monetary fund should not be available, if necessary, to lend more to help resolve the problem. the imf did pick up one-third of the original support packages for greece, portugal, and ireland. i think that was three helpful. not so much in terms of the resources but in helping promote the necessary adjustment. when i say necessary adjustment, i do not mean just fiscal austerity. i mean structural reform, which is necessary to restore growth. what's italy, greece need to restore growth in structural reform of their labor markets, their private sector, their financial systems, all of those structural reforms are needed and the imf is very helpful in promoting that. i believe the u.s. should

support additional imf financial contribution to the european problem, may be the one-third that was done in the previous cases. it could be significant. i think the united states should support the current efforts of the imf to create a new fund which would take the firewall to beyond a trillion dollars. that to convince the markets there will be another to avoid any significant financial disruption. i think the u.s. should support that. however, i do not think the united states should contribute. the funding the imf needs should be barred from the big surplus and creditor countries. china, japan, korea, singapore, hong kong, brazil, russia, mexico.

many of those countries have said they will lend. we should support the effort, but we should not put in our own money. the u.s. really does need to take this as a wake-up call. he suggested that, mr. chairman. if you take those cbo projections and add a little bit more dose of realism, you have u.s. budget deficit exceeding $1 trillion at year, more than 5% of gdp for the decade to come. and then gets worse. if you project the numbers, our deficit numbers, within 10 years, look like greece did as it entered into its crisis. european crisis has shielded us from our own folly because you're a's weakness meant that foreign capital -- europe's weakness meant that foreign

capital. remember that only three or four years ago, great interest rates were at the same level as german interest rates. the abbott patents markets -- and a potential -- omnipotent market's got it wrong. all of a sudden, they realized that was wrong and great interest rates went to the level of germany. -- greek interest rates might to the level of germany. the united states is very happy at the moment to have low interest rates. europe and japan are so weak. the other financial markets to not attract the capital. that could turn very fast, a very viciously, as the european crisis teaches us we have to learn from that example. and not simply delighted in the fact that we have some more

time, but use that time. this committee has played a major leadership role in trying to deal with that. i urge and implore you to take the time to do that. if not, we could go the way of some of the europeans. >> thank you very much. >> thank you for coming. we look forward to hearing your testimony. >> thank you, mr. chairman. there are so many lessons to learn from what has happened in europe. i would like to recapitulate what has happened. europe's crisis is not a currency crisis. the euro has maintained its value. that is within the historic range of 85 cents to $1.60. europe has a fiscal crisis compounded by a failure to

correct -- take corrective action. it is a self-inflicted crisis. the market's accepted this as a fiscal performance guarantee. they thought that -- use all the interest rates on greece's debt to fall from 8% to less than a quarter of 1% above germany. these rules were never enforced. by 2007, you had seven of the original 12 members over the debt limit. by 2010, it was 10 of the members. weak government had used massive borrowing to offer their citizens a standard of living. what you now have come up -- what you now have, the markets

recognize there was a problem. what should happen to years ago is greece should have defaulted on its debts and the other countries should have tightened up their budgets. the fundamental problem in europe, really, it is european policy makers do not understand markets. they do not like markets and they think they can dominate markets. that is why you have seen a mess over the last two or three years. the inability of europe to address the crisis stems from a fundamental disagreement over the responsibilities of members of the euro zone. without a fundamental agreement, all you have seen is a series of political compromises that will only further erode market credibility because they failed. germany leads the north. they believe the cause of the crisis is a lack of discipline in the south. members should cut their spending, lower their wages, increased their productivity. that is the exact path germany

took 10 years ago and that is the source of their current prosperity. under the german view, each member is responsible for its own fiscal well-being. if markets seem credible action, interest rates will fall and the crisis will end. southern europe believes the troubles are caused by germany's success. if germany had not done so well, they would be in good shape. it is an interesting way of accountability, but that is their view. they think union solidarity requires massive transfers from the strong members to the week. -- to the weak. what is interesting is the role that france has played. france has decided to be the head of the south. the reason for this is they see this as a way of gaining political leadership of europe while leading the cost of the

bill else to germany. the french are very bad economics, but good at diplomacy. the great danger is that to you now have a conflict within europe. germany wants immediate fiscal correction by the individual governments. the rest of europe and the obama administration wants the ecb to print up to dollars trillion -- two trillion euros. this is mimicking the federal reserve's policy of just driving interest rates down and flooding the economy with cash. germany disagrees. it is a long-term solution -- if a long-term solution is not offered, there is no amount of money that will solve the problem. if germany capitulates, you will wind it with a currency crisis on top of the fiscal crisis.

