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The Future of the Eurozone

Speakers: Thomas Philippon, John L. Vogelstein Faculty Fellow and Associate Professor of Finance, Leonard N. Stern School of Business, New York University, and Benn Steil, Senior Fellow and Director of International Economics, Council on Foreign Relations
Presider: Frank Brosens, Founder and Principal, Taconic Capital Advisors
November 10, 2011, New York
Council on Foreign Relations

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FRANK BROSENS: Good morning. Welcome to the third and final session of the symposium, the Stephen Friedheim Council on Foreign Relations Symposium on Global Economics, this one entitled "The Future of the Eurozone."

First, just a quick reminder -- two things: One, you've probably heard a few times today, but if you can turn off your electronic devices completely -- not just to silence -- to avoid interfering with the sound system. And second, a reminder that this is on the record.

We are fortunate today to have with us two -- not three -- Jacob Kirkegaard, unfortunately, got fogged in on his way from D.C. -- very prominent economists on the European situation; Thomas Philippon, the John Vogelstein faculty fellow and associate professor of finance at NYU's Stern School of Business; and Benn Steil, a senior fellow at the Council on Foreign Relations, whose recent book, "Money, Markets and Sovereignty," was awarded the 2010 Hayek Book Prize.

We're going to have a dialogue for about half an hour, after which I'll open it to the members for questions.

I heard a great anecdote this morning on the European situation from someone who, when asked what's going to happen to Greece, says, well, it's just going to follow the Greek precedent from 137 BC -- (laughter) -- where apparently the Romans heard that the Greeks were way overleveraged, and so they sent someone to Greece to find out the details and discovered that, in fact, it was true. The gentleman came back and said it's true but not to worry, the creditors all understand the situation perfectly; most of them are willing to take big haircuts, and those that aren't, we're going to pay them in installments over 10 years.

Unfortunately, over the last couple of years since President Papandreou took office and discovered and then announced that the fiscal situation in Greece was far worse than had previously been thought, the markets have bounced back and forth from greater and greater crises to greater and greater partial solutions. And the question now resolves not on Greece -- which is an economy of about 230 billion euros -- but on Italy, an economy over five times the size.

So I guess the question that I'll ask my two panelists to start is will it hold together.

THOMAS PHILIPPON: We'll hold together. So, for Greece, I think the issue is whether it's going to stay in the eurozone or not. And that's, I would say in the medium range, mostly for the Greeks to decide.

The real question is what's going to happen to Italy. And there I think that, in the near term, there are two issues; the near term and the medium term. In the medium term, it's all about growth. So the one thing you have to realize, the growth of Italy from 2001 to 2010 is 0.2 percent a year on that rate, almost no growth. It's such a low growth, it's hard to pay back your debt.

So any credible solution for Italy must involve some growth in the medium and long term. So these are the structural reforms. And then the big issue is whether the government is going to be able to do it. That, nobody can know in advance.

The near-term issue of, you know, the next two or three years for Italy, then it's really all about politics because the economic solution is, I would argue, quite simple. I think if and when the ECB decides to move, it can solve the debt crisis for Italy quite quickly. But it is not clear that this will be a load to move either by German politics or by Italian politics.

So I think the product is that the economics is actually quite simple and the politics is very complicated. So whether it's going to hang together or not depends on whether -- (inaudible) -- can put together a government that's credible.

The one thing I also will mention is we don't know yet for sure that Berlusconi is really gone. He's not gone -- (laughter). Anyway, if you wonder, you know, why is the -- why all the variety -- (inaudible) -- are very high. Well, there's still a lot of uncertainty. The markets interact very well to the announcement that Berlusconi would step down. Well, it's not guaranteed he's gone, and so that's why -- that's why there's still so much uncertainty.

BENN STEIL: But with Gadhafi gone in Libya, he's unlikely to get political asylum there. So his options are relatively limited. (Laughter.)

With regard to Greece, I do think it will need another -- the polite way to put it is restructuring sometime next year. But the eurozone as a whole can survive another restructuring, in my view.
The possibility of Greece leaving the eurozone is a heck of a lot trickier because there are so many webs of connections that go deep into the European economy.

Just to give you one example, if Greece were to leave the eurozone, you would have multitudes of cases like this where there's a German bank that's made a loan to a Greek industrial concern, if any of those exist. And there emerges a big question whether that loan is now denominated in euros and drachmas. And that's going to be replayed throughout the European continent. And that could give rise to a terrible contagion.

So a Greek exit from the eurozone is not, by any means, simple. It's very, very dangerous for Europe.

With regard to Italy, a restructuring, in my view, is out of the question without a breakup of the eurozone, but the problems Italy has, in my view, are manageable notwithstanding the current bond market. That's a big notwithstanding that I'll get back to in a moment.

Italy is solvent. Italy has a very high debt-to-GDP ratio, about 120 percent. But to date, it's been stable and even declining mildly. It has -- it's running a primary budget surplus, meaning that it doesn't have to borrow from the markets in order to fund its current expenditures just to pay debts on -- pay interest on its whole debt. Its current account deficit is much less than half of Greece's, and at least to date, it's had mildly positive growth. So those numbers are pretty good.

