Wisconsin Public Television University Place Global Hot Spots  Mark Copelovitch The Euro Crisis  November 18, 2011 UP662  cc >> Sarah Schutt: Welcome to today's Global Hot Spots lecture. Our topic today is The Euro Crisis: Greece, Ireland and the Future of the Single Currency. Our speaker today is Professor Mark Copelovitch from the Department of Political Science at UW Madison, and he is also with the Robert La Follette School of Public Affairs. Professor Copelovitch studies and teaches international political economy and international organizations. He is the author of the book The International Monetary Fund in the Global Economy: Banks, Bonds and Bailouts. He's a graduate of Yale University and Harvard University where he received his PhD in 2005. We are delighted to have his expertise and him here today. Please join me in welcoming Professor Mark Copelovitch. [APPLAUSE]  >> Mark Copelovitch: Thank you very much. Can everybody hear me? Great. 

Thank you to Sarah and the WAA for having me here. No, you can't hear me?  How about now? >> Better. >> Better. Okay. It's a pleasure to be here, although the last time I was here I had the thankless task of explaining why the global economy had caught on fire in about 60 minutes. This is sort of an equally thankless task, but I'll do the best I can. So I'm hear to talk today about what's going on in Europe in the eurozone. The title is Greece, Ireland, and the Future of the Single Currency. The question mark is there because we actually are at a point now which I really never thought we would be and the Europeans certainly never thought we would be in which is the question of the sustainability of the single currency of the eurozone. And we'll sort of get to that in what keeping the eurozone together might entail and whether or not that is both economically and politically sustainable. 

But I want to start with a couple pictures. You'll see that I like cartoons and pictures. So, flashing back 10 years. This is the eurozone in 2001. This is Christmastime in Paris. And you see the sort of decorations on the streets of Paris in the shape of the eurozone, and the celebration of the culmination of 50 years of European immigration. The adoption of the single currency, something that started as the European coal and steel community in 1951, became a free trade area in large to include most of Europe and now we're adopting single currency. This is sort of the culmination of post-war European immigration. In a very celebratory mood. And we flash forward now 10 years later, and what we're seeing is riots in the streets of Greece, demonstrations against the European Union and the International Monetary Fund, dissatisfaction, particularly on the left of the political spectrum, with the austerity programs that are being imposed on the PIIGS countries, Portugal, Ireland, Italy, Greece and Spain, in order to remain part of the single currency in order to deal with the debt crisis. 

So the question, the big question is, how did we get here and what does the world look like going forward? I'm going to drag us back into a little bit, as I do with my undergraduates, a little bit of economics and political science on the theoretical side before we get to the interesting policy questions. So while it's true that the eurozone is part of this broader project of the European Union and European integration over 50 years, at the core, what we're talking about is a group of countries that have adopted fixed exchange rates. They've fixed their currencies in value to each other. So I want to talk for a second about what that is and what that entails for a economic policy, what a government must do in order to maintain a currency peg. So if we think about the language here as one of exchange rate regimes, what that means is whether the currency is flexible or floating. That is, whether the price of the currency, the dollar, the euro, the yen, is set in global markets by supply and demand. When you pick up the Wall Street Journal or the Financial Times, you see every day the table of exchange rates, and the dollar rises and falls based on a whole lot of things. That's a flexible exchange rate or a float. What we're talking about with the euro is a peg or a fixed exchange rate where a government, or in this case a group of countries, have decided they want the value of the currency relative to other currencies to be stable. So the government is going to say we want one pound to equal X number of dollars, we want one Deutsche mark to equal X number of lira, and it's going to try and maintain that peg. 

Now that involves the government using various policy levers because market demand, supply and demand may want to push that exchange rate either up or down. So what is it that a government does? Well, the easiest thing a government can do, if the markets are pushing the value of its currency down, people are selling your currency and buying another currency, the government or the central bank can directly intervene in the foreign exchange market. The Federal Reserve under Ben Bernanke does this periodically. The Japanese government has been doing this extensively as the value of the yen has appreciated in the last year and a half. The central bank or the government can intervene directly. The more common and sort of more widespread way that this is done is to use macroeconomic policy. If people don't want to hold your currency, for example, if people think that there's going to be a recession in the United States and not one in China so the value of the dollar starts falling, the government can use monetary policy. If we raise interest rates and increase the returns to holding the dollar, then the dollar's exchange rate might rise or it would be easier to maintain the currency peg. The other thing you can do is to use fiscal policy. You can balance the budget. 

And what we're seeing in the countries right now like Greece and Ireland that are facing problems of maintaining their fixed exchange rate and the market's wondering whether or not they're going to stay in the eurozone, this is precisely what they're doing. The interest rates are going up on their bonds, the markets are saying you need to offer me more return in order to hold your debt, and governments are engaging in massive austerity programs, balancing budgets, etc. People want to know that you're not accumulating more and more debt to the point that it's unsustainable. So this is what it looks like graphically. You can ignore the labels on the bottom. The example here, just a sort of general example, if we think about the United States and the Mexico and the dollar and the peso. So in a world of floating exchange rates, the price of pesos in terms of dollars, or here it's actually dollars in terms of pesos, would be the intersection of the supply and demand curves. Now let's say that there's a boom in the US economy and all the sudden all of us want to buy more imported goods from Mexico. What is that going to do? It's going to boost demand in the market for Mexican pesos. In order to buy Mexican goods, we need to sell our dollars and buy pesos. 

So in a world of floating exchange rates, the market will move. The peso will go up relative to the dollar; the dollar will fall relative to the peso. If you were adopting a fixed exchange rate and you don't want to the currency to move, this is where the government has to do something. So if you remember back to your introductory economics courses from a few years ago, what we need to do is shift out the supply curve down to here so the exchange rate stays the same. Now, how does the Mexican government do that? Well, this is the easy case. They control the supply of pesos, and they want to put more pesos out into the world. They go to the US bond market. They buy US treasuries and in exchange they're putting their money out into the global economy. So what that's going to do is drive the exchange rate back to the earlier equilibrium. The tougher case is the case where things are working in the other direction which is what the European countries are dealing with now. 

You can think about an increase in the supply of Mexican pesos. Let's say the Mexican government is printing lots of money, trying to stimulate the economy, and there's a lot of inflation. And so people start to wonder, the markets start to wonder about the value of the peso relative to the dollar. As the supply of pesos shift out, the peso is going to fall in value. Well, if you don't want the peso to fall, what you need to do is increase demand for the peso back up to our earlier exchange rate price. That's a more difficult task because you have two ways to do that. One is you can buy pesos. What do you buy pesos with? You buy pesos with your foreign exchange reserves which are usually dollars or euro or yen or sometimes even now renminbi from China. Well, you don't control the supply of your reserves. The Mexican government can turn on the printing press and create pesos whenever it wants. 

