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Sovereign Debt Problems in Advanced Industrial Countries

Speaker: Willem Buiter, Chief Economist, Citi
Presider: Michael J. Elliott, Editor, Time International
May 7, 2010
Council on Foreign Relations



MICHAEL ELLIOTT: Good morning, ladies and gentlemen. Could I ask you to settle down, take your seats? Thank you. My name's Michael Elliott, and I'd like to welcome you to today's Council meeting with Willem Buiter, part of the C. Peter McColough Series on International Economics.

If I could just get a couple of logistics pieces out of the way, please completely turn off, not just put on stun, your cell phones, BlackBerrys, and all wireless devices, to avoid interference with the sound system. And this morning's meeting is on the record, for those of you who are interested in such affairs.

We're delighted to have with us Willem Buiter, chief economist of Citi since January this year, one of the world's most distinguished and prolific macroeconomists, well known, I'm sure, to many people in this room, with a distinguished record of public service and of academic distinction, including no fewer than three stints at the world's premier institution of scholarship on the social sciences, the London School of Economics. The LSE never gets plugs at places like this. (Laughter.) So as a former teacher there myself, forgive me if I -- if I plug it.

In a(n) absolutely wonderful long paper on sovereign debt that Willem put together just 10 days ago, he kicked off by saying, "The public finances in the majority of advanced industrial countries are in a worse state today than at any time since the Industrial Revolution, except for wartime episodes and their immediate aftermaths. Most of the richest industrial nations are on unsustainable fiscal financial trajectories."

This meeting goes down in the annals of the Council as one of the meetings at which one can honestly say "perfect timing," after what happened yesterday.

So to kick us off with 10 minutes' or so introduction, please welcome Willem Buiter; then Willem and I will have a conversation up here.

Willem? (Applause.)

WILLEM BUITER: Thank you, Michael. It really is a pleasure to be here at the -- at the Council.

Sovereign debt issues is what I started my academic career on. My thesis under James Tobin in '75 was on the subject. The piece that I brewed about 10 days ago on sovereign debt crisis in advanced industrial countries I really could have written much more quickly than I did, simply by opening a drawer which said "Sovereign Debt Crisis in Emerging Markets, 1980s, 1990s" and now relabeling the axes and changing a few of the titles. We are (seeing/sealing/feeling ?) what used to be emerging-market crisis in the advanced industrial countries.

There are a few exceptions, countries that are in reasonable financial shape, but they're few and far between. They're the usuals -- you know, the Scandinavians, the Nordics, sort of slightly boring, but solid, right? There is New Zealand and Australia. And that's it.

There are a couple of countries that think they're in good shape fiscally, but only are so in comparison to their awful neighbors. By historical or by absolute standards, they too are in bad shape. Canada, as an example, compared to the U.S., in fine shape. But by any other standard, any country who has 80 percent of GDP general government debt ratio, you know, should not be thumping its chest too vigorously. Likewise Germany. If Germany weren't in the euro area today, it wouldn't be able to get in, because it violates both the debt and the deficit criteria.

So today's best of breed, as they say in the thing, you know, would have only been a possible entry for the "ugliest dog in the world" contest only a couple of years ago. We really are in trouble.

And even apart from the sovereign debt crisis and possible sovereign defaults that a number of the more extremely challenged countries may suffer, the industrial world will be in fiscal consolidation mode no later than next year. We won't all be getting there with the same vigor and at the same time. And a country like the U.S., which is in dreadful fiscal shape, will be buffered against the market discipline that is prodding countries one at a time into fiscal tightening.

They will be -- they're protected, buffered from that, both by the size of the economy but mainly by the, you know, global reserve currency status of the dollar. But that buffer isn't in -- (inaudible) -- (shape ?). And if, over the next two or three years, all that happens by way of fiscal tightening in the U.S. is the expiring of the Bush tax cuts on the upper quartile of the income distribution, then three years from now the U.S. will have lost its AAA rating and will be tested by the markets through rising loan rates and widening sovereign spreads.

There's no hiding place for anybody. We just -- at least no permanent hiding place for anybody.

The immediate crisis, of course, has struck Greece, and that's appropriate, because Greece is a class of its own as regards to awfulness of its fiscal financial situation. (Scattered laughter.) It has the second-highest -- possibly the highest, because we can't yet be completely sure about the data, but certainly the second-highest debt-to-GDP ratio, and a massive, recently revised up to 13.6 percent of GDP for 2009, general government deficit, much of which actually is structural.

The U.K. and the U.S. are in bad fiscal shape, and, in fact, they are -- the headline deficit numbers aren't that much smaller in the -- than in Greece. And in fact, the U.K., on the commission's projections, is like they have a higher deficit than Greece or Ireland next year.

But a lot of that is cyclical. In Greece, the cycle is only just beginning. We're expecting another six-(percent)-plus decline in GDP as the fiscal screws are tightened.

Now, one of the saddest experiences of the -- of the last year or so has been the complete fumble and bumble of the European economic area and EU nations generally, trying to deal with the sovereign debt crisis among their number. There is a design flaw at the heart of the Eurosystem, right, of the -- of the EMU, and that is the absence of the minimal fiscal (Europe ?) required to support and sustain a monetary union.

