector fragile. A more recent case 
is the Euro Area Summit Statement of June 29, 2012, which contemplated 
the direct intervention of the European Stability Mechanism (ESM) to 
recapitalize banks in certain eurozone countries. It proclaimed the aim 
``to break the vicious circle between banks and sovereigns,'' but only 
``when an effective single supervisory mechanism is established.'' \13\ 
Taken literally, this is somewhat akin to deciding that firefighters 
can intervene to put out a fire only after architects and builders have 
completed their work of design and reconstruction of the firehouse.
    To be more effective in the next phases of the crisis, the eurozone 
should adopt more explicit short-term crisis management contingency 
measures, even if they are designed as temporary steps to be superseded 
by future permanent arrangements. This is particularly the case in 
managing the banking crisis and making progress toward the creation of 
a banking union.
                   banking union: short-term aspects
    Several analysts, including myself, have urged adoption of a 
federal framework for banking policy with centralized functions of 
supervision, crisis resolution and deposit insurance as essential to 
the stability of the European banking system and to the sustainability 
of eurozone monetary union.\14\ Similar views have been advocated by 
the International Monetary Fund (IMF).\15\ Yet such analysis has long 
remained controversial inside the European Union. As recently as early 
June 2012, the European Commission proposed draft legislation on long-
term reform of bank crisis management and resolution that envisaged no 
central deposit insurance, supervisory, or resolution authority.\16\ 
However, the vision of banking union as an indispensable component of a 
sustainable economic and monetary union has gathered a remarkable 
momentum in the spring of 2012. It was forcefully advocated by IMF 
Managing Director Christine Lagarde in mid-April,\17\ backed by ECB 
President Mario Draghi in late April,\18\ promoted by newly elected 
French President Francois Hollande in what can be seen as a significant 
inflection from previous French policy in late May,\19\ and more 
cautiously yet unambiguously endorsed by German Chancellor Angela 
Merkel in early June.\20\
    This momentum created the context for the previously mentioned Euro 
Area Summit Statement of June 29, which asked the European Commission 
to present proposals (now expected in September) for a ``single 
supervisory mechanism'' to be established under Article 127(6) of the 
Treaty, implying an anchoring role for the ECB. The statement further 
creates the possibility for the ESM ``to recapitalize banks directly. 
This would rely on appropriate conditionality [for each relevant member 
state], including compliance with state aid rules, which should be 
institution-specific, sector-specific or economywide and would be 
formalized in a Memorandum of Understanding [between European-level 
authorities and the member state concerned].'' This declaration has 
been rightly hailed as a policy breakthrough, but it also raises far 
more questions than it answers. As previously argued, the next steps 
will require careful thinking about the sequence and articulation of 
short-term and long-term initiatives, as well as about the 
interdependencies between action on the banking system and the other 
components of Europe's ``fourfold union.''
    In the short term, policymakers need to think in terms of systemic 
bank crisis resolution. They could gain precious insight from 
consideration of the lessons from previous episodes of systemic crises 
in developed countries, particularly the U.S. savings & loan crisis of 
the late 1980s, the Scandinavian crises of the early 1990s, the 
Japanese crisis until 2002-03, and the U.S. financial crisis of 2007-
09. The aim is to restore trust in the banking system, starting with 
the more systemically important banks. This necessarily involves 
willingness to acknowledge and share losses; a strong and well-
empowered resolution authority; significant financial risk-taking by 
public authorities; and several phases, from the emergency prevention 
of contagion to the restoration of individual banks' safety and 
    The starting point is that there are probably vast unrecognized 
losses in Europe's banking sector and that the resolution framework 
must allow an adequate sharing of these losses among all relevant 
stakeholders, including private sector creditors. At the same time, 
ordinary bankruptcy procedures are notoriously unsuitable to 
systemically important financial institutions. Some European member 
states, including some but not all in the eurozone, have adopted 
special resolution regimes for banks. But so far, almost no senior 
unsecured creditors have been forced to take losses on financial 
institutions found insolvent in the European Union. Leaving aside a 
handful of tiny bank bankruptcies in Northern Europe, the only 
exceptions have been two medium-sized banks in Denmark (Amargebanken in 
February 2011, and Fjordbank Mors in June 2011) but under a policy 
framework that was later amended so that subsequent situations would be 
treated differently. In most cases, even subordinated unsecured 
creditors of failed banks have been fully repaid, at great cost to the 
respective countries' taxpayers. This stands in stark contrast with the 
United States, where a handful of high-profile federal bailouts (most 
notably Bear Stearns, Fannie Mae, Freddie Mac and AIG) have rightly 
caused much public controversy, but senior unsecured creditors have 
been forced to take major losses on their exposures to dozens of 
depositary institutions, including large ones such as Washington 
Mutual, and medium-sized nonbanks such as CIT and MF Global, not to 
mention Lehman Brothers.\21\
    The European practice of fully bailing out all senior creditors, 
even of smaller banks, and many junior ones is clearly unsustainable. 
The aim to have adequate participation of senior creditors in the 
sharing of losses should become the driving objective of Europe's 
crisis management and resolution approach. The ECB has recently 
signaled its acknowledgement of this reality, in a significant shift 
from its earlier policy positions.\22\ However, most member states and 
the European Commission, ostensibly motivated by contagion concerns, 
still appear to defend the view that no losses should be imposed on any 
senior creditors even of failed banks.\23\
    The best way to address the fear of contagion is to conduct the 
assessment of bank solvency on a systemwide basis, i.e. by including 
all systemically important banks throughout the eurozone in a 
comprehensive, rigorous, and consistent review of balance sheets and 
capital strength. This was the key to past successful systemic crisis 
resolutions, including in Sweden in 1992-93, in Japan (belatedly) in 
2002-03, and in the United States with the Supervisory Capital 
Assessment Program in 2009. Conversely, the fact that in the eurozone, 
capital assessment and restructuring has been left to national 
authorities in spite of the high degree of cross-border market 
integration is a major reason why Europe's banking fragility remains 
unresolved after half a decade of turmoil, three rounds of ``stress 
tests'' (2009, 2010, 2011), and the ill-fated ``recapitalization plan'' 
of October 2011. There is considerable political resistance against a 
genuine systemwide approach to banks' capital assessment, particularly 
in countries such as France and Germany whose official position is that 
their respective banking systems have been kept sound (notwithstanding 
past problems at banks such as IKB, Hypo Real Estate, WestLB, and 
Dexia). But it might be the only possible approach that allows 
significant burden-sharing with senior creditors, an increasingly 
evident financial and political imperative, not to mention the moral 
hazard implications of open-ended taxpayer-supported bailouts.
    Even if it remains impossible to approach resolution synchronously 
across the eurozone, it is a clear lesson of the past few years that 
the resolution authority must be centralized. The most evident reason 
is that national authorities have failed on their supervisory duties in 
several member states, and have lost too much credibility to remain the 
main decisionmaker on future restructuring, as in the case of Spain. 
Moreover, it is difficult to see how to build a perception of fairness 
in the treatment of controversial situations across several countries 
without having a single authority in charge for the entire eurozone (or 
possibly beyond, assuming other member states would want to 
participate). Furthermore, bank resolution is an extremely time-
consuming, skill-intensive, and sensitive process that cannot possibly 
be coordinated across borders without an unambiguous centralization of 
information and authority. Many of Europe's larger banks have 
significant cross-border operations within the European Union, and a 
centralized resolution process is the only practical way to balance the 
interest of home and host countries, as national authorities have 
powerful incentives not to cooperate in such cases. In addition, as 
some banking operations and assets are likely to be brought under 
temporary public ownership as a result of the resolution process, 
centralization of their management and/or disposal would prevent 
ineffective competition among different national authorities to the 
collective detriment of taxpayers, and would help an orderly process of 
price discovery as assets are eventually sold back to the private 
sector. Finally, it makes operational sense to have expertise and 
skills concentrated in one central team rather than having it spread 
thin across various member states, both in terms of cost-effectiveness 
and more importantly of ability to attract talent and learn from 
    No existing institution is well equipped to assume this role of 
eurozone resolution authority. The ECB, in addition to not having the 
relevant skills directly at hand, cannot assume the politically 
contentious responsibility of bank resolution in a manner compatible 
with its jealously safeguarded monetary policy independence. The 
European Banking Authority, in addition to not having the relevant 
skills directly at hand either, is ruled out given its governance 
structure that makes it too dependent from member states and by its 
location in the U.K., a country that has unambiguously refused to 
participate in any effort toward banking union. The European Financial 
Stability Facility (EFSF) and soon-to-be-established ESM are small 
structures with no expert staff with a specialization in banking, and 
even more than in the case of the EBA may lack the independence from 
member states to ensure the impartiality of the resolution process. The 
European Commission has built valuable experience through the 
implication of its directorate-general for competition (DG COMP) in 
most bank restructurings over the past years under the European Union's 
state aid control policy, and its involvement in the ``troika'' that 
negotiates conditionality with countries under assistance programs, 
including in the recent case of Spain. But it is questionable whether 
the task of restructuring may conflict with the Commission's many 
institutional constraints, and whether its staffing by general-purpose 
civil servants is compatible with the need for specialized skills in 
the resolution and restructuring task.
    This suggests that in the short term the best way to achieve a 
resolution authority at the eurozone level might be to create a 
temporary, dedicated structure with wide latitude to recruit 
specialized staff, both from the private sector and through temporary 
leaves from national or European public authorities. In addition, bank 
restructuring and resolution is a thankless task, and those who will 
perform it will gain few friends, an observation which also favors a 
temporary structure that can ensure maximum independence and 
impartiality. Precedents suggest this can be an effective approach to 
systemic crisis resolution, including the U.S. Resolution Trust 
Corporation (1989-1995), the Swedish Bank Support Authority (1993-96), 
or in the case of systemic issues beyond the financial system, the 
Treuhandanstalt that restructured and sold the former German Democratic 
Republic's state-owned enterprises in 1990-94, or the U.S. Presidential 
Task Force on the Auto Industry that coordinated government policy on 
Chrysler and GM in 2009. While none of these experiences was without 
its blemishes, they all suggest that a temporary, well-empowered task 
force structure, obviously with adequate provisions for accountability 
and transparency, would represent a credible and well-suited response 
to the short-term challenge of European bank crisis resolution.
    This leaves open the question of future ownership of those 
institutions that the temporary resolution authority would find 
insolvent following in-depth balance sheet assessment. In legal terms, 
those countries that do not currently have a special resolution regime 
for banks should pass emergency legislation to create one, and those 
that have one might also need emergency legislation to empower the 
temporary resolution authority at the eurozone level. Failed banks will 
generally need to be taken over by public authorities, but there might 
be no uniform framework as to which public authorities will become 
equity owners. One can imagine a combination of national government 
ownership and ownership at the European level (specifically by the ESM 
as suggested by the eurozone summit statement of June 29), depending on 
countries and individual bank situations. This should logically be 
negotiated by the temporary resolution authority together with the 
imposition of losses on relevant categories of creditors (excluding, of 
course, those which are covered by explicit guarantees). While these 
negotiations should be conducted with a sense of impartiality and 
evenhandedness across the eurozone, differences in legal environments, 
banking structures and fiscal positions make it unadvisable, and 
arguably impossible, to adopt a one-size-fits-all approach.
    Beyond this, crisis resolution and restructuring will necessarily 
involve significant financial risk-taking by public authorities--but 
these have to be compared to the current open-ended explicit and 
implicit commitments of support to the financial sector that exist at 
the level of individual member states. Here again, banking policy 
cannot be considered in isolation from the other components of fourfold 
    This is most obvious as regards the protection of retail deposits, 
and more generally the prevention of further capital flight, 
particularly in the more fragile countries. As previously argued, 
European policymakers should refrain from a blanket and permanent 
guarantee of all bank liabilities, but they could and should do more to 
reassure depositors. Deposit data in Europe tend to be only disclosed 
with a lag, and are far from complete, but the available evidence 
suggests that deposit flight is occurring, at various paces in several 
eurozone member states. This is very dangerous for financial stability 
and should be addressed decisively. It would be irresponsible for 
policymakers to delay their action until it is forced by a fully 
fledged retail bank run.
    Three main factors appear to motivate deposit flight: a fear of 
currency redenomination and devaluation in case of eurozone exit; a 
fear of inability of the government to fulfill its deposit insurance 
commitments; and for larger depositors, concerns about their deposits 
above the insured threshold in case of failure of the bank where they 
are held. Addressing the first concern involves reassuring eurozone 
citizens that there will be no forced or disorderly exit from the 
currency union: the crucial case here, in the next few months as in the 
recent past, is obviously Greece, and to say the least, eurozone 
leaders have not done enough to remove uncertainties about its future 
status. To address the second concern, the ESM, when it is in place, 
should provide a temporary and unconditional guarantee of national 
deposit insurance systems across the eurozone, at least until progress 
has been made toward comprehensive bank crisis resolution and possibly 
until a federal eurozone deposit insurance system is in place. Such 
``deposit reinsurance'' should be temporary as it creates questionable 
incentives for member states, but might be a necessary step to achieve 
the eurozone leaders' ``imperative to break the vicious circle between 
banks and sovereigns.'' The third concern could be addressed by 
targeted temporary guarantees until the completion of a credible, 
systemwide process of bank assessment as earlier described.
    Finally on the sequencing, several successive steps will be needed 
and policymakers should preserve as much flexibility as possible in 
their intervention framework. Even under the most optimistic 
assumptions, it would take at least 2-3 months to build a temporary 
European resolution authority; 3-4 further months to reach a 
comprehensive systemwide assessment of the balance sheet and capital 
positions of the most important banks (which would represent a sample 
comparable to that of the 2011 stress tests, say between 60 and 90 
banks); and one or two additional months to negotiate the outline of 
restructuring packages for those banks found insolvent, which might 
number in the double rather than single digits. As a consequence, the 
disclosure of capital assessments, which can only be made once adequate 
backstop plans have been defined for failed institutions, could hardly 
happen before February or March 2013, and possibly not before the late 
spring of 2013 at the earliest, with a long period of prolonged 
uncertainty in the meantime. Even after that, it will take many months 
if not years to complete the restructurings. As illustrated by multiple 
recent cases including WestLB, Fortis, Dexia, RBS, and others, 
resolving or restructuring problem banks in Europe is almost always a 
protracted and legal-risk-ridden process. This long sequence will be 
difficult to manage, and will require very careful and professional 
communication towards the financial community and the wider public.
                   banking union: longer term aspects
    In accordance with the June 29 eurozone summit statement, eurozone 
policymakers have started discussing the long-term design of their 
future banking union even before having set the key parameters of 
short-term crisis management and resolution. In this context, essential 
choices will have to be made shortly about the future institutional 
framework. The only indication so far is an anchoring role to be played 
by the ECB, consistent with the statement's reference to article 127(6) 
of the Treaty on the Functioning of the European Union, which states 
that ``The Council, acting by means of regulations in accordance with a 
special legislative procedure, may unanimously, and after consulting 
the European Parliament and the European Central Bank, confer specific 
tasks upon the European Central Bank concerning policies relating to 
the prudential supervision of credit institutions and other financial 
institutions with the exception of insurance undertakings.''
    A proper banking policy framework includes several dimensions, 
including regulation, supervision, resolution, deposit insurance, 
competition, and consumer protection. In the European Union, regulation 
is mostly defined at the EU level, through legislation (directives and 
regulations) and ``binding technical rules'' which are increasingly 
prepared by the EBA and other European Supervisory Authorities, even 
though the European Commission retains decisionmaking authority in the 
current framework.\24\ While this framework is somewhat clumsy, its 
reform is not a necessary condition for the establishment of a banking 
union. Competition policy is conducted under a time-tested integrated 
policy framework, in which the European Commission's DG COMP plays a 
pivotal role together with national competition authorities. Consumer 
protection might require further convergence, including as part of a 
future economic competitiveness union, even though this has not yet 
been considered an urgent concern by most European policymakers. This 
leaves supervision, resolution, and deposit insurance as the key areas 
on which leaders need to start designing a viable future framework now.
    As previously observed, the inherent political nature of bank 
resolution authority makes it unlikely that such authority could be 
temporarily or permanently granted to the ECB, even assuming a 
separation of teams and a dedicated governance framework within the 
institution. This is especially true in the European context of a weak 
central executive and problematic democratic accountability, which 
advises against delegating excessive discretionary power to the ECB. 
The ECB itself has signaled that it had no appetite to assume the 
inherently controversial task of bank resolution, including by 
stressing that the future banking union framework should allow the ECB 
to act ``without risks to its reputation.'' \25\ Thus, it appears 
inevitable that the long-term framework will include a European 
resolution authority separate from the ECB, and also most likely 
separate from all other currently existing institutions for the reasons 
developed in the previous section. However, it is desirable that the 
resolution authority should be able to have close interaction with the 
ECB, particularly in times of crisis. For this reason it should 
preferably be located in Frankfurt, as geographical proximity would 
help in this respect even as the two institutions would remain 
    The supervisory function has synergies both with the lender-of-
last-resort role of the ECB, and with resolution authority. If the June 
29 decision is to be implemented, the ECB will develop supervisory 
functions of its own in any case. It is likely that the resolution 
authority will require a supervisory mandate as well, as is the case 
with the Federal Deposit Insurance Corporation (FDIC) in the United 
States;\26\ as in the United States, it could be coupled with the 
deposit insurance function, even though a formally separate deposit 
insurance fund could be envisaged as well. Some overlapping of 
supervisory functions across two or more European institutions should 
of course be kept to a minimum as it involves duplication of some costs 
and complexity, but its existence should not necessarily be seen as a 
problem in itself: situations of overlap exist in several jurisdictions 
including the United States (Federal Reserve/FDIC/Office of the 
Comptroller of the Currency) but also Japan (Bank of Japan/Financial 
Services Agency) and Germany (Bundesbank/BAFin). If the eurozone is to 
avoid such overlap, its leaders may need to envisage a change from the 
June 29 decision and a buildup of the supervisory function entirely 
outside of the ECB even though adequate operational links with the 
Central Bank should be established, as is the case in Australia, 
Canada, China, Sweden, and Switzerland among others.
    National supervisors would continue to exist in a future banking 
union, at least in a first phase. The European principle of 
subsidiarity, according to which a European authority should perform 
only those tasks which cannot be performed effectively at the national 
level, suggests in particular that the supervision of most local banks 
should remain in their scope, and they could be delegated other tasks 
by the European supervisor(s). However, their mandate and governance 
will need to be adapted to the new, more integrated approach. To be 
consistent with the eurozone's claimed ``imperative to break the 
vicious circle between banks and sovereigns,'' at least some of their 
functions should be placed under the authority of the European 
supervisor(s) rather than of the respective national government as is 
currently the case, with possible corresponding changes in terms of 
their accountability framework. Conversely, one can imagine a role for 
national supervisors in the governance of the new European-level 
authorities, including possibly of the new supervisory function within 
the ECB, a possibility made arguably easier by the fact that many of 
these supervisors are part of the National Central Banks that 
participate in the eurosystem together with the ECB itself. However, 
appropriate lessons should be drawn from the experience of the EBA and 
other European Supervisory Authorities, suggesting that such role 
should not be exclusive. Officials with a European as opposed to 
national mandate and accountability, as is the case of members of the 
ECB's executive board, should be prominent in the key decisionmaking 
bodies, unlike the situation of the EBA where the so-called supervisory 
board, which in spite of its name is in charge of most key executive 
decisions, is composed exclusively of national representatives. In line 
with previous arguments about political union, strong channels of 
accountability should be built vis-a-vis the European Parliament.
    In relation with the above arguments about the role of national 
supervisory authorities, the European supervisory, resolution, and 
deposit insurance authorities should have competence not only over 
those financial institutions that are systemically important at the 
European level (or E-SIFIs, to mimic the current jargon of the 
Financial Stability Board and Basel Committee on Banking Supervision, 
which identifies G-SIFIs as financial institutions that are 
systemically important at the global level, and D-SIFIs as those that 
are systemically important at the domestic level). It should also cover 
smaller banks, even though most operational duties related to these 
could and should be devolved to national supervisors. This would also 
help maintain, or rather establish, a competitive level playing field 
across the banking union. It is likely however that some member states 
will try, at least in a first phase, to negotiate exceptions for 
sections of their respective banking systems with particularly strong 
links with local and regional environments. Such exceptions from the 
general framework of banking union, which would also encompass separate 
deposit insurance systems, appear unadvisable from the standpoint of 
policy consistency and effectiveness, but may be inevitable to reach a 
political consensus at least in an initial phase. They may concern the 
German Sparkassen-Finanzgruppe, with the possible exception of the 
Landesbanken within it, and perhaps also Germany's cooperative bank 
system (Volksbanks and Raiffeisenbanks, and DZ-Bank). Whether other 
exceptions will be sought by member states other than Germany remains 
to be seen.
    In terms of geographical scope, the generally adopted working 
assumption is that the banking union would be identical in perimeter to 
the eurozone. However, it can also be envisaged that its perimeter 
would be wider and include some EU member states that may not join the 
eurozone in the short term, say Poland or Denmark. This would create 
additional complexity and potential risks, but it is technically 
conceivable and may be ultimately determined by political 
considerations. Under this scenario, common supervisory and resolution 
authorities might span different currency areas (the eurozone being by 
far the largest among them) and be linked to different deposit 
insurance funds, as it appears difficult to envisage how a single 
deposit insurance fund could span multiple currency areas. The opposite 
option, of a banking union that would include some eurozone countries 
but not all, is harder to imagine.
    This brief and incomplete enumeration shows that many different 
parameters remain to be discussed in order to put in place a consistent 
permanent institutional framework for the future banking union. In this 
context, it is to be hoped that pragmatism will prevail and that direct 
financial intervention by the ESM in individual banks will be unlocked 
before all these parameters are set, in order to allow swift and 
effective crisis management and resolution. However, it is also 
desirable that eurozone leaders achieve consistency between their 
short-term and long-term planning, and that an early version of a 
future European supervisor can be set up rapidly and provide continuity 
of approach beyond the short-term phase and beyond the possible 
lifetime of a temporary resolution authority, if such an option is 
indeed chosen.
    Even under optimistic assumptions, the situation in the eurozone 
will remain affected by high levels of market volatility. Many 
observers and investors have gradually lost hope in the eurozone's 
ability to resolve its problems. They are not encouraged by what they 
perceive as a state of denial affecting several senior European 
policymakers, about both the severity of the region's problems, and the 
need to maintain or regain investors' trust to resolve them. In their 
narrative, the eurozone is too diverse to survive as a monetary union, 
and centrifugal forces are too strong to be contained.
    I share the view that Europe's current institutions are not strong 
enough to contain such forces indefinitely, but the European Union is 
and remains a work in progress and is capable of change. The completion 
of a fourfold union as advocated in this testimony would create a much 
more robust and resilient framework that could enable decisions to 
repair investors' trust and keep centrifugal forces in check. Arguments 
that Europe is too diverse for stronger central institutions to exist 
do not hold up to scrutiny. India is one example of a fairly stable 
democratic polity whose internal historical, social, economic, 
religious, ethnic and linguistic diversity is greater than in the 
European Union, let alone the eurozone. Among more advanced economies, 
Canada and Switzerland are other examples of stable, yet diverse and 
multilingual democracies. Many pessimistic observers underestimate the 
extent to which well-designed political institutions can tie different 
communities, provided there is a desire to hold together.
    European integration has been a process of political innovation 
from the start. There is no precedent, and still no equivalent 
elsewhere in the world, for the kind of supranational institution-
building that has been going on in Europe since 1950. Even though 
parallels might be drawn with some cases of constitution of 
federations, particularly the United States in the 1780s and Canada in 
the 1860s, these cases are too different from Europe to have any 
predictive relevance. As with all innovation, success can neither be 
taken as given nor considered impossible.
    In the specific case of the eurozone, powerful ``de facto 
solidarities'' exist and make the bloc more resilient than superficial 
observation might suggest. These solidarities are of a different nature 
from those involved in earlier steps of European integration, and are 
often ill-understood including in the European economic policy and 
research community itself, as the rambunctious debate about so-called 
Target2 imbalances among Eurosystem Central Banks, among others, has 
illustrated.\27\ They are particularly strong in the case of Germany, 
the eurozone's pivotal member state.
    Nonetheless, Greece remains the litmus test of whether the eurozone 
will hold together, and the outcome there is hard to predict. Eurozone 
leaders, including Greek ones, might come to the conclusion that 
further transfer of economic sovereignty by Greece to the eurozone 
level is the only way to prevent a disorderly dislocation. If this 
happens, the issue of European institutions' democratic accountability, 
in other terms the political union agenda, will gain even more urgency 
than is currently the case. Similarly, if a legal impasse is reached as 
the consequence of future rulings of Germany's constitutional court 
about crisis management initiatives, a major strengthening of the 
democratic underpinnings of EU institutions might be the only way to 
overcome the court's reservations against more transfer of 
decisionmaking toward the supranational level.
    There is no easy, simple or painless way to resolve the eurozone 
crisis successfully. An enormous effort of adjustment and 
transformation lies ahead, in addition to the substantial sacrifices 
already incurred by Europe's member states and citizens. In my opinion, 
achieving a fourfold union as described here is indispensable to avoid 
a disorderly and disastrous eurozone breakup. Time and stamina will be 
needed. The changes involved are significant, but not impossible. The 
European does not have to become a ``superstate'' to overcome the 
crisis, and will remain a hybrid in which component nation-states play 
an irreducible role. The fragmentation of Europe's financial, economic 
and social space that has occurred since the crisis started is damaging 
and worrying, but has not reached a point of no-return beyond which it 
could not be reversed. The eurozone faces daunting challenges, but is 
far from condemned to failure yet.\28\