It can't create dollars. And if this pressure, downward pressure on the peso continues, eventually you will run out of foreign exchange reserves. This is what happened in the 1980s in Latin American countries. It's what happened in the 1990s with east Asians countries. The classic currency crisis is a government trying to defend a currency peg at a value the markets don't believe is sustainable. And eventually you run out of your reserves and are forced off the peg. The other way you could do it is to raise interest rates. So if I don't want to spend all of my reserves, if you aren't willing to hold the peso at 5%, what if I offered you 7% or 9% or 11%? The problem there is as you raised interest rates, you're slowing down the economy more and more and more. People pull money out of the investment and put it in the bank. It becomes harder and harder to get auto loans and home loans. 

The economic growth rate goes down. The unemployment rate goes up. So in theory you could do that indefinitely. A government from a technical standpoint could raise interest rates to 500%. To sustain a currency peg, that's politically unsustainable. And what we're getting at in the eurozone that I'll try and convince you by the end of the talk is most of the problems here are not technical economic problems, they're problems of what is politically sustainable, domestically within the countries in the eurozone but also as a group. So that's the sort of mechanics, your basic what is entailed in maintaining a fixed exchange rate. There are costs and benefits to fixing versus floating. So if we think about what the benefits are. The biggest one, the one we most often think about is currency stability if you're very dependent on international trade. 

If you think about trade across borders or finance across borders, there's lots of kinds of risk internationally that you don't have domestically. One of the big ones is currency risk. If currencies are fluctuating around about 10%, 20%, 30%, 40%, it's going to be hard to invoice trade. Over time, international investors are not going to want to lend. So the benefits of a fixed exchange rate, particularly when you're a group of countries that trade a lot with each other like the eurozone, currency stability is the primary reason to have fixed exchange rates. The second reason is what's known as a nominal anchor for monetary policy, which is a fancy way of saying fixing the currency to have low inflation. So if we pick a country at not so random, say, Argentina from 1975 up until about 2000. Argentina, periodically, had very, very high inflation. Not what we think of in the United States as high inflation, 7%, 5%, 4%. 50%, 100%, 250% inflation. 

Inflation, why is it caused? The government borrows, it runs deficits, it prints money, it cuts interest rates to try and stimulate the economy. If you're maintaining a fixed exchange rate, which means you have to hold a lot of foreign exchange reserves and keep interest rates high, then you can't have high inflation. So classically what has happened is lots of countries, say, Italy relative to Germany, will fix against a low inflation country which means they have to adopt the interest rate and monetary policy of the low inflation country. This is known as importing inflation from abroad. So those are the two big benefits of a fixed exchanged rate. Currency risk reduced for international trade and having low inflation. That sounds great. The costs are over here. The first cost is the susceptibility to currency crises. And if you think back to the chart that I just showed you, as long as you're pegged, the markets can wonder how long is that peg sustainable? Can you maintain the economic policies needed? Do you have enough foreign exchange reserves? That question is always hanging out there. 

And it's very frequent and much more common to have currency crisis with fixed exchange rates than floating exchange rates. If there's a floating exchange rate, the dollar may fall by 40% but it might do that over a 10-month period. If you hold on to a fixed exchange rate too long, as, say, Korea did in 1997-1998, once you're forced off the peg, that might happen in a two-week period or even faster. So you'll have a currency crisis. The bigger problem is tying your hands on things like monetary policy and deficits and interest rates. Politicians like to get reelected. They tend to get reelected when the economy is doing well. And it's very difficult to sustain a fixed exchange rate in the face of very high unemployment and very slow growth. So politicians and their economic policy underlings like to cut interest rates, print money, engage in deficit spending as ways to try and stimulate the economy. Classic Keynesian economic stimulus, part of the debate we've been having in the United States about what to do with our current recession. 

Well, you can't do that if you want to maintain a currency peg. That international commitment to the fixed exchange rate is incompatible with what's known as domestic monetary or policy autonomy. So those are the big costs. This is the main reason why the United States has not adopted a fixed exchange rate. We are a very large economy, we trade relatively less with the rest of the world than a lot of smaller countries, and no president of the United States is going to want to tie his hands on monetary policy completely by pegging to the euro or the yen or the renminbi or anything else, particularly in the face of a very severe recession. Now, governments realized this and most of them want the costs while they're also minimizing the benefits. So in reality, if we look around at what type of exchange rate regime countries have adopted over the last 30 or 40 years, most countries are doing something in the middle. I would say about 10% of countries in the world purely let their currency float. Like the United States. Probably about 20% have a very hard peg like the eurozone. 

And most are doing something in the middle. Most of them will let the currency float unless it falls by too much. Canada has done this against the US dollar for most of the last 30 years. If the Canadian dollar falls by more than, say, 15% or 20%, then you intervene to try and move it back to equilibrium. Or you could have something like a crawling peg. This is what Mexico did in most of the 1990s. They would fix against the dollar and then every 6 months to 12 months they would devalue by about 10% and fix again and then devalue again and fix again. So it's sort of trying to have your cake and eat it too, if you want to think about it that way. So the question is, how do countries decide? How do you decide and weigh these costs and benefits and make a decision? The classic story in economics comes from people like Robert Mundell, Canadian economist at Columbia who won the Nobel Prize in 1999 for his work on the economics of exchange rates. And the classic story is not a political story but a purely economic story having to do with a set of economic factors known as the optimal currency criteria. 

And it's these four things right here. So you might want to fix the exchange rate if you're more trade dependent. If you're a small country heavily dependent on international trade, that benefit of currency stability relative to, say, the United States which is a big country less dependent on trade, is more important. Similarly, if factors are very mobile, factors are capital and labor, sometimes land also, the things that go into economic production. If factors are mobile across borders, particularly international investment, then again the benefits of currency stability outweigh the costs of sacrificing monetary policy autonomy. The big one as far as the eurozone is these last two here: the vulnerability of economic shocks and the correlation of those shocks among the members of the eurozone. So if you were very vulnerable to shocks, what that might mean is sometimes unemployment will be 5%, sometimes it will be 10%, sometimes growth will be 9%, sometimes it will be negative. You want to retain that policy autonomy to raise and lower interest rates, engage in deficit spending to try and counteract the shocks that you're being buffeted by in the global economy. And if those shocks are correlated with other countries, then maybe you can peg to them. If you're all booming at the same time and you're all in a recession at the same time, then fixing your currencies and adopting the interest rate necessary to maintain that currency peg makes sense. 

If Germany is booming when Greece is in a recession, then we have a problem, which is exactly what we're dealing with now. The Greeks would like to engage in deficit spending and cut interest rates. The Germans are worried about inflation because the economy is growing so fast, they want to keep interest rates very high. So that's the sort of purely economic story. This is what Mundell won the Nobel Prize for. It's a sort of nice, neat set of criteria. The problem is there really isn't a group of countries that fits these criteria in the real world. We have a monetary union in the United States. We can think of the 50 states of the US like the members of the eurozone. We are not an optimal currency area. 

