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Can the Eurozone be Rescued?

Speakers: Sebastian Mallaby, Director, CFR's Greenberg Center for Geoeconomic Studies, and Benn Steil, CFR Director of International Economics
Presider: Robert McMahon, Editor, CFR.org
October 27, 2011, Media Conference Call
Council on Foreign Relations

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ROBERT MCMAHON:  Good morning, everyone.  And welcome to this Council on Foreign Relations media conference call.  I am Robert McMahon, editor of CFR.org, and I'll be moderating the call on the eurozone deal reached in the late hours at Brussels.

To sum up quickly, the deal includes an agreement by bondholders to accept 50 percent writedowns on Greek debt, an agreement to boost the lending capacity of the rescue fund to some $1.4 trillion.  We have already seen what some are calling the relief rally in global markets today.

But to make sense of the deal, we're fortunate to have the director of CFR's Greenberg Center for Geoeconomic Studies, Sebastian  Mallaby, and Benn Steil, CFR's director of international economics. Each will make an opening set of comments about the deal, with short follow-up from me before we open up to your questions.  And I know there are a lot of you on the line, so we'll get to that as soon as we can.

Sebastian, why don't you lead off with your reaction to the deal?

SEBASTIAN MALLABY:  Sure.  Thanks, Bob.  Let me quickly make five points.

The first thing the sort of pre-dawn euro-climax was addressing was this Greek debt writedown of 50 percent, and that definitely is a more realistic target for what's needed than the 21 percent agreed in July.  But there are several questions, still, about this Greek deal.

The first is that it's supposed to be voluntary.  And if I understand English, voluntary means that the banks may not have agreed to it.  So whether they actually accept the writedown and whether there's some stuff that they will put into the fine print -- which actually happened after the July deal -- that will mean that the real writedown is quite a lot less than 50 percent, remains to be seen. I'd be surprised if they get everything that the headline claims. They certainly didn't last time.

Second thing is -- on this Greek thing is that a voluntary writedown is in some sense worse and more destabilizing than a compulsory one, because it nullifies CDS insurance contracts, which means that banks that thought they had insured themselves on their Greek debt exposure because they had CDS on it will now discover that the insurance isn't paying out.  So that could actually cause more trouble.

Another point on Greece is that even a haircut of 50 percent, if they could get it, is not a guarantee of success.  The goal here is to get a debt-to-GDP ratio for Greece down to 120 percent by 2020. That's still a massively high ratio.  If there's any slippage at all in the program, it will be higher than 120 percent debt-to-GDP.  And even at 120, frankly, I don't think Greece is viable as an economy that can borrow in global markets.

And then lastly on Greece I'd say that, you know, these kinds of writedowns, while necessary, do raise questions about holders of other peripheral European debt, such as Portuguese debt, for example, where the yields are already nearly 12 percent.  If the euro authorities have shown that they will impose this kind of haircut for Greek bonds, why wouldn't they do it for Portuguese bonds too?   And so I think banks are going to be worried about that.

Quickly on the European Financial Stability Facility, they say they're going to leverage it to get more fire power.  I think I read that as effectively admitting that the EFSF that they have, the bailout fund they have, is too small to be effective.  They're admitting that by saying they need to leverage it.  They're not saying how this leverage is going to work or what the unintended consequences might be, so how can a stretched government, which is already in -- take France, which is already facing the danger of a credit rating downgrade -- how can it leverage its commitment to the fund without further imperiling its credit rating?  I mean, when you don't have real money, leveraging is not actually a substitute.  So it's not clear how this leveraging is really going to work.

And also, if it did work and you guaranteed some of the new bonds being issued, there would be consequences which would be negative for the ones -- the other bonds, the outstanding stock, which will not be insured, and that, again, will hurt the banks who own all this dead stock, because I think the insurance is only going to apply to the new bonds that get issued.

There's also talk about a kind of extra EFSF, to which China and Brazil and other non-European countries are going to be invited to contribute.

We'll see at the Cannes G-20 summit on November 3rd if they come through with that money, but my basic prediction would be it will be peanuts.  There will be some face-saving amount.  But why should the Chinese feel more motivated to bail out Italy than Germany?  Germany is a country which actually has a shared border with Italy, and if Germany is not going to do it, I don't see why the Chinese should feel compelled to do so.

Then there's the bank recapitalization.  And there the upshot of this morning's -- Thursday morning's pronouncement is that the goal is to have a 9 percent tier 1 capital ratio in the banks by 2012, to boost it to 9 percent.  Now, I read that a bit as I read the EFSF leveraging announcement.  In other words, the authorities are announcing admitting that they don't have enough capital in the banks yet, so they're admitting to the frailty of the system, but they're not proposing any solution that's going to work in a useful time frame.

They say they want to get this capital shortfall fixed by June of 2012.  Well, I mean that's sort of eight months away oar something. So you're admitting that for the next eight months when markets are in high panic, you don't have a solution.  And that doesn't feel terribly reassuring to me.  And then, of course, again this question of, if you are going to recapitalize, who on Earth is going to stump up the money?  The Germans basically avoided being on the hook for that.

Maybe I should leave it there, Bob, because I don't want to run over, and I want to hear what Benn has to say.