End Notes

    \1\ Financial Times, ``Germany Rescues Subprime Lender,'' August 2, 
    \2\ This informal group included, in alphabetical order: European 
Commission President Jose Manuel Barroso; European Central Bank 
President Mario Draghi; Eurogroup Chairman Jean-Claude Juncker; 
International Monetary Fund Managing Director Christine Lagarde; German 
Chancellor Angela Merkel; European Commissioner Olli Rehn; French 
President Nicolas Sarkozy; and European Council President Herman Van 
Rompuy. See for example Peter Spiegel, ``EU Presses Rome and Athens,'' 
Financial Times, November 14, 2011.
    \3\ Finance ministers of Finland, Germany, Luxembourg, and the 
Netherlands held joint meetings in the context of the Greek debt 
restructuring negotiations. See for example Associated Press, ``Greek 
Debt Talks to Stretch Into Weekend,'' February 3, 2012.
    \4\ See for example Nicolas Veron, ``Banking Federalism is Key to 
the Eurozone's Survival,'' Emerging Markets G20 Edition, November 3, 
    \5\ Press release No. 72/2009 of 30 June 2009, ``Act Approving the 
Treaty of Lisbon compatible with the Basic Law; accompanying law 
unconstitutional to the extent that legislative bodies have not been 
accorded sufficient rights of participation,'' Federal Constitutional 
Court of Germany.
    \6\ It may be noted that an early call for a stronger European 
executive policymaking capacity in the context of the eurozone crisis 
came from then-President of the ECB Jean-Claude Trichet, ``Building 
Europe, Building Institutions,'' speech on receiving the Charlemagne 
Prize 2011 in Aachen, June 2, 2011.
    \7\ ``Towards a Genuine Economic and Monetary Union,'' Report by 
President of the European Council Herman Van Rompuy, Brussels, EUCO 
120/12 .
    \8\ A possible blueprint was outlined before the last European 
Council meeting by Jean Pisani-Ferry, Andre Sapir, Nicolas Veron and 
Guntram Wolff, ``What Kind of European Banking Union?'' Bruegel Policy 
Contribution 2012/12, June 2012.
    \9\ One exploration of the policy options is in Benedicta 
Marzinotto, Andre Sapir and Guntram Wolff, ``What Kind of Fiscal 
Union?'' Bruegel Policy Brief 2011/06, November 2011.
    \10\ National Parliaments may also play a role in strengthening 
democratic accountability, but cannot replace the European Parliament 
as the only assembly where all EU citizens are represented together.
    \11\ Anders Aslund, ``Why a Breakup of the Euro Area Must be 
Avoided: Lessons from Previous Breakups,'' Peterson Institute Policy 
Brief, August 2012.
    \12\ This number will grow to 28 in mid-2013 with the planned 
enlargement of the European Union to Croatia.
    \13\ Euro Area Summit Statement, Brussels, 29 June 2012.
    \14\ In my case, relevant references include ``Is Europe Ready for 
a Major Banking Crisis?,'' Bruegel Policy Brief 2007/03, August 2007; 
``A Solution for Europe's Banking Problem,'' with Adam Posen, PIIE 
Policy Brief PB09-13 and Bruegel Policy Brief 2009/03, June 2009; 
prepared statement on ``The European Debt and Financial Crisis: 
Origins, Options and Implications for the US and Global Economy,'' U.S. 
Senate Committee on Banking, Housing and Urban Affairs, Subcommittee on 
Security and International Trade and Finance, hearing on September 22, 
    \15\ See in particular Dominique Strauss-Kahn, ``Crisis Management 
Arrangements for a European Banking System,'' keynote speech at the 
European Commission conference ``Building a Crisis Management Framework 
for the Internal Market,'' Brussels, March 19, 2010.
    \16\ European Commission Press Release IP/12/570, ``New crisis 
management measures to avoid future bank bail-outs,'' Brussels, June 6, 
    \17\ Christine Lagarde, opening remarks at the IMF/CFP Policy 
Roundtable on the future of 
financial regulation, Washington DC, April 17, 2012, available on 
www.imf.org .
    \18\ Mario Draghi, introductory statement before the Committee on 
Economic and Monetary 
Affairs of the European Parliament, Brussels, April 25, 2012.
    \19\ Transcript of the President of the French Republic's press 
conference in Brussels, May 23, 2012, available in French on http://
    \20\ Reuters, ``Merkel calls for body to supervise major EU 
banks,'' June 4, 2012.
    \21\ For a discussion of this contrast see Morris Goldstein and 
Nicolas Veron, ``Too Big to Fail: The Transatlantic Debate'' in J.F. 
Kirkegaard, N. Veron and G.B. Wolff (editors), Transatlantic Economic 
Challenges in an Era of Growing Multipolarity, Peterson Institute/
Bruegel Special Report 22, July 2012.
    \22\ Interview of Mario Draghi in Le Monde, July 21, 2012.
    \23\ Gabriele Steinhauser and Brian Blackstone, ``Europe's Bank 
Shifts View on Bond Losses,'' Wall Street Journal, July 16, 2012.
    \24\ There are however multiple exceptions to the principle of a 
``single European rulebook'' for banking regulation, as illustrated 
among others by the U.K. debate over implementation of the 
recommendations of the Independent Commission on Banking, or Vickers 
Commission. Moreover, corporate law applicable to banks remains 
exclusively national, a situation which may require modification with 
the creation of a permanent European resolution authority. Banks across 
the European Union will also need to continue to adapt to different 
national tax systems for the foreseeable future.
    \25\ Jorg Asmussen, ``Building deeper economic union: what to do 
and what to avoid,'' speech at the European Policy Centre, Brussels, 
July 17, 2012.
    \26\ The FDIC is the primary supervisor of only a subset of 
depositary financial institutions in the U.S., but has backup 
supervisory authority over all others and is a prominent member of the 
U.S. supervisory community.
    \27\ See for example Isabelle Kaminska, ``*That* Target2 
presentation,'' FT Alphaville, June 27, 2012.
    \28\ Insightful comments on an early draft of this statement by my 
colleagues Andre Sapir, Shahin Vallee and Guntram Wolff at Bruegel, and 
Martin Kessler, Ted Truman, Steve Weisman and John Williamson at the 
Peterson Institute are most gratefully acknowledged.

    Senator Shaheen. Thank you.
    Dr. Johnson.