You don't need much, right? You don't need a big redistributive mechanism. You don't need something to fund massive cross-border public investment programs. But you need two things.

You need a fiscal mutual insurance mechanism, called the European Monetary Fund, with, say, 2 trillion subscribed euros and a smaller amount paid in but the rest callable at the discretion of the fund board, which consists of representatives -- would consist, since (I'm playing ?) here -- of representatives of national governments, the European Commission and the ECB. And it would be accompanied by tough conditionality, including a threat, which better be credible, that if you don't play by the rules, you'll be cut off and you'll (likely ?) default.

Now, that wasn't created even following the Greek disaster. Instead, we had a one-off arrangement to -- not to solve the Greek problem, but, to take the Greek crisis out of the headlines for three years, to basically promise to finance the Greek government for the next three years. So whatever happens in the secondary markets now is of no interest to the Greek government for the next two years. It's of great interest to those who hold Greek government debt, right?

And if at the end of the three years we look back and Greece has met all the criteria, all the requirements imposed on it by the IMF and by the EU; and if the economy, in response, acts roughly in the way predicted by the European Commission and by the IMF; then at the end of three years, Greece will have a non-interest, a primary government surplus, just about, but only 50 percent of GDP (internal government debt ratio ?) instead of 130. At that point, the market has to start funding them again.

Well, I've got news for the people that designed this. The time it is rational for a country to default unilaterally is when you have a massive debt and no deficit, because the only sanction short of an invasion for a sovereign debtor that defaults is a cut-off from the financial markets. But if you have a balanced primary budget, you don't mind being cut off.

If Greece were cut off today, it would be disastrous because they would have to do the entire 10 percent of GDP primary deficit tightening overnight. And that's why the program at the moment is credible. But as soon as the deficit tightens and the debt builds, the temptation to default becomes stronger. In addition, I don't believe that the conditionality will be implemented. I don't think that the political consensus is there and political institutions are strong enough to support what will not just be three years, but more like five years of severe fiscal pain.

So I expect a restructuring, hopefully an orderly one, before long. And this particular episode, the three-year, 118 -- 110 billion euro facility that has been created can fairly much be seen as a way of making the eventual restructuring, with a serious haircut for the creditors, compatible with the survival of the euro area banking system, right? The Greek banks are heavily exposed to their own sovereign. Well, 32 billion is available to take care of that now. And of course, euro area banks, especially French and German banks, are up to their ears in Greek sovereign and Greek -- (very big ?) exposure.

And this window of the three years, although not all of it will be used, I think, is going to be used to either move -- recapitalize the European banks to the point that they can take the shock of, say, a 30, 40 percent writedown in the value of the Greek debt, sovereign debt, or more likely, move it off balance sheet, either through front organizations, like (public ?)-controlled organizations -- CDC, KfW -- or indeed straight onto the government balance sheet if there is an outburst of transparency, which is not completely impossible, although unlikely.

So what is the contagion risk? Well, no other country in the European economic area is in too regretful economic shape the way Greece is. The others should all be able to manage, but they can encounter at any time, because of nervous markets, liquidity problems which could trigger a default if they can't be tided over. Any country -- Spain, Portugal, Ireland, Italy -- could be locked out of the markets because the markets -- (inaudible). And (there is no ?) authority to deal with that, because the opportunity was missed and the risk is there.

The only entity that will be able to come in to tide over other sovereigns at the speed that these markets are likely to act is the ECB. So I expect that the ECB -- after swallowing once very deeply and agreeing to do one thing which it never would do, which is give differential access to the collateralized lending facilities to different sovereigns -- I expect that in due course will not just swallow, but hold its nose and engage in sort of euro-style quantitative easing, buying sovereign debt outright. I see no other way of preventing a liquidity crisis -- which will occur, almost surely, for one of the other sovereigns -- from turning into a solvency crisis.

So, interesting times. Remember also the euro area is in better shape fiscally than -- on average -- than the U.S. or the U.K., so it's going to come here, right? And those of you of Greek descent will be able to give lessons to the others on how to manage it.

Thank you. (Laughter.) (Applause.)

ELLIOTT: Well, that got us off to a cheery start. (Laughter.)

When you and I were chatting yesterday afternoon, shortly before the market plunge -- in fact, I blame us for the market plunge. I think someone was listening in to our conversation.

BUITER: Nothing to do with us. Nothing to do with us. No, no.

ELLIOTT: You set out for me a best case and a worst case of what's likely to happen now. So let's quickly run through those. I mean, I take it the best case is at the very least a significant dampening of growth, making the recovery -- the recovery phase more anemic, but talk us through the best case, and then let's have a look at the worst case.

BUITER: Well, best case is where sovereign restructuring, with maturity lengthening and serious haircuts for the creditors, is limited to Greece; and where (each is ?) a combination of early ECB intervention and the gradual construction of, you know, the European monetary fund that is necessary to provide the mutual fiscal insurance mechanism that's lacking at the heart of the euro zone, then can move to fiscal consolidation across the euro zone and, after that, in the U.K. -- which is just about to experience the joys of minority government -- and then Japan and the U.S. as well face a fiscal tightening, but orderly fiscal tightening; where their fiscal tightening is early enough, soon enough and of the right scale to convince the markets to let it happen without persistent testing, and where the composition of the fiscal tightening is such that it does as little supply side damage as possible. And that means it is mainly focused on unproductive public spending cuts rather than on tax increases involving especially high, you know, increase in marginal tax rates.