the issue then becomes what is the next level of europe? germany has a clear view of what the future of europe is going to be. they have found two tools that will force discipline after years of reasoning and pleading had no effect on their fellow members. they see that market forces can prevail where diplomacy has failed. if you keep painfully high interest rates on the politicians, that will compel them to make the difficult choices that need to be made. the second step they have done is removed the requirement on on major euro zone decisions. before, a single week member could stop any adjustment with a veto. they have such a system where there will be no access to emergency funding unless a member agrees to the fiscal compaq. what will happen is the fear of being left behind is going to

support is going to force fiscal reform. what you will see is germany will drive the euro zone tourre fiscal union with central control over national budgets and strong automatic sanctions against spending offenders. this is a difficult path. the greatest danger is that a crisis will them indian drum. what you are seeing is a very difficult -- a crisis will loom in the interim. what you will see it is the markets will become frightened. the great danger is that the politicians will confuse the end of their world with the end of the world and you will set back economic stability by a decade. what should happen is the ecb should act as a support for this difficult path to adjustment. as the europeans to go towards a

fiscal compaq, they will maintain stability in fragile markets. what the ecb has to do it is not just flood the market, what they should do is announce several of intervention that removes their risk of financial panic, but reserves the incentives for government and in investors. the great problem in europe is not a problem of deficits or dead. europe has a much more serious long-term problem. you can solve the debt easily. you write it off. you can solve the deficit easily. you cut spending. the difficult problem is that southern europe's population expect a lifestyle their productivity cannot supply. the greeks do not have to be german, but they cannot expect to be paid like germans.

you have a 25% gap between southern europe and german labor costs that can only be closed by nominal deflationary because devaluation is not possible within the euro zone. this is a long painful process that will precipitate a five to 7-year recession. you're talking about 40% of the gdp. the only other alternative is a long-term transfer from the north to the south. the unification of germany posed the same problem. what the germans decided is a proposed a solidarity tax imposed on west germany to bring east germany up to the standards. it was envisioned as a temporary transition mechanism. it has been in place for 20 years and there is no concept of withdrawing it at this stage. what you will see is a transfer from northern europe from taxes and payments in order to bring

-- reduce southern europe's debt. one point that you raised is can this happen in the united states? absolutely. if we do not take corrective action, it is going to happen. the fact -- the only reason we have not had a crisis so far is because the u.s. dollar's role as the reserve currency of the world. that cannot go on. it is very difficult to replace a reserve currency. the only other alternative right now would have been the euro and the europeans have their own problems. there is a compaq when you use a reserve currency. there is a privilege, which is

the rest of the world gives you television sets and gives you money to buy cars and houses in return for pieces of paper you print up in the basement of the federal reserve. the agreement is you have to maintain the value of those pieces of paper by sound fiscal and monetary policies. we have not kept up our end of the bargain. you will see the world which draw from the reserve currency. when that happens, the u.s. dollar interest rates will start rising very quickly. we will have a problem very similar to what the weak european countries have right now. >> thank you. >> terrific -- all three. i appreciate your contributions. let me ask this. what is your assessment of how they impact the european

response to the current crisis? what is your assessment of what those changes are required and how that interacts with what was currently happening? >> the reason i asked the question, we've had a lot of commentary among colleagues asking the question -- what are the effects of the increased capital requirements? are they sufficient? are they in sufficient? what effect are they hiding? -- are they having? >> it is a very good question and it is highly appropriate to ask. keep asking it. the problem is not just the increase in capital requirements. there is a much deeper problem went away the international

agreement between the major government, the way they have agreed to think about how much capital you need. they use the concept of risk weighted assets. if you are holding something that is aaa, you do not have to have a lot of equity. what is a aaa assets? sovereign debt. people were convinced that great enjoyment that were very similar -- greek and german debts were very similar. they are not. the entire approach is deeply flawed. the weight is being implemented is problematic. the french and the germans are backing away from what they signed up to. this does not limit what we do. i would argue strongly that we should go further.

there will be some surcharge. but it is not enough relative to the losses that we potentially face. >> remind us, what are the capital requirements? >> it depends on -- is a complex arrangement. it depends on what to financial institutions you are talking about. the number is between 10 and 12%. if it is so fundamentally flawed, they have missed completely the sovereign debt crisis. to the extent that any american bank tells you they have hedged this risk, the counterparty risks is probably the european bank. how profound is that? we do not know. i talked to the senior regulators the nets last week.

i do not -- that not last week. i am confident they do not know. that should give us all pause. i am not saying to move everybody to 20% capital requirements. you cannot do that. but you can suspend dividend payments. that will be well received. that will bolster financial office -- stability. it would not be a negative if it is applied across the board. >> what is your assessment of the capital requirements? sufficient? insufficient? do you share dr. johnson's view of this? >> [inaudible] i very much share his view. i do think capital adequacy is

at the heart of restoring financial stability here and in europe and everywhere else. we should err on the side of caution. in order to achieve that outcome. there is a fascinating implication from the events of the last three or four years we should keep in mind. this last crisis, of course, was rooted in the financial instability. it turns out there was very little spillover to the emerging markets and developing countries. they got some of that from the recession and the weakening of trade flows, but their financial systems stood up much better than ours. why was that? they had crises in the past. the agents had crises in the late 1990's. -- agents had crises in the late

