Tyler Cowen on the European Crisis 12/05/2011

Welcome to EconTalk, part of the Library of Economics and Liberty. I'm your host, Russ Roberts, of George Mason University and Stanford University's Hoover Institution. Our website is econtalk.org, where you can subscribe, find other episodes, comment on this podcast, and find links and other information related to today's conversation. Our email address is mail@econtalk.org.

Econtalk.org.

We'd love to hear from you. Today is November 28th, 2011, and my guest is Tyler Cowen of George Mason University. Tyler, welcome back to EconTalk.

I'm happy to be here, Russ.

Our topic for today is the situation in Europe. We are taping this, as I said, on November 28th. It will air one week from today, uh, if all goes well. And we understand that 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 said, 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 core problem is. Let's say before all the trouble started, you're comparing two banks: a 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 very good times, they are. The Greek banks were solvent, the German banks were solvent, matters proceeded. But when times turn bad, they're not equivalent assets at all. The euro in the German bank is worth quite a bit more than the euro in 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 anymore. 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 Menger writes about how markets evolve, we're now 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.

I wanna— 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're backed by the same FDIC.

Correct. So there's no need to take your dollar out of the Mississippi bank and put it in the Minnesota bank or vice versa, because one, there's 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? Why is the— what happened that caused the value of that euro in the Greek bank to not be worth what it— I mean, it's a euro. Why is it different from the Minnesota bank? 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're near the bottom. They're 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 a run 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.

That isn't unionized. There's no European fiscal policy. Each nation has its own fiscal policy, its own tax policy, its own spending plans, its own tax revenue. They share a currency, and that's what you started off by saying, that's really probably not feasible from the get-go, but that's the way it was set up. And what's relevant— what's going on in the bond market for Greece that's making its life, the life of the politicians there, difficult?

At this point, everyone knows Greece will default one way or another, whether it's legally called a default. If you're a bondholder, you will not get your money back. At first, the talk was 30% haircut. Then it was a 50% haircut. Some people even now are talking of 100% haircut.

Meaning that if you bought a Greek— you lent money to the Greek government, you're not gonna get any of it back.

That's right. Maybe the best guess would be something like an 80% haircut.

Meaning you get 20 cents on the dollar.

That's right.

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, 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, you know, a previous paragon of efficiency. The Turks have done a much better job. You get a nicer vacation in Turkey. It costs you a lot less. You're not paying euro-denominated prices. The yachting clubs are better. The food is better. Pretty much everything's better. And Greece just is not very much a competitive country anymore. Yet they were borrowing and spending money as if they were a wealthy European nation. And now it's turned out they're not.

So they're going to default in some dimension. You say it as if it's a fact. Are there— is there any possibility that things would get, quote, fixed? And is there any sense of what that might possibly mean? Well, let me ask it a different— let me ask that a different way. Is Greece borrowing money right now, daily?

They are getting money from the ECB, the European Central Bank. Private citizens such as myself, we are reluctant to lend Greece money because the rate that we would require is so high that they're not feasibly in a position to be able to promise to pay it back. So that market essentially has collapsed. They are on life support.

So the only question remains if with the aid of ECB money, which I assume is— I don't know, is it a loan or is it an injection? Is it cash?

Well, we'll see. In theory, it's a loan.

Okay, so with the aid of that money, they're covering covering their obligations day-to-day for now. They're not able to borrow additional money in the open market. There's a possibility in theory that through fiscal stringency, through austerity, so-called austerity, they could cut back on their spending.

I don't think it's possible right now.

Right, but that would be the route— that would be a route to avoiding default, right? They could in theory, quote, 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 theory 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, they could have done that. I think now it's too late.

Okay, so what will be the consequences of that outcome if they— if and when they do not— if and when they, quote, default, they do not cover the payments that 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 yet further. So it's very hard to see them recovering without a complete implosion of some kind and just starting all over again. But the key to understanding the crisis is not really Greece, because the Greek economy is about, or was about, 2% of the Eurozone economy.

A shocking number, by the way. There's 17 countries, I think, in the Eurozone. Correct. So on average, you should be about— 1/17th, not 1/50th. They were a very small— they were well below the per capita size of the rest of the zone.

But if Greece were the only problem, I'm quite convinced 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 and—

That's right. And no one would be happy with that, but it wouldn't be that big a deal. But 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 the same way? And those are much bigger. That's the real problem. Italy and Spain are why we're 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 its obligation— their obligations, the 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, if I remember correctly.

