Guest Host: Katty Kay

There’s new evidence of economic and political strains among euro zone countries: On Monday the prime minister of the Netherlands resigned following the failure of his coalition government to find a way to meet deficit reduction targets. First round election results in France have raised doubts about President Nicholas Sarkozy’s political future. Spain has fallen back into recession. Italy, Belgium, the Netherlands and the Czech republic remain there, but the European Central Bank is not likely to come to the rescue once again. Please join us to discuss what’s ahead for the euro zone and its potential political and economic impact on the U.S.


  • Desmond Lachman Resident fellow, American Enterprise Institute.
  • Simon Johnson Professor of entrepreneurship at MIT's Sloan School of Management, a senior fellow of the Peterson Institute for International Economics and author of "White House Burning: The Founding Fathers, Our National Debt, and Why It Matters To You"
  • David Smick Global macroeconomic advisor, founder and editor of The International Economy magazine and author of "The World Is Curved: Hidden Dangers to the Global Economy".


  • 10:06:57

    MS. KATTY KAYThanks for joining us. I'm Katty Kay of the BBC, sitting in for Diane Rehm. Diane's on a station visit, and she'll be back tomorrow. Several eurozone countries seem to be teetering on the edge yet again. Austerity measures combined with the lack of growth are leading to more economic and political strain.

  • 10:07:14

    MS. KATTY KAYJoining me in the studio to talk about the latest developments in the euro crisis and their implications for the U.S. economy: Desmond Lachman of the American Enterprise Institute, Simon Johnson of the Peterson Institute and a professor at MIT's Sloan School of Management and David Smick, a global economic advisor and founder and editor of The International Economy magazine. Gentlemen, thank you so much for joining me.

  • 10:07:36

    MR. DESMOND LACHMANGood morning.

  • 10:07:36

    MR. DAVID SMICKGood morning.

  • 10:07:36


  • 10:07:37

    KAYWe'll be opening the phones in just a short while to take your calls and comments. Do, please, call in for my guests with your questions. 1-800-433 is -- sorry -- 1-800-433-8850 is the real phone number. is the email address, and, of course, you can find us on Facebook and Twitter as well. Do send your questions that way, too. Simon, let me start with you. I thought it was all getting better in Europe.

  • 10:08:01

    KAYAnd then we have this kind of extraordinary week where every government in the center of the continent seems to be looking about whether they're going to be there the next week or so.

  • 10:08:08

    JOHNSONWell, it's an -- it's obviously an on-again, off-again crisis, Katty. The big problem is growth. If you believe these economies are going to turn the corner and start to grow, then their debt burdens look high but manageable. If you think that they're not growing, and the austerity -- the budget contractions, for example -- are going to slow them down further, then their debt looks insurmountable. And we're in one of these it-all-looks-insurmountable weeks.

  • 10:08:28

    KAYBut we have, what, political chaos in the Netherlands with the government resigning. We've got definitely change in the air, at least in France. So the governments who are looking at their political futures and thinking did they made the right economic calculation.

  • 10:08:41

    JOHNSONYes, I think the Dutch developments are fairly significant. They have one of the last remaining AAA ratings among European governments, and they obviously have complete disarray about exactly what to do with regard to the economy and with regard to the budget. These problems tend to get out of control in a situation like this. And the French presidential election -- whatever you think of that exact outcome -- definitely introduces an extra level of uncertainty with regard to the overall structure of the eurozone.

  • 10:09:06

    JOHNSONWho is going to pay for what damage done by whoever you think is responsible? You could blame Greece. You can blame investors. You can blame outsiders if you want. Obviously, there's a lot of that blame game in the European future.

  • 10:09:18

    KAYDesmond Lachman, let's talk a little bit more about what happened in the Netherlands. Were you surprised that the prime minister stepped down this week?

  • 10:09:24

    LACHMANNot particularly that you're talking about a weak coalition government. You keep talking about people getting tired of austerity, so this gives the opportunity of those on the far right to be opportunistic. But I think that what they're doing is they're tapping into something that is really very deep right across the European zone in that people really are seeing that the austerity is producing deep recessions.

  • 10:09:52

    LACHMANAnd they're tired of having more and more measures, so you've got a lot of political discontent that is manifesting itself not simply in -- at the Netherlands. But you're seeing it in France. You're seeing it in Spain. You're seeing it in Greece. So I think that the problem is already deep. What occurred -- the reason that we had calm for the last four months is that the European Central Bank intervened in a manner that is without precedent.

  • 10:10:19

    LACHMANThey threw a trillion euros at it, around about December and February. And the fact that we now seeing strains again is really indicating how deep the underlying problems are if $1 trillion, all that it does is it buys you four months. It means that we really are in deep trouble in Europe. And I think that just throwing more money at it, as they want to do, all that that does is it kicks the can a little bit forward.

  • 10:10:48

    KAYIt's a pretty expensive four months, whichever way you look at it, $1 trillion. David Smick, presumably, though, whoever takes over in the Netherlands, just to kind of finish off there, is going to face the same problems again.

  • 10:11:01

    SMICKYeah, I would say, if you look at the last four months -- if you look at the last two years, actually, the Europeans -- the eurozone officials have played a very clever game. They've been living by their wits. They're like a magician. They're saying, look, concentrate on this one hand on the right side here. And they've set up a series of short-term tactical challenges, you know? Will the Bundestag agree to some slight upping of the rescue fund level?

  • 10:11:29

    SMICKWill a Greek official sign some piece of paper or will ECB do this or that? And they have the markets concentrating on these tactical challenges, and when they meet that challenge, the markets, kind of calm for a while -- used to be for months, now it's just for, sometimes, days. But what they don't want you to see is the 800-pound gorilla in the corner of the room, which is a $7 trillion sovereign debt problem -- sovereign debt and private debt problem.

