IDEAS IN ACTION with Jim Glassman

The End of the Euro? How Far Can the Crisis Spread?

JIM GLASSMAN:
Welcome to Ideas in Action a television series about ideas and their consequences. I'm Jim Glassman. This week: the euro crisis. The Europeans' attempt to form a common currency is in trouble. As America focuses on its own economic problems several European countries are fighting for their economic survival. Expensive bailouts are the only thing keeping them afloat. Could a European economic tsunami hit America's shores? Joining me to discuss this topic are; Desmond Lachman, resident fellow at the American Enterprise Institute; Martin Neil Baily, senior fellow at the Brookings Institution; and Gregor Peter Schmitz, Washington correspondent for the German news magazine Der Spiegel. The topic this week: the Euro-Zone crisis and what it means for America. This is Ideas in Action.

ANNOUNCER:
Funding for Ideas in Action is provided by Investor's Business Daily. Every stock market cycle is led by America's never ending stream of innovative new companies and inventions. Investors Business Daily helps investors find these new leaders as they emerge. More information is available at Investors.com.

JIM GLASSMAN:
In 2002, seventeen European countries embarked on a radical experiment; to merge their national currencies into one- the euro. Today the wisdom of that decision is being questioned. Countries like Greece, Ireland, and Italy have racked up huge debts, dragging down their wealthier neighbors who are suffering from bailout fatigue. What lies ahead for the euro currency and what does this European economic crisis mean for the United States? Welcome gentleman. Gregor, it was about a decade ago that the euro was born and there were nay sayers certainly, but the euro has stood up pretty well until recently. Why is it now on the verge of collapse?

GREGOR PETER SCHMITZ:
Well I think bailout fatigue is a nice way to put it if you look at it from a German perspective. Germans were very reluctant to introduce euro as you already mentioned to give up the Deutsche Mark but then for a while it seemed like a real success model and actually the German export driven economy profited immensely from the euro and that is something that is sometimes not communicated clearly enough in the current debate. But to come back to the bailout fatigue, if you look at the debates in Germany people are understandably to a certain extent reluctant to bailout countries that have borrowed their way in to disaster and the numbers are staggering now. Under the last rescue package Germany would have to vouch for more than 200 billion euros theoretically which is about 85% of the German tax income per year. And of course people are very uncertain if any of the measures be it euro bonds, be it other measures, will really be effective in the long run. So on the other hand of course as I said early, Germany not just profited immensely from the European Union, but also German banks in the run up to the crisis have been part of that bonanza. So in a way you could say the bailout package is now for Greece and other countries have also been bailout packages for the German banks because they are undercapitalized. So it's a very tricky debate and that's why it is so difficult for leaders like Chancellor Angela Merkel to really lead because each side has valid arguments.

JIM GLASSMAN:
Ok I want to really understand is what's going to happen to this currency itself. In other words, I certainly understand that in an economic crisis there are sovereign debt defaults. You saw this you know in Argentina, I think Greece has defaulted five times in its history, but why would that affect a particular currency? Des?

DESMOND LACHMAN:
Well the problem with a lot of these countries on the periphery is they've developed huge imbalances both in terms of their public finances. They've got very big budget deficits, very high levels of debt, and at the same time many of them have lost a huge amount of international competitiveness so they're running big current account deficits that need to be financed. If you're stuck in a fixed exchange rate system and you try to fix those imbalances, which is what a country like Greece is trying to do, through fiscal austerity what that tends to do is produce very deep recessions. So the only way you can really cure these imbalances are-- within a fixed exchange rate system-- is by tightening the belt very tight, by having wages and prices falling, but that drives the economy into a deep recession. So in addition to what Gregor's talking about-- about bailout fatigue that the Germans are tired of throwing money at these cases, what you're not getting is you're getting the clearest of signs of adjustment fatigue. That the countries on the periphery-- I'm thinking particularly of Greece-- are in effect telling the IMF there's so much austerity that we can take and maybe we need to go a different direction and the direction that they'll go will be to substantially write down their debt. That what they'll be doing is telling the creditors we can't pay you 100 cents to the dollar we're going to be paying you 30 or 40 cents on the dollar.

