Tyler Cowen on the European Crisis
Dec 5 2011

Tyler Cowen of George Mason University talks with EconTalk host Russ Roberts about the European crisis. Cowen argues that Greece is likely to default either in fact or in spirit but that the key question is which nations might follow--whether Italy and Spain can find a road to economic health and honoring past debts. Cowen gives his best guess as to what is likely to happen to the euro and the European Union and the implications for the rest of the world. He explores some less likely scenarios as well. He is pessimistic about Greece and the short-run prospects for preserving the status quo, but he is optimistic in the long-run about the European Union though it may have a different structure down the road.

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Explore audio transcript, further reading that will help you delve deeper into this week’s episode, and vigorous conversations in the form of our comments section below.


Dec 5 2011 at 9:35am

Great pod cast. As far as a solution goes, how about competitive currencies backed in nothing but bank assets?

Dec 5 2011 at 10:24am

Slovakia is one of the most corrupted countries in the world. I know, because that’s where I am from and where I live. I guess it’s a common burden of most post-socialist countries. Their nations got morally destroyed by communism.

[Advertisement url removed.–Econlib Ed.]

John S.
Dec 5 2011 at 10:47am

Good podcast, but I have a question: if the euro is in so much trouble, why has it maintained its value relative to the dollar and other world currencies?

Judge Glock
Dec 5 2011 at 11:37am

Another great podcast. In reference to the $30 billion Federal Reserve purchase of Bear Stearns mortgage assets that Roberts mentioned, the Federal Reserve does release their estimate of their portfolio value every quarter.

The Fed holds those assets under their own limited liability company, Maiden Lane LLC, which was funded with a $30 billion non-recourse loan from the New York Fed. As of November 30th of this year, the Fed reported that company as being worth $10.6 billion, which is a loss of about $17 billion from just last year, and almost $20 billion total so far. That portfolio’s value, however, is reported under a “fair value” accounting standard, which means it is based on the price the Fed estimates it would receive if it were sold into an “orderly market,” whatever they assume that means (and they aren’t telling us). The company’s actual market value is certainly much lower. Two other Maiden Lane companies, created to hold risky AIG assets, have also reported multi-billion dollar losses. The absence of news reports on these losses, as well as wide ignorance of the continued quarterly drain of multiple billions of dollars from Fannie and Freddie, shows why quietly nationalizing financial companies has such appeal to policymakers, as Roberts also mentioned.


Dec 5 2011 at 12:44pm

RE: John S.

My take on why the euro has remained strong is this. After the US crisis the integrity of the US and it’s bonds was thrown into great question. Bill Gross decided to take his company and bet strongly against the US. The general mood was that the US was in decline and it specifically was the one and only source of the worlds ills.

So China, Brazil, Russia, etc decided to put it’s money in the next “safest” asset on the market. Euros.

Remember when Geithner went over to Poland by invitation to give his advice on Euro crisis? The EU officials response was “what right does the US have to lecture us on monetary issues? The US clearly has a much worse economy than Europe.”

It’s only very, very recently that investors have begun to believe that the US is actually as safer asset to own the Europe. Which is why this whole this is starting to unravel so quickly right now as opposed to 6 months ago.

Thats my best guess anyway.

Mads Lindstrøm
Dec 5 2011 at 2:54pm

Great podcast.

The podcast touched upon monetizing the debt. I think you are missing an important reason why Germans are very reluctant to that “solution”. In many German minds a large part of Hitler and Nazi popularity can be traced to the hyperinflation in the Weimar republic. In other words, in many German minds, the chaos and unemployment resulting from hyperinflation paved the way for Nazism. Obviously the Nazi regime is not the proudest part of German history, and thus it is naturally for Germans to avoid inflation even at great cost.

The German scare of inflation might even be larger than Americans fear of deflation (resulting from the great depression). After all, the destruction of the great depression were minor compared to the destruction Germany faced due to the second world war.

Mads Lindstrøm
Dec 5 2011 at 3:10pm

But to really increase the capital requirements on these banks–in a way it’s crazy. Europe’s trying to do this right now. Telling their banks, through Basel 3, something like: Come up with $700 billion in capital. That’s from a month or two ago. It’s probably a worse number now.

Yes, it is very weird that we loosen reserve requirements when times are good and tighten them when times are bad. The other weird thing is that cannot remember seeing one journalist in my local paper (I live in Denmark) or local television channel that question the sensibility of tightening reserve requirements while Banks are already in trouble. It is not just that there is a consensus that tightening reserve requirements is a good idea, it is an unquestioned consensus.

By the way, reading my comment above, I did not mean to suggest that the great depression were not very bad for many Americans. Just that, Germany did face even worse times during and after the second world war.

Dec 5 2011 at 8:19pm

Are bank runs relevant when deposits form small parts of the liabilities of banks relative to borrowing from debt markets. Deposits can be met by borrowing more from debt markets. The issue is the debt markets.

Philipp Kübler
Dec 6 2011 at 12:21am

I am not quite sure why one cannot let the bad banks fail and the central bank inject money into the system as Russ suggested.
Currency is not credit. I guess that means you need someone through whom to inject the currency into the system. So that currency becomes credit.
So let the bad ones fail and give the money to the solvent ones.
Or is it really that bad, and there are no solvent ones?

Dec 6 2011 at 12:40am

On the question of the Fed’s intervention, something raised by Russ, Bloomberg has recently uncovered the size and scale ($7.7 trillion) of this. It’s described as a ‘loan book’, which suggests they expect it to be repaid, with interest.

Ron Bramwell
Dec 6 2011 at 12:43am

The tone of the podcast took me by surprise for the following reasons
Europe is not the European Union (EU) – they are two different things
The suggestion in the talk was that the EU was a force for good and should be saved – it is not. Its about ‘experts’, pen pushers, central planning, self seeking politicians and their mates.
The EU is a force for evil

Dec 6 2011 at 8:58am

The reason the Euro is still high is that no one knows what the Euro will become.

On the one hand, it could end up being very weak because of currency printing, defaults, or maybe Germany leaving the Euro.

But, it might actually end up being super strong, if instead the weak countries leave the Euro leaving Germany, Holland, etc. being the Euro currency owners.

So, its like the Schrodinger Cat of currencies right now…no one knows what it will become.

David B. Collum
Dec 6 2011 at 4:27pm

I think the analysis was great; Europe is toast. What was lacking was sufficient discussion of the corrective measures–the chemotherapy–required to cleanse the system of the mutated banking system so as to ensure we don’t end up back here within the decade. If we are writing checks for trillions, I want some change.

Dec 6 2011 at 5:58pm

Tyler made a “assume a can opener” joke at the end. I had to google it, and it’s pretty funny. Here it is:


Definition: The phrase assume a can opener comes from a joke most economists can tell off by heart. There are multiple versions of the joke – the website Notes on Social Security Reform has one of the most common version:
” A physicist, a chemist and an economist are stranded on an island, with nothing to eat. A can of soup washes ashore. The physicist says, “Let’s smash the can open with a rock.” The chemist says, “Let’s build a fire and heat the can first.” The economist says, “Let’s assume that we have a can-opener…” ”
The reference comes from the stereotype that many economic models require unrealistic or absurd assumptions in order to obtain results. The phrase is often used by economists to describe research that has particularly unusual or unrealistic assumptions (by the standards of modern economic research).

Pietro Poggi-Corradini
Dec 6 2011 at 8:24pm

Why isn’t anybody clamoring to ban government borrowing? Or at least heavily regulate it, let’s say, no more than 50% of GDP. The regulation could be imposed on banks: you cannot buy bonds from a country whose debt-to-GDP ratio is more than 50%.

Mr. Bankerman
Dec 6 2011 at 9:50pm

As much as I love the show and respect the undoubtedly brilliant Prof. Cowen, I am once again surprised at the poor quality of analysis on the show this week.