We shall see. So far, the talk is good but the actions haven't been quite as good. There can be mitigation in this case of the dampening effect on growth in the advanced countries through actions of the monetary authorities. They can't do as much as they would like to, because they're basically still at the lower floor for normal interest rates. And until they read my papers and figure out how to set negative normal interest rates (of any ?) value, that will remain a constraint. And they will also be able to revert their exit -- reverse their exit from unconventional, (quantitative easy ?) credit, easy -- enhanced credit support measures.

The ECB, before it gets to the unmentionable outright purchase of sovereign debt, will undoubtedly do other things like extending Greek-type collateral relaxation to all euro-area members -- restoring their three-month, six-month, nine-month, possibly 12-month all-you-can-eat long-term refinancing opportunities, at either a fixed rate or some indexed rate.

And it will undoubtedly also I think reinstate -- (inaudible) -- the currency swaps with -- well, mainly with the Fed but possibly with other banks as well, to make sure that for the corporates at any rate not just euro liquidity is available freely against rubbish collateral but also U.S. dollar liquidity, which can be a problem.

But ultimately of course that helps the banks and the other counterparties. But it doesn't help the governments. And the only thing that really will help the governments, when they hit the buffer, is going to be outright purchases by the ECB of government debt, at prices higher than they could fetch in the market.

So that would be the good news. I hope we get, you know, supportive market policies, more relaxed market policies. And also of course the region as a whole, all advanced industrial countries together, should have their real exchange rate depreciating as a result of the fiscal tightening, vis-a-vis emerging markets.

Now, the good news is, the emerging markets are likely to keep growing -- (inaudible) -- for at least the next year or two. It's robust growth turning to spectacular growth. And part of it is irrational exuberance.

There are credit and asset booms turning to bubbles and eventually to bust going on, from China to Mumbai to Brazil. But at least for the next couple of years, these incipient booms and bubbles will be growth-supporting in the emerging markets and therefore will benefit us.

When the thing goes -- this is still all the best scenario -- in about three years time, we will have a global recession. But you know, that is only to be expected, because that's the way capitalism has always worked.

Now, that's the good scenario.

ELLIOTT: So the good scenario is a global recession in three years time.


ELLIOTT: And the worst case? (Laughter.)

BUITER: That's where the Europeans don't get their act together, and where we get contagion from Greece to other euro-area countries, which is severe enough to turn a liquidity problem, which is what Portugal and Spain and Ireland -- at this stage, that's all they have -- into a solvency problem, because they simply cannot refinance their maturing debt and the new deficits that they still will be running, often in double-digit figures, at the terms available in the market.

So there would be a forced default. Portugal and Greece and Ireland are small enough to not have systemic importance. Spain is the sort of -- is the big canary in the mine.

But Spain relative to euro-area GDP is about the size of California. But it has a deficit which is about eight times the size -- seven times the size of California, and a debt which is about five times the size relative to GDP of California.

So it is -- it will be serious. And after Spain of course lurks Italy, which is a country that has so far been immune largely from market challenges, even though is has the highest debt-to-GDP ratio, because it has a much stronger deficit, especially primary deficit, ratio.

As I pointed out earlier, that is in fact a situation where rational default is indicated. But this is apparently not the course that Italian policymakers have chosen, even though they could have. And that must give the market confidence that they won't. So the ability to resist this is there.

Now, and so this would be a widespread sovereign solvency crisis in the euro area. What happens at that point, there are a number of scenarios. One of them is that the debt countries will simply have to fend for themselves. The other is that there will be an ex post rescue effort writ very large.

And that, should this become systemic, could end up undermining the euro zone, not because of the weak brothers and sisters leaving, because they never had it so good, right -- they're getting subsidized -- but because ultimately the creditors -- the donor countries, the fiscally strong countries -- would decide that this is something that they didn't sign up for.

There's even a problem I think if the ECB acts sensibly and does engage in money creation -- (inaudible) -- that this would evoke strong political response inside Germany.

The threat to the euro zone is from the strong countries, not from the weak. The weak want to stay in the lower-cost.

ELLIOTT: Well, let's pick up that point directly.

I mean, in your remarks and in your wonderful paper, you suggest essentially that there are relatively modest changes to the governance structure of the euro zone, of the European monetary system, that can assist a process of managing crises like this and making sure that they don't happen in the future.

There's another view I suppose, which is that the euro zone is fundamentally flawed and that the sort of adjustment that is required of nations like Greece and possibly Portugal, down the line, is impossible without the ability to do exchange-rate adjustment, which of course is a bit --

BUITER: Yeah, that's an attitude typically found among American economists who don't know the difference between the normal and the real exchange rate. This is a common disease in this country.

Devaluation, right -- okay, Greece decides, we leave the euro area, which they can do provided they're also willing to leave the EU. You can't leave the euro area without also leaving the EU. They throw their toys out of the pram and they leave.

