Economic Prospects for the Eurozone

Friday, March 22, 2013

Willem H. Buiter, chief economist at Citigroup, discusses break-up risk, sovereign debt restructuring, bank creditor bail-ins, debt mutualization, austerity, and growth in the eurozone.

This meeting is part of the C. Peter McColough Series on International Economics.

J. TOMILSON HILL: Well, good morning. Welcome to you all and also to our special guest, Willem Buiter. Who better than Willem to give us a point of view on what the heck is going on in the eurozone? Willem has tenured professorships from five universities -- five. So Yale, Cambridge -- you look at the London School of Economics, Bristol, and Amsterdam. He speaks English, Dutch, French, German, Spanish and swears in Italian, so he says.

If you look at not just the academic credentials but also his roles in various entities, he advised World Bank, advised IRBD (ph), advised any number of other entities, trying to figure out what is going on in the world. But most importantly, he has had real experience in the private sector -- Goldman Sachs and Citibank as chief economist.

As you know, this is the C. Peter McColough lecture series and it's on the record. So, Willem, let's get going.


HILL: Everyone's focused on the short term -- Cyprus, German elections. Step back: Three years from now, crystal ball, what is Europe going to look like? Who's in? Who's out? Deposit insurance, banking reform -- what's Europe going to look like?

BUITER: Well, the euro area will at least have one new member -- Latvia, about to join -- may have one or two more. Lithuania could be a next. It will at most, in my view, have lost two of the existing crowd -- Greece and Cyprus -- who are both at risk of exit. Cyprus will know soon. In fact, they'll probably know by Monday.

If they don't come up with a decent deal, acceptable to the troika, the banks will be cut off from funding. And of course, the sovereign will not get funded. And if both your sovereign and your bank cannot fund themselves as the lender of last resort, you might as well create your own. And so they would storm out, in their particular case. That's unlikely.

A banking union, we will have three years from now, in the following sense: We'll have a single supervisory mechanism where the ECB will have effective control over everything that matters and national supervisors, regulators will be at a strictly subordinate status. We'll have a European-level bank resolution mechanism with it, which will work in three stages.

First, when a bank goes belly-up, or threatens to go belly-up, you bail in the unsecured creditors. Anything below depositors is at risk. Anything below -- in principle, below insured depositors would be at risk. In this new Europe, you also will have sufficient common deposit insurance to get away from the current idiocy that you're seeing in Cyprus, where apparently the troika went along with a proposal from the Cypriot government to bail in the insured depositors.

Of course, the EU mandates deposit insurance up to 100,000 (dollars) per person, per account -- per bank, per account. But this is a mandate besides funding. And at this time, they either drop the mandate -- (laughs) -- or start the funding there. But that, I think, would still leave a very large chunk of deposits at risk, quite properly, I would say. Once you get to $100,000 per deposit, per account, the -- (inaudible) -- argument for insurance is no longer there.

The efficiency argument that it's not worth grandma's while to check on the viability of the banking system if she has a 500 euro account, is also not relevant because if you got a 100,000 (dollars) in the bank, you might as well check, you know, whether the cashier is likely to disappear to the Bahamas anytime soon.

So we will get, you know, limited deposit insurance and the rest of the -- other argument for deposit insurance preventing runs and contagion is what central banks are for, to -- if you can't stop the runs, you fund the runs, and -- until they subside. They will only subside if it either becomes clear that the banks are solvent -- provided they can get funded -- or that the banks and insolvent, in which they too have to be restructured, et cetera, et cetera, et cetera.

So we will have that limited deposit insurance. We will have a Europe with no E bonds -- Eurobonds or any form of large-scale, cross-border transfer of resources through explicit fiscal mechanisms. The current ESM can barely be increased in size, so forget front door mutualization. It's not going to happen. There's no political legitimacy for it.

Within existing nation-states in Europe, the willingness for inter-regional redistribution is evaporating fast, right? In Spain, Catalonia doesn't want to subsidize the rest of Spain. In Belgium, Flanders doesn't want to subsidize Wallonia. In the United Kingdom, there are proportionally more English supporting Scottish independence than Scots, all right? In Germany, the solidarity tax that funds the former Eastern Europe is under political attack everywhere. Well, we all know how much the northern Italians love the southern Italians.

So it's -- so the notion that we would get a Europe that is looking askance at interregional distribution within, you know, established polities; that we could get large-scale cross-border redistributions -- forget it. If you're waiting for euro bonds, you know, you're going to have a long wait. But we -- there's backdoor mutualization, of course, which could come in through the ECB. They'll do some of that. They'll take some losses, but limited.

