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You recently said, “European politicians always act a day late and promise one euro too little.” Will that finally change at some point?
The challenge is still whether they can get ahead of the process. There are really two core issues. One is to ensure a strong banking system, and much of that effort in recent weeks has been focused on Spain. If they get sufficient capital in the banking system, that will give additional freedom for the European Central Bank to put money into banks and deal with the risks of uncertainty that could lead to contagion. The second issue is that Spain and Italy have been undertaking some difficult reforms to get control of their budgets—but also structural reforms such as pension and labor market systems. These will take time to show the benefits. And in the meantime, the borrowing costs, particularly of Spain, have been increasing. So Europe needs to come up with some way to ensure that they can continue to roll over their bonds and get financing as the reforms take hold.
In effect, the balance has been that Germany has been correct, in my view, in emphasizing the need for countries to undertake fiscal and structural reforms. On the other hand, these countries need some backstop as they’re undertaking these reforms.
You’ve also said Europe should stand up to Greece’s threats to quit the euro and prepare for the worst.
Coming off these Greek elections, my guess is you’ll see a renegotiation to somewhat ease the terms for Greece, but Greece will have to commit to taking some very difficult steps to be able to earn the ongoing subsidies from the European Union. My point was that you have to be prepared for the consequences if they leave. I think, most likely now, that won’t be the course.
How does Europe get out of this? A friend of mine was wondering if you thought Europe should look at the ideas of Alexander Hamilton.
I’m a great admirer of Alexander Hamilton. That may refer to the idea of supporting Spain and Italy with Eurobonds, sharing the credit of Europe to make sure that Spain and Italy can roll over their bonds. I haven’t favored broad-based Eurobonds because it would undermine market discipline. What Hamilton did when the United States was created was he assumed the debts of the states after the Revolutionary War. But after that one-time assumption, the states had to stand on their own credit, so they’re subject to market discipline.
There are other ideas out there. A German institute came up with the notion of a restructuring fund to take debt over 60 percent of GDP and put it in a common pool. That may be easier to do under the German constitution. There isn’t one perfect option, but there will be a need for Europe to come up with some mechanism to ensure that Spain and Italy—much bigger economies than Greece and Portugal and Ireland—can roll over their debt at reasonable rates while they’re making reforms.
What’s the most likely Lehman Brothers moment for Europe?
Well, the Lehman Brothers moment would most likely come from an event such as the exit of Greece from the euro. The world is hoping that, if Greece works out an ongoing arrangement, that the European Lehman moment won’t come. However, whenever you start to run into a situation of confidence and psychology and financial markets, and people start to ask questions about banks or depositors start to pull out their money, you could run into the danger of illiquidity, and that’s fundamentally what brought Lehman down.
If you look at what keeps people up late at night, has it become Spain?
There’s no shortage of things that can give you insomnia.
The World Bank recently lowered its global economic forecast. We’ve seen repercussions in the developed world and some trouble in the developing world. How bad will it be?
Now you have a China that has slowed down. I don’t think it’ll be a hard landing, but it may be a bumpy one. Part of this is affected by Europe. Part of this is affected by the fact that some [developing countries] recovered very strongly in the cycle and then had to dial back a bit. You’ve got a U.S. economy that is stumbling along. And as you get closer to the fiscal cliff toward the end of the year, this will also have a downward effect on expectations in the U.S. economy. And then you have the problems in the euro zone. So there’s no doubt this is a very fragile period in the international economy. As people get scared and uncertainty increases, there are certain risks that people can hedge and manage. But if you have political uncertainty, it’s very hard for markets to cope.
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