So then the real question becomes why did the bond markets disagree with me. And I'd point to one factor here that I am sure Thomas will agree is important because we had this conversation yesterday. The eurozone debt package that was put together for Greece a few weeks ago involved the plan to recapitalize the European banks. And they made what I consider to be a fatal mistake in how they set up the rubric.

They basically said that the banks needed to improve their capital-to-asset ratios. That gives the banks a choice whether to increase their capital or to shed assets. And they've been choosing to shed assets, and I think the timing couldn't have been worse because there's no doubt that Italian government bonds have been a big victim of this.

What they should have done is simply tell the banks you will have to raise capital irrespective of what you do on the asset side. And if you can't raise it, you'll have to take government capital just like they did in the United States back in 2008 when Hank Paulson told, I guess it was the 10 big banks, that you won't leave this room until you sign a thank-you card to Uncle Sam for the equity capital we're about to inject. That's what we're going to do in Europe, but that's not what they did. And I think we're reaping the consequences of that now.

BROSENS: Do the governments have the -- the U.S., when it did that, barely had the solvency to be able to inject a significant amount of its capital into the banking system without threatening its very solvency. It's less clear to me that the European countries have that same capability. There's more circularity between the sovereign risks and the bank risks.

You know, as you look at that issue, you know, is the capital that they're talking about raising enough? And do they have the capability to do it?

PHILIPPON: So in the case of -- for that question, the critical country is France, actually, because that's where the -- you know, the biggest exposure to Italy on the one hand, and that's precisely why that question of raising -- of using public money to recapitalize the bank was discussed. And it's clear that the view was that, if the French government was to do a massive recapitalization of its own banks, that would threaten its own fiscal position and its own -- essentially, its own credit rating. And so that's why that option was not chosen.

On the -- I totally agree with the -- the issue with recapitalizing the bank is you can tell the banks I want you to raise money or I want you to have a good ratio. If you tell them I want you to have a good ratio, they can raise money or shed assets.

And it looks like Europe has suddenly a second option, and not only that but also, of course, then the question is where do you shed assets. As you can imagine its bank in its own country is making sure not to shed its domestic assets. But the French banks are not doing a credit crunch in France. They're just getting rid of as much Italian paper as possible.

And I'm sure the Italian banks are doing the same as the French paper and so on and so forth so that, essentially, it's blocking their credit crunch in other countries. So that's a clear case of lack of coordination at the EU level.

So if you want to understand why is it that, you know, the U.S. has coped better with these kind of issues, well, you don't have that coordination problem because that -- (inaudible) -- and then you don't have this issue of California -- or actually, in that case -- yeah, California exporting its credit crunch to Texas. That didn't arise. That's the big issue.

On the specialty issue of the bank -- (inaudible) -- you have to realize one thing, which is there is no amount of capital that you could put in the bank that would protect them against a breakup of the eurozone. So today, for better or worse, that has become a second order issue. You know, the big issue is Italy. I think the eurozone would not survive restructuring -- significant restructuring of Italian debt. So that's it.

And so you think that-- or the whole game is over. It's not a little bit more capital in the bank that's going to solve the problem. The metaphor is: suppose you live next to a nuclear power plant and there is a leak. Well, you know, you could try to fix the power plant -- that's fixing Italy; otherwise, putting duct tape on your window, which is like putting capital in your banks, is not going to help you very much.

OK, so that -- unfortunately, that's where we are now. So I think that this issue of capital in the bank -- the banks have enough capital to withstand a normal recession, even a big recession. They don't have enough capital -- no bank would have enough capital if there is a break-up of the eurozone. So I think that's where the line is clearly at today.

STEIL: Recapitalizing the European banks is much more complicated than recapitalizing the American banks. A dollar in a U.S. bank is the same as a dollar in another U.S. bank, broadly speaking.

That's not the case in Europe. A dollar -- a euro in a Greek bank, however much the Greek government might want to insist that it's credibly insured, is not the same as a euro in a German bank. Those are, for all intents and purposes, two different currencies. And this is one of the things that's fueling the crisis right now -- that deposits have been fleeing the periphery countries, in particular, Greece, and going into Germany. We don't have that problem in the United States, thank goodness.

BROSENS: It seems actually there are a variety of circular issues with the eurozone that didn't exist in the U.S. When you think about the troubled assets in the U.S., they were unrelated to sovereign issues here.

They're related to sovereign issues, and therefore constrains the sovereign ability to help. The EFSF is guaranteed by all the various countries. You know, Italy and Spain actually represent 30 percent of the guarantee, and so you have the circular issue there as well.

Also, and we talked about this a little bit, the overall European banking system is over three times GDP, whereas in the U.S., it's about equal to GDP. Wondering how all of those play out in your view?

PHILIPPON: The two major differences between the U.S. and Europe, with respect to the current crisis, I think, A, the central bank; and B the growth prospect.