MCMAHON:  Thanks, Sebastian.  A somewhat sobering assessment there.

Benn, what's your take?

BENN STEIL:  Well, I'd start by pointing out that this is the 14th eurozone leader summit since the last 21 months, and there are going to be many, many more over the next 21 months.  So this is not the end game by any stretch of the imagination.

Nonetheless, I have positive feelings about the outcome last night, mainly for two reasons.  The sovereigns and the banks have been joined at the hip in this crisis for the past several years.  The sovereigns have taken on the risk of guaranteeing bank debt.  The banks themselves, of course, are massively exposed to sovereign debt. And broadly speaking, the eurozone institutions have been in denial about the dire situation of both over the course of the crisis, and they no longer are.  They're accepting a very major haircut for Greek debt, and they're also acknowledging that the banks will need to be recapitalized.  And I think that's a significant step forward.

To make some specific remarks on what I think are important questions that come out of this agreement, let me start with Greece. As Sebastian mentioned, even with this significant haircut that we're talking about, a 50-percent writedown, Greece will have a debt-to-GDP ratio in 2020 of approximately 120 percent, which is still extremely large.  If you compare this to previous sovereign defaults, this is probably a relatively small writedown when you look at it from that measure.  It is hardly out of the question that we'll be seeing more significant writedowns of Greek debt over the next year or two.

In terms of the bank recapitalization plan, I think it's significant that the eurozone leaders are acknowledging that the banks are going to need to bolster their capital.

They're talking about a requirement of 106 billion euros in extra equity capital that the banks will have to raise by June of next year. But of course, they haven't provided any details about how the banks are supposed to raise such capital.  It'll be exceptionally difficult for them to raise such capital cost-effectively in the market in the foreseeable future.  So that's a major question mark.

If you look at the eurozone rescue fund, the leaders have acknowledged that the existing 440 billion euros that they've committed are not enough.  They want to increase the firepower to roughly a trillion euros.  But as Sebastian emphasized, they haven't been specific about how they are going to get there.

Most likely, what they look set to be doing is turning the EFSF into a form of collateralized debt obligation, a CDO, with the 440 billion euros that's already been committed by the governments becoming, in effect, the riskiest equity tranche of the CDO.  This may remind you of the subprime crisis in 2008, and sure enough, it does bring back memories of CDOs that went bad during that period.  But I'd emphasize that those CDOs ultimately wound up being backstopped by the taxpayer, and in this particular case there is no taxpayer left to backstop this equity tranche.  So this is a very, very risky, in my view, way of increasing the size of the eurozone rescue fund.

With regard to the European Central Bank, the agreement has been mum on their continued role going forward, but I expect them to continue to make bond purchases.

The ECB has been the European institution most in denial over the course of the process.  If you go back to February of last year, you had Jean-Claude Trichet even indicating that it was, quote-quote, "inconceivable" that Greece could ever go to the IMF.  Then, of course, he denied that the ECB would be involved in bond purchases. And of course, the ECB until very recently said it was out of the question that there could be any defaults or haircuts.  They've had to accept that.  So they've been pulled kicking and screaming into this process for almost two years now.   I should point out that the ECB itself only has 81 billion euros in capital, and it may have to be recapitalized over the course of this crisis.

With regard to the role of China, it's understandable why eurozone leaders would like them to play a significant role in the bailout.  The potential is certainly there.  To put it in context, Chinese euro purchases over the past 12 months are roughly equivalent to the entire 2012 net financing needs of the so-called PIGS countries -- Portugal, Ireland, Italy, Greece and Spain.  So that makes their participation rather attractive, but I agree with Sebastian that they have relatively little motivation for committing capital to this.

Final point I would like to make is with regard to the CDS market.  If CDSs are not triggered in this particular case, I think over the coming year or two you're going to see a major unraveling of the CDS market, because it's becoming clear that CDSs are a legal bet and that politicians are willing to run roughshod over them. I think this market is going to lose liquidity.  I think there will be further political attacks against it and I think it will play a much smaller role in the future.

MCMAHON:  Benn, thank you, and Sebastian as well.

So let me just follow up with what happens next.  Sebastian mentioned the summit coming up next week, the G-20.  I believe a few days after that there's going to be an EU finance ministers' meeting. What should we -- I guess starting with you, Benn, what should we expect to see happen next?  When are we going to get signals of some of the details that you've both identified that need to be sorted out?

STEIL:  I don't think we're going to get them at the G-20 summit.  I think we'll get expressions of support for this package from the non-European leaders, certainly from the United States and China.  But I don't think we're going to see details emerging through the G-20 process, just cheerleading.

MCMAHON:  OK, and Sebastian, then, so will there be some calls ahead of time with Chinese and Brazilian attendants, and then some sense of papering over any difficulties at that summit?

MALLABY:  Well, you know, I think Sarkozy of France is going to speak to his Chinese counterpart today.  And they're obviously going to make a big effort, the Europeans are, having announced that they want to get this new funding vehicle in place that would attract capital from other countries.  You know, they're honor-bound to do their best to do that.  And I suspect that, you know, the Chinese and the Brazilians and so forth, who actually did make noises that they would be ready to do this about a month ago, will probably, you know, get diplomatically negotiated into a position where they might put down some token amount.

