[Senate Hearing 114-807]
[From the U.S. Government Publishing Office]





                                                        S. Hrg. 114-807
 
               FINANCIAL CRISIS IN GREECE: IMPLICATIONS 
                          AND LESSONS LEARNED

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

                                HEARING

                               BEFORE THE

                  SUBCOMMITTEE ON EUROPE AND REGIONAL
                          SECURITY COOPERATION

                                 OF THE

                     COMMITTEE ON FOREIGN RELATIONS
                          UNITED STATES SENATE

                    ONE HUNDRED FOURTEENTH CONGRESS

                             FIRST SESSION

                               __________

                             JULY 29, 2015

                               __________

       Printed for the use of the Committee on Foreign Relations
       
       
       
       
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       Available via the World Wide Web: https://www.govinfo.gov
       
       
       
       
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                COMMITTEE ON FOREIGN RELATIONS         

                BOB CORKER, TENNESSEE, Chairman        
JAMES E. RISCH, Idaho                BENJAMIN L. CARDIN, Maryland
MARCO RUBIO, Florida                 BARBARA BOXER, California
RON JOHNSON, Wisconsin               ROBERT MENENDEZ, New Jersey
JEFF FLAKE, Arizona                  JEANNE SHAHEEN, New Hampshire
CORY GARDNER, Colorado               CHRISTOPHER A. COONS, Delaware
DAVID PERDUE, Georgia                TOM UDALL, New Mexico
JOHNNY ISAKSON, Georgia              CHRISTOPHER MURPHY, Connecticut
RAND PAUL, Kentucky                  TIM KAINE, Virginia
JOHN BARRASSO, Wyoming               EDWARD J. MARKEY, Massachusetts


                 Lester Munson, Staff Director        
           Jodi B. Herman, Democratic Staff Director        
                    John Dutton, Chief Clerk        

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

              SUBCOMMITTEE ON EUROPE AND REGIONAL        
                      SECURITY COOPERATION        

                RON JOHNSON, Wisconsin, Chairman        

RAND PAUL, Kentucky                  JEANNE SHAHEEN, New Hampshire
JAMES E. RISCH, Idaho                CHRISTOPHER MURPHY, Connecticut
CORY GARDNER, Colorado               TIM KAINE, Virginia
JOHN BARRASSO, Wyoming               EDWARD J. MARKEY, Massachusetts

                              (ii)        

  


                            C O N T E N T S

                              ----------                              
                                                                   Page

Hon. Ron Johnson, U.S. Senator From Wisconsin....................     1
Hon. Jeanne Shaheen, U.S. Senator From New Hampshire.............     2
    Prepared Statement...........................................     2
Robert Kahn, Steven A. Tananbaum Senior Fellow for International
  Economics, Council on Foreign Relations, Washington, DC........     3
    Prepared Statement...........................................     5
John B. Taylor, Hoover Institution and Professor of Economics, 
  Stanford University, Stanford, CA..............................    13
    Prepared Statement...........................................    15

                                 (iii)

  


      FINANCIAL CRISIS IN GREECE: IMPLICATIONS AND LESSONS LEARNED

                              ----------                              


                        WEDNESDAY, JULY 29, 2015

                           U.S. Senate,    
        Subcommittee on Europe and Regional
                              Security Cooperation,
                            Committee on Foreign Relations,
                                                    Washington, DC.
    The subcommittee met, pursuant to notice, at 2:19 p.m., in 
room SD-419, Dirksen Senate Office Building, Hon. Ron Johnson 
(chairman of the subcommittee) presiding.
    Present: Senators Johnson and Shaheen.

            OPENING STATEMENT OF HON. RON JOHNSON, 
                  U.S. SENATOR FROM WISCONSIN

    Senator Johnson. This hearing will come to order. I want to 
first of all welcome our witnesses and thank them for taking 
the time to appear before us here today, as well as taking the 
time for your thoughtful testimony.
    The title of this hearing, ``Financial Crisis In Greece: 
Implications and Lessons Learned,'' I think pretty well 
describes what I want to talk about. A couple of years ago when 
we saw the riots in the streets of Greece, that was pretty 
revealing in terms of economic models and governmental models 
that were not working too well. One of the first things I did 
is I asked my staff to do a little research in terms of 
describing the level of debt in America versus Greece. So we 
produced a chart, which we have updated as of the first 
quarter. I wanted to keep it all relative.
    I was rather shocked at the result. I was expecting the 
debt per capita of Greece to be a whole lot worse than the debt 
per capita here in the United States, but I found the exact 
opposite.
    At the end of the first quarter in 2015, every American's 
share of our Federal debt was over $56,000. If you were a 
citizen of Greece, your share of Greece's national debt was 
about $31,000.
    One of the questions I have for our eminent witnesses is 
how can that be and what does that really portend for America's 
future as well?
    I am looking forward to this hearing. We need to be 
concerned about the events in Greece, what kind of contagion 
that might produce for the rest of the eurozone. And, of 
course, if it is having an effect on Europe's economy, it will 
have an effect on the world economy. Those are the basic 
questions we need to ask in this hearing.
    With that, I will turn it over to Senator Shaheen.

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

    Senator Shaheen. Thank you, Mr. Chairman.
    Thank you to both of our witnesses for being here today.
    The bailout agreement reached earlier this month by Greece 
and its European partners I think we would all agree is far 
from perfect. But even Greece's Prime Minister, who was elected 
in January with a mandate to reject further austerity, agreed 
that it was preferable to the immediate alternative, which was 
Greece's probable exit from the euro and the undermining of its 
financial system and economy.
    But I think that this latest bailout agreement gives rise 
to a number of important questions about the long-term 
viability of the Greek deal and the future of the eurozone as a 
political and monetary union with which the United States has 
particularly strong ties.
    I would like to submit my opening statement for the record, 
Mr. Chairman, but I held a hearing in this subcommittee I think 
in 2010, where we discussed this very issue, what were the 
implications of the financial situation in the eurozone and the 
implications for Greece and the other countries that at the 
time were experiencing similar financial difficulties.
    The prognosis was, from the people who testified that day, 
actually, that we would be here several years from now with no 
firm resolution to the crisis. Sadly, I think we are exactly 
where that panel predicted that we would be.
    New Hampshire has the highest percentage of Greek-Americans 
in the country, of any State in the country. So for my 
constituents and for Greek-Americans across the country, they 
are asking what the future looks like and what are the 
implications for their relatives and friends, many of whom are 
still in Greece and experiencing tremendous difficulties.
    So I very much look forward to your testimony relative to 
what is happening in Greece and to what we might do to support 
both the eurozone and Greece as they try and deal with their 
financial troubles.
    So again, thank you both very much for being here, and I 
look forward to your testimony.
    [The prepared statement of Senator Shaheen follows:]

              Prepared Statement of Senator Jeanne Shaheen

    Thank you, Mr. Chairman, for calling this important hearing on the 
Greek financial crisis.
    The bailout agreement reached earlier this month by Greece and its 
European partners is far from perfect. But even Greece's Prime 
Minister--elected in January with a mandate to reject further 
austerity--agreed that it was preferable to the immediate alternative: 
Greece's probable exit from the euro and the undermining of its 
financial system and economy.
    However, this latest bailout agreement gives rise to a number of 
important questions about the long-term viability of this deal and the 
future of the eurozone as a political and monetary union with which the 
U.S. has particularly strong ties.
    Does this deal chart a sustainable way forward? The agreement 
imposes additional reforms and austerity measures on a Greek economy 
that has already contracted by nearly 25 percent. Is it possible for 
the Greek economy to stabilize and subsequently grow under the terms of 
this agreement? What are the alternatives?
    Central to any discussion of the Greek financial crisis is the 
issue of Greece's debt burden. The International Monetary Fund, which 
has played a key role in resolving Greece's financial crisis at the 
request of eurozone members, requires borrowers to have a sustainable 
debt level. Yet questions remain about whether Greece's debt, even 
under this deal, can be considered sustainable without some concessions 
on restructuring--concessions some European leaders have resisted. How 
should debt relief or restructuring play into negotiations going 
forward, and what role should the U.S. play in that respect?
    Finally, there are the big questions that hang over any discussion 
of the implications and lessons learned from the Greek financial 
crisis: mainly, what has this episode revealed about European economic 
governance and the European project more broadly? The answers to these 
questions have consequences not only for Greece, but also for Europe 
and the Atlantic alliance.
    I look forward to our witnesses' insights and counsel on all of 
these important issues.

    Senator Johnson. Thank you, Senator.
    Our first witness will be Dr. Robert Kahn. Dr. Kahn is the 
Steven A. Tananbaum Senior Fellow for International Economics 
at the Council on Foreign Relations. Previously, Dr. Kahn has 
held positions at the World Bank, IMF, and the U.S. Treasury.
    Dr. Kahn.

STATEMENT OF ROBERT KAHN, STEVEN A. TANANBAUM SENIOR FELLOW FOR 
    INTERNATIONAL ECONOMICS, COUNCIL ON FOREIGN RELATIONS, 
                         WASHINGTON, DC

    Dr. Kahn. Chairman Johnson, Ranking Member Shaheen, it is 
an honor to testify today on the Greek financial crisis.
    Senator Shaheen said the agreement earlier this month 
between Greece and its official creditors has prevented, for 
now, a disruptive Greek exit from the European monetary union. 
With adequate financial support, this deal offers a very narrow 
path for Greece to return to sustainable growth with the euro, 
but difficult choices face the Greek Government and people in 
the days ahead, and Grexit remains a very real possibility, 
perhaps even the most likely outcome at this point.
    So far, the effects of the crisis on the U.S. economy have 
been modest. Greece is quite small as a share of U.S. trade and 
finance. U.S. banks have minimal exposure.
    Also, since 2009, Europe has established rescue facilities, 
strengthened buffers, eased monetary policy, and there has been 
significant financing and cash relief, and a private-sector 
haircut. All this allowed Greece to return to modest growth 
last year before this year's confrontation with creditors 
returned Greece to recession.
    But my bottom line is that this is not 2008. This is not 
2010.
    Still, I would argue, we do need to be on the watch for 
contagion. Whether inside or outside the eurozone, Greece's 
debt is unsustainable. And the recognition of losses for 
creditors could reveal surprising new sources of financial 
instability.
    Contagion through political channels is equally if not more 
worrisome. We will need to watch closely what the crisis means 
for antiausterity debates in the periphery and for the anti-EU 
movement in the United Kingdom.
    I will go into more detail on these issues in my prepared 
remarks, but let me in my opening remarks highlight five 
critical points that I think will confront the committee in its 
work in coming months.
    First, the plan that was agreed between Greece and its 
official creditors is a framework for a deal, not a deal 
itself. Many details are still to be negotiated. The sides are 
far apart. There are a lot of things that could go wrong.
    Greece in the past 2 weeks has passed significant reforms 
for tax, judicial, banking system, but there is a long road 
ahead, and the political challenges are daunting.
    If all goes well, the best-case scenario would involve 
agreement on reforms, European and IMF financing at record 
levels, restoration of ECB access, debt relief, bank 
restructuring, and the lifting of capital controls, all of this 
by the end of the year.
    And as I said, this program could not only fail, there must 
be very strong domestic ownership of the reforms for there to 
be any hope of success. That is something that is still 
legitimately a concern.
    Given these evident risks, we need to use our leverage to 
strengthen the plan, particularly as it regards debt, but 
policymakers also need to be thinking through a plan B for best 
how to support Greece in the case of Grexit. That would include 
humanitarian aid, recognizing that it would be extraordinarily 
disruptive in the near term and cannot by itself solve Greece's 
problems and structural challenges, including overregulation, 
distorted prices, and the rule of law.
    Second, any program that keeps Greece in the eurozone is 
going to be hugely expensive. The agreement envisages a 
financing gap of =86 billion over the next 3 years, which a 
little more than half goes to meeting debt service. The rest 
would allow fiscal financing, the elimination of arrears, and a 
comprehensive fix of the banking system. But the amounts needed 
are likely to grow due to inevitable slippages and a rising 
bill for the banking system closure.
    This morning, we learned that growth this year is now 
expected to be^-3.3 percent, and the primary deficit in the 
range of ^1 percent to ^2 percent. This underscores the damage 
and the distance that has been done and the distance that still 
needs to be traveled.
    So this is the price of trying to keep Greece in the 
eurozone. Even the strongest market-oriented reforms are going 
to cause some dislocation in short-run situations. So it is 
critically important that Europe pays its share of the 
financing.
    Discussions now envisage a rescue package, a so-called ESM 
program, in the range of $30 billion to $40 billion, less than 
half the amount needed. I think that package probably has to be 
at least $50 billion, so that the excessive amount does not 
fall to the IMF or is left unfulfilled.
    Third, European debt does remain a critical hole in our 
international architecture. We have a policy for private debt, 
and there is a Paris Club for developing countries. But the 
debt overhang in Europe has become a destabilizing force.
    Now it may be possible to address Greece's needs in the 
near term through pushing out debt maturity and lowering 
interest rates. The policy would be better if it came to terms 
more transparently with the need for debt reduction.
    I have called for a Paris Club for Europe, and now is the 
time to put that idea on the table. I would like my proposal 
from October 2014 submitted for the record.
    Fourth, it is important to recognize that any IMF program 
contains risks. It will need to provide exceptional access. And 
if we are honest, we have to acknowledge that even with debt 
relief, there will not be a high probability that the debt will 
be sustainable. Pragmatism will be needed under the rules, 
because strict interpretation of the rules would probably force 
Greece outside the eurozone.
    Now the IMF has been the center of controversy recently, 
but I believe it has acted responsibly in pushing for both 
adequate financing and debt relief. I think the United States 
should show leadership as these decisions are made and, broadly 
speaking, be supportive of the Fund's position on this. In 
addition, the Fund's preferred creditor status, which has been 
challenged by events in Greece, does need to be reaffirmed.
    Finally, let me step back. I think Greece highlights a 
trend that you can trace back really to the mid-1990s when 
there was a Mexico program or a program for Korea, and through 
to the rescue programs of Greece and Ukraine today. Across this 
period, we have seen a rapid growth in financial markets and 
greater integration from developing countries in global 
markets.
    Now that offers important possibilities for development and 
growth, but it means that when crises do occur, the financing 
needs are large and growing relative to the resources the Fund 
has as hand. This is causing increasing conflict between 
official creditors about who is going to pick up the bill. And 
when gaps emerge, it forces restructurings, which may or may 
not come at the right time. These tensions are only going to 
grow in coming years.
    From this perspective, it is critically important that we 
work to modernize the IMF, and we cannot achieve this objective 
unless IMF quota reform is passed. So I see these issues as 
linked.
    In sum, we have a shared interest with our European 
partners in establishing a Greece, whether inside or outside 
the eurozone, that is competitive and growing. We also have a 
strong interest in a cohesive and economically prosperous 
Europe.
    I believe that what happens in coming months with our 
support could go a long way to determining the future of Europe 
and of the eurozone more generally.
    Thank you for your time. I would be glad to answer your 
questions.
    [The prepared statement of Dr. Kahn follows:]

