WILL THE EURO SURVIVE?

Transcription

1 WILL THE EURO SURVIVE? MONDAY, OCTOBER 17, 2011 WASHINGTON, D.C. WELCOME/MODERATOR: Uri Dadush, Senior Associate and Director, Economics Program, Carnegie Endowment for International Peace SPEAKERS: Jacob Kirkegaard, Research Fellow, Peterson Institute for International Economics Desmond Lachman, Resident Fellow, American Enterprise Institute Liliana Rojas-Suarez, Senior Fellow, Center for Global Development Antonio de Lecea, Principal Advisor to the Head of Delegation, European Commission in Washington, D.C. Transcript by Federal News Service Washington, D.C.

2 URI DADUSH: Yes. Good afternoon, everybody. Thank you very much for joining us at the Carnegie Endowment today. This is probably the umpteenth I can t remember the fourth or so event we ve had on the euro crisis since the beginning of last year. And I expect to say that the titles of our events have become more and more alarmist as we ve gotten on. And, you know, so the title this time is Will the Euro Survive. I think our initial title was something like, The Euro Crisis: What Does it Mean? or something like that. (Laughter.) And so I m hoping that there s not going to be a linear extrapolation of titles that at some point that this thing stops getting worse. [00:01:22] DESMOND LACHMAN: Well, at some point you ll drop the euro. (Laughter.) MR. DADUSH: Which sets the tone for the discussion. Let me MR. LACHMAN: You re right. MR. DADUSH: introduce our expert panel today, just very briefly because you do have their vita. So to my left, Antonio De Lecea is the minister for economic and financial affairs and principal adviser to the head of the delegation of the European Commission in Washington, D.C. ANTONIO DE LECEA: It s European Union. MR. DADUSH: Sorry? (Cross talk.) [00:02:03] MR. DADUSH: Of the European Union, I m sorry of the European Union. And that is also symptomatic because you will hear from Antonio the European Union view. And then next to me is Jacob Kirkegaard, who is a research fellow at the Peterson Institute for International Economics. And then to my right is Liliana Rojas-Suarez, who is a senior fellow at the Center from Global Development with expertise on Latin America and on financial services. And she was previously managing director at Deutsche Bank. And to the far right, geographically only, is (laughter) is Desmond Lachman, who is known to you, I m sure. He s a senior is a resident fellow at the American Enterprise Institute and teaches at Georgetown University. And he has been a regular fixture at my euro events over the last year and a half. So we re going to have a conversation and the panelists kindly agreed to that, which makes it a little more difficult on them, but I think I think is better for the audience rather than have PowerPoints and prepared remarks. So I m going to start with one question that I m going to ask all the panelists to address. And the first question is: Will the euro survive in its current form? What is your subjective probability? And let me start with Desmond, to the right.

3 [00:03:57] MR. LACHMAN: Well, if you mean by that, are countries going to drop out of the euro? Then I d say that it s almost certain that countries will drop out of the euro. You know, that we ve got a situation in Greece where it looks like Greece can t avoid a hard default if you look at the numbers. Greece s debt to GDP, according to the IMF projections, is going to peak at 172 percent. The IMF has been notoriously inaccurate overly optimistic in its projections, you know, so it s more likely that it ll go towards 190, 200. So you know that the market has got it right when they re pricing Greek bonds at something like 40 cents on the dollar meaning that the market thinks that Greece is going to have a something like a 60 percent haircut, you know, minimally. It s more likely to be something like 70 cents. You ve then got to think through if a country does have a haircut of that sort, and if its banks are holding a huge number of the bonds, it means that the Greek banking system is going to be in deep trouble. (They re going to?) re-introduce capital controls, so it s not a very far step from there for Greece to be leaving the Euro. I think that it really goes to the heart of the problem in Europe is that what we ve got is we ve got countries in a system where they don t have their own currency but they ve run up huge imbalances, both in their public finances and in the external side. And I think that what we re seeing is you can t correct those imbalances without winding down the debt and without getting out of the currency unit without having the deepest of recessions. And a country like Greece doesn t really have the social appetite to do it. So I would say that Greece leaves. When Greece leaves you ll get real contagion to Portugal and Ireland, you know, that those countries will leave in short order. So, you know, if you re talking about if you re just giving me a year or two I would say that I would be prepared to give you odds on that event occurring. [00:06:07] MR. DADUSH: Good. I mean, bad. Thank you. (Laughter.) Now, Desmond MR. LACHMAN: I don t know. I don t think that is bad from Greece s point of view. It s bad from Germany and France s point of view. But what the IMF is offering Greece is they re offering Greece not only a Great Depression but they re also giving them no prospect of getting out of that for the next decade if they stick within the system. So, you know, what this is not going to be too good for the Germany and French banks and might not be good for Italy and Spain. But I would say that it would be good for Greece and Portugal to be taking the route that Argentina did in 2001 where, you know, with all the stories as the sky would fall if they got out of the convertibility plan they had a very nice decade, thank you very much. MR. DADUSH: OK. Thank you, Desmond. So briefly, apologies, but I have 13 questions, so the Liliana, will the euro survive in its current form, subjective probability? LILIANA ROJAS-SUAREZ: Yes. I think I agree a lot with what Desmond said for practically the same reasons, and I want to add one more. And it s that in the situation like we have right now, a permanent solution needs a transfer from creditors to debtors. We are get more into this with your next questions, but so you re going to get a limit on the patience to which and the limit to which that transfer from creditor to debtors can be extended.