Biggest way to think about that is to think about the fact that there might be, if we think of California as a country and Mississippi as a country, there might be a boom in California and a recession in Mississippi. And so we might want different monetary policies. Well, we have chosen to have a single political union to go with our economic union. The exchange rate regime is almost always a political choice. So when we see countries adopting different exchange rate regimes and they don't fit the optimal currency criteria, we start to look for other reasons why you might adopt a fixed exchange rate. And this is where someone like me who is a political scientist and not a economist starts to think about the political reasons governments might want to do this. So one political story you might tell is that certain groups or interests within a country have lobbied the government for this policy. It's not necessarily the best policy for the country as a whole, but it might be the best policy for groups. So the export sector or international finance may want a fixed exchange rate and be politically powerful. It might be that we have a left leaning government that responds to labor and unions and is less likely to tie its hands on monetary policy because it's concerned more with full employment. 

There's a large literature in economics and political economy is showing that democracies, that political institutions matter that say democracies are less likely to fix their exchange rates than non-democracies. The general logic there is that governments that have so get reelected, A, they're democracies and they care more about the average voter and aggregate welfare, B, because they have to get reelected, they're more concerned with what's going on and how the economy is performing periodically in terms of elections. Sometimes the story is one about international pressure. So sometimes the story is the international monetary fund comes into a country, as it did in the Latin American economies in the early 1980s, and says we will bail you out and help you pay for your financial crisis in exchange for unhooking your currency peg and floating the exchange rate and devaluing your currency. And sometimes, as we know in the case of European monetary union, we have issue linkage. The idea of a single currency in a fixed exchange rate is bundled up in a much larger project of regional cooperation. So we can start again to think about European monetary union as something that is the culmination of 50 years of broader economic and political integration. Again, these are political decisions. These are political factors leading governments to adopt a single currency. The problems we're seeing now, pretty much all of the problems we're seeing now are the result of politically motivated monetary integration in a region that doesn't fit the optimal currency criteria. 

The economics and the politics, there's a disconnect between them and we're dealing with the consequences of that now. Now, that's a general story about fixed exchange rates, the question is, in the eurozone, it's not just that the franc and the Deutsche mark and the lira have been fixed to each other, they've disappeared. We've replaced them with a single currency. You've created a European Central Bank. The equivalent of our Federal Reserve is now the European Central Bank in Frankfurt. Why would you go beyond a fixed exchange rate to a monetary union? And here we have three explanations. One of them at the bottom is the sort of, again, the broader project of regional integration. So monetary union in Europe is thought of as the capstone of this broader geopolitical process of integration. From the economic standpoint, though, there's two explanations. The first has to do with the credibility. 

And, again, you'll recall as I said, if you're fixing the exchange rate, the markets are always going to wonder how long you're going to do that for. Well, if you want a credibly commit that you're going to do it forever, as the Europeans thought in 1999 that they were doing, getting rid of your central bank and getting rid of your currency is a good way to do it. It's a much more serious, secure, long-term commitment. You can think of throwing out the steering wheel in a game of chicken. You're sort of credibly committing that you're going to go straight and you're not going to swerve. You can also think about future governments within the countries of the eurozone want to lock in policies. So let's say you're a conservative government in Germany and you're really concerned about low inflation. Your worried, perhaps, that the social democrats are going to come in power 10 years from now and start engaging in deficit spending and having higher inflation. Well, if you tie their hands on monetary policy, they can't do that anymore. So it's a case of permanent credibility. 

The other reason has to do with some research and literature that's out there in economics, some of which is done by Charles Engel, who's here in the economics department, showing that there are very large trade effects over and above having a fixed exchange rate if you go all the way to monetary union. So Jeff Frankel at Harvard and Andy Rose at Berkeley have some papers showing that countries that have a single currency trade with each other somewhere on the order of two to three times more than similar countries. So the Europeans hoped as part of the broader project of European economic integration that they would have these benefits within the eurozone. That if we got rid of currency risk and had a single currency, there would be a huge growth in trade, the economy would grow more, there would be lower unemployment, etc, etc, the benefits of deeper economic integration and high growth. There's some even more interesting work that Charles Engel has done looking at the United States versus trade with Canada. And the case he focuses on is the state of North Dakota. So if you look at North Dakota's trade with South Dakota versus North Dakota's trade with its neighboring Canadian provinces, it trades 22 times more with South Dakota than with the neighboring Canadian provinces. There's no economic reason for that. If you look at the sorts of goods and the types of economies that we're talking about with the Canadian prairie provinces and North and South Dakota, there's no explanation for that other than political borders actually matter. And so if you get rid of exchange rates, you think if that's part of having borders across countries, if you get rid of the exchange rate and the currencies and have a single currency, the promise is somewhere between 3 and 22 times more trade in the eurozone. 

And again, that sounds very, very good and very attractive. So this is the eurozone. Present and, I guess, future with a question mark. So you have the countries that are in, the countries that are out, I'm not going to say that they're the countries that want to be in anymore because it's not necessarily clear that that's the case, and you have the UK and Denmark which have, right now, permanent opt outs. The sort of price of Britain agreeing to the eurozone in the Maastricht Treaty was that's great but we don't want to be part of it, we want to keep the pound. So that's our eurozone. If we think about why, going through that list of explanations in why the eurozone was created, there's some evidence for all these explanations. So, the first, again, are the benefits of trade, and currency stability. So what this is here is intra-regional trade, trade within Europe, as a share of total trade. So you can see all the sort of different regions of the world. 

If you look at here, Europe as a whole, the EU 12, which was the European Union members in 1992, and then the EU 15 when Austria, Sweden, and Finland were let in the 1990s, the argument for a fixed exchange rate when you when trade 75% of your trade with that group of countries is pretty strong. And again, the benefits of currency stability, very strong, those numbers were growing over time and they continued if you sort of went from 1994 to 1999 up into the 80% range. So there's a very strong trade argument that a single currency is a good idea. And you could look at the exchange rates in the run up to the eurozone and say currency stability is a problem when we're trading with these countries. So if you go back to 1979 and say the exchange rates between the major economies in the European economic community were fixed at 100. We sort of index it at 100 and then look at what happens. Do they go up or down? For the next 10 years, they're moving all over the place. So if you're very heavily trade dependent there's a lot of currency in here. Why not have a single currency and get rid of that currency risk? The second argument, again, for why one might want to have a fixed exchange rate is for anti-inflationary reasons. And here, again, the argument seems to hold. 

So this is inflation conversions in the original 12 countries in the eurozone. It's the annual percent increase in inflation. It goes back to 1961 and up to 2005 or 2006. So one thing you notice here is prior to 1971 there was very little variation. Inflation was low and not very variable. Why was that the case? Well, we had a global system of fixed exchange rates known as the Bretton Woods system from 1945 to 1971. This is how the system worked. The US pegged to gold. We were on the gold standard. Everybody else pegged to the US dollar, and they periodically devalued a little bit against the US dollar. 

Inflation tended to be higher in the European countries than the US up until the 1960s, and so the Germans were peg the Deutsche mark against the dollar and then devalue a little bit and peg again. You had low inflation because inflation was low in the United States and not a lot of variation. We go off gold during the Nixon Administration in 1971. That system collapses and all of the sudden the world's major currencies are floating against each other. We couple that with the oil shocks in the 1970s and we have lots of inflation. Governments are trying to stimulate the economy, they're engage in deficit spending, they're trying to print money. Most of you in the room remember this better than I do. There's a lot of inflation variability going on all the way up until the eurozone. So we adopt a single currency and that goes away. It looks like we're going back to the Bretton Woods period. 