But I don't think it's going to be big bucks because I don't see why China wants to shoulder a bunch of risk in Europe when Germany has the cash and Germany is refusing to do it.

I also think we should keep in mind that, you know, if China was to announce some token contribution, it's not as though it was doing zero in the past.  As Benn said, you know, money has been flowing into European bond markets from China, maybe not into the peripheral bond markets, more into German paper, perhaps, but I mean, one should be careful.  For example, if the IMF was to put money into this additional financing vehicle, the IMF has been putting money into Greece in the first package anyway.  So it's not necessarily going to prove that the Europeans have successfully brought more capital in than would have been there without this new financing vehicle.

So I'm just, overall, rather skeptical.  It feels like a sort of buck-passing effort where, essentially, Germany was faced with a potential for a bigger bill in terms of bailout money, and they've tried to shift that burden onto the rest of the world.  And I don't see it really working.

STEIL:  It should also, Bob, I would emphasize, make the $440 billion euros that the eurozone creditors have already pledged to back the EFSF more risky.  As I said, that would turn it into something similar to the equity tranche of a CDO.

MCMAHON:  OK, well, thanks for setting things up like that.

I'd like to open it up now for questions from those on the line. Operator, are there any questions for starters?

OPERATOR:  Ladies and gentlemen, at this time the floor is now open for your questions.  (Gives queueing instructions.)

And we'll give it just a minute so parties can queue up.

Our first question comes from Mike Dorning with Bloomberg News.

QUESTIONER:  Hello.  I was wondering, in your opinion, how important is what remains to be done on the European debt crisis to the state of the U.S. economy next year when Barack Obama runs for re-election? And how much ability does he have to influence what the Europeans do? You know, he's been talking about that he sees this as a crisis scaring the world and wants to see them take decisive action.  How much ability does he have to influence this, and how big will it be for his political future with the state of the U.S. economy?

MCMAHON:  Sebastian, you want to take that one for starters?

MALLABY:  Well, on the last bit about how much influence the U.S. has, I think the answer is not very much.  I mean, it's been trying, both behind the scenes and then sometimes a bit publicly, to put pressure on Europe for more decisive action.  And there was that famous incident when Tim Geithner flew over to Europe, and the Austrian finance minister, I think to quote actually Bob McMahon here, our conference chairman, who put it very well in a CFR podcast where he said that, to use a technical term, the Austrian finance minister told Geithner to buzz off.  (Laughter.)  I think -- I think that was you, Bob.  Anyway, so I don't think the U.S. has a lot of influence.

Now, does -- is the U.S. highly exposed to what goes on in Europe?  It's interesting because if you look at the kind of visible channels of contagion, they're less awful than I would have guessed. So for example, if you look at the trade channel, about 13.2 percent of American exports go to Europe.  So even if you imagine a big slowdown in Europe and exports to Europe fall by 10 percent, that's a 1.3 percent fall in exports, which translates into something like a .2 (percent) or .3 percent hit to U.S. GDP.

So it's not nothing, but it's not big.

And equally, if you look at the capital markets channels, U.S. money market funds have pulled back from financing peripheral European banks over the summer.  Direct bank lending exposure is relatively small.  I think it's, you know, .5 percent of Tier 1 capital or something.  It's really not that big.

So the visible channels of contagion are not too awful, but the problem is the kind of unknown dangers, the -- you know, the sort of -- the derivatives exposure that we might not be able to see, and then the fear that there might be such an exposure that we can't see.  And the fear itself, of course, can spook capital markets, and I think you see that in the behavior of equity prices in the U.S. over the last month or so where there have been clear periods when the behavior of the stock index in the U.S. has been linked to political progress in Europe or lack thereof.

MCMAHON:  Thanks, Benn.  Do you want anything on the U.S. --

STEIL:  I agree with Sebastian that the trade channel is a relatively minor one here.  A continued slow-down in the euro zone economy will obviously not help the U.S. economic recovery, but it won't hinder it enormously.

The financial channel here is much more important.  Although U.S. banks are not massively directly exposed to Greek sovereign debt directly, they are exposed through the lending channel to European banks.  Obviously U.S. money market funds are exposed to European banks.  And the health of the European banking sector is extraordinarily important to the future of the U.S. economy over the next year.

MCMAHON:  Thanks very much for that question.

Operator, is there another question, please?

OPERATOR:  Yes, our next question comes from Larry (sic) Nakamura with the Washington Post.

QUESTIONER:  Hi, guys.  Thanks for doing this.  It's David Nakamura for the Post.  I just wondered -- I sort of had the same kind of question. I just wanted to see if you could sort of lay out for me what kind of role the U.S. is going to try to play at the G-20, what the president will try to do.  Even if he doesn't have influence, how will he try to influence things there, if he does?  And does, you know, his own troubles domestically here with the economy and with Congress and his jobs plan lessen his influence in any way?

MCMAHON:  So Sebastian, the atmospherics at the G-20 and the U.S. role, what do you see?

