Global Economic Challenges: Europe and Asia

Speaker:Donald Kohn


MR. BOSWORTH: I’m Barry Bosworth from the Brookings Institution.

We’ve changed the order of our conference a bit. In previous years, we started with a session about the U.S. economy.  We’ve changed that mainly because it’s our feeling that this year the real interesting things going on in the world are not happening in the United States, and things are unlikely to be very interesting in the United States until the election is over.

So we thought that instead, we would start by talking about the global economy. One thing that gets neglected by Americans in thinking about that is they don’t pay enough attention to what goes on in Asia. Yet with the magnitude of economic growth, both in China, in particular, but in the rest of Asia as well, Asia now is the center of world economic activity — although it’s hard for Americans to admit that. And I think the policy questions that are dangerous and interesting are largely in Europe.  So we thought we’d start this morning by talking about the global outlook from Asia and from Europe, and we’ll get to the United States right after lunch.

One way to show you the world economic outlook is to begin with a table.

Figure 1. Global GDP Growth

This looks like just a lot of numbers, but there are some important things to say about it.

First, there has been in the last six months a major decline in people’s expectations of what’s going to happen in 2012. The central reason for that is the continuing deterioration of the economic situation in the Eurozone, where it now seems clear that those countries are in for a major recession in 2012, that probably will stretch into 2013, with no real answer in sight on the policy side. And that has big impacts on the rest of the world as well, mainly because of trade.  The U.S. may be the least influenced because we don’t trade much with anybody on the export side.  So we’re not affected as much.  But it’s a big issue for Asia.

And so I think what you see in Figure 1 that’s interesting is that growth is now projected to fall below three percent for the world as a whole.  That’s historically a very low growth rate.

I think the other thing that’s interesting about it is the advanced economies of the United States, Japan and western Europe now are going to contribute less than 1/3 of world economic growth, which shows the extent to which the high income countries have fallen down in their contribution to global growth.


Almost half of the world’s economic growth is now expected to come from Asia, plus some from other emerging market regions of the world. Latin America, for example, has also been doing fairly well, but that region is likely to be very affected by the global economic slowdown because they produce raw materials — and raw material prices are probably going to plunge.

Also, as will come up more when we talk about Europe, I think the other interesting thing to note about Asia is that Asia has lots of options to deal with its worsening economic situation.  The United States doesn’t really have very many options left.  We’ve got slow economic growth. We’ve got a monetary policy that’s basically exhausted, and a fiscal policy with a deficit as large as it possibly could be. And we’ve got this overwhelmingly large trade deficit with the rest of the world. We look like we’ve got a lot of problems, right?

In contrast, Asia is a group of countries with a very solid fiscal position.  Most of the emerging parts of Asia have large budget surpluses. They have high interest rates, meaning that right now, they have lots of room to reduce their interest rates if they should need to.  They have large foreign exchange reserves, so the possibility of an exchange crisis for Asia is incredibly remote, having stockpiled all these financial assets for many years.

And they have the potential, at least, for very strong domestic demand. So they have the ability to move to stimulate the domestic side of the economy should the world economy weaken. And that’s what China did so successfully back in 2009, and most of these countries are in a position to repeat that.

China is a source of some concern recently. There’s no doubt that their growth rate is now moderating because they got very worried about inflation.

The Chinese population is very sensitive to inflation concerns, and so the government moved to restrain it by restricting credit, and now they seem to have popped the bubble in the real estate market, which was driving a lot of the inflation.

I think their question is, can they pop the bubble, so to speak, in real estate without causing a general financial crisis? When the housing market collapsed in the United States, we saw the whole financial system collapse too — but you have to remember that China does not have anywhere near the kind of complex financial system that the United States has. It’s a very crude, inefficient banking system, but it’s backed up by extremely high levels of government reserves. So they could have a financial crisis, but they can manage it because the system is so simple, and they have the monetary resources behind it.

The other characteristic of China that continues to be a big problem with respect to the United States is its very strong emphasis on exports and its very high levels of export surpluses. They can be traced to the large surplus of saving in excess of domestic investment. Figure 2 illustrates the incredible level of savings that takes place in China as an emerging market.