4 [00:07:42] When that patience I m calling patience to a very complex issue gets when you get to the limits of that patience, then I believe that support for Greek for Greece is going to vanish. I really don t think that it s a question as to whether Greece and the European Union wants Greece to continue within the euro zone. What I believe is that it s a matter of fact that Greece will not be able to continue in the euro zone, that it will default and that I agree with Desmond that it I don t see whether it s good for Greece, really, it s just that sometimes there s things in life that we don t choose. They have to happen. And I think that s an event that we must realize. My subjective probability of having Greece with that leaving the euro zone is about 90 percent right now. If you add Portugal to that, it s 70 percent. MR. DADUSH: Thank you very much, Liliana. Jacob. JACOB KIRKEGAARD: Well, starting with my subjective probability that the euro will continue with at least as many members that it has now 100 percent, because I regard it we need to make a very fundamental distinction between whether a country defaults or deeply restructures or whatever we call whatever Greece is going to do and leave the euro zone. These two things are fundamentally different. I believe that Greek debt will be privately held that will be written down by as much as perhaps 50 percent as soon as next week but that on the other hand, Greece will under no circumstances leave the euro zone. And I very much disagree with what Desmond says that what the EU and the IMF is offering Greece is a great recession that s absolutely not the case. They are offering to continue to fund Greece at essentially German interest rates for the foreseeable future, as well as ongoing fiscal transfers through the EU budget, you know, if need be in perpetuity, because the real contagion and here I agree with Desmond is the real contagion for the euro zone only emerges if a country actually leaves. [00:10:01] That s what can create a kind of uncontrolled contagion scenario where markets will fundamentally lose confidence in the entire construction. And that s not something that Germany, France or any of the other countries can survive. So, yes, Greece will default, but it will absolutely stay in the euro zone. And finally, the idea that Greece has any economic benefit outside the euro zone, I regard as a as a as essentially misguided. Greece had an export ratio to GDP in 2010 of 8 percent. This isn t a country that can export its way to prosperity even if it gets a 50 percent real devaluation. It just doesn t it doesn t export anything that the world really wants. The only thing it really exports is shipping services, which are denominated in U.S. dollars around the world. So the domestic currency of Greece is relatively irrelevant for the competitive of that and then it s tourism. Now, tourism clearly, if the domestic price level in Greece fell by, say, 50 percent vis-à-vis the other Mediterranean countries, would have an effect. But tourism is also very, very susceptible to social disturbances. You re just not going to fly into Greece if there s tear gas flying through Athens. And I think if you were to leave the euro that s quite clearly what would happen. So it s not in their own interest, and the idea that there is some sort of pot of gold at the end of the devaluation rainbow is a myth. MR. DADUSH: Thank you very much, Jacob. And Antonio, I think I know what you are going to say. What is the likelihood

5 MR. DE LECEA: Not necessarily. MR. DADUSH: All right. What is the what is the likelihood that the euro will remain in its current form? What is your subjective probability? MR. DE LECEA: At least 100 percent. (Laughter.) Since you asked for subjectivity. (Laughter.) On the same grounds as Jacob said, I mean, it s not in the interest neither of Greek Greece and Portugal. I mean, the problems are not being in the euro or being outside the euro the euro is not a panacea for it s not a substitute for good policies. Therefore, I mean, they have they will have to run the good policies, I mean, inside the euro or outside the euro. And inside the euro they have the assistance of the European Union, plus the IMF not only financial assistance, but assistance to re-haul to overhaul the country, to overhaul the economy and the economic structure so that they can they can grow they can go back to grow and they can be on a sustainable path. [00:12:38] MR. DADUSH: Thank you very much. OK, I m going to group my questions the remainder of my questions in three. First I m going to ask a short question about causes what is causing this problem? What are the fundamental causes? But I want to spend most of the time on short-term solutions short-term solutions first and then long-term solutions. So the short-term fix, financing support, et cetera, et cetera, and then long-term fix, institutional change, so on and so forth. That s the structure: causes, short term, long term. So let me let me pick a couple of our panelists on the causes issues. So my question is, what s the problem anyway? Is it fundamentally a competitiveness issue that the peripheral countries are confronting,or is it a fiscal issue or is it a banking issue? And maybe I don t know if you have other causes (inaudible). And let me let me start with Jacob and then ask Desmond also to address this question. MR. KIRKEGAARD: No, but I think I think, you know, it s we need to just doing this isn t just one crisis. I mean, if you look at a case like Greece, it s quite clearly a fiscal and a competitiveness issue. If you look at Ireland, well, it s quite clearly a banking system crisis. If you look at Portugal, it s probably more like Greece. If you look at Spain and Italy, it s predominantly a competitiveness issue. So it s a little bit of all of the above, and then combined with, what I think is pretty obvious, that Europe is underinstitutionalized. [00:14:27] The euro, as it was described or as it was created in the mid-1980s did not and has not had the institutional structure to withstand a serious crisis. So, you know, it s all of the above plus, you know, under or you know, wrong design, if you like. MR. DADUSH: Good. And Desmond? MR. LACHMAN: Yeah, no, I agree with Jacob that, you know, I think it s a mistake to look for a single cause of the crisis or a single symptom of dysfunctionality. You know, that you ve really got imbalances the size of which, in my career at the IMF, I ve never seen, you know, in a serious country anything of the sort that when you re looking at government, you know, when they re supposed to be running at 3 percent of GDP budget deficit and they run at 15 percent of GDP budget deficit, the debt level is supposed to be at 60; it turns out that it s at 170.