The new drachma would immediately drop by 40 percent in value. (Inaudible.) In fact, I think Greece is not a country where everybody is agreed that there has to be a 25 to 30 percent cut in real wage cost, and everybody else agreed that it has to be done -- it can only be done in the short run, through a cut in actual real wages rather than an increase in productivity. That might be for the long term. (Inaudible.)

And the only thing they can't agree on is how to coordinate this. And then the exchange rate, the normal exchange rate, is a wonderful way of achieving an already agreed-on real wage cut for everybody.

Well, if you think that that's the situation in Greece, go ahead. But I don't think that's the situation in Greece. I think there is no willingness on the part of the modal Greek worker to take a 35 or 25 to 30 percent wage cut. So when -- if they were to have a massive depreciation, money, costs and prices would adjust very promptly and restore the old real exchange rate.

So you'd have basically a rubbish currency but no improvement in competitiveness. Improvement in competitiveness in Greece is nice. It would be nice for the standard of living and for, you know, human happiness and well being. But it is not to be counted on, as part of the fiscal adjustment process.

Greece and many of the other fiscally challenged European countries that have real rigidities -- including Spain, Portugal and Italy -- they will have to do their fiscal tightening with a take of constant size, without counting on growth, to bail them out.

Some people say that makes it hard or even impossible. I think that political economy argument is unconvincing. The notion that pain is, you know, having to give up something is more easily done when there is positive growth, especially fiscal tightening, is just denied by the facts.

When the economy grows, public sector demand -- demand for public sector spending grows. And there is no evidence there is a strong relationship between solvency and growth rates.

You can be insolvent with a high growth rate and solvent with stagnating real GDP. Greece has to find a political agreement, a burden-sharing -- fiscal burden-sharing solution over a period of years, many years, which will succeed in reducing real standards of living by 15 to 20 percent.

That's what has to be done. And it will be done. Will it be done -- (inaudible) -- after an involuntary default, without assistance from the rest of the EU? Or will it be done, you know, in a sort of cooperative and coordinated way?

I think it will be done in a coordinated and cooperative way. But the pain will still be there. And the notion that only a growing Greece can adjust fiscally, it's just naive nonsense. You (can't ?) be poor and solvent and rich and insolvent.

ELLIOTT: And the restructuring, which you would hope would be orderly, which you think is coming in Greece, you think -- you think will come when?

BUITER: Well, they need to have enough time to prepare the Greek banks, which can be done quite quickly, and the other European banks that are -- have this highly concentrated exposure to Greece for the write-down in the sovereign debt. And that will, I think -- should take now through most of -- through this year into 2011. I doubt whether they'll wait until 2012, because that gets us too close to the end of the availability to finance, right? You've got to do it while Greece can still fund itself at the concessional window that has been created. So probably 2011 sometime -- that's the most likely date.

ELLIOTT: And the -- and the size of the haircut?

BUITER: Well, if they did it today, there -- again, this is a straight bargaining problem, right? And once you decided, you know, to lose your virtue -- right? -- from Greece's point of view, they want to go for the biggest possible haircut they can get, right? Because the loss of reputation, of basically having defaulted, even if not in a legal sense, then -- you know, voluntary defaults, like, you know, somebody coming up to you, holding a gun to your head and saying, you know, "Give me your money," then you voluntarily hand over the money, right? But it's subject to the gun being at your head. And that voluntary restructuring is voluntary very much in the Army sense: "Now, I need three volunteers: You, you and you." (Laughter.)

So the reputational loss will be there. And they have for -- the incentive to go for the biggest possible cut in principal write-offs, so -- right?

Now, what can they get away with? I think it's hard for the European partners to agree to anything that would put the Greek debt-to-GDP ratio below the average of the rest of the euro area. So the Greek -- if you were to do it today, you'd get a 30 percent write-off, because that would bring Greece down from 120-ish to about 79, 80, which is the euro area average.

And -- but if it were to -- done towards the end of the three-year period, as the Greek debt-to-GDP ratio goes to 150 (percent) and rises relative to Euro average, I think it will be more like 40 percent.

ELLIOTT: So all the more reason to try and do it within the next 12 months rather than --

BUITER: Yeah. And in fact, if the -- if the European economic area governments weren't such wimps, they would have done it right away, have done it up front, and said, "Okay. We have the choice, you know. We have to (write down ?) Greece. That means we have to bail out their banks." All right? And, okay, do it. If you're going to do that anyway, but you're going to do it in a way that is not politically embarrassing and doesn't have to be done before the -- by election (and no signs ?) of failure and all that kind of stuff.

It has -- it's been a disgraceful episode for European heads of state, especially in Germany, for the narrow-minded parochialism that has been displayed in a way that really endangers not just the euro area, but the whole European Union. And it's quite extraordinary.

ELLIOTT: Let's see if we can pick some of that up in questions. At this moment, I'd like to invite members to join our conversation with questions. Please wait for the microphone to come, and speak directly into it. I think we've got at least two, maybe even three mikes.

If you could please stand and state your name and affiliation. Limit yourself to one question, please, and keep it is as concise as you can, because I'm sure we'll have -- we'll have many queries for Mr. Buiter. So who's going to go first?

Gentleman over there.

QUESTIONER: Tim Ferguson with Forbes. Could you speak to the currency-value implications of all of this?