    Dr. Johnson. Thank you very much, particularly for holding 
this hearing on such an important and timely topic.
    I would describe myself as much more pessimistic about the 
European situation than either Dr. Burwell or Mr. Veron. I 
think I would try to communicate this pessimism in the 
following way. Senator Shaheen, you said in the beginning that 
this crisis has many causes, and of course you're right in some 
sense. But I think also that there is an overarching 
explanation or driving force behind what we're now seeing, 
which is the end of a very large credit boom.
    Now, we had a credit boom, obviously, in the United States 
and we're familiar with the devastating consequences across 
mortgages and across many parts of the economy that are still 
with us 5 years after our crisis, and I think we'll struggle 
for another 5 years to get out from that. The Europeans didn't 
just go crazy on real estate. That was the situation in Ireland 
and Spain. They also went crazy on government spending, 
including most spectacularly in Greece, and their banks became 
very highly leveraged, speculative operations. The notion of 
``too big to fail,'' which is obviously a problem still with 
us, the Europeans have that and more. Their banks became much 
bigger relative to their economies. In Ireland three banks were 
two times the size of the Irish economy. Switzerland, two banks 
eight times the size of the Swiss economy. Not a member of the 
eurozone, but the same general phenomenon.
    The crisis, as Mr. Veron said, absolutely began in the 
summer of 2007. We are 5 years into a financial crisis that 
continues to drag out and a crisis within which the Europeans 
have made many awful mistakes, including introducing or, let's 
say, communicating with some clarity that sovereign debt is not 
necessarily backed by the Central Bank in the European context.
    They have in a sense recreated on the fly a version of the 
gold standard, in which you're not going to get bailed out, but 
they're doing it in a situation where people have already 
borrowed massively assuming that there were Central-Bank-type 
bailouts of the kind to which people have become accustomed in 
recent decades in this country and in Europe.
    This is a really toxic and dangerous combination. I think 
that when people say, as they are now saying, that Mario 
Draghi, the president of the European Central Bank, can solve 
the crisis, he can do whatever it takes, they're kidding 
themselves. The European Central Bank cannot issue credit to 
any degree in any form that will deal with the underlying 
problems, some of which my colleagues have absolutely nailed 
and I would just add on top of that and emphasize the 
competitiveness problem, the intra-European problem that the 
Greeks' real wages relative to the Germans are too high 
relative to their productivity. Either you devalue in that kind 
of situation or you lower your wages and prices, and we know 
that lowering wages and prices is extremely difficult.
    These serious, deep-rooted problems all exacerbated, pushed 
further than would otherwise have been possible by the credit 
boom, all of these problems now need to be dealt with. The 
European Central Bank can't do that.
    In fact, as the Central Bank now moves to provide more 
credit, more so-called liquidity to this situation, I fear we 
move into the most dangerous phase of the eurozone crisis, the 
one in which people seriously begin to question whether or not 
the euro will break up, this dissolution risk. If you have a 
contract with a German bank, for example, you may feel 
comfortable with the creditworthiness of that bank. You may 
even like the creditworthiness of the German state, which you 
might presume stands behind their largest banks. But how 
certain are you that when this contract comes due, for example 
in a year, there will be such a thing as a euro?
    Or perhaps the euro will exist in parallel with other 
currencies. In what currency will you be paid? Does it matter 
whether or not that contract was in Frankfort, London, New 
York, or the Cayman Islands?
    All of these questions become enormously important. And 
remember, we are sitting on a powder keg of opaque, over the 
counter, derivative transactions. The amount of derivatives 
notionally linked to Euribor, the European version of Libor, or 
to the London Interbank Offered Rate, a rate which is already 
called into question by the apparently fraudulent activities of 
the big banks engaged in reporting information used for the 
construction of those interest rates, the notional value of 
these contracts is in the hundreds of trillions of euros.
    Nobody can tell you what is the true exposure of American 
banks to these problems. No one can tell you if Greece exits 
the euro in the coming months, which is my expectation, what 
will be the knock-on effect on the balance sheet of French 
banks? How will that affect the largest U.S. banks?
    I think as a matter of pressing policy in this country the 
Federal Reserve should suspend the payment of dividends and 
suspend share buybacks for all systemically important financial 
institutions. Those funds still belong to the shareholders. 
They remain on the balance sheet of the bank as a buffer 
against the losses they are likely to incur as the European 
situation worsens and as a protection against the taxpayer 
being dragged into another round of expensive and damaging 
bailouts in the United States.
    Thank you very much.
    [The prepared statement of Dr. Johnson follows:]

                 Prepared Statement of Simon Johnson\1\

    (1) Successive plans to restore confidence in the euro area have 
failed. The market cost of borrowing is at unsustainable levels for 
euro banks and a significant number of governments.
    (2) Two major problems loom over the euro area. First, the 
introduction of sovereign credit risk has made nations and subsequently 
banks effectively insolvent unless they receive large-scale bailouts. 
Second, the ensuing credit crunch has exacerbated difficulties in the 
real economy, causing Europe's periphery to plunge into recession. This 
has increased the financing needs of troubled nations well into the 
    (3) With governments reaching their presumed debt limits, the 
European Central Bank (ECB) is now treading a dangerous path. It feels 
compelled to provide adequate ``liquidity'' to avert systemic financial 
collapse, yet must presumably limit its activities in order to prevent 
a loss of confidence in the euro--i.e., a change in market and 
political sentiment that could lead to a rapid breakup of the euro 
    (4) Five measures are needed to enable the euro area to survive: 
(1) an immediate program to deal with excessive sovereign debt, (2) far 
more aggressive plans to reduce budget deficits and make peripheral 
nations ``hypercompetitive'' in the near future, (3) supportive 
monetary policy from the ECB, (4) the introduction of mechanisms that 
credibly achieve medium-term fiscal sustainability, and (5) 
institutional change that reduces the scope for excessive leverage and 
consequent instability in the financial sector.
    (5) Europe's leaders have mainly focused on a potential long-term 
fiscal agreement, and the ECB under Mario Draghi is setting a more 
relaxed credit policy; however, the other elements are essentially 
    This crisis is unique due to its size and the need to coordinate 17 
disparate nations. I suggest four examples of economic, social, and 
political events that could lead to more sovereign defaults and serious 
danger of systemic collapse.
    Each trigger has some risk of occurring in the next weeks, months, 
or years, and these risks will not disappear quickly.
1. The Euro Area's Last Stand
    For over 2 years Europe's political leaders have promised to do 
whatever it takes to save the euro area. Yet problems are growing and 
solutions still seem far off. 
The October 27 and December 9, 2011, agreements of European leaders 
failed to change the dangerous trends in Europe's economies or markets. 
The implicit risk of default priced in sovereign bond markets reached 
all-time highs in the last 3 months. The trend is similar with bank 
default risk. The crisis is continuing to get deeper, broader, and more 
    A combination of misdiagnosis, lack of political will, and 
dysfunctional politics across 17 nations have all contributed to the 
failure so far to stem Europe's growing crisis. I begin with our view 
on the main problems that are pushing the euro area toward collapse. I 
then turn to potential solutions (although we are very aware that the 
complexity of the problems in Europe renders any solution 
questionable), and finally I outline several factors that could trigger 
rapid financial collapse in the euro area.
2. Key Systemic Problems in the Euro Area
    Within the complex sphere of Europe's crisis, if we had to pick one 
issue that turns this crisis from a tough economic adjustment into a 
potentially calamitous collapse, we would argue it is the 
transformation of Europe's sovereign debt market. We outline this in 
section 2.1 and then discuss the economic ramifications in sections 2.2 
and 2.3.
            2.1. European Sovereign Bonds Are Now Deeply Subordinated 
                    Claims on 
                    Recessionary Economies
    In July 2011, Peter Boone and I laid out the case that the euro 
area's immediate problems, in large part, reflect transition from a 
regime where sovereign debts were perceived to be sacrosanct (``risk-
free'') to one in which investors perceived that sovereign defaults 
were possible.\2\ Neither investors nor Europe's politicians understood 
the full ramifications of no bailout clauses in the Maastricht treaty 
until recently. With the new risk premium needed to compensate for 
default risk, some European nations will need to radically reduce their 
debt levels and change its maturity structure.
    The treatment of private investors in the upcoming Greek debt 
restructuring has made it ever clearer that Europe's sovereign bonds 
bear substantial risk. On July 27, 2011, the EU Council of Ministers 
finally admitted that a Greek default was needed--although to date they 
prefer to describe this default as voluntary, referring to it as 
private sector involvement (PSI).\3\ By choosing a default over 
bailouts, it is as if the politicians have inserted a new clause into 
all European sovereign bonds:

        In the event that the issuing sovereign cannot adequately 
        finance itself in markets at reasonable interest rates, and if 
        a sufficient plurality of the EU Council of Ministers/Euro 
        group/ECB/IMF/the Issuer determine it is economically or 
        politically expedient, then this bond may be restructured.

    Soon after this announcement it was apparent Greece could not 
afford the proposed deal, and more funds would be needed. At the summit 
on October 27, 2011, Europe's leaders announced that for Greek debt the 
PSI ``haircut'' would rise from 21 to 50 percent in order to provide 
these funds, while the official creditors promised no additional funds 
specifically for Greece.\4\
    Those nonofficial creditors holding Greek bonds learned a new 
lesson: They are the residual financiers to European issuers when the 
troika's programs fail.\5\ The Greek press reported that the government 
was prepared to change laws governing its bonds in order to force 
nonofficial creditors to bear these losses. For nonofficial creditors, 
a further clause has thus been effectively and implicitly inserted into 
European sovereign bonds:

        In the event of default (i) any non-official bond holder is 
        junior to all official creditors and (ii) the issuer reserves 
        the right to change law as needed to negate any rights of the 
        non-official bond holder.\6\