So what you'll see instead is a Europe that works along what I used to call "you break it, you own it" lines: large-scale bail-ins, if -- of sovereigns and -- sovereign creditors and bank creditors, senior and secured included, up to the point of no insured depositors, if necessary, in order to restore, you know, leverage levels; possibly also in some countries in the household sectors for debt restructuring to levels that are compatible with growth.

With -- three years from now, I expect that this deleveraging will, to a significant extent, be completed, because much of it will be done through debt restructuring. We broke the taboo of Greece -- with Greece of the sovereign debt restructuring. With Cyprus, regardless of how it plays out, now the taboo of the inviolable senior unsecured bank creditor has been broken. So we're going to see more of that. This will be a new Europe of bail-ins, of sovereign debt restructuring and of bank resolution mechanisms.

HILL: Draghi has done an excellent job of putting out fires both with words and with actions. I mean, take OMT last December -- December of 2011. I think markets underestimate the power of central banks to effectively change overnight sentiment. Can you go into, a little bit, the tools right now in the toolbox of the ECB and some of the measures that might be deployed if in fact you begin to get systemic concerns?

BUITER: Like every central bank, anything that involves domestic currency exposure, it puts a central bank in an advantage. Nobody can beat the Fed when it comes to U.S. dollar-denominated financial instruments, right? Nobody can beat the ECB when it comes to euro-denominated financial instruments. They can issue them, in principle, technically, in unlimited amounts at no notice, right, only constrained by their own view of the cost-benefit analysis of unlimited issuance through asset purchases, through collateralized lending, by helicopter money, if they cooperate with fiscal -- so they can do an enormous amount.

They are, however, constrained by history, by culture, by -- sometimes by laws or regulations, although these are much less important than history and culture. And in the case of the ECB, that limits what they can do. They will not, for instance, inflate the excessive sovereign and bank debt away. Other central banks in the advanced countries may do a bit of that. U.K. has already done a bit of that; the Japanese have announced they're going to try and do a bit of that for minus a half to two -- that's actually quite a big jump if they achieve that, and would certainly have interesting consequences for those who are long JGBs and other nominal Japanese fixed-income debt.

But the Fed is engaged, of course, in massive monetization. It just so happens that 85 billion (dollars) a month of QE is -- no, a trillion (dollars) a year -- is roughly the size of the U.S. government deficit. So one way of looking at this is that, OK, some of it is, of course, mortgage-backed securities purchases, but effectively, the Fed is monetizing the U.S. government deficit. It's an enormously supportive action which accounts for the fact that long rates are still low and similar things are likely to happen again in the United Kingdom.

So they can do enormous amounts, but what they do is limited by history and culture. The ECB won't produce inflation. Why not? Because for them, the defining moment in central banking history is different for what it is for Mr. Bernanke and for Mr. King and for all the other Anglo-Saxon central bankers. To King and Bernanke, the defining moment of central banking history is the Great Depression and the failure of central banks to shovel it out.

To continental European central bankers -- Mr. Draghi may be an exception, but he has to, you know, preach the gospel; that comes with the job -- the defining moment is not the Great Depression, it's the Weimar hyperinflation. And that means there is a quintessential difference between the worldview of continental European central banks, like the ECB, and the Fed and Bank of England. So they will never monetize to the -- to the degree that would threaten inflation. And of course they are -- again, for historical reasons, the ECB is basically the child, maybe the illegitimate child, of the Bundesbank, right -- monetizing deficits is not supposed to be part of what they do. Strange, that's all that was said to banks before, but they can't -- can only do it in the secondary markets, and sort of -- it's possible but slightly more awkward to do than if you were able to do it in primary markets.

Now, they even are reluctant to do that because of this -- their interpretation, the mandate that you can't finance government deficits by central banks buying these securities. They only do it under strict conditionality. And that is a self-imposed constraint but it is a powerful one, and they're not going to budge from it, in my view. They can be pushed a little -- nothing is ever completely black and white -- but not very much.

So, what we will see is that the ECB will -- now, who was the one that pulled the plug on Cyprus' attempt to get a massive bailout for its banking sector -- basically saying, no more loans beyond the level at which we believe that the sovereign would become unsustainable, and if you can't fill the gap and recapitalize your banks properly, we stop funding them and exit -- (inaudible).

And similarly with Italy. If Italy cannot come up with a credible, you know, program that qualifies it for OMT support, the OMT may be there but not available for use. And, again, this will be fudged a little but not enough to satisfy the current political (economy ?) in Italy, so we have to see what happens there.

So, there -- yes, the ECB has infinite ammunition but they are only willing to use a limited amount of it. Still very powerful and they're the only show in town in Europe, but they will not -- you know, do either through the front door or the back door what creditors that hold Italian sovereign bank had hoped they will do -- that is, bail them out.