                  Prepared Statement of Robert B. Kahn

    Chairman Johnson, Ranking Member Shaheen, and other members of the 
Foreign Relations Subcommittee on Europe and Regional Security 
Cooperation, it is an honor to testify on the Greek financial crisis. 
The agreement earlier this month between Greece and its official 
creditors has prevented, for now, a disruptive Greece exit from 
European monetary union. With adequate support from major creditors, 
this deal offers a narrow path for Greece to return to sustainable 
growth with the euro. But difficult choices face the Greek Government 
and people in the days ahead, and Grexit remains a very real 
possibility, perhaps even the most likely outcome.
    Greece's direct trade and financial links to the U.S. economy are 
small, and there is less of a direct systemic threat to the United 
States than it was when the crisis began in 2009. But the risks are 
still material, and what happens in coming days and months can have 
dramatic consequences for Europe and for the global economy. While our 
leverage on intra-European negotiations is limited, there are a number 
of channels through which we can influence the path of the crisis, and 
it remains of vital importance to the United States that we remain 
involved--through the International Monetary Fund (IMF), the Group of 
Seven (G7) and bilaterally with European governments.
    In my testimony today, I want to examine the Greek crisis--how we 
got here, where we are going, and the critical decision points in 
coming months on which the United States can and should strive to 
influence outcomes.
       economic decline, fiscal consolidation, and debt reduction
    Since the start of the Greek debt crisis in October 2009, the 
country has experienced one of the most severe economic depressions for 
an economy not at war in the modern era (Figure 1). The size of the 
Greek GDP has shrunk by 25 percent since 2009, the unemployment rate 
has soared to over 25 percent, and youth unemployment is near 50 
percent. After a return to modest growth in 2014, the economy fell back 
into recession as a result of the Syriza-led government's brinkmanship 
with its creditors, which resulted in a fiscal crisis, a bank run, and 
the subsequent closure of the banks.

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    There have been a number of excellent autopsies of the Greek 
experience, and I do not attempt to do service to the painful history 
of the period here. But a few observations are helpful to put the 
current debate in context. Certainly there is plenty of blame to go 
around for this disastrous economic performance: weak Greek policies, 
excessive deficits, and a distorted economy meant that Greece was 
always going to struggle to remain competitive within European monetary 
union. From this perspective, the economic problems of Greece date from 
well before 2009. Repeated adjustment programs prioritized fiscal 
adjustment over tough but necessary structural reforms to labor and 
product markets that would have allowed a return to growth, as we are 
now seeing elsewhere in the periphery. In addition, the incomplete 
nature of economic union in Europe--lagging well behind political 
union--also contributed to the current crisis. In particular the lack 
of fiscal union meant that Europe did not have the automatic fiscal 
transfers that we take for granted in the United States. Further, the 
inability to deal in a comprehensive fashion with the debt problems of 
the periphery further constrained Greece's room for maneuver and, in 
conjunction with weak overall growth in the euro area, limited demand 
for Greek goods.
    Still, the proximate cause for the severe depth of the Greek 
recession was the drag from fiscal austerity. At the start of the 
crisis, the Greek primary fiscal deficit was on the order of 10 percent 
of GDP (with an overall deficit of nearly 16 percent). Even with 
significant financing, the shift from a deficit of that size to a small 
primary surplus last year represented a massive contraction in demand. 
From one perspective, it is unfair to blame creditors for austerity: 
after all, while a portion of the financing went to meet maturing debt, 
external financing also allowed for a much more gradual path of fiscal 
adjustment than would have been the case otherwise, and deficits that 
remained for most of the period were among the largest in the eurozone. 
But the IMF has admitted that it underestimated the amount of drag (the 
fiscal multiplier) that would result from this level of fiscal 
consolidation at a time of low growth and significant economic slack 
across Europe. From this perspective, the surplus countries of Europe 
could have done much more to stimulate demand while the periphery 
countries adjusted.
    Before the crisis, the debt looked sustainable on the basis of 
ready market access at low interest rates (figure 2). With the onset of 
the crisis, borrowing costs soared (figure 3), contributing to a ``doom 
loop'' in which high government debt undermined confidence and 
prospects for the banks, which in turn worsened perceptions of 
creditworthiness for the government to clearly unsustainable levels 
(figure 3).