MALLABY:  I mean, I'm afraid what I see is that the standing of the U.S. internationally is simply not that great.  You know, there's a sense, if you listen to the way that someone like Trichet or other European leaders sort of express what's happened in the last five years in the world economy, the way they put it is, look, you know, there was a crisis that began in U.S. subprime markets because the Americans failed to regulate their finance, and then it spread to us, and we were the victims.  Now, that's not actually true because quite independently of any CDOs in the U.S., Greece was lying about its deficit through its teeth, pretending it had a 3 1/2 percent of GDP deficit when it really had 15 point something percent.

So I mean, Trichet is not correct, but that is what Trichet says, and that's what Europeans think.  And I think, you know, lecturing from American leaders at this point simply doesn't work.  It doesn't -- you know, we don't have the moral standing to say to people, listen, guys, we know how to run an economy, he's how you do it, because we had the financial crisis.  We have ongoing debt crises.  We can't get our fiscal policies worked out.  There's gridlock in Washington.

The president's, you know, facing a tough reelection, even though he's got weak opposition, because of the economy.

So I just -- I think it all adds up to a position in which part of the larger issue behind these, you know, extraordinary series of European summits -- I think Benn said 14 in 21 months, an amazing statistic -- you know, part of -- part of the back-story to that, it seems to me, is that U.S. leadership, which in the past might have been helpful in sort of pulling the Europeans together, has eroded. And so you've got a world where the natural post-war leader has kind of got its hands tied behind the -- behind its back, and the world ain't doing too well as a result.

MCMAHON:  Benn, anything to add?

STEIL:  I think the administration will welcome the fact that the problems in Europe will take some political pressure off them internationally, in terms of addressing U.S. budgetary challenges.  As you know, Bob, we've got the so-called supercommittee meeting right now, with an enormous remit to cut the U.S. budget deficit in the coming years and a looming deadline of Thanksgiving.  I think the administration will be happy to have foreign pressure somewhat ameliorated by the focus of international attention on the European situation.

Having said that, the U.S., of course, still has major issues with China, and particularly its exchange rate policy.  And I think it's going to have trouble getting robust support from the Europeans in these circumstances.

MCMAHON:  Thanks, Benn.  And thanks, David, for that question.

Operator, is there another question?

OPERATOR:  Yes, sir.  Our next question comes from Steven Leslie with The Economist Group.

QUESTIONER:  Hello, I'm looking to see if either of the speakers have views on kind of unexpected possible exposures to the European situation.  And you know, what I'm thinking about is some of the -- some of the things that were revealed in the wake of the Lehman crash. So do you see any of those in the U.S. or, for that matter, in Asia or Eastern Europe or Latin America?  Maybe some of these European banks are going to have to backpedal from some of these far-flung operations they've been running, for example.  Do you see any kind of consequences, second-order consequences of that type?

MCMAHON:  Benn, do you want to start off on that one?

STEIL:  Well, you know, one of the reasons that the euro zone leaders were absolutely adamant that this restructuring had to be voluntary is that they didn't want to trigger the performance of credit default swaps written on Greek debt.  And the main reason they didn't want that is because they really don't know the network of exposures in that market, which is remarkable and very disheartening given how much emphasis was put on rectifying that problem back in 2008 during the AIG crisis.  So we've really made very little progress in that area.  The CDS market is one area of vulnerability.

One I would emphasize longer term that I don't think has gotten nearly as much attention as it deserves is that although many are calling for the European Central Bank to play a much larger role in dealing with this periphery country sovereign debt crisis in Europe, it really doesn't have the sort of ammunition that I think its advocates assume it has.

As I pointed out earlier, the ECB has only about 81 billion euros in capital.  To put that in perspective, a 25 percent haircut on its direct and indirect PIG debt holdings -- when I say indirect, I'm referring to the fact that PIG debt is often used as collateral for ECB lending -- and I'm actually leaving Italy out of the equation here; I'm just referring to Portugal, Ireland and Greece -- that a 25 percent haircut would be roughly enough to wipe out its 81 billion euros in capital.

Now it is not impossible for a central bank to continue to operate for a period without capital.  But someday, at some point in the future, the ECB is going to have to tighten monetary policy.  It's going to need assets to sell.  And in that environment, Germany will have to commit to recapitalizing the ECB in a timely fashion or we would see a god-almighty horrible global run against the euro.  So I don't think that's gotten nearly as much attention as it deserves.

MCMAHON:  Sebastian, any other under-the-radar issues you want -- (inaudible)?

MALLABY:  Well, I think, you know, Benn is drawing attention to a very important one, because the ECB really is at the center of the entire process.  And in fact, you know, when it comes to the -- if you do the postmortem on the Lehman crisis in the U.S., the Fed clearly had a far, far, far bigger role in stabilizing the system than the TARP or any other Treasury-run, congressionally authorized spending program.  I mean, the Fed really was the key player, and in the same way, the ECB, by pumping unlimited amounts of liquidity into European banks to sort of prop them up, at least so far; and it has done the same at crucial points where Italy's bond yields seem to be rising to a dangerous level.

They've stepped in and brought them down again.  So if the ECB, as Benn says, were to run out of capital and if it's sort of solidity were to be questioned, that would be absolutely, you know, Armageddon.