1990's. they opted to have financial systems that are not exotic and high-flying and may be as innovative as ours, they explicitly opted for more risk averse systems. including much higher capital requirements. that paid off. >> what are their levels of capital requirements? >> it differs from country to country. the numbers are much higher than ours. there were all put in place after the earlier crises. as a lesson from those crises. it seems to was paid off very heavily. >> 20% is not an unusual level of capital in this conservative systems. >> 20% -- to the measure on a risk weighted basis as well? >> they are much more careful about what -- the europeans made

a huge mistake on sovereign debts. we made a huge mistake relative to the mortgage. >> we detect a company go down because of sovereign debt -- we just had a company go down because of sovereign debt. >> i would raise two points. there is one true law of economics that was first enunciated by the governor of the bank of england in the 19th century. every regulation will be circumvented. when you start setting off -- setting out a very precise rules, you are setting in motion an entire system of people thinking of how to circumvent it. regulators are always one crisis behind. they do not know where the next crisis is coming from.

they are paid far less, work for less hard, and are not as highly skilled as the people who are attempting to get around the regulations. when you set out clear regulations, you have a problem. the second is, i saw an old photograph of a bank that had been closed in the 1920's. the window front was very interesting. before the federal reserve, on the front window of every bank, it said -- $5 million or $12 billion. now when you look at a bank it says, "fdic insured." that is a serious problem. these levels are much higher in the developing countries. look at switzerland.

switzerland is the developed country that has the greatest interest in preserving the integrity of its banking system. they proposed raising before anyone else -- raising capital to 16%. they will probably go higher in order to establish the absolute credibility of their banks in the world. that is one of the key issues. capital is -- banking should be a boring business. it should not be a high-flying business where you take risks, or you trade. it is a boring business, there is similar to a utility. they are supplying payments, they are supplying loans, this is not an exciting business. it is a fundamental business for the economy. the job of the government is to make sure that banks are not in danger. that is what you should make it boring. >> thank you very much.

senator johnson? >> this was fascinating. i am new here. let me ask a question on the asian banks and what they did to solve their problem. when we passed dodd-frank, and die in a great believer in not reinventing the wheel, if we take a look at what's new rules the asian banks put in place and whether that makes sense. does it still makes sense to do so if we have not? >> you have to ask your colleagues what they did and did not look at. we were very taken with the exceptional nature of the united states. make banking boring. absolutely. the scandinavian have come through this crisis in good shape from a fiscal point of view.

they had terrible problems with their banks in the 1990's. they cleaned them up and made them much more conservative and much more careful, including much higher levels of capital. i fear that we did not collect enough at international -- or did not draw the right lessons. >> there is a great irony here. what emerging markets adopted after their financial crises, it was an idea called an international banking standards, which was invented by one of our staff. the idea was picked out and promoted with the emerging markets by the u.s. government, by the imf, and by all people that wanted greater global

stability. we viewed it as they am adopting our ideas and the implication was our system was fine and should be the model. our system certainly eroded. failed to keep up with the technology in the industry. everything was fine, we were exceptional. it was the u.s. and west that developed and promoted those ideas. the people that adopted them got well ahead of the curve. but we turned our backs on them, basically. would we be smart to look at those and adopt those? >> certification lead to look at them carefully. there -- certainly look at them carefully.

there are some european countries that have done so quite well. sweden and finland had crises in the 1990's. they put their houses in order and dramatically reformed their economies. we used to think that sweden was a socialist economy, how could it ever succeed? sweden has been the start in the recent european economic situation. they are doing very well. there finance minister has been voted finance minister of the year of around the world. having gone through a crisis, at taken a serious reform in your financial system, pays off heavily. my fear is that the u.s. may be

lagging badly and they wind up paying a very heavy price as a result. >> i can connect to would staff in singapore. they know they live in a dangerous world. they are extremely careful with regard to how they operate. they think the way we operate -- they will tell you in private. they think it is reckless and irresponsible and poses a bigger dangers to ourselves and everyone else. singapore is a model that we should all aspire to. if you want those connections, i would be happy to provide them. >> how many pages was their piece of banking legislation? >> there is no question, they have a very tough, skeptical body of regulators that are not captured by the financial system. it is the one place in the world or the regulators are paid as much as the people who work in the private sector. i am not suggesting you will

want to go there. >> bank regulators to not have the incentive that the bankers have. i was fascinated by your assessment of europe. the thought that kept going through my mind was past performance does not guarantee future results. i hope you are right. i am sitting -- i am assuming the others are not as optimistic. >> i think i am more optimistic. i believe the germans are going to drive europe to a stable fiscal union. i think it will take a number of years. we were debating before the conference whether this was the 17th summit and the 19th republican debate or the 19th summit on the 17th republican presidential debate. we have many more sons to go.