6 If you look at the balance of payments side, I d say that countries like Spain have got huge balance of payments problems, running very big external current count deficits still at this stage, and got an external debt that is over 100 percent of GDP. So there are huge imbalances. So I wouldn t want to look at it simply. I think that the more interesting question is, how did we get to this pass? You know, what went wrong? You know, what was the breakdown? Why was more strict criteria not applied? Why did the markets not discipline these countries? You know, and I think that there s a huge amount of government failure, a huge amount of market failure. And we re in an unholy mess. [00:16:06] But there is just one point, if you d allow me just to say that the IMF is not offering Greece a Great Depression, well, you re not really looking at the facts. Greece s economy has fallen over the last two years by 14 percent. Its unemployment I should say by 12 percent. Its unemployment is over 15 percent. And what the IMF is coming in to tell Greece to do is: Why don t you have another round of real fiscal austerity? In this these kind of circumstances you re really just going to drive that economy totally into the ground with these sort of policies, and I m afraid that the same is true with Portugal. Just one other point, if I may, is the damage to the system is not from a country leaving the euro I think that that is a second-order question. The damage that Greece will do and where you ll get the contagion will be when Greece defaults in a major way. And then when that causes a banking problem, that is what s going to cause contagion. That is what the ECB has been emphasizing that they re scared of. That s why they don t want Greece to default at all. But if you have a hard default, whether the country stays in the euro, whether it doesn t stay in the euro, is secondary. The damage is done by the default. That really impacts the banks in the core. [00:17:27] MR. DADUSH: OK, good. So we ve learned today a new word: underinstitutionalization, and a new disease. So, you know, if one of your children or your friends looks to you to be underinstitutionalized, please call the Peterson Institute right away. (Laughter.) Take him on an emergency visit. I love I love underinstitutionalization. All right, the let me now move to short-term fix short-term fix. So the first question on the short-term fix is that now the big debate is around the EFSF the what is it the Financial Stability MS. ROJAS-SUAREZ: European. MR. DADUSH: European Financial Stability Facility, right? MS. ROJAS-SUAREZ: Uh-huh. (Affirmative.) MR. DADUSH: This is the financial backstop Europe created back in May, 2010, and then has decided to strengthen in July, 2011, in order to prevent contagion from spreading further. What changes should be made to the EFSF to make it more efficient? And I m going to ask Antonio and Liliana to address that question. Antonio? [00:18:50]

7 MR. DE LECEA: Well, the changes that have been already agreed are to increase the capacity. And that was already agreed and ratified. It will also be able to intervene on a precautionary basis. It will also be able to intervene to buy government bonds. So and it will be able to intervene to support banking systems when in when in need and when there is a financial stability risk for the euro area. So these in themselves are what, you put it it takes to kind of to provide this backstop for and to avoid contagion. The as you know, there is now the discussion on by how much and how will it be leveraged so (inaudible) to have the adequate capacity to deal with more important both banking and sovereign problems. But these are the changes that are already in the pipeline and that of which the modalities are being discussed. MR. DADUSH: Thank you. Liliana, do you want to elaborate? MS. ROJAS-SUAREZ: Absolutely. I have big issues with the EFSF. I think that a mechanism that uses resources from the same debtor countries to finance those that are in debt is weakening the stronger countries. Let me explain. If I am Italy or if I m in France, and I m using part of my resources through the EFSF, which is (just?) vague, all right, to help Greece and help Portugal, the markets know that me, Italy and France, are increasing my liabilities, right? And if they default, my contingent liabilities are even greater. [00:20:54] So it s even worse when people talk about leveraging the EFSF, which means that, OK, I use first, let me back up for a second. The EFSF does not have right now 440 billion (euros). They have already committed more than 200 billion (euros), so it s much less money, first of all. Second, if you were to leverage that, that even implies creating kind of a toxic asset. It s equivalent of a toxic asset, which now, we say highly-leveraged toxic asset. The markets perceive that, and therefore, the credibility of the new instrument gets destroyed, OK? Why? And what and you asked for a short-term solution. And I hope also you ask me about the bank (inaudible) MR. DADUSH: I will. I will. Don t worry. Don t worry. MS. ROJAS-SUAREZ: OK. But I want to finish with the EFSF something else. This is not the same as when the United States TARP was put in place. At that time, you need to recall something: Nobody was doubting about the debt sustainability of the United States. That was not an issue on the table. Perhaps as a long term, but that was not an issue. So the government was able to make that transfer to the banks. But that s not the case in Europe where sovereign debt problems and banking problems are completely interweened (ph), OK? [00:22:23] So there is no, the only solution for me that can actually bring help support to the European problem right now is fresh external money. You cannot help yourself when you re sick. You need a doctor from outside, OK? So if, as Desmond said, many countries in the world, including the United States, are going to suffer contagion from this, we need fresh commitments from the U.S., the U.K., Japan and the IMF mobilizing these resources, and Germany, of course, which still holds some credibility I say some because it has it decreasing by the day. But the