So no matter what we think, it's still the case that we believe the U.S. economy is going to grow over the next five years. Maybe not as much as we'd like, but something is going to grow. There is no question about that. That's less obvious for some -- for some (sovereign ?) economists in Europe. That's a big deal if you think about the credibility of your debt, because, you know, if you grow, it's a lot easier to pay back your debt. So that's one big difference.

The second big difference, of course -- and I think the main one today, for sure -- is the central bank. In a sense, if you look at it -- if you were to look at this -- (inaudible) -- and you would, like, ask yourself, who should be doing quantitative easing, well, the answer would not be the Fed. It would clearly be the ECB. And the one place where quantitative easing would have a huge positive impact would be Europe, right. And there it's the opposite.

So why is it that the Fed is doing it, even though the returns are much lower and the political risk seems to be even significant in the U.S.; where, in Europe, where the return would be very high, the ECB is not doing it? Well, the answer is because, to do that, you need a credible commitment to sensible fiscal policies going forward. If the ECB starts doing quantitative easing on long-term Italian debt (actually ?), that would certainly help a lot the economy to grow over the next two or three years.

The trouble is, if you get the Italian government off the hook, are they still going to do the reform that you would like them to do? That's the issue. And that's -- that is the main difference between Europe and the U.S. And you can see it very well in the data, doing some research on that. It's very interesting to see that the initial shock -- so think about, you know, 2007, 2008 the big shock happens. It hits everybody. And remember, German GDP fell more than U.S. GDP, right. So the shock was hitting all the countries.

Now, in the U.S. -- people think of the U.S. as one country, but in fact, if you look at different, say, U.S. states, you're going to see that Nevada, Florida, California got crushed, while Texas, New York, Pennsylvania were doing just fine, OK. And now imagine that you look at the collection of states in the U.S. and the collection of states within the eurozone. What you will see, almost exactly the same dispersion.

So employment -- the employment rate fell about 15 percent in Nevada, 12 percent in California. It was 12 percent in Greece and over 10 percent in Spain. And on the upside, Texas essentially had no significant recession, and neither did Germany. So the dispersion is very much the same.
So the idea that the U.S. has one business cycle, where all the states are hit the same, that's not true. There was also a lot of dispersion. And yet we don't have the second round where we start to worry about the solvency of Texas, versus California, versus Nevada. That doesn't happen.

Well, the muni market -- perhaps we can discuss that later on, but it's small anyway, relative to the federal debt market. And so that's, you know, that you can see it vividly, the reason that these issues don't arise in the U.S. is because the state don't have -- don't have their own debt, and therefore the solvency of the state themselves, that's not a big deal. And Europe is exactly the opposite. And so now the solvency of the state is a big deal.

And then second side, of course, which, as you said, is the feedback from the states to the banks. So I don't -- I don't think that the main issue is the size of the banking system per se. Just because, remember, in the U.S. you use the markets more to -- (inaudible) -- credit. But the bank branches are not that big, but then you have the money market fund, which is essentially backstopped -- you know, is a big systematic part of the system, and for all practical purposes, acts like a bank. And definitely eurozone is on the hook if there's a big run on the money market funds. I think we know that.

So if you add that up, that's not going to make a huge difference I think, in terms of the big picture. What is going to make a big difference is, again, the state law issue, which is Italian banks have Italian paper, and French banks have French paper, and so and so forth. So then, locally, all these effects, the feedback from the branches of the banks to the solvency of the sovereign, this feedback get together very quickly at the state level.

So imagine if California had banks, had a lot of debt, and all the Californian banks only hold the paper from California. Well, they would be in big trouble, and they would have spillover to their neighbors, OK. Fortunately, that's not like that. The banking market is completely globalized within the U.S., and so there is no sense in which a state being in trouble, even in a credit crunch -- (inaudible), OK. That's the main difference.

So I think, again, if you really go down to the basics, it's really about the different behavior of the states within the system. That's the fundamental difference, not the rest. At least that's my view.

BROSENS: (Off mic.)

STEIL: With regard to the ECB, I think its powers are much less than many people impute to it. For example, last week at Mario Draghi's first press conference enormous attention was given to the quarter-point rate cut. That will have virtually zero effect on the position of the periphery countries.

To put some numbers on it: Before the crisis -- even, in fact, up to mid-2010, the correlation between the ECB's policy rate and the Spanish three-month government borrowing rate was virtually 100 percent. That is, the ECB dictated the movement of the Spanish government's borrowing rates, and those rates in turn dictated borrowing rates in the private sector in Spain. That's how monetary policy works in developed countries in normal times.

The correlation today between the ECB's policy rate and the three-month borrowing rate in the periphery countries is zero. It has absolutely no impact. Investors are not interested in the ECB's policy rate. With regard to the periphery countries, they're only interested in default risk. Default risk is what determines the spreads.

Now, Mario Draghi made another comment that didn't get nearly as much attention as I thought it should have. He said, quite provocatively, that the European Central Bank is not a lender of last resort for eurozone governments, and indeed the eurozone didn't need the ECB to act as a lender of last resort. That was an extremely forthright statement. There are many dimensions to it.