While Prof. Cowen believes Italian debt is a crisis only solvable through default or the use money from German taxpayers, data and math show it is not a serious problem and that there is a relatively straightforward solution. Like so many guests on EconTalk that discuss finance and banking, I believe that Prof. Cowen’s analysis suffers from the failure to apply empiricism and math to the EU debt “crisis”. It is unfortunate that such a smart person used an appearance on such a great forum to repeat common misconceptions instead of subjecting those beliefs to rigor.
The relevant metric to understand capacity to service debt is primary deficit as a percent of GDP. While Italy’s current primary surplus is only 0.4% of GDP, this is a cyclically low number: Italy’s primary surplus averaged >4.5% over the past 5 years and >6% over the past decade. Assuming a budget with a primary surplus of only 4% of GDP, 120% debt/GDP is sustainable at 5% interest rates with a mere 1.7% nominal GDP growth. This math is why Italy has sustained this “unsustainable” level of debt for over 15 years: specifically, Italy’s debt to GDP has been above 115% since 1993.
Not only is the problem not serious, if it did become a problem there is a straightforward party able to fix it: the Italian citizen. Not only is government spending high, private debt is very low and per capita private net worth is very high (top 10 globally). If markets permanently remained as spooked as they are today and rates went much higher than 5%, budget cuts and taxation are straightforward means of solving the problem. While taxation is terrible for growth, it is politically and economically preferable to a default.
While clearly not great, the Italian situation is OK. Meanwhile the US situation is a crises: debt/GDP may be lower, the primary deficit of >6% does not yet include structural growth in both in old and new healthcare spending programs. It is great that this is getting more attention, but the focus on the non-crisis in Italy/Spain threatens to undermine the credibility of those warning about pending troubles in the US.

Mr. Bankerman
Dec 6 2011 at 9:51pm

Judge Glock brings up a common misconception that Prof. Roberts seems to share, so I believe it is important to address his point.

The conspiracy theory that the Fed suffered losses on the assets from Bear Sterns that formed Maiden Lane I is not consistent with reality.

Judge Glock is correct that the assets held by Maiden Lane have shrunk, but it shrunk as the Fed liquidates the vehicle through the sale of assets and receipt of debt payments. In just the three months through Sept 2011, the Fed realized $8,683m in cash from sale of securities and payments from Maiden Lane assets (see the NY Fed’s outstanding disclosures at this site: http://newyorkfed.org/markets/maidenlane.html).

As it liquidates it is making lot of money. The Fed earned a 12% pretax return in 2010 on the $27B in Maiden Lane securities (see the year end financials here: http://www.federalreserve.gov/monetarypolicy/files/BSTMaidenLaneLLCfinstmt2010.pdf). We do not yet know how much money the Fed made in 2011, but it looks likely that they had a pretty good year.

Boy, what a costly bailout for the Fed! Those Bear creditors should have suffered these “loses” (or massive gains as it turns out). Clearly, JP Morgan was able to use its corrupt connections to engineer this deal that cost them what would have been an outstanding return.

Dec 6 2011 at 11:47pm

Some thoughts:

1) I agree with Russ that there are good reasons to be pessimistic: If you have been watching the process of integration for the last 25 years or so, you will have spotted that this agenda has been pushed forward by national and EU leadership. However, in the rare instances that there have been referenda on issues, the populace has come out as what is referred to in Britain as “Euro Skeptic”. So, there are not only fault lines between nations, but also between the masses and the political elite. This is very dangerous, especially in an era where the distance between the top minority and bottom masses is coming under increasing scrutiny. My thesis is that Europe is not a bastion of democracy as the genuine aspirations of the people have been ignored for at least a generation in the interests of the “European Project”. This has not been a problem in the good times, but will become more evident as stress increases.

2) Treaty amendments require the consent of non-Euro members to be passed. Of course, this could be ignored (which would be illegal), but then that would undermine the whole project as each country would then have a precedent to tear up whatever EU treaties were not palatable to its electorate. A new treaty may well be a way to create credibility, but it will take so much horse trading that it is unlikely to arrive in time — or it will result in too many toes being trampled on for nations to adequately work together once it is enacted.

3) I think the assumption that Germany would shoulder a lot of the load is a bad one. The Germany of today is not the Germany that had just plunged Europe into war. The present generation is far removed from that time, and in their own lifetimes have had to go through a very difficult reintegration of the former East Germany. The capacity and desire or German people for altruism is at a much lower level than has been assumed.

People expect Greece to leave the Euro – essentially being kicked out but not in name. But rather than the weak being forced out, it is surely also a possible play for Germany to walk out first and leave the rest of the EU to it. Merkel probably would not do this, but she is of the old European integration paradigm. A Germany under stress could well become more nationalist and say to heck with it and just walk out. Not very likely as a scenario, but not impossible surely.

4) I look forward to this podcast every week. It’s really superb. Keep up the great work!

Scott Packard
Dec 7 2011 at 12:13am

About 6 days ago the Fed changed the rules on swap lines. They now allow you to pay for them in currencies other than dollars and euros.
“It also provides for swaps in currencies other than dollars and euros, if such a need should arise.”

Well, if you wanted to break away from the euro, but knew doing so would cause short-term chaos, then wouldn’t using swap lines allow you enough cushion to settle and swap out your existing debt without being taken to the cleaners by currency speculators?
Or, am I reading too much into the Fed’s change?

Héðinn Björnsson
Dec 7 2011 at 4:57am

Being Icelandic I would like to correct the few words that were mentioned on this podcast.

1. Icelandic banks were bailed out as long as the state could. What happened was that to “big to fail” became “to big to save”. It was not a strategic choice, but the only option left.

2. The 3 big Icelandic banks were split up and partially nationalized and partially went bankrupt. They were not small even on an international scale. The assets of the 3 banks were 150-200 trillion US$, which is larger than the Worldcom bankruptcy which is the 3rd largest in US history.

3. The Icelandic way did cause a riot, and the riot caused the government to collapse, and the Icelandic street has since had significant influence on government policy of the left wing government that took over.

4. Smaller local banks have continued to be bailed out through this mess and onto this day.

Dec 7 2011 at 9:10pm

Mr. Bankerman,

Tyler responds to all of your arguments in this blog post.


I wish someone had brought up the primary surplus, just to hear the discussion, but I think if you read this blog post you’ll see that Tyler has a real argument that isn’t based on an ignorance of the math.

Also, it’s worth noting that Italy’s 10-year bond is at 6% right now and spent time in November over 7%. With fluctuations like that, it’s hard not to consider at least the possibility that Italy is vulnerable to a self-fulfilling crisis.

And as far as using their sovereign wealth, I think Tyler’s response would be they could, but they won’t.

It’s not that I’m sure he’s right, but I think this was a high quality podcast. I am trying to point out that he had a defensible position, even if you disagree with it.

Modern M. Theory
Dec 7 2011 at 10:18pm

Quickly I want to make something clear, the US has the most transparent central bank in the world.

I often hear on your podcasts that “you don’t know how the transactions the FED has undertaken is doing”. Here is the web site for the maiden lane transaction where it lists a mark to market and amortization and sales table with graphs!!


Additionally you can see the fed’s fair value of all the FNMA/FHLMC debt they have purchased (they have made a lot of money on this) the treasury has as well and they are selling at a profit so it’s not just phantom (clearly that would be the next comment)


Lastly throughout history we have tried time after time to link our currency to Gold or some other metal, it doesn’t work it never has. Money has value because the government accepts it when you pay your taxes, and if you don’t either accept dollars to extinguish a persons debts or pay your taxes they will literally arrest you.

The Fiat currency by design allows for central banks to be lender of last resort to either governments or banks while short term market/political dislocations are worked out by the citizens of the underlying country/group.

This is where the ECB has failed, they cannot bailout governments without approval and have to fix the political issues first which as we can see is messy and probably not the best system. I am thankful the FED does have the printing power and we should stop trying to strip them of it.

Mr. Bankerman
Dec 8 2011 at 10:30pm

Thanks for the reference, Charlie. That post is a more helpful discussion (though it is also unburdened by data).

