and the great danger is the politicians will confuse the emd of their world with the end of "the" world and rush out and bail out every government and bank in site and i'll set back economic stability by a decade. so what should happen is the ecb should act as a support for this difficult path to adjustment, as the europeans go towards fiscal compact and this way they can maintain stability and very fragile markets. what they have to do is not just flood the market, what they should do is announce a rule of intervention that remove the risk of financial panic. but preserve the incentives for governments and for investors and safeguards for inflation-fighting credibility. the great problem in europe is not the problem of deficit or debt. europe has a much more serious long-term problem. you can solve the debt easily.

you write it off. you can the deficits easily, i'm saying economically, not politically, easily, you cut spending. the difficult problem is that southern europe's populations expect a lifestyle their productivity cannot supply. greeks don't have to be germans but they can expect to be -- but then they can't expect to be paid like dper mans. so you have a 25% gap between southern europe and german labor cos costs that are on the closed by deflation. this is a long, painful process that will precipitate a five to seven-year recession in the southern european countries and there you're talking about close to 40% of europe's gdp. the only other alternative is a long-term transfer from europe's north to south. re-unification of germany caused same problem of differing productivity. what the germans decided was

they proposed a solidarity tax imposed on west germany to bring east germany up to west der man standards and it was envisioned as a temporary transition mechanism. it's been in place for 20 years and there's no concept of withdrawing it even at this stage. what you'll see is a transfer from northern europe through taxes and payments and aid, directly and indirectly through higher inflation, in order to bring -- reduce southern europe's debt. one point that you raised in both mr. chairman and you, senator johnson raised -- can this happen in the united states? absolutely. and the fact is, if we don't take corrective action it's going to happen. you raise the concept unsustainable trends, what -- a nobel prize winner had a famous quote about unsustainable trends -- they end! and the fact of the matter is the only reason we haven't had a

crisis is far is because the u.s. dollar's role as the currency in the world butting that not go on. the reason it's not ended is because it's difficult to replace a reserve alternative io and the europeans have their own problems. that saved us. but there's a compact when you're a reserve currency. there's a privilege, which is that the rest of the world gives you television sets and lends you money to buy cars and houses at very low interest rates in return for pieces of paper you print up in the basement of the federal ereserve. in return, we have to keep up the value. we have not kept up our end of the bargain. u.s. dollar interest rates will start rising very quickly. the u.s. dollar will start falling very quickly and we will have a problem very similar to what the weak european countries have right now.

>> thank you. terrific all three. i really appreciate your contributions to the committee. what is your assessment how the basel rounds impact the current european crisis. what is your assessment of what those changes require and how that interacts with what is currently happening? dr. johnson? >> i presume you're talk act the basel records on the capital requirements for banks. >> just so you know, the reason i ask the question, we have had a lot of commentary among colleagues, asking the question, what are the effects of inkresed capital requirements. are they sufficient?

are they insufficient. what effect are they having on the current challenges. >> thank you, senator. it's a very good question, and highly appropriate to ask it. there's something between the agreement of basel and other governments how they agree on what capital should be. if you're holding something that's aaa, you don't have to have a lot of equity. well, what's a aaa asset in the european context? sovereign debt, including greek debt. and as was laid out for you, people were convinced, the markets were convinced greek and german debt were very, very similar in their credit risk. they're not. we're looking at a situation where there's real credit risk across a wide range of european

sovereign debt. the entire approach in bah sese deeply flawed. the way it's being implemented is very problematic. the french and the germans by all accounts are backing away even from what they signed up to in basel. that doesn't necessarily limit what we do. i would argue that we should go further and the federal reserve has indicate there had will be some so-called surcharge, but that's not enough, relative to the losses we potentially face. >> remind us, what are the requirements, what are the capital requirement in the basel round? >> well, it depends on exactly -- it's a complex arrangement. it depends exactly on what financial institutions you're talking about. i would say the did he feel is in the risk-weighted assets. in the risk weights. if the risk weighting is so fundamentally flawed they've missed completely the sovereign debt crisis and the true risks that all these european banks