Figure 2. China Saving by Sector

We usually think that low-income emerging countries can’t afford to save and so they have low saving rates, and rich countries find it easy to save. And so years ago, we used to think that the world would be composed of rich countries running surpluses and exporting them to the developing world, which would then use the capital to grow faster.

But the world has been turned upside down because now what we have is all the rich countries living way beyond their means, running current account deficits, and borrowing from the emerging markets. And the emerging markets turn out to like that because then they have big export opportunities, and they grow faster because they have export-led growth.

Figure 2 shows that national savings in China has exceeds 55 percent of GDP, meaning that more than half of their income as a country is saved. They have very high levels of household saving, but the other factor is that the government enterprises that used to be so inefficient are now very profitable. They earn very large profits, and they just hang onto them, and so corporate sector in China is a second major source of saving in that country.

The third factor, somewhat smaller, is that the government also has consistently run budget surpluses for about a decade.

China has a level of savings that’s hard for the rest of the world to imagine — that you could save half your income.

Figure 3. Capital Formation by Sector

Investment is also high in China. Figure 3 shows that it’s about 45 percent of GDP, but the saving exceeds investment, meaning they have saving of about 10 percent of GDP in excess of investment. That 10 percent of their GDP goes into a net export surplus for the rest of the world.  They export it.

So China is a very high savings country, and a relatively high investment country. The difference between the two gives rise to a large trade surplus. So I think that’s the major driver for China.  It will probably have some slowdown because of financial difficulties, but the notion that China’s going to collapse just seems absurd. It has a lot of positive bases for its growth.  It will probably weather this crisis quite well, and what we mean by a slowdown is growth at the rate of about eight percent a year. We should be so lucky to ever see that.


The other country that I want to briefly mention is Japan. Japan is a major challenge. It’s interesting primarily because it’s the first major country in the world to start aging. When countries age and the labor force begins to decline, and there are lots of retired people to take care of, we have always wondered how well such an economy could perform.

Japan is the leading example, ahead of the rest of the world. They’re aging at a very rapid rate, so they have declining labor force participation, very high pension costs, and they have to face the medical care costs of taking care of their aging population.

The result is that Japan has been stagnant now in terms of economic growth for about two decades. It had a financial crisis just like us, and basically it’s never recovered from it.  Japan just putts along at a relatively low growth rate. But the Japanese are a very homogeneous population, and they seem to be able to handle this collectively, and so they share the lower rate of growth relatively equitably among the overall population.  Unemployment is high, but not as high as in the United States. But there are reduced job opportunities, particularly for younger people now.

Another factor for Japan is that as they began to retire, they needed to use more of their income for purposes of consumption. So what you see going on in Japan is a dramatic decline in saving. It’s no longer a high saving country like it used to be.

Figure 4. Japan Saving-Investment

Figure 4 shows that Japan has a household savings rate that’s now about exactly the same as the United States’, which shows how far it’s come down.  It has a budget deficit comparable to ours.  But the most outstanding point about Japan that contributes to its problems is that there’s just no investment taking place.  It’s become a very stagnant economy.  People don’t see investment opportunities.  So although corporations have high profits, they don’t invest much.  It’s the lack of investment taking place in Japan that’s held down its growth.

After the tsunami, it will do a little bit better, because it’s going to cost about five percent of the GDP just to try to repair the infrastructure damage from the tsunami, and that will give Japan a temporary spurt of growth.  But Japan faces a real long-term problem of weak demand on the domestic side, and deflation.

I think that on balance, Asia is in a very strong position for the global economy, but we always have to keep Japan in mind.

I would characterize the world as one in which the advanced economies are all in serious trouble.  They’re likely to grow at very slow rates, and we are surprisingly reliant on the emerging market, low-income economies to be the source of global growth over the next couple of years.

Let me stop with that, and let Don talk about Europe.


MR. KOHN:  Thank you, Barry. Barry left for me the task of talking about the troubled area of the world, Europe.

I think the fundamental problem in Europe is that they are suspended between a full monetary, political and economic union and a bunch of sovereign states.  When they went to the monetary union, they adopted the same currency before they had full economic and political union.  And that’s the fundamental source of tension over there.

Fundamental Tensions

A lot of the people who pushed for the monetary union were hoping that the monetary union would lead to more economic and political union. But it didn’t, or it didn’t fast enough, and now they’re kind of stuck.