HILL: Well, and let's transition to a discussion of austerity and also structural reform. Jens Weidmann has said -- he's on the record as saying: There's nothing like a little market pressure to get people to do things.

So, how does this play out?

BUITER: That's true. We've seen that. No sooner had Draghi already in July of last year hinted the outlines of what became the OMT and the market pressure diminished, and then on the 6th of September, he unveiled the beast, right? Infinite leverage without spending a penny; the rates came down like 200, 250 basis points. That's really impressive credibility.

And of course, as a result of that, the collective European policymakers who only move at gunpoint, except in Germany where they move even if they don't have to move, they sort of relaxed not just on the fiscal austerity side -- there was an argument there for limited relaxation -- but on the structural reform side, where far too little has been done yet, even in the countries where most has been done.

Spain has done some serious structural reforms but it still leaves you in the position that they are way behind where they ought to be in terms of reactivating the labor market. Any country with 56 percent youth unemployment has some structural problems in its labor market probably. And they have to be tackled head-on by basically a major expropriation of vested rights of the older generation. That's a -- we see intergenerational warfare in the labor markets in Europe. In the U.S., we -- there's less so. There's some, of course, because if you look at the increase in the inactivity rate for young males, especially, in this country it is staggering. But it's, of course, nothing compared to, obviously, in Spain. But in most countries, intergenerational conflict is restricted to the funding of Social Security and the funding of long-term health care.

In Europe, the battlefield is often the labor markets where you have the well-established jobs with protections, with rights, with benefits, and you have the day laborers jobs. And the young basically have the choice between emigrating, becoming unemployed or taking day laborers jobs because Papa claims the remaining, sort of, good jobs. So, that has to go, that particular equilibrium, but it destroys a generation. And I think it's socially and politically unsustainable as well, but it will be awhile.

So, yes, market pressure helps. But it'll take more, I think, than market pressure to get -- to get the right kind of reforms. We need in Europe to find the right balance between structural reform and austerity. In structural reform, I include financial sector reform. There has to be a major shrinkage of the banking sector balance still. The banking sector in the euro area is (323 and is 30 ?) percent of annual GDP. In the U.S., at the peak, it was 100; it's now 85 (percent). And so the banks will have to shrink in number and in size and in scope and everything, and that's part of the structural reform.

Much of it I think's a restructuring, because many of these banks are effectively bust, kept alive by lender forbearance made possible by regulatory forbearance by national supervisor regulators who are about to lose the capacity to do that as the ECB takes over the supervisory function. It will be very interesting change in the -- in the rules of the game there.

So in terms of austerity, it's clear that austerity is part of the solution and has to be, because many sovereigns -- and indeed, private austerity as well, many private -- (inaudible) -- have unsustainable financial deficits. And you can't fund these indefinitely by money from Santa, because there is no European Santa. And so that means -- but the timing and the pace of the consolidation, I think, has to be rethought.

Clearly, ludicrous burdens were imposed on Greece, right? It has done more than 10 percent of GDP worth of primary deficit shrinkage. No country ever in the history of -- (chuckles) -- of IMF programs has tightened as much fiscally, and you see the result, a 25 percent decline in GDP. That's not a recession, that's a depression, right? And it's unsustainable. There will have to be less austerity in Greece; not just less than would otherwise have been, but less. They've been pushed too hard. And there are other countries, I think, that need austerity to be spread out.

But remember, when you say you want to spread out the austerity, for most countries -- except it's lucky few like the U.S. and Japan, at the moment -- this simply means that you ask for nonmarket sources of funding, right? Austerity -- less austerity, it means -- a large fiscal deficit means, you know, somebody filling the funding gap. And that -- the ability to do that, either through fiscal channels or through OMT operations, is strictly limited. So we again have a diminution of the pace and intensity of austerity so we can spread it out a bit, but not as much as those who, you know, believe that money does grow on trees in the rest of the world the way it apparently grows on trees in the U.S. and Japan for the time being, recommend.

So all these people who say we should, you know, just lend more -- spend more in Europe, cut taxes and presumably have the Germans make up the difference, it's not going to happen, very simple.

HILL: While I'm on the subject of European banks, estimates are between 1 trillion (dollars) and $2 trillion of bad loans. In the U.S. after the crisis, Tim Geithner and others imposed stress tests on our banks. They were very helpful in terms of forcing writedowns and forcing recapitalization of the banking system. None of that has happened in Europe. They've had so-called minor looks at stress tests, but nothing close to what happened in the U.S. Why is that?