That's right. 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, you know, the European Fund, 11 to 12% of that bailout fund is supposed to come from Italy. And what we're seeing is more and more countries being shifted from one side of the ledger to the other. There's even some talk of France having some serious problems. I'm not sure that's true, but that there's 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 gonna 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. It's like, let's find someone who's just not related to this somehow, who can avoid— 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. And per capita income in China is much lower even than in Greece. And to tell the Chinese you should bail out the Greeks, they're not idiots, and so on.

You tell the story a little differently than I've heard it, so I wanna ask about one aspect of it we haven't talked 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— it's usually 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 is the right way to think about it. So in particular, 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, as those who've been listening to the program for a while, I'm really focused on creditors, the people who finance leveraged activity, borrowed money. The creditors of Greece are not the citizens of Greece. There are some, of course, I presume, who bought Greek securities, Greek treasuries, whatever their equivalent is, their name is. But they were the French banks, so that rescuing Greece isn't really about rescuing Greece, which after all in theory, if Greece defaults, the effect on Greece is they can't borrow for a while, which is— that's unpleasant. It's 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 owed— who had lent money to French banks might not get it back. And this systemic contagious fragility argument is the real reason we have to worry 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 perhaps have sold off enough that assume that's manageable. But then it's the credibility problem that people think if you're not going to bail out Greece, you're 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's a big reason why things have gone as badly as they have.

So I don't want to go too deeply yet— we may come back to it in a little bit— but too deeply yet into the American financial crisis of 2008, where the decision not to rescue Lehman was viewed by some as the catastrophic moment in the crisis. I view it actually as the decision to rescue Bear Stearns 4 or 5, 6 months, 7 months earlier— 9, 3, 6— 6 months earlier. But in this case, sticking with the current situation, okay, so let's take the worst-case scenario. So let's suppose that if we let Greeks go, that's a signal to the world we're gonna let Italy and Spain go, which as you suggested a minute ago might be an unavoidable fact anyway. There's no secret as to how unhealthy Italy and Spain are. That's fairly well known. The magnitude of the asset liability mismatch is large. It's maybe a trillion dollars for Italy that I've seen. I don't know what it is for Spain, but you're suggesting it's large. Everybody knows that. Everybody's aware that it's very unlikely that a political compromise can be fashioned that would have, say, Germany, Finland, and the Netherlands— or was your third country— on the payout 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 living within their means, and the people who lent their money would lose their money, and that would be a great precedent for 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 and possibly outside 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 that 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 when you interact it with how voters and others might behave. But let's take that dark scenario, that second— 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 fraudulent, with some alleged fraudulent, potential fraudulent activity, but certainly bad bets were made by that firm. They went under. They're going into bankruptcy and that's that. Let's suppose it's not just firms like that, hedge funds with people who expected to 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 United States banks. End up being— we find out, and this is not transparent, which is a huge part of the problem for me, but it's not transparent. We don't know how much European debt, 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'll be large losses. Those firms will become insolvent and The next question will be, will we bail them out? Suppose we decide the magnitudes are such that we can't, or the political will isn't there, and there would be a major, uh, you said depression in Europe, uh, 'cause it'll be like 1929 where bank failure leads to presumably 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 future well-being?

That's a key question. The US 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 just conceptually, could pledge to support Italian banks, Italian debt, Spanish government, Portugal, whoever needed to be covered, and they would make a pledge that they would monetize whatever debts needed 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 who favor doing this, they sometimes give the view, "Well, if the ECB pledges this and if they're credible, they don't actually need to inflate. They can keep the whole ship above water." Just by the expectation that they would. Right. And there's some chance that's correct, but what you're doing is 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 EU cannot credibly pledge anything. We don't even know if it will really be around a year from now. It'll 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.