The monetary union itself encouraged imbalances to increase as the countries basically converged to the same interest rate. The lower interest rate for many countries actually encouraged them to overspend and over-expand.

And because everybody’s using the same currency, facilitating transactions between countries, it strengthened those interactions and interconnections that can lead to contagion.  That means that when one country gets in trouble, it affects the other countries as well, and those effects are magnified by the fact that they’ve had 10-plus years of currency union.

Because Europe is not quite one thing or another, they don’t have the adjustment mechanisms that they would have if they were a complete economic and political union or a set of truly separate and sovereign states.

Think about the United States, and what happens in our political and economic union when imbalances develop, in particular, between regions or states. There are a number of adjustment mechanisms we have that they don’t.

Number one, there are, for the most part, common labor laws and quite a bit of labor mobility in the U.S.  People move from troubled areas to more prosperous areas. There’s a lot of discussion, including in Brookings, about labor mobility and whether it’s declined in the United States, but I don’t think there’s any question that it’s much greater in the U.S. than it is elsewhere. After all, we have pretty much one common language, so it’s much easier for people to move.

There’s also a lot more of the fiscal policy and budgets centered at the national level, and a lot less at the state level.  The states do a lot of important things, but there’s a huge flow — 20 percent of GDP, more or less — into the center, and that means when a particular region or a particular state is weak relative to the other states, there’s kind of a natural balancing:  There’s more income flowing in from the strong areas of the U.S., and it’s distributed nationally through food stamps and other help to the weaker areas of the U.S.

There is much less of that in Europe. In Europe, almost all the fiscal tax receipts end up in the sovereign states, and only a small share goes to the center for redistribution.

The final point here is that, in the United States, there’s a lot more discipline on the states in terms of their fiscal situation than there is in Europe. This goes back, in some people’s view, to the 1840s, when we actually allowed some states to fail to repay their debts. A lot of states at that time — and the states that came into the union after that — put into place balanced budget amendments in their constitutions. These aren’t totally tight, but the proportion of GDP accounted for by state and local debt is very, very small relative to federal debt in the U.S., whereas of course in Europe, it’s just the opposite. The sovereign states have a huge amount of debt, and they haven’t been subject to fiscal discipline.

If these were still sovereign states that had their own currencies, there would be another adjustment mechanism, and that’s the ability for exchange rates to change.

When the European Monetary Union was formed, they put in place something called a stability and growth pact, known as the Maastricht criteria, which said that debts were supposed to be limited to 60 percent of GDP and deficits were supposed to be three percent of GDP.

There was also a so-called no-bailout clause in the Maastricht Treaty so that if one sovereign got in trouble, it wasn’t supposed to be helped and bailed out by the other sovereigns.

Figure 5. The Introduction of the Euro Encouraged Larger Imbalances
Source: Bloomberg: Eurostat

Figure 5 shows what happened to interest rates on the way into monetary union: whereas Greece, for example, had been paying a huge premium over Germany for its debt — it all collapsed, all those interest rates went down, and the differences in the markets collapsed to nothing. It was as if the markets didn’t believe the no-bailout clause.

And then you see that when Germany and France violated the Maastricht criteria, they managed to avoid any penalties for that. They just overrode those criteria.

At that point, the discipline was gone. They weren’t subject to market discipline, and they weren’t being disciplined from the center.

Moreover, there are a lot of political deficiencies in how Europe makes decisions, and a lot of tension between having sovereign states with democratic accountability, and the center — Brussels and the European Commission and even the European Parliament — in which the accountability hasn’t been clear.

In order to make a decision in the Euro area, you need all 17 countries to agree, so in Europe you don’t have the possibility of a TARP-like moment where you have the House of Representatives first voting it down, then voting in favor, some people voting against, et cetera. You don’t have that possibility in Europe, so you have both decision-making problems and a lack of confidence in the center.  Now Merkel and Sarkozy, Germany and France — the two biggest countries — are kind of acting as a decision-making authority.  What happens to the others?  So, there are a lot of difficulties making this monetary union work.

As I noted, the discipline that the markets were exerting on these various states completely disappeared as they went into monetary union — which reminds me a little bit of the U.S. housing market. Where were the markets when all these lousy loans were being made in the U.S.?  Market participants were believing the AAA ratings that S&P and Moody’s were giving them. There was very little discipline on it.