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    By April 2010, the bond spreads rose to such a level that Greece 
essentially lost market access to finance its government. Greece 
subsequently requested financial assistance from the European Union 
(EU) and IMF, the first of a series of rescue packages that 
cumulatively have provided roughly $250 billion in funding. IMF lending 
during this period was well in excess of the normal quota-based lending 
limits, which under the existing exceptional access rules would have 
required a finding that the debt was sustainable with ``high 
probability.'' In the absence of that finding, the Board decided to 
create a new ``systemic exemption'' that allowed this requirement to be 
suspended when there was ``a high risk of international systemic 
spillovers.'' This rule--which has also been used in programs for 
Portugal and Ireland--has become the center of a current debate over 
the appropriate flexibility in an uncertain world where political 
factors can come into play in deciding on IMF lending.
    While there were important successes in the IMF programs, and a 
number of reviews completed, there were also some ``notable failures,'' 
as IMF admits in an ex post evaluation.\1\ The program did not restore 
investor confidence or help Greece regain market access. The debt did 
not become sustainable and had to be restructured in 2012. Their report 
highlighted overly optimistic macroeconomic assumptions, as well as an 
overestimation of the Greek government's ability to implement policy 
reform.
    Following elections in January 2015, the new government abandoned 
its existing program, and sought to open new negotiations with a goal 
of ending austerity and achieving comprehensive debt reduction, all 
while remaining in the eurozone in good standing. These promises, 
coupled with their decision to roll back a number of reforms put in 
place by the prior governments, put Greece on an immediate collision 
course with its creditors. Despite improving regional headwinds 
(including improved growth and low interest rates), there was a 
significant worsening of economic conditions, with the economy 
returning to recession and the primary fiscal positron turning 
negative. A deposit run from the banks was offset initially by 
extensive support from the ECB, but when the government decided to pull 
out of negotiations in late June, the ECB froze that support, leading 
to the closure of the banks.
                        the july 2015 agreement
    On July 22, the Greek legislature passed the second round of 
reforms, focused on: the court system backlog; protecting small 
depositors; and the introduction of rules to allow bank shareholders 
and creditors to cover the costs of failed banks.\2\ These votes move 
Greece and its international creditors into the formal negotiating 
phase.
    European leaders, meeting late into the night of July 12 in 
Brussels, reached an agreement that offers a path for Greece to remain 
within the eurozone. But it is an extraordinarily difficult path, 
requiring a commitment to market-oriented reform that this government--
as well as previous ones--has not been able to sustain. The agreement 
traced out a series of steps which, if fully implemented, would lead to 
Greece receiving financing over the next 3 years totaling at least =86 
billion. The first steps along this path have now been completed. In 
two rounds of legislation, the Greek Government passed measures 
including substantial value-added tax (VAT), other taxation, and 
pension reforms; a new code of civil procedure as part of judicial 
overhaul; full implementation of past EU laws, including procedures for 
automatic fiscal cuts when targets are not met; and, implementation of 
bank recovery and resolution directive as first step towards fixing the 
banks. In return, European creditors provided bridge financing totaling 
=7 billion on July 17 that allowed Greece to make debt payments and 
repay arrears to the IMF. The European Commission (EC) also unveiled 
plans to release =20 billion from the European Structural and 
Investment Funds, and =15 billion from the EU Agricultural Funds to 
support the Greek recovery over a number of years.\3\
    Negotiations have begun this week on a broader agreement with the 
European Stability Mechanism (ESM) rumored to be in the range of =30-40 
billion. These negotiations would address some of the most sensitive 
areas including early retirement and raising tax rates on farmers. 
Further reforms including: (i) Eliminating the pension deficit (that 
now stands at 10 percent of GDP); (ii) Adoption of ambitious product 
market reforms; (iii) Privatization of the electricity transmission 
network (ADMIE); (iv) A comprehensive labor market review including 
collective bargaining, industrial action and collective dismissals and 
a commitment to European best practices; (v) Large-scale privatization, 
including the possibility that =50 billion of assets would be turned 
over to an EU-controlled facility; and (vi) Broad-based administrative 
reform.
    The best-case scenario involves comprehensive economic reform 
backed by agreement on a European package (ESM) by mid-August (ahead of 
a =3 billion payment due to the ECB on August 20) followed by an 
agreement on debt relief in the fall after a first review; tranched and 
conditional financing from the IMF and restored access to ECB programs; 
a comprehensive bank restructuring and a lifting of capital control--
all by the end of the year. While the timing and modalities of IMF 
lending have not been determined, one scenario would have the IMF 
program moving forward after the first ESM review, which would allow 
time for negotiations to begin on longer term debt relief that the IMF 
insists is needed for it to agree on a program it can support.
    This package could easily fail if domestic support for tough 
adjustment policies falters. Already, recent estimates suggest that the 
economy will shrink by 2-3 percent this year (versus a forecast of 0.5 
percent growth previously), apparently necessitating additional 
adjustment measures. Given the evident risks, we need to use the 
leverage we have to strengthen the plan, particularly as regards debt 
(see below).
                     lessons from the greek crisis
    Given the exhaustive array of issues still to be negotiated, the 
plan that was agreed between Greece and its official creditors should 
be seen as a framework for a deal, not a deal itself. Yet the success 
or failure of the plan could be critical not only for Greece but for 
the future of European integration.
    Any program that keeps Greece in the eurozone is going to be 
expensive. The agreement envisages a financing gap of =86 billion over 
the next 3 years, of which a little more than half goes to meeting debt 
service. The rest would allow fiscal financing, elimination of arrears, 
and a comprehensive fix of the banking system. But the amount is likely 
to grow, due to inevitable slippages and a rising bill from the recent 
banking system closure.
    This is the price of trying to keep Greece in the eurozone, 
recognizing that even the strongest market-oriented reforms can cause 
dislocations in the short run. It is important that Europe pays its 
share of the financing, with an ESM program that should be close to =50 
billion--not the =30-40 billion now being discussed--so that an 
excessive amount does not fall to the IMF or be left unfilled, 
undermining the program.
    Already, there are some suggestions that the amount needed could be 
higher due to the recent, sharp economic deterioration following the 
closure of the banks. Further, in any economic program, and especially 
in this one, the risk of slippage is high. It is assumed that there 
will be substantial privatization revenue, and haircuts to private 
creditors of insolvent banks may reduce the official bailout cost. 
Creditors also sought to address these concerns by requiring additional 
budget cuts if targets are missed. But, with substantial headwinds 
already facing the economy, the feasibility and desirability of turning 
off the automatic stabilizers seem questionable.
    Third, European debt remains a critical hole in our international 
architecture. We have a policy of private sector involvement (PSI), and 
the Paris Club for developing countries. But the debt overhang in 
Europe has become a destabilizing force.
    There is a broad consensus that Greek debt is unsustainable, a 
point even conceded by the German Government. It may be possible to 
address Greece's needs in the near term through pushing out debt 
maturities and lowering interest rates, but a policy would be better if 
it came to terms more transparently with the need for debt reduction. 
Over the longer run a new architecture for dealing with debt is needed. 
I have called for a Paris Club for Europe, and now is the time to put 
that idea on the table. (I would like my proposal from October 2014, 
``A Paris Club for Europe,'' submitted for the record.)
                          the role of the imf
    The final piece of the Greek package, financial assistance from 
IMF, has drawn a lot of attention following release by Fund staff of a 
new debt sustainability assessment showing that the proposed policies, 
even if fully implemented and successful, would lead to debt levels 
close to 200 percent of GDP and gross financing needs of over 15 
percent of GDP. The IMF suggests that, for a Greek program to make 
sense, it needs to include nominal haircuts or very long grace periods 
on payment (as much as 30 years). The IMF's document has been read as 
suggesting the Fund will not lend if these levels of relief are not 
delivered. Ultimately, though, the Fund will find it extremely hard to 
say no when its major shareholders are so committed to the program, 
even if the program does not meet the Fund's internal rules (including 
a high probability that the debt is sustainable).
    Nonetheless, the IMF is right to be concerned about both financing 
and debt, and of being pulled into a financing arrangement that it does 
not believe in. On the financing side, as noted above the setting of 
the gap at =86 billion, and a sequencing where the IMF program is 
approved after the European facilities are in place, creates a risk for 
the IMF, and in the absence of adequate financing and debt relief, 
risks making the IMF a de facto lender of last resort.
    It is important to recognize that any Fund program contains risks. 
It will need to provide exceptional access, and if honest we need to 
acknowledge that even with debt relief it will not meet the test of 
``high probability of debt sustainability'' required under IMF rules. 
Pragmatism and flexibility will be needed. As in 2010, a strict rules-
based approach could be equivalent to forcing Greece out of the 
eurozone.
    Overall, the Fund has acted responsibly in this phase of the 
crisis, correctly pressing for strong policies adequately supported by 
financing and debt relief. It is not going to get easier--the Fund 
faces a number of difficult decisions in coming months on lending and 
debt, and it will be vital for the U.S. to show leadership as these 
decisions are made. In addition, the Fund's preferred creditor status, 
which has been challenged by recent events in Greece, needs to be 
reaffirmed.
                   the changing nature of debt crises
    Debt policy, and the IMF's role in resolving crises, has had to 
evolve in the face of changing markets and country conditions. Going 
back perhaps to the 1994 Mexico rescue package and the Korean IMF 
program of 1997-98, we have seen rapid growth of financial markets and 
greater integration in markets by large developing countries. That 
offers important possibilities for development and growth, but it means 
that when crises do occur, the financing needs are large and growing 
relative to resources the IMF has at hand. This is causing increasing 
conflict between official creditors, a conflict that is likely to 
intensify in coming years.
    In recent years, a number of steps have been taken to address these 
tensions. First, there have been a number of changes to Fund rules to 
provide greater flexibility for it to lend beyond what its traditional 
quota-based rules would allow, including the exceptional access 
criteria in 2002 and the systemic exemption in 2010. These reforms are 
controversial, but I am not convinced that there are easy alternatives. 
The reality is that there will always be cases where events require a 
pragmatic policy response. No major policymaker at the time was 
prepared to force a debt restructuring in Greece in 2010 when the world 
was in the midst of a crisis (though a strong case could be made that 
the eventual private restructuring in 2012 came a year too late). 
Similarly, the 2014 Ukraine program arguably required a suspension of 
disbelief to argue a high probability of sustainability, but the 
argument was made to facilitate a loan that was clearly in the interest 
of official creditors including the United States.
    This is not an argument for unlimited discretion, but it is a 
recognition that we are increasingly in an environment where the Fund's 
rules are at odds with broader U.S. objectives. From this perspective, 
it is critically important that we work to modernize the IMF. And we 
cannot achieve this objective unless IMF quota reform is passed. 
Passage of this bill, by enhancing the resource base of the IMF and 
building stronger international support for its efforts, can reduce the 
number of cases where the systemic exemption would be needed.
                 what is at stake for the united states
    So far, the effects of this crisis on the U.S. economy have been 
limited. Greece is quite small as a share of U.S. trade and finance; 
U.S. banks have modest exposure. Also, since 2009, Europe has made 
important steps to address the crisis, establishing rescue facilities 
and strengthening buffers, and easing monetary policies in support of 
growth. There has been significant financing and cash flow relief 
provided to Greece, including through an aggressive reduction in 
private debt, coupled with substantial fiscal adjustment, allowing a 
modest return to growth before this year's confrontation returned 
Greece to recession. This is not 2008, and it is not 2010.
    Financial contagion occurs when financial instability in one market 
is transmitted into other markets.\4\ The Greek debt crisis in its 
early stages gave rise to financial contagion, which contributed to the 
eurozone crisis as a whole. This can be seen in the co-movement of bond 
yields in different markets. Figure 4 shows that since the crisis 
started in late 2009, the bond yield of Greece seems to exhibit co-
movement with those of other European countries particularly Portugal 
and Ireland. But that correlation appears to have broken down this 
year, suggesting less contagion from Greece to the rest of the 
eurozone.

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

    The United States, however, is not immune to a crisis in Europe. 
The EU is one of the largest trading partners of and shares close 
economic links with the United States.
    Consequently, we need to be on watch for contagion--whether inside 
or outside the eurozone, Greece's debt is unsustainable and the 
recognition of losses for creditors could reveal surprising new sources 
of financial instability. More broadly, the crisis has revealed flaws 
in the architecture of Europe and, whether Greece is in or out, makes a 
compelling case for further economic integration. More importantly, how 
the crisis is handled may speak volumes for the future of Europe and 
the eurozone, with important economic, political, and security 
implications.
                      after grexit, what follows?
    Should Greece decide to exit the eurozone, there is a great deal of 
uncertainty about what happens next. The process of introducing a 
proper currency could take time, though a rudimentary median of 
exchange could be put in place relatively quickly (perhaps through the 
introduction of IOUs). This would allow for an effective devaluation 
that would, over time, help to restore competitiveness. After Grexit, 
Greece would need humanitarian and technical support, an issue on which 
the United States could take a lead role. None of this ensures success; 
ultimately it is policies that determine whether Greece could thrive 
outside of the eurozone.
    There is a broad and strongly held view among European policy 
analysts that Grexit, if it occurs, will be negative for the European 
political project and for prospects for further integration. The 
argument appears to be that the brinksmanship of the past month, and 
the divisive nature of the negotiations, has created fissures within 
Europe that will be difficult to mend. There is particular concern 
about French-German relations, and what a break means for solving a 
range of global problems including sanctions toward Russia, support for 
Ukraine, and Iran. There are also concerns that Grexit will cause a 
domino effect of exits elsewhere. In the United Kingdom, in particular, 
there are concerns that a disruptive Grexit will boost support for 
those that would have the U.K. leave the EU.
    One could make a more positive argument, if the difficulty Greece 
faces causes voters in other countries to decide that confrontational 
or nonorthodox policies are likely to be counterproductive. In that 
case, Greece's problems could lead to less, rather than more support 
for parties such as Podemos in Spain. Either way, the most significant 
source of contagion from Greece may be political rather than economic.
                               conclusion
    The intensification of the crisis in Greece has strained European 
solidarity and called into question some of the fundamental assumptions 
of economic and monetary union. The experience has led many to call for 
greater integration in the union, though the terms on how to best 
achieve it remain divisive. As Greece attempts to move forward and put 
in place policies that would justify continued financial support, 
Europe faces a series of difficult decisions--on debt, financing and 
policies--that could be decisive to the outcome. The U.S. Government 
can and should be a partner to those discussions.
    In the end, we have a shared interest with our European partners in 
establishing a Greece--inside or outside the eurozone--that is 
competitive and growing. We also have a strong interest in a cohesive 
and economically prosperous Europe.
    What happens in the coming months could go a long way to 
determining not only Greece's future, but also the future of European 
integration, and consequently Europe's relationship with the rest of 
the world.

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

    \1\ IMF (2013) ``Greece: Ex Post Evaluation of Exceptional Access 
under the 2010 Stand-By Arrangement.''
    \2\ http://www.bbc.com/news/world-europe-33616177.
    \3\ http://europa.eu/rapid/press-release--IP-15-5373--en.htm.
    \4\ Vitor Constancio (2012) ``Contagion and the European Debt 
Crisis.''

    Senator Johnson. Thank you, Dr. Kahn.
    Our next witness is Prof. John Taylor. Dr. Taylor is a 
professor of economics and a senior fellow at the Hoover 
Institution at Stanford University. From 2001 to 2005, he 
served as Under Secretary of the Treasury for International 
Affairs, where he was responsible for IMF and World Bank 
oversight.
    Dr. Taylor.