BUITER: Yeah, the EBA has done stress tests and they have been jokes. Well, partly because the problem is much bigger in Europe. (Chuckles.) The banking sector is much larger. And the capital needs to fill the holes much larger.

The banking sector is also, of course, responsible for 70 to 80 percent of financial intermediation in the euro area, a much higher percentage, more than twice of what it is in the U.S. So that's -- and of course, the fact that in the U.S. there's a number of overlapping but national regulators probably did help. In Europe you have large numbers of nonoverlapping -- (chuckles) -- national regulators, but not on the level of the euro area. And each of these regulator supervisors was co-complicit in the mess that was created, not just in the periphery -- because remember, some of the worst banking messes were in the core.

I mean, the German banks -- I mean, from the Landesbank to Commerzbank and others, right -- were, you know, supervised and regulated, you know, appallingly, obviously; the Dutch banks, right -- ABN Amro, 100 percent state-owed; SNS Reaal, 100 percent state-owed now too; ING -- no, on the -- on the public breast, so it's -- but major failures. And Spain, right, where the -- where the central bank has regulated, you know, spent years trying to convince the world that all was well when it wasn't.

So very few people volunteer for the hangman, and so very few national supervising regulators have played -- have pressed for the revelation of the extent of their past sins. In the U.S., it was more easily done because the different regulators could always try to blame each other, as -- and they did.

So I think we are going to have to do now, come clean on past hidden losses in the euro area core and periphery, and of course, on the ongoing new losses that are being generated after the euro area remains in recession and as the periphery remains in deep recession. So it is a huge tragedy that the courage to tackle the banks' indebtedness -- excessive indebtedness and capital holes was not found earlier. We're now going to have to do it. It's five year into the crisis, five years, and we are only now beginning to do what we should have done all along. A few countries have had proper stress tests -- not done of course by official agencies. Ireland had its done by BlackRock, and that was, by and large, a fair one. I think they still underestimated the likely consequences of the change in the Irish personal insolvency law. Admittedly, that couldn't be foreseen, but which will mean that further losses are likely to come the bank's way. We're going to see similar things like that in Spain as the new foreclosure laws come into effect. So -- but yeah. We are only beginning to recognize that a European banking sector is at the heart of the problem and has to be sanitized, restructured, involving, in many cases, bale-ins of all unsecured creditors before we can ever hope of removing the demand-side obstacles to growth in the euro area.

HILL: Before we open it up to questions, role of Germany in all of this: A well-known macroeconomist said recently that Germany has not led from the front since World War II. And clearly Germany now is setting conditions, but when you have governments that are in flux, like Italy with elections, you've got elections right now in a number of countries, how does the conditionality work when you have unstable democracies?

BUITER: Very poorly, but when you have weak and often incompetent government, things tend to work poorly with or without conditionality. I must say that Europe has suffered from a lack of leadership across the board, and I think the only leadership you've seen has been the duo of Ms. Merkel, and in this last year, Draghi, right? For the rest, the European so-called leadership has behaved like, you know, political pygmies, just very disappointing.

You have to -- however, I think that aspects of what Germany's doing can be criticized. For instance, when I said we don't want the fiscal policy to be excessively pro-cyclical in the periphery countries that are in deep depression because the multipliers are large and the pain is unnecessarily high, that also of course holds for Germany, the notion that Germany is going to tighten its fiscal policy to run a budgeted surplus at a time that they are, you know, either in recession or at best flatlining, that is sort of economic barbarism that is unfortunate. And so they could do somewhat more there.

But it would make a limited difference, those who find that leadership of Germany would mean that they opened their wallets for the rest of Europe, I think -- I -- A, it's not going to happen, but, B, I think that's also not leadership. That's being a soft touch. And that's not the same thing, actually. If Germans are going to give foreign aid, you know, they will give it to sub-Saharan Africa and countries that are in trouble. They won't give it to Greece and Cyprus, all right, which are rich countries. All countries in Europe that are in trouble have the resources domestically to sort it, right? There is domestic political failures that stop them from affecting the internal redistributions from the wealth owners, you know, you know, to the government -- (inaudible) -- to the creditors, that threatens the solvency of banks and governments. And sure it would be nice, you know, but you have to do something painful to have somebody come in and tell you, well, it's all right. He is not a 50 billion (dollars). But it doesn't solve the underlying problem.

If he had single set of fiscal institutions, a federal government with serious taxing -- discretionary taxing, spending and governing powers, it would be a different story. But they don't have that. Europe is not a federal state so -- and it's not going to be a federal state for a long time, not in time for this crisis.