I think there was a period globally in which markets failed to do the disciplining, to look behind the curtain and see what was really going on, and that certainly was true in Europe as well as in the U.S

Part of what happened then was that the countries that had substantial declines in interest rates sort of went and had a party with the benefits they were getting.  So you had both housing bubbles in a number of countries — Spain, Ireland are primary examples of that — just as we did, but they also suffered from overspending and a lack of competitiveness.

Figure 6. Growing Competitive Disparities
Source: OECD

The lowest line in Figure 6 above is unit labor costs in Germany. Germany adopted several reforms of its labor markets in the early 1990s. This was after the unification, and they realized they needed to do something. Productivity increased. Labor costs were held down.

That didn’t happen in the other countries, and there have been huge disparities in unit labor costs and the cost of producing goods and services among these various countries. Look at the countries at the top of the figure, with the highest unit labor costs — Spain, Greece, Italy, the Netherlands, Ireland and Portugal. These are all the countries, except for the Netherlands, that have encountered problems. A major part of their problem is a lack of competitiveness and their current account deficits. They are buying more from other countries than they are selling to other countries. They need to finance the difference by borrowing, so they are dependent on capital inflows to support the spending patterns they are in, and they are highly uncompetitive.

I’ve been at conferences where Jean-Claude Trichet, the former head of the ECB, shows a chart like this for the U.S., and he notes that in the U.S. there are wide dispersions among unit labor costs in various states, and the dispersions aren’t that much different than what you see on this figure.

I think there are two problems with that analysis.  One is, the bottom line in the U.S. for unit labor costs is Idaho, I think.  It’s about one percent of GDP. The bottom line in this figure is Germany. That’s 30 percent of Europe’s GDP.

And of course, the other problem is the one I’ve already mentioned, that there are a lot of adjustment mechanisms in the U.S. that are missing in the Euro area.

The other thing that happened is that these governments, facing very low interest rates, borrowed a lot, as shown in Figure 7 below.

Figure 7. Soaring Government Debt Levels
Source: OECD

Some of the increase in debt is a result of the recessions themselves, but you can see that Greece, Italy, Belgium, Portugal, to name the four bottom countries — and France to some extent — started with very high levels of debt relative to GDP, and then they hit the recession and the problems in the banking sector.

So the low interest rates didn’t do anything to discourage borrowing by the governments.  They are now trying to correct the imbalances, and I agree with Barry’s characterization that the Euro area has probably already in the fourth quarter fallen into recession. Both Germany and, I think, France and perhaps one of the other countries, have shown fourth quarter growth below zero – that is, declining. There are a few signs in the most recent data that maybe the recession won’t be quite as deep or as long as people thought, but I think they’re definitely falling into recession. It may be shallow, but it’s a recession.

Two important forces are pushing Europe into recession. One is fiscal tightening. As they try to do something about the deficits and the debts we saw in Figure 9, they tighten up fiscal policy, raise taxes, and cut spending, which all put downward pressure on the economies. Also, as they try to bolster bank capital, which the banks are being told they need to do, they do so in large part by cutting back lending.

So you’ve got tighter credit at a time when the economies are falling into recession, and that’s a recipe for disaster.

Figure 8. Correcting Imbalances Is Leading to Recession

Figure 8 shows the effects of fiscal tightening and bank deleveraging on the unemployment rate. To the extent that any hiring is happening — and this is true in Italy as well as Spain — it’s largely happening through temporary workers because that’s a much more flexible way to bring in labor and then let it go.

One problem is temporary workers are obviously not a permanent part of your labor force.  They don’t tend to benefit from training. You’re not going to invest a lot in training them for the long run. You bring them in for specific jobs, and then they leave.

So for young people, to the extent that they’re getting jobs, it’s more like temp work than it is like permanent work. They’re not getting the training and education that they need.

Mario Monti, the new Prime Minister of Italy, has proposed — and I think they’ve been carried through — labor market reforms that make it easier to let workers go so that there will be less reluctance to hire. His proposal also encourages more equal treatment of temp workers and permanent workers in the hope that, to the extent that people are hired, they are hired as permanent workers with all the attributes associated with that.