Here is my critique of Tyler’s assertions in that post:

– Tyler alleges that Italy’s zero growth in real per capita GDP makes its debt unsustainable. As my math shows, Italy does not need growth in real per capita GDP, just in nominal GDP. Nominal GDP growth in cyclically weak 2010 was 1.9% and has averaged 2.7% over the past decade. That is more than enough growth given the effect of financial repression on Euro nominal rates.

(You might think this attempt to cause inflation is evil, but preventing deflation is a critical role of central banks. Central banks today have to use high-powered money to undue the deflation that regulators and politicians inflict on the money supply.)

– Tyler (and Charlie) both seem to attribute current high market rates to the fact that markets see the debt as unsustainable. That could be true, but it is less plausible than the alternative hypothesis: there is a panic caused by a growing chorus that insists that default is necessary. This panic is compounded by EU banks that are too hamstrung by new regulations forcing leveraging and relatively weak business models to take advantage of these prices.

The evidence for my theory and against Tyler’s is the history of price changes for Italian debt. All the fact’s Tyler presents for why Italian debt is unsustainable were as true in 1994 as they are today (actually, real yields are much less today, so the argument is weaker today than 1994).

Why did yields wait until 2011 to spike? Why did the yields spike suddenly rather than slowly incorporate the gradually increasing probability of crisis over time? My theory fits these facts better.

– Tyler states that default is politically preferable to austerity for Italians. The empirical evidence against this is that sovereign defaults are exceedingly rare (especially without regime changes ala Cuba, Argentina, and Iran) while austerity is much more common. What is the empirical evidence that total chaos unleashed by default is a politically attractive outcome for countries in a situation like Italy?

– Tyler also states that the Germans are (or should be) politically unwilling to “bail out” the Italians. This ignores the highly sustainable level of Italian debt. Once you see how sustainable Italy’s debt is, you see that a “bail out” combined with modesst austerity is low risk and avoids a devastating crisis.

The US found it preferable to “bail out” Mexico in the early ’90s. Back then, Mexican debt was deemed by experts to be unsustainable and Libertarians were disgusted in the “bail out”. Of course, the US Treasury made a boat load on the bail out and Mexico’s fiscal situation proved perfectly sustainable. The Germans may have to take the position of the US in this analogy, which is ultimately a good position for their economy and taxpayers.

Please do not naively accept news reports at face value. What is happening in the EU is a public debt negotiation: each side is signaling a high level of commitment to their preferred course, but ultimately there will be a compromise.

After that happens, what credibility will the chicken-little deficit hawks in the US have? This is the danger: panicking at this false crisis helps paper over the real coming crisis.

Dec 9 2011 at 11:27am

As usual, a very interesting podcast.

Prof. Cowen is reliably interesting and challenging (see his blog, Marginal Revolution), and I enjoyed his thoughts on the Euro crisis.

Two things continue to strike me about the whole financial system mess (not just Euro). First, how little we actually know about the Fed’s actions. Second, how intent the leadership is on avoiding voter input. I think that the two are related.

Russ Roberts
Dec 9 2011 at 3:38pm

I appreciate those who have posted links to Federal Reserve sites detailing balance sheets and transactions related to the guaranteeing of Bear Stearns assets.

I also appreciate the assurance they have made money or broken even. It is impossible to tell that reliably without more information–I’d be interested in knowing how that conclusion is reached. I can’t tell from the raw material that is presented.

It certainly could be true. But I would add that the net impact on the Fed’s cash flow is not the most important result. For example, Mr. Bankerman reassures us that the guaranteeing of Mexico’s debt ended up not costing the American taxpayer. Here is what Willem Buiter, an economist at the University of Cambridge (and now ironically perhaps, the chief economist at CitiGroup) said at the time:

This is not a great incentive for efficient operations of financial markets, because people do not have to weigh carefully risk against return. They’re given a one-way bet, with the U.S. Treasury and the international community underwriting the default risk. That makes for lazy private investors who don’t have to do their homework figuring out what the risks are.

I think he was right. That rescue of Mexico’s creditors (along with other episodes) helped set the stage for the mess we’re in both in the housing market and in Europe.

My point is that the fiscal consequences are only a small part of the story.

Dec 9 2011 at 6:52pm

“My point is that the fiscal consequences are only a small part of the story.”

I think their point is that you have been saying that these loans were secret or “close to a secret,” and yet it appears you just haven’t looked for an answer.

You have tremendous resources at your disposal through connections with other academics and at the Hoover institute (at least it appears that way). If you say an answer is impossible or very difficult to find, people assume that you came to that conclusion because you looked very hard in a very competent way for it. When it turns out you just have to go to the Fed’s website, it doesn’t look very good.

That said, you create an enormous amount of value with econtalk, and the fact that commenters can add value by pointing us to data like they did is more value. I hope you respond to this by finding someone with the expertise to help us understand exactly what the data means and how its calculated. We should all be interested in what happened to the guarantees the Fed made.

Dec 10 2011 at 3:12am

Great podcast. There was a tantalizing exchange between Russ and Tyler I wish had been pursued. Russ said that the lesson we learned in the Great Depression is not to save failing banks but to prevent the money supply from declining. Tyler seemed to think it might not be possible to to keep the money supply growing if intermediaries are collapsing. Seems to me that very issue is at the heart one of today’s big macroeconomic uncertainties. Can the Fed grow M2, or perhaps not under some conditions? Can Fed efforts to grow the money supply be stymied if banks become dysfunctional? Intriguing that Tyler thought you could get a collapse of credit but also “odd hyperinflation.” How would that work?

All this sounds like great grist for another podcast–is hyperinflation a whole lot of conventional inflation or something different in cause? How would or could the Fed manage the money supply if the banking system is in crisis?

Answers please!

Modern M. Theory
Dec 11 2011 at 12:12pm

Charlie, well said – also worth pointing out the FED was required to release the underlying legal entity name of all participants (which is also on their web site).

Russ – If your thought is to have more say on what the FED can or cannot do, we have a system for that called congress. The basis of our political system is a representative democracy, lobby your representative to politicalize the FED and i’ll do the opposite. As our monetary system seems to be holding up under extreme duress, unless your US Dollars have not been accepted lately, but I highly doubt that.

William B
Dec 11 2011 at 8:48pm

Russ, I’m very disappointed to hear what you thought were the “lessons” of the great depression. I thought you were a Hayekian, but you and Tyler both sounded more like Friedmanites in this podcast. Whatever happened to the idea of liquidating the malinvestments? Hayek would be disappointed.

Michael M
Dec 12 2011 at 9:52pm

Has he got his facts right when he says the ECB is lending to the Greek government? When asked for details he gave none. The ECB insists that its charter does not allow it to buy government bonds diectly from the government concerned. It can buy in the open market only. I think the problem is precisely that the ECB is NOT lending to Greece or buying its bonds.

Dec 14 2011 at 12:48am

Why is there no talk about the Germanization of the Europe? I am not talking about Nazism, but about Germany setting Europe’s agenda, even if the agenda might not be conducive in the least for other EU nations. Foreign Policy has an intriguing article on the Germanization of economic Europe.

Dec 14 2011 at 5:39pm

The economics profession should borrow the following from the medical profession — “First, do no harm.” If economists are certain beyond a doubt as to the outcome of a proposed action, then by all means propose away. If there is uncertainty however, then hold back because the harm could be greater than the benefit. And I’m certain that all proposals to “save” Italy, Spain, the Euro, etc. are conjecture at best and have potential to cause enormous harm.

Dec 15 2011 at 3:33pm

Very sad day for the regular listeners of this podcast. This guy knows nothing about the European crisis. As Michael M points out, when he is asked who is lending Greece money he answers that the ECB. This is false. Greece has been financed by bilateral loans from its European partners (budgetary financing not monetary) and from the IMF. The ECB has only bought a minor percentage of Greek debt in the secondary market.

Dec 26 2011 at 8:16am

Russ recalled he had asked Keynesians what information it would take for them to change their minds. I know for certain: tie their income (of formerly Keynesians) to economic growth and unemployment.