  • 10:12:01

    LACHMANI mean, it's somewhere in there, and it's huge. And, ultimately, this situation won't be resolved because the markets lack confidence. Every time the markets, you know, fall for one of the tactical challenges, they say, oh, but look at this situation. Now, you mentioned the ECB putting a trillion or a trillion two. What they've done is the banks in the periphery countries, these troubled banks have loaded their balance sheets with the questionable toxic debt.

  • 10:12:33

    LACHMANAnd so what's happening now -- it worked for a while, but part of the market's lack of confidence is now they are questioning the banks. So the banks of the periphery countries have really become the soft underbelly of the European sovereign debt problem.

  • 10:12:48

    KAYRight. And, Simon, this -- what had been a problem around the edges of Europe now seems to be moving to the core of Europe, at least politically, with what we've seen in the French elections last weekend.

  • 10:13:00

    JOHNSONAbsolutely. France is about as core as you can get. And the questions are not just about the French banks -- although they definitely have some serious problems -- and their big counterparties in transactions with U.S. banks, for example. But the question is also about French fiscal policy. The rhetoric -- and -- I'm sorry, it's just the rhetoric right now from the socialist side in the presidential election is, I think, potentially quite damaging to their own case.

  • 10:13:25

    JOHNSONThey are talking as if they want to change the fiscal arrangements, the budget arrangements within the eurozone and also not go along with the kinds of reasonable caution that others and the existing government has. So in this kind of situation, that's rather like lighting the fuse under a pretty big pile of inflammable material.

  • 10:13:50

    KAYBut, Simon, if voters are threatening a protest vote, which is effectively what they're doing in France at the moment, saying, we don't like what Nicolas Sarkozy has done to the country, we don't like what our unemployment is like, we're feeling too much economic pain, if they're threatening protest votes before these austerity measures have actually really kicked in, I mean, what's the situation going to be in these countries when people are getting real cuts?

  • 10:14:12

    JOHNSONWell, I think that's the key issue, Katty. I think this is a long-term problem. The Europeans are not going to get out of this in six months or nine months. I don't think they're going to collapse in six to nine months either. I think it's going to be prolonged, prolonged, for example, by the kinds of actions of the European Central Bank that Des and Dave were talking about a moment ago. So they can -- they're rich people, rich countries, a lot of resources, strong central bank. You can draw this out.

  • 10:14:34

    JOHNSONBut it's painful, and the pain is just going to get worse when people refuse to make adjustments to their living standards and they refuse to go along with, whether it's higher taxes or government spending. This is the worst way possible to do any kind of economic adjustment.

  • 10:14:49

    KAYBut, David, when we look at the kinds of adjustments that some people have already had to make, for example, in Greece where there have been real cuts to public sector wages, to pensions, and now you look at the high level of unemployment in Spain -- what is it, 40 percent of Spain's young people are...

  • 10:15:02

    SMICKFifty. Mm hmm.

  • 10:15:03

    KAYThat's real pain. I mean, that is, you know, those are serious consequences. And whether democratically-elected governments are going to be able to withstand that kind of pain is a big question in Europe (unintelligible).

  • 10:15:13

    SMICKIt's a huge question. And if you look at the recent history that -- of emerging market economies that have withstood austerity, they have always -- and that's from Brazil to Sweden or whatever -- not -- as an emerging market, but countries that have taken on austerity policy successfully, they all seem to have one thing in common. They had huge export engines. They were able to export their way, and that was part of their growth strategy.

  • 10:15:40

    SMICKAnd they did this obviously through currency depreciation and then, you know, and the effort to become more competitive. By its inherent nature, it's impossible for a periphery country in the eurozone, obviously, to adopt an export strategy because they're tied to the euro. And that's why a lot of people are asking, you know, fundamentally, how did the eurozone get out of this mess and still, you know, remain intact is a fundamental question.

  • 10:16:10

    SMICKThe -- I mean, the -- there are a lot of different solutions, and they all are very complicated. If you talk about breaking up the eurozone, it's a horror show. But I, frankly, don't see how these economies can withstand the austerity without a growth strategy, and the growth strategy has got to be tied to an export solution.

  • 10:16:29

    KAYDesmond Lachman.

  • 10:16:30

    LACHMANYeah. No, I totally agree with David. That is, the essence of the problem is that what we've got is we've got countries moving deeply into recession, and the policy prescription is that of fiscal austerity. And it's not a small amount of fiscal austerity. We're talking about tightening budgets by three percentage points of GDP, so...

  • 10:16:50

    KAYYeah, I mean, America has seen nothing like what some countries in Europe have already had to go through, right?

  • 10:16:52

    LACHMANWell, I think that if you look at what happened in America is, in America, when America went into a deep recession, what we had was the largest fiscal stimulus in peacetime history. Here, in Europe, what's occurring is, as these countries go into recession, they're imposing the deepest fiscal tightening in post-war history. This is not going to work. If you don't have an export engine driving your growth, what occurs is the economy goes deep in recession.

  • 10:17:23

    LACHMANWhen it goes deep in recession, you find you don't collect the taxes that you thought you were going to collect, so you have another round of fiscal austerity. And at some point, you know, people just say no, and that's what we're really seeing in Europe at a relatively early stage. I'm not so concerned about governments getting thrown out. I'm more concerned about the center losing any authority that we're getting extreme right and extreme left.