BUITER: Well, clearly this is not a great time to be long euro. (Soft laughter.) And there are a number of reasons for that. Forget the breakup of the euro, for the moment. Forget even insolvency of -- you know, sovereigns in the euro zone.

Fiscal tightening leads to depreciation. Admittedly, that -- that is not just a euro concern. As I said, the euro area, as a whole, is in better fiscal shape than the U.K. or the U.S. So I wouldn't expect there to be more overall fiscal tightening in the euro zone than in the U.S.

But the U.S. will be delayed. So at least temporarily we could even out the sequence of fiscal tightening that they'll be undertaking to restore sustainability across the western world. We get a relative decline in the euro over the -- and an overall decline in the real exchange rate of the advanced industrial countries vis-a-vis emerging markets.

Then the ECB's loss of reputation for (being ?) the Bundesbank, right? And that's happened now, right? I really thought -- well, (as you have ?) put it more politely than what I told my colleagues -- that --

ELLIOTT: Oh, no.

BUITER: -- that the -- no, no. I would have thought that the ECB would have, you know, drunk poison rather than -- taken poison rather than give asymmetric treatment on the collateral front to different sovereigns. They have explicitly said, "We cannot do this. It is one monetary union, dah, dah, dah, dah, dah." And of course, no sooner is the gun at the head then it's actually, "We didn't mean this," Greece can -- these sovereign instruments are going to be acceptable as collateral, even if they're rated rubbish.

Now, the next step will -- big step, I think, after these intermediate steps of extending this particular collateral arrangement to all euro area members and restoring the earlier unlimited, you know, "all you can eat" refinancing facilities for corporate, the next step will be quantitative easing.

And that, even though you can do it in a way that technically doesn't mean monetization of sovereign debt -- because the financing of outright sovereign debt purchases by the euro system doesn't have to have this counterpart on the liability side of the balance sheet, an increase in the monetary base -- it could be financed through the asset side, by asset sales, including foreign exchange sales. And it could even be financed on the monetary side by basically the central bank, the Eurosystem issuing nonmonetary liabilities, you know, central bank bonds and central bank bills like Treasury -- (inaudible).

And so they -- but, whichever way it goes, we have the central bank, you know, outright -- in the outright purchase of sovereign debt. And that doesn't (read ?) like Bundesbank; this (reads ?) like Weimar, right? And that is their affair.

So I think the notion that the ECB, while legally also independent, is not substantively -- not because they are threatened, but because they have to recognize that when there is a conflict between their financial-stability mandate and their price-stability mandate, it isn't the price-stability mandate that's going to dominate. That's the lesson they have learned, right? And so the market will -- to see if the ECB is weaker and less -- is less tight, less restrictive, less teutonic. And therefore, that will weaken the euro relative to everything else.

And then, third, the sovereign debt, the general uncertainty and the fear of breakup of the euro zone. Nobody knows what this would mean, right? If -- clearly, if the euro zone were to break up by Greece leaving voluntarily -- they can't be kicked out, either -- but -- much to the regret of some German politicians, but it's not in the treaty, boys, so forget it. If they were to leave, that would strengthen the euro, right?

But if, on the other hand, the euro zone were to break up through the de facto expulsion of the fiscally weak countries through the mass exit of the rest -- right? -- then what would be left would be, you know, a euro where Greece is in charge of the central bank, right? (Soft laughter.) And that would be an extremely weak euro. (Soft laughter.) So these kinds of uncertainties mean that this is a good time to think about ways of shorting the euro. Yes, yes.

ELLIOTT: Very good.

Next question. Yes -- (inaudible) -- Marc. Yeah. Wait for the microphone. Here it comes.

QUESTIONER: I'm Marc Levinson with the council. The interest in joining the euro zone has been an important force in encouraging, should we say, good behavior in any number of countries in eastern and southeastern Europe. What happens in those areas now?

BUITER: Well, it is true that entrance into the euro zone has been a very strong incentive for fiscal good behavior prior to entry. Well, of course, this incentive dies the moment they say, "Okay, congratulations, you are now a member of the (graduate ?) club," right?


BUITER: And they see that, you know. And so it is no guarantor of good behavior, because the stability -- (inaudible) -- turned out to be, you know, a paper tiger, as many of us predicted when it was first created.

Now it is my expectation, however, that we will get the European monetary fund in not too distant future, or something like it, right this mutual insurance mechanism.

And then it will not just come with bags of money, enough to -- for the Powell doctrine of overwhelming force, but also with the ability to punish, including the willingness to turn a -- to put a country into painful sovereign restructuring necessary.

So it is the -- one of the -- this European monetary fund would have -- share with the IMF the ability to organize sovereign restructurings.

ELLIOTT: And you think that would be palatable to German political opinion?

BUITER: Oh, yes.

ELLIOTT: If you got both sides of that --

BUITER: It would -- if they would -- they -- I think --

ELLIOTT: -- and got both sides.

BUITER: If the alternative is open-ended financing of deficit --


BUITER: Yes. And it can be done without a treaty revision. This is the good news. It can be done under alliance cooperation. You just get the 16 euro zone members to set up this thing, and as long as it doesn't violate any of the existing rules of the Eurosystem, which I don't think it -- of the EU, with -- and the treaties, which I don't think it does, then this would work.