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Podcast Episode Highlights
0:36Intro. [Recording date: November 28, 2011.] Situation in Europe. Taping will air one week from today; events may overtake this podcast, so we will do the best we can. Let's start with the problem. What is the problem facing Greece, and Italy and perhaps Spain, and what other countries you want to include in that problem group? The Eurozone is like the proverbial elephant. There are 17 different ways of describing the problem. And most of those ways are correct. But, which is the most important way depends on your point of view. Here's how I see it. The arrangement behind the euro, the common currency, was never workable in the first place. Principle 1). No monetary union without a fiscal union. Principle 2). No fiscal union without a common electorate. Europe is very far from having a common electorate. But that's it. The more practical question is: How did this all unravel? And if I may have just about a minute I'll run through what I think the problem is. Let's say that before all the trouble started, you are comparing two banks: The euro in a Greek bank in Greece, and a euro in a German bank in Germany. A few years ago the markets treated those two assets as basically equivalent in value. And in good times, they are. The Greek banks were solvent; the German banks were solvent; matters proceeded. But when times turn bad, they are not equivalent assets at all. The euro in a German bank is worth quite a bit more than the Greek bank. The Greek bank might fail, even if it's backed by the government. The Greek government might fail. It might be confiscated; it might be turned back into the drachma; there might be capital controls--whatever. So, as troubles approach, people start to realize that financial intermediation in Greece, it doesn't quite work any more. There's a slow and silent run on banks. And in general, what happens is a variety of different capital markets tend to be picked apart, and literally fall apart. Just as Carl Menger writes about how markets evolve, we are not seeing the opposite: the wholesale falling away and destruction of a lot of capital markets in a kind of horror, slow-motion process. And there's a lot more of what's going on--there are still 16 sides to the elephant which I haven't covered. But that's the one side I'll start with right now. To make that comparison vivid, let's contrast a dollar in a bank in Minnesota with a dollar in a bank in Mississippi. They are both worth the same--probably. Sure; they are backed by the same Federal Deposit Insurance Corporation (FDIC). Correct. So, there's no need to take your dollar out of the Minnesota bank and put it in the Mississippi bank or vice versa, because 1. There is an extremely high probability you can take it out whenever you want and what it will buy is the same once you get it out. What's different? What happened that caused the value of that euro in the Greek bank to not be worth--I mean, it's a euro. Why is it different from the German bank? The Greeks made many mistakes. A lot of them were fiscal policy. They spent too much money; they borrowed too much money; they have a very corrupt country; you can't trust the statistics. If you look at how Greece is rated on the World Bank's Doing Business Index, they are near the bottom. They are even below some of the African countries. So, the level of trust there is not high. And Greece has been in default about half of its history, since 1850 or so. So, ultimately: Should people trust the Greek euro and the Greek bank? I would say no. If I had money there--of course, I do not--I would have gotten it out a long time ago. So, there's a run not just on the banks but on the bond markets of the weaker countries. Let's talk about what you mean by that. So, Greece spends more than it takes in--that's the fiscal policy. By a lot. Which isn't unionized--there's no European fiscal policy. Each nation has its own fiscal policy, its own tax policy, it's own spending plans, its own tax revenue. They share a currency. And that's what you start off by saying it's probably not feasible from the get-go. But that's the way it was set up. What's going on in the bond market for Greece that making the life of politicians there difficult? At this point, everyone knows Greece will default, one way or another, whether it's legally called a default. If you are a bond holder, you will not get your money back. At first the talk was 30% haircut; then it was at 50% haircut. Some people even now are talking about 100% haircut. Meaning that if you lent money to the Greek government, you are not going to get any of it back. That's right. I would guess the best guess would be something like an 80% haircut. Meaning you get 20 cents on the dollar. So, how did that happen? Governance in Greece is extremely bad. There was this temporary myth that Greece had become part of the real Europe. There was a sense they would be taken care of. There was a sense they would grow more, that they would adopt political institutions similar to those in Germany, Netherlands, or the Nordic countries. Not all the way there, but that they would do enough of it to give it all a go. And expectations were very high. But in reality very few Greek sectors are competitive. Even something like tourism, which for Greece should be a no-brainer. If you compare what the Greeks have done for their tourist sector to, say, Turkey--hardly a previous paragon of efficiency--the Turks have done a much better job. You get a much nicer vacation in Turkey. It costs you a lot less. You are not paying euro-denominated prices. The [?] clubs are better, the foods are better--pretty much everything's better. And Greece just is not very much a competitive country any more. Yet, they were borrowing and spending money as if they were a wealthy European nation. And now it's turned out they are not.
6:55So, they are going to default in some dimension. You say it as if it is a fact. Is there any possibility that things would get "fixed" and is there any sense of what they might possibly mean? Let me ask that a different way. Is Greece borrowing money right now, daily? They are getting money from the European Central Bank (ECB). Private citizens such as myself, we are reluctant to lend Greece money because the rate that we would require is so high that they are not feasibly in a position to be able to promise to pay it back. So that market has essentially collapsed; they are on life support. So, the only question remains: If with the aid of ECB money, which I assume--is it a loan? Is it an injection? Is it cash? Well, we'll see. In theory it's a loan. So, with the aid of that money they are covering their obligations day-to-day for now. They are not able to borrow additional money in the open market. There is a possibility in theory that through fiscal stringency, through so-called austerity they could cut back on their spending. I don't think that's possible right now. Right, but that would be a route to avoiding default. They could in theory "get their house in order," make a series of political decisions which are very unpleasant, which is very difficult for any nation to do, and particularly maybe this one. They would spend less, raise more money, show that they were responsible fiscally; and in principle they could then borrow money again to close the gap between what they borrowed in the past and what they owe. Correct? Had they started a few years ago, I think they could have done that. I think now it's too late. So, what will be the consequences of that outcome, if and when they do "default"--if and when they do not cover the payments they owe on past obligations? There are a number of different things going on. The first is belt-tightening in Greece has led to a lot of riots and a lot of political turmoil; and it's not clear how stable the basic situation is. That of course hurts the economy all the more. And bank deposits leaving the country hurts the economy even further; so it's hard to see them recovering without a complete implosion of some kind and just starting over again. But the key to understanding the crisis is not really Greece. Because the Greek economy is about 2% or was about 2% of the Eurozone economy. A shocking number, by the way. There are 17 countries in the Eurozone, so on average you should be about 1/17th, not 1/50th. They were a very small, well below the per capita size of the rest of the zone. But if Greece were the only problem, I'm quite convinced that the wealthier nations would be willing to pay the bill, plug the hole, call it a loss, and get on with business. Imposing, perhaps, some restrictions on future Greek spending. That's right. And no one would be happy with that. But it wouldn't be that big a deal. The problem is you have other, larger nations in the queue. And once Greece is treated or resolved a certain way, the question is: Italy, Spain, Portugal, possibly Ireland--do you treat or resolve them in the same way? And those are much bigger. That's the real problem. Italy and Spain are why we are talking about this. Greece is a small problem. So, the idea being that if Italy and Spain had some sort of catastrophic encounter with this failure to meet their obligations, economic consequences for the rest of Europe and possibly the United States would be much larger. And Italy and Spain are too big to bail out. It seems the resources simply aren't there. It's trillions. And the question is: Who is it now that's contributing to the bailout? Well, not too long ago we spoke of Italy contributing to the bailout of Greece. But now Italy needs a bailout. So, when you hear talk about the European Fund--11%-12% of that bailout fund is supposed to come from Italy. And what we see is more and more countries being shifted from one side of the ledger to the other. There is even some talk of France having some serious problems. I'm not sure that's true. But that there is even talk of it. And the notion that at the other end of the balance scale, you have Germany and the Netherlands, and maybe Finland, holding up the accumulated weight of the other countries and the fiscal problems--it's just not going to work. So, we need the Martian Central Bank to intervene--a suggestion I've made in the past. Which some suggest is not plausible. And I guess the Chinese would be a variant on that. Let's find someone who is just not related to this somehow who can help us avoid pain. If the Chinese and the Americans, the Brazilians and the Turks, were willing to put up some money and maybe lose it, you could have a short-run resolution. But of course, they don't want to, either. Per capita income in China is much lower even than in Greece. And to tell the Chinese: You should bail out the Greeks--they are not idiots. And so on. You tell the story a little differently than I've heard it, so I want to ask you about one aspect we haven't heard about. One of the things that is opaque about this crisis for me is who these nations owe money to. It's often discussed as if it's left out of the picture--or it's central to the picture. It's one or the other. And it's hard to know which way to think about it. So, in particular, in the early days in the Greek crisis, my understanding was that much of the Greek debt was held by French banks. Correct. So that the bailout of Greece--again for those of you who are listening to the program know I'm really focused on creditors, the people who finance leveraged activity, borrowed money--the creditors of Greece are not the citizens of Greece. They are some of course, I presume, who bought Greek securities, Greek Treasuries, whatever their name is. But they weren't the French banks. So that rescuing Greece isn't really about rescuing Greece. Which, after all, if Greece defaults, the theory is that they can't borrow for a while. Which is not pleasant. Not fun to have to live within your means. But that's manageable in theory. But that Greek default would mean French bank collapse, which would mean French collapse, which would mean the banks that had lent money to French banks might not get it back. And this systemic, contagious, fragility argument is the real reason we have to argue about Greece. What do you think of that argument? Well, it's become even stranger than that, because the French banks, and a lot of the other banks, have by now sold a lot of their Greek securities, a long time ago to hedge funds, who are doing this as a speculative play. It may end badly for them. So, the problem in that particular case may not even be about saving the French banks. It's about saving the impression that you are still able to bail out Italy, Spain, Portugal, and other countries. So, one could imagine, you could let Greece go. The banks already have sold off enough that, assume that's manageable. But then it's the credibility problem. If people think you are not going to bail out Greece, you are not going to bail out Italy. Which would be a reasonable assumption. And then all hell breaks loose. So, it's the interconnected nature of these different countries. If you could somehow settle them on a one-by-one basis, you would have a much better chance of doing well. But everything you do is a precedent, and that one big reason why things have gone as badly as they have.