And the Spaniards are talking about adopting labor market reforms of a similar nature. I think labor market reforms are an important part of what needs to happen in Europe.

Many Steps Underway in Europe

There are a lot of steps underway right now in Europe trying to address their problems. The first one is a tighter fiscal union. They have tried to deal with the problems that emerged under the Maastricht Treaty, under which nothing has been enforced, by agreeing to more and more enforceable restrictions and limits on the types of deficits that countries can run, when they can run deficits, and permissible debt-to-income ratios.

This is in the process of being negotiated as we speak. There was a finance minister meeting in Europe yesterday. The European Central Bank, which is keeping a careful eye on this, was concerned that even as they were negotiating, there were too many exceptions to the discipline, and enforcement was unclear.

So this is still a work in progress, but it’s absolutely necessary. If they’re going to hold the monetary union together, they’ve got to move towards tighter fiscal union.

Part of moving towards tighter fiscal union — the other side of that coin — is more common support for the countries that are selling debt. They have put into place one mechanism now for supporting countries, allowing them to borrow from a centralized fund, The European Financial Stability Facility (EFSF) rather than having to borrow in the market.

And they’ve got another, new fund that they’re putting together, that was supposed to come into play, I believe, next year, in 2013 but they’ve accelerated that to 2012. So there’s a lot of discussion about whether the Europeans can band together, provide some funds that will help out countries that are undertaking reforms, and give them some breathing room for those reforms to be carried out. That is, the new fund could buy their bonds, or lend them money so that they’re not faced with the very severe downward spiral of having to borrow at very high interest rates, which just makes the fiscal deficit worse.

If these reforms are undertaken, then the countries will get some support. The issue is whether it’s enough support or not.

There is fiscal retrenchment in the periphery, certainly in Greece and Portugal, and Ireland and Italy. So the countries that had some of those large increases in debt have taken a lot of steps to try and raise taxes and cut spending, but they’re still in the initial stages. There’s also the issue of carrying through on the promises they made. This is something you often hear about Greece — that it has made promises to get the next tranche of support, but then doesn’t carry through on them. There is also the longer fuse issue: Everyone concedes that to reduce unit labor costs they need to have more flexible economies and more flexible labor markets. They need to have greater productivity growth, and that’s going to require some structural reforms, and they are starting that process. But that is going to take a couple of years, at least, to go through.

I’ve already mentioned the higher bank capital ratios. One of the problems that they’ve got is the banks own a lot of the sovereign debt. As the sovereign debt becomes seen as less creditworthy, the banks become seen as less creditworthy. So the banks need more capital to absorb any losses that might be out there, and they’re leaning on the banks to get more capital.

The European Central Bank has taken a number of constructive steps to deal with the situation and at least buy time for more fundamental fixes to take effect. Number one is they are funding European banks for as long as three years at one percent. The banks can come in once a month and bid for three-year funds at one percent. That’s pretty cheap three-year money, and it’s happening at a time when European banks themselves don’t really have access to the term funding market.

The European banks are under pressure from two directions. One is trying to build capital.  They’re being held to higher capital standards.  And number two, they’re not able to access funding very easily. So at least the European Central Bank has come in and taken care of the second piece of that. They’re giving them funding.

Now, there’s a suspicion that the banks are using what they borrow from the ECB to come in and buy sovereign debt — Italian, Spanish sovereign debt — because some of the spreads on sovereign debt have narrowed quite a bit in the last few weeks.

No one knows because we don’t know what the commercial bank balance sheets look like.  I think at a minimum, it’s taking pressure off of those banks to shrink as fast as they were shrinking before. So it’s got to be helpful, not only to governments but also to households and businesses in Europe.

The second thing that the European Central Bank has done in the last few months is to ease monetary policy.  They’ve lowered interest rates.  The ECB raised interest rates over the spring and summer, when energy and other commodity prices were increasing headline inflation. The Federal Reserve did not. The Federal Reserve was looking through what it thought was a short run increase in inflation to a downward tilt later, and said we don’t have to fight this.

But the European Central Bank made a different decision, and they said, no, we’re concerned that if inflation remains high, then it’ll get built into expectations. It’ll be self-perpetuating. So they raised interest rates over the summer. I think to Draghi’s credit, he came in, he could see the economy was going into at least a mild recession, and he lowered interest rates in the first two meetings.