JIM GLASSMAN:
Right and so Martin so that's called the default-- writing down--

MARTIN NEIL BAILY:
Or a restructuring--

JIM GLASSMAN:
--Or a restructuring but at any rate the people who loaned the money are going to be out something. How does that actually affect Europe in general and the euro in particular?

MARTIN NEIL BAILY:
The European banks hold a lot of that foreign debt so the German banks, the French banks, and even some American and British banks are holding some of that sovereign debt that could get written down, that could get restructured. So they would take losses-- the banks would take losses. European banks already are facing problems that they may not have enough capital and so their governments will have to put capital in. so if they write down some of their assets then they'll have to be more capital put in. So one of the responses to the German fatigue is, well, take your choice either you bailout Greece or you bailout your own banks--

JIM GLASSMAN:
So the analogy is of course in the United States our banks got in trouble as a result of sub-prime loans and our government stepped in and bailed them out or gave them support at least temporarily. Here the money's going to Greece but it ultimately comes back to the European banks.

MARTIN NEIL BAILY:
Well, yes. Greek banks would be bankrupt so to speak if-- because they're holding a lot assets-- those assets too and so what's beginning to happen in Europe is banks are not willing to lend to each other. So if Greece were to default or if Italy or Ireland were to default really we'll have a breakdown in the banking system and the ability to have transactions and people to sell goods to each other, so it's potentially a very serious situation that they're facing--

JIM GLASSMAN:
But you know as I was saying before, Gregor, you the sovereign debt defaults do happen. They happen all the time when there's a global financial crisis. The complicating factor here is the euro as a currency. I mean if for example the Greeks were still on the drachma it wouldn't be as big a deal, or would it?

GREGOR PETER SCHMITZ:
It's also about the banks because that is a very important aspect that actually the European banks have so much sovereign debt in its books. So if the sovereign debt suddenly loses its value to-- or would be in the books was the real value the European banks would be really in trouble and they are not getting much capital anymore from American banks either as we heard recently--

JIM GLASSMAN:
By the way, sorry to interrupt but, is one of the reasons that European banks hold so much Greek debt the fact that Greece is part of the European monetary system? And if it were still on the drachma that wouldn't have happened? Or does it make that much difference?

GREGOR PETER SCHMITZ:
Of course it has been facilitated. I mean that's what I was hinting at in the beginning that of course there is this is bonanza all over Europe going on that the capital was going to these countries in the periphery and for a long time it worked really well for the banks but now of course they have to face the consequences. What you said earlier about these defaults happening all the time-- the big difference of course is that we don't have one treasury. We have 17 different treasury departments in a way so to make this next step to come to an agreement on a European fiscal authority in a way-- that is something that Germans, the French, others are working on now-- this is much harder even than any bailout. The debates about that are much harder than any bailout and it's very tricky. It's also tricky if you compare it to the U.S. treasury for example. The U.S. treasury doesn't have to bailout California or different states-- it's a huge responsibility now to create that fiscal authority that theoretically would have that to bailout countries like Greece or even much larger countries. Italy has six times that of Greece, so it's a much larger number of course.

DESMON LACHMAN:
Yeah I would just add that it's important to look at this in quantitative terms. That what makes this crisis very different from your run of the mill default is that the amount of debt that you're talking about is mind bogglingly huge. So in other words if we look at the debt of Greece, Portugal, Ireland, and Spain, what we're looking at sovereign debt that totals two trillion dollars. The IMF is making calculations that if the banks in Europe were to mark down their debt to what market levels are, they'd have a shortage of capital of around 200 billion dollars. So what we're talking about is we're talking about a crisis that could be for the banks on the order of what we saw in the United States in 2008, 2009. The ECB itself talks about if Greece defaults we could have a Lehman style banking crisis in Europe. And unfortunately from the point of view of the United States-- the United States has got-- United States' financial system has huge exposure to the European banks. So if you were to get an event in Europe, that would not be solely a European event but it would rather be a global financial event that would impact the United States pretty hard.

JIM GLASSMAN:
Gregor.

GREGOR PETER SCHMITZ:
We did an interview with George Sorros who obviously knows a thing or two about currency speculations and that was one of the first things he said as well that he is reminded of 2008 and of Lehman Brothers and particularly of that capital shortage that might make-- really turn that into a global crisis obviously, yeah.