    We should not underestimate the damage these steps have inflicted 
on Europe's =8.4 trillion sovereign bond markets. For example, the 
Italian government has issued bonds with a face value of over =1.8 
trillion. The groups holding these bonds are banks, pension funds, 
insurance companies, and Italian households. These investors bought 
them as safe, low-return instruments that could be used to hedge 
liabilities and provide for future income needs. It was once hard to 
imagine these could ever be restructured or default.
    Now, however, it is clear they are not safe. They have default 
risk, and their ultimate value is subject to the political constraint 
and subjective decisions by a collective of individuals in the Italian 
Government and society, the ECB, the European Union, and the 
International Monetary Fund (IMF). An investor buying an Italian bond 
today needs to forecast an immediate, complex process that has been 
evolving in unpredictable ways. Investors naturally want a high return 
in order to bear these risks.
    Investors must also weigh carefully the costs and benefits to them 
of official intervention. Each time official creditors provide loans or 
buy bonds, the nonofficial holders become more subordinated, because 
official creditors including the IMF, ECB, and now the European Union 
continue to claim preferential status. Despite large bailout programs 
in Greece, Portugal, and Ireland, the market yield on their bonds 
remains well above levels where they are solvent. This is partly due to 
the subordinated nature of these obligations. De facto, if not de jure, 
Europe's actions have turned these bonds into junior claims on troubled 
    Once risk premiums are incorporated in debt, Greece, Ireland, 
Portugal, and Italy do not appear solvent. For example, with a debt/GDP 
ratio of 120 percent and a 500-basis-point risk premium, Italy would 
need to maintain a 6 percent of GDP larger primary surplus to keep its 
debt stock stable relative to the size of its economy.\7\ This is 
unlikely to be politically sustainable.
            2.2. Crisis Spreads Into Europe's Core Banks and Incites 
                    Capital Flight From the Periphery
    On August 27, 2011, Christine Lagarde, the managing director of the 
IMF, shocked European officialdom with a speech decrying inadequate 
capital levels in European banks.\8\ She referred to analysis by IMF 
staff showing that, if European banks were stressed for market-implied 
sovereign default risks, they were =200 billion to =300 billion short 
of capital. Lagarde's speech was courageous and the logic of her 
analysis raised deep concerns.\9\ This was the first time the IMF 
admitted that sovereign default risk needed to be taken into account 
for the largest banks in Europe. Europe's regulatory regime does not 
require banks to have equity capital funding for sovereign debt--there 
is no capital requirement, in banking jargon--so banks accumulated 
these debts over many years under the assumption no additional capital 
would be needed. They must now revisit those portfolios to take account 
for capital needs on risky sovereign debt. However, the IMF analysis of 
the capital needs to offset this risk was odd. Markets price in a small 
risk of sovereign default, yet a major sovereign default would be a 
large, discrete event. Regulators need to decide: Sovereigns are safe, 
in which case banks need little capital protection against sovereign 
default, or they are not safe. If they are not safe, then banks need to 
accumulate adequate capital--raising their equity relative to total 
assets--to survive plausible sovereign defaults. For example, Bank for 
International Settlements (BIS) data show French banks in June 2011 had 
claims worth $109 billion (on an ultimate risk basis) on Greece, 
Ireland, Italy, Portugal, and Spain (GIIPS); if these nations were to 
default on their sovereign claims, then French banks would surely 
experience large losses on the entirety of this portfolio while the 
repercussions for France's own economy would add further domestic 
    If sovereign default risk is not removed, then banks need nearly 
full equity funding to cover plausible states of nature where 
disorderly defaults do happen. The lesson for banks is clear: They need 
to reduce exposures to troubled nations and batten down the hatches.
    In addition, Europe's peripheral banks are suffering large funding 
losses as capital moves to safer nations--most notably Germany.
            2.3 Macroeconomic Programs: Too Timid To Restore Confidence 
                    or Growth
    While it may already be too late to avoid extensive defaults, we 
can still consider what needs to be done to reduce the risk of default. 
To avoid defaults and restructurings, Europe needs to introduce 
policies that bring market risk premiums on sovereign (and hence bank) 
debts down. Investors need to feel confident that, with a 2- to 3-
percent risk premium, it is worth the risk to hold onto several 
trillion euros worth of troubled nations' sovereign debts, as well as 
the much larger nonsovereign debts.
    In a nation with a flexible exchange rate, adjustment is usually 
achieved with budget cuts and a sharp devaluation. Since euro area 
nations have forgone their right to devalue, they need to regain 
competitiveness through price and wage cuts, while even more sharply 
cutting budget spending. In essence, they need to increase volatility 
of their wages, prices, and budgets if they are prepared to forgo 
similar changes that could be achieved through the exchange rate.
    The available evidence from the outcomes of the troika programs in 
Portugal, Ireland, and Greece, as well as the recently announced budget 
plans in Italy and Spain, suggests current policies will fail at this 
task. These programs all plan for gradual reductions in budget 
deficits, implying continued buildup of total government debts, while 
partially substituting private debt for official debt. In Portugal and 
Ireland the programs rely on external financing until 2013 when it is 
anticipated the program countries will reenter markets to finance 
ongoing budget deficits and ever higher debt stocks at modest interest 
rates. In Italy, optimistic growth assumptions help bring the budget to 
balance in 2013, but debt stocks remain far too high. Spain announced 
it would miss its 2011 budget deficit target of 6 percent, raising it 
to 8 percent. In Greece, budget revenue and GDP growth forecasts are 
again proving too optimistic.
    Any successful program must recognize the fact that appetite for 
periphery debt amongst investors will not recover to ``pre-crisis'' 
levels, because default risk is now a reality that was not foreseen 
prior to 2009 and because debt stocks are now higher in the periphery. 
For example, Ireland is currently running a budget deficit measured at 
12.5 percent of GNP.\11\ The troika program calls for that budget 
deficit to fall to 10.6 percent of GNP in 2012. Ireland's stock of 
official debt will reach 145 percent of GNP in 2013, while it also has 
contingent liabilities to its banking sector that amount to over 100 
percent of GNP. An investor looking at these numbers must recognize 
there is serious risk of default. Since market access is highly 
unlikely, who will finance Ireland from 2013 onward?
    A successful program must also take steps to quickly improve 
competitiveness.\12\ The only nation that shows moderate improvement in 
relative unit labor costs is Ireland, but this is largely a statistical 
artifact driven by the decline of unproductive industry in the 
weighting.\13\ Italian Prime Minister Mario Monti's program includes no 
general wage cuts.\14\ In Portugal, the government abandoned attempts 
to engineer unit labor cost reductions through ``internal devaluation'' 
after meeting political opposition. In Ireland, the Croke Park accord 
prevents the government from further reducing public sector wages.\15\ 
Despite nearly 2 years of troika programs, Greek unit labor costs have 
hardly budged.
    With sovereign risk premiums rising, and capital flowing out of the 
periphery from banks while deficits and competiveness improve little, 
it is not surprising that peripheral economies are in trouble. The 
Purchasing Managers' Index (PMI) indicates a bleak picture. It is no 
coincidence that a new major ``downturn'' started soon after German 
politicians made clear they were planning to let Greece default. It is 
also clear that the troika programs are failing to restore growth.
    The stark contrast between unemployment in Germany and the 
periphery reflects the dynamics of the crisis. The strong core is 
becoming stronger--German unemployment is lower than it was in 2008--
while Greece, Ireland, Portugal, and Spain have high unemployment that 
continues to rise.\16\ Italy's troubles are recent, so with a sharp 
recession beginning, we anticipate Italian unemployment will soon rise 
sharply also.
3. Solutions
    Europe may continue to veer toward a major financial collapse. 
European economies are in decline due to capital outflows from fear of 
sovereign and bank defaults. Recessions and continued budget deficits 
only raise the risk of default. Macroeconomic adjustment programs are 
not strong enough and do not reflect the large measures needed given 
the lack of exchange rate devaluation. As the GIIPS decline, there is 
serious risk that other indebted and heavily banked nations in the euro 
area, such as France, Belgium, and Austria, could be pulled into 
trouble themselves.
            3.1. The Big Bazooka
    Some analysts are now calling for a massive ECB-led bailout to 
arrest sovereign risk and stop this dangerous trend. The general hope 
is that, if the ECB offered to massively finance the periphery, 
investors would return to buying those sovereign and bank bonds. Lower 
interest rates would give breathing space for sovereigns to correct 
budget deficits and banks to build capital.
    To see how feasible this is, first consider the sums required. Any 
bailout would need to unequivocally convince investors that for several 
years these nations will simply not see serious financial problems. 
This means the bailout would need to have enough funds to buy up a 
large portion of the existing stock of ``risky sovereign debts'' plus 
finance those nations for, say, 5 years. The bailout must buy the debt, 
rather than simply refinance debt rollovers, since otherwise secondary 
market interest rates would stay high. The secondary market rates will 
determine the lending capacity of local banks and their 
    We have calculated the sums required to purchase 75 percent of the 
outstanding government debts of the troubled nations (leaving aside 
debt owed to official lenders), plus finance their deficits over 5 
years. In this base case we assume troika programs are implemented and 
deficits decline gradually over 5 years. The total adds to =2.8 
trillion, or 29 percent of euro area GDP.
    We can then contrast this with alternative assumptions.\17\ The 
most dangerous risk facing the euro area is if a ``bazooka'' is 
employed and yet the troika programs fail to restore growth and improve 
budgets. We assume budget deficits decline only modestly, and we 
calculate the financing needed to cover deficits until 2020. Our 
negative outcome implies nearly =5 trillion would be needed just for 
GIIPS, something the IMF implicitly flagged when they reported recently 
that Greece alone may need =500 billion (\1/2\ trillion) by 2020.\18\
    Successful ``bazooka'' interventions often occur when the extra 
financing is no longer needed, so that the financing acts as a backstop 
but is hardly used. For example, when Poland launched its stabilization 
program in early 1990, the $1 billion stabilization fund was never 
spent. The U.S. Troubled Asset Relief Program (TARP) was quickly repaid 
by almost all banks. This is not possible for the euro area. Some euro 
area nations have too much debt in the new regime with default risk. In 
the early days of such a program we expect large purchases would be 
needed. The ECB would have to drive market interest rates down to 
levels where private creditors would not be well rewarded to hold the 
debts. As the ECB purchased the debts, private creditors would be 
further subordinated, and this would add to their desire to sell their 
    There are many reasons we believe such ECB ``bazooka'' programs 
won't occur and are potentially dangerous to euro area survival. First, 
while using the ECB balance sheet may make such risks more opaque, any 
large bailout still poses potential heavy losses for Germany and other 
healthy members of the euro area. In the event there is default in the 
GIIPS, Germany would be responsible for 43 percent of the capital needs 
of the ECB. Hence with a bailout fund of =2.8 trillion, Germany would 
be assuming =1.2 trillion, or 45 percent of German GDP, in credit risk. 
The Bundesbank and other National Central Banks are likely to refuse.
    Second, this measure on its own does not resolve competitiveness 
problems or large budget deficits in the periphery. It would 
undoubtedly cause the euro to fall but the benefits of euro 
depreciation are somewhat muted since Germany would remain relatively 
competitive compared with the periphery. The periphery will still need 
aggressive fiscal and wage cuts to improve their deficits and 
competitiveness relative to Germany.
    Third, it would place the unelected ECB governors in a political 
role they were never destined to play and were legally forbidden to 
play according to the Maastricht treaty. The ECB could quickly become 
the largest creditor to peripheral nations, and as their financier it 
would ultimately need to negotiate budget programs, wage cuts, and 
structural change. It may choose to relinquish those powers to the IMF, 
but it would be the true power behind all these negotiations.
    Finally, the bazooka could well incite an eventual crash of the 
euro area. If the ECB embarked on a program to backstop troubled 
nations, observers would quickly recognize that the potential sums 
needed to maintain stability could be large. Our bad case scenario 
implies over 341 percent of the ECB monetary base and 46 percent of 
euro area GDP might be needed.
    For markets, what matters are the perceived future bailout costs. 
Hence, an announcement of a ``bazooka'' will lead to varying reactions 
in markets as the perceived bailout needs rise and fall. Investors 
could become very afraid if peripheral adjustment programs appear to 
fail or bailout needs spread to more nations. Such concerns could 
rapidly cause financial-market turmoil and euro area collapse (see 
section 4).
            3.2 A More Comprehensive Solution
    If the bazooka is unlikely and probably won't work, while the 
status quo is failing, what is an alternative? The focus needs to be on 
returning the relevant sovereigns to solvency. Once the sovereigns are 
solvent, most commercial banks will have breathing space to rebuild 
capital through operating profits and retained earnings.
    However, there is no easy means to achieve this. In our assessment, 
the GIIPS will need to restructure their debts by extending maturities 
and reducing coupons to levels that they can afford. There is some 
scope for official assistance to offset the total costs of such 
restructuring by subsidizing debt swaps. However, the Greek example 
suggests Europe's politicians have little appetite to provide more 
taxpayer funds for this purpose.
    While preemptive restructuring seems attractive, the needed extent 
and scope is unclear. Carmen Reinhart and Kenneth Rogoff argue that 
countries with no lenders of last resort typically run into problems 
when debt levels reach 60 percent of GDP. Even if we assume advanced 
European economies could manage more debt, it would not be higher than 
the 90 percent that Reinhart and Rogoff flag as a threshold for 
developed markets. Such figures imply that greater than 50 percent 
writedowns of nonofficial debt in Portugal and Ireland may be needed, 
while Italian debt writedowns might be close to 50 percent.
    If the GIIPS followed preemptive restructurings, Europe's core 
banks, insurance companies, and pensions funds would need substantial 
recapitalizations, and the costs of this could draw France and other 
core nations into debt crises of their own. Hence, any plan to 
preemptively restructure debts would need to be applied carefully 
across Europe.
    The second ingredient is a far more aggressive program to reduce 
budget deficits and improve competitiveness in the periphery. These 
nations need to be highly competitive if they are to generate growth 
soon given the large risks overhanging their economies. This requires 
large wage cuts, public sector spending cuts, changes in tax policy to 
attract investment and business, and stable politics.
    If these two steps were implemented, then a bailout program from 
the ECB would pose lower risks. The debt restructuring and measures to 
improve competitiveness would mean far less funds were needed. The 
ECB's role could be to provide confidence that stability would be 
maintained--a sensible central bank role--rather than to refinance 
large amounts of debt and deficits.
    While these steps would be a major improvement on current programs, 
they are hardly likely to be implemented. As discussed in section 2, 
the troubled nations have declined to implement large budget and wage 
cuts. Political conditions have prevented them. Meanwhile, creditor 
nations are claiming there will be no more debt restructurings beyond 
Greece, and at the same time the creditors are refusing to 
substantially raise bailout funds needed to prevent high interest rates 
and default. None of this leads to a credible path out of crisis.
4. Playing With Fire: Ways the Euro Area Could Come to an End
    Policymakers often have trouble grasping the danger that small tail 
risks pose to leveraged systems. As we discussed above, a mere 10 
percent annual risk of an Italian crisis is already inconsistent with 
Italian long-term solvency. If Italy has a disorderly crisis, how safe 
are French banks? And if those banks aren't safe, how safe is France's 
sovereign debt? Low-probability bad events can very quickly generate a 
wave of collapse through leveraged systems.
    Our concern is that, when compared with financial crises elsewhere, 
the potential triggers for a euro area collapse are numerous.
            4.1 A Unilateral Exit, or the Credible Threat of One
    At a midnight press conference on November 2, 2011, in southern 
France, German Chancellor Angela Merkel and French President Nicolas 
Sarkozy for the first time entertained the idea that a nation could 
leave the euro area. Merkel and Sarkozy chose to take a hard line with 
Greek politicians and their electorate: either complete the existing 
agreement or leave. The background to this threat was the tough 
politics in Greece. After 18 months of large budget cuts and some 
structural reforms, Greece's economy remained in decline. Prime 
Minister George Papandreou's government was weak, and in a last 
desperate gesture he attempted to force further reforms through by 
offering Greek citizens a referendum with an implicit choice of 
``reform or exit.''
    An exit from the euro area can be forced in minutes. The Eurosystem 
only needs to cut off a National Central Bank from the payments system 
and prevent that nation from printing new cash euros. Once this is 
achieved, a bank deposit in Greece would no longer be the same as a 
deposit in Germany, because one would not be able to get cash for a 
Greek deposit and one would not be able to transfer it to a non-Greek 
bank. Of course, the moment people understand such a change could be 
imminent in their nation, they would run to their banks and attempt to 
withdraw cash or transfer funds. This is what is now happening in 
Greece. The country is losing 2.5 percent of GDP monthly in deposits 
from banks.\19\
    There would be enormous, painful ramifications for all of Europe if 
Greece or another nation made a disorderly exit. Since there is no 
legal basis for exit, all financial contracts and indebtedness between 
Greek and non-Greek entities would have uncertain value as the parties 
could dispute whether these are to be paid in drachmas or euros. Trade 
between the exiting nation and the rest of the euro area would dry up. 
The mere fact that a country did exit would have ramifications for the 
other troubled nations, most likely inciting further capital flight 
from those nations and producing sharp economic downturns. This in turn 
would question the viability of Europe's core banks and some of the 
core sovereigns. The euro itself would probably weaken sharply, and 
``currency risk'' would be added into the euro.
            4.2 The Weak Periphery Lashes Out Against Germany, While 
                    Germany Fights Back
    The political dynamics of crisis invariably pit creditors against 
debtors, potentially leading to flareups that cause creditors to give 
up. In Ireland, against strong popular opposition, the ECB is forcing 
Irish citizens to take on further debt in order to bail out creditors 
of bankrupt banks. In Greece, Prime Minister Papandreou was essentially 
ordered to revoke his planned referendum, while Greece's opposition 
leader was ordered to write a letter promising he supported Greece's 
troika program, despite the fact that he clearly did not support it nor 
did he participate actively in any negotiations to agree to it. French 
and German politicians are also playing an instrumental role in 
supporting Italy's new technocratic Prime Minister, while they eschewed 
former Prime Minister Silvio Berlusconi toward the end of his term. 
Meanwhile in Germany, ``bailout fatigue'' has set in as electorates and 
politicians turn against more funds to nations that, they perceive, are 
failing to reform sufficiently quickly.
    While there are many outcomes of such discord, one possibility is 
that it leads to a messy grab for power. The troubled nations already 
have the power to take over decisionmaking at the ECB. They may well 
usurp control in order to provide much larger ECB bailouts. This would 
raise concerns in financial markets and could lead to rising long-term 
yields on all euro-denominated debts. Germany would be forced to pay 
more to finance itself, and German savers would ultimately be paying 
for the periphery bailouts through inflation and a weak euro. In 
Germany this would lead to rising calls to leave the euro area.
    Once there is a small risk that Germany could leave, market prices 
for euro-denominated assets would again change sharply. New risk 
premiums would need to be added to national debts where nations are 
expected to have weak currencies, while Germany and other strong 
nations might see their risk premiums fall even further. Such changes 
would reinforce the recent trends in which the core nations continue to 
strengthen relative to the periphery, but those changes would also be 
highly destabilizing for financial markets.
            4.3 Economics of Austerity May Fail
    The third risk for the euro area is that economic, political, and 
social realities eventually prove that the system simply cannot work. 
After all, the euro area is a dream of political leaders that has been 
imposed on disparate economies. Few nations sought popular support to 
create the euro. The German leadership avoided a referendum, and in 
France the Maastricht treaty was passed with a thin majority of 51 
percent. Even though most European leaders are highly committed to 
maintaining this dream, no one can be sure what the costs are in order 
to keep it.
    A plausible negative scenario is that those costs, in the eyes of 
the electorate, eventually appear too high. The evidence to date 
suggests Europe's periphery, even in a fairly benign outcome, will be 
condemned to many years or even a decade of tough austerity, high 
unemployment, and little hope for future growth. A good comparison is 
the ``lost decade'' of the 1980s in Latin America when nations hardly 
grew due to the large debt overhangs from unaffordable debts. However, 
those nations had the benefit of flexible exchange rates, while 
Europe's periphery faces a more difficult period with uncompetitive 
economies. Latin America's problems ended only when the creditor 
nations accepted large writedowns and debt restructuring.
    Another comparison would be the heavily indebted United Kingdom 
during the 1920s when the government managed policies to restore 
currency convertibility after the war. Britain suffered with a weak 
economy for a decade, before ending in the Great Depression, despite a 
booming global economy throughout the 1920s. However, this too is not a 
good comparison since Britain had far more flexible wages and prices 
than Europe's periphery, with nominal wages falling 28 percent during 
the 1920-21 recession.
            4.4 Markets Lose Patience
    Our final scenario is the most likely. Faced with the reality of 
failing adjustment programs, difficult politics, and rising risks that 
one or more peripheral nations may rebel, or Germany may rescind its 
support, investors may simply decide that the cumulative risks mean the 
euro area has a moderate risk of failing.
    If investors decide there is a low but significant probability that 
the euro area might fail, we would encounter another version of Rudi 
Dornbusch's astute observation: ``The crisis takes a much longer time 
coming than you think, and then it happens much faster than you would 
have thought.'' Here's why: The failure of the euro area will be a 
calamitous financial event. As Dornbusch famously remarked of the 
Mexican 1994-95 crisis, ``It took forever and then it took a night.''
    If one believes the euro might fail, one should avoid being 
invested in European financial institutions, and in euro-denominated 
assets, until the outcome of the new pattern of currencies is clearer. 
As a result, a large swathe of euro-denominated assets would quickly 
fall in value. The euro itself would cheapen sharply, but so would the 
value of European bank debt and European shares, and most sovereigns 
would see their bonds trade off sharply. This in turn would make it 
expensive for even the Germans to raise finance in euros. Despite their 
impeccable credit record, they would be attempting to issue bonds in 
what is perceived as a flawed currency.
    A small risk of the euro ``breaking up'' would have great 
importance for the euro swap market. This market is used by Europe's 
insurance companies, banks, and pension funds to hedge their interest 
rate risk. A swap contract allows, for example, a pension fund to lock 
in a long-term interest rate for their investments, in return for 
promising to pay short-term interest rates to their contract 
counterparty. It is an important market that underlies the ability of 
insurance companies, pension funds, and others to make long-term 
commitments to provide society with annuities, pensions, and savings 
from insurance policies. The notional value of these swaps is many 
times euro area GDP.
    The euro swap market could quickly collapse if markets begin to 
question the survival of the euro. Euro swap rates are calculated as 
the average interest rate paid on euro-denominated interbank loans for 
44 of Europe's banks. Approximately half of these banks are in 
``troubled nations.'' So the interest rate will reflect both inflation 
risk and credit risk of the participating banks. If investors decided 
that the euro may not exist in several years' time, swap interest rates 
would naturally rise because people would be concerned that banks could 
fail and that the ``euro'' interest rate could turn into something 
else--for example, the average of a basket of new currencies with some, 
such as the Greek drachma, likely to be highly inflationary.
    If euro swap interest rates start to reflect bank credit risk and 
inflation risk from a euro breakup, then the market would no longer 
function. A pension fund could no longer use it to lock in an interest 
rate on German pensions since it would not reflect the new German 
currency rates. The holders of these contracts would, effectively, have 
little idea what they would be in a few years' time. Hence, investors 
would try to unwind their swap contracts, while the turmoil from 
dislocations in this massive market would cause disruptive and rapid 
wealth transfers as some holders made gains while others lost. If the 
euro swap market ran into trouble, Europe's financial system would 
undoubtedly face risk of rapid systemic collapse.
    This example illustrates why a small perceived risk of a euro area 
breakup could rapidly cause systemic financial collapse. The swap 
market is only one mechanism through which collapse could ensue.
    On November 23, 2011, Germany was unable to sell as many bonds as 
it wished.\20\ The auction failure caused an immediate steepening in 
the German sovereign bond yield curve. Some German officials argued 
this failure was due to ``volatile markets,'' but there is a more 
fundamental concern. Germany's ability to pay low interest rates in 
euro-denominated assets requires the euro area be a financially stable 
region. Today, German yields remain very low and are not at worrying 
levels. However, if these rates were to rise due to fears of currency 
breakup risk, then the euro area would quickly enter deep crisis as 
even Germany would have trouble financing itself.
5. Dreams Versus Reality
    There is no doubt that European political leaders are highly 
committed to keeping the euro area together, and so far, there is 
widespread support from business leaders and the population to maintain 
it. There is also, rightly, great fear that disorderly collapse of the 
euro area would impose untold costs on the global economy. All these 
factors suggest the euro area will hold together.
    However, many financial collapses started this way. A far more 
dramatic creation and collapse was the downfall of the ruble zone when 
the Soviet Union collapsed in 1991. Argentina's attempt to peg its 
currency to the dollar in the 1990s was initially highly successful but 
ended when its politicians and society could not make the adjustments 
needed to hold the structure together. The Baltic nations--Estonia, 
Latvia, and Lithuania--have managed to maintain their pegs but only 
after dramatic wage adjustments and recessions.
    More relevant, the various exchange rate arrangements that Europe 
created prior to the euro all failed. With the creation of the euro, 
Europe's leaders raised the stakes by ensuring the costs of a new round 
of failures would be far greater than those of the past, but otherwise 
arguably little has changed to make this attempt more likely to succeed 
than the previous one. Small probabilities of very negative events can 
be destabilizing. A lot of things can go wrong at the level of 
individual countries within the euro area--and one country's debacle 
can easily spill over to affect default risk and interest rates in the 
other 16 countries. The euro swap market is based, in part, on interest 
rates charged by 44 banks in a range of countries; about half of these 
banks may be considered to be located in troubled or potentially 
troubled countries. If the euro swap market comes under pressure or 
ceases to function, this would have major implications for the funding 
of all European sovereigns--including those that are a relatively good 
credit risk.
    At the least, we expect several more sovereign defaults and 
multiple further crises to plague Europe in the next several years. 
There is simply too much debt, and adjustment programs are too slow to 
prevent it. But this prediction implies that the long-term social 
costs, including unemployment and recessions rather than growth, 
attributable to this currency union are serious. Sometimes it is easier 
to make these adjustments through flexible exchange rates, and we 
certainly would have seen more rapid recovery if peripheral nations had 
the leeway to use exchange rates.
    When we combine multiple years of stagnation with leveraged 
financial institutions and nervous financial markets, a rapid shift 
from low-level crisis to collapse is very plausible. European leaders 
could take measures to reduce this risk (through further actions on 
sovereign debt restructurings, more aggressive economic adjustment, and 
increased bailout funds). However, so far, there is little political 
will to take these necessary measures. Europe's economy remains, 
therefore, in a dangerous state.

