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THE EUROPEAN DEBT AND FINANCIAL CRISIS: 

ORIGINS, OPTIONS, AND IMPLICATIONS FOR 

THE U.S. AND GLOBAL ECONOMY 

HEARING 

BEFORE THE

SUBCOMMITTEE ON 

SECURITY AND INTERNATIONAL TRADE AND 

FINANCE 

OF THE

COMMITTEE ON 

BANKING, HOUSING, AND URBAN AFFAIRS 

UNITED STATES SENATE 

ONE HUNDRED TWELFTH CONGRESS 

FIRST SESSION 

ON 

EXAMINING THE DIMENSIONS OF THE EUROPEAN ECONOMIC CRISIS, 

INCLUDING OPTIONS FOR RESOLVING IT, AND IMPLICATIONS FOR 

THE U.S. AND GLOBAL ECONOMY 

SEPTEMBER 22, 2011 

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

( 

Available at: http://www.fdsys.gov/ 
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS 

TIM JOHNSON, South Dakota, Chairman 

JACK REED, Rhode Island 

CHARLES E. SCHUMER, New York 

ROBERT MENENDEZ, New Jersey 

DANIEL K. AKAKA, Hawaii 

SHERROD BROWN, Ohio 

JON TESTER, Montana 

HERB KOHL, Wisconsin 

MARK R. WARNER, Virginia 

JEFF MERKLEY, Oregon 

MICHAEL F. BENNET, Colorado 

KAY HAGAN, North Carolina 

RICHARD C. SHELBY, Alabama 

MIKE CRAPO, Idaho 

BOB CORKER, Tennessee 

JIM DEMINT, South Carolina 

DAVID VITTER, Louisiana 

MIKE JOHANNS, Nebraska 

PATRICK J. TOOMEY, Pennsylvania 

MARK KIRK, Illinois 

JERRY MORAN, Kansas 

ROGER F. WICKER, Mississippi 

DWIGHT FETTIG, Staff Director 

WILLIAM D. DUHNKE, Republican Staff Director 

DAWN RATLIFF, Chief Clerk 

ANU KASARABADA, Deputy Clerk 

RIKER VERMILYE, Hearing Clerk 

SHELVIN SIMMONS, IT Director 

JIM CROWELL, Editor 

SUBCOMMITTEE ON SECURITY AND INTERNATIONAL TRADE AND FINANCE

MARK R. WARNER, Virginia, Chairman 

MIKE JOHANNS, Nebraska, Ranking Republican Member 

SHERROD BROWN, Ohio 

MICHAEL F. BENNET, Colorado 

TIM JOHNSON, South Dakota 

MARK KIRK, Illinois 

ELLEN CHUBE, Subcommittee Staff Director 

NATHAN STEINWALD, Senior Economic Advisor 

COURTNEY GEDULDIG, Republican Subcommittee Staff Director 

SARAH NOVASCONE, Republican Chief Counsel and Policy Advisor 

(II)
C O N T E N T S 

THURSDAY, SEPTEMBER 22, 2011 

Page 

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

Opening statements, comments, or prepared statements of: 

Senator Johanns ............................................................................................... 3 

Senator Bennet ................................................................................................. 3 

WITNESSES 

Nicolas Ve ́ron, Visiting Fellow, Peterson Institute for International Economics, and Senior Fellow, Bruegel ........................................................................... 5 

Prepared statement .......................................................................................... 28 

Joachim Fels, Global Head of Economics, Morgan Stanley ................................. 7 

Prepared statement .......................................................................................... 37 

Domenico Lombardi, President, the Oxford Institute for Economic Policy and 

Senior Fellow, the Brookings Institution ........................................................... 10 

Prepared statement .......................................................................................... 39 

J.D. Foster, Ph.D., Norman B. Ture Senior Fellow in the Economics of Fiscal 

Policy, the Heritage Foundation ......................................................................... 12 

Prepared statement .......................................................................................... 52 

(III)

(1) 

THE EUROPEAN DEBT AND FINANCIAL CRISIS: ORIGINS, OPTIONS, AND IMPLICATIONS 

FOR THE U.S. AND GLOBAL ECONOMY 

THURSDAY, SEPTEMBER 22, 2011 

U.S. SENATE, 

SUBCOMMITTEE ON SECURITY AND

INTERNATIONAL TRADE AND FINANCE, 

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, 

Washington, DC. 

The Subcommittee met at 2:32 p.m. in room SD–538, Dirksen 

Senate Office Building, Hon. Mark Warner, Chairman of the Subcommittee, presiding. 

OPENING STATEMENT OF CHAIRMAN MARK R. WARNER 

Senator WARNER. Good afternoon, everyone. I would like to call 

to order this hearing of the Senate Banking Subcommittee, which 

topic today we have entitled ‘‘The European Debt and Financial 

Crisis: Origins, Options, and Implications for the U.S. and Global 

Economy.’’ 

Now, when we proposed this date with my good friend Senator 

Johanns, I am not sure we anticipated that this hearing would be, 

unfortunately, quite so timely as it appears to be today with the 

U.S. equity markets down, at last glance a moment or two ago, 

about 4 percent. With the Fed actions yesterday, with the continuing fears of what is happening in Europe, it is very, very appropriate, I believe, to have this hearing and to make sure that we 

recognize and fully appreciate how inexorably linked all of our 

economies are and how clearly what is happening in Europe affects 

the United States and our fiscal challenges directly. 

I want to thank my good friend, Senator Bennet, for appearing 

here, and I know that Senator Johanns will be joining us in a moment, and I again would like to thank all the witnesses. I will come 

back to them in a moment. 

Watching the markets, again, not only over the last couple of 

months but particularly today, it is clear that as U.S. policymakers 

I believe we need a greater and better understanding of both the 

interconnectedness and the implications of what is happening 

throughout the euro zone and, again, how it affects America. I 

think it is important, at least for the record, to restate some of the 

things that are obvious but that sometimes we do not focus on. We 

oftentimes in the Senate look at our growing challenges and imbalances, particularly with China and Asia, but, you know, Europe 

still remains America’s largest trading partner. We exported $398 
2 

billion in goods and services to the EU in 2009 and imported more 

than $419 billion in goods and services, so while slight deficit, a 

relative balance. 

In addition to these trade flows, in 2009 a net $114 billion flowed 

from U.S. residents to EU countries in direct investments, and on 

the other side of the ledger, over $82 billion flowed from EU residents into direct investments in the United States. Our economies, 

again, are inexorably linked. 

On top of these flows, according to the Bank of International Settlements—we will go ahead and put up the first of our two slides— 

while a lot of the attention in the news has directly focused on 

Greece, one of the things that is remarkable to me is we do not 

really have a full recognition of how great our American exposure 

is to the Greek challenges. 

U.S. banks have more than $7 billion, which on a relative basis, 

compared, obviously, to the United Kingdom, Germany and France, 

is not that great a number. But if you look beyond that in other 

potential exposures—and these are just from depository institutions—you have more than $34 billion in potential exposure. 

And, candidly, this does not fully reflect what is our exposure 

just to Greece. We do not have information in terms of our insurance exposure. Hopefully there is not out there the son, cousin, or 

nephew of AIG lurking in terms of insurance. We do not have an 

understanding of our money market fund exposures. We do not 

have an understanding of, you know, banking, lending to hedge 

funds that might be also further invested in Greece. 

If we go to the next slide, even assuming on a relative basis this 

is manageable, if you then look at our exposures to other European 

countries where there have been very real issues about the potential for contagion, you see this exposure growing dramatically. It 

really does reinforce the point that what is happening real time in 

Europe has a direct affect on American jobs, American growth, and, 

again, I believe that we are all in this together. 

I would point out as well, one of the things that is of grave concern to me—and I know on this Committee and in the Senate there 

remains a great deal of controversy about some of the things that 

we did in the so-called Dodd-Frank bill. But with one of my other 

colleagues, Senator Corker, we put together Title I and Title II of 

that legislation, which created the Financial Stability Oversight 

Council and the Office of Financial Research with the goal of at 

least making sure that the regulators could get out of their stovepipes and see what our exposure in these kinds of circumstances 

is. And, unfortunately, I do not believe we have that information. 

At least I do not believe the Senate does, and, frankly, I am not 

sure that the Administration on both FSOC and the OFR has 

moved as quickly as we would have liked to make sure that at 

least we have got that information as we try to plan and coordinate 

action in terms of taking on this crisis. 

So I will now turn to my friend and the Ranking Member, Senator Johanns, for any opening comments he might have, and then 

since we have got a small hearing, I will call on Senator Bennet. 

Then it will be my great pleasure to introduce the witnesses, and 

I am anxious to hear your testimony. Senator Johanns. 
3 

STATEMENT OF SENATOR MIKE JOHANNS 

Senator JOHANNS. Thank you, Mr. Chairman. 

Mr. Chairman, let me just say thank you for bringing us together 

today to discuss the economic situation in Greece, and I guess for 

that matter the rest of the European Union. I have to say your timing is remarkable. 

Senator WARNER. I wish not. 

Senator JOHANNS. I can share that sentiment. But I look at what 

is happening today in the markets, what happened last night, and 

the timing of this hearing could not be better in terms of just timeliness in terms of us trying to get an understanding of what the 

panel of witnesses thinks about all this. 

I do not think there is any question whatsoever that our country 

is facing a fiscal challenge that the current generation probably 

could have never imagined, and we have to start making decisions 

to correct our fiscal ship. 

As a Nation, we are borrowing about 42 cents of every dollar. I 

know of no economist anywhere in the world, whether they are considered a liberal or a conservative, who would put forward the argument to anyone that that is a sustainable course. It just simply 

is not. 

Austerity measures in Greece have not calmed the panic, and the 

contagion around Europe continues to impact other countries. Certainly more fiscally responsible countries are beginning to wonder 

where this is going to lead and how far do they get entangled in 

this, although obviously they already are. 

Widespread uncertainty over what is happening in Greece and 

countries around it is directly affecting the United States, and it 

is not just a big bank and a downgrade that they may be enduring. 

It is the teachers’ retirement, it is the 401(k), it is all of those 

things that are real in the lives of our citizens. 

This uncertainty only adds to the uncertainty of our domestic 

policies, many of which, I believe, are only stifling economic growth 

in the United States. Until nations such as Greece and the United 

States, for that matter, can provide confidence in our ability to control runaway debt and to deal with our fiscal houses, I believe we 

are going to continue to struggle. 

This hearing, I hope, will enlighten us on maybe some mistakes 

that have been made and enlighten us on the interrelationship between our country and what is happening in the European Union. 

My hope is that we will have an opportunity to not only hear from 

you but to ask questions and try to get to the bottom of what is 

happening and get a better understanding today. 

Thank you, Mr. Chairman. 

Senator WARNER. Thank you, Senator Johanns. 

Senator Bennet. 

STATEMENT OF SENATOR MICHAEL F. BENNET 

Senator BENNET. Thank you, Mr. Chairman, and I will be very 

brief because I want to hear the witnesses’ testimony. But I also 

want to thank you for holding this hearing. It is very timely, and 

it is very important. This may surprise our witnesses, but there are 

people in this town that will say that things have to get worse before we can construct the politics that will actually solve the prob-
4 

lem that we are facing. They will say, you know, not until it gets 

worse can we have a conversation with our constituents about what 

is needed to fix this problem. And I think that is a very tragic way 

of looking at it. 

My hope is that this hearing, among other work that is being 

done on the Hill, will show how perilous the position we are in is 

today, how perilous the global economy is today, and the reason we 

care about that is, I think, for two reasons: 

One, the folks in our States that are suffering through the residue of the worst recession since the Great Depression. You know, 

we find ourselves at a place where our productivity is very high, 

actually; our GDP has grown somewhat. But we have got 14 million people that are unemployed that we have not been able to figure out how to put back to work. We were at the end of—not the 

end, but at the end of about 15 years of median family income falling in this country. And those things are only going to get worse 

if we do not deal with these challenges that we face. 

The other issue that we have is the fiscal condition that the 

country is in, which is threatening to constrain the choices that our 

kids and grandkids will make. But it also is having a profound effect on our economic activity in this country, I think. People are 

unwilling to invest when they have no idea what interest rate environment they are going to be in. And, you know, when you have 

got $1.5 trillion of deficit and $15 trillion of debt, and it is unclear 

to everybody that watches what is going on in Washington, the conversation that we are having here, whether we have the political 

capacity to actually get ahead of this, there is a lot of reason for 

concern. 

So the first thing I would say is that it is not a sufficient answer 

to the people we represent that things have to get worse before we 

fix this problem. And, second, if we really are accepting as a Congress a standard of outcomes of success that is just keeping the 

lights flickering with temporary transportation bills and temporary 

FEMA bills and temporary continuing resolutions and all this kind 

of stuff, without doing the hard work that is necessary to deal with 

a crisis it is inevitably going to become, we are all going to rue the 

day that we did not have a more meaningful conversation about it. 

So, Mr. Chairman, thanks for having the hearing, and I look forward to hearing the testimony. 

Senator WARNER. Thank you, Senator Bennet. I again want to 

thank both my colleagues. They have been part of the group that 

has been trying to reach that common ground. 

We have got a very distinguished panel. Let me very briefly introduce each of the panel members, and then we will take each of 

your opening statements. And we have got your statements. We 

have reviewed them. If you want to amend off of those, particularly 

in light of some of the immediate circumstances, please feel free to. 

Nicolas Ve ́ron is a Senior Fellow at Bruegel, a Brussels-based 

economic policy think tank, and has served as a Visiting Fellow at 

the Peterson Institute for International Economics since October 

2009. A French citizen, he has held various positions in the public 

and private sectors, including as corporate adviser to France’s 

Labor Minister, as chief financial officer of the publicly listed Internet company MultiMania/Lycos France, and as an independent fi-
5 

nancial services consultant. Since 2008 he has been a member of 

the CFA Institute’s Corporate Disclosure Policy Council. He also recently co-authored ‘‘Smoke and Mirrors, Inc.: Accounting for Capitalism.’’ Mr. Ve ́ron, thank you for being here. 

Joachim Fels co-heads Morgan Stanley’s global economics team 

and is the firm’s Chief Global Fixed-Income Economist. Based in 

London, Joachim edits the Global Monetary Analyst, a weekly Morgan Stanley research publication. Mr. Fels joined Morgan Stanley 

in 1996 to cover the German economy; later he co-headed the currency economics team and the European economics team, where he 

won several number one ratings in the institutional investor poll 

over a number of years. Mr. Fels was also the firm’s ECB watcher 

from the institution’s birth in 1995 until 2005. He is a member of 

the Germany Banking Association’s Economic and Monetary Committee and Volkswagen Foundation’s Asset Allocation Advisory 

Board from 1999 to 2008. He has advised the German Finance 

Minister on international economic policy and financial market 

issues, and since it seems so much of what is going on in the EU 

now is dependent upon what Germany decides, we are particularly 

looking forward to your comments, sir. 

Dr. Domenico Lombardi is a Senior Fellow for Global Economy 

and Development at the Brookings Institution. As an expert on G– 

20 and G–8 summits, international monetary relations, global currencies, his current projects focus on the recent and ongoing international financial crisis, the ongoing European crisis, and reform of 

the IMF and World Bank. He is also president of the Oxford Institute for Economic Policy. He is a member of a whole series of committees and associations, and we are grateful to have Dr. Lombardi 

here. 

Dr. J.D. Foster, this is the second time we have had a chance to 

hear Dr. Foster—I at least—this week. He is the Norman B. Ture 

Senior Fellow in Economics and Fiscal Policy at the Heritage Foundation. His primary focus is studying long-term changes in tax policy to ensure a strong economy. He also examines changes in Medicare, Medicaid, and Social Security so they are both affordable and 

more efficient. Dr. Foster came to Heritage in 2007 after serving 

many years at the White House, the executive branch, Capitol Hill, 

and private policy institutions. His last job before joining Heritage 

was the White House Office of Management and Budget where he 

was Associate Director for Economic Policy. 

Again, we have got four very distinguished panelists. We are 

anxious for your analysis of not only origins but kind of next steps, 

particularly in Europe. And, again, since many of you know who 

work in this town or here in America we still have this American 

bias, so if you could also help make clear how much real time going 

on in Europe both directly and indirectly affects some of the challenges we have in this country, that will be helpful as well. 

Mr. Ve ́ron. 

STATEMENT OF NICOLAS VE ́ RON, VISITING FELLOW, PETERSON INSTITUTE FOR INTERNATIONAL ECONOMICS, AND 

SENIOR FELLOW, BRUEGEL 

Mr. VE ́ RON. Thank you very much, Chairman Warner, thank 

you, Ranking Member Johanns, thank you, Senator Bennet, for giv-
6 

ing me the opportunity to testify today. It is a great honor. It is 

also the first time, as far as I am aware of, that Bruegel, which 

is a young organization, has one of its fellows giving testimony on 

this Hill. So it is a moment of pride also for this organization and 

for the Peterson Institute. My views are very informed by conversations with my colleagues, which is why I mention many of them in 

my written testimony. My main focus in research is on financial 

regulation, and this also informs the emphasis of my remarks. 

I also call for forgiveness for my imperfect English. I will probably make mistakes in expressing myself, so I call for your understanding. 

Senator WARNER. You heard how badly I did some of my introductory comments in English, so you are doing quite well, sir. 

Mr. VE ́ RON. The roots of the crisis, I believe, are very much to 

do with the European banking system and European banking system fragilities. Subprime, Lehman Brothers collapse, shock was exogenous to Europe. It came from the United States, but it revealed 

very significant weaknesses in the European banking system. One 

big difference between Europe and the United States is that the 

United States by comparison addressed its banking crisis more decisively and more quickly than the European Union, which did not 

have an equivalent to the sort of aggressive stress testing and recapitalizations that was endeavored in 2008 and 2009. Why? Because of a number of factors of political economy. But the fact is 

that the European Union has been in almost continuous stage of 

systemic banking fragility—you may call it systemic banking crisis—basically since 2007–08, so there has been a continuity on this. 

And now we have—and this is my second point—a sovereign crisis which is really a combination between sovereign fiscal crisis 

and banking crisis. So the title of this session is well taken. It is 

really a financial and debt crisis, the two feeding each other. Of 

course, it started in Greece with the statistics manipulation of the 

Greek Government. The contagion went to other countries. In some 

countries, the banking system has had a negative impact on the fiscal dynamics, like Spain and Ireland. In other countries it has been 

the other way around, fiscal dynamics having a negative impact on 

the banking system, like Greece and Italy. But we have had very 

significant contagion. 

Now, this could perhaps have been better resolved if we did not 

have also weaknesses in the EU institutional framework, and this 

is my third point. This is becoming basically a European institutional crisis because the inability of our institutions—and I say our 

institutions not our leaders, because I think institutions are more 

to blame than individual leaders. So their inability to provide the 

right solutions in a timely fashion has been a very significant factor in the crisis, especially at this point. I think when you discuss 

with investors these days, they really express very vividly the feelings that the political systems or policymaking system are not delivering, and this is their major focus on concern, even as much or 

in some cases even more than the bad debt dynamics or the bad 

economic situation. 

My fourth point is that the resolution of this crisis, because of 

all the time lost and because of all these components, will need basically four planks. We need to put in place a credible system of 
7 

fiscal federalism in Europe, and there are many ways to do that, 

but it is something new compared to the current situation where 

monetary policy is being done in a federal framework but not fiscal 

policy. 