 STATEMENT OF JOHN B. TAYLOR, HOOVER INSTITUTION AND PROFESSOR 
        OF ECONOMICS, STANFORD UNIVERSITY, STANFORD, CA

    Dr. Taylor. Thank you, Mr. Chairman, Ranking Member 
Shaheen, for inviting me to this hearing.
    As requested, I would like to consider lessons for the 
United States from the Greek crisis, compare the United States 
and Greek debt situation, and draw some implications for United 
States policy as well as for Greece.
    Obviously, the Greek economy has been performing terribly. 
Real GDP has actually declined to 5 percent per year for the 
last 5 years, and it is continuing to decline. But also for the 
past 30 years, growth has averaged less than 1 percent per year 
in Greece, and productivity growth is nearly zero for the past 
30 years.
    I think there are three key factors that have led to this 
situation. Most important, the Greek economic policies have 
been very poor, I will put it that way, the regulatory rule of 
law, budget, tax, et cetera. It has been documented by many 
observers.
    Just some examples. The Heritage Foundation index ranks 
Greece 130 in the world, on par with many sub-Saharan African 
countries. The World Bank's Doing Business indicator ranks 
Greece 61, and in terms of enforcing contracts, 155th; 
registering property, 116th.
    According to the Fraser Institute, on economic policy, 
Greece ranks 84.
    According to the IMF, ``To achieve [productivity] growth 
that is similar to what has been achieved in other euro area 
countries, implementation of structural [supply side] reforms 
is therefore critical.''
    Of course the United States by comparison scores higher on 
all of these indices.
    One has to be careful about drawing analogies and lessons. 
Nevertheless, I see a problem in the United States, because it 
has been declining on these indicators as well.
    So take the Fraser index, for example. The United States 
ranked two in the year 2000. It now ranks 14th. The Heritage 
index, we ranked five in 2008, now 12. The World Bank's index 
Doing Business, three in 2008, now seven.
    I have noted these changes myself in my book, ``First 
Principles.'' I actually found a connection, I think, between 
these measures of performance, which show some deterioration, 
and the slow economic growth that we have had recently, the 
slow recovery.
    I think a second problem is there is really just one 
central bank for the whole eurozone. That meant going into the 
crisis that the interest rate set by the ECB was just too low 
for Greece. It caused risk-taking, clearly a housing boom and 
eventually a bust. While the United States, obviously, is not 
in a currency zone with other countries, I think there is a 
lesson here for the United States, too, because I think in that 
same period, 2003 to 2005, the Federal Reserve also set 
interest rates too low.
    These events were not completely unrelated. That interest 
rate being too low in the United States was one of the causes 
of the excess risk taking, borrowing, and the housing boom, 
which led to a bust.
    The third problem for the Greek economy is this 
unsustainable debt. Here I would point, in particular, to a 
decision in 2010 that the IMF made to start making more loans 
to Greece without first insisting that debt be sustainable. 
When the IMF did this, it broke its own lending rule, and, of 
course, the United States voted to go along.
    This decision really bailed out the private sector, for the 
most part, and has left the public sector, the IMF, the Euro 
Group, and the ECB, holding the bag.
    Now, if we compare the United States and Greece, you have 
to be careful. I see the chart with the flags. According to 
CBO's recent estimates for the alternative fiscal scenario, 
they have U.S. debt going to 89 percent of GDP in 10 years, and 
139 percent of GDP in 20 years. For some reason, the CBO no 
longer publishes debt-to-GDP ratios greater than 250 percent, 
so I did some of my own calculations and put a chart in, which 
is rather dramatic, I think, in my testimony. It really shows 
an explosion of the debt-to-GDP ratio. It looks much worse than 
the flag in your chart.
    Now, the Greek situation by comparison is volatile. It is 
changing rapidly as we speak. Just at the end of last year, the 
IMF estimated the Greek debt-to-GDP ratio would be 105 percent 
in 2022. In June, they estimated it was up to 142 percent. The 
most recent estimate, a few weeks ago, is 170 percent. So their 
estimates are skyrocketing.
    I think the reason is that, again, both the deteriorating 
situation economically in Greece and the failure to implement 
reforms.
    Now, it seems to me the lessons here are very clear. I just 
have a few seconds left. For the United States and for Greece, 
they are similar.
    The situation in Greece is not that growth is too low. It 
is that it is negative. The situation in Greece is not to avoid 
a crisis. It is to get out of a crisis.
    But nonetheless, it seems to me that the policies are 
similar, and that is to get back to pro-growth policies in 
Greece, get those indices up however you measure. I think it 
will improve growth. Ultimately, that is what they have to do.
    The situation on the debt, there is, obviously, more debt 
forgiveness that has to come, based on these IMF numbers. We 
are not in that situation yet, but, I would say, if we do not 
control the growth of spending in the United States, our debt 
is going to explode, as I have shown in that chart. And we will 
definitely be in a very difficult situation.
    I think a way to start with that is with the fiscal year 
2016 budget resolution. It lays out a path for spending. It has 
to be implemented, but that path seems to me to be sensible. It 
would increase economic growth I think not only in the long 
run, as CBO estimates, but also in the short run as well.
    But that is only 10 years. Beyond that, more has to be 
done. Maybe we need some kind of agreement that spending cannot 
grow any faster than GDP. Certainly, we need that for health 
care expenditures. But something like that is needed.
    But more generally, I think policies that reverse the 
situation where we have been recently on the fiscal side, on 
the regulatory side, on the tax side, would be the kind of 
things the United States needs to do to improve its well-being.
    Thank you.
    [The prepared statement of Dr. Taylor follows:]

                  Prepared Statement of John B. Taylor

    Chairman Johnson and other members of the Foreign Relations 
Subcommittee on Europe and Regional Security Cooperation, thank you for 
inviting me to testify at this hearing on the ``Financial Crisis in 
Greece--Implications and Lessons Learned.'' As requested I will 
consider lessons that the United States can learn from the Greek 
financial crisis, comparisons between U.S. and Greece debt, and 
implications of Greece's financial crisis in shaping future economic 
policy in the United States.
   lessons that the united states can learn from the greek financial 
                                 crisis
    The Greek economy has been performing terribly by any measure. The 
economy has shrunk, with real GDP falling by an average of ^5 percent 
per year for the past 5 years, and over the longer term economic growth 
has been very low. Since Greece joined the European Union in 1981 real 
GDP growth has averaged only 0.9 percent per year and productivity 
growth (on a total factor basis) has averaged only 0.1 percent per 
year.
    Looking back in time, there are three key factors that have led to 
this situation, and all provide lessons for the United States:
    First, Greece's economic policies--regulatory, rule of law, budget, 
tax--have been very poor, as has been documented by many observers. 
According to the Heritage Foundation's index of economic freedom, 
Greece ranks 130 among the countries of the world, the worst policy 
performance in Europe and on a par with many poor sub-Saharan African 
countries. According the World Bank's Doing Business indicator, Greece 
ranks 61, which is well below Portugal, Italy, Spain, Ireland, Germany, 
and France; and on two important pro-growth measures in the World 
Bank's Doing Business indicator it ranks 155 on enforcing contracts and 
116 on registering property. And, by yet another measure, the Fraser 
Institute's Index of Economic Freedom, Greece ranks 84 in the world.
    These factors alone explain much of Greece's poor economic 
performance. For this reason in their latest report on Greece, the IMF 
(2015) concludes that ``To achieve [productivity] growth that is 
similar to what has been achieved in other euro area countries, 
implementation of structural [supply side] reforms is therefore 
critical.'' No quantitative measure is perfect and there are 
exceptions, but there is a general association between these economic 
policy measures and economic performance.
    Of course, U.S. economic policy scores higher according to these 
quantitative measures and one must be careful in drawing analogies and 
lessons. Nevertheless there is a problem: The United States has been 
declining in recent years on all of these measures of good economic 
policy. On the Fraser Index, the United States ranked 2 in the year 
2000, and it ranks 14 today. On the Heritage Index it ranked 5 in 2008, 
and it ranks 12 today. On the World Bank's Doing Business Indicator it 
ranked 3 in 2008, and it ranks 7 today.
    I have also noticed such a deviation from good economic policy in 
the United States in recent years and wrote about it in my book, 
``First Principles.'' I find a connection between our current economic 
problem of low economic growth and this deviation from sound policy 
principles. In the United States adherence to the principles of good 
economic policy has ebbed and flowed over the years, creating waves of 
bad economic times and good economic times.
    A second problem for the Greek economy is that there is only one 
monetary policy--one policy interest rate--set for all countries in the 
eurozone, and that includes Greece since it adopted the euro. In 
particular the interest rate set by the European Central Bank (ECB) a 
decade ago was too low for Greece, and this encouraged excess borrowing 
and a housing boom, and eventually a bust and a huge debt overhang by 
2010. The higher nominal wages and prices in Greece in the boom years 
also negatively affected Greece's competitiveness due to the single 
currency.
    While the United States is not in a currency zone with other 
countries, there is a lesson for the United States here as well. During 
the period from 2003-2005 the Federal Reserve set interest rates too 
low and this was likely a cause of the excess risk-taking, borrowing, 
and the housing boom which ended in a bust and the financial crisis. In 
my view, this was also a deviation from good economic policy that led 
to poor economic performance.
    A third problem for the Greek economy is a large unsustainable debt 
and the decision in 2010 the International Monetary Fund started making 
loans to Greece without first insisting on the Greek debt being 
sustainable. The IMF broke its own lending rule--that it should not 
loan to a country with an unsustainable debt--when it did so, with the 
United States voting to go along. This bailed out the private sector, 
and has left public institutions (the IMF and other European countries 
and their taxpayers) holding the bag.
    The resulting acrimonious policy and debt negotiations have created 
political instability and confusion in Greece with deteriorating 
economic policy and continued low economic growth being the result. The 
debt problem has also caused difficulties for the Greek banks that hold 
some of the debt and thereby the Greek payment and credit system. The 
Greek Prime Minister's surprise pullout of the talks with the IMF, the 
Eurogroup and the ECB last month, his call for a referendum, and now 
the universal recognition that a third bailout is needed, are 
symptomatic of the political and economic instability. The lesson is 
clear for the United States as the Congress considers increasing the 
U.S. quota contribution to the IMF: it is a mistake to break the rule 
about not lending to a country with an unsustainable debt.
     comparisons and causes of the increase in u.s. and greek debt
    This summer the Congressional Budget Office (CBO) released its 2015 
Long Term Budget Outlook for the United States through the year 2089. 
It shows that under its extended baseline assumption, the Federal debt 
will continue to rise as a share of GDP from 74 percent today to 80 
percent in 10 years and to 100 percent in 20 years.
    However, the alternative fiscal scenario is a more useful 
assumption than the baseline scenario. The alternative fiscal scenario, 
in contrast to the baseline scenario, assumes that certain likely 
policy changes will actually occur. For example, compared with the 
extended baseline it assumes that Medicare's payment rates for 
physicians stay at current levels rather than fall, that expiring tax 
provisions are extended, and that federal revenues after 2024 remain 
equal 18.1 percent of GDP rather than rising as a percentage of GDP.
    Under the extended alternative baseline scenario, debt grows to 89 
percent of GDP in 10 years and to 139 percent of GDP in 20 years. For 
some reason, the CBO no longer report debt levels higher than 250 
percent of GDP, as it has in the past, though it does publish the 
primary deficit through 2089. Under the assumption that the interest 
rate remains at the levels reached for the last 10 years of the 
reported debt forecast, I estimated the debt to GDP ratio using the 
primary deficit for the entire length of the CBO outlook.
    The results--both the CBO's extended alternative fiscal scenario up 
to a debt 250 percent of GDP and my calculations in later years--are 
shown in the following figure. The large spike in U.S. federal debt at 
the time of World War II looks quaint compared to the explosion of debt 
if policy is not changed. Clearly the future debt picture is not 
sustainable. A fiscal consolidation--a reduction in the primary 
deficit, the difference between revenues and noninterest spending--is 
needed if the debt explosion is to be avoided. That the debt is 
projected to grow relatively slowly as a share of GDP for the next 5 or 
6 years has led to complacency, but the longer the fiscal consolidation 
is postponed the harder it will be to carry out without disruptions. 
Moreover, uncertainty about how the fiscal consolidation will take 
place--spending growth reductions, tax increases, additional debt 
ceiling debates, sequesters--is likely to be a drag on the economy.
    The decrease in the debt to GDP ratio in the late 1990s, observable 
in the graph, was largely due to a decline in defense spending as a 
share of GDP coupled with strong economic growth. The increase in 
recent year is due to the weak economy--the recession of 2007-2009 and 
the slow recovery. The projected increase in future years is mainly due 
to the rapid growth of entitlement spending compared to GDP.

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]


    How does the Greek debt situation compare to that in the figure 
above? The political volatility over Greece in the eurozone and debates 
and delays over economic reform, create a volatile situation with 
estimates changing frequently.
    At the end of 2014 the debt to GDP ratio in Greece was about 175 
percent, and the IMF estimated that the debt to GDP ratio would decline 
to 105 percent of GDP by 2022. On June 26 of this year the IMF raised 
significantly its estimate of the debt to GDP to 142 percent for 2022 
due to deteriorating growth and lack of reforms. Only a few weeks later 
on July 14 of this year, the IMF again raised the estimate by a large 
amount to 170 percent of GDP in 2022. And even with these increased 
estimates, the IMF says the projections remain subject to considerable 
risk of a worse outcome.
    As the recent increased debt estimates illustrate, the source of 
the high debt to GDP ratio in Greece is largely due to the weak 
economy, which in turn is due to increased or expected increases in tax 
rates, unanticipated or sudden cutbacks in government spending, and the 
lack of pro-growth reforms. The IMF views the debt situation as 
unsustainable and is calling for substantial reduction in the Greek 
debt, which is now held mainly by governments.
  implications of greece's financial crisis for future u.s. economic 
                                 policy
    The lessons summarized above have clear implication for economic 
policy.
    Of course, there are implications for Greece: the best policy for 
Greece would be to change radically economic policy in a pro-growth 
direction, for example, by making it easier to start up businesses, 
ruling out tax rate increases, gradually reducing the size and number 
of government interventions in the economy. These would start to move 
Greece up in the economic policy indexes and, more importantly, 
increase economic growth and job creation, and reduce the debt to GDP 
ratio.
    For the United States, the policy implications are similar, though 
their purpose is to accelerate the slow upward pace of the economy--say 
from a 2-percent growth rate to a 4-percent growth rate--and avoid an 
economic disaster, rather than to stop a precipitous downward drop in 
the economy and get out of an ongoing disaster, as in the case of 
Greece.
    Economic reforms to control the growth of spending in a gradual and 
credible way would prevent a debt explosion in the United States. They 
would increase economic growth in the long run as well as in the short 
run as I testified at the House Budget Committee in June (see Taylor 
(2015)). Gradually reducing spending over the next 10 years as a share 
of GDP to the levels experienced around the year 2000--as indicated by 
the path in the FY 2016 Budget Resolution shown below--is one example 
of such a budget reform.

