lot of discussion in europe about the banning of naked shorts, that is not being 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 in year, something like that. can you bring us up to date on that? there's a fierce argument going back and forth as to whether that's valuable or not. >> it's a good question, senator. i would like to come back to you on the very precise details and latest information. i can do that quickly. my understanding is that some financial institutions in europe are still band from shorting sovereign debt. >> unsovereign debt, yes. >> and particularly the europeans have hedge funds in their sights. i think it a somewhat misguided

approach. a lot of people in financial markets want to be able tone sure against risk and they want to be able to use the swap 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 realtime, i think from a systemic stability point of view, we could become more comfortable with it. it the lack of transparency around derivatives, the ability of mega banks to quickly take pro pprietary positions, for example, betting the house. mf global failed because of bets made by senior management. it doesn't have to be through a naked short position or through cds contracts necessarily. there are other ways to do it. i think that we should move towards transparency if all these markets rather than banning this or that financial -- because you just shift the risks in other ways that are more murky and that we

live to regret. >> in that context, under dodd-frank we're setting up a more transparent derivative market in the united states. are there parallel efforts in europe to clear up an exchange and clearinghouse? >> not at the level and for the instruments that would really matter. there's a lot of cross border trading. they are dragging their feet on key parts of this. for example, take the euro swap market, interest rate swaps. it's over $300 trillion in total exposure there. no one can tell you who owe what is to whom, either on a gross basis or on a net basis, which is the bare minute number you should be able to. that is deeply troubling.

if that isn't keeping regulators in this country awake at night, they're not paying attention. >> it does highlight the point to the u.s. agree to the degree possible has to be involved in a discussion that helps establish that discussion and trading agreement as well in europe as in the united states. >> i wanted to add one point. a fundamental problem in the european regulatory context is they still do it at the national level. they still have not been able to get the european monetary union to encompass european-wide financial regulation. so the problems that we have, as you're describing, are compounded in the european case by their failure to add that dimension across borders. now, there's a similar global problem because the derivative tradings in particular and all these exotic financial instruments really do cry out for international regulation.

that's what basel tries to do but it's been very inadequate. so one of these days we've got to take the big leap to do a globalized dodd-frank because without it the kind of slipping around, the controls that adam lerrick mentioned takes place across bored eshs and you have another escape hatch from what every american union takes place. >> i have to dash. i want to say it been a great discussion. i wanted to mention mr. lerrick it was a number of years ago i remember an article in which warren buffett was replacing his effort -- the threat out there could have profound consequences both enormous shocks but it's also an instrument or a change that would have an impact on the

cost of our goods to the world. and to the degree the dollar becomes weaker, making them more affordable to the world. that's another interesting conversation, i'd love to have. 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 -- >> i can ask a couple quick questions. >> then we're going to go to a second round. >> thanks for holding the hearing. i think it's a really important issue. it critically important to our country both in terms of the impact on our economy but also helping us to recognize fiscal challenges we face in the long term as well. i'd like to get your

perspective, if i might, on the panel to certainly that's been reported, and that is many of the u.s. banks and money market funds have significantly cut their exposure to eurozone bank debt but there's significant exmeasure 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 knows. i spent time with officials at the fdic, the new york fed, other bodies recently. i'm not convinced they know. you're right the mutual funds have cut back their exposure and that's part of the reason the

european banks have wand to draw through the federal reserve in order to get dollar funding. so that part i think we should worry about a little less. would i focus on the drif treri exposures, to the u.s. swap market in europe. and i would urge you strongly in public or in private to bring the relevant regulators before you and discuss this, as a matter of time priority for the budget. because this is a huge fiscal risk that you're facing. 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 tors have they should be sharing them with you. you should be asking very, very hard questions to them, what would it take to figure them out and perhaps you could ask the big banks to come in and testify about this. what is their exposure, what do

they think of their exposure, how do they model it? we still give them enormous authority to handle their own risk management and i'm very skeptical they know how to handle this at all. >> i suspect you're right, that that can't be quantified without bringing them in. anyone else care to comment on that? >> those numbers are not public certainly, as dr. johnson said, it's unlikely even our regulators know them for sure. i would say two thing, though. one, the u.s. financial system exposure to european sovereign debt is not very great. the exposure -- or the mutual funds. the exposure is through the banks systems, either that their credit line, their swap lines. one thing that the europeans have announced publicly is that each national government will stand behind its large banks no