face and that our banks face and they're exposed to the european banks. and to the extent that any bank tells you they've hedged this risk, they're offsetting a contract, the counterparty risk in that swap is probably with a european bank, at least in part. how big is that? how profound is that risk? we don't know. i talk to the senior regulators on this issue. i'm a member of the advisory committee that met last week. i don't know the regulators would tell me, even if they knew, but i'm pretty confident they don't know. i'm not saying move everyone to capital requirements. i'm not saying that. you can suspend payments. that would be well received. that would bolster financial stability and growth prospects in the united states. it wouldn't be a negative in this environment if it's applied across the board because of the

risks by europe. >> what ur your assess. of basel and the capital requirements. sufficient? insufficient? do you share the view on this? >> yeah you can i very much share his view. i do think capitaled a quasi is at the heart of financial stability here in europe and everyone else. and we should err on the side of caution going to higher rather than lower capital requirements in order to achieve that outcome. there's a fascinating implications of the last three or four years we should keep in mind. the last crisis was rooted in financial instability in the united states and europe. it turns out there was very little spillover to the emerging

markets in developing countries. they got some affect from the recession and weakening of trade flows. but their financial system stood up much better than hours. why was that? well, they had crises in the past. the asians had crises in the '90s, the latin americans in the '80s. and they did to a large extent get their acts together. they opted to have financial systems that were not as exciting and high-flying as hours, they explicitly determined and opted for more risk adverse systems inkuding much higher capital requirements and that paid off. >> what are their level of capital requirements? >> it differs from country to koun tr i. simon, do you know? the numbers are much higher than our ps they were all put in place as a lesson from those

crises and seems to have paid off very heavily. >> 20% is not an unusual level of capital in these conservative systems that have previously placed here. >> that is a deep problem in these systems. the europeans made a huge mistake on sovereign debt. we made a huge mistake relative to mortgage -- >> we just had a company go down in part because of bets on sompb debt. >> first of all, i echo simon's comments about the basel rule. i would raise two points. first, there's one true law of economics that was first enunciated by the governor from the bank of england in the 19th century. every regulation will be circumvented.

so when you start setting out very precise rules, you're setting in motion an entire system of people who are certainly going to -- are spending their lives thinking how to circumvent them. and remember, regulators are always one crisis behind. they're always thinking about the last crisis. and they are paid farless, work far less hard, and are not as highly skilled as the people attempting to get around the regular plapgs so you must keep in mind you have a problem. the second is, i saw an old photograph of a bank that had been closed back in the 1920s. the window front was very interesting. in 19 -- before the federal reserve, on the front window of every bank, it said capital, $12

million or $12 million or $5 million. now when you look at a bank, it says fdic ensured. that is a fundamental plob. you have a system where very few people pay attention to the capital of banks. the levels are much higher in developing countries. look at switzerland. it has the greatest interest in preserving its banking system. they propose raising before anyone el, raising capitals to 16%. and probably will go higher in order to establish the absolute credentialn't of their banks in the world. and that's one of the key issues. banking should be a boring business. it should not be a high-flying business where you trade and take risks. it's a boring business.

similar to a utility. they're supplying payments, checking, loans to small businesses. this is not an exciting business. it's not a highly profitable business, but it's a fundamental business to the economy and the job for the government is to make sure that banks are not in danger. and that's why you make it a boring business. >> thank you. senator johnson? >> this was fascinating testimony. i'm new here, so let me quick ask a question on the asian banks and what they did to solve their problem. when we passed dodd frank, i'm a great believer in not reinventing the wheel. did we take a look at what regulationser what new rules the asian banks put in place? and does it still make sense if we haven't? >> senator, you have to ask your colleagues what they did and didn't look at.