I think, first of all, right now he's trying to have it both ways -- trying to be "a little bit pregnant" with regard to Italy, which is a catastrophic situation. It doesn't do any good to stabilize Spanish government borrowing rates at around 7 percent. You either have to go all in, or make it clear that this is beyond your capability here, and that the eurozone creditor governments need to act.

Now, I actually think that the eurozone creditor governments do need to act, and for this reason. The ECB only has 81 billion euros in capital. That could easily be wiped out with, say, just a 25 percent haircut in PIG debt -- Portugal, Ireland and Greece. That's it. Gone.

Now, a central bank can operate for a brief period without any capital. But eventually any central bank will have to tighten monetary policy at some point in the future. And in order to do that, they need assets to sell. And unless the market believes that the ECB is going to be credibly recapitalized, there will be a god-almighty run against the euro and it will, quite frankly, collapse.
That's not the same situation as the Feds in the United States. In fact, if you look at the Fed's reported capital, it's only $58 billion. They made good paper profits off the crisis, I should add, which is very good for them. But nobody doubts that the U.S. government is ultimately going to stand behind the Fed. But investors do doubt that the German taxpayer is ultimately going to stand behind the ECB. And that's a big, big problem.

And I think that's one of the underlying reasons why the ECB is so tepid with regard to the crisis. They don't want to make themselves a ward of Germany, because they don't know if they're ever going to get out of that poorhouse once they get in.

The German public may decide, at that point, enough is enough. That may be a bad decision, but it's still going to be a decision that they can take in a democracy. And I think that's a big risk.

BROSENS: Play devil's advocate a little bit.

I think Mario Draghi is viewed as much more pragmatic, I think, than (Trusche ?). And while he has a moral hazard issue, in terms of immediately coming into the support of Berlusconi -- and still Berlusconi-led government -- if in fact, Italy heads in a direction of a technocratic government led by Monti, and there is confidence that they're going to do the economic reforms and austerity measures that are needed, I'm not sure that there's much choice other than to come in, in a very significant way, and try and get rates down.

And I guess I'd challenge either one of you, in terms of why that wouldn't be the case.

PHILIPPON: I think it would work. I mean, I totally agree that the usual chain of monetary policy, where you fiddle around with a short rate. That's peanuts. That's irrelevant. And so that was completely irrelevant in 2008 and '09 in the U.S. as well, which is why the Fed went into what we call unconventional monetary policy, or also known as quantitative easing.

And quantitative easing, number one, was a huge success. I mean, I just recently discussed a paper at Brookings, doing a micro-estimate, looking at detailed data on all possible spreads you can think of in the U.S., looking at exactly what QE I did. And it's a huge success for all markets -- the corporate bond market; of course, all the mortgage-backed securities. That's completely unconventional. That had nothing to do with their policy rates. That's quantitative easing.

So I'm -- my presumption is, if they were to do it with the Italian markets, it would have the same efficiency. It would work. But I think -- and where we probably agree is, the paradox is if -- you know, if you're credible, you announce you're going to do it, and you're going to do it big, and without limits if necessary. And if that's credible, then the great thing is in terms that you don't have to do that much.

That's the paradox of it. If you're credible and you announce something big, you don't end up having to do a lot. And that's -- we had the -- (inaudible) -- scenario. That's the economy of Switzerland. But if you announce very little, and it's not very credible, you end up having to do a lot. OK, that's the product -- (inaudible).

The problem is, to announce a lot they need two things: They need credibility on the Italian side -- that is, they need to know -- and, of course, Draghi and Monti know each other very well and respect each other very well, so we can be sure they're going to be able to coordinate. But it's obvious that Draghi cannot move before Monti is in and with enough power to implement the reforms that everybody knows are necessary, OK. So they need that, on the one hand. That's on the Italian side.

And then they need the German side, because they need to be able to say, we're going to go in -- we're going to go all in, and we are backed by the rest of the eurozone, which essentially means Germany. If that's credible, that is not going to be very costly, and you can predict that the ECB is going to make big paper profits just like the Fed did. So I think that's the position we're in right now.

STEIL: Politics matters very much here. Ultimately Ben Bernanke is far less constrained by Ron Paul than Mario Draghi is by, say, Angela Merkel. That's not to say that Ben Bernanke can do anything he wants in terms of monetary policy innovations. Congress granted his body independence in terms of making monetary policy, and Congress can take it away. But we're not very close to that.

It's not surprising that the ECB is far more reluctant to engage in those innovations since its ultimate backstop comes from Europe's -- the Eurozone's largest creditor country, Germany. And the German public, the German political class, is very, very uncomfortable with these sorts of monetary policy innovations. And so the ECB's room for maneuver is ultimately limited.

As I say, politically I think it would be a disaster for them to have to be recapitalized. I think whatever independence they have right now would be permanently removed or they have to go down that route. So they're trying to avoid it.