My own view is that it's kind of tragic that on the one hand, the European governments have been willing to put in 440 billion euros of commitments into this bailout fund, the EFSF, and then they want to leverage it and sort of, you know, turn it into sort of more of a bank-like structured financial product, or a CDO-like one.  At the same time, they sort of have a better instrument, I think -- perhaps Benn would disagree here -- they have a better instrument in the form of the central bank already; I mean, 81 billion of capital in the central bank.  If you'd used that 440 billion, you could have multiplied it by several times.  And the European Central Bank could have gone off and, you know, printed the money to get the leverage to go off and stabilize the Italian bond market if that's what's needed.

It seems to me that the ECB is both, you know, the potential Armageddon disaster, if it ran out of capital and people doubted it, that Benn alludes to.  It's also the deus ex machina potential savior if only sort of continental European politics were to liberate it to be that.  And that's where, you know, Mario Draghi, the incoming ECB president, succeeding Trichet at the beginning of November, has an enormous task on his plate.

And it's tragic that Trichet, who had all the credibility of having been in the chair for eight years, having been the father of the strong franc policy before that and really being -- having a huge amount of credibility, could have gone off and done the hard work of stabilizing the Italian BIM market, for example.  He sort of ducked it a bit.  He did a bit of it, but he didn't do it decisively, and now he's left it to an Italian successor who is supposed to stabilize the Italian bond market, which will be politically difficult, and what's more, a successor who doesn't come in with the advantage of eight years of credibility-building leadership under his belt.  So I really think the ECB is pivotal either way.

MCMAHON:  Thanks for that question.

Just a reminder to all that we're about halfway through a CFR media conference call on the eurozone deal reached overnight, and we're speaking with Benn Steil and Sebastian Mallaby of Council on Foreign Relations.

Operator, do we have another question, please?

OPERATOR:  Yes.  Our next question comes from Danielle Kurtzleben with the U.S. News and World Report.

QUESTIONER:  Hi.  I'm wondering about what you think about Silvio Berlusconi's commitments to fixing the Italian debt crisis and how well you think his plans are going to work.

MCMAHON:  Sebastian, do you want to start out, since you were just talking about Italy?

MALLABY:  Well, I mean, you know, Silvio Berlusconi is a leader mired in multiple scandals, who has a record of either snoozing off in meetings when the future of Europe is being discussed, or, possibly worse, pretending to snooze off in meetings just to sort of register his annoyance with the other leaders there.  He really -- you know, you couldn't ask for a less constructive individual to be in that crucial position right now.  But, you know, you don't go to war with the Italian president.  You wish you had.  I'm afraid this is the one we've got, at least until the coalition falls apart, which actually in this week it's been showing some signs of doing.

So, you know, do I think -- do I believe Berlusconi's commitments?  No, not really.  I mean, he made some commitments in the summer, in July, and he didn't deliver on those, and I'm rather skeptical about whether he'll deliver on the next lot, not least because it's not just on his own say-so, it also has to do with whether the coalition partners, who are very anti-European, refuse to play ball.

And this, by the way, is -- in some sense shouldn't be a surprise.  I mean, I used to study development economics.  I read a book about the World Bank.  And one of the central sort of truths that people arrived at in the late '90s about development finance is that conditions imposed by the World Bank or by the IMF on developing countries are more often ignored than actually met, because the political pressures on the government of Pakistan -- or whichever government you're talking about -- the political pressures not to meet some kind of budget-cutting target is much bigger than the external pressure from Washington, D.C., to meet the target.

And I think the same is true right now.  If you're in Italian leadership, you're a politician in Italy, you've got to answer to the realities of Italian politics.  And just because Brussels has made you sign some piece of paper doesn't mean you're going to stick to it.

MCMAHON:  Thank you for that question.

Benn, did you want to -- have something you want to add?

STEIL:  I'd just emphasize that the Greek socialist government has shown dramatically more commitment to addressing its debt problems than the Berlusconi government, and they're having precious little success actually implementing their austerity package in a way that reduces Greece's debt-to-GDP ratio.  As you know, Greece's GDP is falling at an alarming rate.  Given that the Berlusconi government is far less committed to dramatic reforms and given that the coalition government is so much weaker in Italy, I would expect very little progress in Italy.

MCMAHON:  Thank you.

Operator, do we have another question, please?

OPERATOR:  Yes, our next question comes from Marilyn Geewax with NPR.

QUESTIONER:  Hi.  I think there's been a general perception that the Obama administration has not been all that engaged with Europe and that it's much -- been much more focused on Asia and the Middle East.  And if you're saying that the people in Europe don't listen to us much anyway and their economy isn't going to grow much, has this been a good policy?  I mean, is Obama right to be focused on the parts of the world where there's a lot more growth and a lot more energy for U.S. businesses?  Is this -- is the perception true, and was it wise?

MCMAHON:  Benn, you mentioned the supercommittee before.  Is it -- is it wise to be sort of focused on that effort and maybe be sidelining the European issue?

STEIL:  Well, the supercommittee is a -- is a domestic political problem for President Obama, in my view.  And I assume he wishes it weren't there because in my view, it's almost certainly going to fail.