End Notes

    \1\ This testimony draws on heavily on joint work with Peter Boone, 
particularly ``The European Crisis Deepens,'' Policy Briefs in 
International Economics 12-4, January 2012; Peterson Institute for 
International Economics, and ``Europe on the Brink,'' Policy Briefs in 
International Economics 11-13, July 2011; Peterson Institute for 
International Economics. For more background, please see also our paper 
``Will the Politics of Moral Hazard Sink Us Again'' (Chapter 10, in the 
LSE volume on ``The Future of Finance,'' July 2010). I also draw on 
joint work with James Kwak, including ``13 Bankers: The Wall Street 
Takeover and The Next Financial Meltdown'' (Pantheon, 2010) and, on the 
U.S. fiscal outlook, ``White House Burning: The Founding Fathers, The 
National Debt, And Why It Matters To You'' (Pantheon, April 2012). 
Underlined text indicates links to supplementary material; to see this, 
please access an electronic version of this document, e.g., at http://
BaselineScenario.com, where we also provide daily updates and detailed 
policy assessments for the global economy. For important disclosures 
relative to affiliations, activities, and potential conflicts of 
interest, please see my bio on BaselineScenario.
    \2\ Peter Boone and Simon Johnson, ``Europe on the Brink,'' Policy 
Briefs in International Economics 11-13, July 2011, Peterson Institute 
for International Economics, available at www.piie.com.
    \3\ For the definition of PSI in the euro area context, see page18 
in ``European Financial Stability Facility (EFSF),'' available at 
    \4\ At the July 21, 2011, summit euro area leaders called for =109 
billion of official assistance. On October 26 they committed to =100 
billion of official assistance. The IMF did not provide any additional 
commitment in October.
    \5\ The troika is the informal name given to the European Union, 
ECB, and the IMF, which negotiates the terms of external assistance to 
Greece and other troubled peripheral countries.
    \6\ To be clear, this ``clause'' and the preceding clause are just 
our interpretations--such clauses are nowhere written down, which 
greatly adds to the prevailing uncertainty.
    \7\ A 500-basis-point risk premium is consistent with an annual 10-
percent risk that something will trigger a decision to restructure and 
that there would be a 50-percent mark-to-market loss on bonds under 
such an event.
    \8\ Christine Lagarde, speech at Kansas City Federal Reserve 
conference, Jackson Hole, August 27, 2011, available at www.imf.org.
    \9\ European politicians first dismissed Lagarde's analysis and 
later the European Banking Authority revised down the needs to =114 
billion. They argued that the IMF failed to take into account a 
potential rally in the price of safe haven bonds, such as France and 
Germany, which banks hold on their balance sheets. We believe the 
analysis far underestimates the potential capital needs since it does 
not take into account the full macroeconomic ramifications of sovereign 
    \10\ Bank for International Settlements, Table 9D: Consolidated 
foreign claims of reporting banks--Ultimate risk basis, BIS Quarterly 
Review, December 2011, available at www.bis.org/publ/qtrpdf/
    \11\ Ireland's GNP is substantially smaller than its GDP. Due to 
its role as a tax haven, many foreign companies have set up operations 
in Ireland, with a controlling shell company located in a tax-free 
nation, in order to take advantage of Ireland's regulations that 
specify that the controlling owner, rather than the resident company, 
is subject to tax. For this reason companies such as Google, Yahoo, 
Microsoft, Forest Labs, and many others channel license revenues and 
royalties through Irish subsidiaries. These royalties and revenues are 
in large part excluded from the tax base in Ireland. These companies 
would move if Ireland changed rules and made such revenues taxable. 
Since the relevant concept for fiscal sustainability is the taxable 
base, it makes sense that this should be used to measure Ireland's 
indicators. No other nation in Europe has a large difference between 
GNP and GDP. The IMF regularly reported Irish GNP in its staff reports 
but recently removed all reference to GNP. This raises concerns that 
the IMF is attempting to mask fiscal sustainability problems by not 
reporting these data.
    \12\ Unit labor costs are the best measure of competitiveness in 
this context. These also include nontraded goods and are not a perfect 
measure of competitiveness, but the general pattern is clear--over the 
past decade Germany has really diverged from its European trading 
partners by becoming more competitive.
    \13\ Ireland's nontraded goods sector is less productive than its 
traded goods sector (which includes companies such as Google that 
choose to report earnings in this low corporate tax environment.) As 
part of the Irish recession, the nontraded goods sector has contracted 
while ``exports'' from large multinationals have remained relatively 
    \14\ See, for example, Alex Roe, ``Monti's Measures for Italy,'' 
Italy Chronicles, December 5, 2011, available at http://
    \15\ See Harry McGee, ``Freeze on Cuts After Croke Park Accord,'' 
Irish Times, July 21, 2011, available at www.irishtimes.com.
    \16\ The latest unemployment numbers are bad, including 22 percent 
in Spain and 14 percent in Ireland.
    \17\ For more detail, please see Peter Boone and Simon Johnson, 
``The European Crisis Deepens,'' referenced in footnote 1 above.
    \18\ This is a stress scenario in the IMF's debt sustainability 
analysis for Greece. In our view, this scenario could reasonably be 
regarded as something closer to a baseline forecast.
    \19\ Deposits have declined by =61 billion, or 24 percent of GDP, 
since spring 2009. See Bank of Greece, ``Aggregated balance sheets of 
monetary financial institutions (MFIs),'' available at 
    \20\ Paul Dobson, ``German Auction `Disaster' Stirs Crisis 
Concern,'' Bloomberg News, November 23, 2011, available at 