Well, that's a different scenario actually than what I had in mind. So let me— 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 dealt with the 2000— policymakers 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 other things too. Obviously, they guaranteed toxic assets on the books of Bear Stearns that allowed a bidder to come forward and take on the obligations that Bear Stearns had made so that those banks wouldn't lose money who had lent money to Bear Stearns, etc. But basically they decided to save institutions. What if they had not? What if they had let every institution fail? They let Bear Stearns fail. Let's suppose Lehman would not— Lehman, of course, might have changed its behavior, but let's say that was irresolvable as well. Fannie and Freddie would have still gone under. AIG would have gone under, all these— and maybe Goldman Sachs as a result, other firms connected to this, these concatenations of obligations and promises. Well, I understand why that's bad if you're a 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'd be in a major deflation, and that would have devastating impact on the United States. The Fed could counteract that. Instead of counteracting it ex ante by making sure it didn't happen to start with, it could let it happen, let the dominoes 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, for 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 political mismanagement. The banks that lent the money, whether it's their fault or not, they're gonna go out of business, many of them, or 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's a difference here between credit and currency. So, if all these European banks are failing, you're talking of 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, say the ECB, they could still 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 there's a lot of currency, you have a weird mix of a total collapse of a lot 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 US has a credible FDIC. But a lot of these European nations do not. Sure, but we do right now and 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's 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 an association where the weaker countries have nationalized all their banks and keep those banks afloat with some kind of wealth tax. To me, that's a pretty ugly ending. It may be what happens. But that's what we're looking at, not that there's some kind of even process of adjustment that some number of banks go under and you keep up the flow of nominal spending. Credit markets are already collapsing in these countries and we're not even at the worst part of the crisis yet.

Is it imaginable that Greece could nationalize its banks without— would it have any meaning without leaving the euro? Wouldn't they have to leave the euro 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, it may be 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're borrowing just to pay back a lot more borrowing. So if they were cut off from credit markets— cut off from the ECB, it's a better way of putting it at this point— they would have to cut government spending by another 8 to 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 or— somehow that process would collapse before we got to the endgame. So there's not some easy scenario of Greece being cut off and just toppling 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 for better or for worse is unlikely here at a— being tenured at a state university, it's possible. It's 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%. 10% would be— it's an unpleasant set of decisions we'd have to make within our family. We'd sit down with our other family members. We'd talk about what we cared about. 10% cut probably wouldn't require me to move, which would be a dramatic change, right? You'd eat out less. You cut back on extravagances. 10% is unpleasant. It's not even life-changing because you wouldn't have to move to a smaller house in a different neighborhood, different school system. Those would be dramatic changes.

We're well above the median, of course. Correct. But governments don't work this way. Right.

So that's what's fascinating, right? Because an 8% cut is not a big cut, 10% cut, and yet I agree with you. I think the political mechanisms to achieve that might not exist.

Not for Greece, at least.

I'm not sure they exist for us. In the United States.

It's interesting to compare some of these countries to Iceland. Iceland, as you know, 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 decide to do this And the Icelandic government could tell the people, "You're gonna have a hard 3 to 5 years. You're gonna, you know, not be buying so many fruits from abroad. There'll be capital controls. The exchange rate will be a problem. But you need to trust us. We think this is best." I don't completely agree with everything they did in Iceland, but in fact they managed to do it. There were not riots in Reykjavík, right? It's not in that sense a political problem. —so there are governments that can take—

It's a very small homogeneous country.

Absolutely, with a high level of trust. There are governments that 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 a moment Great Britain to the United— England to the United States. I find it fascinating. We're in the middle of a debate over what to do about America's fiscal deficit. The super committee 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 on the order of 50%— 50% in the last 3 or 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— with tax— many people are just arguing that we should not cut spending, we should increase tax revenue. Of course, they have many— people have many agendas, but a 10% cut would be a real cut, meaning a 10% 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 current 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? Do you know? And why might their world politically be so 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. If you govern through Parliament, you can't quite do what you want, but you can try to do what you want, and then there'll be a sort of a referendum on it at the next election. So England tends to get itself into trouble first, and they tend to get out of trouble first. Thatcher came before Reagan, but of course British socialism came before a lot of the US interventions. Yeah. 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. Yeah.

So what's your best guess, which maybe is an unfair question, as to how this might play out in Europe, going back to our PIG 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 about 50%. I just think it's the most likely of all the different scenarios. Uh, 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 macroeconomic 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'll be capital controls introduced suddenly and a return back to earlier currencies, and they will leave the eurozone, and they will have, say, 3 to 5 years, economically speaking, of being a total mess. For Portugal, Spain, and Italy, I think that is likely. For Greece, I think it is nearly certain. For Ireland, uh, 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.

And let's continue to unfurl that, that story. So they reinstitute the lira, the drachma, the peseta, etc. And they're not going to be very happy places economically, presumably, and as that goes forward, because that's— there's 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 that when—I think I've got the direction of this correct—when America sneezes, Europe catches a cold. Mm-hmm. I would suspect that when Italy, Spain, Greece and Portugal sneeze, Europe gets pneumonia, and we're gonna get a really bad flu, right? That would be— that story, which is, you suggest, is the most— although not likely, maybe the most likely— is a very depressing story, correct?