14:40So, I don't want to go too deeply yet into the American financial crisis of 2008, where the decision not to rescue Lehman Brothers was viewed by some as The catastrophic moment in the crisis. I view it actually as the Decision 2 Rescue of Bear Stearns of 4,5,6, 7 months earlier. But in this case, sticking with the current situation: Okay, so let's take the worst case scenario. Let's suppose that if we let Greece go that's a signal that we are going to let Italy and Spain to. Which, as you suggested a moment ago might be an unavoidable fact anyway. There's no secret as to how unhealthy Italy and Spain are. The magnitude of the asset/liability mismatch is large. It's maybe a trillion dollars for Italy--that's what I've seen--may be that for Spain, it's large. Everybody knows that. Everybody knows that it's very unlikely that a political compromise can be fashioned that would have, say, Germany, Finland, and the Netherlands, other third country on the pale of this enormous sum of money. Doesn't the world understand that already? And if indeed that expectation is realized, what would be so bad other than Spain, Italy, and Portugal, say, along with Greece, would be stuck with living within their means, and that people who lent their money would lose their money; and that would be a great precedent to the future that says: Don't lend money recklessly to dangerous places? We may see this a bit differently. I agree with a lot of what you said. But I tend to doubt if it would be a good precedent. Because if all of those countries go under, you have large numbers of banks in Europe being insolvent, and not actually a way to rescue them. So it becomes like 1929, where you have a very large deflation. You would have a second Great Depression, at least in Europe, possibly in other places. And I think the precedent people would take away is not: Boy, we showed them a lesson! They won't lend again! I think the lesson that would be taken away would be: Wow, that got so bad they'll never let that happen again. I understand that the political economy lesson could be uncertain, especially in how you interacted with voters and how others might behave. But let's take that dark scenario, that Great Depression argument. So, let's say all the banks go under. Let's say indeed it's not just MF Global, which is a player in this market that just went bankrupt, John Corzine's firm, perhaps with some alleged fraudulent activity. But certainly bad bets were made by that firm; they went under; they are going into bankruptcy, and that's that. Let's suppose it's not just firms like that--hedge funds with people who expected or which have a small chance of getting their money back--but rather large financial institutions, certainly in Europe, and possibly in the United States--so the French banks, maybe the German banks, maybe the U.S. banks, end up being, and this is not transparent, which is a huge part of the problem for me--but we don't know how much sovereign debt. Sovereign debt meaning issued by countries rather than companies. We don't know how much sovereign debt is held by these European and American banks. If it turns out to be a lot, and they don't get bailed out, there will be large losses; and those firms will become insolvent. And the next [?] we will decide to bail them out. And suppose we can't or the political will isn't there. And there would be a major depression, you said, in Europe. Because it will be like 1929, where bank failure leads to a contraction of the money supply. Can't the ECB counter that? Couldn't the Fed counter that here in the United States? Why is it? I do not understand why it is that the survival of individual institutions is central to our well-being. That's a key question. The United States is in a better position. So, let's focus on Europe here. It's quite possible that the ECB right now, legal issues aside, but quite conceptually, could pledge to support Italian banks, Italian debt, Spanish government, Portugal--whoever needed to be covered. And they would make a pledge. They would monetize whatever debts would need to be monetized to support all of those institutions. And if that were a credible pledge, and if you assume away some legal issues, that is the one thing that could potentially solve the crisis. But the problem is this: To pay for the mess, one way or another you need to transfer real resources. You could tax Germans and send the money. That's unlikely. You could do it through inflation. The ECB pledge is potentially an attempt to do the same thing to plug the gap by inflating. Now the people doing this, they sometimes doing this, they sometimes give the view that if the ECB is doing this and if they are credible, they don't actually need to inflate. They can keep the whole ship above water. Just by the expectation. Right. And there's some chance that's correct. But what you are asking Germany, Netherlands, Finland, to make a very large bet and back it and underwrite it; and it's far from obvious it's correct. I think at this point the ECB, the Eurozone, the European Union (EU), cannot credibly pledge anything. We don't even know if it will really be around a year from now. It will probably be around by the time this podcast comes out; but there's even a tiny chance there that it won't be. So, that's the only possible solution.
20:27Well, that's a different scenario than I had in mind. That's an interesting scenario; that's not what I meant. So, let me try to restate it. And I will now go back to the 2008 Crisis. The way that the United States, the 2008 policy makers, dealt with the 2008 crisis, is out of alleged worries that banks would collapse. They injected, they gave the banks money. They did a couple of other things, too. Obviously they guaranteed assets on the books of Bear Stearns; they allowed a bidder to come forward and take on the obligations that Bear Stearns had made so that those banks that had lent money to Bear Stearns wouldn't lose money, etc. But basically they decided to save institutions. What if they had not? What if they had let every institution fail--they had let Bear Stearns fail--of course Lehman might have changed its behavior, but let's say that would have been resolvable as well; Fannie and Freddie would have still gone under; AIG would have gone under. All these, maybe Goldman Sachs as a result, other firms connected to this concatenations and promises. I understand why that's bad if you are shareholder for those firms. Why do I, on Main Street, care about that? And the standard answer, I thought was: Well, this shadow banking system, these failures, would freeze up the credit market. Interest rates would spike. Commercial activity would go down. The money supply would shrink. We would be in a major deflation, and that would have a devastating impact on the United States. The Fed could counteract that. Instead of counteracting that ex ante by making sure it didn't happen to start with, it could let it happen, let the dominos fall, and inject liquidity into the system generally rather than in specific banks who have lousy management and should have been punished. Why wasn't that option--should that have been an attractive option? And in turn, should the European Central Bank, the ECB, shouldn't they now have the same situation? Let Greece fail, let Italy fail, let all these countries fail, which is a political mismanagement? The banks that lent them money, whether it's their fault or not, they are going to go out of business. Some might still be solvent--we don't know. Some hedge funds, a lot of them might go out of business. Too bad, not a big deal. Let the ECB counter that with expansionary monetary policy. Which is the lesson I thought we learned from the Great Depression. We didn't learn the lesson: Don't let banks fail. We learned the lesson that when banks fail, make sure the money supply increases. There is a difference here between credit and currency. So, if all these European banks are failing, you are talking about injecting liquidity into the system. But that system is collapsing. Loans aren't being made, loans are being sold, margin calls are being made; so everything is collapsing into this vortex of the black hole. The central banks or the ECB, they still could just print currency. But currency is no substitute for, say, what we call M2. Currency is not credit. To have a world where credit is gone and you have a lot of currency, you have a weird mix, a total collapse of economic activity, including the ability of firms to meet payroll; and maybe even some odd hyperinflation. But I don't even think you get that far. The key point here is the United States has a credible Federal Deposit Insurance Corporation (FDIC); but a lot of the European nations do not. We do right now. We did in 2008. So you have everyone essentially in a lot of countries, maybe not every country, losing their bank deposits. And even if one thinks there is something the ECB could do to equalize that in terms of the flow of nominal income, nominal GDP, I'll just predict the political equilibrium is that those banks will be nationalized rather rapidly, before we even get to these extreme scenarios. And this indeed may be what happens: That Europe moves from what it is now, to when association, when the weaker countries, have nationalized all their banks and keep their banks afloat with some kind of wealth tax. To me, that's a pretty ugly ending. But that may be what happens. That's what we are looking at. Not that there is some kind of even process of adjustment, that some banks go under and you keep up the flow of nominal spending. Credit markets are already collapsing in these countries, and we are not even at the worst part of the crisis yet.
