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Europe: Waiting for the Next Shoe to Drop

Speaker: Willem Buiter, Chief Economist, Citigroup
Presider: Rana Foroohar, Managing Editor, TIME
May 16, 2012, New York
Council on Foreign Relations

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RANA FOROOHAR: So if you all would like to take your seats, I think we're going to get started in just a minute here. Thank you.

My name is Rana Foroohar. I'm the assisting managing editor in charge of economics and business for Time magazine. And I'm really thrilled and pleased to be here today with Dr. Willem Buiter, who we all know, the chief economist at Citigroup. He is one of the really pre-eminent voices on the eurozone and on the crisis, and I've been following his work very closely, as I'm sure you all have.

This meeting today is part oft he Peter McColough Series on International Economics. And before we get started, I'd like to remind you all to turn off your phones, not just put them on vibrate, because they'll interfere with the sound system. The meeting is on the record. We do have press in attendance. And just to note that the next meeting in the series will be Friday at lunch, entitled Prospects for Diplomacy in Iran. And we'll see after we hear from Dr. Buiter which will be more difficult, solving the eurozone crisis -- (laughter) -- or diplomacy in Iran.

So we're going to start with some opening comments by Dr. Buiter, and then he and I will talk for about 20 minutes, and then you'll have a chance the last 30 to ask your own questions.

So please, Dr. Buiter, set the stage for us.

WILLEM BUITER: OK, good morning. It's really a pleasure to be here.

Europe continues to be in a dreadful mess. It won't get any better soon, but we'll probably be spared the worst. Everybody is focused on the Greek exit at the moment. It is an important issue, but I -- personally, I'm much more concerned about what's going on in Spain and the lack of progress in Italy.

Europe still struggles with the need to address three, maybe now four crises that are distinct but inter-related. First is a sovereign solvency crisis. A number of sovereigns will have to be restructured, or re-restructured, in the case of Greece. Expect Portugal to follow sometime in 2013. Both Portugal and Ireland will need either new programs or extensions of their existing programs before long because of the -- (inaudible). Ireland, in my view, either will need a lot of additional OSI, official sector involvement, or they too will be pushing on the -- on the -- on the PSI, the private sector involvement button.

And that then brings us to Spain, where I'm of the opinion that the consolidated banking sector and sovereign probably cannot be kept whole and that they have to make a choice between -- assuming there is no Santa Claus -- (laughter) -- that they'll make open-ended cross-border transfers -- and assuring there isn't one, not even in the wildest dreams of the pro-growth party in Europe -- so we will have to either restructure Spanish bank debt or Spanish sovereign debt. The risk of an Ireland experience where an otherwise solvent sovereign, by imprudent guarantees for a "too big to save" banking system, got itself in a hole so deep it's unlikely to get out -- I think we're going to have to beware of that. So that's the restructuring end.

Then they have to -- (inaudible) -- the most likely solvent, but at risk of insolvency through lots of -- (inaudible) -- funding sovereigns in the rest of the periphery, which ranges from the small Cyprus -- which nobody ever mentions, but it's clearly in the firing line also -- as well as Spain and Italy, and beyond that, the soft core, which now includes almost everything else except possibly Germany and Finland and maybe Slovakia.

So this is -- there is really a need for a big bazooka. Fortunately, we have it. We always knew that the ECB had the resources to basically do anything that was required. After all, it is a euro crisis, right, not a foreign exchange reserve crisis for the euro area as a whole. And the capacity of the ECB to issue euro debt is fortunately, you know, from a technical perspective, rather impressive -- in fact, unlimited.

Now, clearly you impose an inflation constraint, rather less can be done, but the noninflationary loss absorption capacity of the euro system is also likely to be at least 3 1/2 trillion, so they have a bit to play with still.

Now, the final -- the (CF ?) crisis that we traditionally recognized and that is in full swing at the moment is the euro area banking crisis. Unlike the American banks and to a certain extent the British banks, Europe did not recognize -- continental Europe -- the (losses of our ?) banking system. In the earlier crisis there has been a massive cover-up, evergreening, but -- (inaudible) -- lender forbearance made possible by regulatory forbearance of the forbearing lenders. And it has been sort of conspiracy of obfuscation. And the truth has been dragged out, one stress test at a time.

And now the EBA, fortunately, without the national sunk reputational capital in the national bank, is forcing the banks to reveal where the holes are, and each time you look, they're bigger. So we're going to ®MDNM¯need massive recapitalization. The scale of what's required is, I think, much, much bigger than even the EBA has so far allowed for.

And of course, it's getting bigger all the time because Europe, while technically not in recession in Q1 -- it's a bit of a surprise -- because Germany's performance was really quite strong, is nevertheless in deep recession in the -- in the weakest countries. And there the banks, of course, are shedding capital, rather than accumulating it, as a result of deterioration of regular loans to households, to nonfinancial corporates.

Finally, we have the exit crisis. Greece now looks to be on the way out. It's not impossible that it could stay in. After all, they can't legally, technically be pushed out. The way they would leave is either, you know, in a -- in a haze of nationalist and populist rage following the next election or through a refusal of the troika to continue funding the sovereign because of noncompliance, rejecting their memorandum of understand and not achieving a compromise open to both sides.