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]


    Beyond that, a credible legislative or even constitutional 
agreement to hold the growth of spending to the long-term potential 
growth of the economy would avoid the debt explosion and the damage 
that would cause.
    In addition to a fiscal reform that would defuse the debt 
explosion, the policy implications point to:

   Monetary reform that leads to a more rules-based monetary 
        strategy;
   Bankruptcy reform that ends bailouts of too-big-to-fail 
        financial institutions;
   International finance reform to prevent loans to a country 
        with unsustainable debt; and,
   Tax, regulatory, and trade reform that would substantially 
        reverse the decline in various indexes of economic freedom and 
        raise economic growth.

    Thank you. I would be pleased to answer any questions that you may 
have.
References
    Congressional Budget Office (2015), ``The 2015 Long-Term Budget 
Outlook Analysis,'' June 16.
    Fraser Institute (2014) ``Economic Freedom of the World: 2014 
Annual Report.''
    Heritage Foundation (2015), ``Index of Economic Freedom''.
    International Monetary Fund, ``Country Report 15/165, Greece: 
Preliminary Draft Debt Sustainability Analysis,'' June 26.
    Taylor, John B. (2015), ``First Principles: Five Keys to Restoring 
America's Prosperity,'' WW Norton, 2012
    Taylor, John B. (2015), ``The Economic Effects of a Fiscal 
Consolidation Strategy,'' Testimony Before the Committee on the Budget, 
U.S. House of Representatives, June 17.
    World Bank (2105) ``Doing Business 2015: Going Beyond Efficiency.''