Then I think we also need banking federalism, which is perhaps 

less discussed but, in my view, as important. We need a truly European banking system. At this point we have an unstable hybrid between national banking systems and European banking integration. It is not sustainable. And to enable this, we need a significant 

overhaul of EU institutions to make them more accountable, more 

accountable to EU citizens, and giving them a better executive decisionmaking capability. So this implies treaty changes. It is very 

complicated. In the meantime, we need gap financing for those 

countries which need it, probably some debt restructuring—I am 

sure we will come back to this—and also some bank restructuring 

which goes with the sovereign restructuring under the current institutional framework. 

My fifth and final point is about the outlook. There is no sufficient political willingness at this point to provide what I have identified as conditions for crisis resolution. So, unfortunately, in the 

case of Europe, I am afraid it will get worse before it gets better. 

And this will have an impact in the United States, the same way 

the U.S. crisis had an impact on the EU in 2008. 

I think there are encouraging recent signs of the debate moving 

forward in Germany and other countries, but we are not yet there. 

Will this lead to a break-up of the euro area? I do not believe so. 

I do not even believe that Greece will leave the euro zone because 

I think this is a case of united we stand together or we fall, and 

that the alternative of break-up or some countries leaving the euro 

zone will be really very negative in their consequences, so leaders 

will not go for it. 

The EU framework may be strengthened in the end by the results of the crisis, but in the meantime, the road will be very 

bumpy, and I think Europeans will pay a high price for it. 

Thank you very much. 

Senator WARNER. Thank you, sir. 

Mr. Fels. 

STATEMENT OF JOACHIM FELS, GLOBAL HEAD OF 

ECONOMICS, MORGAN STANLEY 

Mr. FELS. Thank you, Mr. Chairman. Thank you, Senators. It is 

a pleasure and an honor to be here today. 

I will focus on three issues: first, the origins of the crisis; second, 

the options to resolve it; and, third, the implications, the macro implications for the United States and for the global economy. 

Now, starting with the origins of the crisis, I think there are 

three key factors at the root of the current crisis: 

First—and it was already mentioned by Mr. Ve ́ron—the very peculiar institutional framework of the euro area because we have a 

single monetary policy conducted by a central bank with a very 

narrow inflation focus; then we have a decentralized fiscal policy, 

and we have a decentralized banking supervision in the 17 members states. So a very unique set-up. 
8 

Second, we have an oversized and undercapitalized and fragmented banking sector in the euro area, so that is very different 

from the U.S. situation. 

And, third, we have diverging trends in growth and price competitiveness between the member states, and this has led to very 

large current account imbalances within the euro area, and it has 

led to a buildup of debt in the deficit countries. 

Now, I think that the most important of these three factors is the 

institutional set-up, and one distinctive feature of this framework 

is that monetary policy is centralized, but individual member 

states have retained their fiscal sovereignty. 

Now, we put rules in place to avoid irresponsible fiscal behavior—that was the so-called Stability and Growth Pact—but as we 

found out, it did not work and many member states have been running excessive fiscal deficits because we did not have well-designed 

rules. 

Moreover, the European Treaty contains a ‘‘no bailout’’ clause. I 

think that is well know. It states that no member country can be 

forced to stand in for the debts of other member countries. And at 

the same time, the treaty lacks a mechanism for orderly sovereign 

debt restructuring, and it does not provide for a mechanism to exit 

the euro zone. So, in summary, the euro area’s fiscal framework 

has neither been able to prevent irresponsible fiscal behavior, nor 

does it provide a mechanism for an orderly resolution once a fiscal 

position has become unsustainable. 

Now, to make matters worse, we have a European Central Bank 

that is constitutionally banned from financing governments directly. You may say that is a good thing. However, as a consequence, European governments no longer have a lender of last 

resort that they can resort to in times of crisis. And without access 

to the printing press in extreme circumstances, there is a risk—and 

this is what we have learned over the past year—of self-fulfilling 

runs on otherwise solvent governments. 

Now, I think this lack of access to a lender of last resort helps 

to explain why investors treat countries in the euro area as credits. 

So these government bonds are seen as credits. That is different 

from countries which have similarly high debt levels, like Japan or 

the United States or the United Kingdom, but in these countries 

where governments have access to the central bank as a last resort, 

investors see them as true sovereigns. 

So these are the factors at the origin of the crisis. There have 

been a number of exacerbating factors, namely, a series of policy 

mistakes that have been made ever since the Greek crisis broke 

out, but I would refer to my written statement on the details here. 

Now, briefly on the second point, what is required to resolve the 

crisis, I think to get a lasting solution we need three things: 

First, very bold reforms of the fiscal framework. This involves 

two elements: first, a fiscal transfer mechanism or an insurance 

scheme on the European level—so that is the fiscal federalism that 

was already referred to—and this would provide a backstop for governments unable to fund in the market; and, second, as a compensation, we need a partial transfer of member states’ fiscal sovereignty to the European level in order to avoid irresponsible fiscal 

behavior at the national level. 
9 

The second thing we need is a central bank able and willing to 

serve as a lender of last resort, as I just explained. To some extent, 

the ECB has assumed this role during the crisis. They have started 

to buy government bonds. They have bought Greek bonds, Portuguese bonds, Irish bonds. They have started to buy Spanish and 

Italian bonds. However, the amounts they have purchased have 

been relatively small, and the ECB is constitutionally barred from 

buying bonds directly at auction. 

Then the third thing we need is a large-scale bank recapitalization, and I think this would break the negative feedback loop between the sovereign crisis and the banking crisis that we have already seen. U.S. banks are much better capitalized than European 

banks, and I think this is what needs to happen. 

The problem here is that all these reforms require changes in the 

European Treaty which would have to be ratified in all national 

parliaments, and it would require popular votes. And to be honest, 

I think this is a process that could take years. I am not talking 

months. I am talking years here. So, therefore, I think it is fair to 

assume that the crisis will continue in the foreseeable future, and 

it will probably deepen further. 

My final point, the last point, what are the implications for the 

United States and the global economy? Mr. Chairman, you have already referred to them. The first thing that we need to look at here 

is that the euro economy will probably stagnate in a broad sense 

over the next couple of years. We think that southern member 

states like Italy and Spain will experience a renewed recession next 

year, and this means that European import demand looks set to 

slow, and as a consequence, U.S. exports to Europe will also slow 

further. 

Second, the European crisis deepening means that the euro will 

weaken further. We are seeing this as we speak in the markets, so 

this means a stronger dollar, and, again, this will hurt U.S. exports. 

Then the third and last consequence is the financial market linkages. U.S. banks are stronger in terms of capital, liquidity, and 

asset quality than their European peers, but the European crisis 

has already contributed to higher funding rates also for U.S. banks 

and to a higher cost of capital in the United States and elsewhere. 

So I conclude by saying that just as Europe and the rest of the 

world were severely impacted by the subprime crisis several years 

ago, I think it is very fair to assume that the United States is now 

very severely impacted by the European crisis, which is very unlikely to end soon. 

Thank you. 

Senator WARNER. Mr. Fels, thank you for that very uplifting—— 

Mr. FELS. I did my best. 

Senator WARNER. I am anxious to get to the questions, but a very 

good presentation. 

Dr. Lombardi. 
10 

STATEMENT OF DOMENICO LOMBARDI, PRESIDENT, THE OXFORD INSTITUTE FOR ECONOMIC POLICY AND SENIOR FELLOW, THE BROOKINGS INSTITUTION 

Mr. LOMBARDI. Chairman Warner, Ranking Member Johanns, 

Senator Bennet, thank you for this opportunity to share my views 

with you today. 

The crisis of the euro area has entered a new stage. What was 

initially a fiscal crisis of relatively smaller peripheral economies 

has now turned into something that is very close to a systemic crisis of the euro area itself with large sovereigns like Italy, Spain, 

even France coming increasingly under strains, and not only the 

sovereigns but also their respective financial sectors, as we have 

seen through a number of downgrades of several Italian banking 

and financial institutions and also French financial institutions 

days ago. 

While European governments, of course, are obviously primarily 

responsible for the unfolding of the current events—and Nicolas 

Ve ́ron was reminding us that the Greek Government was fudging 

statistics, and this prompted what we are now going through—the 

incomplete architecture of the euro area also created unprecedented scope for contagion by exposing each member of the union— 

albeit to varying degrees—to the vulnerabilities of the other members. And coupled with the inexistence of a lender of last resort, 

this means, as Mr. Fels has reminded us, market expectations can 

rapidly become self-fulfilling in the context of the euro area. 

In terms of the policy options—of course, I would refer you to my 

written statement for a fuller elaboration. In terms of the policy options, I think the euro area governments ought to implement a 

multi-pronged approach consisting of immediate, short-term, and 

medium-term options. And on the immediate measures, certainly 

the EFSF—that is, the European rescue funds—we should not that 

the euro area leaders already agreed to a number of amendments 

to strengthen the European rescue fund on July 21st, and yet those 

amendments have still not been ratified by the member countries. 

I believe the German parliament is expected to review the amendments sometime in October, as other euro area parliaments will. 

It is important to further strengthen the EFSF, however, perhaps by providing a line of credit to the European Central Bank 

and, therefore, turn the EFSF into an effective crisis manager and 

relieve the ECB from duties that are technically outside of its own 

mandate, like, you know, in some ways the role of a lender of last 

resort that the ECB to some extent has been performing in the current crisis, or certainly that of a crisis manager. 

It is important to ring-fence the Greek crisis because right now 

there is no program of assistance that can work in Greece as long 

as its debt-to-GDP ratio is projected to reach 140 percent. And Senator Johanns was reminding us that whether you are a liberal or 

a conservative economist, having a high burden given by the debt 

of country and economy is—it makes it really impossible for the 

economy to grow, and this is certainly much more true in the case 

of Greece. 

Of course, the fiscal surrounding needs to pooled. There will be 

also a need for medium-term measures like coordinating macroeconomic and structural policies. Of course, if Germany has a cur-
11 

rent account surplus, it cannot expect to continue to have that surplus if the other euro area countries where it was exporting its own 

goods and services are in retrenchment. 

In terms of, you know, the levers that the United States can leverage on, I think given where we are, this is perhaps by far more 

relevant. I think there are five levers that the United States can 

use. No one of them is—of course, the responsibility still lies with 

the European governments in the first place. 

First, there is, of course, the worldwide bilateral relationships between the United States and the single European countries. The 

Administration has been engaging bilaterally with the various European countries. Perhaps it is not a coincidence that German 

Chancellor Merkel declared her public support to the first rescue 

package in Greece on the very same day she had a conference call 

with the U.S. President. 

There is the G–20, and there is a framework that was proposed 

by the United States in 2009, the Framework for Strong, Sustainable, and Balanced Growth. It is very important that we do not lose 

momentum on that, that there are still—there should still be 

progress in terms of rebalancing of global demand in China to try 

to positively contribute to flagging European and possibly U.S. demand. So it is very important this euro area crisis does not sort of 

make these talks lose momentum. 

There is the G–7, and there has been actually a revival in the 

G–7 countries to what many had expected, because I believe continental European countries are more attuned in discussing about 

their issues with G–7 countries. And the United States, of course, 

is a leading member in this forum. 

There is certainly the International Monetary Fund. Of course, 

the United States is represented by one of the executive directors. 

The first deputy managing director has also been an American citizen since the position was established. 

Here I would like to draw your attention to the confidence-building effect that enhancing the IMF war chest would have in terms 

of stabilizing expectations. And the Board of Governors had already 

approved a doubling of the quotas, and, again, national legislatures 

would need to approve—to ratify that agreement. So far only a few 

countries have done so. 

The IMF can rely on the NAB, which is a contingent credit line 

that it can activate should there be any need. Again, it is not about 

enhancing the IMF financial capability to imply that the IMF will 

be spending more money, but just to emphasize the confidencebuilding effect that enhancing the IMF war chest could have. 

And then, of course, there is the U.S. Federal Reserve that has 

been very cooperative with the European Central Bank. There has 

been a number of bilateral currency swaps through which the ECB, 

thanks to the Fed, has been able to ease pressure on the European 

banks so far. 

Mr. Chairman, I am sorry for taking too much time, and I will 

stop here and await questions from the Committee. Thank you. 

Senator WARNER. Thank you, Dr. Lombardi. I would say on the 

EFSF, to my understanding the French Foreign Minister today has 

made some proposal, and we are anxious to hear from you all on 

that. 
12 

Dr. Foster. 

STATEMENT OF J.D. FOSTER, PH.D., NORMAN B. TURE SENIOR 

FELLOW IN THE ECONOMICS OF FISCAL POLICY, THE HERITAGE FOUNDATION 

Mr. FOSTER. Chairman Warner, Ranking Member Johanns, Senator Bennet, thank you for the opportunity to testify today. I am 

J.D. Foster, a senior fellow at the Heritage Foundation. The views 

I express in this testimony are my own and not the official position 

of the Heritage Foundation. 

The European economic crisis is no accident. It is entirely selfinflicted, resulting from two fundamental economic policy mistakes 

begun long ago and since magnified and papered over repeatedly. 

The first mistake was adopting a single currency without the economic policy infrastructure necessary to sustain it. As a matter of 

economics, the euro could have succeeded as envisioned, but Europe largely ignored the prerequisites of harmonizing labor, commercial, environment, labor, and fiscal policy. 

The second great mistake was adopting a generous social welfare 

state without attending to the pro-growth policies necessary to sustain such a state in light of an increasingly competitive global economy. 

But that is past. What is next? 

Europe’s immediate problem is a budding liquidity crisis. European financial institutions are struggling to access short-term dollar credit markets, and depositors are getting very nervous. Confidence, the lifeblood of financial markets, is failing fast. 

The reason? The banks hold vast quantities of dodgy government 

debt. Many have serious solvency problems. Joaquin Alumnia, the 

European Union’s competition commissioner, noted recently that, 

‘‘Sadly, as the sovereign debt crisis worsens, more banks may need 

to be recapitalized.’’ 

Mr. Alumnia has a knack for understatement. An IMF study out 

yesterday puts the shortfall at about 300 billion euros. 

The solvency problem, in turn, traces to the sovereign debt problem—unsustainable debt and deficits—unsustainable because of 

their magnitudes and because these countries also suffer from an 

ongoing growth problem. The problem is not enough growth. Now 

they are contracting, in some cases rapidly. So while their debt is 

high and rising, the economy on which the debt rests is flat or contracting. 

Worse yet, the cost structures in many of these countries render 

them highly uncompetitive, even within Europe. This means they 

cannot run the trade surpluses necessary to generate the earnings 

with which to pay their foreign creditors. 

Liquidity problem to solvency problem to sovereign debt problem 

to growth problem to competitive problem. 

The painful immediate policy conundrum is that addressing excessive sovereign debt and deficits through tax hikes, for example, 

weakens their economies further, thus making current debt levels 

even less sustainable. Meanwhile, issuing even more debt to buy 

time for fiscal consolidation to take hold worsens the bank solvency 

problem by depressing the value of the dodgy debt held by the 

banks. And it gets worse. Drawing attention to the need for more 
13 

bank capital, the financial market solvency problem, brings the liquidity crisis to a fevered pitch. This is a Gordian knot of enormous 

complexity, and I think we have to have a little grudging admiration for the European leadership for at least managing to get this 

far. 

The fundamental transmission mechanisms of the European economic crisis for the United States economy are as straightforward 

in outline as they are murky in detail. There are two such mechanisms, one through financial markets and the second through trade 

flows. 

Five years ago, the European financial crisis might have appeared to us as a European affair that would stop at water’s edge. 

Five years ago, the Europeans thought the same about the thenrumored U.S. subprime mortgage fiasco. The fact is, Mr. Chairman, 

as you noted, the issue is financial global interconnectedness. No 

one, including the participants and regulators, really understands 

all the connections or all the weaknesses. A financial crisis in Europe will spread to the United States Will the shock to the United 

States be great or small? No one knows. And it is this uncertainty 

more than anything else that is rattling markets today. 

European leaders will not be able to kick the can down the road 

indefinitely. At some point this house of cards will come tumbling 

down, taking much of the European financial system with it. That 

is the bad news. 

The good news is, I believe, this part of Europe’s problems will 

be halted in its tracks fairly quickly by recapitalizing the banks 

and other financial institutions. Done quickly and decisively, this 

is a light switch for the liquidity and solvency problems. The questions for the Europeans will be whose capital and how much. For 

the United States, too, the immediate threat will then pass. Europe 

will then be left with a dysfunctional monetary union, uncompetitive economies in many cases, and excessive debt burdens in others, and a deep recession. Even after the financial crisis passes, 

Europe will still face grave difficulties. Most immediately, Europe, 

a major U.S. trading partner, will be in a deep slump, which can 

only mean U.S. exports to Europe will suffer badly, and the effects 

will not be fleeting—again, Mr. Chairman, a point you emphasized 

yourself. 

Our focus today should be in preparing for the immediate threat 

of financial contagion. Above all, the key to preparing for the financial threat is capital. Capital reserves act like levees in the face of 

a flood, protecting financial institutions from the onrushing river of 

failing confidence. Presumably, America’s financial regulators and 

supervisors, and this Committee, are keeping a close eye on bank 

capital reserves and adequacy. 

The American economist Joseph Schumpeter once observed, ‘‘The 

problem that is usually being visualized is how capitalism administers existing structures, whereas the relevant problem is how it 

creates and destroys them.’’ The next few years are very likely, and 

painfully, to bear this out. 

Thank you, Mr. Chairman. 

Senator WARNER. Thank you, Dr. Foster. 

I think I made one comment in private to the panel before we 

got started. You know, I hope the kind of American political ral-
14 

lying cry does not become, ‘‘Well, at least we are not as bad as the 

euro zone,’’ which should not be—oh, boy. Normally, Mr. Ve ́ron, 

what we do is we take 5 minutes each and we rotate around, but 

I am going to try to be brief so that we can try to get a more active 

discussion since we have got a smaller group here. And we will all 

have a chance to ask a series of questions. 

I guess politicians, rightfully, always are accused of shorttermism, and that is true. It is interesting that you have got, I 

think, a variety of economic philosophies along the panel, but we 

all see the institutional challenges that were set up in the euro 

zone. And while we need to come back to the time that it will take 

to make those changes, as Senator Bennet has pointed out, we 

have got to work on some of these things in our own country as 

well. 

I guess what I am looking at is, recognizing the first round of 

kind of short-termism, do you believe the ECB or the European 

regulators even have the appropriate level of data to know how 

deep not only their banking crisis is but other financial instruments, for example, exposure to Greece? So, you know, if you think 

about ring-fencing, do they even know the size of the problem? One 

of the challenges I think we have still got in this country, number 

one. 

Number two, what will be some of the markers that we should 

look at? I know the Germans are now grappling with the decision 

on what will be the trigger mechanism to make the next round of 

emergency relief—I think it is mid-October, I believe, in terms of 

the next payment, and will the Greeks meet those preconditions? 

And are the Finns, by saying they want collateral—if they suddenly take a Greek island or two as collateral, will everybody else 

kind of get in line as well on that? 

Then, three, I would just like a quick comment on some of these 

immediate actions today in terms of what I think Dr. Lombardi 

was referring to, trying to kind of lever up this emergency fund 

that the French Foreign Minister mentioned. So, you know, do they 

have the data? What are the metrics in terms of what we should 

be watching for as the triggering events? And, you know, will there 

be anything we will see even in advance of the middle of October 

of actions being taken? In whatever order. 

Mr. VE ́ RON. Maybe I will start very briefly on the question—— 

Senator WARNER. If I could just again, because I want to make 

sure all my colleagues get time, if you could answer relatively briefly to all these. I have got a lot more questions, but I want to make 

sure they get a chance. 