BROSENS: One last question and then we'll open it up to the members. Two issues, Thomas, that would seem to present challenges to the ECB. One is so much credibility been squandered that it's going to be hard to get back. And the second issue is there seems to be, in a sense, a return to home bias. You talked about it in terms of some of the French banks divesting Italian assets. That's really from a capital perspective.

There is also a growing perception that financial institutions shouldn't own assets outside of their own country for risk reasons. So you look at the money markets in the U.S. owning European bank short paper, the problems that MF Global has obviously run into, the questions about Jefferies. You're seeing it in Europe as well in terms of questions about banks owning the sovereign paper outside of their own country. It seems like that's going to also prevent -- present a fair bit of -- a fair challenge to the ECB in terms of stoking up all of that supply.

PHILIPPON: So there is no question that ECB lost a lot of credibility with the way they dealt with Greece. In fact, it's quite striking that, not so long ago, at least early on in the financial crisis, the ECB was seen as the most credible central bank, ahead of the Fed, because they reacted better to the initial round of financial disasters, like, you know, in the fall of '08.. They were the first to have the credit lines open. They did some of the moves before the Fed.

And also there was the issue of the banks from the U.K. seeking liquidity in emergency, and the EC was much faster at doing that than the Bank of England. So in fact, there was a time when the EC was seen as, well, that's really impressive; they are successful. And they lost everything on the sovereign side. There is no doubt about that.

What is not clear in my mind is should we blame them or should we blame the politicians within Europe? That's a debate we can have. Is it the ECB? I mean, you know, I'm an economist. I don't know. We are not very good at making predictions.

There is one prediction that all -- the ones I talked to, at least, with me that the IMF or some of those places in Europe we all agreed on is Greece is not solvent. So that's not a liquidity crisis. Greece a year ago was not a liquidity crisis. It's a solvency issue. That is, take a big haircut and then get done with it, you know. Don't waste time. Don't waste a year and a half doing half-measures. It's obvious it's not a crisis of liquidity.

I think the ECB also knew that, and my sense is either they don't have the guts to say it or they have too many political constraints to say it. I don't know which one is true. But it doesn't matter. The outcome is they lost their credibility on that. So next time they're going to say this country shall not fail or they'll say, yeah, well, you said that for Greece. And so that's a big issue; I totally agree.

There's a separate issue of, you know, what's going to happen to -- are we going to move away from financial globalization? I don't think I can answer that in two minutes. I think there is certainly a tendency for that. I don't think it's going to be an issue just for the ECB, by the way. I think it will become an issue for the U.S. as well, for banks in Asia as well.

In the short term, it's clearly an issue for the ECB, just because the money market funds pulled out of funding U.S. dollars short term to EU banks. So now what happens is dollars flow from the Fed to a swap line in Frankfurt, and then that's given back to the banks in Europe. That doesn't sound like a good government solution.

And I -- you know, and as long as the crisis is going like that in Europe, I don't see the money market funds putting their money back into short-term EU banks' paper. So I don't think that's -- so that problem is here to stay. Whether it's going to disappear in the long run, I'm not sure. But there is a real chance we're going to see retrenchment from financial globalization, because it looks like this currency mismatch is an issue.

And the other one is, remember what governments do when they have to pay back their debts. That's financial repression, and that's something that has been going on for a thousand years. Every big episode -- and I'm talking really a thousand years, because all the historical periods of government having to, you know, reduce significantly their debt, every time it involved some form of financial repression, which just means forced saving at home. And so whether that's going to be part of the equation going forward, I think it's likely, at least; and not just in Europe, by the way. I think the same is going to happen here.

STEIL: I would be far harsher than Thomas on the ECB with regard to why they deny Greece's insolvency. They were a big Greek creditor. They were talking their book, just like Josef Ackermann at Deutsche Bank. He said it would be an utter catastrophe if Greece were to restructure. Charles DeLauro (sp), who represented all the big banks in Europe, said it would be a catastrophe.

The ECB was just another big creditor talking its book, saying it would be a disaster if it had to take a haircut. And I thought that damaged their credibility enormously. But I think the reason why they persisted in that position was that they were very concerned, ultimately, about their capital.

BROSENS: We can now open it up for questions for the members; if you can state your name and affiliation, please.

QUESTIONER: Rob Rosen. Do you think that any Eurozone solution would require significant -- I was going to use the word massive, but significant liquidation of gold reserves in order to provide leverageable liquidity to allow for the large solution that I think both of you suggested was required?

PHILIPPON: I think gold per se is not going to be a key issue. The issue is going to be inflation, which is, I mean --

STEIL: Things go together.

PHILIPPON: Yeah, exactly, to the extent it's going to influence inflation, then yeah, that matters. There are two scenarios. One scenario is you have some -- it's to convince Northern Europe to accept some degree of inflation. And then the rest -- that is, the southern part of Europe -- stays at zero wage growth, perhaps tiny bit of negative nominal wage growth, and then, you know, if you have a three-person difference between the north and the south, each year you gain 3 percent competitiveness. After 10 years you're at 30 percent. That solves a lot of the issues. So that's the growth and inflation scenario.