24:28Is it imaginable that Greece could nationalize its banks without having any meaning, without leaving the Euro? Wouldn't they have to effectively do that? Most likely. And right now, the Greek government is itself such a bad credit risk, the idea that the Greek government has nationalized the bank is maybe a step backwards. Maybe you'd rather have the bank nationalize the government. So, that's not an answer for Greece. And Greece is also not running any kind of primary surplus. What do you mean by primary surplus? They are borrowing just to pay back just a lot more borrowing. So, if they were cut off from credit markets, cut off from the ECB is a better way of putting it at this point, they would have to cut government spending by another 8-10%. And again, I think that's not possible. No matter what one thinks is the proper role of government. There would sooner be a coup or riots; somehow that process would collapse before we got to the end game. So there is not some easy scenario of Greece being cut off and just toddling along. It would be very ugly. It's a strange thing, really, when you think about it. If you or I had to take a pay cut, which is unlikely being tenured here at a state university--it's possible, not likely but it's possible; we've had some semi-versions of it recently here in Virginia. But let's say we had to take a pay cut, or we lost some outside source of income; and our expenditures might have to fall by 10%. Ten percent would be some unpleasant set of circumstances, we'd have to make within our family; we'd sit down with our family members, talk about what we cared about. A 10% cut probably wouldn't require me to move. Which would be a dramatic change. You'd eat out less. You'd cut back on extravagances. Ten percent is unpleasant. But it's not even life-changing. Because you wouldn't have to move to a different house, in a different school system. Those would be dramatic changes. We're well above the median, of course. But governments don't work this way. That's what's fascinating. Because an 8% cut is not a big cut. A 10% cut. And yet, I agree with you--I think the political mechanisms to achieve that might not exist. Not for Greece. I'm not sure they exist just for us in the United States. It's interesting to compare some of these countries to Iceland. Iceland had a very bad financial crisis, and they took a different route. They didn't do bailouts of the banks; and they could get away with this because Icelandic banks are so small in the global scheme of things, you don't knock down any larger house of cards. And I think Iceland, within the country, there was enough trust that they could do this; and the Icelandic government could tell the people: You are going to have a hard 3-5 years, not be buying so many fruits from abroad; there will be capital controls; the exchange rate will be a problem; but you need to trust us that this is best. I don't agree with everything they did in Iceland, but in fact they managed to do it. There are not riots in Reykjavik. It's not in that sense a political problem. It's a very small, homogeneous country. With a high level of trust. There are governments which can take radical steps which other governments cannot. And I do not think that Greece could do its own version of Iceland. Not at this point. Let's compare for the moment England to the United States. I find it fascinating--we're in the middle of a debate over what to do with America's fiscal deficit. The Supercommittee has just given up in the last week or so. I find it remarkable that in a time when nominal spending, measured in actual dollars, not corrected for inflation, has risen something like on the order of 50%--50% in the last 3-4 years--that a 10% cut is considered shocking. We're trying to get a cut in the rate of increase; we're trying to close the gap with taxes. Many people are arguing that we should not cut spending; we should increase tax revenue. Of course, many people have many agendas. But a 10% cut would be a real cut--a cut in actual spending, not the growth in spending--is somehow seen as Draconian, in a time when we've just had a massive increase. Which is a fascinating real aspect of our political system. And yet in England, have they had some actual cuts? They call it austerity; I don't know what they actually did. Did they really cut anything? Did they cut the rate of increase? And why might there world be politically different from ours? In England, they've done some of the cuts; others are in the works; they are scheduled. They may not follow through on all of it. But keep in mind, their system does not have the same checks and balances which ours does. You govern through Parliament; you can't quite do what you want, but you can try to do what you want and then there will be a referendum on it at the next election. So, England continues to get itself into trouble first; and they tend to get out of trouble first. Thatcher came before Reagan. British socialism came before a lot of the U.S. interventions. So, they go in and out of trouble more rapidly, both ways. Our system has a lot more inertia. But inertia right now is not a good thing. Most of our history it's been our friend, but it's not right now.
30:24What's your best guess, which maybe is an unfair question, as to how this might play out in Europe, going back to our PIGS scenario--Portugal, Italy, Greece, and Spain. Maybe a second double "I" in there for Ireland. What might happen? Here's my most likely guess. But when I say it's most likely, it doesn't mean I think its probability is 50%. I just think it's the most likely of all the different scenarios. Greece, there's simply no way out. There's nothing really to discuss there. It's all about Italy and Spain. My guess is that Germany will not step up to the plate. Those countries will be in informal default by Christmas time. At some point, to pay their bills, not right away, but as more credit markets unravel, as more economic conditions unravel, as aggregate demand weakens, they will be faced increasingly with the option of: Do we go back to creating our own currency to pay our bills, to pay our state employees, to get things back in order? And as that talk increases, there will be further runs on Italian and Spanish banks, which will force their hand. There will be capital controls introduced suddenly. And a return back to earlier currencies; and they will leave the Eurozone; and they will have 3-5 years economically speaking of being a total mess. For Portugal, Spain, Italy, I think that is likely. For Greece I think it is nearly certain. For Ireland I am genuinely unsure--I think they have a real chance of sticking it out in some way. I'm not sure. And that in my view is the most likely scenario. Let's continue to unfurl that story. So, they reinstitute the Lira, the Drachma, the Peseta, etc. and they are not going to very happy places economically, politically. Because there is going to be a lot of uncertainty about the reliability of that currency outside of government employees. All the contracts written in Euros for international trade--how are they honored? External debts in Euros--how is that honored? A lot of legal messes that won't be cleared up very well or very quickly. Correct. So the joke used to be: When America sneezes, Europe catches a cold. I would suspect that when Italy, Spain, and Portugal sneeze, Europe gets pneumonia and we are going to get a really bad flu. Right? That story, which you suggest is, although not likely, is maybe the most likely, is a very depressing story. Correct. I think it's not well understood what would be the implications here. Keep in mind it at least seems that European banks are significant net suppliers to our shadow banking system. To a very large extent. It may be more important than the so-called savings glut coming from China and Asia. So, to the extent European banks have trouble, have to sell assets, need to raise capital, need to scale back, they will presumably be restricting a lot of their activities. They may shrink in size; they may be partially or totally insolvent. That will be a negative shock to our shadow banking system. By shadow banking you mean investment banks--things other than FDIC-insured. Short-term lending among financial institutions. Now, if European banks are pulling out of that, can U.S. or other banks step into the gap and keep that running smoothly? It's possible. But again, this is not something happening during calm times. This would happen with a lot of other uncertainty being carried along as baggage, and I think there's a pretty reasonable chance it would be a very negative financial shock for us, quite possibly larger than Lehman Brothers or you would say Bear Stearns, however you wish to slice that cake.
34:33So we learned or are continuing to learn, unfortunately, of a wide variety of activities the Fed took in the 2008 period that not only subsidized American institutions by a significant amount, but foreign banks as well. If you are sitting in the chair of the Federal Reserve Chair, what kind of decisions is he going to have to try to make in that scenario? They are not very attractive. It's a bad place to be, if you are Ben Bernanke. Vacation, probably--stress on the job, more time with the family. Well, here's one thing he could do; one could debate if it's a good thing or not--but basically, buy up all of the bonds of the weak European countries which are currently on the books of the U.S. banks. And support their value that way, and also protect U.S. banks. Like the original TARP plan, which was to buy up toxic assets to keep the balance sheets of banks solvent. It would not be comparable in size or directness. It would be one way of aiding a bailout, but I'm not sure it can be enough to matter. And then there's the very real issue of if those countries are going under, the Fed is holding the bag. The buying they did in this country worked out fairly well. Well, so far. But it's less clear that loading up on Italian periphery debt is going to work out as well, or be as popular if it doesn't go well, because citizens are aligned between helping out Americans and helping out foreigners, rightly or not. Who would pay a price for that if it didn't work out well? Right now, one of the things that bothers me when the Fed guaranteed the assets of Bear Stearns, $29 billion, later $32 billion, to get JP Morgan Chase to buy up the obligations of Bear Stearns and "own" them, it was said at the time: We might even make money on these. They are at a depressed value now, because the markets are illiquid and it's a thin market and people are scared, but we don't know what these are really worth. They might even be worth 100 cents on the dollar. That turned out to be probably not true; they weren't worth 100 cents on the dollar. Do you think it's strange that we don't know what those are worth? We don't know, the Fed has bought about I think $2 trillion of Fannie and Freddie obligations. How am I doing on that as a taxpayer/investor? I have no idea. You can't look that up anywhere. There's no transparency; it's kind of a secret. If it's not a secret it's close to one. So, let's say they do what you just said--they buy up all this paper from Europe; everybody breathes a sigh of relief; there's a lot of bloggers and pundits who say this was really risky and we're going to lose a lot of money. Who is going to pay a price for that? Where would the political costs of that be? It seems like there would be a lot of political pressure to do that. I think on this issue we disagree. The ECB has been much slower to buy things than was our Fed. Our Fed can act more or less immediately. You need to make a few phone calls, get a few people in a room; but things would run very quickly. You sit down one Sunday, everyone's panicked, and things happened. The ECB cannot really work that way. But I'm saying, the Fed, if they do that, wouldn't that turn out well politically for the Fed because the price, I don't know how it would get paid or who would get upset if it didn't turn out well. Isn't there going to be essentially pressure for the American Central Bank to do something like that? What's the downside, politically? Well, the downside is if those securities really do not pay off, the Fed to some extent needs to be recapitalized with taxpayer money. That's the potential downside. And who would care, besides the taxpayer? So, Ben Bernanke would lose face. Would the President of the United States at that time, whoever and whenever it is--I don't even know when it is. I'm just thinking about the political forces. It would be very unpopular. But it may be better than risking a second European Great Depression, which would also be bad for the U.S. taxpayer in a number of indirect ways. But I doubt if our Fed right now has the political capital to do enough to make a difference. I think you are probably right.