One way to think about that is effectively what's happening is everybody is pegging to the German Deutsche mark and we replace it with is single currency. So one thing to think about it with everything that's going on right now is in many ways the eurozone has been a success. The trade effects, we've seen some of them. The inflation effects, we've seen a return to low inflation in variability. So with all of the costs, that's something to keep in mind. There were good economic reasons why having a single currency might be a good idea. But it's not without costs, as we're seeing. The last reason, as I mentioned, again, is this sort of broader geopolitical project. I'm not going to walk through all of this, but you can think about European monetary union in 1999 is the culmination of something that started as the pooling of German and French coal and steel in the 1950s. Moving on to the European economic community, the expansion from six countries to a very large number of countries and then the deepening in terms of full economic union and the Maastricht Treaty which took us towards European monetary union. 

So the two gentlemen up there are Jean Monnet who was the high commissioner of the European coal and steel community and Robert Schuman, the French foreign minister. They're the sort of fathers of European integration. I like to think what they're doing right there is looking at Italian and Greek bond spreads. [LAUGHTER] I tried to find a picture where I could splice that together, but it didn't quite work. So for all of these reasons, European monetary union made sense. Now, at the same time, everybody realized that the eurozone wasn't an optimal currency area. The politicians knew this in the 1980s and 1990s. They wanted to try and make it as close as possible when we started. And the way they did that in the Maastricht Treaty was to have something known as the convergence criteria. The idea behind these was we would bring our macroeconomic policies as close together as possible and have good macroeconomic policies before we gave up our various currencies. 

If we did that, maybe the shocks will be more correlated when there are shocks. If we did that, maybe you won't have the need to raise and lower interest rates or borrow and engage in the sorts of problems that we're having now. And there were three criteria. One was price stability or low inflation. So the convergence criteria to get into the eurozone was that your inflation rate could be no more than one and a half percentage points above the rate of the three best performing member states that were going to go into the eurozone. Which everybody thought were going to be the Netherlands, Germany and France. Sound public finances, the budget deficit. So the budget deficit in a given year was not supposed to be more than 3%. You were supposed to be there by 1997 and hold that up to 1999. And the debt to GDP level, over time your sort of accumulated debt from running deficits was not to be more than 60% of GDP. 

So we're going to have low inflation, we're going to have balanced budgets and we're going to have sustainable levels of debt and borrowing. Two problems with that. One, which a lot of people knew at the time but we certainly know now, is there was a lot of creative accounting in some of the less developed countries like Greece and Portugal that moved into European monetary union. So cooking the books may be a little strong, but it turns out, people say that the Greeks numbers were probably twice as bad or half as good as we thought they were. That's one problem. The bigger problem is this: so these convergence criteria were institutionalized in something known as the Growth and Stability Pact. If you want a monetary union to be sustainable, you want to carry these types of rules forward and have everybody abide by them. The problem was, and this is hard to remember when we think of Germany as a successful booming economy in 2011, Germany was sort of the sick man of the EU at the start of the eurozone. The first two countries to violate these are Germany and France in 1999 to 2003. Now, you were supposed to be punished with actual monetary fines, and, in the limit, threats that you wouldn't be able to, say, vote in the European Central Bank. 

If you don't live up to the Maastricht criteria you don't get to dictate economic policy in the eurozone. Those were not enforced on the two largest countries and most prominent countries in the eurozone, and that set a precedent. It set a lesson for other countries like Greece and the rest of the PIIGS countries in the eurozone that maybe we won't be punished either. That these were not necessarily enforced. They weren't necessarily credible, and if they're not credible then we're not going to have something that looks like an optimal currency area. So, as I said, this is sort of where we are now. If we think of the successes and tensions within EMU, a lot of stuff has gone right. The euro, the Germans were very worried about giving up the Deutsche mark. It's a very stable currency. It's low inflation. 

If we give it up, will the euro be a global currency like the Deutsche mark was and the franc was? And will it be low inflation? And it turns out that it is. If you think of global reserves that people hold at hard currencies, it's about 60% dollars, 30% euros and 10% other stuff, primarily yen and renminbi and Swiss francs. So the euro is one of the big stable global currencies, inflation in the eurozone has been very, very low, and we haven't seen 22 times trade growth but there's a lot of evidence that there has been a sort of dynamic increase in the level of trade within the eurozone by getting rid of national currencies. The problem is that one size monetary and fiscal policies doesn't fit all. We have surplus countries and deficit countries. If you think of countries are not abiding by the Maastricht criteria, by the convergence criteria, some countries are running surpluses, some are running deficits. The surplus countries like Germany have low inflation and low unemployment. They want to keep interest rates high. They're worried about the economy overheating. So they're going to keep interest rates and they're going to balance the budget. 

The deficit countries, like the United States, like the PIIGS countries, high inflation, high unemployment. They want to engage in Keynesian economic stimulus. They want to cut interest rates. They want to engage in deficit spending. They want to borrow more. They're concerned with growth in unemployment. They're not concerned with inflation. The problem is you can't use those policy tools if you're a deficit country. You already can't engage in unilateral trade policy. Before we had the single currency, the eurozone was a free trade area. 

The European Union was a free trade area. So I can't use trade protection if people are unemployed to sort of protect their sectors. We can't cut interest rates. We can't engage in deficit spending. We're wrapped in an economic straight jacket in terms of policies of adjustment. It's that loss domestic autonomy that's really the problem right now. And this is where we are. So, one thing to think if we look in 2011, you get a sense of how serious the great recession has been. The sort of worst global economic recession since the Great Depression in the 1930s. Even the good countries are not living up to the 60% to GDP Maastricht criteria. 

You have a handful. Slovakia and Slovenia weren't in the eurozone in 1999, so you have Finland and Luxembourg, basically, and maybe the Netherlands if we're generous, look good. Even the Germans and French don't look so hot by the Maastricht criteria, but they're certainly looking better now than Greece and Italy and Ireland and Portugal. So we have this acronym. The PIIGS. The Irish would like to think that they're not one of the PIIGS, and I'll talk about why that's the case in a second. So Portugal, Italy, Ireland, Greece and Spain. And these are their numbers on the debt and deficit, the two and three of the Maastricht criteria, and the unemployment rates. Massive debt, massive budget deficits and extremely high unemployment. If you're Ireland or Spain or Greece, you don't want interest rates as high as the Germans want them in the European Central Bank in order to maintain low inflation because low inflation is the least of your problems right now. 

Those are the PIIGS minus Ireland. That's the best cartoon that I could find. So let me stop for a second. Actually, let me go back and talk about Ireland. Greece is the one that's been in the news the most. Greece really is, if you think about is a country facing a sort of financial bubble type of crisis or really kind of unsustainable sovereign debt crisis. Is the country going bankrupt? Strictly countries can't go bankrupt but in theory they can't borrow anymore because people won't lend to them. Greece really looks like an insolvency or bankruptcy case. They've been running unsustainably high debt and deficit levels all the way back into the 1980s and 1990s. So one way to think about Greece, and this lesser extent Portugal, is these are classic debt crisis like we saw in Latin America in the 1980s. 