And where the -- did the other -- sorry. I seem to be losing my thread here.

FOROOHAR: Easy to do when you're talking about your --

BUITER: (There was ?) -- OK. So Greece will exit unless it finds this ability to compromise on the memorandum of understanding.

There is a widespread, I think, nonsense debate going on in Europe at the moment about growth versus austerity. In all countries except Germany, the argument "we want more growth" is the same as the argument "we want less austerity," except that it adds in "we need more nonmarket funding," right?

Most Europeans actually know that austerity hurts. There may be a few Teutonic knights that believe that austerity is expansionary, right? And you know, I teach there's conditions under which this could be true -- I used to, in my academic days. And I enjoyed teaching it, but I didn't believe it.

FOROOHAR: (Laughs.)

BUITER: And it is -- and it is clear, from a review of evidence, that the austerity we're seeing imposed hurts. That's one.

Second, it is not actually self-defeating, in the economic sense, and if we don't (have a change in ?) -- (inaudible) -- when we fiscally tighten, we don't get a decline in activity so strong the deficit actually increases. Wish it were so, because then you have the solution. With the expansive fiscal policies, reduce the deficit, right? But we all know how that works.

But there are a few countries in the world, and Germany is the only big one in Europe, where the authorities have the choice whether -- when to do austerity, how fast to do it, and yeah -- and really when and how. In most of the euro area, that choice is not there. It's the markets that enforce the austerity. And a request for more growth, less austerity is therefore a request for additional funding. And additional funding may be forthcoming on a very small scale, but for the time being and for the foreseeable future, the EFSF and the ESM together is it. That's 700 billion. It's nice, but it's not enough.

The IMF sits now -- if the whole US$440 billion that Mrs. Lagarde worked out in commitments actually were to materialize, the IMF sits potentially on about US$815 billion of loanable capacity. But of course not all of that can, for political reason, be used in Europe. Historically they've used, you know, 1-to-3 or 1-to-2 ratio, IMF funds versus European funds. So that means that effectively we have a trillion to play with, with the troika -- again, nice, and it will take care of Spain and Italy, the sovereigns, for the ESF, but it doesn't take care of the banks, and it is simply not enough. This is still pocket money.

The ECB can pull out the big bazooka. They print the stuff. They have the massive noninflationary loss absorption capacity, but they rightly think that it's not their job to act in a case of fiscal capacity. They're willing to do so only when nothing stood between us and this collapse of a sovereign -- disorderly collapse of the sovereign or a disorderly collapse of a systemically important finance institution or now a disorderly exit, right, or indeed exit fear contagion.

And let me -- (further ?) on this last thing: The risk to the rest of the Europe for Greek exit doesn't come from direct linkages of trade or portfolios. Greece is 2 percent of euro area GDP, right? You can barely (find ?) it. And the portfolio exposure to the Greek sovereign and the -- and also to the Greek banks has moved from the private sector in the (rest of the euro ?) area to the official sector, to the ECB and to the EFSF and the Greek loan facility. And the rest of the exposure to the sovereign has migrated back home to Greece.

So this is manageable for the rest of Europe. The fear is of course that there will be contagion of exit fear, and exit means three things: new currency -- say, next country -- assume the market focuses on other -- Portugal as the next country most likely to exit -- new currency, new escudo; (the elimination ?) of all existing contracts in the domestic law and all existing securities in domestic law, in the new escudo and then a 50, 60 percent depreciation, right?

Knowing that, you have a sudden stop, not just a deposit slide that we see and fear. That's sort of the visible face of the sudden stop, the sudden funding stop. No sector -- private, public, banking, (reloan ?), financial, government -- can fund itself. And given that there is no way to fund through this market blockade, the country is driven out, because better print your own money than have nothing, right?

Now this, I think, is actually easily manageable. The ECB, supported by the troika, will fund the sovereigns and the banks, and the banks -- (inaudible) -- fund the rest until the markets believe that no country that is more or less compliant with conditionality and not wanting to leave -- and no country in its right mind would want to leave -- would -- will exit and therefore the pressure comes off.

Now how is this going to end? Not with the big bazooka, right? No big pot of money, and no E-bonds on an open-ended (and cap ?) scale. No last-minute opening of the German wallet. It's politically and constitutionally impossible, right?

So what will happen -- and the ECB does not do anything that poses a material threat to its definition of price stability. They tolerate a bit -- they do now; inflation hit us, 2.6 percent instead of 2 (percent). But this is not -- we're not talking about inflating our way out. It would be a solution, but it's simply not politically feasible, unless they send the tanks into Frankfurt.

FOROOHAR: (Laughs.)

BUITER: Now -- and so what will happen is a mixture -- is preventing disorderly sovereign defaults but arranging orderly sovereign restructuring -- (that's point of it ?) -- for those sovereigns that are insolvent; preventing the disorderly collapse of systemically important finance institutions, but not necessarily shirking away from the -- what should ultimately be the provider of capital to banks of last resort, which is not the taxpayer, which can no longer do it in many European countries, but the unsecured creditors. And I expect we'll start to see that.