-- summits to go. they will get there, i believe. what my colleagues use is an analogy. this is a dangerous operation, it you can have the most skilled surgeon in the world, but things can go wrong. something could go wrong. i believe that europeans will manage this process. i believe the germans have found the tools to do that. to keep interest rates lehigh -- really high on all the politicians of the weak countries. that will force them to do what germany did not succeed in doing for two years. if you agree that is great and you will get our support, and if you don't, go with god. you are on your own. " our creditors will entries are

interest rates to force us to do what we need to do. >> that will be but will happen in the end. >> thank you. >> take a moment. i do not want to miss this chance. i do not want to go through your answers at this point. i want to put on the table, i would like for you to tell us what sweden did. my recollection is that they did something with getting the toxic assets off the books of their banks. i cannot i cannot remember what it was, but i was very intrigued by what sweden did. i do not want this time to slip. >> thank you. i will be brief. mr. johnson, you highlighted the unknown nature of the

derivatives exposures. there is been a lot of discussion, every expert i have talked to has said we have no idea how the dominoes are lined up. it is an incredible thing that just in this european and american sector we cannot quite get our hands around who is underwriting, who is holding, and what happens if companies have to perform on those insurance contracts. in that context, there has been a lot of discussion in europe about the banning of naked shorts, that is not being able to buy credit default swaps unless you own the underlying investment. i believe that one step in that direction was taken back in october, and the proposal was ratified, i think it would go into effect of november of this year, something like that. can you bring us up-to-date on that? there is a fierce argument as to

whether that is valuable or not. >> it is a good question, senator. i would like to come back to you on the precise details and the latest information. my understanding is that some financial institutions in europe are still banned from shorting sovereign debt. and in particular, the europeans have had funds. i think, to be frank, it is a somewhat misguided approach. people want to insure against risk, they want to be up to use the credit default swaps market to that end. if this were a transparent market, if he could trace through underlying exposures both on a growth and net basis in real time, from a systemic stability point of view, we would be more comfortable with it. it is the lack of transparency around derivatives, the ability of mega banks to quickly take proprietary trading positions,

for example, betting the house. senator conrad made a reference to ms global, which failed, because of debts made by senior management. it does not have to be a naked short position or contracts necessarily. there are other ways to do it. i think we should move towards transparency of all of these markets, rather than banning this or that financial institution because you just shift the risk into other ways that are more murky and we would look to regret. >> in that context, setting up a more transparent to relatives market, are there parallel efforts underway in europe to create both an exchange and clearing house? >> not at the level and for the instances that would really matter. a lot of trading in the united kingdom, they are dragging their feet on key parts of this, and so for example, take the

european swap market, interest rate swaps, over 300 trillion dollars in total exposure. no one can tell you exactly who owes what to whom, either on a gross basis, which really does not matter, or on a net basis, which is the bare minimum that should be able to record. the lack of transparency in this huge market that has become the basis of much of the european financial system, that is deeply, deeply troubling. if that does not give the regulators. if that does not keep the regulators in this country a week and i, they're not paying attention. >> and it helps establish transparency and trading regime in europe and the united states. >> if fundamental problem in the european financial regulatory context is that they still do it largely at the national level.

but they still have not been able to get the european monetary union to encompass european-wide financial regulation. so the problems we have, as you are describing, are compounded in the european case by their failure to add that dimension across borders. there is a similar global problem, because the derivative trading in particular of all of these exotic financial instruments really does cry out for international regulation, and that is what this tried to do, but it has been very inadequate. one of these days, we have to take the big leap to do a globalized dodd-frank, because without it, the slipping around and controls takes place across borders and you have another escape hatch from whatever domestic regulatory regime is put in place. >> i have to run away. i apologize. apollo to close by saying it has been a great discussion. i hope that we can continue to

wrestle with these issues of international monetary strategy and institutions. i wanted to mention that it was a number of years ago that are remembered and article in which warren buffett was replacing his investments to be denominated in foreign currencies because it was the expectation the dollar was no longer going to be held as a reserve currency. that threat is out there and could have profound consequences, both in on the shocks, but also an instrument or change that would have an impact on the cost of our goods in the world, to the degree it the dollar becomes weaker, making them more affordable. that is another interesting conversation, and i'm sorry that i will miss the swede in solution, but i look forward to hearing about it. thank you. >> thank you, senator merkley. senator, the want to take questioning time now or hold

back? >> it is totally up to ute. i could ask a couple of quick questions. >> yep. then will go to a second round. if you are prepared? >> yes, thank you, mr. chairman, for holding the hearing. this ongoing crisis and eurozone is critically important to our country, both in terms of the impact on our economy and also helping us recognize the fiscal challenges that we face in the long term as well. i would like to get your perspective, if i might, on the panel to something that has been reported, and that is that many u.s. banks and money-market funds have a significant -- have significantly cut their exposure to european debt in recent months. the think that as a positive sign, given the ongoing crisis in the eurozone, but there is 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 the believe is necessary in order to protect financial institutions in this country? >> that is a great question, senator. the honest answer is i don't know, and i don't know anybody else who knows. i have spent time with officials at the fdic, the new york fed, and i'm not convinced they know. you are right about the mutual cutbacks, and european banks have learned to draw on federal reserves indirectly through credit provided to the ecb to get dollar funding. that part i think we should worry about less. i would focus on the derivative transactions and counterparty risks on u.s. bank exposure to the interest rate swap market and euros, a huge market. direct exposure and indirect exposure. i would urge to strongly in public or private, if you prefer, to bring the relevant regulators before you and discuss this as a top matter of