So what -- (chuckles) -- I forgot the question.


BUITER: I guess you --

ELLIOTT: Fine. More questions before I -- yes, over there.

QUESTIONER: Niso Abuaf, Pace University. You said before that three years down the road, there's a likelihood that U.S. government debt can lose its AAA rating. How is that possible when the U.S. funds itself in the dollar that it itself prints?

BUITER: The U.S. is -- like every every country that has independent monetary authority, when it has an unsustainable fiscal situation, has two options. One is default, right, and the other, if the debt is domestic currency-denominated -- is the case for the U.S. -- is inflation.

And (this incentives/disincentives ?) is stronger, based on, I think, the analysis of Rogoff and Reinhart-- or rather not based on, but extrapolating from them -- if much of the debt is held abroad, as it is in the case of the U.S. More than 50 percent of U.S. Treasury debt is held abroad. And it -- it's much easier for a country to, you know, reduce the real value of servicing interest-bearing debts with unanticipated bit of inflation if non-voting foreigners hold the stuff, rather than voting domestic residents.

Now -- but there are powerful constituencies, domestic constituencies, against an inflationary solution to an excessive government debt crisis. That is because there are -- there's private debt as well, and depending on the political configuration in a country, the creditors' lobby may be stronger than the debtors' lobby. That will be the case at the moment. I think at the moment an inflationary solution to the U.S. private debt problem would be politically acceptable to the majority party and to the -- and to the White House, because it would favor basically mortgage borrowers over the banks. Well, we know government would then have to recapitalize the banks, but you know, that's for the next administration to worry about.

So what is the -- but if the U.S. -- if the political equilibrium shifts, then an inflationary solution may be less attractive, because it redistributes also from private creditors towards private debtors, than an outright default solution. Sovereign default is -- (can effect ?) approximately a redistribution of conflict between the owners of the debt, the creditors, and the taxpayers and the beneficiaries of public spending, and it is -- especially when much of the debt is held abroad, it is often attractive, especially if a country is no longer in a significant external imbalance, which the U.S. unfortunately still is -- fortunately, if you're a creditor -- then you may choose the taxpayer and the -- and the public spending beneficiary over the foreign -- over the foreign creditor.

Now how likely is it -- so the motive for a U.S. inflationary solution is there. All right? But you need opportunity as well. You need a non-independent central bank or at least a central bank not committed to price stability. And you'd need serious inflation to really erode the real value of U.S. debt service to a significant extent, because the maturity of the U.S. debt is only half of what it was the last time the U.S. engaged in a big reduction of the debt-to-GDP ratio, from '46, when it was 121 percent of GDP, to '75, when it was 31 percent of GDP.

So the maturity of the U.S. debt, on average, is just under four years. It was eight then. So that means that you have to go well into double-digit unanticipated inflation to make a big dent in that.

Now -- and the current Federal Reserve Board and FOMC simply wouldn't deliver that. They may not be as -- you know, as fearsomely Teutonic in their price stability preferences as we saw the ECB was, but they won't inflate the debt away. And that means -- but of course, the -- constitutionally, the Fed is not terribly independent; only, you know, an act of Congress stands between the Fed and either changing its mandate or change the composition of the board in the FOMC.

So the question is, how likely is it, politically, that you either get a double populist majority, you know, pro-inflation majority, in the Congress and in the White House, or a single superpopulist -- there's a populist supermajority in the Congress, sufficient to override a presidential veto. I think it's possible but highly unlikely.

So I think the U.S. does not -- while it has in principle an inflation option to serve it -- to reconcile its unsustainable debt, through the debt problems, it is -- it will not, you know, likely be able to exercise that option. And that means that if debt's unsustainable, then for the U.S. too there's only one option, and that is restructuring, default.

So (the risk still being on ?) zero and the market's already recognized that through the CDS swaps.

ELLIOTT: Garrick, yeah, then over here.

QUESTIONER: We're talking -- Garrick Utley, Levin Institute -- about the debt problems in advanced industrial countries. There's the other elephant in the room, as there always is, which is China not only holds so much of the American debt but sustains spectacular growth, as you say, danger of a bubble.

A, what do you -- what's your forecast for China? And how vulnerable is it to the bubble bursting? And if that were to happen, how does that impact on what we're talking about this morning?

BUITER: Well, Chinese growth is clearly in the irrational exuberance phase. It's well into double digits, and it's driven by, you know, credit growth and the tail end of a fiscal stimulus, which were, I think, the entirely appropriate Chinese (change ?) response to this -- to the fallout for China of the financial collapse in the West.

And -- but they have not reversed their massive credit injection even when growth was restored, and growth is now running above capacity and credit growth and asset price behavior suggests that there's at the very least booms on the way and selectively already, in isolated pockets, so far, of the real estate market, evidence of bubbles. This, though, can go on -- (chuckling) -- as we know, housing bubbles can go on for decades, but at least in most -- (inaudible) -- market these things move in very fast motion. And I don't think the policy authorities are likely to slam on the brakes with effective instruments to prevent this. So we'll have the full sequence of boom, bubble and bust in the real estate market and also in the stock market in China.

Why aren't the authorities going to respond appropriately? Well, there are a number of reasons for that. First, they're inexperienced in this matter, right? They haven't seen too many asset boom, bubbles and busts. They're a new capitalist economy. So they're not experienced. So mistakes are easy.