But I agree with the questioner that President Obama's focus has been anywhere but Europe.  And I think there's a good justification for that.  Tim Geithner's forays into the European problems was, as Sebastian emphasized, distinctly unsuccessful.  I don't see any reason for President Obama to waste precious international political capital  trying to publicly influence a debate he's likely to have no influence on.

MCMAHON:  Sebastian, anything to add?

MALLABY:  No, I think Benn said it all.

MCMAHON:  OK, Operator, another question, please?

OPERATOR:  Our next question comes from Christina Bergmann with DW German International.

QUESTIONER:  Yes, hello, gentlemen.  Thank you for doing this.  And I have a sort of follow-up on the situation or on the connection between the United States -- the problems of the U.S. and the problems in Europe. Is the United States really sort of the innocent bystander?  Or if you think of the housing crisis, the banking crisis here in the United States, do you see a connection to the debt crisis in Europe?  Thank you.

MCMAHON:  Sebastian, you mentioned the Trichet comments before.  Do you want to answer?

MALLABY:  Yes, well, I mean, I do think it's great to have a question from Germany.  I do think the question sort of concerns what I said earlier about the perception in Europe, or it suggests a consummation about the perception in Europe that, you know, the European crisis kind of grew out of the U.S. financial crisis.

I don't really agree with that.  I mean, I think that the debt- to-GDP ratio in Greece, you know, was building up to an unsustainable level irrespective of what was going on in U.S. mortgage finance.  I think that, you know, Spain was experiencing a huge real estate bubble irrespective of the U.S.  I think Ireland, the same thing.

So I think that, you know, there was a problem in the design of the euro whereby monetary policy couldn't be appropriate for all of the member countries, and the faster-growing, sort of more inflation- prone peripheral countries were probably going to have policy that was too loose because the policy was targeted at the core countries like Germany.  And so under the impact of loose monetary policy relative to their needs, the Spanish and Irish and so forth, you know -- and unsurprisingly -- had huge real estate bubbles that burst and collapsed on the financial sector.  And the result is what we see now.

So I don't really think of these things -- I mean, of course there are some connections, but I think it's more a case of these are -- these are crises that are separately germinated.

Now since you come from Germany, I would like to just try one other idea on you, which is to say that my feeling is that not only is there some sense in Germany that, you know, this crisis was made in America; there's also some sense that, you know, we don't like this transfer union, and we're constantly paying money to bail out the Greeks and the Portuguese and the Irish and so forth, and now we've got to say:  Enough, enough with all the these transfers

And I would just point out that the export performance of Germany has been enhanced by a weak euro over the last two years, so Germany's actually gained something from being in the currency union; that the financing costs to the German government are now are around 2 percent -- i.e., a record low -- so you're borrowing very cheaply, because capital is fleeing the periphery and coming to Germany.

So in my view, Germany actually -- there are lots of transfers in the currency union.  Some of these transfers actually benefit Germany, and Germany should therefore be more willing to both say this wasn't really made in America; this is a crisis of the euro, in Europe, originated in Europe; and we, as the leaders of Europe, benefit from this integration, and we ought to pay more to fix the problem.

MCMAHON:  Benn, anything to chime in with?

STEIL:  I would say that the problems in the U.S. housing markets were a major trigger of the current crisis that we're seeing in Europe.  But what it actually did was reveal very significant underlying vulnerabilities in the European financial markets, which are, as you know, very bank-dependent.  And European banks are vastly more dependent on volatile short-term wholesale market funding than U.S. banks, which are much more dependent on relatively stable bank deposits, which have been credibly insured by the FDIC.

So although the problems in the U.S. certainly did play a role as a trigger, it's -- it is in my view inevitable that these vulnerabilities in the European banking sector were going to give rise to the problems that we've seen.

I should perhaps emphasize as well that European banks were of course massively exposed to European sovereigns.  Sovereigns and European banks have been joined at the hip, and over the past two years, we've been passing dodgy debt from banks to sovereigns and on to the ECB and in some cases back again.

So to come back to the beginning of our conference call, the reason why I'm reasonably optimistic, based on today's announcements, are that I do feel the eurozone is finally coming to grips with some of the underlying vulnerabilities, the underlying reasons for the crisis.

QUESTIONER:  Thank you very much.

MCMAHON:  Thank you.

Operator, is there another question, please?

OPERATOR:  Yes.  Our next question comes from Alex Privitera with N24 German TV.

QUESTIONER:  Yes.  And since Germany has been on -- part of the conversation, I'd like to -- a two-part question.  First of all, to Sebastian Mallaby, whether he agrees with the fact that at least Germany has now recognized that they were very slow at the beginning, and they needed to do more.  The fact that you point out, that they have been unwilling to pay in a transfer union for profligate Southern Europeans, still may be true in general.  The reluctance is still there.

But I'd like just to point out the votes at the Bundestag the other day.  They are all very aware of the fact that even if the bailout fund has -- will be leveraged and no direct funds or guarantees flow into it, at the moment the German taxpayer's on a hook for a much larger sum than just a few months ago or a few weeks ago, when they voted to bolster the EFSF to the current amount of 440 billion euros.

So there seems to be a wide consensus among politicians, both in the opposition and in the government, that more needed to be done, and they actually have done and have delivered on this.