matter what and, secondly, if a national government is not capable, that a guarantee will move to the euro zone itself. they've actually made that statement a few months ago. the issue that mr. johnson raised about derivatives is an important one and comes back to a question that senator merkley raised. one issue about cds which everyone is very dish turnturbet and the europeans because they don't understand are trying to band naked cds is first of all it's very good that cds should be in centralized depositories so we know where they are. it's very good people should have to account for them correctly. three important aspects. cds, unlike bonds, which is one of the big problems for eurozone banks, cds are market to market every day. had you beans in europe carrying their greek bonds at 100 cents on the dollar, even though in

the market they were quoted at 40. however, the cds had to be marked to the 40. so every day that is reflected in realtime. secondly, cds 90% of cds contracts are collateralized by other securities or cash for the counterparty risk. and, third, what's important in cds, the way the cds market works is you have the gross amount and then you have the net amounts. the net amounts are calculated by institution by institution. if an instuns has sold $100 million of cds but has bought back $80 million of cds, the net number is only 20, their exposure. the way the cds market works is in addition to collateral, there is bilateral netting. so if one of the issuers, meaning greece or italy defaults, what happens is the institutions go to each other,

one by one, and they net it against each other. that eliminates to a large extent the danger of cascading through the system. there is not, however, what would be very good multi-lateral netting, which would mean you'd be able to net out the entire system across many institutions and then the net exposure would be your only concern. >> can i interject two things? first of all, i agree the europeans have promised to take over some of these national commitments to the banks, but i think we would agree that the greek banks are about to default. in order, they will not be guaranteed in full, that's the information that i've seen and that -- the you'-- why do you t they would bank -- the second point is on the netting, which is hugely important. remember that -- or let me -- i don't want to get too much into

the weeds but if you and i both have contracts and i fail and you don't, you get to accelerate typically across cds contracts so that i have to pay you immediately but i don't get to accelerate my contract on you because you haven't failed. that is why -- you can bring in the people on fdic who are very good on this, they stress gross exposure through derivatives. you should have the system where there is ways agreed to net it out properly that is not in place within europe, it's not in place across borders and it is not according to the fdic colleagues in place fully for the united states and that is a major weakness of the financial system. >> if i could ask one quickly and i'm out of time. you know, we -- >> go ahead, senator. we've been very -- >> we've seen countries like

spain and portugal, italy that have enacted fiscal con sell dags packages to balance their budgets and enjoyed in some of these sovereign bond auctions some pretty significant demands or pricing relative to what people would have expected but maybe suggesting these austerity steps and measures were the pretty approach and their debt-t debt-to-gdp ratios are over 100%. we're at 100% and we've had ample warnings. what level of debt reduction do you think is necessary over a ten-year period to get our country back on a more sustainable path? >> lots of people have tried to analyze that. we've published a lot of work at our institute, including by carmen rhinehart, who is one of

the great experts on this. the conclusion depends on method analysis but the bottom line is if your fashion debt to gdp ratio exceeds 60%, you're at risk. if it exceeds 90%, you're almost certainly going to take a significant hit to your long-term growth. her database, which goes back a long way, shows that chris whose debt to gdp ratios gets beyond 90% -- >> gross debt? >> gross debt beyond 90% leads to growth rates 1 to 1.5 percentage points per year lower. if your baseline is 2.5 to 3 like ours, that means you're cutting it in hef and getting to what we tend to call a growth recession, certainly not one that keeps the unplomt rate from rising. so somewhere in that range, you can't be too precise, so somewhere in that range, 60 to say 100, you clearly don't want to be beyond that.

