there's four groups of creditors. germany and the other successful northern europeans. the european central bank. the private banks, who are now negotiating their haircut in greece. and the international monetary fund. they're all trying to fob off shares of the rescue packages to the others, and preserve their own negotiating position to do so. therefore, none of them wants to say he or she will take care of the whole problem, even though, in fact, they will. so the result is a situation that's very unsatisfactory for the markets. the markets want to hear assurances, and firm words of rescue. those can't be given, even though i'm confident that those rescues will take place. and, therefore, the market situation is likely to remain unsettled and volatile, even though i'm confident that the outcome will be successful in the sense of successful financial engineering to avoid financial breakdown. but that's not getting to the recession and the underlying economic problem which is still

there. i want to draw two or three major conclusions for the united states and answer more questions on the european situation per se. first, as you said, mr. chairman, the united states has a huge interest in this situation being resolved successfully. so we have to do whatever we can to support a successful solution. i agree with simon that the europeans should provide the bulk of the resources to do that and they got the wherewithal but i disagree with him that the international monetary fund should not be available if necessary. we don't know yet, to lend more to help resolve the problem. the imf did pick up one-third of the original packages for greece, portugal and ireland, and i think that was very helpful, not so much in terms of the resources, but bringing the imf conditionality into play, and helping promote the necessary adjustment in the debtor countries.

and incidentally, when i say necessary adjustment, i do not mean just fiscal austerity, which has to be part of it, but structural reforms which are necessary to restore growth. what italy, greece, all the debtor countries need to restore growth is structural reform of their labor markets, the uncompetitive private sectors, their own financial systems, all those structural reforms are needed. and the imf is helpful in promoting that given its experience and the resources that it can bring to bear. so i believe the u.s. should support if it turns out to be necessary, additional imf financial contributions to the european problem on a minority basis, maybe the one-third in the previous cases, maybe less, but certainly it could be significant, and i therefore think the united states should support the current efforts of

the imf to create a new fund, $500 to $600 billion, which in conjunction with the funds the europeans are raising, would take the firewall to beyond a trillion dollars. which should convince the markets there will be enough there to avoid any significant financial disruption, even from italy or spain. i think the u.s. should support that. however, i do not think the united states itself should contribute. the funding the imf needs should be borrowed from the big surplus and creditor companies. china, japan, singapore, hong kong, brazil, russia, mexico, korea. many of those countries have already said they will lend. they should, in fact, be tapped. they have big surpluses, big reserves. we should support the effort but not put in our own money. the u.s. needs to take this as a wakeup call itself.

and you suggested that, mr. chairman. if you take those cbo realistic projections and i would say, even add a little more dose of realism, you have u.s. budget deficits exceeding a trillion dollars a year, more than 5% of gdp for the decade to come and then it gets worse because of aging. so if you project the numbers, our debt and deficit numbers within ten years look like greece's did as it entered into its crisis. the european crisis has shielded us from our own follies. because europe's weakness meant that foreign capital, global capital moved into the dollar and pushed our interest rates lower despite our inability so far to put our own house in order. remember that only three or four years ago, greek interest rates were at the same level as german interest rates. because the omnipotent markets that we like to extoll, got it totally wrong. the markets thought that greek debt was as good as german debt because greece was part of a eurozone led by germany.

and all of a sudden they realized that was wrong and greek interest rates tripled the level of germany's. the united states is very happy at the moment to have very low interest rates, in large part because europe and japan are so weak and so the other financial markets don't attract the capital but that worm could turn very fast, very viciously. and if the european crisis teaches us anything, it's that we have to learn from that example. and not simply delight in the fact that we have some more time, but rather use that time. this committee has played a major leadership role with that and with your lead, mr. chairman, i urge and implore you to take the time that's now available to do that. if not, we too, two or three years from now, certainly within the next five to ten, could go the way of some of the europeans whose travails we now bewail.

thank you. >> dr. lerrick, thank you for >> dr. lerrick, thank you for coming. we look forward to hearing your testimony. >> i want to recapitulate what happened. the europe crisis is not a currency crisis. the euro maintained its value.