You borrowed too much, you didn't balance the budget, that accumulated overtime and eventually there's going to be a crisis. Eventually the bill is going to come do. Ireland is a very different beast. Ireland, up until 2009, was the success story of the European economies. Ireland was known as the Celtic Tiger. And the name comes from the Asian tigers, the east Asian economies, like Hong Kong, Korea, Taiwan, Singapore, that boomed in the '70s and '80s while the Latin American economies were looking like Greece. They opened up to the world economy to trade, to international finance, they started producing for export, and they doubled their GDP per capita, their living standards, over the course of 20-30 years. Ireland did the exact same thing from about 1985 to 2005. And everybody looked at Ireland and said great economic policies, they're the example you want to follow. They went into the eurozone and living standards in Ireland were among the highest in the European Union and in the eurozone. 

And all of the sudden the Irish economy collapses and those numbers that I just showed you, Ireland looks like Greece. So what we're seeing in retrospect, and you can see the growth numbers on the left here, it's percent change in gross domestic product. In Ireland, you see the boom in the '90s and the 2000s and then the massive collapse. What happened in Ireland? It wasn't that the government was borrowing. Inflation was low, budget deficit, budgets were balanced and Irish sovereign debt to GDP was at the Maastricht criteria level all the up until the crisis. What happened was a lot like what happened in the United States. Massive borrowing by the banks and a housing and construction bubble, sort of the subprime mortgage crisis within Ireland. You see that in the second chart you see construction employment doubling. You see the low unemployment rate and then you see the collapse when the housing and financial bubble burst. What happened when the bubble bust is the Irish government had to step in and bailout, nationalize, the four largest banks to prevent the financial system from coming down. 

So all of that private debt all of the sudden became sovereign debt. And so those numbers now that you see for Ireland where it looks like there's massive budget deficit and debt, it's a different sort of cause. It wasn't bad policies by the government, it was bad policies by the financial sector and the government is coming in to clean it up. The consequences that we're seeing in Ireland is massive out migration. So you history of Ireland is migration elsewhere. From the potato famine on, migration to the United States and other parts of the world, what was fascinating about the 1990s and 2000s was the reversal of that trend. People coming home, Irish expatriates coming home, even people whose parents had been away three-four generations to live and work in Ireland because it was the booming economy of Europe. Ireland is now losing, the number that I saw a couple days ago is 800 people a day leaving Ireland because of the massive unemployment rate. So Ireland is facing a very, very difficult crisis. It's a sort of different crisis than Greece and Portugal and Spain are facing. 

What we're seeing now with the crisis is markets starting to wonder, again, about the credibility of the eurozone. So what we have here are bond spreads, percentage points over German bonds. You see an interesting pattern here. Before the eurozone, you see big spreads for Greece and Ireland, the other PIIGS countries. Once the eurozone happens, the bond spreads go away completely. Well, that makes sense. It's all euro denominated debt, in theory backed by the European Central Bank. So whether you're holding an Irish bond or a Greek bond on Italian bond shouldn't matter. It's all euros. Well, now people are starting to wonder. 

Now the Greek euro debt, people are starting to wonder is that eventually going to be Greek drachma debt. Even France now has tipped up a little bit. So we're starting to see a spread of who do we credibly think is going to pay their debt back and who in the limit might actually stay in the single currency. We've gone back to the world, in many ways, of the pre-euro era where it's not credible that this is all the same. So that's the big problem right now. And the policy solution thus far has been one of bailouts. It started with just Greece. It started with primarily the International Monetary Fund, a little bit of money from the other eurozone countries including Germany. If it's just a problem with Greece, they have a lot of debt, they're probably bankrupt, but we can bail them out. And so Greece goes to the IMF in April of 2010. 

Starting in May, the thought was, well, the IMF, the International Monetary Fund lends to a lot of countries. It's got $250 billion, but it can't lend all of its money to Europe. There might be financial crises elsewhere in the world that the IMF is busy with. The European Union needs its own fund to supplement IMF funding. So the acronym here is the EFSF, the European Financial Stability Fund, which is the pooling of resources of euro countries to get this up to $440 billion. That is supposed to, by 2013, to become something that is even bigger. That pot of money is supposed to be used to now borrow more money on private financial markets so we have a bigger and bigger war chest. And if we have this war chest, what we can do is help countries pay down their debts and bring those bond spreads back down without them leaving the currency union. The problem with that is the markets are starting to believe that this is the only credible part of that rescue fund. So if we're depending on Italy and Spain for $200 billion of our bailout fund but they're precisely the countries whose bonds are being thought to not be credible anymore, you don't really have $620 billion in money there. 

And if you don't have $620 billion in money there, why should bond holders of the PIIGS countries believe that it's really credible that that is going to be paid back. So one of the things we're starting to see now is the question of default. Default right now, or not paying your debt back, is being couched politely in language known as haircut, which is a polite way of saying that bond holders will be chopped off and they might only get 50% of their money back, or debt rescheduling, which is another way to say default. It means that I paid you interest of 5% over 10 years, now I might pay you interest of 2% over 40 years. You're still not going to get all your money back. So it's a polite way. Nobody wants to say default. If you default, the market goes haywire. So it's a polite way of saying default, but if we believe that we're going to maintain the eurozone and there isn't enough money to bail countries out, then something else is going to have to happen. This is the problem. 

This is the sort of calculation that's going on. So when the IMF for the EU countries are coming in and thinking about should we bailout Greece, they're making a calculation of between what's known as liquidity on the one hand and moral hazard on the other. So the bailout or the loans in economic jargon is liquidity. The amount of money we're going to give you might actually solve the problem. It might help the borrower country avoid a default and pay its debt. It might, more broadly, solve this debt crisis. The problem is there's a cost to it. And the cost is what's known as moral hazard. Moral hazard is a concept from insurance, the gist of which is if I bail you out, cover your losses, then you have every incentive to engage in the bad behavior that got you there in the first place. The classic example, or one of the classic examples that you'll learn about in classes about insurance is slumlords in New York City who might own a $2 million building and insure it for $4 million, and then lo and behold there's an arson and the building burns down. 

The insurance sort of made the bad behavior okay. The less extreme example is to think about something like auto insurance. Maybe if I know that my car is fully covered, I'll drive a little faster on the freeway. The issue is the same when we're thinking about crisis lending. If we bailout Greece and we always bailout Greece, or in the United States if we think about if we bailout Goldman Sachs or Citibank and we always bailout Goldman Sachs and Citibank, what is the incentive to fix the problem and not find ourselves here again down the line when the bailouts might have to be even bigger? So if you're thinking about those calculations, here is the tradeoff. When the IMF for the European Union is coming in and giving money, it's not really a bailout. It's not free. It's not just a hand over of the money. There's policy conditions, what's known as conditionality, that are attached. The IMF comes in and says we will give you the money in installments over five years if you go off the fixed exchange rate. 