On the other hand, they also point out that they can't do too much, because at some point even Germany could risk losing its AAA rating, the same way that France is now on the brink.

So one question --

MCMAHON:  So is the question a response to that, then, what you --

QUESTIONER:  It's a response and a question whether, you know, that has -- whether Sebastian is actually taking that into account when he -- when he makes those remarks about Germany.

And the other question is, since the haircut is for about 50 percent and recapitalization of banks has a limit of about 100 -- 100- plus billion euros, whether that's basically just to cover losses on Greek debts, and whether the assumption is that the bond markets will have to stabilize in -- you know, regarding other peripheral countries, like Italy for instance.  Otherwise, all bets are off again.

MALLABY:  Sure.  And so let me just take the second question first.  You know, the IMF came out with an estimate, which you probably know about, which was that if you mark to market the sovereign bonds that European banks hold, the shortfall in capital is 200 billion euros.  So now, you know, if the European authorities are saying 108 billion euros, that sounds like it's a low estimate relative to marking the whole of the sovereign debt market to market -- right? -- and recognizing all the losses across all of the troubled European governments.

But it's more than just Greece, so 108 billion (euros) I think is bigger than the size of whole -- I mean, maybe Benn or somebody else has a better fix on this, but my guess is that, you know, even a 50- percent write-down of Greek debt is a smaller hit to the banks than 108 billion (euros).  That would be my guess.

Now, on the other question, I guess I do see it a bit differently from you.  I mean, I -- my sense is that, you know, Germany committed to about 27 percent of the 440 billion euros that the EFSF has.  And then after that -- and of course, it also gave money separately to Greece, and the first package for Greece and another -- and a number of other things.

But since that time, the emphasis in the European leadership, led by Germany, has been to avoid putting more money in, and instead to come up with new kind of tricks.  One trick is:  We won't put more money into the EFSF; instead, we will leverage it.  Another trick is: We won't put more money into the EFSF; but instead, we will get the Chinese and the -- and the Brazilians and so forth to come into this new, special-purpose vehicle.

So I think, you know -- and there was also a debate, as you know, between Sarkozy and Merkel, leading up to this recent meeting, which basically was about who was going to pay for recapitalizing the banks that need to be recapitalized.  And the French said it should be done by the EFSF; and since the Germans give a lot of money to the EFSF,  that would have been a burden on Germany.  And Germany said:  No, we should try the capital markets, we should try national governments recapitalizing their own banks, and we should only go to the EFSF as the very last resort.

QUESTIONER:  Yes.

MALLABY:  So I -- look, I mean, I understand, you know, why Germany would prefer not to pay more money than it has to.  I understand that, you know, it's not very nice to have to give money to a guy like Berlusconi, who is involved in multiple court cases against him, or to give money to Greeks, who retire in their 50s and have, you know, swimming pools that they don't pay taxes on.  I get all that. But in a crisis, one ends up bailing out people who, you know, maybe are not morally deserving, but if you want to stop the crisis that's what you've got to do.

And I -- and I think, you know, Germany has been behind the curve, both directly and, maybe even more importantly, in its indirect influence over the central bank.  I mean, the fact that both Axel Weber and their chief economist, Juergen Stark, resigned, for whatever reasons they stated publicly -- we all know that, you know, the real story is, you know, that they were uncomfortable with the problem -- with the policy of buying sovereign bonds.  And, you know, yes, in some pure sense, you don't want the central bank to monetize the debt. But, you know, we're not in a first best world now; we're in a world where we're fighting to keep this European integration, which has taken a generation of effort to build -- we're fighting to keep that together.  And I believe Germany will -- you know, Germany cum the ECB will end up rescuing the system.  And if you come to that realization late, you will pay more; and if you come to the realization earlier, you will pay less.

And I do fault the sort of -- you know, the political leadership in Germany for not sort of forcing the debate to a -- to a place where, you know, the Bundestag understands and German voters understand that this really is in the country's interest.

It's not a transfer union where the money is exclusively transferred to the periphery.  In fact, Germans gain from this union through the export channel, through the cost of financing that they experience now.

QUESTIONER:  And you still -- and you still believe that they haven't realized, you know, despite all the things that have happened in the past week, for instance?

MALLABY:  Well, I just observe that, as I said, instead of putting more money into the EFSF or authorizing a euro bond, there's talk of other stuff instead like -- you know, like bringing the Chinese in, like bringing -- doing a leverage plan even though they haven't actually explained how on earth this leverage thing works. They're still clinging to this vision because they clearly don't want to put more money in themselves.

MCMAHON:  Thanks a lot for the question.

QUESTIONER:  Sure.

MCMAHON:  Operator, could we have another question, please?

OPERATOR:  Certainly.  Our next question comes from Dominic Rushe with The Guardian.

QUESTIONER:  Hi.  Sebastian, you seem very gloomy, and yet the markets have reacted very well.  What -- (inaudible) -- just closed up and the Dow's up and everything.  What do you think's going to burst our bubble?