it's at $1.3 which is in historic range. europe has a fiscal crisis compounded by a failure to take corrective action. that's just destroyed its credibility in the capital markets. it is a self-inflicted crisis. the european monetary union set out rules that limited deficits to 3% of gdp and debts to 60% of gdp. and the markets accepted this as a fiscal performance guarantee. they thought that homogenized the credit throughout the union. you saw the interest rates of greece's debt fall from 8% of germanys to less than a quarter of a percent above germany's. but the rules were never enforced. by 2007, you had ten of the -- seven of the original 12 members over the debt limit. by 2010, it was ten of the members. what had happened was weak governments had used massive borrowing to offer their citizens a standard of living, their productivity could not deliver. and so now what you have when this crisis started in greece in 2009, greece just denounced our deficits, two times what we told you a few months ago. and the markets recognized there was a problem. what should have happened two years ago is greece should have defaulted on the debt and the

other countries should have just tightened up their budgets. the fundamental problem in europe, really, is european policymakers don't understand the markets and don't like markets and think they can dominate markets and that's why you've seen a mess over the last two to three years. the inability of europe to address its crisis stems from a fundamental disagreement over the responsibilities of members of the eurozone. without a fundamental agreement, all you've seen is a series of political compromises that have only further eroded market credibility because they failed. germany leads the north and they believe the cause of the crisis is a lack of discipline in the south.

profligate members should cut their spending, lower their wages, increase their productivity, which is the exact path that germany took in the approximately ten years ago and that's the source of germany's current prosperity. under the german view, each member is responsible form its own fiscal well being and growth. if markets see credible action the crisis will end. southern europe believes its troubles are caused by germany's success. if germany hand done so well they'd be in good shape. that's an tetabity but that's t view. they think union solidarity requires massive transfers from the strong members to the weak and that what they need is a collective euro bond to lower their financing costs and reduce adjustment in paying. what's interesting is the role france played in there. france, instead of signing with the other aaa countries, has decided to be the head of the south. they see this as a way of gaining political leadership of europe while leaving the cost of bailouts with germany. as one of the germans told me, the french are very bad at economics but very good at diplomacy. the great danger is that you know have a conflict within europe. germany wants immediate fiscal correction by the individual governments. the rest of europe and the obama

administration, want the european central bank to simply print up $2 trillion euros and buy every weak government bond in sight and drive interest rates down to 4%. they believe the real problem can be dealt with later and that's basically mimicking the federal reserve's policy of driving down the interest rates and flooding the economy with cash. germany disagrees. if a long-term solution is not offered, there's no amount of money that will solve this problem. and i believe that if germany capitulates as my colleague believes they will, you'll wind up with a currency crisis on top of a fiscal crisis. the issue then becomes -- what is the next level of europe? germany has a clear view of what the future of europe is going to be and they've found two tools that will force union fiscal discipline after two years of reasoning, threatening and pleading had no effect on their fellow members. first they see that market forces prevail where diplomacy failed. if you keep painfully high

interest rates on the politicians that will compel them to make difficult choices that need to be made. the second step they've done is removed the unanimity requirements before all the eurozone decisions. before they could stop the euro without a veto and therefore, they set up a system where there will be no access to emergency funding unless a member agrees to the fiscal conduct. and what will happen is the fear of being left behind is going to support -- left behind without support is going to force submission to this fiscal reform. and so what you'll see over the next two to three years is germany will drive the eurozone towards a fiscal union with central control over national budgets and strong, automatic sanctions against spending offenders. this is a difficult path. it's the greatest danger is that a crisis will loom in the interim.

what you're seeing is a very difficult process and there's going to be missteps. there's going to be obstacles and what you'll see are the markets will become frightened. and the great danger is the politicians will confuse the end of their world with the end of "the" world and rush out and bail out every government and bank in site, and you'll set back economic stability by a decade. so what should happen is the ecb should act as a support for this difficult path to adjustment, as the europeans go towards fiscal compact and this way they can maintain stability and very fragile markets. what they have to do is not just flood the market, what they should do is announce a rule of intervention that removes the risk of financial panic, but preserves the incentives for safeguard for inflation fighting credibility.

the great problem in europe is not the problem of deficit or debt. europe has a much more serious long-term problem. you caso easily. i'm saying economically, not politically. easily, you cut spending. the difficult problem is that southern europe's populations expect a lifestyle their productivity cannot supply. greeks don't have to be germans but they can expect to be -- but then they can't expect to be paid like germans. so you have a 25% gap between southern europe and german labor costs, that can only be closed by nominal deflation.