But in much of Europe, we can't have banks recapitalized by, say, converting unsecured creditors into equity because in only three out of the 17 euro area member states do we have a special (issue ?). And so resolution is -- (inaudible) -- for banks. In addition depositors are still not (senior ?) to other unsecured creditors. So you don't want really to turn depositors necessarily into shareholders. That would be a shock to Grandma. (Laughter.) So -- but this is -- will be remedied. The ECB is now calling for it -- for a special resolution regime, for the -- Europe-wide, actually, for the 34 largest banks, national resolution regimes for the smaller banks, and indeed, also, very important, for a euro recapitalization fund or -- and this, I think isn't -- is something that will probably be funded by E-bonds, where there will be finite taxed amount of E-bonds issued for, quote, "a project," right, rather than 50 percent of your deficit henceforth will be for joint and several accounts.

OK, let me also say that the Greek crisis is probably going to result in another important step on the way to banking union in Europe, which is the necessary condition, I think, for the euro area to survive in the longer term. And what we will see -- probably see coming out of it will be some form of euro-areawide bank deposit guarantee scheme. Clearly with the money now likely to be loaded on donkeys and shipped over the Albanian border, the ECB has effectively two choices, right? They either replace the disappearing deposits with other forms of funding -- if you do that for the euro area as a whole, well, deposits are 6 trillion, for the -- not for the -- just for the periphery, for the -- (euro area is all ?) 15 trillion, but that's -- so, see -- so that's not conceivable.

And so that means we're looking for a way of stopping deposits from leaving. That means a credible deposit insurance regime could be provided by the ECB. It's not their job. In the short run, there may be an alternative. But ultimately I think we will see here some concessions by the eurozone to the creation, again, of a small fiscal pot, for deposit -- sovereign backing, joint and several, of deposit insurance. That -- I expect to see that because the alternative would be, I think, so much worse than the cost of doing this and also because constitutionally and legally, it is compatible with the current treaty because the beneficiaries would not be governments but the private sector. And there's nothing in the treaty that stops the national central banks or governments providing assistance, provided it meets the competition laws, to private entities in their economies.

So I think we will see this small step toward banking union as a result of the currency crisis that we're currently seeing in Greece. I'll stop here.

FOROOHAR: Wow, that's terrific -- really great overview of so many topics.

Let me take you first to this idea of an orderly versus a disorderly exit for Greece and how we get from disorderly to orderly. What policy steps do you think need to be taken right now? What hasn't been done to ensure that that's the case?

BUITER: Well, I think there must have been a lot of midnight oil burned in Frankfurt, in Brussels and certainly at the central bank of Greece. Even no later than when Greece exits and possibly even sort of before it exits, you see the imposition of capital controls, foreign exchange controls, and bank holidays, right? Just that's -- it's all incompatible with the treaty, the first two. But you know, as they say, necessity and the law are sometimes uncomfortable bedfellows and necessity always wins.

So in -- so that is to make it more orderly for Greece. And Greece, provided it does not actually storm out in a nationalist red rage and cuts off its nose to spite its face, Greece will remain in the European Union and will continue to receive financial support from the European Union, not necessarily through the EFSF, but from structural funds, which can be accelerated and other forms like that. They'll undoubtedly remain on the -- on the IMF program as well. So that would minimize damaging risk. It'll still be horrendous, right?

The only possible upside for Greece, which is much emphasized by American commentators who take to attention short-run -- (inaudible) -- into the structural side of things -- there is a widespread belief among economists here that you can devalue your way into prosperity and competitiveness. Well, I've got news for you: Greece is not a changing economy, right? It doesn't have rigidly downward money wages and very flexible real wages. It has rigid real wages and very flexible upward money wages.

And so the 65 percent devaluation or more that you would get up front will indeed give Greece this momentary fantastic competitive advantage, which it won't be able to take advantage of because they don't have that many resources in the tradable sector, and shifting was difficult. But apart from that, even if there were highly mobile resources that could be moved from the monetary to the traded sectors, the Greek worker and the Greek shopper certainly do know the difference between real and money wages, and domestic inflation would explode, I expect, following exit by Greece. Unless they get material financial aid to fund their ongoing deficit, I expect hyperinflation in Greece.

Even if they effectively write off their debt, which they will, whether they stay in or out -- I mean, a de facto NPV wipeout of their debt, except they're exposed to the IMF, is, I think, a given. If they do that, they still have, in all likelihood, between 2 (percent) and 3 percent of GDP primary deficit, which has to be funded. And that is more than can be funded at any constant rate of inflation. They would get hyperinflation out of that.

Remember, nobody would want to hold the new drachma. It's a loser's currency, right? It was the currency of a country that could not stay in the monetary union. And the currency itself -- the private sector will remain heavily euro-ized. The only people that hold the new drachma will be the ones that get paid in it because they're government officials that have to deal with the government, paying taxes, or because of contracts with the sovereign. In the private sphere, everybody will continue to use the euro certainly as the (numerary unit ?) of account and probably -- (chuckles) -- (inaudible) -- as well.