38:44Let's turn to an optimistic scenario. Can you imagine a scenario that isn't as bad as the outcome you think is most likely, and what might that scenario be? It's hard to think of it, but I bet you can. Here's the most optimistic scenario. Again, Greece--write that off. They are basically in default, even though they are not in a legal sense. The optimistic scenario is Germany gets its 'druthers together and sits down with a few other countries and says we are going to reform the ECB. Probably in the meantime the ECB has to act illegally and the ECB will guarantee a lot of markets and it will be credible and there will be an absolutely strong pledge; and it will be believed; and you will have countries like Italy, Spain, still with a lot of growth problems, a lot of capital market problems; but the bleeding will be stopped. There won't be any big implosion or explosion. And then you could deal in the longer term with the structural problems and grow your way out of it. I don't believe in that scenario, but it's logically possible. There's some chance it can happen. I don't think the Germans are willing to try it, and also if they tried it, it would work, but it could possibly work. And if they tried it, though, the people of Germany paying a price--it's very hard for them to extract anything in return. They would have to get some sort of ECB governance change, European Union governance. Because what we are really talking about here is a loan that can't be paid back. Essentially it's saying: We're going to give you something now in hopes that you'll get healthy; and you'll do something for us later. And right now the only thing they can do for them later is to say: We won't get sick. That's not so good. There was a recent poll on Eurobonds. This is not exactly a Eurobond but it involves a similar kind of commitment. And the German citizens were against that something like 4 to 1. There's also an issue whether this way of committing resources is Constitutional. It may be illegal for the ECB; it may be unconstitutional for Germany. You have 17 nations, each one of which has some degree of veto power. We saw this with Slovakia and the European Fund. It's like 17 different branches of government, each one has typically a coalition ruling and its own branches of government. And they have to in sufficient numbers, sufficiently rapidly, agree to something decisive. It's not like Ben Bernanke and Tim Geithner and Barney Frank getting together on a phone call downtown here. I just don't think it could happen. And if you tried to get it to happen, you could get the worst case scenario, which is that you start doing it; you get some of its bad effects in terms of moral hazard, cutting off reforms, inflation; but you can't see it through and you postpone an even bigger explosion when at some point the German taxpayer stands up and says: Enough is enough; we're not going to do this any more. And the support for the policy vanishes. And that, of course, is why Germany is reluctant. With all these obstacles they just have to doubt whether they can see it through, even if they were willing to pay the price. Which is why you don't put that as your most likely scenario. But it is possible.
42:01Germany recently tried to borrow some money in the open market and it required a higher interest rate than the previous entry by Germany. It was a small increase; it went from something like 2.63% to 2.81%. You view that as quite significant. You were joined this morning in a Bloomberg column by Simon Johnson, co-author who argued that this is the end of the Euro. Period. It's over. What information did that "failed auction" as some have described it--what's your analysis of what that tells us and what are its implications? Of course, it's still a low rate. I wish I could borrow at that rate. So, I wouldn't quite call it a failed auction. Here's how I took that number. The market is not saying: We are afraid about Germany. The market is saying: We're afraid the whole deal collapses, and when the whole deal collapses, if you've bought Euro-denominated bonds, even if backed by Germany, there's something messy; there's a re-denomination issue, there may be legal judgments, there may be tie-ups, there may be a period of interim uncertainty. And it's not that you are doubting the Germans will pay you back. But I think some parties are just saying: For the time being we want to stay away from the whole mess, because we've actually begun to doubt that it's going to be around in its current form. That's how I read that. And some of that is just pure inflation risk. It could be inflation risk; it could be Germans' underwriting someone else's credit risk. But I think more likely than not it's simply the risk that there will be a lot of chaos in a way which is hard to quantify, hard to plan for. Like Knightian uncertainty [Frank Knight], in Austrian economics lingo. I don't need to buy more German bonds today; I trust Germany, but I'm going to buy something else today. And that's not unreasonable. Or, if I'm going to get a low return, I'd rather get a low return holding a U.S.-dollar-denominated allegedly safe asset rather than this one. But once that kind of thinking kicks in, even if there is no mistrust of an actual repayment from Germany, if you are Merkel leading Germany, you have to take that into account. You can't just play games with your country's credit rating and bond auctions. And I think it's a sign to the Germans, also to the Netherlands, saying: Look, are you really up for this? And what must they be thinking? Nothing they can say in public, but I think to us it's obvious. So, part of the unsustainability of this situation, which you argued and others have argued again on day 1, which was a currency union that was not coordinated with fiscal policy and a unified electorate. So, you didn't create a Europe. Right. A Euro of the currency of something called Europe, had a governing body, a European Parliament, European spending activity, European tax revenue. Instead we have these 17 different nations. The public choice aspect of this, the political economy, is pretty stark. There's an enormous tragedy of the commons/free rider problem here. The Prime Minister of one of these relatively healthy countries--Germany, Netherlands, Finland--you certainly don't want to impose costs on your own citizens to bail out people who have been irresponsible. The famous example--I think it's true--Greeks retire at 52, which is much lower than the German retirement age; the idea that you are subsidizing the pensions of early retirement Greek citizens is not a political winning strategy. And tell this to the poor Slovakians, whose standard of living is well below that of Greece. So, there's no political incentive to do that. And yet, the bus you are all on is going over a cliff. You don't have your own parachute. You may end up less damaged, with fewer limbs lost than the other folks, but as a politician, that's not much consolation. You are going to get thrown out of office. It's a rock and a hard place. What might those conversations, if we could listen in, between Merkel and her colleagues in the stronger nations--what are they saying to each other that could possibly be productive? I think they are going through every possible scenario. But one thing you see with all of these developments is the way things used to be done in the EU is Germany and France would get together, have a two-nation phone call, possibly with some preparation with some other countries, and then present it to the others, not quite as a fait accompli, but: We're in charge here. In this matter, it seems you have Germany and France on opposite sides. French banks are extremely vulnerable and France is in danger of losing its triple A rating. It probably will lose it. Germany is seen as someone who can pick up the bag for France. So it's not that France and Germany can get together and plot out the answer in advance and shove it down the throats of the other countries. They are on opposite sides, and the customs and conventions for resolving the disputes when Germany and France are not working together are just not there.
47:39So, in another time, and maybe this time, these kind of stories wouldn't just lead to a really bad year for an economy. They'd lead to revolution and a war. We assume that France and Germany, because they've been at peace now for 65 years, that that's what we're used to. They don't have a great history before that. A series of brutal, horrifying wars. You want to get dark on me and tell me a worse scenario than the likely one that could end that way? On that question, I'm not at all a pessimist. I think in France and Germany, certainly all of the smaller countries, there's a real belief in the European project; and if this in some way collapses, which I think it will, within 5 years' time I think there will an attempt to pick up the pieces and do it better. They still then may not get it right. The only country where I see a chance of a politically nasty outcome is Greece. And that wouldn't matter very much for Europe as a whole. And the other countries--I don't want to call myself an optimist, but I think in the medium term they'll be okay. They used to have their own currencies; there's a very bumpy road to get back there. Once they are back there, they've lived with that world; it will be fine. They'll need a little bit of time to get over the split, but I think a lot of European integration will continue. It makes too much sense. I'm more worried about the transition period. We don't know how ugly it will be, if that's indeed the way it plays out. I look at the United States which has now a fairly long history of Constitutional governance; and yet when I look at the inability to find common ground in the current political map at least for the impending train wreck of Social Security and Medicare, it's a bit demoralizing. I don't see the mechanisms for compromise and muddling through that have worked in the past. We see, in the United States and in these countries as well, European countries, a set of promises made by the governing class that are not sustainable. The normal way you deal with that is you change your promise. That's the way nations deal with that. I don't see the political will, the structure, to deal with that in a way that isn't going to lead to the kind of situation we saw in Greece with the riots. We see it in France every once in a while over labor issues. In the United States we've seen Tea Parties and Occupy Wall Street folks on the opposite ends of the political spectrum showing a lot of displeasure with the way things are going. There's a little bit--it's a real test for democracy, democratic government in general. It's not clear that they're going to make it. Again, I'm much more optimistic. The two key countries are France and Germany. For a long time both have had a real rule by consensus. Not always on good policies, I would add. That governments in those countries are trusted; maybe in some ways trusted too much. Also in Germany there is a sense of sacrifice having been necessary to reunify the country to recover after the war. So, if there are outcomes where France and Germany need to take hits and have lower standards of living, I'm really pretty confident they will manage that. Of course, it will be painful. But I think European government is extremely stable. No non-democratic force has a credible way to solve the problem. Come along and say: After fascism we won't cut your benefits. It's just not there. And if France and Germany are on board, it's not as if the Netherlands will launch a war against Austria. So, I think Europe will remain liberal Europe--at least the Western part. The counterpart is fascism wouldn't be that or whatever the alternative would be wouldn't be that rational. They'd appeal to nationalism as it has in the past. I would worry most about Hungary on this account, because they are in a very bad financial crisis themselves. They would be caught in the fallout. They are not in the Eurozone. They would be like their own podcast, I suppose. But can I imagine a country like Hungary or other countries in the East going fascist--I absolutely can. I'm not predicting it, but I think that's entirely imaginable.
52:20So, one of the disheartening aspects of all this--there are many--is: What lessons are to be learned? People of course argue about that the way they argue about every aspect of this. I want to read something that Scott Sumner wrote recently, which I found rather remarkable, and get your reaction to it. This was on his blog, Money Illusion. He wrote:
Banks pour huge amounts of money into one particular asset class. They are encouraged to do this by public policymakers, although there is some dispute about whether that was the main reason for their decisions. These assets have a long tradition of doing well, although a close look at the evidence would have raised red flags. The asset market in question suddenly takes a big dive as default risk increases sharply. This drags down many large banks, forcing policymakers to provide assistance.