So Germany insisting that yes, we will make, you know, contingent loans available -- actually soft loans -- (inaudible) -- is about as good as it gets. It's not Germany's, you know, responsibility to solve Italy's political problems. Italy can't service its debt, it's sovereign debt, all right? It has a primary surplus. But of course, if they don't -- if they don't get their act together politically and propose the kind of programs acceptable to activate the OMT (ph), at some point they will be frozen out of the markets again, because they're all over 25 percent of GDP of this enormous debt stock each year. So a country like Italy is always an accident waiting to happen unless you have a land of (last support ?); the land of last resort is contingent, conditional. Get used to it. This is the way it's going to be.

And if the choice is that Italy -- if and when Italy is cut off and cannot come up with a program between bailing Italy out through the front door or the back door on a large scale, limited scale can happen, but large-scale -- trailing here, trailing there -- it won't happen. Or restructuring that there, then the ECB will opt to restructure it because they know that the alternative would mean the breakup of the euro area, so the exit of the strong.

Germany, the Netherlands, Austria, Finland, and the other core countries will simply not permit the Weimarization of the balance sheet of the -- of the ECB. You may deplore that; I actually think it's quite sensible. But whether you deplore it or not, it's not going to happen. So, there will be German leadership -- it cannot substitute itself for the weakness of political institutions in a number of European countries.

HILL: Let's open it up for questions. Please stand up, identify yourself -- name and affiliation -- and make it a question, please.

QUESTIONER: Tim Ferguson with Forbes. Could you specifically comment on the prospects for France?

BUITER: France has very good wines, yes. (Laughter) -- out of my reach. But, no, France has the most bloated public sector of any EU member-state. Public spending as a share of GDP is higher than Sweden and Denmark. So, 56 percent of GDP or thereabouts. That's right up there. At the -- it also has some of the most over-regulated labor markets in the euro area. There's a lot of competition for the crown there, but it does have that. And it has a -- you know, problems of -- if you want administrative protectionism in large parts of its -- of its service sector, including (key ?) public utilities where the substance of the single market gets violated on a regular basis. It also, of course, has a fair number of internationally exposed world-class companies which is why it's a rich country, has great infrastructure; its primary and secondary educational system beats the U.K. and the U.S. hollow. People can actually count when they graduate high school there, and some of them -- most of them speak two or three languages. So, you know -- well, that's a separate issue.

So, it needs -- France needs -- France also has a large government deficit and a debt that is now just north of the euro area efforts. So, they need fiscal austerity. More than austerity; to fund the deficit, they need to cut back the size of the public sector. The tax burdens that are implied by the spending program, I think, are not financeable in an efficient way without -- you know, they really will harm future economic prospects on the supply side even if they get the demand side problems -- (inaudible). And they need labor market reform.

How are they doing? Well, I think so far actually slightly better than I feared, but then my fears were pretty bad because while Mr. Hollande is a man of the extreme center, right, he's a Social Democrat, really, not a traditional French socialist, whose church is the Cour des comptes, the audit office. He is the prisoner of his -- of his left wing, which has views of economics in which words like "incentives" really don't occur. So he had to do a number of rather stupid things that hurt France's image and also its position in the international economy. The latest example, for instance, of the spat about ArcelorMittal when the French minister of industry told ArcelorMittal they didn't respect France and weren't welcome anymore; that's a great way to attract FDI, right? So, and, you know, 75 percent margining of tax rates are not really sustainable in a country where most people know the way to Calais, right? And I'm grateful for this because I just sold property in London and did rather well as a result of this.

But it is -- there are some silly things there. But I think France has -- if you compare France to the two other critical countries -- Spain and Italy -- France has a stronger economy than Spain and it has better politics than Italy. And I think France is therefore not on the list of countries that -- unless they get their act together -- is at risk of sovereign debt restructuring. I think they will -- whether they will get out of this, reform radically, sufficiently radically to get growth back, that remains to be seen. I was encouraged by the fact that they at least started first minor labor market reforms without being under the gun of the markets. That was actually self-generated. And they also seem to be doing in response to the obvious overshoot of the deficit enough to keep markets happy. So I'm giving them the benefit of the doubt in terms of the -- not the ability to become a growth engine, but the ability not to migrate into the periphery, right? At the moment, they trade 90 percent Germany, 10 percent Italy. If they go the wrong way, they will trade 90 percent Italy and 10 percent Germany. But I think they'll probably avoid it.

HILL: Next question, please.

QUESTIONER: Maurice Tempelsman, Leon Tempelsman & Son. Let me pick up on your historical memory that affects the DNA in the decision-making process. Obviously there's a difference between the United States' memory and the European. But let me move that to the politics. How do you startle that memory to some rather dramatic radicalization of politics as a result of the European approach? Looking ahead three years, how do you look at the sustainability of the political pattern and the will to continue to apply that?