Mr. VE ́ RON. Very briefly on the data, of course, there is never 

enough data, and there has been some improvement with the latest 

round of stress tests where the disclosure part of the stress testing 

was a much better quality than the previous round, so the latest 

round was July 2011, the previous in 2009 and 2010. The stress 

testing itself was not very harsh, but disclosure was valuable. 

I think, however, the contagion we are witnessing is not reducible to something we can analyze, that we can model with, you 

know, equations. If you look at the contagion patterns to Italy in 

July, to French banks in August, which are the two latest dramatic 

developments of the euro zone crisis, I do not think they can be 
15 

well captured by an analysis of the direct exposures, of the direct 

financial interdependence. Even so, it is important to know them, 

the sort of numbers you showed on the two slides. There are many 

other things at play, including the political factors. In a way it is 

what makes the situation so difficult right now. 

Take a country like Italy. You look at it objectively, frankly, it 

has a primary surplus. It has a fiscal situation which is characterized by high debt but also quite sound in terms of fiscal management. But because of all the uncertainty in surrounding factors, nobody can be sure that this is enough. 

Senator WARNER. Thank you. 

Mr. FELS. All right, Mr. Chairman. Well, on your first question, 

I think that, you know, does the ECB—do the regulators know 

enough? I think the good news is that Europe is still a largely 

bank-financed system, so about 80 percent of all the loans to the 

private sector come from the banks rather than from the capital 

market or the shadow banking system. So in that sense—and the 

regulators and the ECB know a lot about what is going on in the 

banks due to the stress tests. So I think they have a very good 

grasp of how deep the problem in the banking sector is. And, again, 

this is what really matters for the euro area economy. 

The bad news is, Where does the capital come from to recapitalize the banks? I think we all agree with need bank recapitalization. The problem is in many of these countries, where the capital 

would have to come from the sovereign, from the national government, these governments do not have access to the capital markets 

anymore, so they do not have the money. And so far it is very difficult to explain to the taxpayers in the stronger countries, Germany and others, that they should put capital into the peripheral 

banks. There is strong resistance in those countries to recapitalize 

their own banks because, obviously, people are angry with the 

banks, given that we had a major and still have a major crisis. It 

is even more difficult for them to explain that they should put capital into peripheral banks. 

Then your question on Greece, will they get the next tranche, 

and, you know, will the EFSF changes, the rescue fund changes go 

through parliaments? My answer to both questions is yes. Greece 

has come up with additional measures. I think it is very unlikely 

that Greece will be allowed to fail in the near term. Nobody has 

an interest in that. So it looks as if Greece will get its next tranche 

in October. 

On the EFSF changes that have to go through national parliaments, I am also quite confident that these changes will go 

through by the beginning or the middle of October, and then I 

think the real problems only start then, because then when the 

EFSF will be able to put money—or to lend to governments so they 

can recapitalize their banks. When the EFSF will be allowed to buy 

government bonds in the secondary market, there may be a bigger 

incentive among some politicians to let Greece go bankrupt because 

the view would be that we will be able to ring-fence this. 

I do not believe that the ring-fencing will be possible. I think the 

EFSF is not big enough to do that, and I think it would be a major 

mistake if we would allow Greece to go bankrupt over the next couple of years. But the thinking may be very different in some polit-
16 

ical circles, so this is a key risk to watch, once the enhanced EFSF 

has come into action in mid-October or early November. 

Senator WARNER. Thank you. 

Mr. Lombardi? 

Mr. LOMBARDI. Thank you, Mr. Chairman. 

In terms of the data, I would say that in continental Europe 

there is a good wealth of data. The Bank of Italy has a credit registry, so we know perfectly well, almost perfectly, how the banks 

have allocated their portfolios. I think the same is true in France 

with the Banc de France, and these systems are very much relying 

on banks rather than intermediaries outside of the banking system. 

So data-wise, I think the ECB more or less, you know, is in good 

shape. 

Turning to your other points, Mr. Chairman, the EFSF has a potential capability of 440 billion euros because roughly 175 of them 

have already been committed in some way or another. The residual 

will not be able to even fund a program for Italy should, you know, 

Italy for some reason be unable to borrow from the financial markets. And for that matter, 1 year of the Italian funding needs currently standing at roughly 235 billion a year would also deplete the 

IMF capabilities. 

So this is why it is important that the EFSF is able to exceed 

an ECB credit line, so just—line of credit, sorry, so just, you know, 

enhancing the EFSF but without enabling the EFSF with the needed financial capability would essentially be almost unhelpful. 

The EFSF could be used as a device to recapitalize the European 

banking system so to make banks to be in a better position once 

a substantial part of the Greek debt will have to be written off in 

terms of—in order for the Greek economy, you know, to rebound, 

of course, in exchange of strict conditions and in exchange of some 

commitments from the Greek authorities. But certainly the EFSF 

could be used well beyond its current capabilities if, you know, the 

euro area parliaments were to act in that direction. 

Senator WARNER. Dr. Foster? 

Mr. FOSTER. Yes, Senator. In terms of the exposures, I am reasonably confident the ECB and the IMF have very good data as to 

the exposures of the banks to the direct threats. But, as you alluded to in your remarks, sir, it is the indirect exposures that are 

the risk. You may think you are holding a perfectly good asset, but 

it turns out the company you own through asset is itself in trouble 

because it holds too much bad debt. We have read a lot over the 

years about how much of this risk has been hedged through use of 

credit default swaps. CDS does not eliminate risk. They shift it. To 

whom? We do not know. That is the issue. 

The issue is also only contextualized by the numbers. The real 

driving force is confidence. That is the lifeblood of financial markets, people trusting each other and what is going to happen. 

Remember back in 2008 in the peak of our crisis, fully solvent 

large banks stopped talking to one another. Markets broke down 

because of a lack of confidence in basic business arrangements. It 

is a psychological matter, and it could be triggered by anything— 

a bad soccer match. It could be triggered by an event where some 

politician makes an unfortunate statement. But whatever it is, it 

is a question of psychology. Greece primarily, but other nations in 
17 

the periphery as well, are hanging by a thread, and that thread is 

being eroded as the confidence erodes. When it goes it is hard to 

say. 

One last note about Greece. I think there is no question that if 

Greece were to default or spin out of the euro, the consequences for 

Greece would be terrible. The consequences for Europe would be 

terrible. It does not change the fact, in my opinion, that this is inevitable. It is only a question of time. And the reason for that is 

very simple. It is not a question of fiscal matters. It is not really 

a question of finance. It is a question of the fact that Greece’s cost 

structure, wages and prices, are grossly out of line with their productivity. They cannot possibly produce the trade surpluses with 

their current cost structure necessary to pay off their foreign creditors. That is not a question of financing. 

There is one way it could occur, and that is if the German people 

were willing indefinitely and with unknown amounts to bankroll 

the Greeks. I do not see that happening. 

Senator WARNER. With that, I am going to turn to Senator 

Johanns, recognizing that Dr. Foster said, you know, this issue 

about confidence. And I was a bit taken aback when he said that 

occasionally a politician might make an ill-suited comment. 

Senator JOHANNS. Be careful. 

Mr. FOSTER. Not the Members of this Committee, sir. 

Senator JOHANNS. I remember during the height of the financial 

crisis of a few years ago in the United States, I was visiting with 

a president of one of the major banks, and the bank is still operating today. I was probing as to the condition of the bank, you 

know, the capital and a whole host of things, you know, what is 

the loan portfolio like, et cetera. And kind of at the end of it, I said, 

‘‘So how do you feel about your current situation? How do you feel 

about the security of the bank?’’ And he said, ‘‘You know, Senator, 

when a run starts, it is very hard to stop.’’ And it was to me a very 

telling comment that you could have a secure financial institution 

that seemed to be doing all the right things, and I believe today 

they were. But what he was saying is when things start going 

downhill, they really can go downhill very quickly. 

I saw that because I would like to offer a perspective, and then 

I would like your reaction to it. Certainly we go to Greece and we 

see the challenges there, and, Dr. Foster, I found your comments 

to be very interesting. Something bad is going to happen. We just 

do not know how bad and to what extent. But we know something 

bad is going to happen. But to have Greece out there that, I agree, 

how you get this country competitive is a significant issue. But it 

does not stop with Greece. It is Spain and Portugal and potentially 

Italy and potentially France. And once the run starts, where do you 

stop it? 

Now, my experience with the European Union is that it is even 

hard to define the structure. Those who work there and are experienced in it could probably give us 2 hours of what the structure is. 

But what is it? It is a governing body that, by and large, operates 

on consensus, and when they want to change the treaty, they have 

this very cumbersome process. 

So you lay out the pathway, and then you say, ‘‘But they have 

got to change the treaty, and here is what they have to do.’’ And 
18 

I am thinking, holy smokes, that is like amending the Constitution 

of the United States. This does not happen anytime soon. That is 

why we do not do it very much. 

And so I look at all of these things that are happening, and then 

I add in this factor—and, again, this comes from our own experience in the United States. There is a point at which you are asking 

your strong countries to bail out weak countries who maybe have 

better social benefits, better whatever, and those strong countries 

with their citizens are saying, ‘‘Excuse me? Why? Why would I, 

who worked so hard, be forced to do that?’’ 

And then the final thing I wanted to mention—and then I will 

ask for your reaction to what I have said—is it just occurs to me 

that if part of the key here is to recapitalize the banks, where do 

you find the capital, number one? And, number two, how do you 

muster up the willingness of the citizens to tolerate that? Much 

like we ran into here in the United States, there is a point at which 

the population, our constituents just say no, enough is enough, no 

matter what the consequences are. 

Adding those factors in, where am I missing the point here? 

What about my analysis of this is not accurate or misses the mark 

here? Dr. Foster, I will start with you. 

Mr. FOSTER. Thank you, sir. I do not think your analysis misses 

the mark hardly at all. The question ultimately will be, as I noted, 

the recapitalization of the banks. When that occurs—likely not 1 

minute before it has to. When that will be we do not know. Where 

the capital will come from is the big question, but the European 

tradition and, in fact, our own in the recent crisis, says it is going 

to come from the governments. Simply put, the governments are 

going to own the banks. Germany can do that. France can do that. 

They have access to capital markets. I suspect Italy will be able to. 

What Greece is going to do, and some of the peripheral countries, 

is another matter. But one way or another, that is how you address 

the financial system. You had insolvent banks. Now you have solvent banks. They are owned by the government. Why would Europeans tolerate this? Well, the Europeans, frankly, are more tolerate 

of governments owning financial institutions than we are. When we 

do it, the expectation is that the banks will pay back the money 

and so will get rid of the public ownership. AIG is trying very hard 

to become a private institution again. The banks that received 

TARP funds tried very hard to give the money back, and that was 

our policy as well as a Nation. 

The Europeans—I am not sure how anxious they are going to be 

to resell those financial institutions. But that is where the capital 

is going to come from; ultimately it is going to be from the governments. 

Why would the strong continue to bail out the weak? They would 

do so as long as they think they are sustaining a sustainable system. There is something to the European vision that is widely 

shared across the continent. It may not be always comprehensible 

to Americans, but we have to acknowledge its existence, and they 

will defend it, to a point. I think it is pretty clear that point has 

been reached in Germany, in Finland, and some of the other countries. And so I do not expect this to continue. They are going to 

have to find a resolution pretty quick. 
19 

Senator JOHANNS. Mr. Lombardi? 

Mr. LOMBARDI. Thank you, Senator Johanns, for your question. 

I would say I think in the current context of the euro area crisis, 

there has not been an even perception of the benefits of the single 

currency. So in a way it is the politicians’ jobs, I would say, to highlight to their own national electorates what the benefits of the current European projects have been and are and can be in the future. 

I mean, it is a very hard job to do, but it really hinges on the European senior political leadership. 

I think if Chancellor Kohl had called a referendum on the euro 

or on the European single market, I doubt that the national electorates of the various euro area countries would have ever voted 

yes. And yet, you know, over several decades of sustained economic, 

financial, and political integration, I think that there have been 

substantial benefits overall that this crisis should not obscurate. 

Clearly there is more than a perception, the reality that the peripheral economies, including even Spain, you know, other economies like Ireland, have benefited from low interest rate policies 

that they were able to access thanks to the single European currency. But I think also Germany—and I am referring to Germany 

because it is always the strong country that is very competitive, of 

course, with a very sound fiscal stance. So this is why I am referring to Germany. Even Germany has benefited from the single currency. Germany has been able to run current account surpluses in 

proportion of GDP even higher than those of China but, however, 

without the compensating mechanism given by the appreciation of 

the currency, because being part of a monetary union, of course, 

the euro did not rise as it should have if Germany had its own currency. So, in a way, Germany has benefited from a sort of hidden 

subside through the single currency as much as, you know, other 

countries have also benefited from some other forms, perhaps not 

so hidden, of subsidies. 

In a way this is the benefit of creating a single market, so there 

are benefits for all in different forms. Some are more evident, other 

times less evidence. But there are for all. 

In terms of the other levers that politicians could leverage in Europe, I have here the projections that the IMF has released a day 

ago, and, again, Germany last year grew at 3.6 percent, which is 

a rate of growth that, I would say, used to be pretty normal in the 

United States, maybe even low-ish, but it was really extremely 

high compared to European standards. This year Germany will 

grow at 2.7 percent. Next year and the next again, it is going to 

grow at 1.3 percent. 

So, of course, Germany is being affected by the crisis. German 

consumers will have, of course, less resources to spend compared 

to what they would have had otherwise. But in the end, again, everything, you know, hinges on the political leadership sort of explaining very difficult things to their own national electorates. 

Just one more quick point on Greece, if I may. I understand the 

reasoning made by Dr. Foster, and, you know, as an economist, 

there is certainly substance to it, I have to acknowledge. But at 

this moment I think entertaining the idea that Greece could be 

exiting the euro area would just be destabilizing because it is going 

to be impossible really to draw the line. You know, after Greece, 
20 

is there going to be any other country that will leave the euro area? 

And where are you going to put Italy or Spain? 

So I think the emphasis should be in stabilizing the Greek situation by perhaps leveraging on the EFSF to strengthen the balance 

sheet of the banks, and then perhaps in the medium term certainly 

there should be at least an institutional framework allowing the orderly exit of some countries who voluntarily want to leave the euro 

area. But right now I think it would just be destabilizing and 

would just trigger contagion and further destabilize the prospect 

for exiting from this crisis. 

Thank you. 

Senator WARNER. I am going to go to Senator Bennet, and maybe 

he can start with Mr. Fels or Mr. Ve ́ron. 

Senator BENNET. Sure. Thank you, Mr. Chairman. 

I have two questions I will get out here. Mr. Fels, when you had 

your list of the things that would be required for—in order to accomplish them would require treaty changes, was the bank recapitalization on that list? Or it would require treaty changes to do 

the—— 

Mr. FELS. No. Bank recapitalization does not require treaty 

changes. 

Senator BENNET. OK, so it was my—— 

Mr. FELS. The other changes do, but bank recapitalization should 

be relatively easy to do. 

Senator BENNET. OK. And the other smaller question I had was 

on Italy, Mr. Ve ́ron or Mr. Fels. In trying to understand the domestic politics of the countries there, when you think about Italy and 

who holds the Italian debt, I gather 50 percent of it is held by 

Italians and the rest by others, but the first question is: Do you 

know, do we know? And the second is: If banks like the large German banks own a lot of that paper, how does that inform the decisions about recapitalizations and the politics of the work going forward? 

Mr. FELS. Senator Bennet, if I may start on the Italian question, 

slightly more than half of the Italian debt is held abroad. We pretty much know where it is. It sits largely with banks in the rest of 

the euro area, but also in large portfolios here in the United States. 

and the rest of it is owned by Italian banks and Italian citizens. 

The Italians have a very high savings ratio, so Italy is country that 

has, you know—it is a poor state or a poor government, but rich 

citizens with a savings rate of around 20 percent of disposable income year after year. The comparable number here in the United 

States is now 5 percent, and that has gone up a lot over the 

last—— 

Senator BENNET. It was zero. It was zero. 

Mr. FELS. It was zero before the crisis, correct. So I think we 

know where the debt sits, and the issue with Italy is that, as I am 

sure you are all aware, Italy is the third largest bond market in 

the world, and it is the largest bond market in terms of bonds outstanding in the euro area. It is larger than Germany. It is a smaller economy, but they have a higher debt ratio. So Italy is too big 

to fail. If Italy fails, then I think it is game over, and that would 

be a major financial crisis. I think Lehman would pale in comparison. Everybody knows that. 
21 

The other problem is Italy is not only too large to fail, it is also 

too big to rescue because there is nobody around in the euro area 

who could, you know, bring up the money to bail Italy out. This is 

why it is absolutely crucial to follow what is happening in Italy. To 

me, Greece has become a sideshow. 

Senator BENNET. Exactly. 

Mr. FELS. This is really about Italy. 

The encouraging thing—now, I said a lot of things that, you 

know, may have depressed you, but the encouraging thing is we 

have seen considerable responses in Italy. This Italian Government 

has responded. They have come up with additional fiscal savings. 

They have agreed to put a balanced budget amendment into their 

constitution. Now, that has not happened yet, and they are still debating how. But this is something that has happened. And I am actually quite confident that Italy can get through this for a simple 

reason: they have done it before. Italy managed in the 1990s, before the euro started, to push through very significant pension reforms that put the country’s debt on a sustainable level, and this 

will play out over the next 10 to 20 years. And so Italy has a high 

inherited debt-to-GDP, but its long-term trajectory is much better 

than that of most other countries of—and that is a big ‘‘if’’—they 

can continue to fund at reasonable interest rates. That is the big 

question, and this is why this contagion has to be stopped, and this 

is why the ECB buying is playing a very important role here. 

Mr. VE ́ RON. I think what Mr. Fels just said is very important. 

European countries have shown a significant ability to reform, including to accept painful reforms, with different levels in different 

countries, but if you look at certainly the most graphical examples—Latvia, Ireland, they have taken exactly painful economic 

medicine and with a very stoic population not only the decisionmakers. 

I think Portugal and Spain also have very much owned up to 

their crisis. They have gone way past the stage where they blame 

it on foreigners or outsiders. They really, you know, understand 

that they have to take the bitter medicine, and they are taking it. 

I agree with a lot of things that Dr. Foster said, but I do not 

think there is anything mechanistic or deterministic in these dynamics. If you look back a decade, many people were saying Turkey 

and Brazil are basket cases, there is no way they can get out of 

their predicament, and they did. So I am not saying that—I mean, 

of course, the question is: Can Greece avoid debt restructuring? I 

am not sure I can answer yes to this. But to the more general question of ability to reform and take painful measures, I think it is 

higher than how it is sometimes depicted both in Europe and outside Europe. 

Regarding Greece, they announced yesterday some very, very significant measures of adjustment, which will be painful, which will 

be depressing on growth, but I think were necessary. 

I would also say on this account that the electoral dynamics are 

not as dire as perhaps sometimes they are described. There has 

been a lot of press coverage, rightly so, of populist parties gaining 

ground in Europe, but they remain very much in the minority. If 

you look at the German opposition, they are more pushy on EU integration and solidarity with the Greeks than the ruling coalition. 
22 

So it is not the case—even when the coalition has a problem in parliament, it is not the case that that means there is just a minority 

willing to go further with EU joint action in Germany. 

Of course, this is one political cycle. The next political cycle 

might be different, and I think we have to be very cautious on medium-term political assessment, but I think it is important to mention these facts. 