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 of funds 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, need to sell assets, need to raise capital, need to scale back, they will presumably be restricting a lot of their activities. They will 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, other things other than FDIC-insured—

Short-term lending among financial institutions. Now, if European banks are pulling out of that, can US 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 bigger than Lehman Brothers, or you would say Bear Stearns, however you wish to slice that cake.

Right. So we learned, or we're 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're 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're not very attractive.

It's a bad place to be if you're Ben Bernanke.

Time for a vacation, maybe. Stress of the job, more time with the family.

Well, here's one thing he could do.

Gonna get a lot of attention, though.

This is one thing he could do. One can debate if it's a good idea or not. But basically buy up all of the bonds of the weak European countries which are currently on the books of US banks and support their value that way and also protect US banks.

Like the original TARP plan, which was to buy up toxic assets to keep the balance sheets of banks solvent.

But 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 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 draw a line 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? I mean, right now, one of the things that bothers me when the Fed guaranteed the assets of Bear Stearns was $29 billion, later $32 billion to get JPMorgan Chase to buy up the obligations of Bear Stearns and quote, own them. It was said at the time, well, we might even make money on these. You know, they're depressed value now because these 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 worth of Fannie and Freddie obligations. How am I doing on that as a taxpayer/investor? I have no idea. There's no transparency. You can't look that up anywhere. It's kind of a secret. It's kind of— if it's not a secret, it's close to one. And so let's say they do what you just said, they buy up all this paper from Europe, everybody's— breathes a sigh of relief. There's a lot of bloggers and pundits who say this was really risky and we're gonna lose a lot of money and who's gonna pay a price for that? Where would the political costs of that be? It seems like there'd be a lot of political pressure to do that.

Well, 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 were done very quickly. You sit down over a 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? And the downside, I don't— 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? I mean, who would— so Ben Bernanke would lose face? I mean, would the president of the United States at that time, whoever that would be, when it is— I don't even know when it is. And I'm just thinking about the political forces working. It would be very unpopular. Yeah, it would be.

But it may be better than risking a second European Great Depression, which would also be bad for the US 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. Yeah, I think you're probably right.—

So let's turn to an optimistic scenario. You said what you thought was the most likely scenario. Can you imagine a scenario that isn't as bad as the outcome that 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're basically in default, even though they're not in the legal sense. The optimistic scenario is Germany gets its druthers together and sits down with a few other countries and says, "We're gonna 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 I also don't think if they tried it, it would work. But it, it could possibly work.

And it would require, 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 European Central Bank, ECB governance change, European Union governance, because it's— what we're really talking about here is a loan that can't be paid back, right? 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 euro bonds. This is not exactly a euro bond, but it involves a similar kind of commitment. And 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. So when you have— it's like 17 different branches of government, but 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 Kim Geithner and Barney Frank together on a phone call downtown here. I just don't think it can happen. And if you tried to have it 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 just stands up and says, "Enough is enough. We're not going to do this anymore." And the support for the policy vanishes. And that, of course, is why Germany is reluctant. With all these obstacles, they must have to doubt whether they could even 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. Germany recently tried to— ähm— borrow some money in the open market, and it required a higher interest rate than the previous entry by Germany. It's a small increase. It went from something like 2.63% to 2.81%. You viewed that as quite significant. You were joined this morning in a Bloomberg column by Simon Johnson, a co-author, who argued that this is the end of the euro, period. It's over. What's your take? What information did that, quote, 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, that number. The market is not saying, "We're 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 redenomination 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're 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 just is pure inflation risk, right? 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, sort of like Knightean uncertainty in Austrian economics lingo. And a simple decision on the part of some people, I don't need to buy more German bonds today. I trust Germany, but I'm gonna buy something else today. And that's not unreasonable.

Or if I'm gonna buy something safe, if I'm gonna get a low return I'd rather get a low-return holding, a US dollar-denominated— Sure. —allegedly safe asset rather than this one.

But once that kind of thinking kicks in, even if there's no mistrust of an actual repayment from Germany, if you're a Merkel leading Germany, you have to take that into account. You just can't play games with your own country's credit rating and bond auctions. And I think it's a sign to the Germans, also to the Netherlands, just saying like, "Look, are you really up for this?" And what must they be thinking? Nothing they can say in public, but I think, you know, to us it's obvious.