8 bottom line of what I just said is, I don t believe that the eurozone problem can be solved with only eurozone money. MR. DADUSH: And I am going to come back to that later. And let me ask now about the other short-term fix everybody s talking about, which is the European Central Bank increasing its purchases of government bonds or, for that matter, increasing its lendings liquidity support to the banking system. So my question is, what is the appropriate course of action for the ECB? And will it take it? And here I m going to ask Desmond and Jacob, perhaps, to address this question. [00:24:02] MR. LACHMAN: I think that the ECB is very uncomfortable doing these purchases. What we ve seen over time is they enter into this market very reluctantly. They enter in extremis. I think that s I would perhaps disagree a bit with what Liliana said in that I don t think that there s an alternative but to leverage up the EFSF if you don t want contagion to Spain and Italy. If you don t have a real firewall for Spain and Italy, it s going to be game over for the euro. So the ECB would prefer to see this done by governments through instruments like the EFSF rather than the ECB compromise its functions as a central bank. What you re doing is you re compromising the independence of the central bank; you re making its monetary policy a lot more difficult. This is not something that the central bank should be involved in on a permanent basis. Having said that, the Europeans the policymakers are likely to fall short, so they re likely to leave the ECB once again in a position where the ECB is given this terrible choice between standing on the principle of its independence and good monetary policy and letting the whole structure fail. So I think that you know, when the ECB is pushed, the ECB will come in at the last minute and prop them up the way in which they (have?) been doing before. But I don t think that that is the way to go. You know, I think that if you wanted to try to save the system, you really do have to come up with a firewall of something like at least 2 trillion euro; otherwise, you re really going to get real contagion like we saw in July and August on Spain and Italy. And if Spain and Italy were to fail, you know, that would be a total disaster. [00:25:59] So, you know, if I were sitting in (Berlin?) the problem is that politically, it s very difficult to do this, you know, because 90 percent of your at least, should I say, 70 percent of the electorate in Germany don t want to do this. And as far as the ECB goes, it s very difficult for the ECB to pursue a line when not only does Axel Weber not want to it and Jurgen Stark, both of them leaving the ECB, but the president of the Bundesbank doesn t want to do it, Otmar Issing doesn t want to it, the whole German establishment monetary establishment doesn t want to do it. So they re going to be very reluctant to get into supporting Spain and Italy, which means that they re going to be too late, too little, that this thing is going to just fester. MR. DADUSH: Thank you, Desmond. Jacob? [00:26:48]

9 MR. KIRKEGAARD: No, I find myself in surprising agreement with Desmond, and But I think it s important to distinguish between what will be the optimal position for the the policy action for the ECB to take to finish the crisis end the crisis as soon as possible, and what is optimal for achieving what the ECB actually wants, because if the ECB wanted to end the crisis, what they would essentially be able to do is, they could break very blatantly Article 123 in the treaty and just say, look, we stand fully behind all Italian debt. They could do that. They might be sued under the European court, but probably nothing would come from that. So the ECB has the ability to end the crisis if they want to do it. But I would contend that they re actually not interested in that, because if you look at the ECB, you have to think of it, it s not a normal central bank. It s a it s a central bank that is so independent that it s essentially unaccountable to anybody. You know, they send letters to policymakers, not like in the U.S. where, obviously, the Federal Reserve receives letters about what they should do from Congressional leaders. It goes the other way around. [00:28:04] So what if you look at what the ECB has been doing throughout this crisis, it has essentially, I would argue, proven to be a conditional lender of last resort, which is what happened, obviously, in May, 2010, when they first initiated the security markets program, and it s what happened again in August this year when they agreed to expand the security markets program to include nonprogram countries and first and foremost, of course, Spain and Italy. And if we look at what is going to happen going forward next week, if this is your strategy the ECB strategy is essentially to put maximum leverage on governments to do what the ECB wants them to do, which is to put in place binding constraints on the on the Stability and Growth Pact, put together a longer-term fiscal you know, what the ECB or (that?) Trichet calls a European finance minister and then implement a lot of structural reforms. So what they are going to do is, they re going to unfortunately, if you want to end the crisis they re going to refuse to leverage up the EFSF; that s very clear. What they want instead is this EFSF bond insurance program for new primary issuances of debt so that the EFSF insures 10, 15, 20, 30 percent of these primary issues, because what does that amount to? It essentially amounts to governments, the euro area governments, self-insuring their own primary issuances, which is the functional equivalent of actually strengthening the enforcement of the Stability and Growth Pact. [00:29:44] What the ECB is going to offer to that deal is, they re going to not say it out loudly, but they re going to leave the securities market program intact, which means that in the you know, at the end of days, the ECB will still ride to the rescue of Italian and Spanish bonds if a true crisis comes. So as I said, there is a distinction between ending the crisis and achieving the outcome that the ECB would like. MR. DADUSH: OK. At some point I will encourage our panel to come back to this to Jacob s assertion that the ECB could end the crisis today if it wanted. I will ask him to come back to that. I think it s a very important and controversial point. But let me just continue with my line for the time being, which is to ask Liliana, what action must be taken to shore up the banks in Europe?