  • 10:17:49

    LACHMANAnd this just does not look like it's a sustainable position, that, as big a horror show as we might think it is, this is not a sustainable arrangement. This arrangement, at some point, breaks, and the ECB can throw as much money as they like at it. They're not going to change the fundamental underlying economic problems that you need to get currency depreciations to boost the exports. And, you know, my view is that we're just a year or two away from countries actually leaving this union.

  • 10:18:22

    KAYOK. And we have seen in France, of course, the rise of the far right, the strength of the far right's vote and then some passion as well on the far left. We've seen that already in the elections that we saw last weekend. Desmond Lachman is a resident fellow at the American Enterprise Institute. Simon Johnson is also here. His newest book is "White House Burning: The Founding Fathers, Our National Debt, and Why It Matters To You."

  • 10:18:44

    KAYI'm also joined by David Smick. He's a global macroeconomic advisor, founder and editor of The International Economy magazine. We will be back after this short break. We'll be opening the phones. 1-800-433-8850 is the phone number. Do call us with your questions and comments. Stay listening.

  • 10:20:04

    KAYWelcome back. I'm Katty Kay of the BBC, sitting in for Diane Rehm. We're discussing the eurozone crisis. There have been a lot of political consequences during the course of the last few days, and, of course, we'll be getting on to the impact that it's having on the American economy as well. I'm joined in the studio by Desmond Lachman. He's a resident fellow at the American Enterprise Institute.

  • 10:20:24

    KAYSimon Johnson, senior fellow of the Peterson Institute for International Economics, is here as well, as is David Smick. He's the author of "The World is Curved: Hidden Dangers to the Global Economy." Just before we went to break -- and I know, Simon, you're going to jump in with a great sunny ray of optimism for us, you promised me this -- we were talking about how the stresses, the economic stresses are also creating political stresses.

  • 10:20:50

    KAYChristine Lagarde, the head of the IMF, has called it the potential for a 1930s moment in Europe where we see a rise of populist, nationalist politicians, and we saw a hint of that in France over the last weekend. But I hope that you're going to tell me that, actually, it's a lot more sunny than that.

  • 10:21:05

    JOHNSONWell, not a lot more sunny, Katty.

  • 10:21:07

    KAYOh, go on, Simon.

  • 10:21:08

    JOHNSONBut on an interesting and perhaps unusual upbeat note, German labor unions are asking for big pay increases at the moment, three to 6 percent. Now, Germany can -- I would suggest before that, Germany has a big current account surplus. If you're looking for source of growth, something to boost the economy, something to help the periphery with their attempts to export, then a much stronger German consumption, higher wages, higher consumption, could actually be helpful under these circumstances.

  • 10:21:33

    KAYBecause isn't that -- I mean, isn't that the sort of fundamental fault line in the eurozone experiment, that we try to put Germany, a nation of high savers, in the same house as Greece, a nation of high spenders? And the two don't cohabit very well.

  • 10:21:51

    JOHNSONWell, they certainly haven't cohabited in the existing arrangement. It's a very rigid arrangement. The Germans had a lot of productivity gain since they started the euro, the Greeks, not so much. So the Germans actually became more competitive. The idea was the Greeks would catch up and become more Germanic. Well, that obviously hasn't happened. You can't change the exchange rate without that being extremely traumatic 'cause the way they've locked into the eurozone. So there aren't very many good options, particularly...

  • 10:22:12

    KAYBut you're suggesting maybe the Germans are going to become a bit more Greek.

  • 10:22:15

    JOHNSONWell, if the Germans -- absolutely. If the Germans went on a big spending spree, the German government wanted to expand -- again, not very likely -- but if the German wages go up significantly and you get some consumer-led growth in a sustainable fashion, which, for the Germans, is possible at this moment, that would absolutely be helpful to the Europeans and to the world economy.

  • 10:22:33

    KAYOK. David, let's re-orientate this discussion about Europe to our listeners here in the United States and remind listeners why what's happening in Europe and all of the developments that we've had this week matter for people here in this country.

  • 10:22:47

    SMICKWell, European banking is -- represents about 60 percent of global banking. I mean, people think of American banks and Chinese banks -- they are sideshow to a certain extent. European banks are huge, and they are the main financiers of emerging market growth. And you're already seeing contraction there. And so -- and, you know, we depend on emerging markets for our exports, so I think you've got -- but you also have a banking system globally that's interconnected. And there's such a lack of trust.

  • 10:23:22

    SMICKThere is something called the interbank market. In Europe, the interbank market has ceased to function. It's -- the interbank market is essentially the European Central Bank. And you say, why would a bank in Europe put money aside overnight at the European Central Bank at a much higher cost or at a higher cost than they would using the interbank market? It's basically European bankers don't trust each other. They think they're all fudging their bank balance sheets.

  • 10:23:50

    SMICKAnd that now has become a global concern within global banking. There's just such a lack of trust. Everyone assumes the other banker in the other country is carrying junk on their balance sheets at unrealistic valuations. And so we live in a global economy with a interconnected financial system. It's like a spider web of dependencies and relationships. And what we have now is a complete breakdown of confidence in that system. So that's why it affects the average American.

  • 10:24:25

    KAYOK. So if I am businesswoman in Minnesota, Desmond -- I make paper clips -- why would I be worried about the fact that banks in Spain are so indebted in the housing sector, the risk perhaps that some of them might even fold?

  • 10:24:40

    LACHMANWell, it's like David says, is that the European banking system is huge. The United States banks have got very big exposure to the European banks. And if things go wrong in the European financial system, what that is bad for is global equity markets. The whole mood changes, but I'd say that, beyond that, what one's got to keep in mind is that Europe is about 30 percent of the global economy. It's our largest export market.