So I really -- I -- so we will minimize the damage to Greece this way. The key thing is to provide the markets with a clear statement -- we believe that no other country wants to leave. And provided a country adheres to the broad outlines of the hopefully somewhat, you know, flexibilized, on the fiscal side especially, memoranda of understanding of programs -- as long as they are, you know, compliant in spirit, we will simply provide them with the funding that they need to stay in. This is, after all -- the in or out is just a matter of liquidity. It's not a matter of solvency. And liquidity -- the issue will be we (can ?) provide an infinite amount.

So they just have to set a tone, who has more euros, me or you, right? And that has to be winnable. If it's not winnable, then somebody in Frankfurt, you know, needs a (long haul ?) there, and I don't think that's the case. They are aware of that. This is an anticipated event.

There's a small chance that Greece would stay in. I think one way it could happen, of course, if -- is if the troika simply gives up, gives in and says, OK, never mind, there's -- your debt is -- (inaudible) -- but the rest of your -- (inaudible) -- is gone -- though they have to do the structural reform -- no pain, no gain -- here is the money. It's possible. I think it's about as likely as me being the next pope. (Laughter.) It's not going to happen, right? You couldn't get it past the German parliament, the Dutch parliament. You couldn't get it past the constitution, of course. It's simply out of the question. But there is this -- (inaudible).

They could do a deal -- the only deal I can see realistically is what -- (inaudible) -- hinted at. Europe is now realizing that they have been excessively pro-cyclical in their fiscal policies and that any program that is agreed that -- following implementation, say, for a year or so, led to an overshoot of the deficit target had to be corrected in the original window time frame, regardless whether the overshoot was due to bad faith or bad luck, right -- so nonimplementation of measures or simply the economy being weaker than expected.

And I think there is now an intellectual readiness even at the level of the commission, prompted very strongly, I think, with the IMF -- Olivier Blanchard would argue for this -- that you should at least condone and give additional time for the correction of deficit overshoots that are due to weaker than expected activity, as long as you're compliant -- (inaudible) -- of course, with prior funding. (Chuckles.) Otherwise, it's empty talk. Only the U.S. and Japan and Germany can choose the amount of austerity they do and the timing of it. The rest of the world is told by the markets what to do.

FOROOHAR: Doctor, I want to make sure to draw you out a little bit on the banking situation as well.

BUITER: Yeah.

FOROOHAR: Back in November things were on code red. The ECB came in, put a trillion euro into the system, trillion euro plus, I believe. Why are we back in a banking situation again? I mean, tell -- walk us through the high point -- (inaudible) --

BUITER: Well, much of the banking sector in the euro area is solvency-challenged, right, and needs massive additional capital. Everybody knows it. The banks knows (sic) it, which they're -- which is why we don't lend to each other. And there have been attempts to recapitalize them, and that has not been done on anything like the scale required.

And we had the -- and all the ECB does -- well, most of what the ECB does is simply provide liquidity, which is the manifestation of the fear of insolvency. They only address the insolvency issue to a very limited extent. They do address to some extent because this 1 trillion LTRO, the three LTRO, in my estimate, involved over the three years a net subsidy to the banks by the ECB of about at least a hundred billion euro, right, because they're giving the stuff out for -- over three years, and they're very tied to the refi rate, which is now a hundred basis points -- will be 50 basis points by the end of the year. So over the three years, there's going to be 60 basis points funding, right, against any rubbish collateral. And so if they had to get that kind of funding in the market, it would be 400 basis points plus if they could get it at all.

So there's a massive -- (inaudible) -- fiscal subsidy involved, and so that helps a bit. But a hundred billion for the whole year earlier, right -- it's a fraction of what is required. It -- this -- the EBA estimate said this is what is required. But we all know how good these kinds of estimates are. Remember the Spanish central bank in March 2010, '11, right? The total capital needs of the Spanish banking system by the -- by the Spanish central bank -- estimated 15 billion -- .15. It was a nice number, 1-5, 1-5. (Laughter.) And a week after this was announced -- (inaudible) -- the IMF -- (inaudible) -- and they -- I think that one of their people -- their central bank system supervisor, the regulator -- (inaudible). And I asked him whether the decimal point was in the wrong place. (Laughter.) And they thought this wasn't funny.

But I was underestimating it greatly, right? When the -- all the -- even the latest program for recapitalizing the Spanish banks that the authorities have come up with, an additional 35 billion of provisioning, which brings the total provisioning to 137, right? All that still assumes that household mortgages are safe, right? And the 600 billion euro was (outstanding ?). And -- (inaudible) -- very low loss ratio, 2.6 percent or something like it. And I know that Spain has recourse mortgages. They have tough personal insolvency laws. And the entire extended family, right -- in fact, the extended family plus the house pets, right -- (scattered laughter) -- guarantee any mortgage, but -- (inaudible) -- it was 24 percent unemployment, right? And there's rising long-term unemployment. Ability to pay becomes an issue.