JIM GLASSMAN:
And so do you agree on-- Martin that the effect on the United States of a default or a restructuring would be pretty profound?

MARTIN NEIL BAILY:
Yes I think it would. First of all it's the amount that they would stand to lose and then there's a kind of contagion effect that people's expectations. You might see the stock market doing poorly. We've seen it going up and down those different rumors have come across the Atlantic about what's happening in Europe. So, quite a bit of this has to do with expectations. And also United States' recovery itself as I think you mentioned in the beginning of the show is very fragile. So we have two-- the two largest economic entities really both of them struggling to get out of recession and that's what makes this crisis so difficult.

JIM GLASSMAN:
And Europe is actually-- has a larger GDP combined than the United States so it's a pretty big economic entity. Do you think the United States would bail out European banks or European countries?

MARTIN NEIL BAILY:
Well it'd be very difficult to do. I mean I think one of the things, which was somewhat evident at the time and has become more evident, is that the Federal Reserve was sending a lot of dollars to Europe when we were in the '08 to '09 crisis-- or maybe going back to '07. And they were providing money because there was a dollar shortage. People were rushing to dollars as a safe haven. There's a certain amount of dollars that are needed for world trade and world transactions and when people-- when banks are not willing to lend those dollars then the Federal Reserve came in to try to provide more dollars. I'm not sure they can do that now. One of the consequences of financial reform and one of the concerns of congress is that the Federal Reserve has too much power to go out and lend money to people. So I don't think they have the same power. I don't think they would be able to step in in the same way to bail out Europe that they did in the previous episode.

JIM GLASSMAN:
Do you agree with that?

DESMOND LACHMAN:
Yeah, I agree that I think the task of bailing out is going to fall to the European governments as well as the ECB's going to have a huge role and that is going to be problematic because I think what Gregor was referring to at the start is that you've got bailout fatigue in the main country-- Germany. They don't want to see this currency union change into a transfer union. If you look at the polls in Germany, 65% of the German populations are against bailouts. So it's very difficult for the political elite to come to rescue to these countries as you might wish to occur.

JIM GLASSMAN:
And what about the solution or potential solution of having a kind of unified euro-bond? The Greek government borrows money, it borrows it in euros, but it's the Greek government that's on the hook and so there's a proposal that there will be a Euro-bond with all of the members of the European monetary union on the hook. What would people in Germany think of that?

GREGOR PETER SCHMITZ:
Well, it depends on who you talk to. I mean euro bonds is basically a dirty word in German politics now or even European politics. When you talk to an official-- to a politician, I mean if you talk to civil servants they will tell you you're probably at some point we're going to Euro-bonds. We're also at some point going to have a fiscal union in Europe and we are working on that however if you talk to an elected official like Chancellor Merkel for example who recently said in parliament again we are not going to have Euro-bonds. Or German finance minister Wolfgang Schaeuble who also says no we're not going to have euro bonds because of course the downsides are very obvious to a country like Germany. We would probably lose our AAA rating; we would be on the hook for tremendous amounts of money as Desmond pointed out. Our payments and our interest would increase significantly, but yeah probably that is one of the solutions that is discussed but it is so hard to communicate in Germany. It's so hard-- not just in Germany but also in some of the other countries that would be affected.

JIM GLASSMAN:
Des?

DESMOND LACHMAN:
This basic problem is that the markets move at one speed, they're moving at the speed of light, and by the time you'd get a treaty changed in Europe that would permit a Euro-bond you're talking about months or years--

JIM GLASSMAN:
--Or years. Right.

DESMOND LACHMAN:
You're talking about something very slow. So I think that the solution even if politically it were on-- it's not just Germany where this resistance to this-- there's strong resistance to this in Finland, in the Netherlands, in Austria, just to mention a few countries, Slovenia I think as well. You need unanimity to get the idea of the Euro-bond occurring so by the time that the European politicians would get their act together the market would of have rendered its verdict long time before.