Easier monetary policy is absolutely essential to make the adjustments they need to make.  The deeper that recession, the tougher that recession, the harder it’s going to be on all the parts of Europe to make the adjustments. The peripheral countries are in for a very difficult time.

Will the Adjustments Work?

I couldn’t make up my mind, actually, whether the adjustments will work. I think one of the really hard parts of the European situation is there are so many possible outcomes. Greece is a special case. A lot of people say Greece is just off the charts.  As you saw it was at one end of the charts on unit labor costs and on debt as well. And if you could take care of Greece, and deal with their debt and sustainability problems, maybe the rest of the area can move ahead.

But the problem, as I noted early on, is there are a lot of interconnections in Europe, and people are very worried that if Greece were to really default — not a voluntary default — that that could spread to other countries.  There are a lot of interconnections in the banking system there. There are a lot of possible outcomes, and there’s a lot of pain to be felt over a long period of time in these countries with high unit labor costs in order to make that adjustment.

If they were independent countries with their own currencies, they could depreciate the currencies and become competitive by changing the price of the currency.  But because they can’t change the price of the currency, they have to change the price of labor and the productivity of labor, and that is a very, very difficult, long, drawn-out thing to do.  But they need to make it happen.

To do this, they need support from the center.  They need Germany, France, and northern Europe to help them — as long as they’re actually doing what they say they’re going to be doing — get through this without making the pain even worse than it otherwise would be.

There is a problem with patience on both sides: the patience of the German taxpayers to advance funds to Mediterranean countries who they see them as not taxing themselves, as retiring earlier than the Germans, et cetera, and the patience of the peripheral countries to undergo the very tough reforms and live with their very, very weak economies.

We saw the unemployment rates on Figure 11.  Look what’s happened to the Spanish and Greek unemployment rates.  They’re awful, and getting worse, and are going to get even worse.

There are a number of ramifications of all this. For one, there is the risk of contagion to the United States.  Europe is one of our important trading partners. We do export there. It’s not a huge amount of exports to Europe, but certainly, if they’re in recession, that’s going to damp our trade, and damp our ability to export.

Also, as they get into recession, the euro has — until the last few days at least — tended to drop and the dollar to rise. As the dollar rises in value, that’s also going to damp our exports.

So they’ll have some effect on our economic activity directly, but I think the more important point is the financial contagion.  And that’s what we saw over the summer and fall, when problems in Europe had a major effect on U.S. stock markets, and on the willingness and ability of U.S. banks to make loans because their exposure to European borrowers was large enough that problems in Europe were putting downward pressure on U.S. bank stock prices and upward pressure on their borrowing costs.

The interconnectedness from Europe and the U.S. importantly runs through the financial markets, and it goes both ways. Recent data suggest that the European banks have drawn back from lending in the U.S.  Their loans to U.S. businesses have been declining, and they are tightening up their criteria for lending to U.S. businesses very substantially.

At the same time, U.S. banks are being hurt by what’s going on in Europe, so perhaps they’re not easing loan standards quite as rapidly as they were before. I think if European banks get in trouble, the exposure of U.S. banks and U.S. money funds that have lent a lot of money to European banks will come back to the U.S. through tightening credit conditions, a lot of volatility in equity prices, et cetera.


SPEAKER:  What do you think are the chances of Greece or any of the other peripheral countries leaving the European Union?

MR. KOHN: An interesting part of the problem here is that there is no provision in the treaty for exit.  Of course, that was deliberate.  This was the Hotel California.  I mean, you could not move out once you moved in, and that was key — because if markets saw that a country could move out, they would put a lot of speculative pressure on the weaker currencies, and they’d be forced to move out.

The Europeans had experience in the early 1990s with a European exchange rate mechanism that had Britain and others tied to the German mark, and once the market smelled weakness, they just pushed them out.

So not having an exit and not having provided for an orderly way to dissolve the union was a deliberate decision on their part. I’ve talked to people in Europe about this.  They say it would be extremely difficult — as soon as people smell that coming, there’s going to be a huge run on the banks.  There have already been runs on the banks. People have already been running from Greece, and from Italy, Spain and Portugal to Germany, where their currency will strengthen.  And then you’ve got all these contracts denominated in euros, et cetera.