You see that in Ireland. Ireland had -- (inaudible) -- recourse mortgages. I could pursue them to the seventh generation, right? And Ireland, of course, had also very tough personal insolvency laws. Well, Ireland is revising these personal insolvency laws, and they're not making them tougher, right? And as a result, Moody's expected that it could get up to -- this is the extreme version -- for Ireland, up to 35 billion of additional losses coming the bank's way. And that is on mortgages outstanding of only just over a hundred billion.

Now, I -- Spain is not having any plans, don't get me wrong, for changing the personal insolvency laws. But there is political contagion in these things as well. And I'm sure that, you know, just as the Greek deal, right, be noncompliant and have a -- (inaudible) -- decide to send NPV right down on your privately held debt, right, that that must be ranking somewhere in Portugal and in Ireland, even though they are still fully compliant.

And similarly, the Irish example of getting rid of the Dickensian sort of personal insolvency laws and allowing people to walk away from all their debts, including recourse for their debt, will be hard to resist. So I think they haven't begun yet to recognize the losses. And that stuff flares up periodically whenever there is a trigger.

The trigger now is Greece. Three months from now, the trigger may be Mr. Hollande engaging in a short-lived Keynesian redistributional experiment, right, until the markets and the rating agencies discipline him and force him to be back -- to be in austerity back in the fall. That could trigger the need for another LTRO, right, this time to help -- see, the triggers can be anything. It doesn't really matter because the underlying problem is that the banks are oversized and undercapitalized, right, that there's many unrecognized losses that have been systematically hidden from us, right? So nobody trusts the authorities anymore. And that problem has has not been addressed. It's very important, therefore, that the Spanish government has said that they will have an independent audit.

Ireland did themselves a lot of good by getting Blackrock, I think it was, to do their audit. They -- the only thing they didn't anticipate was the change in the personal insolvency laws. So this last 35 billion that might be -- well, we -- actually, I think it's less than that, 25 billion, the -- (inaudible) -- the banks -- (inaudible) -- of losses was not in the -- in those stress tests. But you need serious independent information.

I would like to see some entity -- private entity -- serious, independent private entity and the ECB and the European Banking Authority, who of course only employs three people, right, to go in there and vet these accounts, because unless we have the facts, the markets will never be -- have their minds put at ease. Sorry.

FOROOHAR: OK, no worries. I'm going to ask you one more question, then I'm going to open it up to the participants here. Speaking about politics for a moment, how have the French elections changed anything or not, in your view?

BUITER: Well, as I say, the recognition that fiscal policy is -- you know, if what it sounds like, that the contractional policy is contractionary and that some of these programs may have been excessively pro-cyclical, assuming that you can get non-market funding to prevent this -- (inaudible) -- was already in the pipeline well before Mr. Hollande was on the presidential track.

Mario Monti made these statements, I think last October or November, that the -- if it were to overshoot its deficit targets, he would not go back for additional austerity measures. That's of course a declaration of intent, not necessarily something that he can make true if he doesn't get funded. (Laughs.) And this is the issue. You can not, except in a few blessed or benighted countries like the U.S., Germany and Japan, you know, choose when you engage in austerity unless you have access to sufficient nonmarket funding.

So but it makes a -- it makes a difference that you now have him, you know, saying, well, we'd like to do a little of the work to get something out of it. The EIB -- they will come in, they will take the remaining money in the European financial stability mechanism, about 12 1/2 billion additional capital -- they do, you know, 40 billion additional lending -- (inaudible) -- which is .4 (percent) or .3 of percent of euro-area GDP. So it's nice, but it's not going to make a difference of day of and night.

And therefore the rest -- no, I think we'll, if Mr. Hollande, gets a left-wing majority at the parliamentary election in June -- June 27th -- I think we will have the Keynesian in one country and a redistributionist in one country experiment. He will call it balanced budget. That's because he will be making wildly optimistic revenue projections. The markets will rightly interpret this as an increase ex ante in the deficit and punish him with higher yields.

And the rating agencies will downgrade funds. And if he engages in the aggressive redistributionalist policies, now 255,000 Frenchmen will pack a suitcase and move to London, keeping up property prices there, which -- it's fine with me, but -- (laughter) -- not so much with those who are still trying to get into the housing (ladder ?) there.

So -- and -- but fundamentally French socialists of Mr. Mitterrand's and now Mr. Hollande's ilk are strongly pro-European, more so than the historic centrist parties. He and Mrs. Merkel already did a nice, you know, box and cox yesterday. And they will -- they will get their act together and come up with a slightly relaxed version, slightly less (pro-cyclical ?) version of this -- (inaudible) -- growth pact. There will be a growth pact component attached to the fiscal compact -- the growth compact. After all, the original thing was called the stability and growth pact. But it can't be more than a statement that says, we like growth; don't you? (Laughter.) And that'll be it.

FOROOHAR: OK, very good. Well, we're going to open the floor up to members now with questions. We have microphones over here. And if you could just keep it to one question, brief, and introduce yourself as you have the microphone.

Does anyone want to start?

Right here.

QUESTIONER: Thank you. I'm Richard Weinert (ph), Concert Artists Guild. You made a very convincing case of why a disorderly Greek exit would be disastrous for Greece. Could you walk us through what an orderly exit would look like?