As regards recapitalization, I think we all see the paradox—it is 

a Catch-22, right? The big risk right now for the banks is the solvency risk for euro zone countries. So the bank capital assessment 

is dependent on the solvency assessment of these countries. So the 

two are completely linked, and there are banks which say, well, 

Italy is solvent so why should I mark-to-market Italian debt? There 

is no point of doing that. And it is a very difficult cycle to break. 

I will only say that, yes, there will be probably some need for 

public capital eventually for the recapitalization of the European 

banking sector, but I think there are two crucial questions which 

will vastly affect the shape of the outcome. One is, are cross-border 

acquisitions possible in Europe in the banking system? There is a 

lot of economic nationalism, especially in the banking system in 

many European countries, including, I must say, my own. If politicians in those countries realize that they have to deliver on the vision of an integrated banking market and that, say, the acquirer 

of an ailing French bank may be a Spanish bank or a German bank 

or a U.K. bank or a U.S. bank, then we have a very different picture than the picture we have if there is the constraints that any 

merger and acquisition have to be inside individual countries. And 

also in terms of the public capital, we said, national governments, 

now that the EFSF has been explicitly also raised to intervene in 

the banking sector, at this point indirectly through loans to individual member states for them to restructure their banks, I think 

at some point we will start discussing the injection of EU money 

as opposed to national government money, and this will also bring 

to it a different picture, of course, with a lot of difficult political 

issues involved. 

My last point on this is on Greece. There are scenarios in which 

a disorderly Greek debt restructuring would force an exit from the 

euro zone, and this cannot be ruled out because some of these scenarios are very serious. 

Now, I think the trick with Greece will have to be how to restructure the sovereign debt without Greece exiting the euro zone, in 

spite of the temptation, of course, as an economic boost of devaluation in the short term and so on. But I think my hunch and my 

expectation is that the contagion from a euro exit would be so impossible to manage that leaders in the end will do their best and 

may succeed in having a Greek debt restructuring, if this is really 

necessary—which it may be—while keeping Greece inside the euro 

zone. This requires very hands-on extraterritorial, I mean supranational instruments on the Greek banking system. It is an absolutely necessary condition. But it may happen. 

Senator BENNET. Thank you, and I appreciate the answer. I am 

going to ask a question with the Chairman’s indulgence, and then 

we will answer it. 
23 

One of the things that I am worried about in our country is that 

we have seen periods of growth in the 1980s and the 1990s where 

there was a relationship between the growing GDP and growing 

wages and growing jobs. And we saw a decoupling of that during 

the decade before this recession happened, and we are seeing in 

this recession here a deepening of that disconnect between growth 

and job creation and income. 

I wonder, in thinking about the political cycles that Mr. Ve ́ron 

was talking about, whether you could give us a picture of what that 

looks like in Europe. There was a lot of discussion here about the 

program that Germany had in place to keep people employed during this downturn about a year or two ago. Is there any insight you 

can give us on what that looks like? Is the cycle we are seeing here 

repeating itself there? Mr. Lombardi, do you have—— 

Mr. LOMBARDI. Thank you. Yes, this is indeed a very crucial 

issue because right now the Europeans, of course, the peripheral 

economies under stress, but also all the other economies have embarked on fiscal retrenchment programs just fearing what may be 

happening to them if they would not do so. 

Clearly, this implies, you know, lagging demand with effects on 

jobs, and in a way the euro area has always focused on, you know, 

fiscal stability. But there has never been enough emphasis on 

structural policies, on, you know, enabling the euro area economies 

to grow more. And now we are in a way—you know, they are paying the price. 

Just to give you a more concrete example, there is now in Italy 

a lot of emphasis on achieving this balanced budget objective. Of 

course, this is certainly something that the Italian authorities 

would need to embark on. But yet if the public debt sustainability 

is the main issue, that does not come from a balanced budget because the Italian public finances have been run in a pretty conservative way over the latest decade. The crucial issue is the very low 

rate of growth. Clearly, if the economy grows at a very low rate and 

you have a high and increasing public debt stock, there is no way 

the economy in the very long run can be solvent. 

And at the European euro area level, there have been a lot of 

discussions on keeping the fiscal deficits shrinking, but there has 

never really been enough emphasis on these other crucial aspects, 

also important for the fiscal sustainability in the long run. And, 

clearly, this has alienated a lot of consensus, and I have to say that 

right now there has been no lesson learned in a way because what 

euro area governments have committed to, in a way well before 

that we would achieve this kind of escalation of the prices, was fiscal retrenchment across the board. So even countries in a better position, they have focused on fiscal retrenchment, and, again, there 

has not really been enough emphasis on creating jobs, and this is 

why the euro area economy as a whole is performing very poorly 

in terms of its own potential rate of growth. 

Senator BENNET. Thank you. Thank you very much for your excellent testimony. 

Thank you, Mr. Chairman. 

Senator WARNER. Thank you all. Let me just as a brief question, 

and then if any of my colleagues would like to ask another brief 

question. I think Senator Johanns made an interesting comment 
24 

earlier when even those of us who take an interest in trying to understand, you know, all the EU mechanisms, it sometimes seems 

probably as challenging as understanding the American congressional processes. 

We do have another chance in the United States now before the 

end of the year through this so-called Super Committee to set a 

process in place. And I agree with Dr. Foster so much about the 

issue of confidence. We do not know what will spark something 

that could lead to this contagion. 

What should we be—between just now and the end of the year— 

we have not even got to long-term structural, but what are the 

events or things that as American policymakers we should be 

watching for to see if progress is being made? Obviously, the next 

tranche of the Greek relief, but are there other events or markers 

that we should either say, Aha, we are moving in the right direction, oh, my gosh, or should further evidence be on the 486-point 

drop we just had today of, oh, my gosh, this may be getting worse? 

Mr. VE ́ RON. I think there is a temptation to put Germany in an 

even more central position than it is, but actually it is central right 

now. It is a pivotal country. So I would suggest watching very 

closely the German internal debate, including perhaps spending a 

bit on translation, to understand what are the currents and undercurrents in the German debate. I think it is moving perhaps too 

slowly, but it is moving in directions which are encouraging, with 

a lot of uncertainties, and ultimately the German debate will have 

a huge impact on what gets done or does not get done. 

Senator WARNER. And when will that conclude? 

Mr. VE ́ RON. There is a bunch of parliamentary votes that are 

planned. There is obviously at each time that the German constitutional court has to give a ruling, it is important. But I would also 

watch indicators like, you know, what do senior figures in the German business community say, how do, of course, parties, change 

their stance or not change their stance. So it is a lot of moving elements, and I acknowledge that it is very complex to watch from 

outside. But I think it is crucial. 

Senator WARNER. Just very briefly, any other markers we should 

look—because I want to make Senator Johanns gets another round, 

and we are going to have to conclude around 4. 

Mr. FELS. Just one thing. The crucial vote in Germany on the 

EFSF, the changes, is on the 29th of September, and I agree we 

need to watch that very closely. And then after that, after the 

EFSF is—the reforms are in place, I would really watch the bank, 

how we are progressing on bank recapitalization because I think 

that is at the core. 

If the new EFSF will be used to recapitalize some of those banks 

in the weak countries through their governments, I think that 

would be a very, very positive sign. 

Senator WARNER. And you think that process can start before the 

end of the year? 

Mr. FELS. It can start before the end of the year. I think the regulators will be pushing it as soon as the reformed EFSF is in place, 

which should be around mid-October. 

Mr. LOMBARDI. Mr. Chairman, I would say in the immediate I 

will be looking at, of course, Germany, would also be looking at 
25 

Italy for the simple reason that the government has issued to us 

budget supplementary plans in less than 2 months. But now they 

are working on a third supplementary plan just because the previous one, which was approved by the parliament days ago, and 

then, you know, the following day Italy was downgraded by Standard & Poor’s, of course, relying on growth projections that were in 

a way exceedingly overoptimistic. Now these growth projections 

have almost been cut in half, and, of course, the plan that the government was confident would allow it to achieve a balanced budget 

in 2013 does not any longer have a basis. 

So there is already a shortfall which has already been assessed 

by the IMF, and the authorities are working on a third supplementary plan. 

However, this also highlighted the lack of a comprehensive strategy, at the European level but also in Italy, because you cannot 

clearly tackle the crisis from month to month issuing a budget supplementary plan each month. 

In the more medium term, again, by the end of the year, which 

was your timeframe, I would also look in Germany at the German 

parliamentary discussion on the European Stability Mechanism 

that is the mechanism which will succeed to the EFSF for the simple reason that there was a few days ago a decision by the German 

constitutional court that would prevent Germany from joining any 

permanent rescue mechanism. And the EFSF is a temporary mechanism and will be replaced by this ESM, European Stability Mechanism, which is permanent in nature. And, therefore, as currently 

we think, the German participation to this new mechanism—the 

German constitutional court has decreed that would be unconstitutional. 

Senator WARNER. Dr. Foster, and then Senator Johanns will get 

the last questions. 

Mr. FOSTER. Yes, sir. Very quickly, following up on this last 

point, the issue really is Germany. The real issue is the constitutional court decision. What they decided almost looked like it was 

written by Angela Merkel herself, because what it said was that 

the budget committee of the Bundestag must be consulted if there 

is any more German funds to be used. Well, basically what that is 

saying is this is a way for Germany to say no without the problem 

landing in Angela Merkel’s lap. They now have the ability to say 

no, and she will not be blamed. 

Senator JOHANNS. This is going to be a bit of a general question, 

so I will just warn you of that as I think about all these moving 

parts and pieces and what has to happen and trying in my mind 

to prioritize what is absolutely critical from something that maybe 

is not. 

Can you describe for me what I would say would be a tipping 

point? Is there an event out there that you are anticipating must, 

must happen to set up the line of defense, and if it does not happen, all of a sudden it is the catalyst that things really start unraveling and will be very hard to corral, if you know what I am saying? Maybe I will start at this end. 

Mr. VE ́ RON. Well, I would say two things. One is something that 

would look like what Secretary Geithner suggested apparently in 

his discussions with the European Finance Ministers last weekend, 
26 

which has been mentioned in this panel, i.e., access to ECB liquidity for the EFSF. I think this could be really something that would 

stabilize the market situation enormously. 

And on the banking side, a clear signal by euro zone governments that they are ready for a truly European banking system, 

for decoupling their national banking system from the national sovereign. And this takes various dimensions. Some of them are mentioned in my written statement, but I think it is basically a political statement that the era of national banking systems within the 

euro zone is over. 

Mr. FELS. My answer is very similar. The EFSF changes have to 

come through over the next 4 weeks. The EFSF has to be leveraged 

up, so to increase its size by access to ECB funding. 

And my last point is bank recapitalization has to happen. I think 

that is crucial, and it can happen once the EFSF is reformed and 

is larger. And as I said earlier, the bank recapitalization, that is 

what I am watching. 

Mr. LOMBARDI. I would say that over the next few weeks we will 

be watching a possible escalation of the crisis in the Italian bond 

markets, and this will come with an increasing weakening of the 

several large financial institutions, European financial institutions. 

And that could provide a tipping point for really a quantum leap 

in the political debate that we have been watching in Europe. 

I think we have not reached that tipping point, and I think once 

a systemic economy of the euro area comes under hit, this will generate—this hopefully will generate a new perspective in the political debate at the euro area level, and this trigger, this tipping 

point, I think will come from intensification and escalation of the 

crisis in Italy. 

Mr. FOSTER. Senator, I think all of what my co-panelists said I 

would agree with. I would only add that if Greece were somehow 

denied its next tranche of help, that would certainly be a major 

event. I do not expect that to happen. Europe will find a way to 

rewrite its rules to make sure Greece gets the money. 

While I cannot tell you the date, I can give you a bit of the timing—24 to 48 hours after we have an unpleasant, unexpected event 

from some direction we were not anticipating, something nobody 

was looking for that will so unsettle the markets, that will trigger 

the contagion. I cannot tell you what it would be. It could be a financial institution suddenly finding that one of their traders committed $2 billion of bad trades—UBS, for example. It may not be 

Greece. A Spanish provincial government that suddenly decides, 

oh, we have been running much larger deficits than we were telling 

the central government, as we saw a few days ago. 

Any one of these kind of events—a shock from an unexpected direction—24 to 48 hours later the balloon is up. 

Senator JOHANNS. Let me just say that was very, very helpful 

testimony, and I really appreciate you taking time this afternoon 

to work with us and give us your best thoughts on this. 

Senator WARNER. Let me just add as well, this has been sobering, but I think you have given us some of the markers. I would 

love to—I am going to look through your testimony. Maybe we can 

continue this conversation as we think as well about—we have focused on the immediate, the intermediate, and longer-term struc-
27 

tural changes and how—not to be answered because we have to 

break now—but how we in the United States can be helpful to our 

European friends and allies in that process, but, boy, oh, boy, anyone that denies the interconnectedness that we are all in this together, I think that would—I would hope they would listen to this 

presentation today. It has been excellent testimony, and again, I 

thank my colleagues for joining me in this. 

Thank you, gentlemen, and with that the hearing is adjourned. 

[Whereupon, at 4:04 p.m., the hearing was adjourned.] 

[Prepared statements and responses to written questions supplied for the record follow:] 
28 

PREPARED STATEMENT OF NICOLAS VE ́ RON 

VISITING FELLOW, PETERSON INSTITUTE FOR INTERNATIONAL ECONOMICS, AND

SENIOR FELLOW, BRUEGEL

SEPTEMBER 22, 2011 

Thank you Chairman Warner, Ranking Member Johanns, and distinguished 

Members of the Subcommittee for the invitation to appear at today’s hearing. The 

European crisis is entering a critical phase as policy initiatives undertaken so far 

have not prevented systemic contagion. I will concentrate my remarks on the role 

of Europe’s banking system in the crisis, the steps needed at the European level for 

the crisis to be resolved, and the short-term outlook. 

I currently work both at Bruegel and the Peterson Institute, on a half-time basis 

in each organization, and divide my working time between Europe and the United 

States. Bruegel is a nonpartisan policy research institution that started operations 

in Brussels in 2005 and aims to contribute to the quality of economic policymaking 

in Europe through open, fact-based and policy-relevant research, analysis and discussion. The Peter G. Peterson Institute for International Economics is a private, 

nonprofit, nonpartisan research institution devoted to the study of international economic policy. The views expressed here are my own and not those of the Peterson 

Institute or Bruegel. I have no financial or commercial interest that would create 

a bias or conflict in expressing these views. 

The key points of my statement are the following: 

• First, Europe’s banking system has been in a continuous stage of systemic fragility since 2007–08, in contrast with the United States where banking crisis 

resolution was swifter and was essentially completed in 2009. The inability of 

European policymakers to resolve their banking crisis so far can be explained 

by deeply embedded features of their respective countries’ financial systems and 

political economy structures. 

• Second, the current phase, which is often described as a sovereign debt crisis, 

is really a sequence of interactions between sovereign problems and banking 

problems. Had Western Europe’s banks been in a better shape a year and a half 

ago, the policy approach to the Greek debt crisis would have been entirely different, possibly allowing for a much earlier sovereign debt restructuring. So the 

situation is best described as twin sovereign and banking crises that mutually 

feed each other. The result of this interaction is a gradual contagion to more 

countries and more asset classes. 

• Third, the crisis has exposed a major deficit of executive decisionmaking capability in the EU and Eurozone institutional framework, which helps to explain 

the insufficient policy response. It can thus be said that the banking and sovereign crises are compounded by a crisis of the EU institutions themselves. Specialized European bodies, primarily the European Central Bank (ECB), have 

partly bridged this gap with policy initiatives that go beyond a narrow reading 

of their mandate, but they could do so only to a limited extent that has not been 

sufficient to stop the contagion. 

• Fourth, a successful crisis resolution will need to include at least four components at the European level, in addition to steps to be taken by individual countries: (a) fiscal federalism, i.e., mechanisms that ensure that fiscal policies in 

the Eurozone are partly centralized with shared backing across countries so as 

to meet the requirements of monetary union; (b) banking federalism, i.e., a 

framework for banking policy at the European level that credibly supports the 

vision of a single European market for financial services; (c) an overhaul of EU/ 

Eurozone institutions that would enable fiscal and banking federalism to be 

sustainable, by allowing centralized executive decisionmaking to the extent necessary and by guaranteeing democratic accountability; and (d) short-term arrangements that chart a path toward the completion of the previous three 

points, which is bound to take some time. These should involve expanded instruments to intervene in the banking sector and to provide interim funding to 

struggling Eurozone governments, taking into account the possibility of insolvent member states having to undergo debt restructuring. 

• Fifth, these requirements for crisis resolution cannot be met unless political 

conditions change sharply in their favor. This leaves the United States exposed 

to a risk of financial contagion, which it can partly mitigate with adequate contingency planning and proportionate precautionary measures. The United 

States can and should also continue to play a constructive role by providing advice to its European partners, and thus helping them rise to the momentous 
29 

challenges they face. However, only the Europeans themselves can solve their 

current predicament. 

I would not want these remarks to sound unduly pessimistic. In the U.S. public 

debate, one frequently hears the Eurozone described as an inherently unsustainable 

experiment, and European nations as incapable of reform. Such dark depictions of 

the European situation are unhelpful and misleading. European monetary union is 

certainly an experiment, but it is not doomed to fail: Eurozone countries have shown 

and are showing an extraordinary degree of political commitment to perpetuate 

their currency union. They have already taken very significant institutional steps 

toward more centralized economic and financial management since the beginning of 

the crisis, and are gradually accepting the need for further steps, even though the 

process is not as swift as external observers might wish it to be. Most Eurozone periphery countries have taken very serious and painful initiatives to reform and place 

themselves back on a sustainable economic track. And elections in many European 

countries since the start of the crisis have shown that the vast majority of citizens 

resist the temptation of populism and are willing to embrace the needed adjustment 

policies. 

I personally believe that the integrity of the Eurozone will be defended in this crisis and that the EU will eventually emerge from it with a stronger, more resilient 

economic and financial policy framework. But I also expect the road to be very 

bumpy, and that the Europeans will pay a high economic price for the inadequacies 

of their collective decisionmaking processes. 

The rest of this statement expands on these points and provides additional background. 

Europe’s banking crisis 

Europe has been in a continuous state of systemic banking fragility since August 

2007. This puts it in contrast with the United States where the phase of systemic 

banking crisis ended in 2009, even though the broader economic crisis has proved 

difficult to address and casts a shadow on America’s long-term fiscal outlook. One 

indication of Europe’s prolonged state of fragility is that the ECB’s extraordinary 

liquidity support to Eurozone banks (in the ECB’s parlance, fixed-rate full allotment 

in refinancing operations), introduced in October 2008, remains in place to this day. 

By contrast, the closest comparable program on the U.S. side, the Federal Reserve’s 

Term Auction Facility, was gradually phased out and expired in March 2010. Similarly, in October 2008 the European Commission’s Directorate-General for Competition Policy (DG COMP) made its enforcement practices on the control of State Aid 

to the banking sector more flexible on the basis of Article 87.3b of the European 

Community Treaty, which allows for aid ‘‘to remedy a serious disturbance in the 

economy of a member state.’’ This adaptation of competition policy to crisis times 

has been continuously in place since then, and European Commissioner for Competition Policy Joaquin Almunia recently announced that it would remain so until early 

2012 at least. 