10 [00:30:44] MS. ROJAS-SUAREZ: OK. One of your questions was, do we have a fiscal crisis, a (competitive?) crisis, a banking crisis or whatever? When I heard your questions, my first reaction is, who cares? Once it gets to the banks, you focus on the banks. Why? Because behind the banks are the world payment system, right? I mean, basically, you cannot do any kind of transactions if they are not done through the banks. So once you hit the banks, then you have a banking crisis. People are talking about the formation of a banking crisis; that s nonsense, right? We re in the middle of a banking crisis right now. So people can say, well, but I don t see huge runs out of the banks. I ve never seen a banking crisis that starts on the liability side. They always start on the assets side. And the asset sides are have a lot of problems. Some of them made by their own countries, including in Spain, with the lending to real estate, but all most of them, because of the large holdings of government securities, which are in trouble these days. Now, when you get to that point, then you move to banking crisis resolution. Banking crisis resolution is very hard and requires lot of political will. And the first step there are two steps that needs to be taken; the question is, how did you do it? And we have examples in the world on how to do it right. The two things that needs to be done is, the banks need to be recapitalized, and there have to be huge debt haircuts. OK, now let me explain. You to have the banks recapitalized yourself is again an illusion, because that s like going telling the banks, go to the private market and borrow. No, the private markets don t want to lend the money. So that means some form of government intervention, right? People say, that s going to be nationalization. Yes, temporary. But that s the only way to go. First you have to capital recapitalize. [00:32:47] Why do you first have to recapitalize? Because first, you need the banks to be strong to then hit them. How do you hit them? Through the debt haircuts. The debt haircuts means, basically, that what they have or what they think they had of assets is worth much less, right? Why are you doing that? Because you are now transferring what I just first said that is absolutely needed, and it s a transfer from creditors to debtors. That has to take place for every solution of the banking crisis. In the United States, one mistake was done. We still have are not totally out of the banking crisis. And the reason is that you still have a problem with the mortgage markets. And Fannie and Freddy has not been resolved yet. So there has not been enough transfer from creditors to debtors, and that s why we still have problems in the United States, and those are constraining the growth of the economy. OK. We need to think, in the case of in Europe, exactly in the same way. We need to solve the banking crisis, which implies a transfer from creditors to debtors; private holdings of banks are going to suffer big losses; and recapitalization has to come from national money because private money is not available right now. I told you that there is lot of stories about how to do this. I just want to tell the story from Brazil. MR. DADUSH: Short, please. MS. ROJAS-SUAREZ: Huh?

11 MR. DADUSH: Short. MS. ROJAS-SUAREZ: Very short. (Laughter.) [00:34:24] The problem was different. But Brazil had to devalue in 1999? Yeah. It had to devalue, OK? There was no way out. I m not talking devaluation (inaudible). The problem was that if it was going to devalue, because of the composition of assets in the banks, a banking crisis was to emerge. Arminio Fraga was the president of Central Bank of Brazil at the time. He did something he first issue a large amount of dollar-denominated assets and place it in the banks basically shield the banks, then devalue. And Brazil has passed, in 99, as one story in which there was a currency crisis, but not a banking crisis. It was because the president of central bank took the right action to protect the banks. OK, we need to think in that direction to solve the problems of the banking system in Europe now. MR. DADUSH: OK. Thank you very much. My last question and then I m going to come back to monetary policy on the under the short-term heading, the short-term fix is related to Spain and Italy. Everybody knows that an important part of the solution is adjustment in the periphery countries. And Spain and Italy are huge countries, much, much bigger, again, then Portugal, Ireland and Spain Portugal, Ireland and Greece. So I want to ask anybody in the panel who wants to take it on: Are Spain and Italy, in your view, doing what is necessary to adjust? Go ahead. [00:36:16] MR. KIRKEGAARD: No, I mean, I think it s pretty blatantly obvious that Italy is not, because Italy has a structural growth problem more than anything. They don t actually need a lot more austerity. But the Berlusconi government has clearly put in you know, has not moved down that in that direction in the many the many years he s been in power, so I think it s fair to say that Berlusconi needs to go before anything sensible can come from Italy. In the case of Spain, I think it s fair to say that you had a fair amount of reforms taking place since May last year. The Zapatero government has done has begun to liberalize the labor market, has and I think has probably done as much as a socialist government can be expected to do. And then, finally, they ve also moved to put in place a constitutional debt limit similar to one in Germany. And, you know, then Zapatero decided to he cut publicsector wages, which is political suicide for any socialist government. And, you know, he basically called an early election which he knew he was going to lose. So he fell on his political sword, leaving the way for the PP to emerge and continue the consolidation, the reform effort. So I d say in Spain, you ve done most, but Italy is clearly lagging behind. [00:37:49]