They're not doing that in the eurozone but in Latin America they did that. If you devalue the currency, if you balance the budget, if you privatize state-owned industries, if you do X, Y, and Z. So there's conditions attached. If you're really worried about moral hazard, it's going to be a relatively small loan with a lot of strings or conditions attached. If you really think it's a sort of shorter term cash flow problem or financial bubble, not necessarily something that the government did to get in crisis, then maybe I will give you a larger loan with fewer strings attached. And here Greece and Ireland are actually informative and an informative comparison. Ireland, for all of its problems with the financial bubble, has a good track record over the last 20 years, and they've actually gotten fairly good treatment from the IMF in the European Union countries relative to Greece where everybody is worried that the last 25 to 30 years don't suggest that if we give you a bailout it's really going to solve the problem. So countries are being treated differently by the IMF and the major economies within the eurozone in terms of the bailouts that they're getting. Now, again, how you decide it's not an economic question, it's a political question. It's very hard to say here is the number in terms of debt to GDP or your budget deficits which is the cut point between a liquidity problem and an insolvency problem. 

It's a political question. Now, there's lots of things that might explain how one decides, politically. This is my answer based on my research on the IMF and what I think part of the story is here. What this chart is here is bank exposure to the PIIGS countries by the major countries in the eurozone and also the major country that is have influence within the IMF. So what do you see here? You see that in spite of the German public being deeply opposed to bailing out the PIIGS countries and in spite of Angela Merkel saying that there are going to be no more bailouts, the Germans thus far have ponied up the money at every stage when the bond spreads have gotten really, really big. Why are they doing that? Look at all the bank exposure of German and French banks. If Greece goes under and Greece defaults and we have a 50% haircut, who is taking that haircut? It's Deutsche Bank and Dresdner Bank and the entire German banking system and French banking system. Politically, governments can't afford to do that. This is an old story. Again, if we think about the Latin American debt crisis, Mexico in 1995, the east Asian crisis in the late 1990s, countries that US, Japanese, and European banks had very high bank exposure to tended to get better deals, bigger bailouts, more money, fewer strings attached. 

It wasn't because these countries were being altruistic, it was because they had domestic political interests in protecting their financial sectors. So if we think about who is getting treated more toughly, the Greeks are getting treated very tough right now, but even in the end so far the Greeks are getting their money. So liquidity and moral hazard, it depends who you ask. The problem, though, yes? >> Can you go over that last thing again a little bit more slowly? >> Yes. German banks are holding $500 billion of debt to the PIIGS countries. French banks are also holding $500 billion of debt, not necessarily to the same countries. So this is Germany to Ireland versus Germany to Spain, Greece, etc. So Greece, Ireland, right. Greece is actually the French banks. The big one for Germany is Ireland. 

They're all exposed to Spain. You look at Britain and Ireland, you look at the United States, it's primarily Italy. So you can look at the different countries and say who is going to get protected by which major power in the eurozone or in the IMF. And it's going to be a function of how much my financial sector is on the hook. So you can think about it, are you bankrupt or not? Well, that's in the eye of the beholder and there's multiple beholders here. The problem is, the bigger problem is this strategy of bailouts, even if they're politicized, is unsustainable. So if we take the money that is out there in this European rescue fund of $440 billion, that's enough to maybe bailout the PIIGS. If we throw Italy into the PIIGS, though, as the next country that now has $306 billion due next year, $465 billion due total, I think, over the next three years, there's not enough money out there. There's not even enough money if the IMF came in and lent all of its money to Europe. There is one actor that has enough money. 

It's the European Central Bank. The European Central Bank controls the supply of euros. If it wanted to, it could print money and solve the debt crisis tomorrow. Now, the euro would fall in value relative to the dollar and the yen and the renminbi, there would be a lot more inflation in the eurozone, but that would solve the debt crisis. In theory, everybody in the world holds euros like dollars, these are not Latin American countries that the 1980s that really don't have access to any other resources. So the question you have to ask yourself is, why is the European Central Bank not doing that? It's bought up some bonds. It's bought up about $250 billion of bonds of the PIIGS countries to try and lower the spreads in installments over the last year and a half. You can compare that, though, with the US Federal Reserve. The US Federal Reserve spent $2 trillion at the height of the crisis buying up everything and anything, including worthless mortgage backed securities, to try and back up the dollar in the US economy. The European Central Bank could do precisely the same thing and they're not doing it. 

So the question is, why aren't they doing it? This gets us to start thinking about the answers. Here's my attempt, at least, to think about four possible resolutions. One is precisely that. Very aggressive monetary policy and a weaker euro. If the European Central Bank tolerated higher inflation, printed a lot of money, bought up all of this distress sovereign debt from the PIIGS countries, that would solve the crisis economically. It's politically unacceptable to Germany. Germany still remembers very deeply, it's deeply engrained in German culture, the hyperinflation experience of Weimar Germany in the 1920s. The reason Germans did not want to give up the Deutsche mark was fear that they were going to not have a low inflation currency anymore. No German chancellor can go to the public and say it's going to be okay, we're going to have 8% inflation for a few years but don't worry, we'll get back to what we thought before. And the Germans have the most influence in the European Central Bank. 

So that works economically but it's unacceptable to Germany politically. You can think of a maintenance of the status quo. If that's not going to happen, well maybe more bailouts and that's just going to be the solution. The problem is it's unclear how that is politically sustainable permanently. It might bankrupt the core countries. If Germany and France have to do this themselves because the European Central Bank is not going to do, it's hard to see how that is either economically or politically sustainable. It's also hard to see how that's politically sustainable in what is supposed to be a monetary union of equal countries. If you permanently have the countries that bail people out and the countries that get bailed out, that's not politically sustainable. There's a lot of disagreement in intentions. There are signs all over the place in the Greek protest right now of Merkel in Nazis clothing. 

The Greeks are not happy with the Germans right now. They're even less happy with the Germans than the Germans are with the Greeks. So that's the not a politically sustainable outcome. Nor is austerity alone. The no bailouts rule really is we don't do this, you solve the problem yourself. Well, solving the problem yourself in Greece, they've already cut their budget by 20%. Laid off 20% of government workers, raised taxes, etc. There's only so much you can do. Think about the tensions and debates and problems we're having in trying to cut the debt and deficits in the United States. You can't have 40% unemployment. 

You can't cut 50% of the government budget and do that for 15 years to solve a debt crisis. That's politically unsustainable. That's politically acceptable on the street in Germany. I was in Berlin a couple months ago. I took a nonscientific poll of my German academic friends. Clearly not the sort of cross-section of German society, but every one of them who most of them who know a lot about this thought that was the solution. The lazy Greeks need to get their house in order. Pay more taxes, not be as corrupt, stop working 20 hours a week, stop retiring at 55, all of these things. Again, that's not politically, economically you can make those numbers work; politically, you can't make those numbers work. That leads to the scenario that everybody, including me, thought we were never going to entertain, which is debt restructuring, or default, and a partial break up of the eurozone. 