    Senator Johnson. Thank you, Dr. Taylor.
    Let me just clarify, so when you take a look at this, you 
are cautioning to be careful of this because it understates the 
problem? That is basically what you are saying, that even 
though we are almost doubled Greece's debt per capita, this is 
understating the problem because you are looking at the long-
term fiscal projections?
    Dr. Taylor. It is understating in that sense, absolutely. 
Also, currently, my debt-to-GDP numbers that I recited are 
different than this. That is because they are relative to GDP, 
not relative to a person. And GDP per capita, of course, is 
much higher in the United States than in Greece.
    Senator Johnson. So let me ask you, how are we getting away 
with this when we have almost doubled the debt per capita? Why 
are we not seeing riots in the streets?
    Dr. Taylor. Partly, as I say, is because our GDP per capita 
is quite a bit higher. So I think in terms of measuring our 
ability to service and pay back the debt, measuring relative to 
GDP is more reasonable to do.
    Senator Johnson. It is the more relevant figure.
    Dr. Taylor. I think in addition, if you look at the details 
of the charts, there is kind of a relatively flat period that 
is projected for the next few years under the current 
assumptions. I think that leads to people feeling a little bit 
better about it. ``Maybe we will address that problem later. 
Maybe if it is not you, it is your successors,'' people are 
thinking. I do not know.
    But I think that is part of the problem why you are not 
seeing the harm. I would say, though, you do hear a lot of 
complaining about the economy. You do see problems in certain 
areas of our country. You do see income per capita stagnating, 
certainly, in certain places.
    I do not think it is unrelated to the uncertainty about how 
this debt is going to be resolved.
    Again, that explosion in my chart is as current law 
implies, so there has to be a change in the law. What is it 
going to be? People do not know. How are we going to get 
spending under control? Is there going to be a tax increase? Is 
there going to be a problem with respect to the debt limit? We 
do not know. I think that is an element of policy uncertainty 
that has to be a drag on the economy right now.
    Senator Johnson. One of the things we did, we held a 
hearing in our Homeland Security Committee with CBO Director 
Hall, and we have converted to dollars their long-term fiscal 
scenarios and the alternate fiscal scenario. That shows over 
the next 30 years--which I think is really our problem, the 
demographic bubble, the baby boom generation, all of the 
promises made and we cannot pay for them--a deficit projected 
over about $103 trillion. Talk about unsustainable.
    Talk to me a little about what is being measured in those 
indicators, either one of you, the indicators that Dr. Taylor 
was talking about. I understand Greece is very high in the 
Heritage Foundation, but talk about what that actually 
measures.
    Dr. Taylor. The various indices, they measure the rule of 
law, how independent the judiciary is. They measure how long it 
takes to start up a business. They measure the degree of 
regulation and its interference with the economy.
    They do this in various ways. Sometimes it is judgmental.
    They measure openness to trade. That is a common one that 
is less judgmental. But even there, how do you measure openness 
to trade?
    The reason why I mentioned several is because they all tend 
to say the same thing. To be sure, you have to be very careful 
on using indices like that.
    You mentioned my being at the Treasury. At that time, we 
tried to use indices like this to help decide what our foreign 
aid should look like to the very poor countries. There is, I 
think, a quite strong correlation between these indices and the 
growth of the economies. It does not mean it is causation, but 
I believe a lot of it is.
    Senator Johnson. Would you say, in general, if you had to 
kind of typify a term, it measures economic freedom, the 
ability of a free-market system to operate effectively without 
being hampered by governmental interference?
    Dr. Taylor. Yes, I like the word economic freedom. In fact, 
it is used in some of the indices. The World Bank uses ``Doing 
Business.'' It is the same kind of concept, how free are people 
to start a business, how difficult is it, how difficult is it 
to operate in the marketplace?
    But I think the concept of economic freedom is the way I 
have talked about it to my students and try to explain it, 
because it is a freedom there, which to me, if I might say a 
few words, to me economic freedom requires a strong rule of 
law, it requires a predictable government policy, it requires 
orientation to a market system, it requires a focus on 
incentives, and a limited role for government in the sense of 
government's role is based on what government should do, not 
what the private sector can do. It is basically a cost-benefit 
approach to government policy.
    Senator Johnson. You could argue government should provide 
that stability of a legal framework for businesses to have some 
certainty in terms of making investment and understanding what 
is going to happen to them.
    Dr. Kahn, based on those types of measurements, can you 
compare and contrast what went wrong in Greece and the 
differences between Greece and America right now?
    Dr. Kahn. I think there are very dramatic differences in 
the fundamental freedoms, which I do not call freedoms. I call 
operating conditions. That speaks to corruption and rule of 
law. It also just simply speaks to government involvement that 
is pervasive in the economy.
    It also helps to explain your chart, in the sense of saying 
why is it that some countries have such a lesser capacity to 
carry debt, because a country that has a rigid economy, that 
has extensive government-induced distortions in it, is not 
flexible to adapt to shocks and to produce a capacity to repay.
    I think what we have seen in many countries that have had 
deep crises--Argentina, one that John worked on a number of 
years ago; Greece now--the actual levels of debt measured this 
way are not that high when you enter the crisis. What it really 
is is an economy that is not able to adjust, not able to 
operate anywhere near full employment where people cannot 
recognize their potential. So it is not able to generate the 
resources for the government, or at least that the government 
can capture, in a way that allows it to credibly service its 
debt.
    I think we are very much seeing this at play in Greece. We 
can compare it very much to the United States. We can also 
compare it, by the way, to other countries in the periphery. I 
think what we have seen in Spain and Portugal, and particularly 
in Ireland, are countries that have, since the crisis hit, and 
by some measures were in equally bad shape, have done a much 
better job of becoming more competitive, developing new 
industries, opening those up for private sector involvement in 
ways that have made them much more attractive to markets now 
and much more resilient.
    So I do think it speaks to that issue.
    Senator Johnson. We all hear the anecdotes of Greek 
citizens being able to retire at a pretty early age and the 
general level of the welfare state. Can you make some kind of 
comparison to America or those other countries that have 
snapped back from their financial crises?
    Dr. Kahn. Among the industrial world, I think Greece does 
stand out for an extraordinarily large pension deficit. It was 
16 percent of GDP last year, in terms of the deficit of the 
pension system. That required, I think, over 10 percent direct 
transfer from the government. These are large numbers, and 
after 4 years of adjustment.
    I think to be fair, it is not so much the levels of 
pensions that are extraordinarily high. What it is, you touched 
on, it is early retirement and exemptions and special deals 
that have been cut over time as part of the political process 
in a way that has political and economic implications. One is 
that it creates a huge and unfinanceable deficit, but it also 
creates a political problem because if I am a Latvian middle-
class worker and I am working very hard and working to 65 or 
now 67, and I am being asked to finance the pension of somebody 
who may be able to retire in their mid-40s, it seems 
inequitable and it, certainly, undermines the politics.
    Certainly, getting at the early retirement system is going 
to be core for any sustainable solution in Greece.
    Senator Johnson. Thank you.
    Senator Shaheen.
    Senator Shaheen. Well, as you point out, that speaks to the 
challenges in terms of trying to negotiate the recent bailout 
agreement. So what are the prospects that this latest round 
could be successful?
    I have been impressed, so far, by the ability of the prime 
minister to actually get the reforms that he negotiated passed 
through Parliament when a lot of people thought that was not 
possible. But is that enough to set them on a course to growth 
again? Clearly, until they can figure out how they can begin to 
deal with economic growth, it is going to be hard to maintain a 
political situation that is viable and also to be willing to do 
some of the things that they need to do.
    Dr. Kahn. I think we are in the first inning of a very 
difficult process. I agree with you that Prime Minister 
Tsipras, while I was deeply critical of the policies of the 
government in terms of the confrontation they created with 
creditors and the way they managed it up to the referendum, 
since that time, he has been extraordinarily capable in terms 
of getting through the initial stages of the agreement and the 
passage of two rounds of bills, some very tough measures that 
not only Greece has not done in the past, but he had been 
deeply resistant to. They enabled a bridge loan of over =7 
billion so they could pay off some of their debt, but also, 
more importantly, started this process of negotiating with 
Europe.
    There are huge differences, though, on this negotiation of 
this European program, or ESM program. Part of it is that the 
Europeans and the IMF believe there is going to have to be a 
lot more adjustment to come to deal with this decline in 
activity and the wider deficit. The Greeks are basically taking 
the view now that we have done what we are going to do, give us 
the money. That is a very difficult bridge to cross.
    They have a large payment due in August. They need to get 
this ESM agreement done by then, so they can get another bridge 
loan to pay that. That will produce a first drawing from the 
Europeans. They will then have to do more measures and complete 
a review, maybe in October or November. That will then allow a 
discussion of debt relief.
    And Prime Minister Tsipras has made it very clear that 
without debt relief, the political support for this collapses. 
So he is pressing to get that accelerated. But I do not think 
that happens until October or November.
    And the IMF has then said we are not willing to go ahead 
unless there is adequate debt relief. We can decide whether 
that is a credible threat, but that creates a very difficult 
sequencing problem, which may be incompatible with the domestic 
politics, which I think are very much fraying even as we speak.
    If there is an election called, a snap election called 
right in the middle of all this, it is very hard for me to 
predict.
    But there is so much to get done and the sequencing has to 
get done just right. I think the odds, quite honestly, are 
quite long.
    Senator Shaheen. Since we are talking about the IMF, you 
pointed out that you think we need to pass IMF quota reform, 
which I certainly agree with. But maybe you could talk a little 
bit about why you think that would be helpful in this 
situation. I think it would be helpful in Ukraine, as we are 
looking at how we can do more to help Ukraine,
    But if you would, talk a little more about that.
    And then, Dr. Taylor, you might want to weigh in as well.
    Dr. Kahn. I will. I also will maybe come back and give a 
shoutout to a proposal John has on this score, which I think is 
very constructive.
    As I noted, I think we are now in this environment where we 
are facing these very difficult, large programs, which 
inherently have a political element, inherently involve 
geopolitical interests. Nothing illustrates that more than the 
Ukraine program of 2014 and 2015, where the Fund clearly bent 
their rules to lend outside their normal limits.
    As John said, they have these sort of archaic lending 
limits based on what they call quotas, how much you put into 
the Fund. They are out of date. They have expanded. They have 
adjusted. They have been very flexible in some ways, a number 
of ways, both creating the so-called exceptional access and 
then the systemic exemption, which was sort of putting the 
rules aside and saying we can put them aside to some extent, if 
there are these broad systemic consequences.
    In 2010, I do not know any major policymaker in place then 
who wanted a very strict interpretation of the rules for Greece 
because it was very hard to say that debt was sustainable. It 
was not a zero or one. It was not unsustainable or fully 
sustainable. But it was clearly a risky program. And the idea 
that you could say a high probability, it was not true.
    So they came up with this idea, saying that when there are 
these broad systemic consequences, we are going to be able to 
be more flexible. I think Ukraine was another example where, if 
you looked at the numbers, the Fund should not have been 
lending. But they were at war and there was a broad imperative 
to help this country deal with that and to implement a program 
which on its face looked extremely promising and deserved a 
chance.
    These are the kinds of choices we are increasingly going to 
face.
    Now I do think that on the one hand we need to be able to 
build a fund that has the right-size quotas and has the 
flexibility to lend on sensible criteria. But on the other 
hand, it cannot be unconstrained discretion. There has to be 
some rules that constrain the use of that. It really has to be 
in these extraordinary cases and it has to be by a process that 
is disciplined.
    But I still think that the IMF reform is critical here, not 
just in terms of getting the numbers right, but because it is a 
signal to China, to Brazil, to these other countries that we 
want them to be participants in the global infrastructure or 
architecture.
    Do not go your own way with AIIB. Come here and negotiate 
with us. Let us build a framework that makes sense.
    So I think it is very important from that perspective as 
well.
    Senator Shaheen. Thank you.
    Dr. Taylor, you have a reform proposal that has merit?
    Dr. Taylor. I have an idea. It is related to the IMF's 
policies, though.
    So around 2002, 2003, the IMF instituted something called 
exceptional access framework. It was basically a way to limit 
lending to cases where they should not have been lending. It 
actually came out of the financial crisis of the 1990s where 
they were all over the place. So it was reform. I think it was 
a sensible reform.
    It basically said do not lend to a country with 
unsustainable debt. There are some nuances, but do not lend to 
a country with unsustainable debt.
    It worked pretty well, until 2010. Then Greece came.
    Greece, by any measure, as Rob indicated, did not have a 
sustainable debt. The IMF had the framework. What did they do? 
They changed the framework. They added an exception for this 
case. I think it is a real problem.
    In fact, it is such an illustration of the problem, because 
once that decision was made for the public sector to be lending 
to Greece, it enabled the private sector to get out. So now all 
that debt, which was originally almost all private sector, is 
now almost all public sector.
    It is a classic bailout of the private sector. It is 
visible for everybody to see.
    And what has it done? It has led to these very acrimonious 
government-to-government discussions, where the debt of Greece 
is held by governments. That is what we are hearing. That is 
why it is so difficult politically, so unstable.
    So I think it would be very good if the IMF went back to 
the policy it had before. I think if it became part of a quota 
voting bill, it might make it more visible to people. That is 
an important thing for the United States. It would show some 
U.S. leadership, I believe, if we did that, because it is a 
problem.
    You asked about Greece. Very briefly, I think it is 
unfortunately a kicking the can down the road situation. The 
IMF is now saying they need much more debt relief than seems to 
be in the cards. And I think they are right. They are looking 
at it as best they can.
    So right now, it seems to me like it will be another 
discussion later, which will not be so comfortable, perhaps 
with a different government.
    Just one last thing, the changes in Greece in this 
agreement I think are very small, in terms of really making a 
difference. They really have to do really pro-growth reforms. 
There is some of that, but not enough.
    Senator Shaheen. Thank you. My time is up.
    Senator Johnson. Thank you, Senator.
    Let us talk about the Grexit. The transfer of this debt 
from the private to the public, even back then, was a haircut. 
The private sector did suffer pain, correct? Something like a 
50-percent write-down?
    Dr. Kahn. And a little bit more in present value terms, but 
yes, it was substantial, about 70 percent, by some measures.
    Senator Johnson. I just want to understand, why did Europe 
do it? What would have been so terrible about letting Greece 
exit? And what would be so terrible about letting Greece exit 
now? Together with potential political contagion aspect, could 
you also discuss this from the standpoint of Spain or Portugal 
or another country in a similar situation, where they will just 
demand concessions and more debt, more loans from Europe?
    I know it is kind of a broad range, but can both of you 
handle that?
    Dr. Taylor.
    Dr. Taylor. So if by exit, you mean exit the eurozone?
    Senator Johnson. Yes.
    Dr. Taylor. I think that would be very difficult. It is the 
euro. We can debate about whether they should have gone in or 
not, but getting out is a big deal. It is a new currency, how 
that is going to be implemented. Right now, a lot of the debt, 
the remaining private-sector debt, is held by the Greek banks.
    So it is a big deal to get out. Maybe that is where it is 
going.
    Senator Johnson. Can you describe what happens, why it is 
such a big deal?
    Dr. Taylor. You have to introduce a new currency. You would 
have to decide what the exchange rate should be from the euro 
to the new currency. It would be a lot of debates, and that is 
hard to do.
    In the reverse direction, Germany did that with East 
Germany.
    I have some experience with this in putting a new currency 
into Iraq, actually. When I was at the Treasury, it was one of 
our jobs to replace the old Saddam dinar with a new dinar. It 
is a big deal.
    So there are a lot of things that can go wrong.
    I would say, if it could be avoided, it is probably best to 
avoid it. And to me, that is not the only problem, I would say. 
To me, and I mentioned that, the problems are really with these 
economic policies that Greece has. I mean, they could be doing 
very well if they had better policies. That is where I would 