12 MR. DADUSH: Good. Thank you. MR. LACHMAN: I would take the other side of that analysis, you know, that I would think that Italy is OK in a relatively good state of the world, that they got very high debt level, but Italy s been running a primary surplus, so if Italy were to have growth and it were to have a favorable external environment, I wouldn t be that concerned about Italy. The reason part of the reason for my concern about Italy is that what we re now doing is we re seeing, partly for the reasons Laviana is mentioning, that you ve already got real strains in the banks, you ve got a real credit crunch that s developing, and you ve got already got clear signs that France and Germany have basically run out of steam; it s only a question of time before France and Germany go into recession. So that s the reason that I d really worry about Italy, is that it s something external. [00:38:44] Spain is a lot more complicated. Spain had the mother of all housing booms that they financed from abroad, so Spain is stuck with house prices that still haven t adjusted. Spain s house prices have probably got to fall another 30 percent, and they re expected to take fiscal adjustment, fiscal austerity for a number of years in that kind of environment. I just don t see how Spain is going to grow. And likewise, Spain s just got a huge external debt problem. I don t see how you get out of that by just crunching the economy because if you try to crunch the economy, what that s going to do is, it s going to then exacerbate your public finance problems. So if you ve got a public finance problem, a housing sector problem and a huge external problem, not to be able to write down your debt and not to be able to devalue the currency, you re really in serious trouble. MR. DADUSH: OK. Good. Let me ask you wanted to comment this? MR. DE LECEA: Yes, just for a second. Just to underline that the case of Italy and Spain is much different from the one of the other countries in the case of Italy and Spain, it s not a problem of solvency; it s a problem of liquidity. And the measure that are being taken are so are such that I mean, they try to reassure the markets that the that the government has the capacity to rein in the economy. And secondly, especially in Spain, they are also overhauling the structure the structure of the economy so as to promote that growth that is desperately needed for the for the next few years. So this is I mean, I think that putting them together is an error. [00:40:32] MR. DADUSH: OK. Thank you. Let me come back to Jacob s point. Is it true and ask the other panelists, anybody who wants to kick in is it true that the European Central Bank could stop this crisis tomorrow by issuing a blanket guarantee that it will purchase the government bonds of the countries in trouble? Anybody want to take that? MS. ROJAS-SUAREZ: Yeah. MR. DADUSH: Liliana.

13 MS. ROJAS-SUAREZ: No, I don t agree. I don t think that the ECB is like the Fed. If you look at current data right now and the only thing I hate about not using PowerPoint, I have such a bad memory that I don t remember any number (chuckles) so, but what you would see is that the holdings of euros of foreign (inaudible) reserves in the world is declining. I think that a blank check without proper corrections or fundamentals will not solve the problems in Europe because in contrast to the Fed, which is by definition only because there s nothing better the safest asset in the world these days all this is man-made, and so, you know but right now it is perceived as the safest asset in the world. And there s a run towards there. A huge blanket guarantee at the end will imply a run out of the euro. This is not when you have a and I have to go back, again, to the banks. When you have a banking problem, then the increase in liquidity, buying back of assets, that does not solve the problem. You need real capital otherwise banks are not going to lend. You give more liquidity to banks, banks will save the same way they have been doing in the U.S. for a very long time. [00:42:24] So the resolution of this problem will start with the banks and end with the banks. The European Central Bank has a very important role to play. It s a provider of liquidity. So where liquidity is needed, it helps. But it would be a big mistake to think that the actions of the ECB are similar to the actions that can do the same actions that the Fed that the U.S. Fed can do. MR. DADUSH: Thank you. Desmond? MR. LACHMAN: Yeah. No, I disagree. I d say hypothetically there is a very easy solution to this problem you know, that you can push this problem many years is if the Germans were one way or another prepared to write a blank check to these countries, you wouldn t have a problem. You know, you would just finance it. You could keep the bond levels at that (side?). And Germany initially would be capable of doing it because Germany s public finances are very much better than those, for instance, of the United States. I realize I m setting the bar low. But Germany does not have an 8 percent of GDP primary budget deficit like the United States does. It not does not have as high a level of budget of public debt. So they can do it either directly through writing a check through the ESFS or ECB, whichever mechanism they like. If they were to finance it that way, you wouldn t have a problem. [00:43:44] The Germans, of course the citizens understand that if you go that route what you d be having to do is you d be having to write a check year in, year out (inaudible) eventually it will sink you. You know, so the discussion is for it s not better just to cut loose, recapitalize our banks, and then we ve got some kind of resolution to this problem. But theoretically you can do this. MR. DADUSH: Sorry, I didn t quite understand. Are you agreeing with Jacob or not? He said that the ECB can, today, stop the crisis. MR. LACHMAN: Absolutely theoretically the ECB can do it. But I what I m saying as well is that you ve got to be looking at it ECB in a political context. The ECB, like the Fed, can expand its balance sheet until the cows come home. They can you want 2 trillion (dollars)? You need it. You want 3 trillion (dollars)? You know, you just use the printing press to do that. You can do it.