    Senator Shaheen. Well, where to begin? That made me feel so 
much better, Dr. Johnson, about our prospects.
    I actually am going to start. We did another hearing on the 
eurozone crisis before this subcommittee last November, and I'm 
going to start with the last question that I asked that panel. 
That was what the United States could do to help address the 
situation in Europe. I will tell you that to a person the 
members of that panel said the most important thing we could do 
is to get our own fiscal house in order here.
    I want to ask each of you to start, if you agree with that 
assessment? Dr. Burwell, you actually mentioned some other 
things in your testimony, but how do you assess what we heard 
from that other panel?
    Dr. Burwell. I do agree with that, if for nothing else than 
it gives us more credibility when we talk to the Europeans 
about their crisis. I also think, though, that one of the other 
things that we can do is to try and keep the temperature low. 
The European situation is often made worse by the market. As I 
pointed out, I think European leaders do not see it as a 
priority to respond to the market in the way that perhaps some 
of our leaders do. We could talk more about why that is. But I 
do think that it's in our own interest not to spur the market 
into going after certain currencies.
    But yes, first we have to get our own house in order in 
order to be credible in this discussion.
    Senator Shaheen. Thank you.
    Mr. Veron.
    Mr. Veron. In a way, it's frustrating, but my impression is 
that there is relatively little that the United States can do 
on top of what it already does, which is provide discreet and 
sometimes public advice to European leaders and play its role 
in the International Monetary Fund, which is one of the members 
of the European troika.
    Beyond this, it's my impression that the European crisis 
can only be solved by the Europeans themselves. And one reason 
for this is that Europe is a rich continent. The problem is not 
that Europe needs external financial assistance. Actually there 
is enough wealth and money inside Europe to resolve this crisis 
by a margin. So the roadblock is internal in Europe. It is 
political inside Europe. There is little that the United States 
can do except leading by example, as you have suggested.
    Senator Shaheen. Thank you.
    Dr. Johnson.
    Dr. Johnson. I would make three suggestions. The first is 
to strengthen the capital basis, increase the capital funding, 
the equity funding of our largest financial institutions. 
That's tremendously important, both for our own financial 
stability and for global financial stability because we're the 
heart of the world's financial markets.
    The second point would be clearly to at least avoid another 
debilitating fight over the fiscal cliff or over the debt 
ceiling. Remember that, while the GAO has recently, their study 
recently said that the last fight we had in the summer of last 
year did push up U.S. borrowing costs by a little, an 
insignificant amount, the big impact was on other countries. 
When you scare the world and investors become frightened, 
actually the larger effect is that capital comes into the 
United States, which, other things equal, would tend to push 
down our interest rates. But that will make it harder for 
countries that are viewed by the market as potentially in 
trouble, harder for them to fund themselves.
    If you want to cause a sovereign debt crisis for France, 
the best thing you can do is have an enormous fiscal fight on 
Capitol Hill in January and February of next year. I don't 
think you really want to go there.
    The third point is with regard to the IMF. I completely 
agree with what Mr. Veron said. The eurozone can, should, and 
must, and ultimately will solve this problem by itself. The 
IMF's involvement in the eurozone and intra-European support I 
think should be wound down. The IMF played a useful role 
initially in Greece. I'm not supportive of the IMF being 
dragged into and being used as a scapegoat, for example, in a 
program for Spain or Italy, wherever this goes.
    However, in terms of potential knock-on effects, if you 
take the downside scenario seriously, as I'm urging you to do 
today, you should worry about lots of other countries that are 
not in the eurozone, that don't issue a reserve currency, that 
are also important to us for trading reasons, financial sector 
reasons, or security reasons. Those countries could well suffer 
a huge hit, and we are not good and we're not organized in such 
a way as we can provide bilateral support quickly and 
effectively. We always work through the IMF in these kinds of 
settings. We need to look at whether the IMF has the resources, 
the people, and the right mindset, given that it is excessively 
dominated by Europeans, to handle the potential knock-on 
effects of the European crisis really does get out of control 
    Senator Shaheen. So let me just ask you, when you talk 
about the potential impacts on other countries outside the 
eurozone, you're not talking about other countries that might 
be members of the EU. You're talking about a much more 
extensive global impact.
    Dr. Johnson. Yes. Certainly the impact could be completely
 global. I would worry about some parts of Eastern Europe, by 
the way. East European countries that are not members of the 
eurozone, it's not clear, if the pressure is really on, how 
much support they could count on purely within that European 
context. They don't have the euro as their currency. They're 
not issuing a reserve currency. They're much more likely to be 
pressed hard by the markets, and we could go country by country 
or talk about it with your staff afterward.
    So I would not rule out some dangerous developments within 
Europe, and I think we have serious security interests there 
that need to be--on which we've done very well over the past 20 
years. Those need to be safeguarded, because you can throw away 
a lot of progress very quickly in this kind of crisis.
    Senator Shaheen. Sure. No, I was just trying to get some 
sense of, when you said the other countries that would be 
affected, where your focus was, whether it was on the rest of 
Europe or whether you were thinking in particular some other 
region of the world.
    Dr. Johnson. Well, anyone who's a commodity exporter is 
typically vulnerable when you have a dramatic slowdown, and 
there are many countries which really have made progress with 
democratization and with opening themselves up in a responsible 
way to global trade, in Africa, in Latin America, in some parts 
of Asia. All of this could take a big step back if the European 
crisis causes big disruptions and if nobody is there to help.
    Who is there to help? We're not going to do it ourselves. 
You're not going to put that in next year's budget, I'm sure, 
under any circumstances. It falls on the IMF. Is the IMF 
prepared to do this? I worry because we've allowed the IMF to 
become excessively dominated by the Europeans, who are largely 
in denial about the scope of their own problems and the way in 
which those can damage the world.
    Senator Shaheen. Thank you.
    My time is up. Senator Barrasso.
    Senator Barrasso. Thank you, Madam Chairman.
    I want to follow up, as we had been doing from the hearing 
from last November, and specifically with the implications for 
the U.S. economy, for our financial system. Perhaps we could 
just start in the order in which our guests have testified. So 
could you talk about some of the implications to the U.S. 
economy, financial systems, transatlantic relations, should the 
current crisis lead to a breakup of the eurozone or specific 
countries leaving, as Dr. Johnson has suggested that may be 
occurring within the next 6 months, and how would that 
specifically impact us as well as U.S. exports?
    Dr. Burwell. Let me first say that I think the breakup of 
the eurozone and certainly the breakup of the European Union is 
a very unlikely event. I think that we often in this country 
underestimate how closely tied these countries are, how 
integrated they are.
    It is true that over the last 18 months many of the non-
Greek countries have been pulling their assets away to protect 
themselves should something happen in Greece. But what we need 
to think about in terms of the implications for the United 
States, even if the crisis goes forward as I would predict for 
2 more years with European summit after European summit that 
incrementally puts in place the minimal decisions that they 
need to make to keep their heads above water, I think we're 
looking at a couple of consequences and then I think my 
colleagues who are real economists are much more capable of 
talking about some of the specifics.
    But two that I see on the economic side are: first off, the 
impact on the stock market, and for many middle-class Americans 
and others who have their retirement in 401(k) plans.
    The other consequence is the lack of business confidence. 
You have many companies in this country who have funds to hire 
or expand or invest, but who are being conservative, little 
``c'' conservative, about that, and it's probably prudent 
business practice, because they don't know what markets will be 
like in the future.
    So I think that those are things that we will have to deal 
with in terms of the U.S. economy not growing as fast because 
the overall pressures are to be very guarded about what you do 
in terms of investment and expansion. So I'll leave it at that.
    Senator Barrasso. Thank you.
    Mr. Veron. First, I think it's striking to see the contrast 
between the seriousness with which the breakup scenario is 
taken on this side of the Atlantic and the denial of the 
possibility of breakup that you often sense in Europe and 
particularly in Brussels. I would inevitably sit a little bit 
in the middle of this. Personally, I think that a breakup is 
seen as more likely than it really is in many American circles, 
but I would also accept the proposition that many Europeans are 
in denial and that actually this denial is very harmful in 
terms of crisis management, where those who would need to be 
most paranoid, those who would need to take the downside 
scenario most seriously, should be the European policymakers, 
and I often have the impression that they're not doing that 
    That said, on Greece particularly, which is a flashpoint 
and will remain one I think for some time, I don't share Dr. 
Johnson's prediction. I think that many observers, including 
many market participants, are considering the possibility of a 
Greek exit more likely than I would. The reason that I consider 
it less likely is not that I see Greece doing well or being on 
track in its adjustment program, which it is not, but just the 
fact that I think the contagion of a Greek exit to other member 
states would be absolutely impossible or at least could be 
absolutely impossible to manage. I think there is an awareness 
of this situation in European policy circles.
    Now, that doesn't get us to a clear view of what to do with 
Greece if it continues to veer off track, and I think here 
we'll have very difficult decisions to make in Europe in the 
next few months, including some that could go further than what 
the troika has already done in terms of temporarily depriving 
the Greek Republic from some attributes of sovereignty.
    For the United States, the United States has to cope right 
now with a European recession. I think in any scenario Europe 
will remain in recession in the near future. I don't see a 
scenario of a strong European rebound. Maybe I'm not optimistic 
enough on this one, but I really don't see it as possible under 
the present circumstances.
    However, a breakup of the euro would plunge Europe into a 
deep depression, and I think this would create shock waves that 
the United States would not be able to escape, even though, as 
Dr. Johnson mentioned, it's very difficult to model this. It's 
very difficult to know where exactly the exposures are because 
the system is so complex. The interactions are everywhere. 
There are linkages all over the place.
    As regards financial institutions, I'm less sure than Dr. 
Johnson about the need for radical measures in terms of capital 
strength. My impression is that many U.S. banks, including 
large U.S. banks, have rebuilt capital in a fairly strong 
manner in the past few years. Maybe I should take a closer look 
at them, but my impression is that the Federal Reserve and 
other members of the U.S. supervisory community have been very 
careful in watching the interconnectedness of the U.S. 
financial system with the European financial system and in 
nudging the financial institutions into adequate contingency 
    But I think there's no denying that shock waves from a 
eurozone breakup and depression would affect the United States. 
I think in terms of the rest of the world, the point that was 
discussed just before, we already have seen a lot of European 
bank deleveraging, particularly in Asia, also in Latin America 
and other parts of the world. So this has already started, and 
I think this has strategic consequences, including for the 
United States, because what we have seen is that a lot of the 
credit that was provided by European banks to Asian or Latin 
American economic agents has been replaced fairly effectively 
by credit from other players, including U.S. or Canadian banks, 
but including also Chinese or Japanese or other Asian banks. So 
there is a redrawing of the global financial map which has 
already started, has actually gone very rapidly in the past 2, 
3 years, and I think this has strategic consequences as well. 
It's already happening. It has already happened to a large 
    Senator Barrasso. Thank you.
    Dr. Johnson.
    Dr. Johnson. It's all about the financial sector, Senator, 
and the transmission of shocks, I believe, through opaque 
derivative transactions. To give you one specific example, not 
to single someone out, but to give you an example. J.P. Morgan 
Chase has a published balance sheet under U.S. GAAP of $2.3 
trillion. U.S. GAAP allows a very generous netting of 
derivative transactions. If you use international accounting 
standards, as they use in Europe, with a less generous netting 
of derivatives and one that is considered by many authorities 
on resolution to be more appropriate when thinking about the 
potential losses, then J.P. Morgan Chase's balance sheet is not 
$2.3 trillion, it's $3.9 trillion.
    They have shareholder equity around $180 billion capital. 
In their own living will that they have presented, they model 
the scenario in which losses of $20 to $30 billion trigger a 
collapse of J.P. Morgan Chase and therefore a systemic crisis. 
Now, that living will was put together before they lost $6 
billion on those trades in London, which happened in a 
relatively benign period for the world economy.
    We need to worry a great deal about the vulnerability of 
the systemically important institutions. Unfortunately, with 
all due respect, I disagree very strongly with Mr. Veron. I 
spend a lot of time with regulators. I'm on the FDIC Systemic 
Resolution Advisory Panel. I do not believe that our 
authorities, including specifically the Federal Reserve, both 
the Board of Governors and the New York Fed, have pushed hard 
enough to strengthen the capital base.
    The stress tests that were run repeatedly, including most 
recently this year, did not model any of the events that we are 
now all regarding as part of our baseline scenario.
    Senator Barrasso. Thank you.
    Thank you, Madam Chairman.
    Senator Shaheen. Senator Risch.
    Senator Risch. Thank you very much.
    For those of us I think that are unschooled to the extent 
that you are in economics, it was fascinating to watch the 
eurozone first of all be created. I just kind of shook my head 
and I didn't understand how this could work, where you had 
sovereigns who had not given up sovereignty, but yet decided to 
combine their currencies.
    I suppose it's not dissimilar to what happened at the 
Constitutional Convention when the States got together and did 
this. They created a constitution and probably had a lot of the 
same questions that were presented to the eurozone, and they 
left the Constitutional Convention without resolving those. 
Indeed, a lot of them walked away with different ideas about 
the sovereignty versus the strength of the central government.
    However, fortunately they lived in a lot simpler times than 
we live in today. You don't have the complexity of the 
institutions or the interrelation of the institutions that you 
have today or, for that matter, the Internet and communications 
that tie us together. So as the country went along, they had 
serious problems, but I guess they had the luxury of the train 
wreck was slow instead of a fast-moving train wreck, which we 
don't have the luxury of today.
    So as these issues come up and as the EU continues to 
wrestle with them, but not seem to be able to resolve them, I 
think I worry about how quickly the house of cards could come 
down. So I guess I'd like all of your thoughts about how--I 
mean, this is going to end sooner or later. You have to think 
it's going to end sooner or later, one way or another.
    So the question I guess I have for each of you is your 
predictions as to how this--what does this look like on the 
other side?
    Dr. Burwell.
    Dr. Burwell. Well, I think it will be very messy getting to 
the other side. I think that no matter--I consider myself an 
optimist on this and my prediction is still that we have a few 
years to go. I believe that if we come to the point where it 
looks like Italy or Spain will fall out of the eurozone that 
the Germans at that time will lift their political objection to 
mutualization of debt. As Mr. Veron said, there are the 
resources in Europe to solve this problem.
    The scenario that Dr. Johnson has painted of what happens 
at the end of the breakup of the eurozone I think is something 
that everyone keeps in mind, and precisely for that reason 
they're unwilling to go there, because it is so horrible. The 
estimates that I have seen for even Greece leaving the eurozone 
are 30 to 50 billion euros in costs for Greece. That doesn't 
say anything about the costs outside Greece for that. You can 
imagine what that would be if we actually had 17 countries who 
were all using one currency suddenly decide not to use that 
currency any more.
    Germany, which is leading a very comfortable economic 
existence right now, would suddenly find that its exports were 
priced much more highly if it went back to its own, the 
    Senator Risch. You're convinced, though, that there will be 
mutualization of debt at some point in the future?
    Dr. Burwell. At some point in the future. If we take the 
nonemergency scenario, then I think that we will see over the 
next 2 to 5 years--they will bring the fiscal compact into the 
European institutions, which means having another round of 
referendums, which will be difficult, but I think will happen. 
You will see more and more of the countries actually bring 
their economies closer together through these structural 
reforms that are being pushed on Spain and the others at this 
    Only once that has been in practice for some time, so 
perhaps 10 years from now, will you see a formal eurobond 
issuance or something of that sort.
    Senator Risch. And of course there's huge political 
problems in places like Germany before that gets done.
    Dr. Burwell. The problem actually is that Germany is doing 
well right now. I mean, there are little issues and we've seen 
business confidence decline in the last couple of months. There 
are little indications in Germany, for example, that their 
exports are slowing because of the slowing of economic action 
in the rest of Europe.
    But Angela Merkel will face election in fall 2013. Her 
approval ratings now are at 66 percent. Most of the Germans 
believe that she's doing pretty well handling this.
    Senator Risch. Those of us in politics know that there is a 
short, very short shelf life on your ratings.
    Dr. Burwell. Yes.
    Senator Risch. Mr. Veron, could you give us your view on 
how this unwinds, what this looks like after it's resolved?
    Mr. Veron. I think it looks different. In other terms, I 
certainly don't believe and have never believed that the 
eurozone and the European Union could come out of this crisis 
with a return to something that would look like what they had 
before. This crisis is transformational and there is no middle 
ground, and I would argue has never been, between resolution by 
failure, which is the breakup of the eurozone and the dire 
consequences that we've already talked about, and what I would 
consider a successful resolution, even though it will carry a 
cost and it will not be a cakewalk, which is deeper 
    In a very remarkable speech in Berlin a couple of months 
ago, Radek Sikorski, the Foreign Minister of Poland, expressed 
it that way: ``If we are not willing to risk a partial 
dismantling of the EU, then the choice becomes as stark as can 
be in the lives of federations: deeper integration or 
collapse.'' And this is a noneurozone country which was 
considered by a former Secretary of Defense here as part of so-
called ``New Europe.''
    Senator Risch. Mr. Veron, do you agree that eventually 
there's going to be mutualization of debt?
    Mr. Veron. Yes.
    Senator Risch. Dr. Johnson, how about you?
    Dr. Johnson. Well, Senator, I wrote a book recently on U.S. 
fiscal history and I think we share the same perspective on 
what happened at the Constitutional Convention in 1787. The key 
issue coming out of that, as you know, was exactly the 
assumption of State debts by the new Federal Government.
    I think that will be the sticking point for the Europeans. 
There was a legitimacy to those debts in the United States 
because of the joint effort of the War of Independence. There's 
no legitimacy behind the fact the Greeks had a great party and 
the Spanish went crazy with their real estate, and so did the 
Irish, and that banks are going to be failing left, right, and 
center. That's going to be the problem.
    So that mutualization of debt on an ongoing basis, perhaps 
that could be one thing that gets put on the table. But what 
are you doing about this overhang of debts? After Hamilton 
restructured the debt in 1789, 1790, the United States had a 
debt-to-GDP of around 40 percent. That was high for the day. 
The Europeans, the eurozone, are at 90 percent average if you 
take all of their debts and divide by eurozone GDP. There's not 
a lot of room to play with there, and I think ultimately it's 
going to come back to the political legitimacy. Ultimately, why 
should the Germans pay for what their euro partners did over 
the past 10 years, the counterpart of the massive credit boom 
that led them into this.
    Senator Risch. That's a good point. There's a little bit of 
that debate going on up here because some of the States have, 
although not directly, at least obliquely, looked to the 
Federal Government, saying: Look, we've got serious problems 
    Dr. Johnson. But the problem we haven't had in the United 
States, at least not since the 1840s, is the expectation that 
the Federal Government is going to be bailing out the States. 
And that's clearly an expectation that----
    Senator Risch. But some do.
    Dr. Johnson. Agreed. But that was an expectation that was 
more generally shared in Europe recently, and that's now been 
withdrawn, or maybe it's not. Or maybe Mr. Draghi will provide 
it, or maybe they don't know what they're doing.
    That I think goes directly to the issues that were salient 
in 1787 and unresolved, I would argue, until after the War of 
    Senator Risch. Thank you, Dr. Johnson.
    Thank you for being generous with the time.
    Senator Shaheen. Thank you, Senator.
    I want to go back to Greece because it's come up both from 
all of your testimonies. Dr. Burwell, let me start with you 
because I think you pointed out in your testimony that 
Germany's vice chancellor, it was reported, said that a Greek 
exit from the eurozone had ``lost its horror,'' quoting.
    So what do you think would be the actual impact of Greece 
leaving the eurozone? First, if you will, talk about what the 
prospects of that are if you had to weigh the percentages, and 
then what you think the impacts of that would be?
    Mr. Veron. Frankly, I'm reluctant to give a percentage. I 
think it's a very difficult question to answer. I would say 
that the only way I find to escape the burden of your question 
is to say something like 50-50. It's very undecided.
    I think many investors think the likelihood is more than 
that, but I would submit that the marketplace is overestimating 
the chances.
    Senator Shaheen. Let me then get to Dr. Burwell and then 
Dr. Johnson on that question. I won't ask you to give me a 
percentage. Everybody can assess it at 50-50. But what would be 
the real impact of Greece's leaving?
    Mr. Veron. I think investors----
    Senator Shaheen. Mr. Veron, can I get Dr. Burwell to answer 
that first?
    Mr. Veron. Sorry.
    Dr. Burwell. I think Nicolas can talk more on the actual 
economic consequences. I do think that the biggest risk 
probably is contagion. Greece is something like 2 percent of 
the European economy. I think politically, internally in 
Greece, it would be a huge blow to the country's confidence and 
perhaps to its democratic institutions.
    I would say that we currently face a situation in Greece 
where many in the public blame their political leaders for the 
situation which they are now in and there is some justice in 
that, given that some of this crisis comes out of the fact that 
no one quite knew how big the Greek deficit was.
    And I fear that if Greece leaves the euro, which has been a 
very popular symbol among the Greek people of their acceptance 
as one of the mature European countries, even though we all 
know that when Greece got into the euro, was accepted, there 
were some, shall we say, financial tricks that were accepted. 
But if that is taken away, I fear that there would be a real 
loss of legitimacy of the government among the Greek people and 
a much more serious rise of nationalism in Greece than we face 
today even with the struggles to try and restructure their 
    As long as they are in the EU, one of the safety valves 
they have is that Greeks can leave Greece easily and go work 
and make money elsewhere in the Union. If they leave the Union, 
they lose that opportunity and they remain stuck in Greece with 
very few jobs.
    Senator Shaheen. Mr. Veron, I'll ask you to answer this. 
Haven't we seen, though, opposition on the part of the Greek 
public to be willing to accept the reforms that their leaders 
have negotiated? Then, recognizing what Dr. Burwell said about 
how Greeks feel about themselves and their involvement in the 
euro, isn't there a contradiction here, and can we expect that 
the reforms that are being required of Greece will actually 
have public support to be completed?
    Mr. Veron. There's a massive contradiction, but I would 
argue that Greece, the Greek public opinion's, willingness to 
stay in the euro is even greater than their reluctance to face 
the reforms that are needed. So obviously the message of the 
two rounds of elections this year was that they would like to 
have both, not do the reforms and stay in the euro.
    But ultimately my understanding of the current state of 
Greek public opinion--and who knows about the future, but my 
understanding of the current state is that they prefer to stay 
in the euro, even though that means very bitter medicine. Of 
course, the question is will this be delivered by the Greek 
political system. I think this is the most difficult question, 
because so far the Greek political system has displayed a 
systemic difficulty to deliver.
    Senator Shaheen. Dr. Johnson, do you think that the 
eurozone could survive a Greek exit?
    Dr. Johnson. Well, Senator, I think the probability of 
Greece leaving the euro by the end of this year is about 90 
percent. This would do without question significant damage to 
the eurozone and how far that would go depends on how they 
handle it. If they decide to form a more unified core 
completely and unambiguously backed by the European Central 
Bank and they put in place the fiscal unification measures, for 
example, to make that meaningful, that will be one thing. If 
they leave Portugal, Spain, Italy out in the wind to be beaten 
by financial markets, that's obviously a very different and 
much more scary scenario.
    On the dynamics of Greece, I would just point out that the 
measures currently under way call for the banks to be taken 
over by the government and brought closer to the government 
apparatus. This government is the same government that managed 
Greece--is led by the same people who managed Greece into the 
crisis prior to 2008, 2009. The level of corruption, for want 
of a better word, throughout Greek political life is profound.
    I'm not sure if you remember, but when the United States 
and the IMF tried to help Indonesia in the fall of 1997 a key 
issue that emerged was the corruption of the Suharto regime as 
manifest in how the banking system behaved and in who did and 
did not get a banking license, including in one notable example 
Mr. Suharto's son. I think the same kind of collapse of the 
legitimacy of the bailout effort as seen from the outside, as 
seen by people who feel they've been trying honestly to help 
over the past 3 or 4 years, that is exactly where this is 
    Senator Shaheen. So you're not optimistic, not only that 
the leadership in Greece will deliver the correct message to 
the public, but that they will actually be willing to undertake 
the reforms, and haven't been to date, that are going to be 
necessary in order to stay in the eurozone?
    Dr. Johnson. I think they're in an end game within which 
elites typically grab what they can, take the resources, move 
them offshore, get ready for being wealthy after the collapse; 
you can come back and buy assets. This is what you saw at the 
end of the Soviet Union, for example. This is what you see at 
the end of other kinds of regimes. That is the moment at which 
I believe Greece now finds itself.
    Senator Shaheen. Thank you.
    Senator Barrasso.
    Senator Barrasso. Dr. Johnson, I know you spent time at the 
IMF as the chief economist there. I'm just curious about the 
role of economic growth in a time of austerity and how to 
balance that out and what sort of economic growth potential you 
see in it. Perhaps you can give just a little discussion on the 
role there, given the IMF has requirements of significant 
austerity currently combined with the monetary policy 
    Dr. Johnson. So the thinking at the IMF and the experience 
in recent decades has exactly been that, while some situations 
call for and require austerity, and the Greek public finance 
would be one of them, in other situations it can be quite 
counterproductive to press your foot too firmly on the fiscal 
brakes. Spain today would be one example. Italy would be 
another example.
    The question is always one of financing. Do you have the 
ability to finance yourself in markets or is someone else 
willing to lend to you so you can have a larger deficit on a 
temporary basis to help buffer your way through your troubles 
and aim for--the IMF will always tell you--aim for a 
sustainable medium-term fiscal outcome.