the budget because this is a huge fiscal risk. i cannot give an number, and that is not because i don't follow this closely -- i followed very closely. those numbers are not made public. they will should be sharing them with you on some basis. if they don't know how to calculate that, you should be asking very hard questions of, why not? what would it take to figure it out? and also banks could come in and testify about this. what is their exposure? how did they think about exposure, how do they model it? we give them enormous authority to handle their own risk management, and i am very skeptical they have a handle on this at all. >> anybody else want to comment on that? i suspect you are right, that maybe cannot be quantified without bringing them in. i would hope they would have some idea about that, but would anybody else care to comment? >> those numbers are not public, certainly. i doubt, as dr. johnson said, it

is not likely are irregulars even know them. i would say two things. one, the u.s. financial system exposure to european sovereign debt is not very great. the exposure -- or the mutual funds. they have cut back. the exposure is through the banking systems, either their credit lines, the swap lines. one thing the europeans have announced publicly is that each national government will stand behind its large banks no matter what. and secondly, if the national government is not capable, that guarantee will move to the eurozone itself. they have made that statement a few months ago. the issue mr. johnson raised about derivatives is important and comes back to a question, that the senator raised, the issue about cds, i think europeans cannot understand how markets work and are trying to

ban cds. first of all, it is very good they should be centralized and monetary because we know where they are. it is very good people should have to account for them correctly. first, credit default swaps, unlike bonds, they are marked to market every day. so that you could have -- up until recently, you had european banks during their greek bonds at one hundred cents on the dollar, even though in the market they were quoted at 40. however, the credit default swaps had to be marked to 40. every day, that is reflected in real-time. second, credit default swaps, 90% of the contracts are collateralized by other securities or cash. what the top party risk. third, what is important with them is the way the market works, you have the gross amount of credit default swaps, then the net amount. the with the net amount as calculated is institution by

institution. an institution has sold $100 million of credit default swaps, but has bought back $80 million of credit default swaps, the net number is only $20 million, their exposure. the way that market works, in addition to the collateral, there is bilateral net. if one of the issuers, like greece or italy, the faults, what happens is the institutions go to each other one by one and a net against each other. that eliminates, to a large extent, but the danger of cascading through the system. there is not, however, will the latter role netting, meaning across a lot of institutions, and that would be the only concern. but the bilateral does reduce some of the risk. >> if i could interject, first,

agreed european markets have promised to take over some of these national commitments, but i think we agree the greek banks are about to default. in other words, it will not be guaranteed against default. that is the information i have seen. therefore, why would they not back portuguese or irish banks? the second is on the net, which is hugely important. i don't want to get too much into this, but if we both have a contract and i fail and you don't, you get to accelerate, typically, across cds contracts. i have to pay you immediately. i don't have to accelerate my contract you because i have failed. they stress rose exposures through derivatives because at the moment of systemic weakness, the gross cannot

actually cascade through. you should have a system emphasize ways to agree to net it out properly. that is not a place in europe, across borders. it is not in place fully for the united states. that is a major weakness of the financial system that will spill over and have financial risks. >> if i can ask quickly, i know i am out of time, but -- >> go ahead, senator. >> we have seen countries enact significant financial consolidation packages to balance their budgets, and have enjoyed, i think, in some of the sovereign bond actions some pretty significant demands, surprising i think, relative to what people would have expected, may be suggesting these austerity stem some measures with the right approach. their debt to gdp ratios are over one hutson sign in some

cases, greece is at 143%. we have had ample warning about where we are and what we need to do. i guess this is a quick question, but i will pose it to all of you. what level of debt reduction do you think is necessary over 10 years to get our country back on a more sustainable path? >> lots of people have tried to analyze that. we have published a lot of work at art institute, including by a great expert, and conclusions depend a lot on method of analysis. the bottom line is that if your national debt to gdp ratio exceeds 60%, you are at risk. if it exceeds 90%, your most certainly going to take a significant hit to your long- term growth. the data shows that country whose debt to gdp ratios get beyond90%, a gross debt