MR. BOSWORTH:  I think the other thing to keep in mind is that this is not a problem of the government. The government of Greece could exit or, in effect, go bankrupt.  That’s happened before. It’s happened here in the United States. It’s a manageable problem. But doing so does not solve the state of Greece’s problems, which is that it’s a completely uncompetitive country. And if you have the government say, well, we’re not going to repay our debt, what happens to the private firms in Greece?  They’ve got debts written in euros.  If, all of a sudden, they had a big devaluation, their revenues drop and their liabilities stay the same. At that point, all the Greek private enterprises go bankrupt.

A good example of a bankruptcy would be Argentina, but Argentina never had the same magnitude of the private sector investing in a foreign currency. Their private debts were denominated in Argentine pesos, so they were not so severely affected.  If you borrow all your money in a foreign currency, then devaluation gives you a huge short-term problem as the local currency cost rises sharply, even though it may make you more competitive in the long run.

For Greece, it is really an incredible mess to figure a way out. You can let the government go and default.  That’s what we did in the U.S., for example, with Illinois.  They’re not in a big crisis. We didn’t do it quite that way with New York City, but we brought it under outside control — so you could think of a mechanism like that for the Greek government.

But if that happens, what do Greeks do afterwards for a job? That just doesn’t solve all the problems. It’s not so much the government, it’s the people in Greece that have to be considered.

MR. KOHN: Just to follow up, there’s no substitute for good policy and, as Papademos has pointed out, it’s not as if Greece was doing really great outside the euro, right?

So they had bad policies before — depreciations and devaluations, and bad labor markets, and it’s true that going into the euro didn’t do as much for them as it should have to reform those policies.  I don’t care whether you’re in or out, or if your exchange rates are fluctuating or they’re fixed — if you’ve got lousy policies, nothing’s going to work very well for you.

SPEAKER:  What are the possibilities of reform in the public sector labor market in Greece?  It seems that that would help.

MR. KOHN:  Well, I think they’ve done some of that. It’s hard.  And they’ve done some of that in Ireland as well, I believe. Having the government sector take pay cuts is already happening.  One problem in the government sector in Greece is that it’s against the Constitution to fire people.  And so instead they have closed down some parts of the government.  They can close something.  I think they can get rid of the employees, and the total employment in the government has gone down because they’re not replacing people as they retire or leave for whatever reason.

So they’ve done some of those things.  Now you can’t impose that on the private sector, but I think to your point, taking a pay cut in the public sector means that you’re more likely to be able to do that in the private sector because you don’t have that competition there.

So some of it’s beginning to happen. Is it enough? Not yet.

Speaker: My wife’s sister worked for the European Parliament for 25 years, and she said that they realized a long time ago that their greatest single mistake was admitting Greece, for structural and other reasons.

Martin Wolf in the Financial Times has made a number of points about this, notably that not everyone can, through austerity, solve this problem in what is essentially a closed system.

And if the Germans and/or the French are unwilling to make adjustments to some extent in response to the adjustments that are being made in the peripheral countries, they’re not only in for a very difficult economic situation, but eventually for the potential of populations to say, we’re going to discard the democratic model.  And then there’s an opening for demagogues to come in and say, this is just too much to bear, and we’re going to go in a different direction.  Do you have an opinion about that?

MR. KOHN:  Right. I think it’s a risk. That’s why I was talking about the patience, both at the center for making this happen, and at the periphery. Progress on fiscal and structural issues will bring more support.  So I think they’ve got to have some plan where if reforms are carried out, then you’re going to get some support — and not just in Greece but everywhere.

MR. BOSWORTH: Right.  And think about this sort of pious fiction that’s going on in the negotiations about restructuring the Greek debt, that this is voluntary. If you listen to Charles Dallara, who represents the private sector, saying, this is far enough.  No, this is far enough.  No, this is really far enough.  They’re at about, what, 60, 70 percent? Most people think the value in the market of that Greek debt is probably about five cents on the dollar.  So there’s a big gap there that has to be absorbed somewhere.