BUITER: Well, it is clear that there is a -- growing strains of populist, antiestablishment parties, both in the core and the periphery. It used to be a actually mainly in the -- in the core. The Netherlands has its so-called Freedom Party, you know, the man with the bouffant hairdo. Belgium has assorted Flemish extremist parties. France has the Le Pen movement. And so clearly, they were united in opposition to any kind of serious transfers, budgetary or though the ECB to the periphery.

But it was simply the tip of an iceberg that is much larger. I bet you that the vast majority of the citizens in the core do not want even the existing level of transfers to the periphery. And in the periphery we see growing what's called austerity fatigue. It's well beyond fatigue, actually. It's austerity anger and resistance. And that threatens an orderly resolution. It doesn't -- of the problems.

It doesn't alter the fact that restructuring is likely to be an important part of the resolution. It simply will occur in a messy way, right? We can either restructure in an orderly way the banks and the sovereigns and, in some cases, the households that are clearly in too deep to make it out on their own, or we do it in a disorderly way.

And the risk is that popular resistance to further austerity will result in the movements that at the moment still are threatening to take control, like the Golden Dawn, the outright fascist movement -- neo-Nazi in fact -- in Greece, or the Five Star Movement, which stands for God-knows-what, in Italy, right?

If these were to take hold, they are sufficiently countercultural, antiestablishment, antiausterity and by now also anti-European, that they could, if they achieved a controlling or even just an effective veto power, over sensible policies in these countries, they could cause disorderly defaults by sovereigns and banks and, indeed, exits for the euro area of these countries.

Exit is not going to come because countries are pushed out. It's only going to come because countries domestically shift their political equilibrium to the populist, antiestablishment, anti-European way. It's not happening yet on the large scale. For instance, the largest party in Greece now, Syriza, right, is left wing and antiausterity, but they're pro-European and they want to keep the euro.

And so -- but remember, collective decisions -- Ken Arrow got a Nobel Prize for that, right -- even in principle cannot be made democratically and rationally. And so you often see that -- well, you at times see that countries end up doing things that are clearly against the identified self-interest of the majority of the people in that country. Nobody wanted World War I to happen, right? It did.

HILL: Next question, please.

QUESTIONER: (Off mic.) What would be the ramifications -- what would be the ramifications of the U.K. leaving the EU?

BUITER: It would make me very sad, yeah, but that is -- that is me. For the U.K., it would -- you know, have its last remnant of G-7-ness -- substantive G-7-ness stripped off it. It would just become a medium-sized European country with no say in the European fora. It would be, you know, sort of a large version of Norway without as much oil, which, you know -- which may be what the U.K. has in mind, but I think it would be a shame. And the city of London would really become the victim of, you know, attempts -- successful, in that case -- of the competitors on the continent to freeze it out of lucrative activities.

I mean, at the moment, when the -- it was the ECB of all things -- proposed that the clearing and trading sometimes of certain euro-denominated contracts should take place, you know, in euro geography, right? The U.K. could go to the European Court of Justice -- now who will, I think, treat that proposal with the respect it deserves, all right? But once they're out of the EU, they no longer have standing in the matter. And they -- I think they will -- it will be very costly to the city of London. It benefits -- well, OK, they can't get rid of the Working Time Directive and, you know, more power to that. It's one of the sillier directives, but it would much -- would be much more effective, I think, if Britain stayed in the EU and got allies who could change the Working Time Directive for everybody in the European Union.

For Europe, they -- it would lose, of course, one of the more liberal, less dirigisme member states. And the evolution of the European Union towards a more etatiste version of integration economy would accelerate. So I think both regions would suffer quite grievously. FDI, of course, in the U.K. would diminish. Existing foreign investment might leave. Yes, it definitely would not be good for public values.

HILL: Please.

QUESTIONER: Glen Lewy, Hudson Ventures. In response to Tom's first question about what would -- how do you envision Europe looking three years from now, you commented that you thought that both Greece and Cyprus were strong candidates to exit.

BUITER: At risk, at risk.

QUESTIONER: At risk. But you seem to say that without -- somewhat sanguine about it. And of course, we've read all kinds of things about great contagion and once that happens, one is bank runs, one has lots of things -- is it true that Europe's somewhat sanguine about it, that that could happen without great dislocation or --

BUITER: Contagion -- I mean, contagion is a word used a lot by creditors who want to avoid being bailed in. It is a reality. The question is how likely, how severe and how could it be handled? Undoubtedly, if any country were to leave the euro area, taboo would be broken, another one, right? Because this was, after all, joining the euro, an irrevocable commitment, right? A permanent bond. And if you revoke the irrevocable and if you, you know, break the unbreakable, you damage not just the party that leaves but the one that stays behind as well, because they couldn't make it work either. So there will be immediate fear that other countries might follow. Substantively, neither Greece nor Cyprus are systemically significant in their own right, except through the contagion channel. Cyprus is .2 percent of euro area GDP and Greece now under 2 percent. So you know, it's manageable. The only, you know, channel of systemic stress for the rest is through contagion, and it would be fear of breakup and of other countries leaving, larger countries.