BUITER: It's always going to be disorderly to a certain extent, but you'd have to have the capital controls in before they exit. You basically have to have a bank holiday, foreign exchange controls, a rapid introduction of new currency, comprehensive redenomination -- basically the effect of writing off of the remaining Greek sovereign exposure -- that and then continued funding. This is going to be the hard part.

You kicked the ECB and the European members of the troika where it hurts by effectively defaulting on their debt, especially for the official creditors. You don't call it "default," right? But this is -- basically what they get is a constant face-value, zero-coupon perpetuity, right, which is worth nothing. But since the public sector doesn't do NPV accounting, that they -- they might be able to get away with that.

So -- but you need continued funding for the 2 or 3 percent of GDP primary deficit, otherwise they'd have to tighten immediately on top of that. And in fact since I do believe that the disruptions to the portfolio -- a wrenching that will take place as a result of the redenomination, right -- all assets, liabilities under domestic law have to be redenominated; all assets, liabilities under foreign law probably not -- some maybe, whatever. But -- so there's going to be balance sheets that looked balanced -- (inaudible) -- are going to be completely mismatched. There will be some doing well, but others going bust. And you know, you can't be super solvent, but you can be insolvent. So the next job is going to be, I think, a deeper recession and therefore a larger deficit.

So, again, if they don't get funding to deal with -- to fund a new -- the primary noninterest deficit, it would be a catastrophe. So hopefully they will get it, and of course the ECB has to keep on, even after they're out, helping them by through funding their banks because these banks will still have at least some euro-denominated liabilities that weren't under Greek law. So all these banks are insolvent again.

So it -- you need continued assistance -- financial assistance both from the euro system and from the -- (inaudible) -- and from the IMF for a post-exit Greece and, for the rest, prayer. (Scattered laughs.)

FOROOHAR: OK. Other questions? Surely there's a -- oh, over here. Sorry.

QUESTIONER: Andreas Billmeier with Brothers Investments. You're painting picture where Greece leaves the euro, but stays within the European Union.

BUITER: Yeah.

QUESTIONER: A couple years ago, I think, the ECB issued a legal working paper, explaining that essentially it's -- there's no clear way of how to do any of the two, because it's not in the treaty, but that presumably an exit from the euro area would also come with an exit from the European Union. Now, are you saying that this is a case of they're just going to make it up as they go along or is there something else?

BUITER: No, this is exactly what it is. Remember one great thing about the European treaties is that everything that's not in it, right, can be done, right? So there isn't the -- no provision for exit from the euro area. So there is simply no provision for exit from the euro area. There is a provision, the first time in the Lisbon treaty, for exit from the EU. And presumably, exit from the EU would imply exit from the euro area, although it doesn't even say that. So you -- (chuckles) -- theoretically, anyway. Never mind. (Laughter.) This would -- it would be too crazy.

So it -- I know the papers will say, interesting, it's the first, I think, serious study of that issue. Are they going to make it up as they go along? And they will permit Greece to exit, reintroduce a new currency and stay in (euro area ?), absolutely, no doubt about it. And it's in Europe's interest. It's in Greece's interest. Europe doesn't want a failing state on its -- on its southern border, southeastern border, right? And if they really, you know, kicked Greece into the Middle East, that would be not a wise move even from a totally selfish national perspective. And I think that's going to be -- that is the least of our troubles. We -- for -- you know, you can always hire a lawyer that will say it's OK. (Laughter.)

FOROOHAR: Dangerous statement in this audience. I still want to ask you one other question, before we take a few more from the audience, about Germany. You know, we hear a lot here about the need for economic rebalancing in Germany, and you hinted earlier that the Bundesbank was willing to tolerate slightly higher inflation, perhaps. We see that the consumer spending is a little stronger. Is that happening, or is Germany still the China of Europe?

BUITER: Not really. Germany, until very recently, was overheating, right? They were doing their bit for Europe. They've been growing at a rate that hasn't been seen since the '60s. (Inaudible.) So in effect, there were signs of overheating in the labor markets, not hitting prices so much. In fact, the inflation in Germany is below the euro-area average, but it's largely, I offer, because of the southern (bits ?), right? There are the peripheral countries having massive indirect tax increases as part of fiscal austerity, which show up as country -- (inaudible) -- inflation. So I think the underlying rate of inflation in Germany is probably below that of the euro area, which the Bundesbank is willing to accept.

The Bundesbank has no say in the matter. The Bundesbank doesn't make Germany monetary policy. There is one monetary policy, and it's made in Frankfurt, but for the whole euro area. All that the Bundesbank has done is discover arithmetic. (Laughter.) No, if the target -- and the ECB is quite serious about it -- is, say, 2 percent on average, they're above it, right? And if you know that the periphery will have to do less than 2 percent if it is to regain competitiveness, then somebody is going to have to do more than 2 percent. That's not economics; that's arithmetic. So Germany will therefore -- and Finland and the other (bits ?) that are not trying to improve their relative competitive positions in the euro area -- they'll have higher inflation. And whether they like it or not, they can't do anything about it. They don't set interest rates. They have a little bit of discretion over the collateral they accept, but even that is rather minimal.