MALLABY:  That's a very -- a very (good ?) question.  I've been puzzling over the behavior of equity markets over the last few days because it's been fairly obvious to me that, you know, for the last week that, you know, we would end up with a summit like the one we just had where there are more gaps in the solutions than there are solutions.  And I'm -- you know, I mean, I take Benn's point.  Benn makes a very good point that, at least now, the leadership in Europe is talking about the real problems.  It recognizes that, yes, there is a shortfall in the capital of the banks.  It recognizes that, yes, the previously announced 21-percent haircut for Greece was utterly inadequate.  So the debate is moving towards a better recognition of what needs to be done.

But the debate is not moving to having an answer to -- you know, to actually providing the solutions.  So we recognize the problems but we don't provide the solutions.  I find it hard to understand why the equity market rallies in the face of that kind of news.  But then, you know, the market sometimes does what it does.

MCMAHON:  Benn, do you want to take a crack at this?

STEIL:  Yeah, I would just add that there's other good news out in the markets today.  U.S. GDP apparently rose at a 2.5-percent rate in the third quarter, which is of course much better than people were fearing a month ago.  So there's good news coming from multiple sources.  So I think we shouldn't attribute today's rally entirely to what's going on in Europe.

MCMAHON:  Thanks for the question.

Operator, is there another question on the line?

OPERATOR:  Our next question comes from Tom Burgess (ph) with Financial Times.

QUESTIONER:  Hi, there.  I just wanted to go back to some comments about China and Iran, especially from Sebastian.  Do you think that any likely contribution to the special fund -- (inaudible) -- is likely to be peanuts from China and/or other BRICs?  I just wonder if, given that as we've been hearing, the Obama administration is taking a lesser -- kind of a lesser interaction with Europe and that China would probably be able to extract some sort of guarantees to those investments and that it is a political opportunity for China to increase its presence in Europe, whether we might not expect (a little bit ?) more than that?

MALLABY:  Well, I'm guessing, and you're suggesting an alternative guess, and you may be right.  I don't -- I don't claim a monopoly of the truth on this.  I would just say that my sense of it is that, you know, this is an idea that was floated a month ago by -- at the BRIC summit which took place just before the IMF World Bank meetings, when the Brazilians, I think, you know, echoed by the other BRIC members, said, you know, wouldn't we like to sort of, you know, come and help a bit.  And so it's been around.

And it's telling that at this summit this morning, when they concluded, they didn't actually have any concrete pledges yet, right? So it didn't -- it wasn't an idea they just came out with last night. They (haven't ?) had time to ask people -- they have had time to ask people and they haven't had any pledges.

You know, I'd also say that the way I hear Chinese official comments on this topic -- and you know, you may be tracking them more closely -- but my sense is, you know, there's kind of a general willingness to, yes, put capital into Europe.  Well, that's not a surprise because China has a massive capital surplus, and it's got to  park it abroad someplace.  The question is, where is it going to park that exported capital?  And I think it's more likely to want to buy, you know, safe German government debt than -- (inaudible) -- Italian debt.

And I think if it goes into Italy, it's more likely to want to have a stake in infrastructure, you know, owning some Italian ports that would be processing Chinese imports and where, you know, the physical ownership of infrastructure gives you some assurance against holding paper assets that could be, you know, defaulted on and so forth.

So I mean, the Chinese -- and this is true, by the way, of their attitude towards putting capital into the U.S. -- they would love to get out of paper assets and into hard assets.  That's why they've, you know, got a sovereign wealth fund, to do that.

And you know, so in a general sense, yes, they want to put capital into Europe.  In a specific sense, do they want to put money into some sort of leveraged, you know, bailout fund that is targeted specifically at the dodgiest kinds of paper money?  That's where I doubt they would do -- or not, but you know, I'm making a guess, a prediction about the future.  And perhaps I'll be proved wrong.

MCMAHON:  Benn, do you want to weigh in on China?

STEIL:  I agree with Sebastian.

MCMAHON:  OK.  It looks like we have time for one more question.  Operator, is there another question, please?

OPERATOR:  Our next question comes from Alex Ribeiro with Valor.

QUESTIONER:  Hi.  We have a rule in Brazil that says that the Brazilian central bank can invest only in AAA safe assets.  And I wondered if you have a prediction on how would be the credit rating for this EFSF fund if it would have all this leverage?

MCMAHON:  Benn, you want to start out with that?

STEIL:  Well, the EFSF -- the whole idea is premised on the core commitments from the eurozone creditors being AAA-rated.  If it were not to be AAA-rated, for example if France's -- France were to be downgraded, it would no longer be viable.  So I mean, there are different directions in which they can go.  But at the -- at the end of the day, this mechanism has to be a AAA-rated credit.  Otherwise, it collapses entirely.

MCMAHON:  Sebastian, anything you'd want to --

MALLABY:  No, I agree with Benn there.  That's fine.

MCMAHON:  OK.  Well, I -- this -- I think this will conclude this call.  It's been a really stimulating call.  I appreciate all the questions and interest.

And thanks very much to our speakers, Sebastian Mallaby and Ben Steil of the Council on Foreign Relations.  This concludes our Council on Foreign Relations media conference call on the eurozone.

MALLABY:  Thanks, everybody.

STEIL:  Thank you.

OPERATOR:  Ladies and gentlemen, that concludes today's call. You may disconnect at this time.

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