my impression is that we were very taken with the exceptional nature of the united states and there were, of course, various lessons we could have drawn from candidate knave yeah. make banking boring, absolutely. and the scandinavians have come through this crisis from a fiscal point of view and from a growth point of view. their banks got completely out of control, just like emerging problems and they cleaned them up and made them much more conservative and much more careful, including much higher levels of capital. so i fear that we didn't even look enough at international experiences or didn't draw in this dimension the right lessons. >> senator, there's a great irony here. what the asians and other emerging markets adopted after their financial crises, was an idea called an international

banking standard which was actually invented by one of our staff. and the idea was then picked up and heavily promoted with the emerging markets by the u.s. government, by the international monetary fund, and by all right-thinking people who wanted greater global financial stability. but we viewed it adds their kind of adopting our ideas and the implication was our system is fine and should be the model. whether or not our system was fine back then, our system certainly eroded. the regulatory zeal dropped sharply. it was actually the u.s. and the west with its more sophisticated financial systems that developed, promoted those ideas

and then as often happens in history, the people who adopted them got well ahead of the curve. >> the question i'm asking, would we be smart to look at those and adopt those? >> certainly look at it carefully. and s mentioned, there are some other high income countries, including european countries which have done this quite well. sweden and finland are two cases in point. they had deep financial crises in the early 990s, put their houses in order, dramatically reformed their economy. we used to think sweden, the socialist economy, how could it ever succeed? sweden has been the star, even more than germany in this recent european economic situation, which has come through this current unscath unscathed, because the neighborhood is rough, but largely unscathed, doing very,

very well. they're voted financial minister of the year, et cetera. having gone through a crisis, taken serious reform in your macro policy pays off heavily when you get hit again. the u.s. which has so far escaped that crisis may be lagging badly and may wind up paying a very heavi havavy pric result. >> they know they live in a dangerous world. they're extremely careful with regard too how they operate. remember, singapore where fiscal prudence is a model we all aspire to. if you want those connections i'm happy to provide that.

>> how many pages was their piece of banking legislation? >> that urks i would have to get back to you on, senator, there's no question, though, that they have a very tough skeptical body of regulators who are actually not captured by the financial sector. it's the one place in the world where the regulators are paid as much as the people who work in the private sector and work harder. i'm not suggesting you'll want to go there for the united states. obviously bank regulators don't have the incentive. >> the thought that kept going through my mind is pass performance doesn't guarantee future results. i hope you're right, but i'm assuming dr. larik and johnson aren't as in agreement in your rosy scenario. >> i think i'm more optimistic because i believe the germans are going to drive europe to a

stable fiscal union. it will take a number of years. we're debating before the conference whether this was the 17th summit and the 19th republican debate in republican presidential candidate debate, or the 19th summit and the 17th republican presidential debate. we have many more summits to go, but they'll get there. i believe. but there is a large risk. one of my colleagues uses an analogy. he says this is a dangerous operation. you could have the most skilled surgeon in the world, but things can go wrong. and so something could go wrong. i think the germans have now found the tools to do that nchs, which are just to keep the interest rates really high on all the politicians that are of the week countries and that will

force them to do what german threats and pleading and reasoning did not succeed in doing for two years. and secondly, the new strategy, which is, if you agree, that's great and you'll get our support. if you don't, go with god. you're on your own. >> and that's the same discipline that will be imposed on the u.s. our creditors will increase our interest rates to force us to do what we need to do? >> yes, that will be what will happen in the end. >> thank you. >> just take a moment, senator. not on your time. i don't want to miss this chance. i want to go to senator merkley.

sweden did something to get their toxic assets off their books. >> i have to leave in five minutes. mr. johnson, you highlighted the unknown nature of the derivative exposures. there's been a lot of discussion about this. every expert i've talked to has said we really have no idea of how the dominos are lined up. it's an incredible thing that in this -- just in this european and american sector we can't quite get our hands around who is underwriting, who is holding and what happens if companies have to perform on those insurance contracts. if that context there's been a lot of discussion in europe about the banning of naked shorts. that is not able to buy a credit default swap unless you own the

underlying investment. i believe that one step in that direction was taken back in october, and if the proposal is ratified, i think it would go into effect in november of this year, something like that. is there a fierce argument back and forth as to whether that's valuable or not? >> my understanding is some financial institutions in europe are still banned from unsovereign debt. to be frank, i think it's swa a misguided approach. a lot of people want to be able to ensure against risk and they want to be able to use the