So part of the unsustainability of this situation, which you argue and others have argued, began on day one, which was a currency union that was not coordinated with fiscal policy and an electorate any unified electorate. So he didn't create a Europe. Right. A euro that was the currency of something called Europe where Europe had a governing body, a European Parliament. It had 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. You're the prime minister of one of these healthy countries, relatively healthy countries, Germany, Netherlands, Finland, where else? Maybe— I don't know where else, but let's start with those. You certainly don't want to bear the costs, impose costs on your own citizens to bail out people who've been irresponsible. The famous example, I think it's true that the Greeks retire at 52, some Greeks can retire at 52, which is much lower than the German retirement age. So the idea that you're subsidizing the pensions of early retirement Greek citizens is not a politically winning strategy.

And tell this to the poorer Slovakians.

Right, whose standard of living is—

Well below that of Greece. Right.

So there's no political incentive to take care of that, to do that, and yet the bus that you're all on is going over a cliff of which 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're 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're 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 AAA 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, plot out the answer in advance, and shove it down the throats of the other countries. They're on opposite sides, and the customs and conventions for resolving the disputes when Germany and France are not working together They're just not there.

So in another time, and maybe this time, these kind of stories wouldn't just lead to a really bad year for an economy. They lead to revolution and war. It's— you know, we assume that France and Germany, because they've been at peace now for 65 years, that that's just what we're used to. They don't have a great history. Before that, we know, 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, in Germany, certainly in all of the smaller countries, there's a real belief in a European project. And if this in some way collapses, which I guess I think it will within 5 years' time, I think there'll be an attempt to pick up the pieces and do it better. They still then may not get it right. But 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're back there, they've lived with that world, you know, it'll be fine. And they'll need a little bit of time to get over the split, so to speak. But I think a lot of European integration will continue. It makes too much sense.

I'm more worried about the transition period. It's— we don't know how ugly it will be if that's indeed the way it plays out. I mean, I look at the United States, which has now a fairly long history of constitutional governance, right? And yet when I look at the inability to find common ground in the current electoral 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, other European countries, 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 do that in a way that isn't— can 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 end of the political spectrum showing a lot of displeasure with the way things are going. There's a little bit of— it's a real test for democracy, democratic government in general. It's not clear it's going to make it.

Again, though, I'm much more optimistic. The two key countries here— So glad, Tyler. —are France and Germany. For a long time, both have had a real rule by consensus. Not always on good policies, I would add. But governments in those countries are trusted, maybe in some ways trusted too much. Also in Germany, there's 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, coming along and say, "Vote for 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, you know, the Netherlands will launch a war against Austria. So I think Europe will remain liberal Europe, at least the Western, the successful Western Europe.

I mean, the counterargument to that is that they wouldn't— 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. We'll see.

I would worry most about Hungary actually on this account. Because they're in a very bad financial crisis themselves. They would be caught in the fallout. They're not in the eurozone. They're 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.

So one of the disheartening aspects of all this— there are many, of course— but one of the disheartening aspects of the current economic world we're living in is what lessons are to be learned. And it's— 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. He wrote the following, and this is on his blog, Money Illusion: 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 subprime 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. What do you think of that claim?

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 we face— I suggested a minute ago that democracy is in serious— is undergoing a serious test. That the Bastiat insight that the state is the great lie, that it's a way we can all live off each other, which is impossible. And I'm corrupting that quote, I apologize, Frederick. But one of the— I think democracy is under great test, is under 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— and we regulate certain parts of it quite heavily to reduce risk to depositors and others through FDIC and other means. It seems to have run amok. Sure. 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 that we are faced with a future where bank runs are a pretty 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's not answering your question, but I think there's more credit out there than can be guaranteed. The age of AAA is essentially over in most places for most times, and the financial system is in some key ways broken, and we're gonna suffer through it. We're gonna have some fantastic growth coming up in some key sectors, And let's hope that's, you know, worth the pains we're going to suffer through.

Any ideas on how to make that pain less likely? Any suggestions on how— I mean, 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?

Well, 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're 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. You know, Europe's trying to do this right now. They're telling their banks through Basel III, something like, "Come up with $700 billion in capital." That's from a month or two ago. The number now, 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're 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, lot of skin in the game on the capital side, and not regulate too much else, and realize bailouts are going to occur.

Happy holidays, everybody. My guest today has been Tyler Cowen. Tyler, thanks for being part of EconTalk.

And we'll see what's gonna happen in this week to come. Thank you all for listening. Thank you, Russ.

This is EconTalk, part of the Library of Economics and Liberty. For more EconTalk, go to econtalk.org, where you can also comment on today's podcast and find links and readings related to today's conversation. The sound engineer for EconTalk is Rich Goyette. I'm your host, Russ Roberts. Thanks for listening. Talk to you on Monday.