    Now, I think that that can be done in some parts of Europe. 
That is where the IMF has urged the Europeans to go at some 
moments in the past. It's obviously not the trajectory right 
now in Greece.
    Senator Barrasso. Just to kind of follow up, I'm looking 
at, there was a column in The Economist this past week. You're 
familiar with the Big Mac Index, relative value of Big Mac 
hamburgers around the world. I think they mentioned that a 
couple years ago the euro was about 18 percent overvalued 
relative to the dollar, now it's about 4 percent undervalued 
relative to the dollar.
    So I just look in terms of the implications for a long-term 
continued weakening of the euro versus the dollar and the 
impact of that on U.S. businesses and consumers as we get back 
to the question of how does this all impact the United States 
and our own economy. I would like you to comment on that.
    Dr. Johnson. Well, it's very hard, as you know, to forecast 
where exchange rates are going to move. But I agree with the 
logic of your question, which is that the European situation, 
whether I'm right on the more negative side or whether my 
colleagues are right on a more positive side, this would seem 
to push the euro to becoming more undervalued and therefore at 
least some parts of Europe become more competitive relative to 
U.S. industry.
    Now, remember, though, that credit is becoming extremely 
disrupted in many parts of Europe. In Germany, however, it's 
not. In Germany credit is pretty easy, partly because the 
capital flight from southern Europe or peripheral Europe is 
going toward, at this stage still going toward, Germany.
    So competition between German firms and United States 
firms, yes, I would expect that to be heightened. Will other 
parts of Europe be stronger as a result of this? No, probably 
not. And overall I would expect the euro to weaken 
significantly, which is not going to help our economic 
    Senator Barrasso. Thank you.
    Thank you, Madam Chairman.
    Senator Shaheen. I'd like to pursue that a little more, 
because, Dr. Johnson, I think you talked about the extent of 
exposure, that we're not even sure--let me rephrase that. We're 
not sure about the extent of the exposure on U.S. banks because 
of the opaque instruments that exist.
    Secretary Geithner has consistently stressed that direct 
U.S financial exposure to the European crisis is modest. So I 
wonder if you can elaborate a little bit, Dr. Johnson, on the 
reasons that you draw the conclusions that you do about the 
extent of the exposure and whether you have any assessment as 
to how great that exposure is for U.S. banks?
    Dr. Johnson. Well, Senator, I would remind you of the 
complexity of these derivative markets and the difficulty even 
of the organizations themselves, the institutions, to 
understand their true exposure. So again just as an example, 
J.P. Morgan Chase's trading losses in London were not known to 
Jamie Dimon and other senior executives in New York until they 
read about it on the front page of the Wall Street Journal.
    So it is actually not possible for Mr. Geithner or any 
other official to know more than the banks know about their 
true exposures, and the banks do not know to what extent severe 
movements in security prices, which is what's implied in the 
scenarios I'm talking about, would impact their counterparty 
    For example, if you come to believe, just as a 
hypothetical, that the French Government will not stand fully 
behind all of the obligations of large French banks--I'm not 
saying they'll default, but I'm saying they could selectively 
choose to pay out on a different basis to different kinds of 
creditors--how would that impact the position of J.P. Morgan 
Chase or Bank of America or Citigroup? We don't know. We do 
know that they have very large derivative books. We know that 
their net exposure measured properly, I would suggest, under 
international accounting standards is very large relative to 
their capital base, and according to the modeling that they 
present in the public domain--for example, I recommend to you 
the living will discussion that J.P. Morgan Chase executives 
have made publicly available--the dynamics there are 
potentially devastating.
    I don't know how much capital would be necessary to 
safeguard the American financial system. I'm not comfortable 
we've got there and I don't believe, or I know for a fact, the 
stress tests run by the Federal Reserve did not take into 
account any of these scenarios, any of these massive losses 
that we're now discussing.
    Senator Shaheen. So are there other measures that you would 
suggest that we as Members of Congress ought to be thinking 
about in terms of how we could better assess the extent to 
which our financial system is exposed to what's happening in 
    Dr. Johnson. This is a hard thing to do from where you sit, 
but I think a key point on which to press is the Office of 
Financial Research, OFR, which was created by the Dodd-Frank 
legislation to support the Financial Stability Oversight 
Council, needs to work on exactly this and needs to be in here 
on a very frequent basis presenting to all relevant committees, 
including your committee.
    I don't know if you and your staff had a chance to review 
their latest report that just appeared yesterday. It's about 
400 pages long, so I understand it may take some time. There's 
nothing in it with regard to the issues that we're discussing, 
nothing that would significantly inform or reassure you that 
I'm wrong or my concerns are exaggerated, nothing in it.
    OFR, I'm afraid to say, has not done a good job. The 
Financial Stability Oversight Council is generally considered 
to be moving slowly. I belong to a new private sector Systemic 
Risk Council founded and chaired by Sheila Bair and we have 
released some public statements about specific pressing 
measures that could be taken now and should be taken to 
safeguard the system. I'm not saying that Ms. Bair or the rest 
of the council shares my view on the dangers that could come 
from Europe. So whether or not I'm right, we're arguing that 
these changes should be pressed forward, and it's not 
happening. This administration is not pushing to make our 
financial system safe enough soon enough.
    Senator Shaheen. Do either of you want to comment on that?
    Mr. Veron. I would absolutely agree with what Dr. Johnson 
just said about the need to have a well-resourced, competent, 
and reactive Office of Financial Research. That said, it is 
also my impression that a purely American such organization 
cannot really do the job that you have outlined, because we are 
talking here about a very integrated global financial system on 
which many of the information points are outside of the United 
States. So of course, the United States can do what it does at 
its own scale, which is building an Office of Financial 
Research, and more should be done in that direction. But I 
think there is also a need to scale up global initiatives to 
collect data and analyze them in a way that would provide more 
insight on the very complex, very difficult issues that we are 
talking about here.
    I would argue in the same logic that what Dr. Johnson said 
about the need to have a better understanding of big banks' 
balance sheets in the United States is an argument for more 
decisive adoption of international financial reporting 
standards or at least some moves in that direction, which this 
administration unfortunately has not made. It doesn't have to 
be quick, it doesn't have to be radical, but I think this would 
be very constructive on the global stage, even though it's a 
slightly different consideration from the main focus of this 
    Senator Shaheen. So should the ECB be taking measures that 
it isn't currently, recognizing that there has to be agreement 
from a lot of places in order for that to happen? But are you 
also advocating that they take different measures?
    Mr. Veron. I think the ECB has signaled in the past few 
days that they will do more to stabilize the situation in the 
marketplace even than the significant actions that they have 
undertaken so far. This goes back to the executive deficit at 
the core of the eurozone problem, because the ECB has been 
forced to take action in place of the political authorities, 
and I think we'll continue to see that because ultimately the 
ECB is the only institution which is able to act in the short 
term. And I think they are taking this responsibility very 
    I also believe that, compared to some of the criticisms 
that are placed on the ECB, especially from here in the United 
States, that it doesn't do enough, the ECB cannot act as if it 
was the Federal Government of the eurozone. So it has to 
acknowledge that its scope for action is limited and that 
elected governments, elected institutions, political 
institutions, have to do a bigger part of the heavy lifting.
    So I would submit that the ECB has a very difficult balance 
to keep here, but I think they have kept it fairly skillfully 
in the past few months at least.
    Senator Shaheen. I know Dr. Johnson wants to comment, but, 
Dr. Burwell, did you want to comment on the original question 
before we go back to him?
    Dr. Burwell. Yes, just two comments. Dr. Johnson pointed 
out, brought to the fore a very good question, I think, which 
is: Greece didn't undertake reforms before; these are the same 
people or the same political elite that got Greece into so much 
trouble; so why should we believe anything will change? I think 
in point of fact, because there are so many EU supervisors in 
the Greek Government at this point. They have extensive 
supervision on the ground, to the point where I've had Greek 
officials certainly tell me that there is no sovereignty left 
in Greece as far as economic policymaking goes.
    And of course, they are being held with their backs to the 
wall if they want to get any more money from the EU. And if 
they don't get money from the EU, if they don't get the tranche 
that is now overdue because of the elections, I've heard some 
estimates that they will have to start issuing script in about 
2 months to be paying government employees, of which there are 
quite a few in Greece.
    So the government is in a position where it will have to 
make some very difficult decisions, but it will be forced to 
make them.
    I also think that Dr. Johnson was right in pointing out 
that we don't really know what's going on in terms of the 
banks' balance sheets. The conversation that I'm hearing from 
Europe is about too big to supervise and too big to fail, and 
the idea that these banks are now simply too large. I would 
expect that we will see some legislative movements in the 
European Parliament to explore whether there are ways of making 
the banks more supervisable, more susceptible to adequate 
    In a way, the LIBOR scandal and HBSC has kind of morphed 
together with this eurozone crisis in a way in Europe which has 
become much more susceptible to strong banking regulation than 
we have heard discussed in the United States, and that's 
something that I think the U.S. Congress should be aware of and 
be watching in terms of its own agenda in the future.
    Senator Shaheen. So you think there will be a move to set 
limits on size?
    Dr. Burwell. I don't know quite how it would be done, 
because, as Mr. Veron pointed out, these are global entities in 
many regards. So I'm not quite sure how you would be able to do 
it. But I have--when Sharon Bowles was here, the head of the 
Econ Committee in the European Parliament, which is the 
legislature now for doing this, addressing this question, she 
was quite concerned about this in a public forum. So I would 
expect that there will be some serious thinking about how one 
does this.
    Senator Shaheen. Thank you.
    Dr. Johnson, I think you wanted to respond to the ECB 
    Dr. Johnson. Yes. The problem is that if you ask the ECB to 
do more, you're asking it to provide more credit to the system, 
which will weaken the euro, create the prospect of inflation, 
and further undermine the legitimacy of the monetary union for 
key countries, including Germany. So it's not clear at all that 
doing, ``whatever it takes'' has any meaning when providing 
more credit actually undermines the political legitimacy of the 
very arrangement that you're trying to protect.
    If I could just add a point to what Dr. Burwell said about 
the extensive supervision on the ground of the Europeans, the 
experience of the IMF quite clearly is that when you're on the 
ground doing someone else's reforms for them it doesn't work. 
There has to be local ownership. The politicians have to want 
it. There has to be a mandate. It has to be in this kind of 
context--it has to have sufficient democratic support. That 
support has to be sustainable.
    That's where all these programs fail, not because they're 
poorly designed. Typically you can always adjust the design. 
And not just because of creditor fatigue. Creditors get 
fatigued because you don't deliver things on the ground because 
there's no ownership. I think that's exactly where the European 
situation is going.
    On the bank size, I think this is a very important point 
that again will become increasingly salient. Too big to manage. 
The banks don't know what's going on. The bank executives have 
no idea of the exposure. As banks collapse or come under 
pressure and have to be rescued, you will see more and more of 
these stories in the European context, just as we're seeing 
more of them now in the American context.
    Senator Shaheen. Well, so that really leads back to the 
question about to what extent is public opinion behind the 
efforts to address the eurozone crisis. Dr. Burwell, you talked 
about Chancellor Merkel's continued popularity among the German 
public, but in fact somebody just pointed out to me this week 
that there is a recent poll that was published that showed that 
33 percent of Germans believe that she's making the right 
decisions on the eurozone crisis, down from 63 percent back in 
earlier in July.
    So how much is public resistance going to impede the 
ability to really address the crisis in Germany? I guess we 
could ask the same thing about France. Obviously, we've already 
seen the change in government in France as the result of 
concern among the electorate about whether they were headed in 
the right direction. Obviously, Spain is an ongoing issue.
    Can we expect that public interest--it goes back to the 
Greek question: Can we expect that public interest in staying 
in the eurozone is ultimately going to outweigh frustration 
with the impact of austerity measures on people's own personal 
prosperity and thinking about their futures?
    Dr. Burwell. I believe that the public's commitment to the 
eurozone and to the EU particularly is strong enough so that it 
will get through this point. However, I would say that the 
decline in Chancellor Merkel, public opinion is not because 
Germans believe she is being too tough and not making the right 
decisions as we would see them, but because they think she's 
being too soft.
    Senator Shaheen. Right. No, I understand that.
    Dr. Burwell. So, if anything, you do have diametrically 
opposed public opinions. But the one thing they're all united 
on is they want to stay, not necessarily together, Greeks and 
Germans, but they all want to stay in the European Union, with 
one exception, and that one exception is the U.K. And here I 
think what we are seeing is a combination of, shall we say, 
longstanding British skepticism coupled with the eurozone 
crisis, which I think is on the verge of leading to a very real 
change in Britain's position within the EU. That is something 
that as we think about Anglo-American relations we should think 
about very seriously.
    But on the whole----
    Senator Shaheen. Can you elaborate on that a little bit in 
terms of what you think the effect will be on Britain's 
position in the EU?
    Dr. Burwell. The December decisions on the fiscal compact, 
when Britain decided not only not to be in the fiscal compact, 
but prevented the others from making this intra-EU, and now 
they had to do this outside, was kind of a final straw for many 
in Europe about the British, what they see as the British lack 
of commitment to the European Union.
    What I have been hearing since then is that if the British 
want to go, that's OK; we'd like for them to stay, but it's 
their decision. Whereas before there was much more of a desire 
to have the British engaged.
    I do think that the Cameron government until very recently 
has managed their euroskeptic constituents skillfully. However, 
they have I think--recently this has been something that has 
threatened to get a little out of control. There are increasing 
calls for a referendum and if we see the fiscal compact 
eventually being put into a treaty and the need for referenda 
in some countries and probably in the U.K., then I think you 
have a crisis point about 3 to 5 years away where this question 
will be asked.
    So I think there is more talk now in the U.K. about halfway 
arrangements. The problem is that most of those halfway 
arrangements, the one that Norway has, for example, where it's 
part of the Europe economic space, they have to agree to 
everything but they don't get to sit at the table, and I think 
that would be unacceptable.
    So we are a long way from any decisions, but I think the 
temperature has changed, if I can put it that way. It's subtle. 
It could change back. The city of London has a lot to gain or 
lose through Britain's participation in designing the rules for 
financial services within the EU, and I think that will be the 
thing that will keep Britain in if it decides to stay that way.
    Senator Shaheen. Thank you.
    Mr. Veron, did you want to add to that?
    Mr. Veron. I totally share the concern about the position 
of the U.K. I think it's a strategic worry and challenge for 
the U.K., for the rest of Europe, and also for the United 
States. I think that the U.K. has gone very far already on a 
slippery slope that could bring it outside of the European 
Union and I personally believe this would be to the advantage 
of precisely no one.
    So I think there's a big concern. It was a big change a 
year ago when Chancellor Osborne spoke about the remorseless 
logic of political integration inside the eurozone that is 
reversing almost three decades or four decades almost of U.K. 
policy, where the stance had always been having a seat at the 
table. So I was surprised by this change of tack and I think it 
will have consequences.
    In Spain, Greece, Italy, I think we're seeing serious 
indications of deep problems in the political system, to say 
the least. But I'd like to comment on Germany and France 
because that was your initial question. In Germany, we've seen 
time and again that the commitment of the main parties 
ultimately was for more Europe, and this has been most 
obviously the case when the liberal party, the LDP, started to 
consider a different strategy. This led it nowhere and that 
reversed to a large extent this stance.
    It's notable in Germany, it has been--I'm sure you're aware 
of this and it has been commented many times, but it has to be 
reaffirmed, that in Germany the opposition is criticizing the 
government for not going far enough in terms of European 
integration, in spite of the difficult situation of public 
opinion that you have referred to.
    If I get back to the question which was asked by Dr. 
Johnson, why would Germany accept debt mutualization, given the 
difference in historical circumstances with, say, the 
assumption of States debt by the federation in the early 
history of the United States, I think there is a very deep 
sense of responsibility in Germany, that Germany has a stake 
and has a burden to carry in terms of the future of Europe, the 
future of the eurozone.
    So my response to this question, which is a very relevant 
question on why would Germany accept mutualization, is that 
there is an awareness that the consequences of not accepting it 
is something that Germany doesn't want, the German elites don't 
want it, but more importantly the German public doesn't want 
it, and that would be the breakup of the euro.
    As regards France, I would not see the recent change in 
government as a direct consequence of the European saga. It had 
been driven--first, it was a very close result, and I would 
argue as a French voter that it has been driven predominantly 
by domestic issues and individual issues that had little to do 
with European policy.
    Now, in terms of European policy there is a lot of 
continuity between the previous administration and the current 
one. I will note that the one point on which there is a change 
of direction, which is the push toward banking union, which was 
not there under the previous administration, the inflection has 
been in the direction of more integration, not less. Of course, 
this is not a judgment on what the future steps will be, and I 
think when we are talking about political union and empowering 
the European Parliament and basically having some more 
political features of a federation in the European 
institutional framework, this is something that will be more 
difficult possibly in France than in any other eurozone member 
state. So I am not underestimating the future challenge and I 
think the current administration is very aware of it. But I 
would argue that there is no indication that France is becoming 
more euroskeptic, particularly in the recent political 
    Senator Shaheen. Thank you.
    Dr. Johnson.
    Dr. Johnson. Well, I hate to sound more optimistic than my 
colleagues, but I will on this point. I think the eurozone is 
going to go into a deep crisis. It will break up. A core will 
be reconstituted and work together very closely. The big 
question is whether or not France is in that core, and related 
whether or not Italy is in that core.
    The British like to complain and certainly have not been 
always constructive. But in this crisis type situation, I think 
that they will be helpful and I think Europe will pull 
together. I don't think the European Union will disintegrate. I 
don't think we're going to have a war in Europe. They have far 
too much history. And I think the British will negotiate some 
complicated arrangement where the big question is to what 
extent you can do that and have a proper seat at the table and 
get to have some say with regard to regulations, including 
around finance. That's hard to predict. But I think the British 
will stay engaged and I think that ultimately Europe will come 
out of this. Ultimately there will be a shared currency, a more 
Germanic eurozone, and a rival reserve currency to the U.S. 
dollar. Of course, at that time we should worry about how 
international investors see the United States. If and when 
there's a viable reserve currency to the dollar, the pressure 
on us potentially becomes much greater. And if we don't have 
our fiscal house in order by that time, there will be trouble.
    Senator Shaheen. Listen. If we don't have our fiscal house 
in order by that time, we've got a lot more things to worry 
about than just how the dollar's going to compare against the 
euro, at least by my assessment.
    Dr. Johnson. I agree, Senator. But in terms of interest 
rates and in terms of pressure on short- and long-term interest 
rates, those presumably would be much more severe if 
international investors already could shift out of the dollar 
into some other asset.
    Senator Shaheen I know we're about to wind down, but I did 
want to ask before we close about the potential for growth in 
Europe because, as several of you have mentioned, one of the 
debates that's gone on has been austerity versus growth, and at 
what point do you need to include some growth measures along 
with austerity in order to provide hope. And Europe's back in, 
at least I think everybody agrees that Europe is now in a 
double-dip recession, so to what extent do measures need to be 
taken that can help speed growth in Europe in order to improve 
prospects for economic prosperity there.
    I don't know who wants to address that first. Dr. Burwell?
    Dr. Burwell. Let me take a noneconomic stab at it and say 
that I think sometimes on this side of the Atlantic and on the 
other side, when we talk about growth versus austerity we're 
actually talking past each other and talking about different 
things. The countries that are in difficulty right now often 
have large public sectors, where getting a job in the 
government is the best thing and you should be there for all of 
your career. The universities have not learned how to educate 
people for jobs. It is very difficult to start a new business, 
so they don't have the small business sector that has been the 
engine of employment in this country.
    I'm not saying necessarily that they should come to 
duplicate our economy. There will always be differences. But 
when Americans go over and talk about growth, Europeans are 
often leery about a stimulus from the government because they 
fear that it will only lead to the hiring of more government 
workers, which then exacerbates the problem and how they got 
    So hence the very strong emphasis on austerity, which is 
really code for structural reforms. And the German experience 
is that if you do these reforms then you will see growth. We 
can ask whether the German model is the only one suitable in 
Europe, but right now Germany is the predominant country 
calling the shots in this economic crisis.
    We have seen some moderation of the emphasis on austerity 
and I think, in fact, that President Hollande's election has 
allowed more discussion of the need for growth and, as one of 
my Spanish colleagues put it to me once: We can do the 
austerity, but we need to have a glimmer of hope at the end of 
that. So I think the conversations we have seen between Mr. 
Monte and Mr. Hollande about this, it's not necessarily that 
they're setting up an opposition to Germany, but they're 
setting up a moderation of the debate.
    There are some infrastructure funds that are now going to 
be disbursed. Infrastructure is something the EU has always 
used to boost economies. It's one of the reasons for the 
success of the Polish economy right now. So I think you will 
see more along those lines, more moderation. But the trick in 
Europe is to do it without necessarily funding the public 
    Senator Shaheen. Am I correct that one of the other 
successes of the Polish economy has been that their banking 
system was not affected by the fiscal crisis that we 
experienced here and in Europe?
    Mr. Veron. The Polish banking system had been very 
conservatively supervised in the years before the crisis. It's 
also a relatively unsophisticated banking system, so fewer of 
the big derivatives exposures that Dr. Johnson talked about.
    Senator Shaheen. That may be a good thing, though.
    Mr. Veron. In the circumstances, it has been a good thing. 
There is a wider debate which goes beyond this hearing whether 
it's always a good thing. But in the circumstances it has 
certainly been, as in a number of emerging economies, by the 
    I completely agree that the terms of the debate on 
austerity versus growth are very different in Europe and the 
eurozone from what they are in this country. One simple 
difference is that this is one single currency zone, with no 
risk of fragmentation, and where, at least since the middle of 
2009, in spite of possible problems in the banking system, 
credit is flowing relatively normally in the U.S. economy, more 
in some segments than others, but generally normally.
    In Europe, credit is a major factor and the threat of 
fragmentation is a major factor. So basically you have a 
situation where in countries like Greece, but also in Spain or 
Italy or others, one of the main impediments to growth is that 
many people are concerned about investing in a currency area 
where there could be a depreciation risk. You see that in terms 
of capital flight, but you also see this in terms of paucity of 
    So the risk of breakup to me is the No. 1 factor that 
inhibits growth in the eurozone. The second most important 
factor is the lack of credit because of the dire condition of 
the banking system, which goes back to the debate on banking 
union. These factors to me are bigger factors than the fine-
tuning of the fiscal stance or of what the European Investment 
Bank can do.
    Obviously very important is the question of structural 
reforms in order to boost the potential of high-growth firms, 
which is what Europe needs most, not just new firms but new 
firms that grow fast from small to large. This is the biggest 
challenge I think in almost all of the European Union, 
particularly in the periphery.
    Part of this is state reform. I think there is no denying 
that the state needs to be reformed for growth to come back, 
for both economic and political reasons, in countries like 
Greece, but also some other eurozone countries.
    So I would see all these factors as really center stage. So 
yes, Europe needs more growth, but the determining conditions 
in the near future will be about the perception of breakup risk 
and credit conditions.
    Senator Shaheen. Thank you.
    Dr. Johnson, final word?
    Dr. Johnson. If these countries did have flexible exchange 
rates with their major trading partners, so if Spain had an 
exchange rate that could depreciate, then the way that you 
would square the circle and have austerity but also get growth 
is the kind of way that Korea did it, for example, in 1997-
1998, which is you'd have some tightening on the fiscal side, 
you would have a big depreciation, you'd have an export boom.
    You can't do that as long as you remain within the currency 
union. You would therefore have to get something similar 
through a fall in your nominal wages and your nominal prices. 
That's incredibly difficult. The history of modern economics--
go back to the 1920s, go back to the gold standard. It broke 
down in part because our societies don't tolerate that kind of 
nominal flexibility.
    The Governor of the Central Bank of Mexico, Agustin 
Carstens, likes to say it: There's two ways to paint a house; 
either that the house stays where it is and the person with the 
paintbrush moves around it, or the painter stays where he is 
and you move the house. That's what you're asking the Europeans 
to do within this fixed exchange rate system, this ultra-gold 
standard arrangement that they have between the major trading 
partners. It is incredibly difficult to do that. The Central 
Bank can't wave some magic wand and make it happen. The result 
is going to be, I think, exactly what I guess that you fear, 
which is austerity on top of austerity, loss of growth 
prospects. Then everybody's debts look much worse because 
there's no private sector growth and there's no growth to 
sustain the public finances, and then you go into some even 
deeper crisis from which it's harder to extricate yourself.
    Senator Shaheen. Well, thank you all very much. You've 
given us a lot to think about. I appreciate your insights.
    I will submit all of your testimony for the record, and I 
also had a longer statement that I will submit for the record. 
We will leave the record open for 48 hours in case there are 
other questions that are submitted.
    At this time, again I want to thank you, and declare the 
hearing closed.
    [Whereupon, at 4:08 p.m., the hearing was adjourned.]