14 [00:44:48] The ECB is not going to do that because its major shareholder, the Germans, that is not their view as to the way in which a central bank is to be run. So, you know, one s raising a very theoretical question. Practically, the Germans have got a constitutional court that would have problems with debasing the currency or not doing independents. You ve got the Bundesbank that is going it s apoplectic about what s going on (chuckles) right now, Uri. If you went that direction, the Germans would really have trouble staying within this union. MR. DADUSH: OK, anybody else? Antonio? Yeah. MR. DE LECEA: Yes, one point relating to your second question. To the extent that this crisis is fiscal structure, banks and institutions, I mean, one single measure or one single institution cannot solve it. So yes. MR. DADUSH: OK. So you (inaudible). I want to come back to Jacob. You had MR. KIRKEGAARD: No, I mean, I just want to emphasize what Desmond also said. I mean, when I said that the ECB could end the crisis (snaps finger) like that if it wanted to, you know, I m not talking about that the ECB can make Greece competitive overnight. Of course it cannot. You know, but what it could do, in my opinion, by issuing, for instance, a blanket guarantee to the Italian to Italian debt, it could mean it could basically make Italy trade much more like the U.K. than it does today. Because if you look at it, why is why is the U.K., given its fundamentals, et cetera, et cetera, raising 10-year debt at, what 2, 2 ½ percent of the markets and Italy is about 5 or 6 percent? Well, I would contend that it has a lot to do with the way the markets perceive the role of the central bank backing the pound and the euro respectively. That the ECB could, if it wanted to, you know, change. But I agree with Desmond completely that for political reasons they obviously won t do it. [00:46:43] MR. DADUSH: OK. All right. Good. What I am I am getting from this discussion on the ECB, which I think is tremendously important, is what I m getting from Desmond and Jacob together is that in the end, this boils down to the same thing as saying the Germans and the other core countries have to expand he EFSF, have to issue euro bonds or whatever it is that the solution is because in the end, the ECB will have to be backed, so to speak, by the whole of the euro zone. And this backing, so to speak, can take the form either of, you know, financing the European Central Bank s deficit or taking an inflation tax, you know, basically in the form of higher prices. One way or another, the European taxpayer pays. And therefore, it becomes a political decision. And the political decision so far has been, no, we are not going to we re not going to accept that kind of burden. OK. So that does the short-term questions. Now I m going to ask one question about the long term and then I want to I want to open it up. The all the things we ve talked about, you know, are about how do we stop this thing over the next year or two. How do we how do we guide the countries in difficulty over? But this is a very different question than what should this European monetary union look like in order for it to be a sustainable thing not over the next two years but over the next 50 years a hundred years?

15 What is the shape of this thing? What is needed in order to make sure we don t get into this problem again in a big way assuming we can get over the current crisis. And some people Desmond, obviously, believes we can t get over the current crisis anyway. But let s assume that you can for a second. What would how would you design it now? What would you what would you do differently? [00:49:16] I want to stress this question because so much of the action has been oriented towards the short term. And clearly not enough attention is being given to: What does this thing look like in the longer term? And until, I think, markets have a sense that this thing is sustainable in the longer term, they re going to be very nervous about the short term. MR. LACHMAN: No, I think it s exactly the reverse. MR. DADUSH: Yeah, all right. Go ahead, yeah. MR. LACHMAN: That markets don t have got real concerns about the short term, as to whether you re going to get towards the longer term you know, they you know, they just find it fanciful when you re talking about what are you going to do in 2013 or 2014 how are you going to design this all. You know, you ve got a fire. You know, that this thing is it s the real conflagration that the market thinks that you haven t got ahead of this crisis one bit, you know, from the beginning May 2010 each time the policy makers have fallen short of getting ahead of the markets. And you know, the markets have still got the question, is this really going to (inaudible)? [00:50:24] But, you know, if I would just say to answer your question on the long run, I think that what you really have to do is go back to basics about the optimum currency theory of the monetary union, that for a monetary union to work you ve got to have conditions satisfied for that. You ve got to have the wave (ph) flexibility, you ve got to have the labor mobility, you ve got to have the fiscal federal union, you ve got to have countries that are similar in kind that will actually be playing by the rules. You know, so my answer to your question is that for the euro to survive in the long term, what you ve really got to do is you ve got to strip out the countries in Southern Europe. You know, you ve got to have a core a reduced you know, go back to your original euro the strong countries that can abide by this that have got similarities. You know, then you ve got a currency you know, that s I wouldn t be surprised if that s where we re going to be in five, 10 years time that s probably too long two or three years time is, you know, we ll have a strong euro with the countries in the north, you know, and that ll be a very serious country that could really be a proper reserve currency. MR. DADUSH: Anybody else on this question of the long term? What is what is needed? Antonio? MR. DE LECEA: Yes. Let me come back to also to your first question of whether the euro will survive. I mean, the it s not a question of surviving. But, I mean, the euro will take the opportunity to come to come strengthen from the crisis. And how? By completing the institutionalized setting. You call it underinstitutionalized. Well, it is may be it it may be a teething problem. But so it is clear that the we needed some more some more cohesion, some more integration, to avoid countries going the wrong way and disregarding having effects on the others and disregarding the sustainability of their policies.