So Germany, in monetary policy, has, you know, one vote through its national central bank president, the Bundesbank president. And though Mr. Asmussen technically is not speaking for Germany, but if you say that, no, he's -- you know, by -- he has an intellectual legacy there, he might -- that is two out of 23. So this is not a choice of the Bundesbank. They haven't decided to accept inflation; they just decided that two plus two indeed equals four, yeah.

FOROOHAR: OK. We can take a few other member questions over here.

QUESTIONER: Mike Pokna (ph), Emirates NBD Bank. To what degree will media get involved? And will one country try and talk to the electorate of another country? Will people in Germany or entities of some sort advertise and present the position of the Germans to the Greek voters or to the Portuguese voters or to the French voters? Will that start to happen?

BUITER: Well, it may well, but I hope not, though we've had many examples, of course, of politicians lecturing the electorates of other countries on what they ought to do, and especially I remember -- (inaudible) -- the many Irish referenda, right? The French were pointing out that no country that accounted for whatever it was, less than 2 percent of euro-area GDP, you know, with 3 1/2 million people in it should hold 400 million Europeans to ransom, something like that. And that, of course, went down like a ton of bricks, right? So if there's one way, for instance -- (inaudible) -- Irish referendum lost, right, it is for -- certainly for German or French politicians to remind the Irish of where their national sovereign interests lie.

As private entities do it, you know, they'll probably be written in bad English -- (laughter) -- and you know, I can hardly imagine (Bild ?), you know, conveying messages that would be convincing to anybody anywhere. (Laughter.) So I -- it may well happen, but that -- we don't even have a European (polis ?) yet to get a(n) effective cross-border lobby of either industrial groups or consumer (groups ?). It's possible. It's possible. But I think that is -- it would be a rather minor issue and more be likely counterproductive.

FOROOHAR: And there was a question over here.

QUESTIONER: Jeff Trinklein, Gibson, Dunn & Crutcher. How much is this reminiscent of the situation 30 years ago, in the '80s, when Mitterrand came into power in France? There was a bunch of disarray in the eurozone -- wasn't then a euro, but in the European zone. The U.S. currency became very strong for a three- or four-year period. Do you see that same sort of phenomenon happening again, and what are the consequences that you --

BUITER: Yeah, it's similar, except that things move a lot faster, right? It took Mitterrand two years before he realized that he couldn't have Keynesianism in one country, with an unrestricted capital account -- fairly unrestricted capital account at the time. And it now will take three months, I think. That's the difference.

So if Hollande gets a majority -- a left -- a majority either of his own party or joined with the hard left, he will have to, I think, simply do -- you know, justify it with his voters and his political existence -- he will have to engage, I think, in this pro-growth -- with unfunded policy. And he will get slapped down, I think, by Q4 -- (another ?) summer -- late-summer crisis. Yeah.

FOROOHAR: OK, are there any other member questions. Mr. (Soros ?).

QUESTIONER: Could you comment on the TARGET2 of euro system and the controversy of the articles by Hans-Werner Sinn on the contingent liabilities incurred by Germany?

BUITER: Yes. Seldom has one economist done a greater disservice to his discipline than Mr. Sinn in the writing of these pieces on TARGET2.

What is the TARGET2 imbalance for -- (inaudible) -- position, say, of a central bank in the euro area? Any central bank has one. It is simply the stock of net foreign exchange reserves held by the central bank vis-a-vis the other euro area member states, which of course don't have foreign exchange reserves any longer within the euro area but have euro claims, right? So it's the cumulative overall balance of payments surplus, the official settlements balance surplus within the euro area.

Now -- and it's increased massively because Germany -- it doesn't just run historically an overall current account surplus, it runs a current account surplus -- you know,they aren't very good on this -- within the euro area. And in addition, we have sort of capital inflows into Germany, so the finance -- financial account is in surplus as well. And so the central bank makes it all add up, and it has been accumulating claims on the other euro area central banks like crazy.

Now if that measure, these TARGET2 imbalances -- it's now somewhere between 6(00 billion) and 700 billion; I haven't looked recently -- euro -- is it a measure of the exposure of the Bundesbank to the rest of the system, the euro system? No, it's not. Even if they had no TARGET2 imbalance, right, as a zero net credit, they're still responsible for 27 percent of any losses or profits -- (inaudible) -- made by the euro system in its monetary policy operations. Right? So that's what the exposure is.

Now if the euro area breaks up, of course, and Greece leaves, the same formula applies. If there are losses associated with that for the euro system, regardless of the TARGET2 imbalances, then Germany pays out slightly more than 28 percent, because Greece is out now, OK? Something like that, right?