because devaluation is not possible in the eurozone. this is a long, painful process that will precipitate a five to seven-year recession in the southern european countries and there you're talking about close to 40% of europe's gdp. the only other alternative is a long-term transfer from europe's productive north to the south. the reunification of germany poses the same problem of differing productivity. what the germans decided was they proposed a solidarity tax imposed on west germany to bring east germany up to west german standards and it was envisioned as a temporary transition mechanism. it's been in place for 20 years and there's no concept of withdrawing it even at this stage. what you'll see is a transfer from northern europe through taxes and payments and aid, directly and indirectly through higher inflation, in order to bring -- reduce southern europe's debt. one point that you raised in both mr. chairman and you, senator johnson raised -- can this happen in the united states? absolutely. and the fact is, if we don't take corrective action it's going to happen. you raise the concept

you raise the concept of unsustainable trends. one of the nobel prize winners had a famous quote about had a famous quote about unsustainable trends -- the end! and the fact of the matter is the only reason we haven't had a crisis is far is because the u.s. dollar's role as the reserve currency in the world. but that cannot go on. the reason it's not ended is

replace a reserve currency. the only other alternative would be can euro and the europeans have their own problems. that saved us. there's a compact when you're in the reserve currency. there's a privilege, which is that the rest of the world gives you television sets and lends you money to buy cars and houses at very low interest rates, in return for pieces of paper you print up in the basement of the federal reserve. the agreement is, you have to maintain the value of those pieces of paper. we have not kept up our end of the bargain. over time, you will see the world withdraw from the reserve currency. when that happens, the u.s. dollar interest rates the rise quickly, and the u.s. dollar will fall very quickly, and we will have a problem similar to what the weak european countries have right now. >> thank you. >> thank you. terrific, all three. i really appreciate your contributions to the committee. let me ask this, what is your assessment how the basel rounds impact the european response to the current crisis? what is your assessment of what these changes require, and how that interacts with what is currently happening? >> i presume you're talking

about the basel accords on capital requirements for banks? >> just so you know, the reason i asked the question, we've had a lot of commentary among colleagues asking the question, what are the effects of the increased capital requirements? are they sufficient? are they insufficient? what effect are they having on the current challenges? >> thank you, senator. it's a very good question, and highly appropriate to ask it, keep asking it, at this moment. unfortunately, the problem is, with basel, it's not just the latest agreement, the increase in capital requirements, which i think is insufficient. there's a much deeper problem, the way they've agreed to think about how much capital you need. they use the risk weighted assets, that means if you're holding something that's aaa, you don't have to have a lot of equity relative to that position.

what's a aaa asset in the european context? sovereign debt, including greek debt, people were convinced, and mr. bergsten said the same thing. greek and german debt were similar in their credit risk, they're not. they're fundamentally different. the entire approach is deeply flawed, not only that, senator conrad, but the way tease being implemented is very problematic, the french and germans by all accounts are backing away from even what they signed up to in basel. this doesn't limit what we do, i would argue we should go further and the federal reserve has for systemically important financial institutions have indicated there will be a surcharge, that's not enough relative to the losses we face.

>> remind us, what are the requirements, what are the capital requirements in the basel round?>> well, it depends whof financial institutions you're talking about. and the headline number is between 10 and 12%. i would say the kev sill in the risk weighted assets. and if you -- if the risk weighted is so fundamentally flawed that they've missed completely the sovereign debt crisis and the true risks that all these european banks face, and our banks face because they're exposed to the european banks. they've hedged this risk through some offsetting derivative contract. the counter party risk in that swap is probably with a european bank, at least in part. how big is that in how profound

is that risk? i don't know. i talk to the senior regulators on this issue. i don't know if the regularities would tell me if they knew. we shouldn't be -- i'm not saying move everybody mutually to 20% capital climates, you can't do that. you can suspend dividend payments, absolutely, across the board. given the european situation, that would be well receives, that would bolster financial stability and growth prospects in the united states. it wouldn't are a negative in this environment, if it's applied across the board, because of the risks posed by europe. and the uncertainty that we all agree still looms. >> dr. bergsten. what's your assessment of basel and the capital requirements sufficient, insufficient? do you share dr. johnson's view of this? >> i very much share his view.

i do think capital adequacy is at the heart of restoring financial stability here, europe, everywhere else. and we should err on the side of caution, going to higher rather than lower capital requirements in order to achieve that outcome. there's a fascinating implication from the events of the last three or four years, we should keep in mind. this last crisis, of course, was rooted in financial instability in the united states and europe. it turns out there was very little spillover to the emerging markets and developing countries. they got some effect from the recession and the weakening of trade flows. their financial system stood up much better than ours. why was that? well, they had crisis in the past. the asians had crisis in the late '90s, the latin americans in the '80s, and in response to those, they did to a large extent get their acts together. they opted to have financial systems that were not as exotic and high flying and maybe as innovative as ours. they explicitly and determinedly

opted for more risk averse systems, including much higher capital requirements, and that paid off. >> what are their level of >> it differs from country to country. simon, do you know? but the numbers are much higher than ours. they were all put in place after those earlier chris's, as a lesson from those chris's.