In comparison with the United States, the European banking sector has until now 

gone only through modest restructuring as a consequence of the crisis, particularly 

in the Eurozone. Among major European financial institutions, only Halifax Bank 

of Scotland (HBOS) in the United Kingdom (U.K.) and Fortis in the Benelux countries were dismantled or forcibly merged into competitors at the height of the crisis, 

in comparison to Countrywide Financial, Bear Stearns, Lehman Brothers, American 

International Group, Washington Mutual, Wachovia and Merrill Lynch which were 

merged or restructured in the United States. Moreover, the U.S. bank receivership 

process administered by the Federal Deposit Insurance Corporation meant that a 

significant number of small- and medium-sized banks (and some large ones, such 

as Washington Mutual) were allowed to fail. In Europe, where most countries did 

not have an orderly resolution process for depository institutions in 2008–09, senior 

creditors were made whole in almost all cases of individual bank problems, and so 

were junior creditors in the vast majority of cases. 

In the spring of 2009, the U.S. Supervisory Capital Assessment Program (commonly known as ‘‘stress tests’’) identified 10 of the country’s 19 largest financial institutions as undercapitalized, and the subsequent wave of capital strengthening 

helped investors regain trust in the institutions at the core of the U.S. financial system, even as smaller banks continued to fail in large numbers in 2009 and 2010. 

In the EU, no similar process of triage and recapitalization was conducted in time 

to restore confidence. A first round of European ‘‘stress tests’’ in September 2009 

had negligible market impact as only aggregate numbers, not bank-by-bank results, 

were published. A second round of stress tests led to the publication of bank-bybank results for 91 financial institutions across the EU in July 2010, but the disclosures lacked specificity and comparability, and some institutions that had passed 
30 

the tests, such as Allied Irish Banks, were exposed as severely undercapitalized 

shortly afterwards. A third round of stress tests led to better disclosures in July 

2011, but identified only limited recapitalization needs. 

The European reluctance to accept bank failures and banking sector restructuring 

can be traced to various factors. To start with, banks are comparatively much larger 

in Europe than they are in America, compared with the size of national economies 

and even after the consolidation that the crisis has induced on the U.S. side. According to the Bank for International Settlements, in 2009, the aggregated assets of the 

top three banks represented 406 percent of GDP in the Netherlands, 336 percent 

in the U.K., 334 percent in Sweden, 250 percent in France, 189 percent in Spain, 

121 percent in Italy, and 118 percent in Germany, compared with 92 percent in 

Japan and ‘‘only’’ 43 percent in the United States. This is due to a combination of 

two main factors. First, banks generally play a larger role of financial intermediation in Europe than in the United States, where nonbank financial intermediaries 

and capital markets provide a larger share of total capital and credit. And second, 

many European banks have aggressively expanded internationally, thus increasing 

the scope of activities that, to the extent that these banks aren’t allowed to fail, are 

implicitly supported by taxpayers in the home country. On average, the largest European banks have 57 percent of their activity outside of their home country (in the 

rest of Europe and in the rest of the world in about equal proportions), while the 

average ratio is only 22 percent among a comparable sample of the largest U.S. 

banks. 

Moreover, there is a high degree of interdependence between banking systems and 

policymaking systems in most Western European countries. This interdependence 

also exists in the United States, as my Peterson Institute colleague Simon Johnson 

has repeatedly argued, and its specific forms vary widely from one country to another. In Germany, many locally elected officials sit on the boards of local public 

banks, an activity from which they typically derive a not insignificant part of their 

personal income; publicly owned banks at regional (Land) and sub-regional levels 

are often used as tools for local economic development policy. In Spain, a similar 

situation used to exist with the local savings banks (Cajas), even though this is now 

changing as many Cajas are being merged and restructured under compulsion from 

the central government. In Italy, non-profit foundations with strong links with local 

political establishments are key shareholders in most prominent financial institutions. In France, the regional component is perhaps less strong but at the national 

level, financial policymakers and bank executives tend to come from the same small 

pool of senior civil servants, and it is common practice for the former to switch to 

a high-level bank position at mid-career. In all these countries and elsewhere in Europe, this interdependence is a significant factor in the national political economy. 

Moreover, the protection granted by national governments to their ‘‘home’’ banks 

does not have to be a function of cozy links between public and private-sector elites, 

as there is also a strong component of economic nationalism at play. In most 

Eurozone countries, banks are frequently seen as national or local ‘‘champions’’ 

whose prosperity is presumed to be broadly aligned with the national interest—even 

where this presumption does not rest on specific, compelling evidence. Resistance 

to cross-border bank takeovers remains deeply entrenched particularly in France, 

Italy and Spain but also in parts of Northern Europe—even though the ongoing restructuring of the Spanish banking sector might eventually result in a change in 

attitudes there. The same factors help explain why national policymaking communities are often in collective denial of the moral hazard created by the too-big-tofail problem, as well as in denial of the conflicts of interest that are potentially embedded in the universal bank model which combines retail banking, investment 

banking, plus in many cases asset management, insurance activities, and proprietary investment within diversified financial conglomerates. In many Continental 

European countries, supervisory authorities harbor a culture that favors keeping 

sensitive information tight between themselves and the supervised entities, and are 

thus inclined to resist calls for public disclosures about financial risks and exposures, as was illustrated by controversies around the successive rounds of European 

stress tests. 

Banking crisis and sovereign crisis 

The financial crisis spilled over into a sovereign crisis in the Eurozone in early 

2010. A year before, in the first months of 2009, the tense situation of several Central and Eastern European countries had raised widespread market concerns, but 

was subsequently stabilized thanks to energetic efforts of economic reform and 

budget tightening, most remarkably in the Baltic countries, and to successful international coordination in the form of the so-called Vienna Initiative to maintain liquidity to local banking systems. The Eurozone sovereign crisis started when the 
31 

Government of Greece, freshly elected in October 2009, revealed that its predecessor 

had misled its Eurozone neighbors and the public about the true state of the country’s public finances. The ensuing deterioration of Greece’s access to capital markets 

led it to seek help from fellow Eurozone countries and the International Monetary 

Fund (IMF), resulting in the May 2010 announcement of a first conditional assistance package of EUR110bn, quickly followed by the decision to set up a European 

Financial Stabilisation Facility (EFSF) with EUR440bn financial firepower to intervene in similar situations. Simultaneously, the ECB initiated a ‘‘Securities Markets 

Programme’’ under which it buys sovereign debt of troubled countries in secondary 

markets. Subsequently, the EFSF and IMF jointly agreed to provide conditional assistance packages to Ireland (November 2010) and Portugal (April 2011), and in 

July 2011, further assistance to Greece was decided by the Eurozone heads of state 

and government. 

The interdependence between sovereign credit and banking systems has been a 

running theme of this sequence of events. Eurozone sovereign debt assets are held 

in large amounts by Eurozone banks, with a significant bias for the bonds of the 

country in which the bank is headquartered but also significant cross-border exposures to other Eurozone countries’ sovereign debt. This is partly due to policy 

choices before the crisis which in retrospect appear questionable, particularly the 

risk-weighting at zero of Eurozone sovereign bonds in regulatory capital calculations, the longstanding acceptance of such bonds with no haircut by the ECB as collateral in its liquidity policies, and possible instances of moral suasion by homecountry public authorities that resulted in large holdings of the home country’s sovereign debt. In early 2010, the concern about the possible financial stability consequences for banks in France, Germany and other countries of having to book 

losses in the event of a Greek debt restructuring was a significant motivation for 

the decision to provide financial assistance to Athens. Even though it is impossible 

to know counterfactuals, had the Western European banking sector been less fragile 

at that time, it is very possible that a different course would have been taken involving Greek debt restructuring as early as 2010, and everything afterwards would 

have developed very differently. Put bluntly, the moral hazard created by the Greek 

package is largely a consequence of the failure or unwillingness of European policymakers to resolve the European banking crisis in 2009. 

Similarly, the perceived fragility of Continental European banks is the main reason why the Irish Government was not allowed to impose losses on holders of senior 

bonds issued by the country’s banks, including the collapsed Anglo Irish Bank, in 

the discussion of the November 2010 assistance package provided by the IMF and 

the EFSF, with a strong involvement of the ECB in the negotiation of that package. 

This condition correspondingly increased the burden of fiscal adjustment for Ireland 

and remains to this day a matter of controversy in the Irish political environment. 

Conversely, deterioration of sovereign debt prospects in Greece, Portugal, and Italy 

has had a knock-on negative effect on their domestic banking systems, given local 

banks’ high levels of home-country sovereign debt exposure, as well as on French 

banks which hold large portfolios of sovereign debt from the Eurozone’s periphery 

countries. 

In the latest step to date, a relatively mild debt restructuring scheme 

euphemistically known as ‘‘private sector involvement’’ (PSI) was made a condition 

for the new assistance package to Greece whose outline was announced on July 

21st, 2011, largely because of domestic political factors in countries including Germany and the Netherlands. However, the continued banking fragility led leaders to 

go for a ‘‘voluntary’’ form of PSI that would only entail moderate impairment of the 

affected assets. This arguably results in the worst of both worlds for Greece and the 

Eurozone: a further deterioration of Greece creditworthiness (PSI being considered 

‘‘selective default’’ by the main credit rating agencies) and contagion to other 

Eurozone countries, in spite of solemn declarations that the Greek case is unique 

and would not be used as a template for other country situations; and simultaneously, a reduction of the Greek debt burden that is too limited to significantly improve its debt dynamics. 

The interconnectedness between the banking and the sovereign crises helps to explain the lack of consensus about the current capital strength of Europe’s banks. 

The official position of EU authorities and all Eurozone governments remains that, 

with the possible exception of Greece, Eurozone countries are not going to default 

on their sovereign obligations. Under this assumption, the current depressed market 

prices of periphery countries’ debt need not be reflected on the balance sheets of 

banks with large held-to-maturity portfolios of such debt, and the European banking 

sector would appear adequately capitalized as a whole. If, however, market signals 

are taken at face value, or simply if a prudential approach is applied that compels 

banks with high exposures to periphery sovereigns to hold sizable additional capital 
32 

buffers, the average level of capital strength appears seriously insufficient. Thus, 

the solvency assessment of Europe’s banks crucially depends on the view one has 

of the seriousness of the sovereign crisis. The rapidity of contagion, which extended 

to Italy in July and to French banks in August, suggests a conservative attitude is 

warranted, as the IMF is also arguing in its latest Global Financial Stability Report. 

A crisis of EU institutions 

This sequence of events highlights that European policymakers missed an important opportunity when they neglected to address their banking sector’s fragility decisively when market conditions were relatively favorable in 2009, especially after the 

success of the U.S. Supervisory Capital Assessment Program. This failure is not for 

lack of good advice: the IMF, among others, had emphasized this challenge in its 

policy recommendations to European leaders. Had this advice been taken, and had 

Greek debt been adequately restructured in the first half of 2010, we would probably not have a major systemic crisis in Europe. 

In decisions taken after May 2010, and until now, European leaders have often 

appeared to be behind the curve, and to react to the crisis’s previous stage rather 

than to the current one. The European Commission, with the significant exception 

of DG COMP (the European Commission’s Directorate-General for Competition Policy), has not been able to make executive decisions that it could impose on individual market participants. Its Directorate-General for the Internal Market and 

Services (DG MARKT) has focused on drafting new financial legislation but has devoted limited resources to its core mission of enforcing the integrity of the single 

market for financial services. Its Directorate-General for Economic and Financial Affairs (DG ECFIN) has provided valuable economic analysis, but so far has not presented a blueprint for crisis management instruments that would bring the situation under control. The Commission’s President, Jose ́ Manuel Barroso, has been 

very successful and proactive on one important occasion, when he commissioned a 

report from a blue-ribbon group led by former French central banker Jacques de 

Larosie ́re, which resulted in a major overhaul of the EU’s supervisory architecture 

(see below). But in terms of crisis management, the Commission has generally not 

been able to get ahead of events, partly because of its limited de facto decisionmaking autonomy vis-a`-vis member states (apart from DG COMP, which enjoys special status). This has left much of the action in the hands of the Council, i.e., the 

group formed by relevant representatives of the individual member states’ governments, who, being accountable as they are to their respective national constituencies, have found it difficult to overcome their differences. 

This is better analyzed as a failure of institutions than of individual leaders. A 

different set of political leaders might have done better, but the core problem has 

been the insufficient political mandate of the Commission (and of the permanent 

president of the Council since the entry into force of the Lisbon Treaty in January 

2010, Herman Van Rompuy), combined with the misalignment between the incentives of individual countries’ leaders and the collective European interest. This combination works more or less satisfactorily in ordinary times, but its shortcomings become much more apparent in a crisis environment as it does not allow for effective 

executive decisionmaking at the EU level. The ‘‘French-German couple’’ is occasionally presented as a pragmatic option to bridge the executive leadership gap, but its 

accountability and legitimacy have been insufficient to provide the required impetus. 

In the course of the crisis, individual EU bodies have occasionally found it possible to bridge part of the executive leadership gap. This has been most obviously 

the case of the ECB, particularly since May 2010 with the Securities Markets Programme of buying sovereign bonds from selected Eurozone countries on the secondary markets. However, the extent to which the ECB can go further on this path 

is not unconstrained, because it is seen by a number of constituents (notably in Germany) as a dangerous intrusion into fiscal policy that is bound to compromise the 

ECB’s independence and its integrity in delivering on its core mission of ensuring 

price stability. Similarly though less prominently, since 2008 DG COMP has leveraged its authority to examine state aid by individual member states to individual 

financial institutions to press for more aggressive recapitalization of the weaker 

links in Europe’s banking system, but its mandate has not allowed it to embark on 

a system-wide approach. 

As mentioned above, a high-level group led by Jacques de Larosie`re was formed 

in late 2008 at the initiative of the European Commission’s President, and in February 2009 this group recommended the creation of three European Supervisory Authorities to help oversee Europe’s financial sector from a pan-European perspective—respectively, the European Banking Authority (EBA) based in London, the European Securities and Markets Authority (ESMA) based in Paris, and the European 
33 

Insurance and Occupational Pensions Authority (EIOPA) based in Frankfurt. These 

supervisory authorities were complemented by the creation of a European Systemic 

Risk Board (ESRB) to coordinate macroprudential policy. The corresponding EU legislation was (by EU standards) swiftly approved and the new institutions officially 

started operations on January 1, 2011. Even though it is still early to form a judgment, the EBA has had a material impact in making the disclosures accompanying 

the July 2011 stress tests markedly more reliable than had been the case in the 

previous round a year earlier. Thus, it can be hoped that these new agencies can 

bridge part of the leadership gap in the future as they gather institutional strength. 

However, as with the ECB and DG COMP, their mandate is limited and cannot be 

overextended to matters that entail major dimensions of political legitimacy and accountability. 

The European Parliament has been gaining competencies in successive revisions 

of the European treaties, and is now an important player in shaping legislation. 

However, its oversight powers on the EU institutions, especially the Council, remain 

restricted in comparison to most national parliaments. Moreover, the European Parliament, unlike lower houses in democratic regimes, is not elected on the basis of 

electoral constituencies of about-equal demographic weight, as smaller EU member 

states elect more Members of the European Parliament (MEPs) than larger ones in 

proportion to their population. These shortcomings have led Germany’s Federal Constitutional Court, in a landmark ruling in June 2009, to find the EU institutions 

not democratic enough to be granted powers in key areas of sovereignty, including 

fiscal policy. 

In the words of the Court, ‘‘With the present status of integration, the European 

Union does, even upon the entry into force of the Treaty of Lisbon, not yet attain 

a shape that corresponds to the level of legitimisation of a democracy constituted 

as a state. ( . . . ) Neither as regards its composition nor its position in the European competence structure is the European Parliament sufficiently prepared to take 

representative and assignable majority decisions as uniform decisions on political direction. Measured against requirements placed on democracy in states, its election 

does not take due account of equality, and it is not competent to take authoritative 

decisions on political direction in the context of the supranational balancing of interest between the states. It therefore cannot support a parliamentary government and 

organise itself with regard to party politics in the system of government and opposition in such a way that a decision on political direction taken by the European electorate could have a politically decisive effect.’’ This ‘‘structural democratic deficit’’ 

(also in the words of the Court) is a fundamental impediment to building up an effective executive capability at the EU level. 

Conditions for crisis resolution 

The design flaws of the Eurozone, including the lack of a federal fiscal and banking policy framework and the democratic deficit of EU institutions, had been well 

identified by analysts at the time the Maastricht Treaty was signed in 1991. However, this did not prevent the euro from being introduced in 1999 and from having 

what can fairly be described as a highly successful first decade, ostensibly disproving its doubters’ warnings. Similarly, the same shortcomings need not be fatal 

now if individual member states succeed in bringing their sovereign finances, their 

banking systems and their economies back on a sustainable track. However, the unfavorable global economic environment and loss of investor confidence during the sequence of events so far make it unlikely that the crisis can be overcome without 

meaningful progress in addressing fundamental weaknesses in the European institutional framework. 

Structural reforms that favor entrepreneurship and enhance the economy’s 

growth potential, fiscal adjustment, and bank restructuring are required at the level 

of individual member states. They are an indispensable dimension of any successful 

crisis resolution. They vary from one country to another and their elaboration would 

require detail beyond the scope of this testimony. At the European level, the necessary steps can be (rather simplistically) summarized into four components: (a) a 

consistent federal Eurozone framework for fiscal policy (fiscal federalism); (b) a consistent federal Eurozone/EU framework for banking policy (banking federalism); (c) 

a general overhaul of the EU’s political institutions that would upgrade their executive decisionmaking capability; and (d) adequate short-term crisis management arrangements to bridge the time gap between the present turmoil and an ultimate crisis resolution that would include the previous three components. 

The first component, fiscal federalism, already exists in Europe in indirect forms, 

including the borrowing capacity of the European Commission and the European Investment Bank (which are however tightly limited) and the collateral policy of the 

ECB, which allows it to take risks with an ultimate guarantee from member states. 
34 

A further tentative step was taken in the direction of building a Eurozone fiscal federation with the creation of the EFSF, even though its design is strictly intergovernmental, and the decision to provide loans to struggling Eurozone countries at belowmarket rates. However, none of this prevents the possibility of fiscal or economic 

mismanagement or financial shocks in individual member states putting the stability of the entire monetary union at risk, as is now the case. 

A vivid debate in Europe centers on the possible practical form of such fiscal federalism. One much-discussed proposal, by my Bruegel colleagues Jacques Delpla 

and Jakob von Weizs ̈acker, would have Eurozone members pool debt issuance up 

to 60 percent of their respective GDP in the form of Eurozone-wide ‘‘blue bonds,’’ 

and meet any additional funding needs through higher-yielding ‘‘red bonds’’ that 

would instill market discipline at the level of individual countries. Another option, 

typically referred to as ‘‘Eurobonds,’’ would be to federalize all sovereign borrowing 

in the Eurozone under a joint and several guarantee from all Eurozone countries. 

A more limited approach, first suggested by Daniel Gros at the Centre for European 

Policy Studies and Thomas Mayer at Deutsche Bank, would be to allow the EFSF 

to leverage its current resources and vastly expand its lending capacity by allowing 

it to borrow from the ECB. All these proposals imply new mechanisms to discipline 

the economic policy behavior of individual member states and mitigate the moral 

hazard inherent in any pooled borrowing scheme. 

In a landmark speech in Aachen on June 2, 2011, ECB President Jean-Claude 

Trichet has outlined what he sees as the necessary next steps: in a first step ‘‘in 

the medium term,’’ giving the European Council, on the basis of a proposal by the 

European Commission and in liaison with the ECB, the right to veto national economic policy decisions that may be harmful to Eurozone stability; and in a second 

step, ‘‘in the historical long term,’’ establishing a European ‘‘ministry of finance’’ 

that would exert ongoing surveillance of both fiscal policies and competitiveness 

policies, that could take over direct responsibility for economic policy in failing countries, and that would also exert responsibilities in financial sector policy and external representation. Even though he did not specify how this intrusive authority 

could be legitimized from a political standpoint, this vision emphasizes the need for 

executive decisionmaking capacity at the core of the future fiscal federal framework, 

as not all future policy challenges can be captured in a set of ex ante rules and automatic sanctions, no matter how well designed. 