              Additional Material Submitted for the Record

           Responses of Nicolas Veron to Questions Submitted
                        by Senator John F. Kerry

    Question. Business groups on both sides of the Atlantic are 
advocating a U.S.-EU agreement to further reduce barriers to trade and 
investment. Would such an agreement help with the eurozone crisis, and 
if yes, what should the scope of such an agreement be?

    Answer. A substantial transatlantic trade and investment agreement 
would be a welcome signal of economic cooperation and openness and a 
positive factor for Europe's overall economic outlook. However, it 
cannot be seen as central in terms of crisis resolution given the 
nature and magnitude of the eurozone crisis.

    Question. Despite the effects of the crisis, Europe remains a 
wealthy continent, with ample resources to address the crisis. If a 
solution were to be found that required greater financing than has been 
marshaled to date within Europe: (i) what would be the most efficient 
way to raise these resources; (ii) how would the burden be distributed 
across euro area countries; and (iii) on whom is the burden likely to 
fall the hardest?

    Answer. Indeed, the eurozone crisis differs from many crises of the 
past, especially in developing and emerging countries, in that external 
financial assistance is not indispensable to resolve it successfully 
given the high level of wealth of the eurozone as a whole. The 
roadblocks are about economic and political decisionmaking arrangements 
inside Europe. Even though individual member states' fiscal discipline 
is necessary for the future robustness of Europe's monetary union, I 
also believe that a degree of debt mutualization will have to be part 
of a successful crisis resolution strategy. In my opinion, this 
requires significant changes in the EU institutions which might need to 
go as far as the creation of a European framework for taxation, and 
granting powers to the European Parliament to exert adequate control 
over revenue and expense decisions at the European level.

        Responses of Dr. Frances Burwell to Questions Submitted 
                        by Senator John F. Kerry

    Question. In your testimony and responses to questions, you 
suggested that some degree of increased integration was required to 
resolve the current crisis. You also noted the risk that, through that 
process, the U.K. would become increasingly estranged from the rest of 
the EU. To play devil's advocate, in light of the disparate views on 
political integration and economic policy within the euro area and the 
broader EU, should the resolution of the crisis be sought, instead, in 
a smaller, tighter euro area, and less centralization of authority 
among other countries and in other policy areas?

    Answer. The crisis has made clear that the European Union is now at 
a transition point. Greater integration--at least in financial policy--
will be required to resolve the current situation, but for a few EU 
members, the further transfer of sovereignty in such a core area is 
unacceptable. Currently, it is estimated that between 60-70 percent of 
national legislation is actually determined by the Brussels 
institutions, and then ``transposed'' by national parliaments. Although 
the EU has brought many benefits to Europeans (and we should not forget 
the anniversary of the outbreak of World War II in September), there is 
no doubt that it also constrains national policy options. The fiscal 
compact will certainly add to that constraint. In this environment, 
some governments accept that their small countries can only be secure 
and influential as part of a larger group. Others, like Germany, find 
some constraints acceptable for historic reasons. Others (France, 
Poland) believe they can lead the EU and thus have greater global 
impact than on their own. But some, particularly the U.K., but perhaps 
also Denmark, do not relish giving up so much sovereignty to Brussels.
    There has long been talk of a multispeed Europe or ``Europe a la 
carte'' and we already see this in the eurozone, Schengen arrangements, 
and even the Common European Security and Defense Policy (Denmark has 
an ``opt out), where the memberships can vary from that of the EU. But 
we are now at a fundamental division: those who remain in the eurozone 
can only keep the currency healthy by embarking on a much more unified 
set of economic policies. They now realize that they cannot be held 
back by the objections of those outside the eurozone who wish to move 
more slowly. As we see the eurozone government seek to resolve the 
crisis, we will see the emergence of a two-tier Europe. Most of the 
current eurozone will remain, and those new countries pledged to join 
the eurozone will eventually come in (there may be some delays, as 
these countries will have to meet tighter requirements and will also be 
reluctant until the eurozone has recovered).
    But beyond the core and the ``core aspirants,'' there will be an 
outer ring of the U.K., perhaps Denmark and Sweden, but also Norway, 
Liechtenstein, and others in the European Economic Area may reconsider 
whether they wish to join this ``outer EU.'' As for Turkey, whether 
Ankara would find being in such an outer ring acceptable is uncertain. 
The evolution of such an EU, may well lead the Turkish Government to 
rethink the desirability of EU membership. The main challenge of such a 
structure will be defining the rights and responsibilities of those in 
the outer ring so that it does not become just a way station on the 
path to exiting the EU. In sum, whether one favors it or not, the most 
likely future of the EU is along the lines of the bifurcated two-tier 
organization suggested by the question.

    Question. Business groups on both sides of the Atlantic are 
advocating a U.S.-EU agreement to further reduce barriers to trade and 
investment. Would such an agreement help with the eurozone crisis, and 
if yes, what should the scope of such an agreement be?

    Answer. A U.S.-EU ``jobs and growth initiative'' would not help 
directly to resolve the eurozone crisis, but it could have some 
important and positive indirect consequences. The announcement of such 
an initiative could signal U.S. confidence in the long-term health of 
the European economy, and perhaps encourage the markets to be a bit 
more patient, thus lowering the costs and risks associated with the 
current sovereign debt and banking crises in Europe. The markets may 
even realize that such an accord would have significant economic 
effects for both the United States and EU, and inspire a greater sense 
of business confidence. [Figures range from $180 billion added to GDP 
over 5 years from an agreement that only eliminated tariffs on goods (A 
Transatlantic Zero Agreement, ECIPE Occasional Paper #4, 2010) to 
significantly higher (but less certain) gains from an agreement also 
erasing barriers on services and investment.]
    Once the launch of negotiations is announced, most policymakers 
anticipate that it would be 2 years at least before an agreement is 
signed and accepted by the U.S. Congress and European Parliament. Only 
then would the economic effects be felt directly. However, even before 
the final agreement, companies may start to anticipate the impact of 
the accord, especially as they make decisions about establishing or 
enhancing investments (including factories). One peculiarity of the 
transatlantic economy is that at least 30 percent of trade is intra-
firm; that is, companies such as Ford or Unilever shipping parts from 
one factory to another. In these cases, tariff reductions free up funds 
that could be used for greater investments--and job creation--on both 
sides of the Atlantic. Tariffs also affect decisions on where to put 
manufacturing facilities. If it looked, for example, as though U.S. 
tariffs on the export of fully assembled cars to the EU would be 
reduced to the level charged by Mexico, some companies may think about 
building more facilities in the United States. Because such decisions 
are normally made with a long lead time, we may see some developments 
before the final conclusion of an accord.
    As for the scope of such an agreement, most experts agree that it 
should be comprehensive, going beyond elimination of tariffs and quotas 
(including on agricultural goods) to include services, investment, and 
regulatory measures, as well as some specific areas such as trade 
facilitation and government procurement. Some analysts (including this 
one) look forward and think that privacy/data protection issues might 
also be important, as they are likely to become a significant factor in 
future transatlantic commerce and investment. Similarly, the issue of 
visas, especially for highly skilled workers, is likely to grow in 
importance as companies become more ``transatlantic'' and need a mobile 
workforce. These last two issues, however, are not on the current 
mainstream agenda, but rather identified as challenges that will 
increasingly confront an integrated transatlantic economy.
    The main question about negotiating such an agreement is whether it 
is a ``single undertaking''; that is, follows the normal practice of 
trade negotiations that ``nothing is agreed until everything is 
agreed.'' This strategy does allow tradeoffs between the parties across 
different issues. In the current political climate, however, it is 
worth considering whether certain elements of such a comprehensive 
accord should be separated out when agreed and thus allow for some 
early victories, while preserving a comprehensive accord as the end 
goal. A trade facilitation package (supposedly largely agreed already 
under the Doha Round) might be a good example of an accord that can be 
relatively quickly concluded, or even the elimination of manufacturing 
and agricultural tariffs and quotas. A public victory or two might 
invigorate negotiations as they reach the difficult and opaque areas of 
trade in services and regulatory mutual recognition. In the end, 
however, this distinction between a single undertaking or separate 
packages leading to a comprehensive accord is less important than 
simply getting this initiative underway.

    Question. Despite the effects of the crisis, Europe remains a 
wealthy continent, with ample resources to address the crisis. If a 
solution were to be found that required greater financing than has been 
marshaled to date within Europe: (i) what would be the most efficient 
way to raise these resources; (ii) how would the burden be distributed 
across euro area countries; and (iii) on whom is the burden likely to 
fall the hardest?

    Answer. I will let my two economist colleagues comment more 
specifically on the technical aspects of such financing, and will focus 
on the political. It is certainly possible that greater resources will 
be required, especially as the eurozone crisis is likely to persist for 
a few years. That funding can come from three basic sources: private 
sector, ECB, and governments (via the EFSF and ESM). I believe that we 
will see greater use of all of these. First, except for the Greek case, 
the private sector has not taken large, official losses (in Greece, the 
``haircut'' was about 70 percent). Especially as the banking crisis in 
Spain must now be faced squarely--a crisis that results at least in 
part from speculative real estate investments--more private sector 
investors will be forced to write off debt. Second, the ECB will also 
be forced to intervene more frequently and in more direct ways. This 
will only happen gradually, and there will be much uncertainty largely 
because of German criticism of such actions. At times, Mario Draghi 
will have to be very imaginative in finding a way forward that works 
but also keeps German pressure at an acceptable level. Third, during 
this crisis, we have seen an accumulation of capital in Germany as 
investors seek a safe harbor (even though German bond yields have 
sometimes been negative). Some countries, such as France, will be 
limited in contributing further to financing arrangements as their own 
debt level is now affected by their earlier contributions. In this 
situation, it will be Germany that will bear the primary burden of 
future financing (although it will insist on other countries continuing 
to pay into the ESM, perhaps at lower percentages).
    Although Germany might seem reluctant to provide more funds, based 
on the public debate in that country, there are two countervailing 
factors. First, the Chancellor has made clear that she will do what is 
necessary to save the euro, and her dominance of the German political 
scene is still strong. Second, there seems to be a distinction among 
German policymakers between making an additional, but finite 
contribution to the ESM, and making an open ended commitment to support 
pan-European financing through a eurobond. Thus, particularly in a 
crisis, and confronted with a possible default by a eurozone country, 
Germany is likely to step forward and provide an agreed amount of 
additional funds, even while it continues to object to any open-ended