JIM GLASSMAN:
Gregor you wanted to say something--

GREGOR PETER SCHMITZ:
--And it could actually undermine the willingness of some of the countries to really be serious about cutting expenses now because they'll say well there's still this other solution out there at some point that will affect the markets or the anticipation of the markets as well.

JIM GLASSMAN:
Okay, so what's going to happen-- what would happen if Greece and Portugal and I don't know maybe even Spain or Ireland dropped out of the euro and you only had the kind of stronger economies?

MARTIN NEIL BAILY:
It would be very hard to do that in an orderly fashion that did not create a financial crisis and let me just respond to my colleagues on the panel by saying there was a lot of opposition in the United States to bailing out the banks but I think if people had realized what was the alternative-- letting the financial system collapse-- they would realize that it was better to do the bailout. And I think in Europe Germany and France, for very good reasons don't want to do this but I think they have to do it otherwise the crisis will be much worse and they themselves ultimately will be effected. There's no real mechanism for dropping out of the euro, so it would have-- they'd have to come up with a mechanism. How they're going to do it, how they're going to separate their banking system, what's going to happen to the debts, it'd be very hard to do in an orderly fashion that would avoid a really severe crisis.

JIM GLASSMAN:
Has the euro-- do you think the euro has failed? The euro itself was an economic idea but also a political idea--

GREGOR PETER SCHMITZ:
Exactly, I mean we talked about the initial resistance in Germany and some other countries but then after a while of course people realized oh I can travel to any country in Europe now in the Euro-Zone and I don't have to exchange money anymore, it's great, it's an achievement or so-- so it became more popular but of course people now see these downsides and they realize that the second step wasn't taken-- this idea of come to an agreement on European economic policy and that's going to be the painful part.

JIM GLASSMAN:
And was this inevitable? I mean what did you think of the euro before it started?

DESMOND LACHMAN:
I thought that the idea was conceptually flawed right from the start. You know I was in the camp with people like--

JIM GLASSMAN:
I knew that I wanted to give you the opportunity so say it--

DESMOND LACHMAN:
--Marty Feldstein that you can't put countries in this kind of arrangement when they don't satisfy the conditions. They don't have the labor market flexibility, they don't have the fiscal transfers, they're subject to different kind of shocks. You just don't have the right kind of conditions. I think that what surprised one was how large the imbalances could be within this arrangement. And I think that that's taken everybody by surprise that countries running within this fixed exchange rate arrangement when they're only supposed to have budget deficits of 3% of GDP and they record budget deficits of 13% of GDP, 15% of GDP, when the debt levels rise too high. So there was inadequate policing, the Stability and Growth Pact; that was a failure. You know markets didn't discipline the way that you wanted to so we're now witnessing a unraveling of an arrangement. Imbalances that took ten years to build up are not going to be resolved overnight. You know there's no silver bullet. This is going to-- I'm afraid I'm in Martin's camp that this is going to unravel in a disorderly way that is very likely to produce a real financial crisis in Europe and it's going to be much like the housing problem in the United States that during the run up it was great you know everybody thought well of it but today when we look back to the mistakes on the housing side-- you know we regard the Federal Reserve's policies at that time a total disaster and I think that the same thing's going to happen with Europe.

JIM GLASSMAN:
And actually that's a good question that I wanted to ask Martin. Do you think that the euro was fundamentally flawed from the start--looking back on it?

MARTIN NEIL BAILY:
Yes certainly with the benefit of hindsight I agree with Desmond that there was really no-- the fiscal discipline problem was one; countries were not effectively constrained from running up these big budget deficits. But also there was no adjustment mechanism for countries that became uncompetitive. I mean that's a big part of the problem. Greece and Italy, they're not growing. The big adjustment mechanism in the U.S.--and it's been slow has been the movement of people-- and so people have migrated to where the jobs are. Now that's a pretty slow process that takes place. Now there is some migration-- in principle people can move in Europe but it's more difficult. First of all they have social safety nets so a lot of them don't want to leave because they maybe collecting benefits at home, there are different languages-- it's just much harder to have that mobility taking place. So the only other way you can adjust is to make countries competitive by lowering wages and actually Germany did that. That's how Germany got to be such a strong exporter in the last several years was they kept control, they didn't literally lower wages but they kept wage growth very much under control, they did a certain amount to improve productivity and they became competitive. Greece, and Italy, and other countries just haven't done that so they haven't compensated for the lack of ability to adjust their exchange rate by trying to make themselves more competitive in other ways. Nor have you had the mobility of labor, which you've had in the United States.