The second component of eventual crisis resolution, banking federalism, also exists in embryonic form in the EU, with a largely though not completely harmonized 

banking regulatory framework in the form of EU financial legislation, and the recently created EBA which was endowed with limited supervisory and crisis management competencies. Even so, however, most supervisory and resolution authority 

still rests with member states, and so does a still significant amount of rulemaking 

that affects financial institutions, on conduct of business and consumer protection 

but also on prudential aspects as is illustrated by the current debate about the recommendations of the Independent Commission on Banking (or Vickers Commission) 

in the U.K.. Member states provide the guarantee for deposits, even though the modalities are harmonized under EU legislation, and only the member states have the 

fiscal capacity to intervene with equity or capital-like instruments in a crisis situation (even though liquidity policy in the Eurozone is mainly conducted by the ECB, 

and the ECB also has a say over additional liquidity assistance that may be provided by the Eurozone’s national central banks beyond its own operations). 

A European banking policy framework would imply the consistent formulation 

and implementation of regulatory, supervisory, resolution, deposit guarantee, and 

competition policies with regard to the banking industry throughout the EU. Compared with the present situation, this would entail at least four steps: 

• The EBA should be granted supervisory authority over all credit institutions in 

the Union, which it would exercise either directly (specifically, over the central 

operations of banks with a pan-European scope) or indirectly (by delegating it 

back to national agencies, over banks that are only active in one country, or 

over local operations of pan-European banks); 

• The EBA’s own governance should be overhauled so as to ensure its decisionmaking is better aligned with the European public interest (the current decision 

framework involves single-majority voting by representatives of the 27 EU 

member states, which can lead to massively skewed outcomes because of the 

disproportionate influence of smaller countries); 

• The EFSF should provide an explicit guarantee of national deposit guarantee 

schemes in all countries in the Eurozone, in order to prevent bank runs in the 

event of national sovereign-debt difficulties; 
35 

• Existing processes that allow member states to block cross-border acquisitions 

of ‘‘their’’ banks should be dismantled or brought under the control of European 

authorities. 

The combination of these measures would have the effect of ‘‘decoupling’’ the 

banks from their national governments, putting an end to the single major impediment to the formation of a genuine European banking system, as opposed to a collection of national ones, as an indispensable complement to monetary unification. 

These proposals are broadly similar to the ones outlined by the IMF’s then Managing Director Dominique Strauss-Kahn in a speech in Brussels on March 19, 2010. 

The third component of crisis resolution is the upgrading of EU institutions, to 

enable them to support the federal frameworks for fiscal policy and banking policy 

in a politically sustainable manner. Essentially, this means bridging the current 

democratic deficit to a sufficient extent that executive decisions can be legitimately 

taken in these policy areas at the European level and not only at the national one. 

This cannot be achieved without significant changes in the EU treaties. One aspect 

has to be the correction of the design flaws identified by Germany’s Federal Constitutional Court in its above-quoted 2009 ruling, namely the redefinition of the European Parliament’s electoral constituencies in order to ensure equal representation 

of EU citizens, and enhanced oversight powers for the European Parliament over 

the executive and budget functions of EU institutions. Whether these measures 

would be sufficient to close the democratic gap is debatable, and would obviously 

warrant further public deliberation. 

One additional layer of complexity is the tension between the Eurozone perimeter 

and that of the EU as a whole. At this point, the Eurozone comprises 17 of the EU’s 

27 member states, the outliers being the U.K., Sweden, Denmark, and seven Central and Eastern European countries (Bulgaria, Czech Republic, Hungary, Latvia, 

Lithuania, Poland, and Romania). Some of these countries may move toward joining 

the Eurozone assuming that the current phase of turmoil is overcome, but this does 

not seem to be a likely prospect for the U.K., and perhaps others. How the EU institutional framework can cohabit with what U.K. Chancellor of the Exchequer George 

Osborne has memorably termed ‘‘the remorseless logic of monetary union that leads 

from a single currency to greater fiscal integration’’ among Eurozone countries remains an open question. This is particularly true in the area of banking policy, 

which is currently set at the EU rather than Eurozone level, a fact that is reflected 

in the location of the European Banking Authority in London. This tension may become increasingly prominent in the years ahead. 

Finally, the fourth necessary component of crisis resolution is to manage the transition from now to the completion of a federal fiscal and banking policy framework 

under reformed EU institutions, which, even under extreme assumptions, is bound 

to take an extended period of time, measured in years rather than months, to 

achieve. By definition, these transition arrangements represent a more short-term 

concern that needs to be addressed within the existing Treaty framework. Here too, 

in addition to action at the level of individual member states, the twin issues of 

banking crisis and sovereign crisis need to be addressed. 

A central role could be played by an instrument to be created on an explicitly temporary basis, analogous to the Resolution Trust Corporation (RTC) that brought 

about the resolution of the U.S. savings and loan crisis in 1989–90. More than 2 

years ago, in June 2009, Bruegel and the Peterson Institute published an analysis 

in which Adam Posen, now on the Monetary Policy Committee of the Bank of England, and I suggested a blueprint for such a European RTC, or as we termed it with 

reference to a German precedent a ‘‘European Banking Treuhand.’’ The role of this 

ad hoc entity would be to catalyze and steer the necessary restructuring and crossborder consolidation of Europe’s banking sector, by identifying which institutions 

are undercapitalized on a consistent basis across national borders, by taking over 

and restructuring those that cannot find enough capital from arm’s-length sources, 

and by managing the corresponding assets and reselling them when market conditions allow. In the context of the sovereign crisis, this trust corporation could play 

an additional stabilizing role by ensuring the orderly functioning of the banking system in countries which undergo a sovereign debt restructuring. To fulfill its role, 

it would require enabling legislation passed in emergency by all relevant member 

states. 

With a proper framework in place to manage banking emergencies on a consistent, system-wide basis, the Eurozone could envisage energetic debt restructuring 

in member states that cannot meet their obligations, which I believe to be the case 

for Greece alone at this point. This would send shock waves through the system but 

would also contribute to a reduction of uncertainty. It would need to be backed by 

enhanced liquidity assistance to other member states. The most likely option for this 
36 

in the short term is expanded intervention by the ECB, possibly through the agency 

of a leveraged EFSF that would be granted access to ECB liquidity. This appears 

to be what was recommended by U.S. Treasury Secretary Timothy Geithner in his 

conversations with his European colleagues last week. It is also the short-term solution that emerged from a collective simulation exercise jointly hosted by the Peterson Institute and Bruegel last week, on which my colleagues Guntram Wolff at 

Bruegel and Ted Truman at the Peterson Institute have reported on the two organization’s respective Web sites. Our simulation suggests that this could be compatible 

with the ECB’s mandate under the existing Treaty and that it could have a material 

impact in addressing market contagion. 

Short-term outlook and policy options for the United States 

Spelling out these conditions for crisis resolutions underlines the Herculean political challenges of their implementation. Treaty changes that involve multiple referendums and also likely amendments to national constitutions, including in Germany; the shift of core areas of sovereignty from the national to the EU level; the 

definition of a modus vivendi with non-Eurozone members within EU institutions 

whose functioning would become dominated by Eurozone-only processes; and, inevitably, the public acknowledgement of major policy failures in the treatment of the 

crisis so far. 

At this point, it appears very difficult to identify a reliable path from here to 

there, and the short-term outlook is not the most encouraging. Things are likely to 

get worse in Europe before they can get better. In the current circumstances too 

many European citizens, and too many of their leaders, remain in denial of their 

collective predicament, which prevents necessary initiatives from being undertaken. 

This means that contagion may spread further in the very short term. 

This, however, remains a crisis for the Europeans to resolve. Europe’s international partners can help, but cannot take their place to fix the situation. The 

Eurozone as a whole is not in a state of financial distress. Its aggregate debt and 

deficit metrics compare favorably to the United States, U.K., or Japan. 

The IMF has played a very constructive role since the beginning of the crisis. Beyond the financial assistance it has provided to Greece, Ireland and Portugal, it has 

brought invaluable experience and technical input to the discussion among Europeans. The U.S. Government, together with other non-European countries, has provided pointed advice at critical moments. But none of these external partners of Europe can unlock the key bottlenecks in the current phase, which are primarily political in nature. 

Financial contagion to the United States from further deterioration in the 

Eurozone cannot be ruled out. In spite of the recent downgrading by Standard and 

Poor’s, U.S. sovereign debt retains safe haven status and I do not expect this to 

change in the short term, including in the case that things would take a sharp negative turn in Europe. However, because of multiple financial interdependencies across 

the Atlantic, deterioration in Europe could have financial impact in the United 

States. These transatlantic contagion risks can be mitigated to an extent by appropriate contingency planning and enhanced dialog between financial supervisory authorities in the United States, on the one hand, and the U.S. arms of European financial firms, as well as U.S. financial firms with financial exposure to Europe, on 

the other hand. Under the current circumstances, the United States should not 

overreact and financially ring-fence itself from the rest of the world to an extent 

that would compromise global financial integration from which the United States is 

one of the key beneficiaries. Thus, precautionary measures are warranted but 

should remain proportionate. This seems to be the current mindset of U.S. financial 

authorities. 

The Federal Reserve is also participating, together with others of the world’s 

prominent central banks, in a network of currency swaps with the ECB that facilitates the access of Eurozone banks to liquidity in dollars and other non-euro currencies. The benefits of this initiative in terms of financial stability, at the global 

level and also from the strict domestic point of view of the United States, appear 

to vastly exceed the risks involved to the Federal Reserve. 

The United States, the IMF and others global partners have an important role 

to play by providing advice and what John Maynard Keynes called ruthless truthtelling to their European partners. Many Europeans still find it difficult to acknowledge the extreme seriousness of the current conditions in the Eurozone. Expressing 

concern in constructive but frank terms can help, as Secretary Geithner apparently 

did last weekend in Poland. But, once again, only the Europeans themselves can 

meaningfully address their current, dangerous situation. 
37 

PREPARED STATEMENT OF JOACHIM FELS 

GLOBAL HEAD OF ECONOMICS, MORGAN STANLEY

SEPTEMBER 22, 2011 

Introduction and Summary 

1. The origins of the euro area’s twin sovereign debt and banking crisis include 

(i) a weak institutional framework with one money but many nations; (ii) an 

oversized and undercapitalized banking sector with high exposure to sovereign 

debt; and (iii) diverging growth and competitiveness trends between euro member countries, leading to large current account imbalances and a buildup of 

debt in the deficit countries. The crisis was exacerbated over the past eighteen 

months by a slow and inadequate response to the Greek and the banking sector problems, and more recently by the decision to involve the private sector 

in the latest Greek bail-out package. A lasting solution of the crisis requires 

bold reforms of the euro area’s institutional framework, including (i) a big step 

toward closer fiscal union between member states with a (partial) loss of fiscal 

sovereignty to avoid moral hazard, (ii) large-scale recapitalization and restructuring of the banking sector, and (iii) a central bank able and willing to serve 

as a lender of last resort to member states in order to prevent self-fulfilling 

‘runs’ on otherwise solvent sovereigns. Major political and legal obstacles to 

such reforms imply that a quick resolution of the crisis is unlikely. A deepening 

crisis potentially involving a default by one or several members states and, as 

a worst case, a break-up of the euro would have severe adverse consequences 

for the U.S. and global financial sector and economy. 

The Origins of the Crisis 

2. There are three key factors at the root of the current sovereign debt and banking sector crisis in the euro area. First, a unique institutional framework combining a single monetary policy conducted by a central bank constrained by a 

narrow inflation mandate with decentralized fiscal policy and decentralized 

banking supervision in the 17 member states. Second, an oversized, undercapitalized and fragmented banking sector highly dependent on wholesale 

funding. Third, divergent trends in growth and price competitiveness between 

member states’ economies, which led to large current imbalances within the 

union and a buildup of debt in the deficit countries. 

3. The most important of these three factors is the euro area’s peculiar institutional framework. One distinctive feature of this framework is that while monetary policy is centralized, individual member states have retained their fiscal 

sovereignty. To prevent countries from running excessive fiscal deficits, the 

Stability and Growth Pact (SGP), an inter-governmental agreement that accompanied the move to a single currency, set limits for individual countries’ 

debts and deficits and envisaged fiscal sanctions for fiscal sinners. However, 

the SGP lacked teeth because the imposition of sanctions always required a 

qualified majority vote by all finance ministers (‘sinners watching over sinners’), and because the criteria were watered down further in 2003, when the 

two largest countries, Germany and France, missed the fiscal criteria and coalesced to change the goal posts. Moreover, the Treaty regulating monetary 

union contains a ‘no bail-out’ clause, stating that no member country can be 

forced to stand in for the debts of other members. At the same time, the Treaty 

lacks a mechanism for orderly sovereign debt restructurings and it does not 

provide for a mechanism to exit the euro area. In fact, while a country may 

chose to exit the euro, there is no provision for excluding a non-compliant 

member state. In summary, the euro area’s institutional framework has neither been able to prevent irresponsible fiscal behaviour, nor does it provide a 

mechanism for an orderly resolution once a fiscal position has become 

unsustainable—either in the form of fiscal transfers or an orderly insolvency. 

4. To make matters worse, another distinctive feature of the euro area’s institutional framework is that the European Central Bank is constitutionally banned 

from financing governments directly, be it through direct loans or purchases 

of government bonds at auction. This provision was enshrined in the Treaty 

establishing monetary union to enhance the ECB’s credibility as an inflation 

fighter—the Treaty states price stability as the ECB’s primary mandate—and, 

in particular, to placate Germany’s fears of financing governments through the 

printing press, which are rooted in the experience with hyperinflation in the 

Weimar Republic of the 1920s and the experience of financing two wars 

through the printing press. However, an important consequence of this provision is that governments no longer have a lender of last resort to turn to in 
38 

case creditors refuse to fund them at reasonable interest rates. Without access 

to the printing press in extreme circumstances, there is a risk of self-fulfilling 

‘runs’ on otherwise solvent governments. 

True, access to the printing press, if overused, can be inflationary. But investors typically fear default more than inflation, which is usually much slower 

to materialize and less disruptive for the financial system than a default. The 

lack of access to the central bank as a lender of last resort helps to explain 

why investors treat countries with high debt in the euro area as ‘credits’ and 

thus differently from countries with similarly high debt levels (Japan, U.K., 

U.S.) who, in principle, have access to their central bank and are thus ‘true 

sovereigns’. 

Exacerbating Factors 

5. While the three key factors above—a weak institutional framework, an oversized and undercapitalized banking system, and growing imbalances within 

and between euro area member countries—have been at the root of the crisis, 

it was exacerbated by a slow and inadequate policy response ever since the 

Greek problems became apparent in late 2009. Delaying the initial aid package 

for Greece until May of last year helped spark contagion into Portugal and Ireland. Making the rescue fund (the European Financial Stability Facility EFSF) 

a temporary institution scheduled to expire in 2013 fueled fears that default 

would become likely after the fund’s expiration. Including the principle of private sector participation in post-2013 bail-outs into the blueprint for the post2013 permanent rescue fund (the European Stability Mechanism ESM) confirmed those fears. Failure to force banks to recapitalize faster and more aggressively undermined both investor confidence in the financial system and 

companies’ and private households’ access to bank credit. Moreover, by breaking an earlier promise and involving private investors in the latest Greek bailout package decided on 21 July 2011 through a ‘voluntary’ debt exchange, euro 

area governments sparked the latest round of contagion into the Spanish and 

Italian bond markets as the promise that ‘Greece is an exception’ was not 

deemed credible. In all these cases, domestic political considerations in the face 

of widespread public opposition to further bail-outs especially in Germany, the 

Netherlands and Finland, prevented bolder and more timely steps. Rather than 

blaming governments in these countries for delayed or misguided decisions at 

the European level as many commentators do, we view this outcome as the logical consequence of what we identified as the most important underlying cause 

of the crisis—the euro area’s inadequate institutional economic governance 

framework. 

Options to Resolve the Crisis 

6. A lasting solution of the crisis requires bold reforms of the euro area’s institutional framework—fiscal and monetary—as well as banking sector recapitalization and restructuring. Fiscal reform should include two elements. First, a fiscal transfer mechanism or insurance scheme that provides a backstop for governments unable to fund in the market at reasonable interest rates. Second, 

a (partial) transfer of member states’ fiscal sovereignty to a European authority to avoid irresponsible fiscal behaviour. 

7. Second, to prevent self-fulfilling runs on otherwise solvent sovereigns, the euro 

area needs a central bank able and willing to serve as a lender of last resort 

to member states in exceptional circumstances. To some extent, the ECB has 

assumed this role in the current crisis by buying government bonds of Greece, 

Portugal, Ireland and, more recently, Spain and Italy in the secondary market. 

However, the amounts purchased have been relatively small and the ECB is 

constitutionally barred from buying bonds directly at auction. 

8. Third, to break the negative feedback loop between the sovereign crisis and the 

banking sector crisis, banking regulators should push for a large-scale recapitalization program including both private sector and EFSF involvement. 

9. There are major legal and political obstacles to bold and far-reaching reforms 

of the euro area’s fiscal and monetary framework. These reforms would require 

a change in the Treaty of Europe, which would have to be ratified in all national parliaments and would, in several countries require popular votes. Past 

experience with Treaty changes suggests that this could take several years. 

Yet, without such reforms, the euro area’s sovereign debt crisis is unlikely to 

be solved. As a consequence, it is safe to assume that the crisis will continue 

in the foreseeable future and probably deepen further. 
39 

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

research assistance. 

Implications for the U.S. and Global Financial Sector and Economy 

10. A deepening crisis potentially involving a default by one or several members 

states and, as a worst case, a break-up of the euro would have severe adverse 

consequences for the U.S. and global financial sector and economy. First, 

higher funding costs for the public and private sector, fiscal austerity measures and banking sector stress suggest that the euro area economy will broadly stagnate in the foreseeable future, with many Southern member countries 

including Italy and Spain experiencing a renewed recession. Thus, European 

import demand looks set to slow, which will dampen U.S. and other regions’ 

export growth. Second, a deepening European crisis is likely to push the euro 

exchange rate lower versus the dollar and other currencies, which will also 

hurt U.S. and other exports to Europe. Third, while U.S. banks, in general, 

are viewed as stronger in terms of capital, liquidity and asset quality than 

their European peers, the European crisis has contributed, alongside global 

growth concerns, to higher funding stress and a higher cost of capital in the 

United States and elsewhere. 

PREPARED STATEMENT OF DOMENICO LOMBARDI 1

PRESIDENT, THE OXFORD INSTITUTE FOR ECONOMIC POLICY AND SENIOR FELLOW, 

THE BROOKINGS INSTITUTION

SEPTEMBER 22, 2011 

Chairman Warner, Ranking Member Johanns, honorable Members of the Subcommittee, thank you for this opportunity to share my views with you on the euroarea crisis and its implications for the United States. 

I have organized my remarks as follows: in the first section I elaborate on the 

origin of the crisis and provide a basic chronology of the main events until the downgrade by Standard & Poor’s of Italy’s sovereign bonds on Monday. In the following 

section, I focus on the policy response, highlighting the many gaps that still persist 

and proposing a multi-pronged strategy consisting of immediate as well as shortand medium-term measures. Finally, in the last section, I focus on the implications 

for the U.S. economy and elaborate on the diplomatic and institutional levers that 

the United States can mobilize to affect current developments in Europe. 