Then the barometer of that scenario is how much inflation is Northern Europe willing to tolerate? And my hunch is actually the answer is not much. And I think that it's not realistic to think it's going to be above 3 percent, and I don't think it's very realistic to think it's going to be sustainable above 2-and-a-half (percent), if I had to guess. That's my hunch. I don't have a -- I'll try to show that, but I think my understanding of people's preferences and the political realities in Germany is -- I don't buy the idea they're going to be willing to accept significant inflation.

OK, so that means what? That means that 2 percent is going to take a long time unless there is also deflation in the south, which is exactly what's happening now. The thing is, that's going to come together with big unemployment. And then the big issue is that makes it harder, at least in the short term, to pay back your debt. That's why this scenario is such an inefficient one.

But these are the two scenarios. You know, you're going to have either massive deflation in the south or some inflation in the north, together with either no inflation or small deflation in the south. And that's these are two scenarios that can keep the Eurozone together.

I don't think, actually -- I would be very bearish on the second one, because I don't think it's significant deflation in the south for a long period of time. I don't think it's going to be particularly sustainable. And therefore, I don't actually buy that scenario at all. I think that's not -- I don't buy that thing. I think that would not be sustainable. It would increase the debt burden too much and it would not make the -- it would make the political commitment to reform almost meaningless. That's why I think inflation is going to be the key.

BROSENS: But what you're saying is effectively austerity increases the deficits, decreases GDP, increases all of your ratios. And so the austerity that you actually have to perform is --

PHILIPPON: It's terrible.

BROSENS: -- is too big.

PHILIPPON: But the thing that's striking -- I mean, I don't know if I was very struck by that. I thought the IMF learned that from the Asian crisis, but they did exactly the same to Greece, I mean, literally. Well, that's kind of surprising in a sense, is that you would at least think that they would have learned from the Asian crisis. I think the politics is very different, so perhaps that explains some of it. But in terms of the economics, it looks like the same mistake again.

BROSENS: Another question? Yes.

QUESTIONER: (Off mic) -- Pace University.

What does it mean for a central bank to be backstopped by the central government? At the end of the day, doesn't the Fed print its own money? It doesn't have to borrow from the U.S. government.

STEIL: This is true. But if the central bank has no assets, then it can't tighten monetary policy. How does a central bank tighten monetary policy? It withdraws currency from the market, and it does that by selling assets; for example, the U.S. -- in terms of the Fed, usually it would sell treasury bonds. The Fed has to have treasury bonds. Likewise, the ECB has to have assets to sell in order to tighten monetary policy. Those assets ultimately have to be provided by the creditor member states.

Now, Thomas and I would agree completely that the ECB is not going to need to tighten any time soon. That's not the point. The point is, if the markets were to come to the conclusion -- for example, if the Bundesbank were willing to sell all its gold to fund the bailout and the ECB were to go down to zero or negative capital position, if the markets were to conclude that this institution is never going to be recapitalized because it has no credibility with its ultimate financier, Germany, then the Euro is finished. There will be a massive run on the currency, just the way we've seen with developing-market currencies in a financial crisis.

So that's the problem. Sure, they can print. That's the easy part. But you have to have credibility as a central bank that once the crisis is over, you're capable of reversing your expansionary policy. That credibility is central.

PHILIPPON: You know that Tom Sargent, who was my colleague at NYU, got the Nobel Prize this year. And among other things, he's famous for looking at this issue. At the end of the day, there is one -- (inaudible) -- from the government -- (inaudible) -- together. That's the one that has to hold. No matter what happens, it has to hold. But, yeah, this one could be on the money side or the fiscal side. There is one budget constraint.

And so if you remove entirely the fiscal side, then that means that you're going to have -- the only solution will be massive inflation. And that's probably not going to be a very good one -- (off mic).

BROSENS: Yes.

QUESTIONER: I'm Padma Desai, Columbia University.

If the European Central Bank will not and cannot play the role of lender of last resort in order to bail out EMU governments and banks, can the European financial stability fund be augmented from its current size of, what, 440 billion Euros, supplemented by IMF funding? Can it be augmented by liquidity flow from China? Or is this a nonstarter? And how do European leaders react to that suggestion?

STEIL: Politically, this is the most critical issue that's dividing Germany and France right now, whether that fund needs to be boosted and to what extent, also how to do it. There's quite naturally great political resistance to sinking more money into the fund on balance sheet. That's why there's been talk of, quote unquote, leveraging the fund, essentially turning it into a CDO, collateralized debt obligation. That could be extraordinarily risky. It means that that $440 billion that would be the equity tranche of the CDO, becomes far more risky than it is today. In other words, more likely to be depleted.

I think it's clear from the past two weeks of international discussions that China is not going to play a role through the EFSF. They might be willing to play some sort of role through the IMF but only at a price. They're going to want more influence in the institution, and I would contend that they would also make it a condition of their increased support that there shall be no more discussion in public criticizing the Chinese exchange rate policy.

So I think we're in a very difficult position right now. I don't yet see the political will in Europe, meaning in Germany and France, to boost that fund significantly and that money is not likely to be forthcoming from persons outside Europe.