and it seemed to have paid off fairly heavily. >> do you know the answer? >> 20% is not an unusual number of capital in these conservative systems that have previously faced serious crisis. >> 20% pressured -- do they measure on a risk weighted asset basis as well? >> that is a deep problem across all these systems, but they are much more careful, have been much more careful. the europeans made a huge mistake, because we made a huge mistake. >> we just had a company go down in part because of bets on sovereign debt. dr. lerrick. >> i echo simon's comments about the basel rule. i would raise two points. first, there's one true law of economics. that was first enunciated by the governor of the bank of england in the 19th century. every regulation will be circumvented. when you start setting out very precise rules, you are setting in motion an entire system of people. certainly spending their lives thinking how to circumvent them. remember, regulators are always one crisis behind. they're always thinking of that last crisis, they don't know where the next crisis is coming. they are paid far less, work far less hard. and are not as highly skilled as the people that are attempting to get around the regulations. you must keep in mind when you set out clear regulations, you have a problem.

the second is, i was looking -- i saw an old photograph of a bank that had been closed back in the 1920s. but the front -- the window front was very interesting. in 19 -- before the federal reserve in the 1920s and '30s, on the front window of every bank it said capital, $10 million or $12 million or $5 million. now when you look at a bank it says fdic insured. that is a fundamental problem. you have a system where very few people pay attention to the capital of banks. simon raised that the levels are much higher in developing countries, many emerging market countries. look at switzerland. switzerland is the developed country that has the greatest interest in preserving its banking system. they live off its banking system. they propose raising capital to 16% before anyone else. and probably will go higher in order to establish the absolute credibility of their banks in the world. and that's one of the key issues. capital is -- banking should be

a boring business, it should not be a high flying business where you take risks, you trade, do you all these things, it's a boring business, very similar to a utility. they're supplying payments, checking, they're supplying loans to small businesses, this is not an exciting business. it's not a highly profitable business. it's a fundamental business for the economy. and the job of the government is to make sure that banks are not in danger. and that's why you should make it a boring business. >> thank you very much. >> this was fascinating testimony. i'm new here, let me quick ask a question on the asian banks and what they did to solve their problem. when we passed dodd/frank. i'm a great believer in not

reinventing the wheel. did we take a look at what the new asian banks put in place when we designed dodd/frank? does that make sense and would it make sense to do so? >> my impression as someone who followed it closely is that we were very taken with the exceptional nature of the united states. and there were various lessons we could draw from scandinavia. he hit the nail on the head. make banking boring. and the scandinavians have come through this crisis in relatively good shape from a fiscal point of view, in part because they had had terrible problems with the banks in the 1990s. got completely out of control, just like emerging markets. and they cleaned them up and made them much more conservative and careful including much higher levels of capital.

>> what the asians adopted was an idea called the international standard which was invented by one of our staff, morris goldstein. the idea was then picked up and heavily promoted with the emerging markets by the u.s. government, by the international monetary fund and by all rightk greater global financial stability. we viewed it as adopting our ideas and implications is our systems were fine and should be the model. whether or not our systems were fine back then, our systems eroded and failed to keep up

industry, regulatory zeal dropped sharply and we were exceptional. the west with its more sophisticated financial systems developed and ideas -- >> we turned our backs on them. the question i'm ask, would we be smart to look at those and adopt those? >> certainly look at it carefully. and simon rightly mentioned there are some other high-income countries, including european countries, which have actually done this quite well and sweden and finland are two cases in point where they had incredibly deeply financial crisis in the early 1990s, put their houses in order, dramatically reformed their economy. we used to think sweden, a socialist economy, how could it ever succeed, sweden has been a

star even more than germany in this recent economic situation, which has come through this current crisis not totally unscathed because the neighborhood is rough, but largely unscathed doing very, very well. their financial minister has been voted finance minister of the year around the world, et cetera. so having gone through a crisis, taken a serious reform in your financial system and your macro policy, pays off heavily when you then get hit again. my fear, just to reiterate the obvious, is the u.s., which has so far escaped that existential crisis may take a very hit for it. >> in singapore, they know they live in a dangerous world, they're extremely careful with how they operate. they'll tell new private, not in public, they think the way we operate our system is reckless