90% leads to growth rates 1%, 1.5% per year lower. if the baseline is 2.5, 3, like ours, you are cutting back and have and getting into a growth recession, not one that keeps the unemployment rate from rising. somewhere in that range, not too precise, but somewhere in that range, 60, to say 100, you not want to be beyond that. we are already beyond that. all of the trajectories take us beyond that off the charts, and that is why that is right. >> i have written a book that is coming out in april. how would aimed at you aim for 50% debt to gdp by 2013. about a gross debt or publicly held? >> held by the public sector. >> that would translate into 80%. >> right, and there is a little

problem with the details. in some countries, such as japan you look at the gross number. in the united states, we look at the net debt held by projects, which is what the cbo and the sizes. at that goal is entirely achievable and that is the right time frame and that would not cause massive problems for the economy consistent with sustaining growth, 50% gdp. on spain and portugal, i would suggest that there slightly lower yields -- have done very little. senator johnson quite a great phrase of what is happening, monetary innovations to deal with fiscal mismanagement. it is the ecb providing cheap credit to the banks, the bank's buying up the debt with a lot of arm-twisting. the government is running or pushing the banks very hard. the quid pro quo is not a

solution, it is kicking the can down the road is what they're doing with monetary policy. if you let monetary policy become subservient to fiscal mismanagement, it will end in high inflation and many other problems we have experienced in all of these countries before. i don't think that spain, italy, and portugal are not on a more stable path. >> the reason yields are down and the peripheral countries is because the ecb has given unlimited three-year funding at a highly subsidized interest rate. that is why the interest rates on short-term have come down at a lot more than the long term. they can buy out to three years, have no mismatch, and be fine. i would raise it to other points, which are the level of debt depends on two other factors. first, what is sustainable? that depends on the savings rate of the economy. it makes it very different.

japan and italy are very different than the u.s. bacon support much higher debt levels because they are private sectors -- they can support much higher debt levels because their private sector. that does not mean it is good, just sustainable. you are diverting resources from the private sector to the inefficient public sector, but it is sustainable. the second issue is what percentage of the debt is held by foreigners. in this country, a large percentage of the debt is held by foreigners. that means that every day, an increasing share of every american's money is spent working to pay the chinese, effectively working for the chinese. that is what we are doing. as our debt increases, as the interest rates and the interest expense goes up, that money is just shifted out of the economy. if that that was held by other americans, you'd be transferring money from one group of americans to another group of americans, but it would

stay in the u.s. economy. when it is owned by foreigners, you are taking all of that economic output in just sending it abroad. and that makes it even on note -- that it's even more unsustainable. that means our standard of living is going to fall unless we corrected that. >> i want to add a caveat on italy and spain. my colleagues have implied there denigrating the european central bank's money creation to win part pushed down the yield on those bonds. i think that is a good thing. i think that is avoiding the apocalyptic outcome we talked about before. it is also buying time for those countries to put an adjustment programs into place. they cannot just be austerity programs, there have to be economic reforms and structural change to get reasonable economic growth going again. but they cannot do it overnight in the best of worlds. the fact that the ecb is in this way and acting as a lender of last resort i think it's a good thing to be applauded as part of

the scenario i spelled out in my opening statement, what i think the apocalypse will not happen because, among other things, the ecb will play that role. >> thank you, mr. chairman. >> let's go to a second round and asked the witnesses to continue. we appreciate that. that has been incredibly valuable. membershat other staffs are here listening, because a lot of education going on here that is important to us. i would like to go back to what sweetened bid. if you could remind us of the steps they took that have proved so effective-- i would like to go back like tosweden did. >> the swedes took over the banks. people used the word

nationalized. that is a swedish word we did not like to use here. they did an fdic-type takeover and liquidated the bank. they made them bankrupt in a government-managed process. they took the toxic assets, the bad loans off the balance sheets of those banks, traded asset management companies -- just like we had the revolution trust co., the jobless to recover value over three, five years, sell the assets, get rid of them. they launched three clean up banks, new balance sheets, new management, new owners. the old owners were wiped out as part of the deal, and privatize them. the government ever won at or around the credit system -- the government never wanted to run the credit system. it was an fdic-type resolution process that went pretty well. you end up with banks that are not encumbered by bad loans or

by litigation around those loans. at that all good stuff into the asset management co., which recovers value. the main point, in terms of what they were emphasizing earlier, they came out of this with a totally different approach to the financial system, much . for regulations. not 50 pages, but a much more skeptical view of the bankers. they got rid of the previous powerful interests that control the banks, captured the hearts and minds of regulators, that were allowed to take on egregious breast. -- the egregious risk. the bank became boring, which is extremely good advice. if you are young, aggressive swedish person and what to go into the risk taking financial sector, you go to london or new york, not stockholm. >> let me go to another set of

questions. if, god forbid, we would have another financial crisis, what are federal reserve have the ability, along with the u.s. treasury, to take over aig the way they did it in the other crisis? >> well, my understanding of the precise legal situation and where the fdic and other regulators are in terms of developing their authorities is you cannot bailout 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 do any systematically important item, including institutions that he cannot think more important to 4:00 on a friday afternoon, you realize there are about to fail and you need to do something by monday. there are greater powers not to