  • 10:25:08

    LACHMANIf they go down, if they go into a real recession, that means that the demand for our goods is less. It probably means that you've got a weaker euro, a stronger dollar, which means we get priced out of other markets. So we get really impacted both through exports and through the financial market channel and through the equity market. We're talking about a huge event in Europe. This is talking about one of the largest economic and financial developments that we've had seen, you know, since breaking off the gold standard.

  • 10:25:42

    LACHMANSo if this goes badly wrong, this is a major global event. You know, much the same way as when Lehman collapsed, that had reverberations throughout the globe. Again, what you'll be seeing is if you saw Europe having real stresses, that it could very well have in a year or two, that would impact the rest of the globe much the same way as our financial crisis did in 2008.

  • 10:26:07

    KAYAnd when you look, Desmond, at what's happening in Europe at the moment -- I know we've had this period where things have been relatively calm, but we've certainly seen stresses re-emerging in the last week or so. When you look at what's happening in Europe, would you be advising that businesswoman in Minnesota to start paying attention again to what's happening in Europe? Are you now concerned again about the breakup of the eurozone?

  • 10:26:26

    LACHMANOh, absolutely. Well, I'm not expecting the eurozone to break up imminently because I think that there's big incentives for the Europeans to keep kicking the can forward. But what they're finding is you can kick the can down the road so much. It looks to me like we're running out of road. You know, all you've got to do is look at what's occurring in Greece right now that the (word?) in Greece is only going to get something like 33 percent of the vote.

  • 10:26:54

    LACHMANThey've got to do a huge amount of austerity that we talked about, an economy that has already contracted by 16 percent, unemployment's over 20 percent. And they've got more blood, sweat and tears ahead of them with no prospect of getting out of this. So their real risk -- I'm not saying that it's going to occur the next six months, but, you know, certainly, this is not a sustainable position. And we will get to see countries like Greece leaving.

  • 10:27:21

    KAYSimon Johnson.

  • 10:27:22

    JOHNSONWell, just to compound those issues, unfortunately and bizarrely, the Federal Reserve has taken a rather complacent attitude, particularly with regards to the amount of capital that we have in our largest banks. Looking at the world and looking at these kinds of stresses and listening to people like Desmond, they've decided, no, no, don't worry, be happy. They allow the banks to pay dividends, allow them to do share buybacks, reducing the level of shareholder capital, which is their buffer against losses.

  • 10:27:45

    JOHNSONSo your businessperson in Minnesota should be very worried about the risks to the U.S. banking system. You should be asking a lot of questions, for example, to the -- through the Federal Reserve system about why are you not safeguarding financial stability through ensuring that we have enough capital, enough equity in our very largest banks with these incredibly big exposures to European banks and European sovereigns?

  • 10:28:06

    KAYAnd yet, David, I get a sense from the White House that they think that the clouds have kind of blown over in Europe and that they don't -- they -- a few months ago, I had White House officials saying to me, listen, you just got to fix Greece. If we want to get re-elected, we've just got to get Greece fixed. We're worried about an October surprise. The mood has shifted in the White House. They seem to now think, this is no longer such a political liability for us.

  • 10:28:30

    SMICKYeah, I think that's coming back in the last four or five days, the fear. Look, every market person -- every stock market person, everyone involved in the bond markets, any financial institution right now, is looking for one thing. They're looking for the next black swan, the unpredictable, the unknown unknown that comes along and whacks the global economy on the side of the head and...

  • 10:28:56

    KAYAnd the recovery here is fragile enough that even a smallish whack could send things up.

  • 10:28:57

    SMICKThe recovery is fragile, and our soft underbelly is our banking system. And so the black swan could very easily be an unexplained, you know, breakup of the global -- of the European -- eurozone financial system. I mean, the key thing here is that the financial uncertainty that would inject into the entire world economy and financial system would be enormous.

  • 10:29:23

    SMICKAnd I think, you know, uncertainty at this point, when you -- to go back to the banks, given that we're in a recovery, when you look at the amount of volatility in bank stocks today, that's very troubling. They shouldn't be that volatile.

  • 10:29:35

    KAYOK. Let's go the phones to David in Dallas, Texas. You've joined "The Diane Rehm Show," David. David...

  • 10:29:43

    DAVIDI'm really enjoying the discussion this morning. My question is I hear politicians from all different countries saying that the answer is growth. And if we could just get some growth, we'll -- we will fix the economic problem. And it's going to be done through exports. Where I get confused is, where is this global growth coming from, especially on the heels that everybody, every country is trying to do the export?

  • 10:30:07

    DAVIDAnd then when you consider -- at the same time, economists are saying that at 7 billion, we're starting to run at some fundamental human capacity issues on the planet. So I'm curious. If growth isn't possible, then what is the economic play that's going to work for each of these individual countries?

  • 10:30:26

    KAYOK. Simon Johnson, do you want to take that one?

  • 10:30:28

    JOHNSONYes. I think David's make -- makes two good points. First of all, it can't be the case that with the world exports -- somebody has to be buying those exports. Somebody has to be importing. Somebody has to have a strong domestic economy. People look to the United States traditionally to play this role, but our recovery is pretty weak. And we have a big fight coming over our budget, which is going to further destabilize things potentially at the end of this year.

  • 10:30:52

    JOHNSONIf the Germans could push their economy to expand, that might be helpful, certainly within the European context, but they seem reluctant. And David is right that if you think we are running up against human capacity issues -- that's obviously a very big question -- then growing out of debt problems is no longer an option. That has been the number one way that countries have successfully managed growth, managed debt problems in the past. Just have the economy grow, and the debt becomes smaller relative to the total size of the economy. We'll see how we get on in the United States in that regard, too.