What have I just described? The sub-prime fiasco or the PIGS sovereign debt fiasco? I'd say both. I'd say these two crises are essentially identical. (I should clarify that by "essentially identical" I mean in essence, not in every detail.)
It was a great post by Scott; I remember it well. One lesson of both episodes is that banking regulation doesn't work very well. But I don't say we have a clear lesson as to how to fix it. What might we do? It seems to me--I suggested a minute ago that democracy is undergoing a serious test, that the Frederic Bastiat insight that the State is the great lie that we can all live off each other, is impossible. I think democracy is under a great test; and I think the role of our financial sector is under a similar test. We've sort of had in the back of our minds that the financial sector allocates capital and we regulate certain parts of it quite heavily to reduce risk to depositors and others. It seems to have run amuck. The political interface between the financial sector and the political class. What might we do to correct that and get it back on track to something a little healthier? My current view is we are faced with a future where bank runs are a common occurrence, as they were in the 19th century, if only through shadow banks; and we will live with it and flounder in search of a solution. I know that that's not answering your question, but I think there's more credit out there than can be guaranteed. The age of triple-A is essentially over, in most places, for most times; and the financial system is in some few ways broken. And we are going to suffer through it. We are going to have some fantastic growth coming up in some key sectors, and let's hope that it's worth the pains we are going to suffer through. Any ideas on how to make that pain less likely? And suggestions on how? My preferred solution is to limit the power of the Fed to finance and ease the pain along the way. I might be wrong, but that's the direction I would head. I would try to get a little less discretion and a little more rule into the Fed's behavior, whether that's by eliminating it and replacing it with something else, which is politically out of the question right now but might not be in a few years, or by restricting its charter in a very different way than it's currently set. Where do you think we should go? I would do everything possible to limit financial leverage in the private sector. Now, I don't think that's feasible, either. Limiting financial leverage means you take a macroeconomic hit in the short run, and of course no politician wants that. But my view, which I'm pretty sure is different from yours, is that we are not close to a position of committing to no bailouts. There will be bailouts. You have them be less frequent and less painful by having less leverage. Having the private sector players have more skin in the game. But to really increase the capital requirements on these banks--in a way it's crazy. Europe's trying to do this right now. Telling their banks, through Basel 3, something like: Come up with $700 billion in capital. That's from a month or two ago. It's probably a worse number now. Now, no one is against those banks having another $700 billion in capital. But you and I are sitting here talking about how possibly they are all insolvent. So, it's quite absurd. It's the ultimate "Let's assume a can opener"-solution. And how you get from where we are to a situation of low leverage, well-capitalized banks--I just don't know how to do it. But where I would like to be is have tough restrictions on leverage; a lot of skin in the game on the capital side; and not regulate too much else. And realize bailouts are going to occur. And we'll see what's going to happen in the week to come.