The problem with a partial break up of the eurozone is it's a very slippery slope to a complete collapse of the entire thing. The analogy that I like to use, and unfortunately I couldn't find the picture that I had in a lecture from a couple years ago for my undergraduates, is a bunch of mountain climbers roped together climbing up Mount Everest. How do you cut the last four people off without everybody being pulled over the cliff as the winds are blowing at 150 miles an hour and you're approaching the summit of Everest. It's not easy to say, well, maybe Greece has to go and Portugal has to go. We'll stop the bleeding there and everybody else will stay in the eurozone. Because as you think about those bond spreads, then the markets are going to wonder about whoever else is now the hind most country. And eventually you're going to get to the point that the only two countries left in the eurozone are Germany and France. And really Germany. So it's not clear how we get there. That is a politically and economically sustainable solution. 

It's possible that you could go back to what looks a lot like the European monetary system of the '70s, '80s and '90s where you have Germany, France and the Benelux countries, Belgium, Netherlands and Luxembourg, as sort of hard core single currency, and everybody else would have some sort of crawling peg against them. That would look just like the Bretton Woods system. The US pegs to gold and everybody pegs and periodically devalues against the United States. The problem is, how do you get there? So that's a sustainable solution but nobody has figured out how do you get to that outcome without having the whole thing unravel. So what is necessary for the euro to survive if we put these things together? My thoughts on the four things that are necessary. So the European Central Bank might not need to buy up all of the debt and print so much money that you have to completely do what the Federal Reserve did and spend $2 trillion, but it has to be willing to tolerate more inflation and do more of that. It's just not sustainable to say the IMF and these sort of bailouts to the member states is going to be enough. So if the Germans are going to insist on tight money and no deviation from that and no more inflation in the eurozone, then things will be unsustainable. The ECB, again, it's also going to have to start acting more like a serious lender of last resort, like the Fed, like the IMF. So those two sort of go hand in hand. 

If you're not willing to step in and deviate from your mandate of low inflation and print and buy up bad debt to vex out the economy, then there isn't going to be a recovery. The biggest thing is domestic political support. So none of this will be sustainable if the PIIGS countries are pushed to the edge or if Germany and France, for domestic political reasons, refuse to step up and do what needs to be done in terms of leading the group and putting up the money and sort of agreeing to some of these policy changes. So domestic politics really is at the heart of this. Domestic politics both in the debtor countries and the creditor countries. The final question, which I'll get to in a second, is whether even if all of that work and the eurozone was sustainable, whether you need a fiscal union in the long-term. So I'll come back to that in a second and with some pictures. [LAUGHTER] So if you put those together, it's amazing how many pictures can you find of Sarkozy and Merkel kissing each other or hugging each other. Can this marriage rescue? This is the marriage that has been the engine of European integration all the way back to the beginning. When the chips are down and there's a crisis in the European Union, it's the Germans and the French getting together and cooperating and doing what needs to be done. 

You can think of them as the hegemons of the eurozone in sort of the same way that the US has played a hegemonic role in the international system for quite a long time. So this is one question. The second question that's in the news in the last week or so is, can the technocrats rescue the euro? So the first technocrat is Mario Draghi who's the new head of the European Central Bank. It's possible that he could come in and use his influence. He's very well respected. He's Italian. He's thought to be less of an inflation hawk than the outgoing central bank head, Jean-Claude Trichet, from France. Maybe he can use his influence and initiative to move the European Central Bank towards tolerating higher inflation and playing more of that lender of last resort role. The two other technocrats to think of is we've already lost two prime ministers now in the PIIGS countries. And what has happened? Well, Berlusconi is gone finally after how many years. 

Silvio has finally gone on it his retirement. Mario Monti, one of the former European commissioners, is coming in as the sort of technocratic government of experts in academics. And here, this is Lucas Papademos who has replaced George Papandreou in Greece. He was the deputy governor of the European Central Bank until a week ago. The idea here is you're bringing in non-politicians to do the hard things that the politicians couldn't do. The problems is, at least from my perspective, is as soon as these guys come into those offices, they're no longer technocrats. Technocrats don't really exist. They're going to be in office, they're going to get blamed by voters because they're probably going to run in the next election, so they're going to have all the same domestic political incentives that the previous guys did. So if we're resting our hopes on technocrats, then I think we're in trouble. But it might be some combination of the Sarkozy/Merkel marriage and this together that solves the problem. 

The bigger question I said is this, which is even if Sarkozy and Merkel and the technocrats succeed over the next three, four, five years in solving this crisis and getting the eurozone back on stable footing, what we've learned from the crisis is it's an open question of whether you can have an economic and monetary union in the abscess of political union. Even now, Merkel is saying, in spite of all the German opposition, that what we need to more Europe. And again, you can go back to the 1950s and the crisis in the European Union, the solution always proposed and pushed forward has been more and deeper integration to crisis in the European Union. This is precisely the debate that we had in the United States at the outset. So those of you that remember your American history classes, this is Alexander Hamilton, Thomas Jefferson, you might refer the debate about assumption. Assumption of the state debts by the national government. Alexander Hamilton's argument, Alexander Hamilton, was from the federalist party, his argument was we can't have a strong central government, we will never have economic union if we don't have control of the budget and the debt at the national level. Thomas Jefferson and the democratic republicans were deeply opposed to that. Much more in favor of state's rights, favoring a small, more decentralized federal government, worried that Virginia would have a lot less influence and a lot of autonomy if you had an overarching, very powerful federal government. They called Hamilton a monarchist, and the story, the marketing campaign behind it was we've traded one monarch on the other side of the Atlantic that we just fought a war to get independent of for a new monarch. 

A new very powerful central government that controlled all the purse strings. This is precisely the debate that the Europeans are having now. Can you have unenforceable Maastricht criteria and a single currency. So we have a supranational monetary policy and one money, but we have governments that can run deficits and issue their own debt. It's all denominated in euros but Greece controls some of it, Ireland controls some of it. So the jargon that you've been hearing about euro bonds in the Wall Street Journal on the Financial Times is precisely this question. The question of whether the European Central Bank needs to be the only one that issues euro denominated debts. And the fights about budgets are going to happen in Frankfurt and Brussels, not in national capitals. So it looks very much like what happened in the United States. The outcome is unclear. 

It was unclear with the Articles of Confederation in the early United States about how centralized the American government was going to be. We know now that Hamilton effectively won out. We have a very strong centralized federal government. States have very strong restrictions on their debt and their borrowing. It's unclear going forward. The sort of common language, common identity, factors that led to the integration of the continent in the form of the United States of America don't necessarily exist in the eurozone. So what it's going to depend on is governments not doing this or doing less of this and more cooperation. Otherwise, the euro is already crumbling, otherwise if everybody is blaming each other, we're not going to have a euro going on. So I'm loathe to put numbers and percentages on it, but when people ask me at the outset of the global financial crisis in 2008, would the euro collapse? I pretty much think I said, are you crazy? It's unclear now. It's not clear, I don't think the euro will completely collapse, but I think it's a perfectly plausible scenario to think that we might end up with some sort of two speed European monetary with some countries leaving. 