  • 10:31:24

    KAYDesmond, why is it that four years after the financial crash of 2008, we still haven't resolved this issue of austerity versus growth, of which is the right balance between the two? And why has it become so political now -- with austerity being equated to government cuts and growth being equated to government spending -- that it seems almost harder that we're going to find the right balance?

  • 10:31:49

    LACHMANRight. Well, I don't think that it's entirely unexpected that after you have a major financial crisis and you have it really impairing public finances, that you're then stuck with a problem for a long period of time, that this is really what Rogoff and Reinhart predicted some years ago, that once you have a financial crisis of this order of magnitude, you're going to be on a very low-growth path.

  • 10:32:15

    LACHMANAnd I think the trouble is that once you're on a low-growth path, and once you do have recessions, then it always becomes very difficult to cut budget spending. But just going back to Europe, I totally agree with Simon that, basically, what we really need to have at least some coherence to what they're doing is for the Germans to be following far more expansionary policies. But what they're doing is exactly the reverse.

  • 10:32:41

    LACHMANThey're tying themselves to a fiscal pact that requires all countries to move to a balanced budget. So you can't expect Greece to increase its exports if Germany is, at the same time, cutting back. So this is the reason that I think that their policies make no coherence. And what's worse is they're enshrining this in a treaty, which makes it really very difficult to back off. They don't have the policy flexibility.

  • 10:33:09

    KAYI'm Katty Kay of BBC World News America. You're listening to "The Diane Rehm Show." And if you'd like to join us, do call 1-800-433-8850. You can send us an email to, or find us on Twitter or Facebook. While talking of Germany, let's go to Dave. He is calling us from Berlin in Germany. Dave, you have a question for my panel.

  • 10:33:30

    DAVEYes. Hi.

  • 10:33:31


  • 10:33:31

    DAVEIt's a very bright day here and with white swans on the lake here. And I'm feeling very good about what the trade unions are doing here. I'm glad that -- Simon and others mentioned that -- that we are intensely trying to increase domestic wages and the domestic supply. And Merkel was recently in both Vietnam and China, and the Chinese were here. And there will be a lot of developments in that score.

  • 10:33:57

    DAVEThe problem, however -- I wish that the panel would focus more on -- my question is, how are we going to deal with the imploded asset in the banks? It's not a public debt problem here. It's a private debt problem. It's a problem in the banks. And when is the United States -- one of the things that did happen in Greece was the cut in the investor hair -- OK, haircut. When are the banks going to be -- take the haircut?

  • 10:34:26

    KAYOK. Well, David, that's happened to some extent in Europe, hasn't it...

  • 10:34:29

    SMICKYeah, it has. Yeah.

  • 10:34:29

    KAY...that the loaners have had to -- lenders have had to say, OK, we'll take some of the pain as well?

  • 10:34:34

    SMICKThat's happened. I think the big issue and the big mystery is how the Spanish real estate market is going to be unwound. The Spanish real estate market is still highly valued. I mean, it's come off some. But if you look at the kind of private deal leveraging that we've had in the U.S., it's been pretty significant relative to Spain. I mean, housing prices here have come down. They probably haven't bottomed.

  • 10:35:01

    SMICKBut Spain's process is just beginning. And so you have real questions about the European banks. Once they have the mark-to-market, the, you know, the valuations of this, of the real estate market in this -- in the -- Spain does not -- you know, at least initially, did not have a sovereign debt problem. It had, you know, a problem of excessive, you know, private investment and an extraordinarily overvalued real estate market. That is going to be -- I mean, that's another 800-pound gorilla in the room. Spanish real estate prices...

  • 10:35:32

    KAYAnd, David, that's going to happen, right, just because the size of the housing debts in Europe...

  • 10:35:36

    SMICKIt's going to happen.

  • 10:35:37 Spanish banks are so huge?

  • 10:35:38

    SMICKYeah. It's going to happen, but it's not just the Spanish banks. It's, you know, French banks and Italian banks and -- so it's a big challenge to come to term -- for the eurozone to come to terms with, you know, what is likely to be a -- the Spanish have at least another 50 percent to go in declining housing prices.

  • 10:36:01


  • 10:36:02

    JOHNSONThe thing to remember, Katty, is these European banks are very big relative to the size of their economies. Now, our banks are big. They've gotten bigger. The biggest few banks in this country are about 50 percent, half the size of the economy balance sheet compared to GDP. But in Europe, it's not uncommon. In fact, most of the countries, the largest couple of banks have a total balance sheet two or three times the size of the economy. They've got big losses, for example, from real estate that David was talking about.

  • 10:36:25

    KAYSo the state can't bail them out.

  • 10:36:27

    JOHNSONWell, that's where this is going, of course: big losses relative to the size of the economy, big losses relative to the government's ability to help out. Europeans, if they pool their money, maybe don't have enough. They turn to the IMF now. The IMF has raised that, they say, an additional 400 or $500 billion to throw into the mix. But is that enough when the Italian public debt is already close to 2 trillion euros?

  • 10:36:52

    JOHNSONThese numbers -- people's eyes blur when you talk about them. They start to get big. But, remember, large public debts, large private debts, big losses, not much equity or capital in those banks. Governments really can't afford to bail out the banks. This can easily get out of control.

  • 10:37:09

    KAYWhich is what we're starting to see when people are turning around to their governments and saying, you haven't fixed this. And they're throwing them out, bringing in technocrats.

  • 10:37:18

    JOHNSONThat's right, which, in some case, is helpful. The change of government in Italy surely was an improvement over Mr. Berlusconi. But I think at the international level, there's also a big question. Does anybody have the money to help? Does anybody really want to help when the Europeans' problem is their own governments?