take over and liquidate such institutions, not run them, not run a conservatorship. you can liquidate an institution, and an orderly manner, and you can buy for the rest of the financial system against the consequences of that liquidation. whether those mechanisms are sufficiently credible, i have my doubts. on the advisory committee, i might stand out as one of the skeptics about what the fdic has put on the table so far, but they're moving in the right direction. it is the ability to credibly threaten, a bankrupt company, without using the bankruptcy term because that can lead to the cataclysmic post lehman brothers' tax consequences. that is a very sensible role. if the markets believe, really, that bank of america, citigroup, goldman sachs, other big banks liked mf global, those banks would not be able to build these massive, dangerous exposures

across borders. but we are not there yet. we are moving in that direction. i think we need a much more capital system which should not be bound by this lowest common denominator approach. that is absolutely a blind alley. >> just to be clear, if we have -- i remember being called to the leader's office, leaders of the house and senate, republican and democrat, the chairman of the federal reserve, the secretary of the treasure, and they informed us were taking over aig in the morning. they told us that if they did not, there would be a global financial collapse in days. that is pretty sobering. but if we had a repeat said area -- if we had a repeat scenario, it 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. the second question. if, god forbid, we had a second crisis, the federal reser operating with the treasury have the ability to guarantee money market funds as they did in 2008? >> the fed to stop iran? that is a good question. i believe the first part of your description, around liquidating, the options of the anc and systemically risky enterprises, failing enterprises, i believe that is correct. on the guarantee money market, the use of the federal reserve emergency powers, 13-3, are much more constrained. the view that i get from talking with officials -- they can speak

for themselves, but my impression is they would feel much more constrained on the use of those powers relative to before 2008, but they do say in private that we needed, we will come in and save the day, which i think would include guaranteeing -- >> the chairman of the federal reserve told me yesterday -- the chairman of the federal reserve -- that he does not believe that he would be able to guarantee money market funds as they did in the 2008 crisis. he does not believe. >> i'm sure that is what he believes. there is a problem with the issue that we have a very resourceful country with extremely smart people running the executive branch. if there is a deep enough crisis, there are many innovations they would come up with. the key to any ability to manage failure in our system is we would have to have individual banks or a small group of banks fail, but would data, without

damaging the rest of the system and bring down the economy and worsening the budget. if you credibly threaten that yourself, to everyone come to the market, you are in relatively good shape as the markets understand that and it will price risk in a more appropriate manner. if you get into a situation where they think there will be a bailout and you are playing chicken with them, i would submit to you that the 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. if they give you the choice of a 20%, 30% decline in gdp for an innovative interpretation of legal powers, and not sure which we will go with that. i suspect you do not want the 30% collapse in gdp. all of this should be moving much more faster towards making fill your possible. capitalism without failure is

not capitalism, it is a bad form of socialism, to be frank, and that is what we have with regard to the mega banks and other human as institutions in our economy. >> senator conrad, no matter what the regulation say, no matter what laws and congress is written, no matter what executive order has been published, when they call the secretary of the treasury and head of the federal reserve and president and the leaders of congress into a room and say, if you don't do this, it is going to be the end of the world, you will do it. right? the rule of law, one thing i have learned, looking at the financial learned, looking at financial crises over the last 15 years in person, when push comes to shove, and the danger is great enough, every government will forgo the rule of law and change the law and rules, right then and there.

it is a sad fact. we all like to think we live by the rule of law. the only difference between a banana republic and a save the democracy is how big the danger has to be for the government to rewrite the rule of law. >> i will add one sentence. i am not sure you have to ignore the law, because there are laws that sometimes are not mentioned in this context that could be invoked. the emergency economic power pact, which supplies the principle to you look -- u.s. international financial economic involvement but is also in vogue for the purposes, that would be directly relevant if there was a courtesy dimension to the crisis, an international dimension. that law can be invoked to do almost anything. so, it was the successor of the old training with the enemy act, which we changed in the 1970's. i happened to be involved.

it does give authority to an executive branch to do almost anything under the guise of dealing with an international economic emergency, which would certainly be. whether asked to violate the law or come up with interpretations, i think adam is right. >> i hope adam is right. we have an example in this country where you have the crisis of bankruptcy, the government rewrote the bankruptcy code in terms of creditors. >> let me say that before we ever get there, my hope is that we take steps necessary to prevent a for getting in that spot again, which is really come in large part, what this hearing is about. so, let me go back to each of you. if you have the power to take a series of steps to protect the

united states, given the risks that are known and those that are not known, what would be the advice that you would give to this committee? what should we do to protect the united states? >> i think it is conceptually simple, and actually doable politically. you should prepare for enactment right after the elections later this year, 2013, a budget plan which simultaneously provided some support to economic growth in the short-run by continuing, for example, the payroll tax cuts for another year or so, but, that is the huge but, put into place concrete, tangible measures that would reduce the

budget deficit to achieve the 50% or 60% debt to gdp ratio over the next5 to 7 years. procedures, like we did last summer, where you commission certain deficit reduction supposed to be going on now, set a super committee, and put in place -- what that did was put in place procedures, not budget correction. so, i think you need to actually vote two or three major measures that would phase in a over 5 to 10-year period, and reduce the budget deficit to the targeted limit over that time. for example, social security reform, where you change the indexation formula, increase the retirement age, maybe one or two other elements of that, which would, by definition, say, over a number of years, which is what you want, but, we take up to