put my focus.
    The Johnson. Dr. Kahn.
    Dr. Kahn. I suppose I would come at it a little bit 
differently, in the following sense. Yes, there are a set of 
policies that if they were as strong as John would like would 
put Greece on a course back to growth within the eurozone, but 
they are very strong.
    I have, as I have suggested, some doubts whether the 
political economy of Greece can sustain those.
    If they cannot, for whatever reason, be put in place, then 
the only way you are going to deal with 25 percent 
unemployment, 50 percent youth unemployment--this is 
devastating socially within Greece, and should not be a long-
term solution--would be to exit, because then you have your own 
monetary policy. You have your own fiscal policy. Any you have 
a currency that will adjust probably quite a bit to the point 
that new export industries expand. We have seen this in places 
like----
    Senator Johnson. And tourists would start flocking to 
Greece.
    Dr. Kahn. Tourists would come back in.
    Senator Johnson. So is it really a good deal?
    Dr. Kahn. It would take a big move and would take a degree 
of political stability, but they would come back in. New 
industries would spring up, intermediate goods production or 
transshipping, some agriculture probably. There would be new 
industries, as well as compression of the imports that go on 
now.
    So I actually think that the case for Grexit is actually 
perhaps stronger from a geopolitical perspective than not.
    Now, it is almost always painful to do it, and incredibly 
disruptive. In East Germany, West Germany, it was an artificial 
experiment. It was negotiated and planned. Most of the time 
this happens out of failure and out of the chaos of failure. So 
you see IOUs often get issued by a government as they are at 
the precipice and deciding what to do, a breakdown of the 
payment system.
    So when that exit decision occurs, you can have a bank 
holiday, you can do an initial redenomination. But finding the 
right prices and deciding what stays in euros and what goes to 
drachmas is really only a first step of a comprehensive 
restructuring and workout process.
    Now, you asked the question to start, why is it so hard? I 
think this is part of the reason. It is very scary, even if in 
the long run it is good. Part of it clearly is political.
    Europe has moved quite well ahead in terms of political 
integration. But the economic integration has lagged. In 
particular, the ability to do fiscal transfers of the sort we 
take for granted that allow that if there is a shock in Texas 
while California is booming, that money through the Federal 
system can move, and that is a huge buffer to economic 
activity.
    They do not have that. They have been resistant to doing 
it. The Germans, in particular, have been resistant to what 
they would see as enabling moral hazard, of encouraging bad 
behavior. And the lack of trust between these countries is 
contributing to that feeling.
    So I do think that in some sense this unwillingness to 
acknowledge either that a country can leave or that we have to 
deal with the debt and these kinds of issues in context in a 
sense is constraining smart thinking on this issue and limiting 
them to sort of what the rules allow.
    There has been value to having those rules, but I think now 
we are in a place where they may be counterproductive.
    Senator Johnson. But again, I think you would acknowledge 
that probability of this working out, of this being the last 
bailout and the getting their policies right, is quite small, 
correct? So the next step will be another bailout for the 
future. And they will never address the root cause of the 
problem, which is these awful economic indicators, lack of 
economic freedom, and, as a result, high unemployment, awful 
business creation, that type of thing. So game it out.
    Dr. Taylor. I think the change in the currency, obviously, 
would have some of the effects you mentioned. It would not last 
forever, obviously. I gave you a statistic of 30 years of low 
growth in Greece. It would be a temporary thing, and welcome.
    It may take pressure off the other actions. In Argentina's 
crisis in 2001, they devalued. They had effectively a peg and 
got off it. It was little bit of a boom but it was really quite 
destructive in terms of contracts that were supposed to be owed 
in one currency versus another. I think it probably made the 
situation worse for a while.
    Senator Johnson. Senator Shaheen.
    Senator Shaheen. So I totally agree that it would be very 
disruptive. I was with some Senators in 2012, meeting with 
Greece, then the Greek Prime Minister and other Ministers, 
talking about their efforts to address their challenges at that 
time. One of the things that really stood out to me was we met 
with a group of business people who were the Greek heads of 
American companies in Greece. We went around the table and 
asked all of them individually to say what they thought was the 
best outcome. Was it staying in the eurozone or was it leaving? 
To a person, they all said that they have to stay, that this 
was their future.
    But looking at where we are now, and given the fact that 
all the countries in the EU are not in the eurozone, is there 
the potential to have a managed exit from the eurozone for 
Greece in a way that would help minimize some of that 
disruption? Because we are looking now at going into 7 years of 
a financial crisis that has really gotten harder and harder for 
the Greek people to manage. So is there the possibility for 
some other action to be taken that could help stabilize this 
situation and yet give them some relief in some way?
    Dr. Kahn. Theoretically, I think a managed exit is 
certainly possible, but I see it as very difficult, given the 
way Europe is now operating. Interestingly, German Finance 
Minister Schauble in the late hours of that all-night meeting 
that produced the agreement, the run up to it, raised this idea 
of a plan B of a temporary timeout in the eurozone. And it had 
an element of what you are touching on, the sort of idea that 
you go into a holding area. You would receive humanitarian 
assistance. Potentially, it might be easier to negotiate debt 
relief. It would be less arduous, in terms of policies. It 
would be this kind of a standstill, in some sense, from a legal 
perspective.
    I actually think the idea speaks to what you are talking 
about. I actually thought there may be some merit to it.
    Now, unfortunately, or fortunately, that proposal was put 
on the table in a way that was perceived by everybody inside 
and outside the room as rather a threat to Greece. We have a 
plan B. You can go into the penalty box, if you are not willing 
to accept our terms.
    So it became very much part of the politics of that and in 
a sense has been ruled out. I think it would be very hard to 
get back to something like that, given, particularly in the 
Greek debate, it has become so very poisonous.
    The one other footnote I would just add on your point, if 
you do a survey, as you said, I think to this day you would 
still find very strong support in Greece for staying in the 
eurozone. In that sense, I feel the Prime Minister Tsipras has 
done a disservice. When he came to power, he said I am going to 
get you debt relief. I am going to end austerity, get you lots 
more money, all within the eurozone. That was never a 
combination that was on offer.
    So ending austerity, people have never faced that tension 
between doing the policy as John wants and the tough element of 
that with staying in the eurozone, that that is the price of 
staying in. I think that has never really been confronted.
    So I worry that those polls are fragile.
    One case I might note, and I think it was as late as 
December 2001 in Argentina, there were polls showing very 
strong support for the currency board, even though it had been 
very austere and there was a lot of criticism from it. What 
happened was the government was forced to put banking controls 
on and then support evaporated very quickly.
    I think if it is the breach of promise that has been made 
that has happened and probably will continue to happen I think 
could destabilize that consensus or at least challenge it. 
Okay, you cannot have both, now you really have to decide. And 
that could change very quickly.
    I agree with you, at this point, it is a force keeping 
things going in the right direction.
    Senator Shaheen. The other question is, you both talked 
about the economic situation and consequences of where we are. 
But as you point out, there are also political consequences.
    It seems to me that the eurozone, as you pointed out, has 
to make a decision about how they are going to deal with 
southern Europe and some of the economic challenges that they 
are facing in a way that provides more unanimity across the EU 
for how they are moving forward. And there are some other 
potential threats, I think, to failure to act, one of which is 
Russia.
    There are frequent reports about Russia's efforts, not just 
in Eastern Europe, but also a suggestion that in Greece, it is 
a place where they have looked to try and destabilize the 
situation and move the Greeks away from the West and more 
toward Russia. Prime Minister Tsipras met with Putin, and I 
assume was offered some assistance.
    So can either of you talk to some of those challenges and 
why this is critical to us here in the United States that they 
work out the challenges around Greece?
    Dr. Taylor. So I think it is a longer term issue. It is 
hard to make the judgments but even creating the euro in the 
first place, the arguments were, we will avoid war, even to 
that extent. And what I think the problem was, yes, that is a 
good political argument, but economists at the same time, in 
the same meetings, would say yes but this is going to cause 
some economic problems. You are going to have only one interest 
rate for all these countries. You are not going to be able to 
let the exchange rate adjust, if wages move more quickly in one 
country than another.
    One of the things that should have been said is that in 
this situation you have to really watch your debt. In fact, 
they did put the so-called Maastricht rules in place, but they 
broke them. That is where the debt started to rise.
    But I think, in many respects, it reminds me of the debt 
backdrop to this meeting. If they had actually adhered to those 
Maastricht Treaty rules, we would have avoided an awful lot of 
this.
    So sometimes the economic things that go along with these 
political sides get discarded. I think that is to some extent 
what you are seeing now. There is a disconnect between those 
who say they want to keep Greece and the euro with that 
exchange rate and the things that have to go along with that, 
the economic policies that go along with it, the fact that the 
Greek banks are holding Greek debt. All those things are just 
not part of the discussion. So it is a little wishful thinking.
    In the Argentine polls wanted to keep their fixed exchange 
rate at the time, pegged or currency peg, and they did not vote 
against it. They just lost it. It was like an instantaneous 
thing because there was no choice. They had to get out of it.
    Dr. Kahn. I think that there are two important elements to 
your question. One is a Europe that is not cohesive that is at 
odds with each other. We worry about a French-German alliance 
now. We worry about the ability to obey the rules, to make 
sensible rules. A Europe that is divided and frozen is going to 
be a difficult partner for us on a whole range of global and 
international issues.
    I think Russia is perhaps one of the most important ones, 
as you pointed out. The effort with Greece was an effort to 
divide. When Cyprus had their crisis, we had a similar dynamic.
    I am skeptical whether much money is ever going to come to 
these countries, but the point is that the United States does 
value very importantly a Europe that can also lead and can act 
responsibly on a range of issues. Trade, global trade and 
dealing with China, is another one where I think that 
partnership is very important.
    So I think there is that broad issue that we want a united 
Europe that can grow and be prosperous and to be successful.
    There are also country-specific elements that are pretty 
interesting. Now a lot of the tension has been elsewhere in the 
periphery. So, for example, Spain was actually quite tough on 
the Greeks in the negotiations, partly because they have an 
opposition party, not unlike SYRIZA, called Podemos, that until 
recently was rising very sharply in the polls. I think there 
was a great deal of concern by the Spanish leadership that if 
Greece got too easy of a deal that, indeed, it would empower 
those in their country to say we do not have to do all this 
hard stuff. I think that was very much an important dynamic.
    If Greece has a crisis, if they do exit, it will be very 
interesting and important to watch what that does. Does it feed 
the opposition or is there a sense, as we saw in Brazil I think 
in 2003, 2004, after the Argentina crisis, ``I do not want that 
what they are having.'' I am hopeful that is the case.
    The other one is Brexit, what happens in the United Kingdom 
where there is a very active debate, not on the eurozone entry. 
That is not on the table. But if in fact they want to stay in 
the EU.
    Some commenters, I think it is interesting, have suggested 
that the Greek exit could be very difficult for the government. 
If you had an exit, you would have to have a treaty change to 
basically allow for exit, because right now the rules say you 
cannot. So the Germans and the French would want a very clean, 
quick treaty change to accommodate the reality.
    But if I were an opponent of the British participation in 
the EU, this would be a Pandora's box I would want to open. So 
it will have a very uncertain debate on the internal British 
debate where people have been saying can we trust the EU? Is it 
a reliable partner? Do we want to be part of this coalition? Of 
course, that feeds into, as you mentioned, a whole other set of 
countries that are in the EU, value it importantly, 
particularly in Eastern Europe, but have no interest right now 
and being in the eurozone.
    So I think it is a complex environment right now.
    Senator Shaheen. Thank you. My time is up, but let me just 
be clear.
    I agree with you. I think an EU that is unified, that is at 
peace, that is economically strong, is very important for the 
United States. They are our best ally and I want to do 
everything I can to support them. So I did not want to 
mischaracterize the issues that I was raising there. Thank you.
    Senator Johnson. So you touched a little bit on the moral 
hazard aspects. I guess you are saying it could go either way. 
As you rightly said, I think the concern is it is going to go 
the one way where people have said that it worked pretty well 
for them, where there is no sense of moving toward economic 
freedom or cutting back on pensions. We will just demand a 
bailout. I think that is more likely.
    Dr. Taylor, what is your assessment of that?
    Dr. Taylor. Of the moral hazard for further debt reduction?
    Senator Johnson. Yes, and how that will affect other 
governments.
    Dr. Taylor. Yes, there is kind of a political contagion 
that, certainly, you have to worry about that is there. I mean, 
a lot of people did not expect a left-wing government to come 
into Greece, and it is there. And I think it has stabilized to 
some extent with the other countries, but it is still a risk.
    I think that the difference here though with the usual kind 
of moral hazard with respect to debt is that debt is held by 
the public sector. We usually think if it is a bailout, then it 
is going to take away the incentives people have to be careful 
about who you are lending to or take away the incentives for a 
government to watch its budget. It is now another government 
that is holding it. So it changes the dynamic completely.
    It is worrisome to me politically because it creates an 
enormous amount of intergovernmental tension. And personalities 
can become a big part of it, as we have seen in this case. So 
it is not so much a moral hazard now. Maybe it is just a plain 
old government hazard that has been caused.
    Senator Johnson. Let us to consider lessons learned first 
by going back to the history of Greece. They entered the 
eurozone on January 1, 2001. I think there are reports that 
they were not exactly forthright on precisely what their 
financial situation was. But they were not anywhere near in 
this deep of trouble in 2001, correct?
    Dr. Khan. Correct.
    Senator Johnson. The first bailout was in 2010, so it took 
10 years. Again, this is 15 years in the making here.
    Is anybody willing to go through the history from 2001, and 
quickly walk us through exactly what happened? Again, the whole 
purpose of that is then to relate to what we are looking at. I 
mentioned a 30-year window, the definition of our problem with 
the baby boom demographic bubble.
    Unfortunately, I have white hair. Thirty years goes by 
pretty fast.
    So who is best to walk us through the history of the Greek 
crisis?
    Dr. Kahn. I can start. I am sure John will correct me in a 
couple places.
    So as you point out, with the start of the euro in 2001, 
Greek entry was initially fudged. There was flexibility that 
had to already be applied to basically say they met the 
criteria, but it was subsequently learned that they had 
misrepresented their fiscal data in order to get in.
    Senator Johnson. But their debt was not at----
    Dr. Kahn. Their debt was at quite more moderate levels. So 
it was seen as sustainable.
    Now the interesting point to emphasize here is that, from 
2001 to about 2007, there is a great deal of market enthusiasm 
about the eurozone, the sort of belief that everyone is in is 
never going to have any trouble. They are all going to change 
their policies and become Germany. There was going to this 
great pull to the higher level associated with being in.
    I have some charts in my presentation. Markets provided a 
great deal of finance at very low rates. Also, I think, 
globally, there was a sort of reach for yield, if you will, 
that I think exacerbated it.
    So in some sense, Greece could sustain weak policies, 
weaker than the rest of the eurozone, and there was little 
pressure, even though there were these rules, little pressure 
on them, because they had effective market access. Of course, 
that all changes in the runup to the global financial crisis.
    So then you had this period of time where they basically 
were trying to delay an inevitable need for a program. That 
crisis really hits in 2009. But people had seen it coming, 
really, I think, for some time before that.
    Senator Johnson. They are in such deep trouble. The deep 
recession of 2009, that was basically the catalyst for the 
ongoing crisis.
    Dr. Taylor. I think they had in the interim some other 
problems. I mentioned the interest rates set by this time by 
the European Central Bank, which may not been too low for 
Germany but most indices are they were too low, at least for 
Greece, actually Greece, Ireland, and Portugal, when you look 
at the data. So the too low interest rate, too low for too long 
business, is a problem. It does cause search for yield. It does 
create excess borrowing. And it was quite a housing boom 
increase. So all that comes to an end with a thud.