we're already beyond it. all the trajectories take us just off the chart beyond that and that's why your basic point is so right. >> i've written a book that's coming out in april that partly addresses this pip would suggest you aim to 50% debt to gdp -- >> gross debt or publicly sneld. >> held by private sector. >> so that would translate into 80% gross. >> and there is a little problem with the way you compare these numbers across countries. we can go into technical details afterward. the u.s. in some countries such as japan up shouyou should look gross number. in the united states we should look at the net number. that's a goal that's entirely achievable and that's the right time frame and that would not cause massive problems to the economy and is consistent with sustaining growth. but on the spain, italy and portugal point you made, i would

suggest their slightly lower slf late because they did significant fiscal adjustment and did very little. senator johnson coined a great phrase for what's happening. monetary innovations or solutions to do with fiscal mismanagement. it's the ecb providing cheap credit to the banks and the banks then buys up the debt with a lot of arm twisting. the government is running or pushing the banks very hard to the quid pro quo. they're kicking the candidate do down the road. if monetary policy is sub serve yants to fiscal mismanagement it will end in high inflation and many other problems that we've experienced in all these countries before. so i don't think spain, italy and portugal are on a more stable path. >> the reason yields are done in the peripheral countries is because the ecb is given unlimited three-year funding at

a highly subsidized interest rates. that's why you see the interest rates on the short term come down much more than the long term. they can buy out to three years and have no mismatch and do fine. i would raise two other points to the question raised, senator, which are the level of debt depends on two other factors. that is, first question what is sustainable. that depends on what the savings rate of the economy is. it makes a -- japan and italy are very different than the united states. they can support much higher debt levels because their private sector saves a much higher level of their income. that doesn't mean it's good. it's sustainable. you have lower growth and very bad. you divert resources from the private sector to the inefficient public sector but it's sustainable. what percentage of the debt is held by foreigners?

in this country a large percent of the debt is held by foreigners. that means every day an increasing share of every american's life is spent working to pay the chinese. they're effectively working for the chinese. that is what we're doing. as our debt increases, as the interest expense goes up, that money is shifted out of the economy. if that debt was held by other americans you would transfer money from one group of americans it to another group of americans, but it would stay in the u.s. economy. when it's owed by foreigners you're taking all that economic output and just handing it -- sending it abroad. that's why that makes it even more unsustainable, makes tun sustainable and makes sure that our standard of living will fall unless we correct that. >> i want to add one comment on the italy and spain point. they implied they were den grading the european stra bank money creation to yield down the

p push on bonds. that's a good thing. that's avoiding the apock liptic outcome we talked about before. it's also buying time for those countries to put adjustment programs into place. they can't be just austerity programs. they have to be economic reforms, structural change it to get reasonable economic growth going again. but they can't do it overnight under the best of worlds. so the fact the european central back is asking as a lender of last resort is a good thing to be applauded and it's part of the scenario i spelled out in the opening statement why i think the apocalypse won't happen because they play that role. >> thank you. >> let's go to a second round now and ask the witnesses to continue. we appreciate that. it has been incredibly valuable. i hope, you know, other members, staff are here listening, because a lot of educating going

on here today that's important to us. i'd like to go back to what sweden did. if you could remind us of the steps they've took that have proved so effective. dr. johnson. >> yes, senator. this is route not taken by the obama administration. it was considered in january/february, perhaps into march of 2009. the swedes took over the bank. people used the word nationalized. i would say they resolved them. they did an fdic take-over and liquidated the banks and made them bankruptcy. they took the toxic assets out of the balance sheets of banks and created asset management companies just like we had the resolution trust corporation after the s and ls in the 1980, the job is recoversome value and

sell the assets and get rid of them. they launched three cleaned-up banks, new balance sheets, new management, new owners. of course, the old owners were wiped out as part of the deal. the government never wanted to run the credit system. so the word "nationalization" was misunderstood. it was an fdic resolution process. have banks not incumbered by bad loans or litigation around those loans. that's stuffed into the asset management company, which does its best to recover value for you. but the main point in terms of what fred was emphasizing earlier is they came out of this with a totally different approach to the financial system. much tougher regulator approach. not 1500 pages i would probably write on that senator johnson, but a much more skeptical view of the bankers. they got rid of the previous

powerful interests that controlled those banks that captured the hearts and minds of regulators and shifted the power. swedish banking became super boring, which is his advice here, extremely good advice. if you're a young, aggressive swedish person, you want to take risks you go to london or new york and don't do it in stockholm. >> let me go to another set of questions. if, god forbid, we would have another financial crisis, would our federal reserve have the ability along with the u.s. treasury to take over aig the way they did in our crisis? >> well, my understanding of the precise legal situation and where the fdic and other regulators are in terms of developing the relevant