Origins 

What started in the fall of 2009 as a fiscal crisis in a smaller European economy— 

Greece, accounting for just 2 percent of the total area’s GDP—has evolved into a 

systemic crisis of the euro-area itself. This crisis now threatens not just to melt 

down one of the world’s major economies, but to destroy the social and political fabric that several generations of European political leaders have laid down with the 

unwavering friendship of the United States since the end of WW II. 

In October 2009, when Greece’s newly elected Socialist government revised the estimate for that year’s budget deficit from 6.7 percent of GDP up to a whopping 12.7 

percent of GDP, and then further revised to above 15 percent, credit-rating agencies 

began downgrading Greek bonds while investors faced increasing concerns about the 

country’s high debt and about allegations that the Greek government had altered 

official statistics so as to enable spending beyond the country’s means (Tables 1 and 

2). 

In May 2010, a loan agreement between the euro-area countries, the IMF, and 

the Greek government was announced in the amount of EUR110 billion, of which 

EUR80 billion would be financed by the euro-area countries and EUR30 billion by 

the IMF. 

The inertia from the euro area in assembling a stabilization program for Greece 

until almost the middle of the following year focused market investors and analysts 

on the vulnerabilities of other countries sharing the single European currency. A 

few months later, Portugal and Ireland had to request a stabilization program from 

the IMF and the EU. 

Following intense economic and financial pressures, triggered by a critically weakened banking sector in Ireland, public finances were weighed down by a deep fiscal 

deficit as a result of commitments to bank support. In late November 2010, an 

agreement was reached between the IMF, the EU, and the Irish authorities on a 

policy package of EUR85 billion for the period 2010–2013, of which EUR22.5 billion 

would be funded by the IMF. 
40 

Portugal was the third member of the euro area to seek assistance from the IMF 

and the EU. Its long-standing structural problems—including low productivity, lack 

of competitiveness, and high unemployment—had severely undermined its growth, 

which averaged only 1 percent during the previous 10 years. The lack of growth, 

combined with the impact of the global financial crisis, had resulted in a large fiscal 

deficit and high levels of debt (Tables 1 and 2). The joint EU–IMF financial package 

agreed for the period 2011–2014 was for EUR 78 billion, of which one third committed by the IMF. 

Late this summer, market pressure on Italy escalated and the spreads of its government bonds vis-a ́-vis the German Bund widened to over 400 basis points—levels 

not seen since the introduction of the euro (Table 13). As a result, the Italian authorities put forward two supplementary budget plans in less than 2 months—the 

latter having been approved by the Parliament only days ago. Soon afterwards, just 

this Monday in fact, Standard & Poor’s downgraded the country’s sovereign rating, 

keeping it on a ‘‘negative outlook,’’ which may prompt a further downgrade over the 

coming weeks. 

Other large sovereigns have also been affected. French government bond spreads 

have risen vis-a ́-vis the Bund, albeit by far less than Italy’s. Last week, two large 

French banks were also downgraded on account of their exposure to the distressed 

peripheral economies of the euro area. 

While interest rates on German government bonds have been decreasing, it would 

be inaccurate to say that Germany has not been affected by the euro-area turmoil. 

Following a strong rebound of 3.6 percent last year in the aftermath of the international financial crisis, Germany’s GDP growth will be subdued this year at an estimated 2.7 percent, and will further decline to 1.3 percent next year, according to 

the data released by the IMF on Tuesday (Table 8). 

The stabilization programs pursued by the economies in distress and the fiscal retrenchment enacted by the rest of the euro area will, moreover, increasingly affect 

the ability of German manufacturers to export their products in the area. Compounded with increasing uncertainty, this is likely to result, at the very least, in 

a slowing down of the German GDP growth for the next few years—as a best-case 

scenario and barring significant repercussions in its financial sector. 

While the national governments are obviously primarily responsible for the unfolding of the current events in Europe, the incomplete architecture of the euro area 

has created unprecedented scope for contagion by exposing each member of the monetary union—albeit to varying degrees—to the vulnerabilities of the other members. 

Italy is a case in point. While the sluggish growth of its economy and the highlevel (and increasing) public debt are not new phenomena, the crisis of the peripheral economies has provided the trigger for market investors to focus on the Italian 

economy’s long-run ability to service an increasing stock of public debt. 

Coupled with the inexistence of a lender of last resort, market expectations can 

rapidly become self-fulfilling in the euro area. 

Options 

The Policy Response So Far 

As the Greek crisis reached its peak, the EU, concerned about contagion risks 

within euro zone countries, came forward in May 2010 with a broad package of 

measures worth EUR500 billion to preserve financial stability in the region. In addition, the IMF expressed its aim to support such financing arrangements with an additional EUR250 billion, bringing the total amount of the ‘‘safety net’’ to EUR750 

billion. 

The European Council also established a special-purpose vehicle, the European Financial Stability Facility (EFSF), which was incorporated weeks later in Luxembourg, with the objective to provide temporary financial assistance to euro-area 

partners. The EFSF became fully operational on August 4, 2010, and is designed 

to operate for 3 years. 

It is authorized to issue bonds and/or other debt instruments on the market, with 

the support of the German Debt Management Office (DMO). Issues are to be backed 

by guarantees from euro-area countries, for a total amount not to exceed EUR440 

billion. In September 2010, EFSF bonds were assigned the top credit rating (AAA) 

by rating agencies. EFSF debt instruments can be used as collateral in refinancing 

operations through the European Central Bank. 

The EFSF is not a preferred creditor along the lines of the IMF. Its claims on 

a particular country have the same standing as any other sovereign claim. If too 

many creditors were granted preferred status, private investors would be reluctant 

to offer loans to the country concerned. 

The EFSF has a very lean structure, with a staff of only about a dozen people, 

made possible because the German DMO and the European Investment Bank both 
41 

provide the EFSF support. The board of the EFSF is made up of high-level representatives-Deputy Ministers or Secretaries of State or director generals of national 

treasuries-from the 16 euro-area Member States. Observers from both the European 

Commission and the ECB also sit on the EFSF board, which is chaired by the EU’s 

Economic and Financial Committee Chairman. 

The euro zone summit held on July 21, 2011 widened the EFSF’s scope of activity 

by allowing it to: i) act on the basis of a precautionary program; ii) finance recapitalization of financial institutions through loans to governments, including in non-program countries; and iii) intervene in the secondary markets on the basis of exceptional financial market circumstances and risks to financial stability, or on the basis 

of a mutual decision by the EFSF Member States, to avoid contagion. 

Earlier on, at their summit on June 24, 2011, EU Heads of State and Government 

had also decided that the EFSF may intervene in exceptional circumstances in the 

debt primary market, in the context of a program with strict conditionality. These 

amendments are still not operational as they await approval by national legislatures. It is expected that they may enter into effect sometime in October, at the earliest. Meanwhile, a recent decision by the German Constitutional Court appears to 

preclude the possibility that Germany will join the new permanent crisis mechanism, the European Stability Mechanism, which EU Heads of State and Government decided to establish on June 24 as a successor to the temporary EFSF. 

Moreover, earlier in the summer, euro-area leaders had agreed to a follow-up program for Greece on the order of EUR100 billion, which also awaits parliamentary 

approval. The German Parliament is expected the program sometime in October. 

Uncertainty exists as to whether, under what terms, and in what proportion the 

IMF might join such a program. 

The European Central Bank Governing Council has taken extraordinary measures 

in filling a political and institutional vacuum. In the period from May 2010 to April 

2011, the Eurosystem—the ECB and the euro-area’s national central banks—conducted open market purchases of Greek, Irish, and Portuguese bonds for EUR78 billion through the Securities Market Program (SMP). 

Following escalating market pressures on Italy and Spain over the summer, the 

Eurosystem reactivated the SMP by intervening for EUR80 billion as of September 

16, 2011. Unofficial reports from trading desks suggest that approximately 65 percent has been spent to buy Italian government bonds, 30 percent to buy Spanish 

bonds, and the remaining 5 percent for Ireland and Portugal bonds. While the ECB 

has not disclosed for how long it intends to continue the SMP, it is reasonable to 

assume that it may plan to do so until the EFSF will be able to step in, following 

ratifications of recent amendments noted above. 

The ECB has also intervened to ease pressures on European banks in the U.S. 

dollar funding market. At the end of June, the ECB extended the liquidity swap arrangement with the U.S. Federal Reserve to provide U.S. dollar liquidity to those 

banks unable to access the interbank dollar market. Research conducted by Barclays 

Capital (Euro Money Markets Weekly) reports that some European banks have recently been using ECB dollar facilities. 

Assessing the Policy Response 

Admittedly, the institutional framework established at the outset for the single 

European currency did not include a safety pillar such as an EFSF-type mechanism. 

This is mainly a reflection of the assumption, not fulfilled ex post, that subsequent 

to the introduction of the euro, the overall stability of the euro zone would be underpinned by a sustained convergence toward a unique policy process—one that would 

go well beyond monetary policy and would be geared toward macroeconomic stability. This expectation has not materialized, as economic policies have diverged. 

More than a year after the establishment of the EFSF, there are still no emergency instruments for intervening in support of large sovereigns, like Italy, should 

market pressure significantly escalate in the coming weeks or months. Given that 

the EFSF has currently committed some EUR175 billion—based on estimates from 

Barclays Capital Research—of its EUR440 billion potential endowment, the remaining EUR265 billion would be insufficient to ring-fence Italy, should it be cutoff from 

markets. 

In 2012 alone, the Italian Treasury will need to provision an amount of, at least, 

EUR235 billion, excluding T-bills (Buoni Ordinari del Tesoro). Assuming an approximately similar amount for 2013, this implies that a hypothetical joint 2-year EU– 

IMF program would deplete both the EFSF and the IMF. The resources of the latter 

were, as of September 15, SDR246 billion (or about EUR290 billion) in terms of its 

forward commitment capacity. 

Oddly enough, if euro-area countries were to step up their guarantees in any substantial way to make the EFSF a viable financing instrument for large sovereigns, 
42 

the contingent fiscal liabilities that would arise for each euro-area member would 

increase proportionally by a few percentage points of GDP. For France, this could 

entail losing the AAA status. 

In other words, in an attempt to stabilize Italy, France could make itself more 

vulnerable. As a result, Italy, and other large sovereigns, is currently exposed to 

self-fulfilling market runs against which there are no safety net, unless the ECB 

were to monetize public debt, which it is prevented from doing. 

Against this background, an effective, credible, and comprehensive response would 

need to rely on three pillars of emergency, short- and medium-term measures. 

i) First Pillar 

In the immediate, the EFSF should be strengthened by implementing the decisions already agreed upon by euro-area leaders during the summer. Further reforms 

should also be introduced to step up the decisionmaking, operational, and financial 

capabilities of the EFSF so as to stabilize market expectations about the euro-area’s 

immediate-response firepower. 

The EFSF suffers, in fact, from a number of limitations. Its governance is symptomatic of a purely intergovernmental approach to the management of the euro-area 

crisis, with lending decisions requiring the unanimous approval of all the euro-area 

countries. Yet, one of the key reasons for the current crisis is precisely the fact that 

markets have very deep reservations about the credibility of a monetary union run 

on the basis of an intergovernmental approach rather than a federalist one. 

As for its financial capability, the EFSF funds its lending programs by issuing 

bonds guaranteed by its euro-area shareholders. As a result, subscriptions to the 

EFSF’s bond issuances cannot be taken for granted in the case of a systemic crisis, 

where contagion to otherwise healthy national financial markets is a serious possibility. Even when the EFSF can borrow from markets, its financial capability is severely constrained by the time lag needed to provision resources from the markets. 

As has been suggested, the possibility of acceding to a credit line by the ECB 

would, instead, confer easy and timely access to funding, would enable the EFSF 

to amplify its financial capacity by leveraging on that funding, and would relieve 

the ECB of the role of crisis lender, which is outside its mandate. Admittedly, uncertainty would still persist against the lack of a lender of last resort, which would be 

needed to stabilize large sovereigns with substantial refinancing needs, should they 

be hit by a severe liquidity crisis. 

Moreover, euro-area leaders and the Greek authorities would need to establish the 

sustainability of any new follow-up program. The Greek debt-to-GDP ratio is currently projected to reach over 140 percent; under these conditions, it is simply impossible for the Greek economy to return to a sound footing—all the more so given 

that monetary and exchange rate policies are outside the control of the authorities. 

A more extensive engagement by the private sector (i.e., ‘‘orderly default’’) is required to decrease the ratio to a lower, sustainable level. The enhanced EFSF could 

provide the resources to strengthen the European banks that will have to write off 

part of the Greek debt. 

As long as the Greek crisis is not credibly reigned in, uncertainty will persist as 

to whether other euro-area economies may be stabilized, regardless of the required 

efforts that their national authorities have to implement. 

ii) Second Pillar 

In the short-term, the euro area would need to establish a framework for pooling 

the fiscal sovereignty of euro-area members. This would not need to result in a euroarea-wide finance ministry. Rather, a centralized entity such as the European Commission should be allowed to vet national fiscal policies or strategies on behalf of 

the euro area as a whole and on the basis of commonly agreed-upon and binding 

criteria. 

In return, member countries could issue eurobonds, that is, government bonds 

backed by a common, euro-area-wide guarantee, up to a certain threshold, such as, 

for instance, 60 percent of GDP, as has been suggested. Admittedly, the issuance 

of eurobonds alone, without the safeguards afforded by the centralized vetting, 

would not stabilize all euro-area countries. 

For instance, with a debt-to-GDP ratio of 120 percent or EUR1.9 trillion in absolute value, Italy would still need to issue the upper 60 percent tranche of its debt 

under the current framework of nationally guaranteed bonds. In other words, from 

Italy alone, there would be almost EUR1 trillion in bonds floating with no euro-area 

guarantee. 

iii) Third Pillar 

In the medium term, euro-area countries should establish a coordinating framework that would go beyond fiscal policies by encompassing macroeconomic and 
43 

structural policies. In fact, this is required to ensure that aggregate demand is sustained over time and that national economies do not pursue policies that are inconsistent at the euro-area level. 

Along those lines, for instance, some euro-area economies like Germany cannot expect to run a persistent surplus in their current accounts while other economies of 

the area have to reduce their aggregate demand and, therefore, their imports from 

Germany as well. Accordingly, the latter could balance the reduced demand from 

the rest of the euro area by expanding its own domestic demand. This would have 

the advantage of supporting the rest of the euro-area economies that would otherwise be facing substantial retrenchment for years to come. 

Up to now, there has been no mechanism to balance current accounts within the 

euro area. Germany has been able to accumulate consistent surpluses, even greater 

than those of China in proportion to GDP, without the restrictions of a compensatory mechanism provided by exchange-rate appreciation, such as that in play during the 1970s and 1990s with the German mark. Because of this asymmetry, Germany multiplied the benefits for its economy after the introduction of the single currency, with current account balances consistently in surplus and for the most part 

on the rise, reaching about 6 percent of GDP in 2010 (Table 9). During the 3-year 

period 2006–2008, the balance was even greater, representing a historical high for 

Germany, at least with respect to the last 40 years. 

On the other hand, the current account balance with respect to GDP of the euro 

area in general has hovered, on average, around zero over the course of the past 

decade, without therefore generating any direct pressure for a compensatory adjustment in the exchange rate of the single currency. Never has this asymmetry been 

more evident than at the height of the international financial crisis, when the German economy benefited from a considerable increase in exports outside the euro 

area. Over the course of 2010, taking advantage of a relatively weaker euro—by 9 

percent compared to the year before, in real terms—manufacturing orders from beyond the euro area for German firms reached their highest in a decade. 

Implications for the United States 

The U.S. exports goods to the euro area for approximately US$100 billion (Table 

3) or a bit less than 10 percent of its total goods exports (Table 6). They are mostly 

skewed toward Germany, France, and, also, Italy. Flagging demand in Europe due 

to a gloomy outlook and increasing uncertainty is likely to result in fewer exports, 

thus increasing the fragility of the U.S. economic recovery. From a financial standpoint, U.S. banks are exposed to the euro area for US$2.7 trillion, largely reflecting claims toward France (US$643 billion) and Germany 

(US$623 billion) (see Table 10). These claims account for 29 percent of the United 

States total exposure to foreign counterparts (Table 11). Exposure to France and 

Germany accounts for 14 percent altogether of total foreign exposure (Table 11). U.S. banks are also exposed to the U.K. for some US$2 trillion or 23 percent of 

their total foreign exposure (Tables 10 and 11). Exposure to the peripheral economies under stress is modest—claims on Greece, Ireland, and Portugal account for 

3 percent of total foreign exposure (Table 11). 

Therefore, any significant impact to the U.S. banking system would accrue 

through the largest euro-area sovereigns, once or if the crisis becomes a fully blown 

systemic one. Accordingly, there is still an important window of opportunity that the 

United States may use in trying to stabilize the euro-area crisis. 

While, of course, any resolution of the euro-area crisis ultimately hinges on the 

European countries themselves, the United States can rely on the following levers 

to affect the current developments. 

i) Bilateral Relationships 

Euro-area countries are traditional allies to the United States, with whom the 

United States has developed longstanding diplomatic and working relationships. 

The press has reported regular conference calls and meetings between senior officials of the current administration and their respective European counterparts. 

The President has reportedly engaged European political leaders on a regular 

basis. Perhaps it is not a coincidence that German Chancellor Merkel publicly announced support for the first rescue program for Greece in the spring of last year, 

following a conference call with the U.S. president the very same day. 

ii) The G–20 

The G–20 played a pivotal role in the 2007–09 international financial crisis. The 

Bush administration convened the first Leaders’ Summit in Washington in November 2008 (‘‘Washington Summit’’). Subsequently, President Obama and other world 

leaders from the G–20 decided to hold regular summits and ‘‘designated the G–20 

to be the premier forum for.[their] international economic cooperation’’ (Pittsburgh 
44 

2See, for instance, the Dow Jones wire available at: http://www.foxbusiness.com/industries/ 

2011/07/19/in-flurry-calls-g7-governments-signal-eu-meeting-critical/. 

Summit, September 2009). Yet, the G–20 has kept a remarkably low profile in the 

wake of current developments in Europe, mainly as a reflection of the hesitation of 

its continental European members to involve the global G–20 forum on issues they 

consider ‘‘internal.’’ 

Regardless of whether the G–20 gets formally involved in the European crisis, it 

could still fulfill a very important coordinating role. In September 2009, the United 

States launched the Framework for a Strong, Sustainable, and Balanced Growth. 

The rebalancing of global demand through some large emerging economies’ switching to a greater extent to domestic sources for their economic growth becomes a 

more urgent issue against flagging demand in Europe and the increasing fragility 

of the U.S. economic rebound. 

Today and in the next few days, the G–20 will meet at the margins of the IMF 

and World Bank Annual Meetings. It is important that the G–20 makes tangible 

progress on global rebalancing by the time of the forthcoming summit in Cannes in 

early November. There is, however, a sense that expectations should be low as 

progress may not materialize. 

iii) The G–7 

The G–7 has been increasingly active in the context of the European crisis and 

has represented the international forum where Continental European countries 

have exchanged views with other nations on the developments unfolding in Europe. 

The longstanding, small network of G–7 officials provides a more intimate forum in 

contrast with the G–20, and the Europeans themselves regard this forum as better 

suited to have internationally broad discussions with traditional allies. 