JIM GLASSMAN:
Gregor do you agree with that? Do you think that the euro was fundamentally flawed from the start?

GREGOR PETER SCHMITZ:
Well, I wouldn't go that far. I think you always have to take into consideration that it was ultimately a political project also. It was part of the European unification process. It was very important at that time because whatever happens even if you install a European fiscal authority, basically it will be run by the Germans of course. And that will lead to even more animosity because as you know from your time at the IMF it's not really popular if you dictate to other people what to do with their money, what to do with their households, what to do with their people ultimately. So that is a huge problem. What Martin says exactly right that's what it's so much harder in Europe to introduce a common currency because we thought that maybe this European unification process would be much easier to move from let's say Finland to Greece, from Germany to Belgium or whatever, but in reality it is pretty tricky. It's hard and we don't really have that European public sphere yet that some people were dreaming about at the beginning of the unification process and right now it-- yeah it doesn't seem to happen anytime soon--

JIM GLASSMAN:
I want to just finish by going back to the United States-- I mean you know we in the United States shouldn't feel you know cocky or superior ,we've got our problems too. How can-- is there something we can do to insulate ourselves from this what appears to be coming-- it was already a crisis but from the effects of what's going on in Europe?

MARTIN NEIL BAILY:
Well I thought one of the things that Obama should be doing-- he's worried about jobs as you should be-- I don't think it's something he should do in public or a speech necessarily, but I think he has to work with congress and with the Federal Reserve to have actually a plan for how the United States would react to further problems in Europe to try to insulate our banks, to let sort of congress be in at the beginning so that if there's a need for the Federal Reserve to provide more liquidity they can do it or if there's need for the treasury to provide more capital to banks that's available and we don't have to go through some process like we went through with the debt ceiling. So if I were Obama that would be one of my priorities is trying to figure out an action plan for what we do if there's a failure in Europe and obviously that's not something you do in public but it's something I think that should be being done.

GREGOR PETER SCHMITZ:
I think it's something the Americans are extremely worried about. Chancellor Merkel was here in D.C. in June to get the presidential medal of freedom and from what I heard from talks to government officials that's pretty much the only thing they discussed the euro crisis. Not Afghanistan, not Iraq, so it's just the euro crisis.

MARTIN NEIL BAILY:
Well she's getting a lot of pressure from the Americans to--

GREGOR PETER SCHMITZ:
--Definitely yeah.

MARTIN NEIL BAILY:
--Bit the bullet and do the bailout.

GREGOR PETER SCHMITZ:
Exactly.

JIM GLASSMAN:
Des? What can the United States do?

DESMOND LACHMAN:
Well I think I would totally agree with Martin is that they do need to do contingency planning and this is not something that is going to occur in the distant future. This crisis is showing all the signs intensifying. It looks as if really already are approaching the end game. 2012 I think is going to be a very challenging year for American economy because it's going to be hit by a big shock from Europe. And I think that all that one can do is prepare those kind of policy responses that you would do to a situation you know that could look like a Lehman crisis.

JIM GLASSMAN:
Well on that cheery note-- thank you Desmond, thank you Marty, and thank you Gregor.

GREGOR PETER SCHMITZ:
Thank you.

JIM GLASSMAN:
And that's it for this week's Ideas in Action. I'm Jim Glassman, thanks for watching. Keep in mind that you can watch Ideas in Action whenever and wherever you want. To watch highlights or complete programs just go to ideasinactiontv.com or download a podcast from the iTunes store. Ideas in Action because ideas have consequences.

ANNOUNCER:
For more information visit us at ideasinactiontv.com. Funding for Ideas in Action is provided by Investor's Business Daily. Every stock market cycle is led by America's never ending stream of innovative new companies and inventions. Investor's Business Daily helps investors find these new leaders as they emerge. More information is available at investors.com. This program is a production of Grace Creek Media and the George W. Bush Institute, which are solely responsible for its content.