    So I think during this period, you saw some imbalances, 
which in terms of your questions about lessons for the United 
States, I think that is a lesson. That was not the greatest 
monetary policy, at least for Greece at the time. And it is 
part of the overall policy picture. It was one of the reasons 
why they have this debt problem today.
    Senator Johnson. Talk a little bit more about what I would 
consider the possibility or almost certainty of the 
misallocation of capital when you have unrealistically low 
interest rates, how you do chase yield, how you end up putting 
money into high-risk assets, creating the types of bubbles that 
we saw burst in the housing crisis. Can you speak a little bit 
more to that, because we are still there, correct?
    Dr. Taylor. Yes. There is definitely a risk. You never know 
where these imbalances will show up. A lot of people did not 
predict it was going to be such a problem with respect to 
housing. And now we look in retrospect and we see it not only 
in the United States but some other countries.
    But what happens is if you are a manager of an investment 
portfolio and you are getting these very low yields, you are 
going to look for something else. Or if you are an elderly 
person trying to survive on a fixed income, these very low 
interest rates are going to lead you to take some risks with a 
higher interest rate. So it is very common.
    I think in housing, it is particularly an issue. We have 
these adjustable-rate mortgages. So the very low interest rates 
that were set at that time made it very easy for people to 
borrow.
    So that is the kind of thing that happens. It is also a 
sense the market is not allocating capital as much because the 
central bank is actually keeping the interest rate and a floor. 
Those cause additional distortions, some of which we do not 
know about. Some people blame the liquidity problems on that. I 
do not think it is so obvious.
    But a lot of these distortions take place because of this 
very unusual type of policy that is taking place.
    Senator Johnson. The mandatory spending programs, the 
pensions in Europe, we call them entitlements here, Dr. Kahn, 
you said that was 16 percent of Greece's GDP. I know in the 
CBO's alternate fiscal scenarios, the average over 30 years is 
going to be about 14 percent of Social Security and our health 
care entitlements.
    So we are not there yet. I think currently we are around 8 
percent. Do not quote me on that, but I think that is it, off 
of the top my head. So those burdens are going to be Greece-
like in not too many years.
    So again I just want to walk that forward. With Greece, 
have they always been at 16 percent, since 2001? Did that 
increase dramatically over that time period?
    Dr. Kahn. I think it has increased a little bit recently. 
There were actually some cuts at an earlier moment. But I think 
it is a dynamic that is somewhat similar to the one we have 
struggled with, although on steroids, which is the fiscal 
consolidation of the last 5 years.
    And we should emphasize that there has been an 
extraordinary fiscal consolidation in Greece. They have not 
done all the structural things we think are so critical for 
growth, but they have been willing to cut the deficit. I think 
the primary deficit was 10 percent of GDP when the crisis hit 
and it was in primary surplus last year. So probably 13 
percent, 14 percent of measures over that period.
    But what that means is discretionary spending and 
investment, in particular, has been cut to the bone. And there 
is no discretion for what we think are some high-priority 
investment projects because you cannot touch, for the most 
part, the entitlements.
    So in some sense, the desire of the IMF, in particular, to 
reform the entitlements is not just about putting overall 
fiscal policy on the right track, but also creating space for 
high-priority needs.
    Senator Johnson. I always relate national debt loads to 
family debt, where if you are in debt over your head, how are 
you going to grow your personal economy? Any income above what 
is needed for just the basics is going to service the debt. Is 
that a reasonable analogy?
    Dr. Taylor.
    Dr. Taylor. I think it is reasonable. To service the debt, 
you have to have a certain amount of income. And in the United 
States, to service our debt, it has to be tax-generated or the 
debt is just going to grow and grow. It comes, ultimately, from 
taxes. So I think that is the problem with unsustainability.
    If you look at the CBO's numbers, they have rising primary 
deficits, excluding interest payments. If that occurs, this 
debt is going to explode.
    I think to me the numbers that are most striking are the 
entitlement spending numbers as a share of GDP. They just take 
off. That cannot be sustainable. That is really the problem.
    Discretionary spending, if anything, is flat in their 
projections as a share of GDP, maybe even defense is coming 
down.
    Senator Johnson. They actually decline.
    Dr. Taylor. So the problem is clearly entitlements, and I 
think there is a reasonable chance to get a handle on that. To 
me, keep the growth of entitlements roughly equal to GDP. For 
certain things like Social Security, that is not as hard as it 
looks. For health, it is harder.
    But I think if there could be a bipartisan agreement that 
we better keep the growth of entitlements roughly in line with 
GDP, and then we will not debate about how to do it, should it 
be premium support, should it be other kinds of methods, I 
think we could tackle the problem.
    But it is a very serious problem, this entitlement growth, 
whatever the word you want to use in the United States.
    Senator Johnson. Senator Shaheen.
    Senator Shaheen. I want to go back to Greece and to whether 
there are lessons for the European Union in what has happened 
there.
    To avoid another Greece, should the European Union embrace 
a different approach to its fiscal and monetary policy? I mean, 
is that ultimately what they should be thinking about?
    Dr. Kahn. I believe they should. They should accelerate the 
economic integration in the eurozone. That would mean fiscal 
union, in particular, so that there is some greater 
automaticity at the federal level, in the case of shocks. And 
it can be done in a less politically disruptive way.
    I think accelerating banking unification, some steps have 
been made but more could be done so that you really had a true 
backstop for the banks in a way that meant that you do not have 
a run on Greek banks, even if the Greek Government has some 
problems.
    I have to be honest, the German Government would draw 
exactly the opposite conclusion. They would make the judgment 
that this shows bad behavior and cannot be rewarded, that the 
moral hazard concerns are significant, and greater integration 
is fine but that it would have to be on a very strict rules-
based basis. And debt relief, which I also think it is 
critically important here, some sort of process for debt 
relief, would only come really at the end of the process and 
after all the other reforms are done. I just do not think that 
is politically very viable.
    Senator Shaheen. Dr. Taylor.
    Dr. Taylor. But in a way the European policy is itself a 
problem. I would use the word economic freedom. It is not as 
stressed as much. The unemployment problem is all over the 
place to me in Europe. We would never accept unemployment rates 
like they see for most of the area.
    So to me, those are structural problems that have to be 
addressed. Some of it has to do with taxes. Some of it has to 
do with labor market reforms. I think if we could stress that 
more in our engagement with Europe, it would help a lot.
    We talk about international discussions and talks, the G20, 
the G7, the G-whatever it is. I think if more of those were, 
``Here is what we are doing for our structure reforms. Here is 
what we are doing to raise our growth rate.'' The G20 tried to 
do that a couple years ago through the interventions of the 
Australians. I do not think we see enough of that. I do not 
hear enough about it. I know that the times I had an 
opportunity to do that, I tried to drive it in that direction.
    But in a way, there is too much focus on these shorter term 
things, not that they are not important. But the real problem, 
if we want to be friendly to Europe, it seems to me we want to 
encourage them to be a good growth economy, not the mediocre 
growth economy they are.
    Dr. Kahn. Just one point in maybe defense of the Treasury 
Department on this. I think if you look, for example, when the 
European crisis first breaks in 2009, 2010, we had really just 
started to come out of our crisis on the back of very 
aggressive policy action. We felt we knew something about how 
you should address these issues and we had an experience that 
was worth conveying. So I think if you look at the President's 
involvement in 2010 in the first Greek program and the like, 
for better or worse, we had strong leverage in those 
discussions.
    Honestly, it is natural that as time has gone on, our 
direct ability to leverage over these conversations is going to 
diminish. The G20 maybe is not as effective now as it was at 
the heat of the crisis. The Europeans have been through so many 
rounds, I think they feel they know what they are dealing with, 
and thank you very much for your lectures.
    I was heartened to see the administration get involved in 
this last round, encouraging maybe a more constructive 
negotiation. But I think we also have to be honest. We have to 
think pretty carefully, how do we have leverage in this 
environment? It is trickier than it once was, and maybe it does 
relate back to the geopolitical issues you raised earlier.
    Senator Shaheen. And we, certainly, took a different 
approach to the financial crisis than Europe did, because their 
approach was to go full speed ahead on austerity. Ours was to 
provide investment in a way to prime the pump of the economy. 
So, obviously, it produced very different results.
    One of the things, Dr. Taylor, I would disagree with you 
on, when you said we would never accept such high unemployment 
rates, I would say we have inner cities and communities where 
we do have those high unemployment rates.
    Dr. Taylor. We should not accept them either.
    Senator Shaheen. We should not accept them there. Sadly, 
too often, we have accepted them. It is something that we 
should address.
    Unfortunately, I have another hearing, but I want to thank 
you both very much for being here, and for shedding light on 
what is a very challenging problem, as we think about what is 
going to happen.
    I, certainly, hope the EU and the eurozone and Greece will 
be successful in addressing this challenge. Thank you.
    Senator Johnson. Thank you for attending. I appreciate it.
    I just have a couple more questions. It really does relate 
to that high unemployment rate. But I want to look at a 
different statistic, the percentage of population in the work 
force, the labor participation rate. Both of these measurements 
right now in America, I do not have them right off of the top 
of my head, but they are at some pretty low levels compared to 
even 10 or 15 years ago.
    Dr. Taylor, can you explain that?
    Dr. Taylor. There has been a lot of research and debate 
amongst economists as usual on this.
    I feel that a good fraction of the decline in the labor 
force participation rate is due to the weak recovery itself. It 
is basically jobs not growing much more rapidly than the 
population. In fact, the employment-to-population ratio has 
hardly budged since the bottom of the recession. It has just 
now increased slightly.
    So yes, we are creating jobs but hardly enough to employ a 
growing population. So, I point to that. It is, certainly, more 
than demographic because the labor force participation rate of 
young people is down. I think it is an important issue to take 
up if you want to raise economic growth. If you want to raise 
economic growth, part of that is going to come by employing 
more of the labor force, to get the labor force participation 
rate up close to where it was before this precipitous drop.
    And I think that, to me, that should be a focus of policy. 
To me, if you want to have stronger growth, you need to have 
more jobs, you need to have more productivity, so each worker 
producing more, those two things. And both have to be 
addressed.
    I think you are asking more about the jobs part, the drop 
in labor force participation, the employment-to-population 
ratio. I think in a way, that is an opportunity. We could get 
more jobs with a better performing economy.
    But the other part is productivity.
    Senator Johnson. Is the economy not a combination of labor 
and capital? So if you do not have as many people employed, you 
are going to have a smaller economy.
    Talk a little bit about your valuation of a reduction of 
median household income and what is the explanation behind 
that? We are literally 5, 6 years into a recovery and median 
household income has actually declined.
    Dr. Taylor. Well, I think it is the same story. The numbers 
are harder to measure, but if you are going to have a low 
growth, lower growth economy, say 2 percent, 2.2 percent, and 
that is going to measure the growth of your income in real 
terms, too. So that is going to mean growth of income is less. 
The population is growing, and the labor force is growing too, 
and the number of jobs is growing. It is just not growing fast 
enough.
    In some sense, that is the productivity side of it, the 
income per worker, even per person, per capita. And 
productivity, maybe this is the best way to answer your 
question, productivity in the last 4 or 5 years is remarkably 
low for an expansion. It is like 0.5 percent, 0.6 percent per 
year.
    So I think that is really the reason for these income 
numbers that we are concerned about. It is not clear when they 
started down or what, but I would not want to debate too much 
the beginning, the timing, the political part of it, because it 
is there and we need to address it.
    Senator Johnson. I am not an economist. I am a business 
guy, so I have done a lot of strategic planning. I have done 
things like SWOT analysis, Strengths, Weaknesses, 
Opportunities, and Threats.
    A very simple SWOT analysis, I just want your comments on 
this, I think America's primary strength, number one, is that 
we are the world's largest market, which means we are the 
world's biggest customer. Coming from a manufacturing 
background, I can tell you, manufacturers want to be close to 
customers. From my standpoint, that is an enormous competitive 
advantage on the global scene. So we are the world's biggest 
market.
    We do have, because of innovation, fracking, hydraulic 
fracturing, horizontal drilling. We have an energy boom, so we 
have relatively cheap, abundant energy.
    So if you are going to manufacture things, you need power. 
Cheap power is better than expensive power. From my standpoint, 
that is an advantage. And it directs your policy as well. Let 
us keep the energy prices low.
    On the weakness side of the ledger, our regulatory 
environment is onerous. There are numerous studies pegging that 
at about $2 trillion per year. I know it is disputed, but it 
gives you some sort of sense. I would add, there are only 90 
economies in the world that are larger than $2 trillion.
    Our tax system is uncompetitive. We are going to be holding 
a hearing tomorrow in the Permanent Subcommittee on 
Investigations, laying out how uncompetitive our corporate tax 
rate is versus the rest of the world. You have to benchmark 
these things.
    Our legal environment does not provide certainty. All of 
the rules, all of the precedents, as a business person, leaves 
you very uncertain.
    To me, those are, in a nutshell, the strengths and 
weaknesses, which pretty well should direct government policy 
in terms of, not driving up the cost of power, trying to reduce 
the regulatory burden, making our tax system more competitive, 
and letting us bring some certainty to our legal and regulatory 
framework.
    Do you have other strengths, other weaknesses? Can you just 
basically comment on that?
    I will start with you.
    Dr. Taylor. I agree. I could probably list a few more, like 
trade and openness.
    But the question is getting it done. How do we move this 
agenda forward? I think that is what I worry about at this 
point. There is no question that that is the kind of thing that 
needs to be done.
    Senator Johnson. We have to understand it. One of the 
reasons I throw it out there is you have to simplify what it is 
that we need to do, so people understand. Otherwise, you get 
drawn down into the very detailed policy debates.
    With trade, you have to keep open markets.
    Dr. Kahn. I very much believe that is critical. We need to 
be able to be the rule setter for a large, open global 
marketplace that is attractive to other countries to come and 
participate in. I think that is a core element of our 
prosperity, and entrepreneurship.
    Obviously, we talked about these Doing Business indicators. 
I still think in terms of many of these characteristics that 
the United States is an extraordinarily dynamic and vital 
economy.
    I spend most of my time looking at countries that are in 
crisis. So it may be a low bar, but I think there are still a 
lot of great strengths in the U.S. economy.
    Senator Johnson. Again, we like those indicators improving 
for America.
    I will give both of you a chance, if you have any kind of 
closing comment, if there is something on your mind or if there 
is something you want to get off of your chest, I am happy to 
do that before I close out the hearing.
    Dr. Taylor, anything?
    Dr. Taylor. So tell me what specifically----
    Senator Johnson. I am just asking if you have any closing 
comments before I close out the hearing, something we did not 
address.
    Dr. Taylor. I am sorry. Just more generally, it seems to me 
that the underlying set of ideas here, that there are lessons 
to learn from other countries and Greece, is very important. 
And we can look at our history, what has worked and what has 
not worked. You can look at different countries.
    It is a way to convey the important issues to people, to 
voters, to people in America.
    So I would say keep it up.
    Senator Johnson. Dr. Kahn?
    Dr. Kahn. Just to go back to my opening remarks, just to 
emphasize, there are a kind of series of almost subtle 
decisions that are going to be made by the international 
community in the coming weeks. It will deal with debt for 
Greece, but as we have been talking about, but with precedent 
for others. It will deal with financing and most of all, who 
pays, who picks up that bill.
    The IMF is in many ways caught in the middle of it. I think 
for the most part, we should be supporting them.
    But I think the important emphasis for you, given the 
committee's jurisdiction and our general interest in this 
strong, vibrant, global economy, is the United States should be 
involved in those decisions because ultimately, cumulatively, 
they can have a pretty material impact on how the global 
economy operates.
    Senator Johnson. Thank you.
    Again, I want to thank both of you for coming here and 
giving your time, thoughtful testimony, and answers to our 
questions.
    This hearing is adjourned.
    [Whereupon, at 3:26 p.m., the hearing was adjourned.]