  • 10:37:34

    KAYOK. Simon Johnson, professor at MIT Sloan School of Management. We'll be right back after this short break with more of your questions, calls and comments. 1-800-433-8850 is the phone number, more on our discussion on the eurozone crisis and the impact on America. Stay listening.

  • 10:40:04

    KAYWelcome back. I'm Katty Kay of the BBC. You've joined our discussion on the eurozone crisis and the impact that it will have on the world economy and, of course, on the U.S. economy.

  • 10:40:15

    KAYJust before we went to break, we were talking a little bit about the politics of this here and how the White House has kind of shifted from seeing Greece as a potentially major -- Europe as a potentially major political problem in the run up to November's election, to kind of thinking that it all being fixed to starting to get worried about it again. But the truth is, Simon Johnson, there is not very much that the White House can do about this problem.

  • 10:40:37

    JOHNSONWell, there's certainly nothing they can do in terms of providing additional money. I don't think you could get five or even -- or $10 billion from the House of Representatives right now to support the global economy or the IMF or the Europeans, depending on how you pitch it.

  • 10:40:50

    JOHNSONSo it is remarkable that this system, which we set up -- this is the American system for market-based economies, their trading and their financial relationships set up by the U.S. after World War II, been run with a lot of U.S. direction and guidance over the past 60 years. We are stepping back from -- we are disengaging in part because of our own actual or perceived budget difficulties.

  • 10:41:10

    KAYSo if you're in the White House at the moment, David, you've got to be watching this with some frustration. There's this huge storm cloud brewing across the Atlantic, which can affect your chances of re-election, but there's not a lot you can do about it.

  • 10:41:21

    SMICKExactly. And the emerging markets are, you know, China, Brazil, they have the dough. They have the resources. And they're not necessarily stepping forward either. And I'm sure if they would step forward, they would say, fine, we want much more say in the future of how the IMF is run. We want some power in exchange for this. And so there's a certain stalemate there.

  • 10:41:45

    SMICKBut I also think when -- you know, if you're in the White House and you're financially sophisticated, you'd have to say to the president, look, you can put up some more money. You can expose U.S. taxpayer a little more. But it's probably not going to have an effect because the numbers over there are so huge, and the psychology is so daunting, the psychological boundaries of trying to convince markets that this is quickly turning around and that there's a growth strategy that's viable.

  • 10:42:13

    SMICKAnd so you, you know, you really can't tell the president of the United States, yeah, go ahead with that, spend political capital, you know? I'm sure that's one reason why you're not hearing much. If I were at the White House, I would tell everybody, stop talking about Europe. There's nothing we can do.

  • 10:42:31

    KAYHope it goes away. There is an email coming from us. I'm afraid all of you have been speaking about this rather theoretically and now are going to have to come up with concrete solutions to the euro crisis. Jim writes to us from Chicago, "Yes. Your guests have accurately described how the continuing austerity programs have led to no growth and ergo little relief from more debt but have not yet suggested changes the EU countries need to take to change this continuing breakdown in confidence.

  • 10:42:55

    KAYDo away with the euro, other ideas. Let's hear some suggestions or proposals whether this is -- where there is -- whether there is the political will to accomplish them or not." Desmond, can you fix the euro crisis for us?

  • 10:43:07

    LACHMANI'm not sure I can fix the euro crisis. But, certainly, the countries in the periphery, they do have options. You know, one of the options countries have is what Greece has just done, is write down the debt or something like 75 percent, you know, that makes the amount of adjustment. They've got to do a lot less. But I think the reality is that these countries' interests would be served by leaving the euro, by reintroducing their own currency. And if they manage that well, what they can do is they can use that to get export growth.

  • 10:43:43

    LACHMANIt really is a very risky proposition. Things can go wrong. But the reality is not doing that, sticking with these IMF-EU kind of hair shirt policies, is we've got a country like Greece that's already deep in depression. And what the IMF and EU are offering them are perhaps another 10 years of this sort of depression with unemployment rates that, for youth, are above 50 percent. This is just not sustainable. One really has to go in a different direction.

  • 10:44:15

    LACHMANAnd I think denying -- being in denial doesn't help it nor does the idea of throwing additional money, you know, kicking the can down the road. You're just making the problem very much bigger. It might be politically expedient, you know, so you get beyond the next election. But it doesn't really provide a solution. So I think one's really got to face up to the fact that this is a currency system that countries didn't play by the rules. They've run huge imbalances.

  • 10:44:43

    LACHMANAnd these imbalances can't be corrected within the straightjacket of that currency union. So I think my view is it has to break and that what policymakers should be doing is focusing on how do you get out of this in the least costly way. It's not going to be pretty. But if we don't get out of it, this is going to drag us down for years, much the same way as the gold standard dragged us down for many years.

  • 10:45:09

    KAYAnd as we were saying earlier, of course, then that drags other countries around the world down.

  • 10:45:13

    LACHMANOh, absolutely. You're talking about a major block. And, you know, like David and Simon have been saying, we're not even talking about a major economic block. But you're talking about a banking and financial system that has got huge implications to the rest of the world. So if that is dysfunctional for a long time, that really does cause a pull over the global economy.

  • 10:45:34


  • 10:45:35

    JOHNSONI would suggest, as a potential alternative, a constitutional convention. United States in the 1780s had a lot of problems parallel to Europe today. You needed to establish a federal government with a power of taxation. You needed to have the ability to manage a national debt, ultimately written -- underwritten by that power of taxation. And ultimately, of course, you needed a modern, well-functioning central bank, which was backing that debt. The Europeans don't have any of this.