authorities is that you cannot bail out individual companies in the way that aig was bailed out. you cannot put taxpayer money at risk in the same way that was done for aig. however, there is broad authority to deal with any systemtically important financial institution including i presume institutions you didn't think were important until 4:00 on a friday afternoon. you realize they're about to fail, and you need to do something by monday. there are greater powers now to take over and liquidate such institutions, not tlinl, not run a conservatorship. you can liquidate an institution in an orderly manner and buffer the rest of the financial system against the consequences of that liquidation. now, whether those mechanisms are sufficiently detailed and credible, i have my doubts, and on it this system resolution advisory committee i might stand out as a skeptic of what the fdic has put on the table so

far. they're moving in the right direction. the ability to incredibly threaten to bankrupt such a company without necessarily using the bankruptcy code, because that is part of what can lead to the cataclysmic lehman brothers, that's a sensible goal. if the markets believed that bank of america, citigroup, goldman sachs could fail like mf global failed, then they could borrow so cheaply and at that take on the big risks and build the mass itch, dangerous exposures across borders. we're not there yet but moving in that direction. we need to expedite and have a capital sound. we shouldn't be bound by the lowest deno, ma'am senator approach of basal. that is a blind alley. >> just to be clear if we had -- i will never forget as long as i live being called to a meeting in the leader's office where the leaders of the house and senate, republican and democrat, chairman of the federal reserve, secretary of the treasury. they informed us they were

taking over aig the next morning. they told us they believed if they did not that there would be a global financial collapse in days. that's pretty sobering. if we had a repeat scenario, the federal reserve and the secretary of treasury would not have the ability to do what they did with aig. they have a new authority, which allows them to liquidate a systemically risky enterprise. second question. if, god forbid, we had a second crisis, would the federal reserve operating with the treasury have the ability it to guarantee money market funds as they did in 2008? >> the federal reserve -- >> stop a run? >> that's a good question on the

money market funds. i believe -- i think your description of the first part of your description around the liquidating -- the options for aig and the liquidation of systemically risky enterprises, failing enterprises is absolutely correct. on the guaranteed money markets, the use of the federal reserve emergency powers or so-called 133 are much more con strained. the view from officials -- they can speak for themselves, but this is my impression. they would feel much more con strained on the use of those powers relative to the fall of 2008, but they do say both current officials and former officials when needed they will come in and save the day. >> let me say to you the chairman of the federal reserve told me yesterday, the chairman of the federal reserve, that he does not believe they would be able to guarantee money market funds as they did in the 2008

crisis. he does not believe. doctor. >> i'm sure he's -- i'm sure that's what he believes. of course, there is the problem or issue we have a very powerful and resourceful country with extremely smart people running the xex tifl branch, which is what you want. there are many innovations to come up with, and the key to any credible ability to imagine failing our system is we have individual banks or a small group of pounds fail and be liquidated without massively damaging the rest of the system and worsening our budget. if you can credibly threaten that to the markets, you're in relatively good shape. the markets understand na and price risk in a more appropriate manner. if you get into a situation where they think there's a bailout and you play chicken with them, i would submit to you that there are very smart people running the fed and treasury and white house will propose to you, congress, that they find some

emergency powers to provide unanticipated forms of bailout in order to prevent a global collapse. dp they give you the choice of a 20 or 30% decline in gdp or some innovative interpretation of the legal powers, i'm not sure which way to go. i suspect you don't want the 30% collapse in gdp. all of this should be moving much faster towards making failure possible. capitalism without failure is not capitalism. it's really a bad form of socialism, to be frank, and that's what we have in regard to megabanks and certain humongous financial institutions in our country. >> no matter what the regulations say, no matter what law congress has written, no matter what executive order has been published, when they called secretary of treasury and the head of the federal reserve and the president and the leaders of the congress into a room and

say, p if you don't do this, it going to be the end of the world, you will do it. all right? the rule of law -- one thing i've learned looking at financial crises over the last 15 years in person and looking at this, when push comes it to shove and the danger is great enough every government will forgo the rule of law and change the law and the rules right then and there. it's a sad fact. we all like to think we live by the rule of law. the only difference between a banana republic and a stable democracy is you how big the danger has to be before the government rewrites the rule of law. >> well, i think -- i want to add one sentence. i'm not sure you'd even have to ignore the law, because there are laws that sometimes are not even mentioned in this context that could be invoked. the international economic powers actic