Second, they're in election mode, all right, and seven of the nine supremos will turn over in -- well, just over two years from now, late 212 (sic), early 213 (sic). And then that means that both the seven incumbents that are retiring to make way for the fourth generation will be jockeying for position to retain power, post-retirement, and the new second-tier candidate leadership will be, you know, jockeying for position. And you don't increase your chances of being elected to the highest office or of retaining sort of post-retirement power and influence if you're going against the boom and the bubble.

We know that in this country it's a -- (chuckles) -- and so I think that there'll be a massive display of timidity and the use -- the determined use of ineffective instruments -- (laughter) -- the way we are seeing now in the reserve ratio requirements.

Where are the interest rate increases, right? Where is the appreciation of the renminbi? And where are the constraints on first mortgages, right? And they have constraints on second and third mortgages. Well -- well, good luck. But this is -- it is just -- it's classic, you know, "Let's hope it lasts until early 2013" behavior.

So -- and it's not just that way, of course, in China. It's that way in other emerging markets, as well. In India, the conservative but independent previous head of the central bank has been replaced by a Treasury official who is much more pliable. And India has double-digit inflation now on the wholesale price -- (at least, that's an issue that they use ?). And they have negative real interest rates, in the face of a massive boom.

In Brazil, things have improved slightly, because there looked like there was going to be a double transition: that both the president and the head of the central bank were going to turn over. Now the head of the -- the head of the central bank by becoming a candidate for vice president, actually. (Laughs.) But head of the central bank is now going to stay, so that -- Meirelles -- so there's some chance of continued tightness there.

But the -- it's unlikely that Lula's successor -- at least, the expectation should be that Lula's successor is not going to be the same conservative trade-unionist that Lula was. And so they may well turn out to surprise us all but -- as Lula surprised us -- but the expectation is -- (inaudible). So my expectation is that the fiscal loosening that has gone off -- gone on in Brazil since the crisis -- most of it off budget, which is -- in itself, is worrying -- will be more likely to continue under successors. So in Brazil, too, not yet on the monetary side, but on the fiscal side they're behind it. So we see, you know, the classical, you know, boom, feel-good, you know, and who knows, this might be different this time, right, behavior that we see whenever a boom is happening. So, yes, we will -- they will (give us ?) growth for the next couple of years, and it will help us. But after that, see you in 2013.

ELLIOTT: Just to round that out, that's why -- that's why your best-case prediction is that, in 2013, whatever --


ELLIOTT: -- recovery we have seen runs into the sand?

BUITER: Yes, the external stimulus will go.


BUITER: And I don't think you will have improved fiscally then yet to the point that we can (be agents ?) domestically to stimulate demand, because they still have the albatross of an excessive debt, the impossibly -- unpleasantly large, structural primary deficits, to spook the markets, that it could lose more to adverse market reaction to fiscal expanse than they gain from the conventional -- (inaudible) -- multipliers, whose power, I recognize, provided the markets, you know, don't take flight.

ELLIOTT: Gentleman over here, please.

QUESTIONER: Thanks. Brian Silver, Morgan Stanley.

So the U.S. is also a -- sort of a currency union. What happens when the constituent members of the U.S. currency union hit the wall, in terms of re-funding their debts, as looks like it's happening at the state level in a number of states, including this one?

BUITER: Well, they'll be bailed out by the federal government.

QUESTIONER: And so what's the implication of that?

BUITER: Well, there'll be more need to -- it doesn't change the -- this -- the total magnitude of the pain. It changes the distribution, right? So I haven't seen the distribution of U.S. debt burdens by state. The state and local debt problems in the U.S. are actually minute compared to their -- the national (current ?) debt problems in the -- in the euro area. Because even California -- well, it has less than 2 percent of GDP deficit. And its debt-to-GDP ratio is 16 percent now? Something like that? No -- and every -- every country except Luxembourg in the EU -- and Luxembourg's not a country -- (laughter) -- would -- you know -- would cut off at least one vital organ to have those kind of numbers. (Laughter.)

So, yes -- so these are small problems from a macro point of view. They may be unpleasant problems from a local and regional point of view. I mean, the U.S. states have, of course, you know, this extraordinary capacity to restrain their ability to raise revenues, or indeed to cut spending. And that makes for local problems and extreme squeezes on particular unprotected spending categories. But it's not -- it's not a macroeconomic problem.

If the entire U.S. -- if you tore up the U.S. Constitution and said, okay, all state debt is now federal debt and the states -- every governor is now an employee of the Treasury, and you (sign Treasury bills ?), it wouldn't make any difference macroeconomically.

ELLIOTT: Yesterday -- I'm sorry. Yes, a question right in the back. Then I'm going to ask one.

QUESTIONER: Hi. Mark Luke (sp), Columbia Law.

I want to ask if you could talk a little bit more about Japan. How concerned are you about Japan? Or how does the scale of its problems compare to European countries, advanced European countries, the big powers and the U.S.?


QUESTIONER: And given the political constraints, or incompetence that some would say they face, what's your forecast for how it will either muddle its way through this problem, or how bad could you think it could get over the next five years?