  • 10:46:01

    JOHNSONIt still would not be easy. There's a lot more debt in the European context. The exchange rate system is much more of a problem. And in 1789 and 1790, Alexander Hamilton, as first secretary of Treasury, assumed almost all of the state debts onto the federal government. Hugely controversial then -- a lot of people still argue about it now. I don't think that would happen in Europe. So there's still the question of the legacy debts.

  • 10:46:21

    JOHNSONBut if you want to put the public finances on a more sustainable basis and create a union -- perhaps not all the countries can make it into this union, by the way, but some of them -- the core countries could absolutely unify fiscally and use that as the basis for not going down this incredibly traumatic difficult route, which would emerge from any kind of breakup.

  • 10:46:39

    KAYThe federal states of Europe.

  • 10:46:40


  • 10:46:41

    KAYOK. Let's go to Nick in St. Louis, Mo. Nick, you've joined "The Diane Rehm Show."

  • 10:46:45

    NICKGood morning.

  • 10:46:46

    KAYGood morning. Thanks for waiting.

  • 10:46:47

    NICKOh, it's very interesting, tragic. But I guess my question is -- I trying to change where I'm going. What's being done to leverage new technologies that could create a viable export? My own personal experience, in 2007, I worked in Cambridge at a biotech consortium up there and noticed the tremendous amounts of technology that exist in the UK. And I'm sure it's probably similar -- the other hybrid academic government institutions.

  • 10:47:15

    NICKWhat are they doing to leverage this technology to create a viable export versus losing the technology completely, and it ends up being licensed and pulled out of the country where there's no multiplier of the technology? I don't see that happening in Europe. And so I'm curious if you can comment on that and see if that will help curb some of these issues.

  • 10:47:35

    KAYNick gets to another issue that I've heard about, you know, that people are clearly talking about in terms of the growth issues. What's the underlying strategy for dealing with the seismic shift that our economy has gone from a manufacturing-based economy to an intelligence, high-tech-based economy and yet trying to maintain growth and unemployment levels, Simon?

  • 10:48:00

    JOHNSONWell, if you're talking about the U.S. economy, certainly, this technology-driven growth is absolutely in our future. The question is, what kind of jobs does that generate?

  • 10:48:07

    KAYRight. Much fewer jobs in manufacturing jobs.

  • 10:48:09

    JOHNSONWell, probably strong jobs for people with a lot of education. The jobs for people with only high school education have been diminishing. And it seems that, even if we have a good outcome relative to the recovery, we're not going to have a lot of those middle-skilled, middle-income jobs. So the middle absolutely gets squeezed in the American way structure. To next point about the Europeans, I think in Britain, because the pound can depreciate, you will have some bounce back. You will have some export based on technology.

  • 10:48:36

    JOHNSONThere's better prospects there. The Europeans, if they really go down this path of austerity above all and if the exchange rate remains roughly where it is that then you don't get any turnaround, the technology will drift away from them, and the skilled people will come work in Cambridge, Mass. or in Silicon Valley. It's a global startup arena, and you go where the capital is. You go where the market is. You go where people are optimistic. The balance in that regard may well shift back to the United States.

  • 10:49:06


  • 10:49:06

    SMICKWell, I think it's an interesting question. I think it kind of fits in with the earlier question about, you know, if everybody's an exporter, who will buy the world's stuff? You look at the U.S. economy as part of this situation. You just say, why has growth underperformed, really, since 2000? From the Second World War to 2000, we grew at roughly 3.4 percent, 3.2 percent. But suddenly now, we're growing in the mid-twos since 2000.

  • 10:49:35

    SMICKAnd the, you know, one -- some of the interesting thoughts on this is that we may be experiencing an innovation gap where the level of innovation is failing to keep up with the real cost of energy. And, you know, we think we -- we think we've, you know, have applied the computer and the digitalization of the economy to become more efficient, more productive and all the rest, but that may not be enough given the real cost of energy.

  • 10:50:03

    SMICKAnd this may be a global phenomenon. So, you know, we really need to maybe take a view from 30,000 feet and look down at the world economy and say, OK, why are we not achieving the levels of growth today and in the last decade that we -- even before the financial crisis that we achieved in the post-war period? There are a lot of explanations, but I don't think we really have formed a global policy. We certainly haven't formed the U.S. growth policy on -- I mean, you have two examples.

  • 10:50:37

    SMICKYou have the Bush period and you have the Obama period, a pretty significant fiscal stimulus. Different types of fiscal stimulus, and in both cases, we had underperforming economies. We have underperforming recovery, but during the Bush years, we grew at -- I think if you didn't have -- Niall Ferguson argues that if you didn't have the, you know, the ability to refinance and do other things as a part of the dubious bubble economy, the Bush years would have grown at 1 percent.

  • 10:51:07

    SMICKSo this European eurozone financial crisis may be reflective of something much more fundamental in the world, which is we have underperforming economies and we're not sure exactly why.

  • 10:51:19

    KAYDesmond, I mean, in the time of economic crisis when government seem to be stumbling from election to election and vote to vote just to try to keep their governments in office and get through the crisis, the kind of thinking that David is talking about, which is clearly what we need to be doing, isn't happening at a political level anyway, is it?

  • 10:51:37

    LACHMANBut I think the problem is deeper than that. It's a question that...

  • 10:51:41

    KAYEven deeper than the fact that economies aren't growing as much as they should be around the world.

  • 10:51:45

    LACHMANWell, I think that it certain is deeper in Europe in that it's not a question that economies aren't growing. It's a question that economies are contracting, and they're in what economists would call a deflation. We trap -- or they're in a vicious cycle. They're having to do fiscal adjustment to the tune of three percentage points of GDP, raising taxes, cutting expenditures that are huge, not simply in 2012 but in 2013 to meet the targets of this fiscal pact.