And, again, the question is, how do you do that and get to that outcome without the whole thing coming undone? So I'll stop there and have some time for questions. Thank you very much. [APPLAUSE]  >> If you want to raise your hand, I'll it get you the microphone so everybody can hear. >> They might not hear you in the back, though. >> Audience: One of the most frightening things, I think, is that Italy is the third largest economy in the eurozone, and it's too large to bailout, and so what do we do? >> Well, we've talked about the menu of options. The problem is you can bailout one or two of these economies, but you can't bail all of them out. So it's a question of politically which is the decision? You could have a rescheduling or default of 50% of their debt. We could bail them out. The European Central Bank could bail them out. They could print enough money to cover Italy. 

So it's really a question of there are winners and losers from each of those outcomes. If Italy gets completely bailed out because the European Central Bank starts printing money and buying up Italian bonds, then the banks are going to get their money back, the eurozone will continue. If there's default, things might go up in flames, but again, there's sort of costs to each of these. There's no good choices. We're sort of past the easy choices of we can just bail you out and not really think about making you change your policies at all. So in the end it's going to be some combination of bailouts, austerity and default, and what we're debating right now is the mix of those three things. But none of those on their own really is going to solve the problem. Yes? >> I'm wondering what happened with the proposal by China to help bailout the European Union, what you know about that and how that's been dealt with. >> So this is another possible solution. It does turn out that there's a country that has $3 trillion in foreign exchange reserves and is wondering what to do with it besides buying US treasury bills. 

That would be China. That's a lot more money for the IMF or the European Union. So it's possible, and the Greeks have actually explored this, that China could come in and help them pay their debts. Well, that's not going to come free. Altruism tends not to be a big motivation in international affairs, at least in the things that I've studied. So the question then is, whose conditions do you hate the least? So the IMF is going to have a set of conditions because the Americans and the Japanese and the Europeans have a lot of influence. The EU, the conditions are going to come from Germany and France. Well, China is not just going to give the money free. It's unclear what the conditionality would look like. It's also unclear, it would be great to stick it to the Europeans and the Americans and say the Chinese are riding to the rescue. 

That would sort of fit with the broader narrative of the rise of China in the global economy. But if the goal was to find something better to do with your investments than gold or US treasuries, distressed Greek debt is probably not the thing you want to invest in. [LAUGHTER] So I'm skeptical that that's going to be a major part of the solution. Mostly because if push comes to shove and the Chinese really credibly said here's a trillion dollars, that would probably be impetus for the Germans and the Americans to kind of motivate and mobilize some alternative which would be politically more palatable. Yes? Do we have the mic back already? Okay, sorry, let me get that. >> What are the odds that in the long run the eurozone and the euro are going to be tied to Germany, France and a few other smaller countries that are stable? >> So that we would have the sort of hard core? >> Yeah, the hard core would become the eurozone and the euro. >> I think that purely as the outcome is unlikely. I think it would be more likely to say you would have, there would be the sort of euro one and euro two. There would be the hard core and that would be the eurozone, and everybody else would sort of be in limbo in transition into being in the eurozone. And, again, the question is, how do you get there? I think, at this point, it's a conceivable outcome to say Belgium, Netherlands, Luxembourg, Austria, Germany, Italy, France, Spain. 

You're not going to have a eurozone without the Italians. The Italians have been there in the European Union all the way back to the beginning in 1951. And Spain is too big probably not to be in there. But you could have that and everybody else sort of pegged to the euro. So I'm not sure how likely it is. I think it's a conceivable outcome, but, again, the problem is how do you get there? How do you do that where you could cut it off at Italy and Spain? And I don't think people know the answer to that. [INAUDIBLE] What's that? >> How you get there is you save it that way. >> Well, but if you say that five countries are going to leave, why not the sixth? Why not the seventh? There's a lot of bond holders to negotiate with. >> I was wondering about the time line of the banks exposure to the PIIGS. Was that gradual over the period since the formation of the EU? Or was it a bubble? >> This year? >> Yeah. 

>> That's all of it and so it's cumulative. >> No, the time line over time because if there's a bubble in the last few years, which I think it was... >> Right. >> Then how much has the global income inequality fueled all of that? >> So, I don't know about inequality but part of what's driving this and the big problem in the eurozone is surpluses and deficits. So a lot of this is German corporate profits because they're running massive trade surpluses that go into the banking system and then get recycled back towards Greece. So it is cumulative in the sense that that's the top line number. Some of that is debt from 15 years ago. Some of it is debt from five days ago. It accumulates over time. That sort of gets at the big problem. 

It's unsustainable. The Germans want to tell the story that we need austerity because it was over-borrowing in those countries. Well, the only way you can run a deficit is if somebody else is running a surplus. And the same way that the Chinese want the story to be that we, as Americans, have lived beyond our means and they're sort of following good economic policies, the only way they have massive surpluses is because we're buying their stuff. So part of what's going on here is if we're going to move towards balance, you're also going to have to have Germany move from a massive trade surplus towards balance, and you wouldn't have the recycling of the debt. But again, how you get from here to there is a difficult question. >> Hello, Mark. >> Yes, hi. >> Wondering if we could bring this discussion a little bit closer to home. So if we look at our own PIIGS here in the United States, California, and Illinois, and the tremendous deficits of those states have been running. 

>> Not Wisconsin? >> Compared to maybe Texas that seems to be more like, say, Germany. So how are we... >> Well, Texas now looks like Greece. >> Okay. >> Turns out they were cooking the books. [LAUGHTER] >> But anyway I guess can you maybe draw some analogies about what's happening in the United States vis-a-vis our states and the federal government because it seems like we need to be informed here at home about some of our own fiscal problems. >> It illustrates the difference to sort of go back to Hamilton and Jefferson. So we have a fiscal union in the United States we also have a lot more labor mobility. So people move around the country easier when there's high unemployment in one part of the country and not the other. That's harder to do right now because of the housing market. 

One of the big things coming out is people can't move right now because they can't sell their houses that are under water. But we have a fiscal union. So there is redistribution from surplus states to deficit states through federal government, social security, all kinds of transfers that go through Washington, DC. The other thing we have is lots of states are in debt but there's limits to how much states can borrow. Lots of states have balanced budget amendments. They can't just run up all of the debt that they want. That was the battle at the heart of Hamilton and Jefferson about assumption was the federal government is going to have ultimate say about how much borrowing there can be in the country. And they're going to control all of the issuing of the currency. So there severe debt problems in many of the states here, but it's different. California looks like Greece in terms of levels of debt, but there are lots of ways in which there are fiscal transfers going to California to make sure that California doesn't default. 

That's different from saying Germans are sending money to Greece across sovereign states. So the problems within the United States are different and budget constraints are different primarily because we have that unified federal government that is moving money across borders. You can think about New York taxpayers are paying taxes and sending it to Mississippi. Oregon taxpayers are paying taxes and sending it to Illinois. That isn't happening right now except in the form of these direct bailouts within the European Union or the European monetary union. >> Okay, that's all all the time we have today. So thank you very much for your great questions, everybody, and thank you, Mark. If everybody would please join me in thanking Mark. This is the best turnout we've ever had for Global Hot Spots. >> Thank you very much. 

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