BUITER: Well, Japan, I find, and always found, one of the most difficult countries to make sense of because -- it is their physics that gravity wouldn't work in Japan, right? (Laughter.)

And now, the gross debt-to-GDP ratio in Japan is the highest in the known universe. It's 200 percent of the annual GDP now. Net is about half that. That's much better, but this is it: It's only good compared to 200. A hundred-percent debt-to-GDP ratio -- remember, this requires that countries be able to generate primary surpluses, on average, in the future, as a share of GDP, equal to the average interest rate on the debt, minus the growth rate of GDP, times this debt stock.

Now, if Japan grows -- I think normal GDP grows, on average -- let's be optimistic. Let's say it's going to be 3 percent, right? If you think that a risk-free interest rate is 3 percent, then in fact Japan would, on average -- if people believed the debt were safe, right? -- only have to -- you know, to run a balanced primary surplus. And they're not that far away from that. No, it's about -- what is it? The corrected primary surplus is -- in fact, is minus-5 (percent) -- 6 percent -- 5-1/2 (percent), 6-1/2 percent. So that looks correctable.

So that's an equilibrium. That's the equilibrium that Japan appears to have. Massive debt stock, but since the deficit is not that large, the structural primary deficit, it looks correctable, especially since the Japanese, unlike the Greeks and unlike -- you know, pay their taxes; and again, unlike the Greeks and the Americans and the Brits and the Irish, save. Right? And therefore, there's a large stock of private financial wealth which, and to a certain extent -- and I'll make this clear -- balances the stock of public-sector financial debt, as reflected, therefore, in the net international investment position of that country.

Japan, therefore, faces the problem of an internal transfer to restore fiscal sustainability. As currently constituted, the Japanese situation is unsustainable, you know? You need at least, I would say, 5 (percent) or 6 percent of GDP, of permanent tightening, to make it sustainable. But that looks do-able in a country that pays taxes, especially if you grew the stock of private financial wealth as a potential sort of tax base -- either, you know, a sort of capital levy on the stock, or some tax on the income streams that could be regenerated by it. Or, indeed, if you view -- even if you can't tax -- that you knew that you could cut public spending in the future, because the private wealth is there to allow people to fund privately what previously was from the public. So there is this -- you just have an internal transfer problem, from the taxpayer and the beneficiaries of public spending to the state and to the creditors.

Now, other countries have an internal and external transfer problem. Right? They have a lot of -- a large negative net foreign investment position. I have learned that a number of them have paid -- I think Greece is close -- in the 60s, I think, of -- 60 percent of GDP, negative net foreign investment position.

Spain's slightly larger; Ireland in the 50s, although most of the Irish -- the foreign liabilities -- a large part, not most -- of the Irish liabilities are FDI, right? But another part is bank debt, so that's the nasty stuff. But the FDI is, of course, a discretionary obligation, so it is -- it gives you more -- some flexibility in the default risk associated. And the U.S. is a significant net foreign debtor, and -- as is -- as is -- as is the U.K.

So these countries have to achieve both an internal transfer to stability --

QUESTIONER: And the external -- yeah.

BUITER: -- and the external transfer through the (generation ?) of primary -- call it trade surpluses, and the depreciation of the real exchange rate. And that's a lot harder.

Now, I would be very worried, however, if I were the Japanese minister of finance, because I -- say that this looks manageable if people believe the debt is safe. Right? But say if people suddenly say, oh my God, we have a 200 percent of GDP gross debt stock and 100 percent net, right? I'm going to -- this could default. And you just put a 400-basis-point risk threat on the (safe ?) rate.

Well, this gross debt of 400 -- 200 percent of GDP, that is 8 percentage points of GDP additional interest payments, right, after the debt -- not instantaneously, but as the debt rolls over. That could well become unsustainable. And it -- what this means is -- and this is the worrying point -- there exists, in fact, always in a situation where a country has a large stock of debt, even if the deficit is not that large, even if the deficit is a surplus, there always exists a fear of default strong enough to make default a reality.

If everybody believed for sure that the Japanese authorities would default, then they would be frozen out of the market immediately, they wouldn't be able to fund themselves, and they would default. They would go -- and so for some reason Japan -- I think because there's been a liquidity cap for a long time -- has got stuck in the low-interest and safe equilibrium. But I think it could shift to an equilibrium where sovereign debt fears begin to haunt the investor population. And in that case, the situation could become unsustainable simply because it is feared to be unsustainable. You can bootstrap yourself into unsustainable equilibria, and Japan is a prime candidate for that, because it has this massive stock of debt.

ELLIOTT: Well, we've ended up worried about Japan. We started out worried about Greece and the rest of the euro zone. We've tucked in worries about the U.S.. We've decided that there is a bubble that is going to bust in China. We can, I think, thank the Lord for the -- as you said at the start -- the boring Scandinavian countries, bless their hearts, and Australia and New Zealand. We could -- both of which are, unfortunately, a long way away --

BUITER: And small.

ELLIOTT: And small. But thank heavens for them.

We could carry on talking about these topics for at least another hour. But meanwhile, please join me in heartily thanking Willem Buiter -- (applause) --

BUITER: Thank you.

ELLIOTT: -- for a fabulous morning.

Have a wonderful day and weekend! Thank you, everybody.







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