  • 10:52:15

    LACHMANNow, certainly, if you had technology-led investment, that would mitigate to some degree, but one really has to look at it in quantitative terms. And one also got to look at it in terms of time that we need the boost to growth now to offset this huge amount of fiscal tightening. And I just don't see technology-led investment -- while it might be terrific for the long run, we're in a very short-term immediate problem that I don't see how you can redress it, you know, with little measures.

  • 10:52:46

    LACHMANAnd this is really what the European discussion is. Let's have a little bit of supply-side structure reform that everybody knows only produces its result way down the road. We're needing the boost right now.

  • 10:52:57

    KAYI'm Katty Kay. You're listening to "The Diane Rehm Show." And if you'd like to join us, we have a few minutes left on the show. Do call 1-800-433-8850. You can send us an email as well to Let's go to David in Medusa, N.Y. David, you've joined "The Diane Rehm Show."

  • 10:53:11

    DAVIDThank you for taking my call.

  • 10:53:12

    KAYYou're welcome.

  • 10:53:13

    DAVIDFirst, I just want to make a statement that if you look in history at the last time that austerity was used so much in the media and whatnot, it was during Nazi Germany. But anyway, I just wanted to know -- in America, they all talk about, I think, $15 trillion that the government is in debt, but that doesn't take in personal debt, corporate debt. And when you take in all, you know, government, personal and corporate, you're talking about 30 to $50 trillion. That doesn't even count what Europe is in debt to.

  • 10:53:40

    SMICKAnd then you have China growing and India growing at 10 percent, and everyone says, you know, we're going to have to see some growth here in these countries. How can there ever be the growth that can lift up Europe, lift up America and let, you know, China, India, Vietnam, all those people growing at that percentage? This is the largest growth spurt the planet has ever seen or the universe has ever seen in history. Now, in America, we're spending 1.2 to $1.4 trillion a year on the military, while the government just tells it's just $540 billion.

  • 10:54:16

    KAYOK. David, I'm going to have to jump in next. We've only got a minute or two left on the program.

  • 10:54:19

    DAVIDI'm sorry for that.

  • 10:54:20

    KAYBut let me take your point and put it to Simon Johnson.

  • 10:54:25

    JOHNSONWell, I think the question was about limits to growth and whether we can grow out of this at a global level. And I think the answer is yes, we can, if you have the right policies in place, if you don't have a huge fight, for example, over the U.S. budget. The U.S. does not need to go down this deflationary path to be sure our public debt has increased, to be sure we need to bring it under control absolutely, but we don't need to do a precipitate damaging austerity. We can do it in a relatively managed way.

  • 10:54:54

    JOHNSONWe could do it over a couple of decades. There's a responsible path for this. We're about a quarter of the worlds' economy. We can certainly grow in a more environmentally responsible fashion, absolutely. We can certainly find ways to invest in technology that'll take us forward in terms of using less fossil fuels. All of this is entirely possible. And who else is going to do it? The Europeans are not going to do it. They are trapped one way or another with some very unfortunate macro policies.

  • 10:55:18

    JOHNSONThe emerging markets are hell-bent for growth to be sure, but that has a lot of spillover if you check out the pollution levels, for example, in India or China. The U.S. has an opportunity here. But are we going to do this? Is that where our critical process is heading? Will these be the key issues in the election in November? I'm not so sure.

  • 10:55:36

    KAYSimon, you're suggesting that what America has is not so much an economic problem. It has a political problem, and we're going to see that played out in the last few months of this year.

  • 10:55:45

    JOHNSONAbsolutely. We actually -- we have a political opportunity. We have a chance to regain global leadership here, Katty, in a way that we haven't had in quite a few decades. But I'm not sure if politicians on the right and the left are going to structure their discussion around these issues. I think they're going to fight on much narrower, much more introspective and ultimately not that productive and sensible grounds.

  • 10:56:05

    KAYWe have just a couple of seconds left on the program. I want to find out if both of you agree with what Simon is saying. Basically, this is a political problem in this country. It's not fundamentally (unintelligible).

  • 10:56:14

    SMICKI would love to agree with that, but I'm worried that the U.S., like the rest of the world, is in a vicious cycle. If you look at -- in response to the financial crisis, the world through fiscal and monetary stimulus came up with about $17 trillion of -- to try to bail out the world economy. You know, it's huge amount of our -- of the global GDP. The world is growing at 1.2, 1.5 percent rate and, you know, and debt is -- has increased by 14 percent in the process, so it's a vicious cycle.

  • 10:56:50

    KAYI didn't want to leave it on a vicious cycle. I wanted to leave it on a virtual cycle, but we have to end it there. David Smick, global macroeconomic advisor, Simon Johnson, author of "White House Burning: The Founding Fathers, Our National Debt, and Why It Matters To You," Desmond Lachman, resident fellow at the American Enterprise Institute. It's been a fascinating hour. Thank you all so much for joining me.

  • 10:57:08

    SMICKThank you.

  • 10:57:09

    KAYI'm Katty Kay of the BBC, sitting in for Diane Rehm. Thanks so much for listening.

  • 10:57:13

    ANNOUNCER"The Diane Rehm Show" is produced by Sandra Pinkard, Nancy Robertson, Denise Couture, Monique Nazareth, Nikki Jecks, Susan Nabors and Lisa Dunn, and the engineer is Tobey Schreiner. A.C. Valdez answers the phones. Visit for audio archives, transcripts, podcasts and CD sales. Call 202-885-1200 for more information.

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