market to that end. if this were a transparent market, if you could trace through underlying exposures, both on a gross and net basis in real time, i think from a sys m systemsyste systemic stability point of view, we could become more comfortable with it. mega banks take proprietary positions, for example, betting the house. senator conrad made a bet. it doesn't have to be through a naked position necessarily. there are other ways to do it. i think they should move towards transparency in all these markets, rather than banning this or that financial institution. you just shift the risks into other ways that are more murky and we live to regret. >> well, in that context, under dodd/frank, we're setting up a more transparent derivatives

market. are there parallel efforts to create both an exchange and a clearinghou clearinghouse? >> not at the level and for the instruments that would really matter. there's a lot of trading we haven't talked about. they're dragging their feet. and for example, take the euro swap market, interest rate swaps, over $300 trillion in total exposure there. no one can .tell you who exactly owes what to whom, either on a gross basis, which is what really matters or on a net basis, which is the bare minimum you should be able to report. the lack of transparency in this huge market that's become actually the basis for much of the european financial system, that that is deeply, deeply troubling. if that didn't keep the regulators in this country awhack at night, they're not paying attention. >> it does highlight a point that the u.s. to a degree

possible needs to involve in a discussion that helps us establish that transparency and trading regime, if you will in europe and in the united states. >> i just want to add one point. a fundamental problem in the european financial regulatory context is they still do it largely at the national level. they still have not been able to get the european monetary union to encompass european wide financial regulation. and so the problems we have as you're describing are compound the in the european case by their failure to add that dimension across borders. now, there's a similar problem because these exotic financial instruments really do cry out for regulation. that's what basel tries to do. we've got to take the big leap

to do a globalized dodd-frank. because without it, the kind of slipping around controls takes place across borders and you have an escape hatch for whatever regime is in place. >> i have to dash away. i apologize for that. it's been a great discussion. i hope we can really continue to wrestle with these issues of international monetary strategies and institutions. and i wanted to mention that it was a number of years ago that i remember an article in which warren buffett was replacing his investments to be denominated in foreign currencies because of his expectation that the dollar wasn't going to be the global currency. that is also an instrument or a change that would have an impact on the cost of our goods to the world. to the degree the dollar becomes weaker, making them a more

affordable to the world. so that's another interesting conversation. i'm sorry i'm going to miss the sweden solution, but i look forward to hearing about it. thank you. >> thank you, senator merkley. senator thune, would you like to take questioning time now or hold for a moment and we come back to you? >> it's totally up -- i can ask a couple of quick questions. it won't take long if you want. >> okay. then we're going to go to a second round. so if you're prepared, gha. >> thanks for holding a hearing. i think this is an important subject. this is critically important to our country, both in terms of the impact on our economy, but also helping us to recognize the fiscal challenges we face in the long term as well. i would like to get your perspective, if i might, on the panel to something that's been reported. and that is that many of the

u.s. banks and money market funds have significantly cut their exposure to euro zone bank debt in recent months, which i believe is a positive sign given the ongoing crisis in the euro zone. but there's significant exposure that remains. i'm curious to know what your estimate is of the current total u.s. exposure to the european banking system and what level of reduction do you believe is necessary in order to protect financial institutions in this country. >> that is a great question, senator. i think the honest answer is i don't know. i don't know anybody else who knows. you're right, they've cut back their exposure and the european banks have wanted to draw on the credit reserve in order to get dollar funding. so that part i think we should worry about a little bit less.

i would focus on the derivative transaction, on the counterparty risks, on u.s. bank exposure, for example, to the interest rate swap market in euros. it's a huge market. direct exposure and indirect exposure. and i would urge you strongly in public or nor private if you prefer, to bring the relevant regulators before you and discuss this. as a naert of top priority for the budget. because this is a huge fiscal risk that you're facing. so i can't give you a number, and that's not because i don't follow this closely. i follow it very closely. those numbers are not public. if the regulators have them, they should be sharing them with you on some basis. if they don't have them, if they don't know how to calculate that, you should be asking very, very hard questions to them, why not? what would it tack to figure this out? and perhaps you could ask the big banks to come in and testify about this as well. how do they think about exposure, how do they model it? we still give them enormous authority to handle their own risk management.