PHILIPPON: I was always skeptical of this idea of China bailing out Europe. China is a complicated country. They have internal politics. People in China are not very keen on the idea of throwing money at Europe's problem. I think that's a non-starter politically in China. So they would only do it if they get really big political gain from abroad, mentioned like, you know, the extent of it in the IMF. So I never thought that would actually fly.

The biggest -- I mean, so if France wanted to turn the EFSF into a bank, which is very close to what the U.S. did. You have seen money which is physical money, if you want and then you lever it with monetary policy. That's pretty much exactly what the Fed and the Treasury did together. And you can solve all the -- (inaudible) -- on it. And again, that's the rational solution from an economic perspective. The trouble is, you do it in a country that has a fiscal union like the U.S. Then it's fine. But you should do it in a country where it's not a fiscal union then it's not fine. And Germans said no because they don't want to give a free blank check to the Italians. That -- it comes onto that.

The thing we have to remember, the eurozone as a whole doesn't have deficit. If you aggregate the eurozone together, it's actually probably more stable than the U.S. in the sense that its current account is balanced, it's not borrowing from the rest of the world. It's balanced and its debt-to-GDP ratio altogether looks very much like the one in the U.S. Whole package seems kind of similar.

So there is enough money in Europe to solve its own problem. It's all about politics. And that's so it comes on to that. That's why I don't think -- then when you read this -- I think what I'm trying to say is, when you read this news about outside involvement in Europe, don't think about economics as much as politics. That's the way to interpret it. Because we need a bad cop in Europe. That's the bottom line, OK. Because otherwise we're never going to get reform from Spain, Italy and Portugal. So we need the bad cop. The question is, who's going to be the bad cop?

When you know European history, you know Germans are not going to be great bad cops. And they don't want to do it, for good reasons. They say, you know, that's not the job we really want to do. Then who is going to be the bad cop? Well, A, the market guru -- (inaudible) -- Berlesconi? It's not like we haven't tried, but the market did it. And then the IMF because then you can blame Washington. That's great.

So involvement of outside creditors, you have to think of it as these are the guys who can be bad cops, you know. If the Brazilians say, well, you know, we've loaned you money; we want our money back, so you put your finance in order, that's more acceptable to the Italians than if the Germans say the same thing.

So it's not really -- the quality of money is not the issue here. If Europe had no political problem, it could solve its own problem. That's no problem. It's the politics that matter in that case.

BROSENS: Although the EFSF has gone in a direction -- while the Germans did not allow them to leverage it, they're heading in a direction of using a good portion of that 440 billion (dollars) in as a first-loss piece for the purchase specifically of Italian and Spanish debt. And whether that works or not is an open question.

STEIL: This idea, at least the way they've characterized it right now, I think it's foolish. They're talking about guaranteeing the first 20 (percent) to 25 percent of losses. But no sovereign is going to restructure 20 (percent) to 25 percent. When you're in default, you're in default, 50 percent-plus. So that's not going to calm the markets, 20 (percent) to 25 percent.

BROSENS: But it will lead to lower cost of funds. It may not make it a risk-free asset by any stretch, but if you --

STEIL: I personally don't believe it will if the markets still believe that there is significant default risk because they are going to know that any restructuring is going to involve a haircut that is much, much larger than what the EFSF is going to absorb.

PHILIPPON: But for Italy you could -- well, I think there are two issues. One is, this 20 percent is for the new bonds, not for the old ones. So that doesn't stabilize the Eastern markets. It's only for new -- borrowing. And then there are two issues. One is the one that we just mentioned, which is, you know, if you believe the haircut is going to be 80 percent anyway, 20 percent of that isn't that much. So it helps for medium restructuring.

But even there you have to be careful about, you know, are you going to be sure that this is going to be a real insurance policy? That is, these things are not going -- like when Germany or -- (inaudible) -- creditors lend money to these countries, if they lend senior, that can completely undo the 20 percent insurance you get, OK.

Now if you read the news from Europe, and if I tell you we have an instrument which is supposed to give you insurance against sovereign defaults, you should pay for that because if there is default, you are going to get some insurance back. Well, I don't think you would buy that insurance today because that's called a CDS and we made sure that they don't work. So the 20 percent is the same thing. It's precisely the same thing, if you think about it. So is that more credible? The same government would essentially try to get rid of the sovereign CDS market are now offering their own CDSs?

So again, you see that the issue is politics. I don't think that's completely credible.

BROSENS: Other questions? Yes. In the back.

QUESTIONER: Pierre -- (inaudible) -- from the French newspaper -- (inaudible). You have stressed the lack of coordination within the eurozone. I was wondering what do you make of the deficit of decision-making capability in the EU, and do you think the French elections could have an impact on the policy response in May? Policy response to the European debt crisis.

PHILIPPON: So there is no question that if there had been a better long-term working relationship between Sarkozy and America some of these issues could have been dealt with better. So that's a fact. So we are paying the cost of not having two leaders that are really on top of the game, and definitely not really on the same level one day. So they don't seem to be working very well together. Let's put it that way.