Now -- and if of course everybody walks out and Germany is the last one standing, right, then they will simply have a bunch of bilateral claims, then the 2 -- the 27 percent share becomes the same as the -- as the -- as the TARGET2 imbalances. The claims on the other national central banks -- these claims are not extinguished by the euro area breaking up. The problem of course becomes to collect on them. So undoubtedly -- so should there be a wholesale breakup, right, the Bundesbank will take losses -- the Bundesbank, not necessarily Germany, Inc., right, because much of the increase in TARGET2 imbalances since the crisis started is simply the German private sector shoving its bad foreign assets into the Bundesbank and indeed into the German government, because there has been some increase in net German exposure to the euro area since the beginning of the crisis, because their figurative current account deficit -- in fact, the euro area of Germany has been positive, but it's much more than the capital inflows. And most of these capital inflows is simply Germans taking foreign assets home. And since they can't do that in the aggregate, because that requires a bigger current account surplus than they have, they're simply shoving it into the public sector.

So the main exposure change has not been with Germany but within Germany that the German taxpayer is now much more exposed than the German private creditor.

There is an enormous capacity in Germany to forget that you can't have an irresponsible borrower without having an irresponsible lender. And of course Germany, in the run-up to the financial crisis, was the prime example of the irresponsible lender, right? They were shoving money into the periphery -- Ireland, Spain, (superstructure ?) -- (inaudible) -- as if there was no tomorrow. And then as a result, of course -- and that reflected the massive Germany savings rate and their unwillingness to invest it at home because of the rather boring returns that were obtainable there.

So they invested it all, and then they recognized that the periphery was in deep trouble. They repatriated and put their money either in -- shoved the bad assets either into the ECB, to the Bundesbank or into the government. KfW took some, the German state bank, and the German facilities.

So most of the debate is actually between the German taxpayers and the original German creditors. Germany prefers to think of it as the fight between the -- you know, the fiscally incompetent Mediterraneans and the virtuous German saver, but that's only a very small part of the story.

FOROOHAR: So we have about a minute or two left, and I just want to ask you one sort of longer-term question. You spoke earlier about a small fiscal pot. And I'm wondering, once we're beyond exits, orderly or disorderly, are we going to see at some point a stable, broader fiscal union in Europe?

BUITER: Not in my lifetime, and I expect to live forever. (Laughter.) But we will see a minimal fiscal Europe, which is basically a collection of pots. We will see, for instance, the ESM, that they'll be the successor of the current alphabet soup, I think, ultimately increased, even in its authorized capacity, to multiple trillions. My view is, they need something like the noninflationary loss absorption capacity of the ECB "pour decourager le marche," right, so to speak.

But even then, just as there is now, that there will be a line that says this limit -- this ceiling can be raised with the unanimous consent the (13 ?) governments. So -- and when -- and a liquidity facility, an insurance facility -- not the redistribution facility -- not going to have significant cross-border redistribution. We could have significant cross-border insurance.

And then of course it has to be associated with a sovereign debt restructuring mechanism, even -- it's already part of the (NSDLM ?) -- of the ESM to deal with future fiscal insolvencies that I think are likely to occur, because when you have 17 and, I think, going down to 16, then Lithuania -- (with ?) Lithuania and Latvia coming in, 18 and soon, you know, 26 countries in the euro area with only the U.K. out and then 27, with Scotland in and England out, but -- (laughter) -- that will -- they'll all work, that -- so in fact -- and then we need banking union, right, with just a single banking regulated -- do away completely with national sovereignty in the banking sphere, a single resolution regime for banks, a single resolution fund as well.

And I think since there will be serious unsecured bank debt restructuring, both subordinate and senior, in the euro area before this is over, for a number of years afterwards it will be very difficult for banks -- most banks to get their own funding, unsecured, without guarantees, and again, sovereigns won't be able to give that in most countries. So it needs to be a -- what I call a unsecured bank debt guarantee facility, which requires a finite fiscal pot, again, for both the recapitalization facility, the fiscal pot, the project, the loan guarantee facility -- the borrowed debt guarantee facility.

And then they need European deposit insurance, which, again, until they set up the privately funded backup fund large enough to handle any possible run, which will be never, they will have to be backed jointly and severally, and that -- hopefully they will also have the nice symbolic gesture of telling every bank and all the SIFI (ph) to incorporate as Societas Europaea instead under national law. That would really make it clear that that's where you cut this, you know, deadly umbilical cord between the sovereign and the banks, and it will be a necessary condition for survival.

So a little bit of fiscal Europe, but no serious -- (inaudible) -- distribution. The notion that simply because Portugal is much poorer than, say, whatever -- than Sweden, they're going to have equalizing transfers -- it doesn't play within Europe anymore, right? Within the existing nation-states, the willingness to engage in interregional redistribution is vanishing fast. There are more, proportionately, Englishmen in favor of Scottish independence than Scots, right? There are more -- rich Catalonia no longer wishes to give its largesse to poor Andalusia. In Belgium, you know, rich Flanders is -- so that they're subsidizing poor Wallonia. In Italy, you know, the -- (inaudible) -- believes that, you know, Italy stops not too far south of Rome and it wants to end the transfers to the -- (inaudible). So I think that the notion that we're going to have a transfer Europe is largely politically impossible. You're going to have an insurance Europe, and that should be good enough -- and hopefully a preventive Europe. They've been very bad at that so far.

FOROOHAR: OK, well, that's probably a good place to stop. Doctor, thank you so much.

BUITER: You're welcome.

FOROOHAR: A pleasure to hear your views. Thanks to all the members. (Applause.)

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