Well, until we had the LTROs and the OMT, I was very concerned about that. And because clearly, if the market fear cuts off the nation's banks and sovereign from funding, you can, you know, easy to get self-fulfilling, you know, exit fear equilibria and outcome. So the ring fencing, first of the banks -- and remember, they put in a trillion (dollars), right, into the banks in November '11 and February 2012, and against any collateral that didn't bark, right? So it was an incredible, you know, when in doubt -- (inaudible) -- operation. And the OMT is the counterpart for the sovereign.

However, you know, the LTROs and the vestry of the banks is much less conditional -- there's some conditionalities, you see in Cyprus now -- than the conditional of the sovereigns. And there is therefore still some risk of contagion spreading and forcing other countries out of euro area should a -- should any country leave, if a country whose sovereign gets frozen out of the market, it's for political reasons, for domestic political reasons, incapable of qualifying for OMT support.

There are those who believe that the ECB would cave in at that point, right, that they would provide unconditional funding or, you know, cosmetic conditionality. If you listen to the -- (inaudible) -- of this world, you will recognize that that is a bridge too far. Remember, Germany, now for the first time, has a sort of aspiring anti-euro party, you know, Alternative fuer Deutschland. And they're still mainly, you know, a movement of gray-haired men in suits, right, and -- but it could pick up steam. And it is significant that even in the most pro-European country in Europe, which is what Germany -- (inaudible) -- is, we have a party now that now wants the local currency back.

So I think there are risks. But I do think that -- I do believe that the collective death wish of even politicians that show some tendency towards it in countries like Italy, in terms of inability to qualify for OMT support will not be strong enough if push comes to shove to force them into unnecessary sovereign default or exit from the eurozone. So I am optimistic that the existing tool kit is enough; in terms of the ammunition, it is enough. It has the willingness to fire it, there are still some question marks that I spoke about earlier.

HILL: Willem, apart from the last several weeks, the Euro has been on a relative basis, quite strong. Sitting where you are now about six months ago on this stage, a well-known Harvard economist said that one way out for the eurozone would be to have a dramatically weaker euro. First, why has the euro been so strong? And secondly, how do you feel about, you know, the advantages of a dramatically weaker euro?

BUITER: Well, the two drivers of the currency's strength sort of -- one is confidence-- (inaudible) -- monetary policy, right? So whenever there's existential angst about the existence of the euro area, euro will weaken. And that's why we see a little bit weak euro at the moment. You know, the paper open the paper on Thursday, think oh my god, Cyprus is going to go, and down -- and then next day, oh maybe they're still in, Plan B, right, up again. So there's a -- but for the rest it's -- you know, it's monetary policy.

And the reason that the euro is strong is that monetary policy is -- compared to monetary policy in the rest of the advanced industrial countries, is tight in Europe. The fed is shoveling it out at 85 billion (euros) a month. I mean, this is an unbelievable amount of money in a country that's actually growing. In the euro area, we have, you know, a recession, rising unemployment, in doubt excess capacity, inflation's below target -- what are they doing? Well, they're not expanding the balance a sheet and they're not cutting rates. They still have 75 basis points to play with.

So in Japan, Mr. Kuroda is about to open the liquidity hose in a big way, right? And he really is going to do whatever it takes to get inflation up from minus 1/2 (percent) to plus 2 (percent). In the U.K., there has been a, you know, a temporary sensation of QE, but it's clear from the admittedly minor tinkering with the Bank of England's mandate that the chancellor has just performed, that they're going to be resuming QE, do more aggressive credit easing and start using forward guidance most systematically, while on -- just on a quarterly basis with inflation reports to try and get, you know -- support the economy.

So the expanse in monetary policy in the U.S., in Japan, in the U.K. all drives down the exchange rates. And so it is not surprising anyway that the least expansionary monetary policy in the euro area be reflected in a currency that is uncomfortably strong. And I hope that the ECB will see the light, and that it cut rates, start deducing negative rates on deposits with the central banks and do whatever it is -- whatever it can to make it unattractive for banks simply to take the liquidity injected by the ECB and to put it back in the ECB, which is what they're doing at the moment.