16 [00:52:30] So this, to some extent, is now in place. Only two weeks ago a series of measures were approved in order to restrain the possibility of this of this (inaudible). So that s one part. Probably is not enough. But going back to theory I mean, to the optimum currency theory, I mean, misses a crucial point, which is the political aspect. And I m sorry, but this is what binds people together. And you cannot disregard that. I mean, the countries of the you call the periphery will not leave the euro. So you can I mean, you need to take that into account if you look at if you look beyond. I mean, countries the public opinion in the countries may be may be upset about the euro the euro area or the euro authorities, but they are much more upset about their own their own national authorities. So and the latest euro barometer the poll of European public opinion shows clearly that the people believe that it is within the EU that they may solve better their problems. So and but, indeed, I mean, for that for that to work you need some more constraining instruments and institutions. And this is what has partly been done and is probably more in the making. MR. DADUSH: Go on, Jacob. And please tell me also if in order for the euro to be viable in the long term we need to have a fiscal union. MR. KIRKEGAARD: Yeah. No, I mean, I think that, you know, we could all debate for a long time what does a fiscal union mean. But, I mean, at least for me, what it means is that you need to give the center, or Brussels, or whatever you want to call it, the ability to overrule national government budgets you know, essentially veto them. And I would probably disagree somewhat with Antonio that the current six-pack is not nearly enough for that. You basically need to have what s now called the European semester with the with the veto power, meaning before it becomes national, you know, budgets. That would clearly require a new treaty. I think that kind of treaty will have to, in my opinion, to be approved by national referendas in all countries, not just in some of them, to have the proper electoral anchoring. If you read the German constitutional court it ll probably this type of fiscal union would also require a change in the German constitution, requiring a referendum. Clearly, I think, you will need to have common, centralized banking regulation and essentially a European FDIC version. Because of the size of the banking system it makes no sense to have it sort of essentially continue to be backstopped by national governments. That s simply too much; it ll be too unstable. And the risk for capture of national regulators is too big. [00:55:36] So if that s I think that s the two main parts of it. And then, of course, you need to have, you know, all the things that national governments, in terms of structural reforms, need to do anyway. That s another given, which you clearly will have to address. MR. DADUSH: Yes, Liliana? Yeah, quickly.

17 MS. ROJAS-SUAREZ: Just one small thing. I think that regardless of what we dream the euro zone could be if we could redesign it again, the way this crisis evolved is what is actually going to determine whether there will be the same kind of a structure, the same kind of countries or whether they will backtrack completely from initial intentions. I agree very heavily with what you said about the political differences between countries and willingness. Remember that when these things happen, we will have a new government in Spain. We don t know what s you know, what s going to happen. I mean, Merkel will be out of the of the game too. So, you know, the whole political spectrum will be completely different and so dreaming about what the new the new stable, long-term euro zone will be, it s fun, but I couldn t tell too much. MR. DADUSH: OK. Very good. So I d like to open it up. I do have some more questions I have many more questions. But I will hold off and open it up for you for the audience to ask. Yes, sir? [00:57:11] Q: Microphone? MR. DADUSH: Yeah, microphone, please gentleman here. Can you please introduce yourself? Q: OK. My name is Stanley Kobrick (ph). One thing that hasn t been discussed yet is population movements. And I am reading about, hearing about younger people leaving, not seeing any opportunities. And if that s the case, that would affect any scenarios for economic growth. If the talented young people leave, then where will the growth come from? How will the transfer payments for social security and health care be paid? MR. DADUSH: Yeah, Jacob, you want to take that? MR. KIRKEGAARD: Well, I think two things there. One, actually one thing to keep in mind is actually that the legal immigration in-flows into the EU-15 have actually, in the last decade, been about twice the level of the United States. So this idea that on in the aggregate that everybody is leaving the EU is actually not empirically founded. Secondly, I think it s an important aspect to note that the reason that many, you know, young, educated people in Spain, Italy and the periphery are leaving is, in fact, that you have these archaic insider/outsider labor market structures that grossly favors essentially the baby-boomer generation, because these are the people that have very well-protected jobs from which they are essentially un-fireable. [00:58:52] But it s the young people that are denied these contracts because they re very expensive contracts. And so obviously employers are very reluctant to hire new staff on them. So therefore, young people are essentially condemned to remain outsiders and be on very short-term, part-time contract at much lower wages. But this is so this is essentially a structural reform issue which simply, in my opinion, shows that the labor market reforms, particularly in the southern part of the euro zone, has not gone near far enough. MR. DADUSH: Yes, the lady at the back? Is oh, sorry, the gentleman. Sorry about that, yeah.