And so we would hope that -- and that's -- part of it is probably linked to the behavior of Sarkozy in some cases, so you would hope it would be marginally better if we have a different president. But deep down, though, you have to realize that I think the bargaining power between France and Germany has changed and is not going to be reversed any time soon, just because the fiscal realities are like that.

You know, Germany has the credibility, France does not. That is not going to change any time soon. So I don't -- in that sense I don't think it's going to have a very big impact. I think the key is more the German politics in and of itself than the interplay with the French politics. That would be my hunch.

BROSENS: Yes.

QUESTIONER: (Off mic) (RTHA ?) in Hong Kong. Along that same line, Mrs. Merkel yesterday spoke of more Europe as the solution, and wanting to do something, that there have been intense discussions with the French about something. It seems that this is moving rather fast in terms of Greece maybe choosing to pull out if they can't get a government, to say nothing of Italy.

I wonder if you'd say more about the implications of alteration of the system, someone leaving, northern zone, southern zone.

STEIL: I think the eurozone could survive the pull-out of a small periphery country like Greece. Would be touch and go because the financial repercussions in the markets would be enormous, but I think that's possible. If it goes beyond that, I don't see it persisting.

I mean, there's been talk about the reverse happening, that Germany and a few northerners would essentially leave the euro and the euro would be a sort of Club Med-like currency for the remainder. I don't see that as particularly credible. That currency wouldn't survive, and the deutschmark that would be reintroduced, whatever one might call it, would appreciate so radically that it would have a terrible effect on the German economy.

No one has an interest in seeing this unravel. But when we talk about more Europe, that has to be translated into certain concrete actions. One proposal has been, as you know, to create a Eurobond, not bonds issued by Germany, not bonds issued by Italy, but by the eurozone as a whole, and Germany is the one who is primarily resistant to this particular innovation. That's a significant political obstacle to moving things further in that direction.

PHILIPPON: I think there is no question that we're going to need more integration. You can read it both sides. You can see actually what we achieved over the last year and a half under intense pressure. It is a lot more than I would ever have expected. The fact that we have an active discussion about the Eurobond, even though the Germans are definitely against it as of now, and for good reasons. Again, I go back to my same point. It's not possible for a German chancellor to say yes to the Eurobond until they know for sure they can control deficits in the other countries. So then the question is what mechanism do you have in place to do that?

By the way, the same exact story played out in the U.S., 1840 (ph) in the U.S. You have nine states that are bankrupt, and big ones. And they all asked for federal bailout. And they were -- at that time loans were extended and U.S. was pretty big relative to federal debt. And it was actively discussed in Washington and the outcome is no. Go bust. And they did.

After that you have strict limits on the amount of debt that states can have and then it becomes clear that states don't have that much debt and all the debt is federal. So that a big -- (inaudible) -- the birth of the U.S. bond, OK. It didn't happen smoothly. It happened through big crisis with huge effort.

So in Europe of course the Eurobond is something that is required in the medium run. The question is how you get there. And the trouble that I have with EU policymaking is that they are not very good at tracing the path of how to get there. It's one thing to say, oh, it's hard. Yes, I know it's hard. But, you know, what are the concrete steps you could at least start so that we see how we would potentially get there? And with constraint you can put on a sovereign government on the spending side so that you could start by having some Eurobonds.

The Eurobonds -- one thing that's very important to realize is it's going to have to be some kind of -- either you put very strict limits on how much more we can -- and Italy and other guys, other countries can do. Or you have to have two types of bonds. You have a local bond which is backed by the EU, which it was proposed as blue debt, red debt. The blue debt is something which is issued at the EU level, backed by the entire eurozone, and that would of course would trade like goods, very low yield, very high liquidity. And so that's providing financing for the government. But then it's capped at some limit -- (inaudible) -- of that.

Beyond that limit then you're on your own, which means at that point you have the market price which prevents you from raising too much. So that solution has -- going back to my earlier point, that has the market being the bad cop because once you've issued your allocation, your quota of blue debt, well the next step is going to be not backed by Germany any more so you're going to pay the high price for that. And that's what prevents you from going crazy and borrowing too much, and that's the market being the bad cop. At least it's credible.

STEIL: Bank supervision and deposit insurance will also have to go pan-European. You remember the crisis didn't start just in Greece, which had a large sovereign debt problem. It started in Ireland and Spain, which had banking sector problems. So early on in the crisis Ireland issued a blanket guarantee on all the debt of its six largest banks and it's reaping the consequences of that now. We can't have a situation like that again in the future. That's why Ireland's in the position it's in now. That's why the ECB is so massively exposed to Irish sovereign debt. So banking supervision and deposit insurance will be a fundamental area that will have to be reformed on a pan-European basis.

BROSENS: I think that concludes our session. It's now noon. One thing that strikes me in terms of the comments have been made in terms of the limits of ECB is it's been said that the Fed in its actions are haunted by 1937, whereas the ECB is haunted by the hyper-inflation of Weimar, and they are still acting accordingly. So thank you. (Applause.)

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