HILL: Please.

QUESTIONER: Good morning. Al Cho from Xylem. On the topic of structural reform, I wondered if you could talk a bit about, given the political difficulties, what changes you see in the delivery of public services in Southern Europe. Is there a real appetite for privatization, appetite for alternative concession models, et cetera, to try to deal with some of the fiscal challenges?

BUITER: Well, appetite, no, but necessity, as always, is the mother of invention, right? And there are two pressures towards greater, if you want, involvement of private sector -- the private sector, in a variety of formats in the provision of what were heretoto (ph) public services. One of them is budgetary. If you hope that privatizing gets some revenues, you might do that. That's actually, on the whole, a bad reason for privatization, right? Anybody who's tried it has been disappointed.

You know, the greatest example of large-scale privatization in Europe in recent times has been the Treuhand-Anstalt in Germany. And their bottom line after the four years that they were in operation was a large negative number. You know, if you privatize properly for efficiency reasons, you often end up losing assets -- losing money unless you're lucky and you have unencumbered, you know, natural resources -- maybe land and a few other easily privatizable things -- state industries, concession models, it is -- you often get very little resources for that. But what you can get, by all means, do.

The second is that there's the pressure from the conditionality in these programs. The public sector is, on the whole, a lousy manager of entities that could use, basically, private goods and services. Private in the sense of rival and excludable. And so it -- there is therefore pressure from countries on programs -- the creditors -- to engage in structural reform. So yes, we will see that.

I mean, Spain doesn't have that much to privatize -- not like Greece or Italy, but we will see privatization of, probably, of the airports there -- utilities are going to be privatized to a greater extent, maybe even in France if the -- if the budgetary pressures increase there -- certainly in Italy.

There's no political appetite for it. People don't want -- if they have publicly-owned and operated public utilities, they don't want it to be run privately, because they recognize they'd probably end up paying more, because they would be subsidized by the taxpayer to the same extent. But I think it will happen. It is one of the obvious ways in which the state can (exert ?) some its current spending responsibilities.

HILL: And we have time for one more question. Right here, please.

QUESTIONER: Yeah, Dan Rodriguez from Credit Suisse. You mentioned the banking reform going on in Europe and how that's been lagging the U.S. In that discussion, you did mention Basel III. Could you address how effective Basel III's been to this point, and maybe the outlook going forward?

BUITER: I'm with Andy Haldane on Basel III. I think it's a complete disaster. It is a classic example of the triumph of box-ticking over (actually ?) managing risk. I'm deeply despondent about -- it imposes huge costs on banks without making them safer. The fundamental -- one fundamental problem that sort of -- that remains as a source of incurable risk is that Basel III, for its risk rates, continues to rely on information that's private to the party that's being regulated. That's like asking, you know, somebody who's up in court, you know, what sentence would you like, right? You're always going to have, rather shorter, thank you, your Honor. And the same with banks.

So this is just an invitation, you know, to deception and manipulation, and I don't understand why, after the debacle of Basel II, we have -- we continue to do this for Basel III. So anything -- (inaudible) -- as an economist, you know, how do you -- (inaudible) -- the risk rating? But with -- only with risk rates that are independently, externally verifiable. Anything that relies on private information, out with it. And for the rest, yes, huge -- I'm speaking for myself here, right? I mean -- but I don't think that you can make for these capital requirements on banks so high that I wouldn't want to see them a bit higher, right?

But liquidity requirements? Rubbish, right? Liquidity is a public good. Insolvency is a private good; you have to provide it yourself. But liquidity is confidence, trust and optimism, right? When these vanish, nothing is liquid. When confidence -- (inaudible) -- everything is liquid. That means, you know, that you need liquidity backstop in the form of, you know -- (inaudible) -- the central bank to provide emergency-level liquidity, to require companies, as Basel III now does, right, to hold emergency levels of liquidity in the balance sheet, right, during normal times is, I think, bad economics. And the only sort of, quote, "rational," unquote, explanation for this particular aberration is that it is probably designed to facilitate financial repression by governments, who will undoubtedly declare that the one thing that's really liquid is sovereign debt, including Greek and Cypriot sovereign debt.

So I think Basel III is going to be a disaster, a costly disaster. It will not make the banking sector safer, except to the higher capital requirements. But the liquidity requirements make no sense and, of course, the complexity of the thing -- anybody who understands Basel III in its full details is either an idiot savant or a liar. (Laughter.)

HILL: Well, on that note, Willem, we've seen -- we've seen why Citigroup has chosen to take a dazzling brain and a sense of humor from London back to -- as you call -- New Amsterdam.

So thank you. (Applause.) Well done, Willem.