The United States has used this forum to persuade the Europeans and to prod 

them to a credible and urgent course of action.2 Following the latest recent financial 

summit in France, the G–7 will meet again at the margins of this week’s IMF and 

World Bank Annual Meetings. 

iv) The IMF 

The IMF represents an important source of leverage for the United States, given 

its status as the largest shareholder. The U.S. appoints an Executive Director in the 

Executive Board. Moreover, the post of First Deputy Managing Directorship has always been filled by an American citizen, since the position was established in the 

1990s. 

Given its role of overseer of the stability of the global financial and monetary system, the IMF has not just the right, but the duty, to intervene—on its own terms— 

in the current developments. Its role goes well beyond lending and falls under its 

original surveillance mandate. 

The IMF has jointly funded, with the EU, all the programs in the distressed euroarea economies. Whether or not it will join future programs is a matter the Executive Board will have to decide on. Regardless of future lending commitments, however, the confidence-building effect from a step up in the Fund’s financial capacity 

should be seriously considered. 

Just as the G–20 leaders fortified the IMF’s financial position with an extraordinary injection of capital following the London Summit in April 2009, the membership of the IMF should, at the very least, implement the reform package already 

agreed on by the IMF Board of Governors in December 2010 and previously endorsed by the G–20 leaders in Seoul the month before. Once approved, IMF resources will increase from SDR238.4 billion to approximately SDR476.8 billion 

(about US$750 billion). As part of the agreement, moreover, Western European 

countries will release two seats on the Executive Board in favor of emerging and 

developing countries. 

The United States has not yet ratified this agreement. 

The IMF also relies on contingent credit lines through the New Arrangements to 

Borrow. In the event the Fund needs to readily supplement its permanent resources, 

the NAB is a first-recourse facility. Once activated, it can provide supplementary 

resources of up to SDR367.5 billion (about US$580 billion) to the IMF. The NAB 

was activated last spring for a period of 6 months, in the amount of SDR 211 billion 

(about US$333 billion). The United States contributes with SDR69 billion (approximately US$100 billion). 

Given the prospect of a meltdown of the euro-area, the NAB provides a fundamental backstop to the IMF’s lending capacity, even more so as the final ratification 

of the doubling in IMF quotas will inevitably require several more months, at least. 
45 

v) The U.S. Federal Reserve 

The Fed has provided the ECB with dollar funding through currency swap operations since the outbreak of the international financial crisis, to enable the ECB to 

provide U.S. dollar funding to euro-area banks. In May 2010, the ECB reintroduced 

this form of transaction, as the Greek crisis led to tensions in the U.S. dollar liquidity market for European banks. In January 2011, the ECB then dropped the facility 

to reintroduce it again this summer. Accordingly, at the end of June 2011, the liquidity-swap arrangements between the ECB and the Fed were extended to August 

of next year. 

Notably, the Federal Reserve’s cooperation lent to the ECB allows European financial institutions to meet their counterparty or loan obligations in U.S. dollars 

thus minimizing the risk of contagion in U.S. markets. The extension of these credit 

lines does not expose the Federal Reserve to foreign exchange or private bank risk. 

When the Federal Reserve provides dollars through the reciprocal currency swaps, 

they provide them to the ECB, not to the institutions obtaining funding through the 

liquidity operations tendered by the ECB. Nor does the Federal Reserve assume any 

exchange-rate risk, because the supplying of dollars in exchange for foreign currency, and the subsequent receipt of dollars in exchange for foreign currency at the 

swap’s maturity date, take place at the same rate of foreign exchange. 
46 
47 
48 
49 
50 
51 
52 

PREPARED STATEMENT OF J.D. FOSTER, PH.D. 

NORMAN B. TURE SENIOR FELLOW IN THE ECONOMICS OF FISCAL POLICY

THE HERITAGE FOUNDATION

SEPTEMBER 22, 2011 

Chairman Warner, Ranking Member Johanns, thank you for the opportunity to 

testify today. My name is J.D. Foster. I am the Norman B. Ture Senior Fellow at 

The Heritage Foundation. The views I express in this testimony are my own, and 

should not be construed as representing any official position of The Heritage Foundation. 

The European Economic Crisis is no accident. It is entirely the product of fundamental policy mistakes begun long ago and since magnified and papered over time 

and again. I believe there are two root mistakes that have produced this outcome. 

The first is the relatively recent mistake of adopting a single currency without the 

economic policy infrastructure necessary to protect it. Without arguing the wisdom 

of the Euro one way or the other, the fact is that if it were purely a matter of economic policy the Euro could have succeeded as envisioned. But there were prerequisites relating to harmonization of labor policy, commercial policy, environmental policy, and so forth, and absent these it was imperative to harmonize fiscal 

policies. Europe made some progress in some areas and little in others. It was undeniably woefully inadequate. 

The second great mistake was the adoption of a generous social welfare state 

without attending to the pro-growth policies necessary to sustain such a state in 

light on an increasingly competitive global economy. In the absence of increasing 

global competition a slow-growth big government economic model is viable; not, in 

my view, preferable by any means, but viable. In the face of fierce and rising competitive pressures from outside Europe, economic growth through rising productivity 

and improved economic competitiveness is not merely beneficial, it is essential to 

national survival. 

The Europeans have long been aware of this tension, hence their efforts to cajole, 

coerce, or otherwise convince the rest of the world to adopt their economic model. 

An obvious example is their efforts to force Ireland to adopt a higher corporate income tax rate. Rather than adopt the policies necessary to speed their own economies to match those of the competition, Europe tried to slow the economies of the 

competition. It didn’t work. 

I very much regret what our friends across the pond must now endure, and what 

awaits them in the days, months, and years ahead. For them, there are no easy answers. For us, there is little we can do to help, but there are preparations we can 

make and lessons we can learn. 

These causal questions are important and interesting, but the issue of the day is 

what is happening today, and what effect it will have on the United States. In the 

testimony that follows, I will attempt to describe briefly the basic dimensions of 

what continental Europe now faces, and then the transmission mechanisms by 

which the United States may be affected, and conclude with what the United States 

can do to prepare. 

Europe’s Many Layered Problems 

Europe’s immediate problem is a pending and building liquidity crisis. European 

banks and other financial institutions are experiencing increasing difficulty accessing short-term credit markets, and depositors are getting very nervous. According 

to reports, for example, Siemens recently withdrew 500 million Euros from a French 

bank. Greek banks have been on life support from the European Central Bank for 

months, and central banks have just recently pumped more billions of dollars into 

the continental-wide banking system. Confidence, the life blood of financial markets, 

is failing fast. 

The reason, of course, is that these banks hold vast quantities of dubious assets— 

dodgy government debt. Some, perhaps many or even most, European banks have 

a solvency problem. As Josef Ackerman, Chief Executive Office of Deutsche Bank 

recently explained, ‘‘Numerous European banks would not survive having to revalue 

sovereign debt held on the banking book at market levels’’. This view was reinforced 

on September 20 by Joaquin Alumnia, the European Union’s competition commissioner, who noted that ‘‘Sadly, as the sovereign debt crisis worsens, more banks may 

need to be recapitalized’’. 

In this Alumnia was restating a view presented recently by Christine Lagarde, 

managing director of the International Monetary Fund (IMF) from which she subsequently beat a hasty retreat under withering fire from the EU establishment. 

Madam Lagarde had committed the unpardonable sin of speaking the obvious truth, 
53 

a truth that is likely to be laid bare by an IMF report expected to be out at the 

end of September reportedly showing banks need a ‘‘whopping 273.2 billion (euros)’’ 

in recapitalization. A big problem in this regard for credit markets is nobody really 

knows which bank would and which would not survive today. 

The solvency problem, in turn, traces to the sovereign debt problem—some governments have issued debt and run budget deficits to unsustainable levels. And a 

big reason these debt levels are unsustainable is not merely their sheer magnitudes, 

but that these countries also suffer from an ongoing growth problem. The growth 

problem—even in good times they experienced little growth. Now they are contracting, in some cases rapidly. So while their debt is high and rising, the economy 

on which the debt rests is flat or contracting. 

But growth rates tell only a part of the story. The larger story is that the cost 

structures in many of these countries render them highly uncompetitive economically, even within Europe and certainly outside of Europe. This means they cannot 

hope to run the trade surpluses necessary to generate the earnings with which to 

pay their foreign creditors. 

The painful immediate conundrum Europe faces is that attempts to address the 

sovereign debt problem, through tax hikes for example, make the economic growth 

problem worse thus making current debt levels less sustainable. At the same time, 

issuing even more debt in an attempt to buy time to deal with the sovereign debt 

problem typically make the bank solvency problem worse by driving down the value 

of the outstanding dodgy debt. 

And it gets worse. Attempts to address the financial market solvency problem by 

drawing attention to the need for more bank capital often bring the liquidity crisis 

to a fevered pitch. This is a Gordian know of enormous proportion and complexity, 

and one must express a grudging admiration for the European leaders in having 

managed so well for so long, all the while knowing they could not do so indefinitely. 

Taking a step back for perspective, the long-run implications of being highly uncompetitive are catastrophic. Europe will, at some point and in some fashion, overcome the liquidity problem, and the solvency problem, and even the sovereign debt 

problem. These can be overcome in a variety of ways, all of which are painful to 

someone and all of which will cause hardship for years to come. But I am confident 

they can and will be overcome. 

In contrast, the inability to compete globally presents problems of an entirely different nature. Greece is, unfortunately, an excellent example. Greece achieved an 

artificially high standard of living largely by borrowing from abroad. This also led 

to increases in wages and prices that far outstripped productivity growth, leaving 

Greek producers uncompetitive within and without Europe. However, in the good 

old days being able to borrow from abroad made up the difference in terms of income. Greek borrowing is today on a very short leash, the economy is contracting 

rapidly, and with their artificially elevated wage and price structures Greece cannot 

hope to generate the net exports and earnings needed to service its existing debt. 

This leaves Greece with two very unpalatable options. One option is to let a deep, 

prolonged depression drive down wages and prices to the point where Greece’s workers and companies can generate a trade surplus. Greece would quite possibly look 

enviously at Japan’s lost decade. 

The other option is to make the adjustment the old fashioned way—to devalue. 

And there’s the rub—as a member of the monetary union, Greece lacks a currency 

to devalue; which is why the arguments about how difficult or painful it would be 

for Greece to break out of the Euro are irrelevant. There is no less painful alternative as long as Germany refuses to work so Greece can enjoy the fruits of German 

labor. As Financial Times columnist James Mackintosh wrote in Wednesday’s paper, 

‘‘Fixed exchange rates force economic adjustment via wages and prices; Greece 

needs dramatic wage deflation to regain competitiveness against Germany. The political impossibility of slashing pay packets enough is a reason it may have to leave 

the Euro, even though living standards will fall either way.’’ 

The Implications for the United States 

With this as overview, the fundamental transmission mechanisms of the European Economic Crisis for the United States economy are as straightforward in outline as they are murky in detail. There are two such mechanisms, one through financial markets and a second through trade flows. 

Five years ago, one might have viewed the European financial crisis, that is, the 

existential threat to European financial institutions and markets, as mostly a European affaire. To be sure, American financial institutions hold some of this dodgy European debt, as well. There have even been stories that super-safe money market 

funds have loaded up on scary levels of high-yielding Greek debt. But, on balance, 

one would have thought a financial contagion in Europe would be stopped at water’s 
54 

edge. Five years ago, the Europeans thought the same thing about the then-rumored 

U.S. subprime mortgage fiasco about to unfold. 

The issue is global financial interconnectedness. This is where matters get murky. 

No one, including the participants and including the financial regulators, really 

knows or understands all the connections, or all the weaknesses. We know in great 

detail, for example, how much foreign debt by country each of our banks own. But 

for years the Europeans have assured the world their true exposure to sovereign 

debt risk was limited because they had hedged their positions with credit default 

swaps (CDS). Note, however, that CDS do not eliminate risk but merely shift it. To 

whom? No one really knows. 

Suppose, for example, you are the CEO of a well-run U.S. bank. You have carefully assessed your exposures to the European sovereign debt crisis and have built 

up a proper capital cushion. Your exposures to Europe all appear to be through 

credible institutions which themselves appear to have adequate capital. But what 

are their other assets? How much of these CDS do they own? How much capital 

do they have when they have to make good on their CDS exposure? They may not 

really know. You don’t know. And so you as CEO don’t really know how safe your 

bank really is. 

European leaders will not be able to kick the can down the road indefinitely. Matters worsen almost daily. Italy’s debt was recently downgraded. Economies are contracting. Greece is fighting for one more breathe in the form of the next tranche 

of oxygen from the IMF. 

As these events unfold, the essential consequence for the United States economy 

is a large dose of bad uncertainty. Bad uncertainty is analogous to bad cholesterol. 

It builds up and creates economic blockages. In the economic sphere, this shows up 

as decisions delayed or downscaled, decisions that under normal times would 

produce the actions that produce growth. Europe is clearly adding to the headwinds 

facing the economy today. 

At some point, this house of cards will come tumbling down, taking much of the 

European financial system with it. Fortunately, this part of Europe’s problem can 

and I believe will be halted in its tracks fairly quickly by recapitalizing the banks. 

The questions for the Europeans will be—whose capital and how much? For the 

United States, too, the immediate threat will then pass. 

As the financial crisis fades, as it will, Europe will be left with the remaining fundamental economic problems of a dysfunctional monetary union, uncompetitive 

economies in many cases, and recession. This, again, is where matters get murky. 

The monetary union may evolve in any one of a number of paths, none of which 

appear particularly germane to the U.S. situation; likewise the policies necessary to 

restore all the nations of Europe to a state of international competitiveness. 

The depth and length of the recession in each country will vary, but none will 

be immune. Many of these countries suffered poorly performing economies before 

the crisis. For the United States the implications if not the magnitudes are clear— 

a major U.S. trading partner will be in a slump, and so U.S. exports to Europe will 

suffer. 

If the U.S. economy were in good shape, a drop in exports would simply be another headwind to be overcome. In 1997, during the Asian economic crisis, the U.S. 

experienced an event similar in nature if not magnitude, but the U.S. economy was 

reasonably strong and accelerating and so the headwinds from the Asian crisis were 

essentially imperceptible in the aggregate. 

Unfortunately, rather than strengthening, the U.S. economy today is flat on its 

back, and facing the very real possibility of yet another recession even without the 

headwinds of Europe. President Obama’s economic policies have failed utterly and 

completely. Mounting a sustained, robust, job-creating U.S. recovery under the circumstances will prove very difficult. 

What the United States Can Do to Prepare 

There is very little the United States can do to help the Europeans through their 

troubles. There is, perhaps, some harm the U.S. Government can inflict, and Treasury Secretary Geithner appears to have done his best to inflict some in his recent 

lectures to the European leadership at their recent finance meetings in Poland. No 

doubt his counterparts are wondering to themselves the old refrain, ‘‘with friends 

like this, who needs enemies.’’ 

One rather nebulous issue for the United States arising from Europe’s troubles 

is that once again the United States, despite all its troubles, is perceived as a safe 

haven for capital. Thus enormous capital inflows from abroad have propped up the 

dollar exchange rate to an extent, and driven down domestic interest rates. Given 

the current weakness in the U.S. economy and the Federal Reserve’s current policy 

of maintaining very low interest rates and its expected attempts at driving down 
55 

long-term rates in particular, these interest rate pressures may actually be benefiting the U.S. economy today. On the other hand, there will be a flip side—at some 

point these capital inflows will become outflows, pushing up interest rates at an inopportune time. 

As there are two definable threats to the United States economy, preparations 

should focus on dealing with those two threats. Above all, the key to preparing for 

the financial threat is capital. Capital reserves act like levees in the face of a flood, 

protecting financial institutions from the onrushing river of failing confidence. Presumably, America’s financial regulators and supervisors are keeping a close eye on 

bank capital reserves. However, in light of what may be in the offing, it is reasonable to question the prudence of banks and other financial institutions paying out 

dividends at this time, dividends that if retained would add a few sandbags to the 

levees. 

The second threat is from the expected drop in exports to Europe and the effects 

this will have on the U.S. economy. Little or nothing can be done about the drop 

in exports, but much could be done to strengthen the economy to absorb the blow 

better. All of these actions fall under the guiding principle of ‘‘do less harm’’. 

To Grow, or Not to Grow, That is the Question 

The fundamentals of our economy remain sound. The natural productive tendencies of America’s workers, investors, and entrepreneurs remain undiminished. 

The economy is poised to grow. 

Why, then, does it hold back? 

There are, of course, the unusual headwinds, such as the follow-on effects of Japan’s devastating earthquake and tsunami. But the economy faces and overcomes 

such headwinds even in the best of times. Headwinds there are, to be sure, but they 

do not explain the economy’s lethargy. 

The economy suffers from two categories of troubles. The first are structural troubles, which today primarily reflect a housing sector still in deep disequilibrium in 

many areas of the country. 

There is very little substantively that government can do to return housing markets to normal, and heaven knows Congress and the President have tried just about 

everything. And that is part of the problem. Government’s well-intentioned meddling has delayed and distorted the essential requirement for normalization—price 

discovery. On balance, these policies have set back the housing recovery by months, 

perhaps a year or more. There is an important lesson here. 

The second category of trouble is what might be termed environmental—not the 

natural environment, but the economic environment. Most relevant for our discussion is alternatively a shortage of confidence or an excess of bad uncertainty. Those 

who could make the decisions and take the actions that would grow the economy 

lack the confidence to do so. Even today, the economy abounds in opportunities for 

growth. But turning potential into reality requires action, and action requires confidence—confidence in the future, confidence in the specific effects in government 

policy, and confidence that government can properly carry out its basic functions, 

like agreeing to a budget. 

America suffers a confidence shortage, and Washington is overwhelmingly the 

cause. 

Confidence, in turn, is lacking because of an excess of uncertainty: Uncertainty 

about the future, but also uncertainty about the effects of government policies—tax, 

regulatory, monetary, trade. Uncertainty is natural, of course. The future is always 

uncertain. But there is good uncertainty and bad uncertainty, much as there is good 

cholesterol and bad cholesterol. Good uncertainty, for example, presents opportunities for profit. Bad uncertainty arises largely when investors and entrepreneurs 

have very real questions about the consequences of government policy. 

Tax policy provides a good example of bad uncertainty. The President’s repeated 

insistence on raising taxes on high-income workers and investors slows the economy 

even without the policy being enacted. It does so by raising the uncertainty about 

the tax consequences of various actions. It does not stop all such actions, but it stops 

some, and therein lies the difference between growth and stagnation. 

The President’s insistence is a twofer in terms of bad uncertainty. The specific is 

that taxpayers don’t know what their tax liability will be. The general is that suggesting raising taxes on anyone in the face of high and possibly rising unemployment suggests a gross lack of understanding about how an economy works. That’s 

a source of bad uncertainty that afflicts the entire economy, not just those threatened with higher taxes. 

In this environment, Congress need not enact bad policy to weaken the economy. 

Threats suffice to do real damage. 
56 

Unfortunately, President Obama’s recent and urgent deficit-building jobs plan was 

so weak Senate Majority Leader Harry Reid (D–NV) refused even to attempt to 

bring it to the Senate floor. And his subsequent deficit reduction plan was so full 

of gimmicks and misrepresentations even his allies on the left had to stifle their reactions. Clearly, President Obama has chosen to campaign for re-election on a far 

left populist message that sacrifices economic strength and job growth for ideology, 

leaving the U.S. economy to fend for itself as events in Europe unfold. 

The American economist Joseph Schumpeter once observed, ‘‘the problem that is 

usually being visualized is how capitalism administers existing structures, whereas 

the relevant problem is how it creates and destroys them.’’ The next few years are 

very likely to bear this out. 

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