Just one last thought — for the first time, again, in the Financial Times over the weekend, John Dizard was speculating that a structured withdrawal by several countries at once, managed through the system, might mitigate some of those potential bank runs, and might take some of the pressure off, at least temporarily. It was the first time I’d seen something like that.  I don’t know if you’ve seen anything about that Don.

MR. KOHN:  I don’t know whether you could do that and keep it secret. I mean, you have to surprise people, or you’re going to produce a very unstable situation.  I’ve had a couple conversations with people, both at the ECB and one or two of the central banks, and I have said to them, I hope you guys have somebody in the basement, some really smart person who won’t tell anybody what he or she is doing, figuring out how to do something like this.  And they say, no, no, no, we don’t have that.  And they didn’t wink, but I was hoping they were winking.

On your other point, I think that getting to debt sustainability is increasingly difficult because more and more of the debt is held by the official sector.  So as the European Central Bank buys the debt, as the IMF makes loans, as the European Fund for Financial Stability (EFSF) makes loans, more and more of the debt is held by the public sector. The public sector doesn’t want to take, and the IMF by tradition doesn’t take, these haircuts. And when only half the debt is held by the private sector, they have to take bigger and bigger haircuts.  So you’ve got a very adverse dynamic there.

One of the things I think I read in today’s Financial Times was some speculation that the European Central Bank could sell its debt to the EFSF, at the price at which it bought it, which was at a discount, and then the fund could tender it at a bigger discount to this new setup.

So people are beginning to think about that.

MR. BOSWORTH:  While managing to avoid triggering the credit default swaps, which would be the real bad thing.

SPEAKER:  How is its aging population affecting Europe?

MR. KOHN:  Well, I think that many of the European countries have the same problem we have, which is that they’ve made promises in the past for support in retirement that will put increasing tax loads on the smaller proportion of the population that’s working.

MR. BOSWORTH:  I would put it a little differently for Europe. Europe has done a lot.  Up until this crisis, you would have held Europe up as a really good example of countries scaling back their fiscal commitments. I remember attending a conference in 2009, before this emerged, and Europe was held up as the model of how to scale back the public sector commitment.

So there’s been a lot of cutting back of pension funds, and they don’t have the same problem that the United States has with respect to healthcare for the elderly. It’s just a different problem for them.

One difference is that healthcare costs are a fraction of what they are in the United States, and secondly, they already provide healthcare for everybody.  So when people age, there’s some increase in the healthcare cost of older people compared to younger people, but in the United States, the public sector only provides for older people.

So in the United States, the increase in the cost when somebody turns 65 is 12-fold for the federal government because when they were under 65, the federal government essentially paid nothing, and then when they turn older, they’re covered by Medicare, and that becomes a government liability.

So Europe has a problem with pensions, but they’ve taken a lot of action to begin to reform in the major countries – Germany, France and the UK.  And they don’t have the same degree of problem in the healthcare system that the United States does.

So I don’t think population aging is driving their current difficulties.

SPEAKER:  Are Europe’s high unemployment rates driving up enrollment in higher education? Is the return to education as high in Europe as it is in the United States?

MR. BOSWORTH: The biggest problem in Europe that holds down the return to education is their labor laws.  And so it’s not enough to say younger people should get a good education.  They do get more education than in the United States. Most of the European population is better educated than Americans are, but they’ve got these labor laws that prevent them from moving freely into the labor market to take advantage of their education.

And the differential between the equivalent of a high school education and a college education, which has widened so much here in the United States, making it very profitable to go to college, is less true in Europe.  There’s not the same reward for people getting a higher degree of education — yet they’ve done so.

So I would say no. The thing that Don mentioned first is the importance of labor market reform, to let the more skilled people be able to get first draw on wages is important, and that will raise their productivity.

MR. KOHN:  Aside from the labor market, I think the other aspect of this issue is the product market and businesses. It’s very hard to start a business in Greece. Everything requires a license.  And people who control the licenses control entry because that’s what keeps their profits high.

One of the reforms that they’re talking about is loosening up on licenses.  Starting businesses, getting people into the labor force — all seem like doable reforms that would help increase productivity, but there’s resistance on all these fronts because there are vested interests already in the labor market, with high wages, who don’t want the competition, and there are businesses already operating that don’t want the competition either.  But the structural reforms are critical.