1.5% of budget deficit of gdp off the budget deficit over that time, which is what the market wants to hear. secondly, if you could agree on some revenue increases, which i think will be unnecessary as part of the package, then you -- which will be necessary as part of the package, then you face it and over 10 years. it has a gradual impact on the economy, can be accommodated by the private sector, not disrupt either growth for their business transaction, because it stays in, but get to an end point, which has a significant impact in reducing the budget deficit. if you can find similar measures on the health care side, obviously, it would be desirable to do that. the point being, however, to actually vote substantive, tangible, concrete measures, put them in law that sets you on a path to phase in the budget

correction over the desired time. that seems to square the short- term with the long-term. only that will avoid the risk to our country that are continuing to kick our can down the road otherwise generate. >> i agree that making progress on the budget would be huge, particularly in this context. the extent you would need if you were roughly going to a 50% debt gdp prague -- product by 2030 is pretty large. the one step -- i think there are many ideas on the table. i don't see a lot of political traction for any of them at the moment. the one thing that you may be due, depending on circumstances, is you might not extend the bush-share tax cuts -- bush-era

tax cut. that requires agreement between both houses of congress and the president in order to extend them. i understand you don't want to go there. if you were to do that, that could be huge. if you look at that relative to the fiscal adjustment the united states would need to take, it would take the issue off the table. it is slightly more than half of fiscal adjustment you need. it is not a whole story. there are other things that need to be considered. i would go up for tax expenditures and face amount over a decade. the question is, can you communicate to the markets, i think we all agree there would be looking increasingly skeptically, that we can do financial adjustment? we did it in the past, the somewhat distant past. the markets are going to question us. i agree also with what both my colleagues have said.

we do not get a letter saying, in the 90's, the markets will turn against you. they turn against you very quickly. we should get ahead of that. otherwise, we will be forced into a precipitous and self- defeating austerity, which is where the europeans are. >> the cbo told us yesterday if we were to let all of the bush- share tax cuts left -- lapse and allow things to proceed as is currently in the law, economic growth in this country would drop dramatically. we would go from 2.2%, 2.5% growth this year to just over 1% growth next year. that kind of a precipitous change does not make sense. what does make sense is to have, fred, i like what you described, which is something in the short- term that gives additional lift.

i personally believe we should look at infrastructure. i know economists have resistance to that. i will tell you,f going to be priority funding available for projects that have national importance in the transportation infrastructure of the united states, and you gave them a certain amount of time, it would happen, but only if simultaneously you put in place a policy that made the adjustment to entitlement and, yes, revenue, that come to me, i like the goal of balancing in 10 years. that would take us a long way in the direction to getting to a debt to gdp that is sustainable.

your recommendation to us? >> i think the u.s. government is lulled into a false sense of security because of how low interest rates are on our debt right now. it is trimmed by three factors. one, the mess in europe. two, the fact that the dollar is a reserve currency. finally, the federal reserve is buying from many of them themselves. we have very few private investors in the united states buying u.s. treasuries. i think, going back, what is lacking in this country from a government policy standpoint is a simple program that answers five questions. what are you trying to do? how're you going to do it? why is it going to work? how much is it going to cost? where are you going to get the money?

no, congress has not answered that question. the administration has not answered that question. the market is waiting for an answer to that question. the innovation in economic science over the last 50 years has been the role of expectations in how people in the economy, financial markets, work. if the u.s. government were able to announce a program that answer those five questions, the markets would immediately, and it was credible, the markets would immediately take that expectation of future stability and give us stability today. until we answer those questions, any stability issue will be short-lived. it could vanish at any moment, as mr. johnson said. >> thank you. senator johnson is recognized for the equivalent amount of time as i just consume. >> i will be quick because you're questioning covered a lot of what i wanted to talk about.

we have talked about the book written "this time it is different." past history, nation states of got into high levels of debt, by and large got themselves off by inflating their currency in devaluing debt. our debt is structural in terms of entitlements. our liabilities are tied to inflation. from my standpoint, we cannot inflate our way out of this debt. that is the question i am asking. like your comments. are we in a bigger pickle than past nations? dr. johnson, you're shaking your head. i will go to you first. >> i was nodding my head, actually. we're certainly in a big people. there's no question about that. you cannot inflate your way some of -- out of some of the liabilities.

you can inflate your way out of some debt obligations. the u.k. has much more incentive to inflate in the classic way than we do. and, ultimately, we need to look at the liabilities and the revenues that we're willing to raise to back those, including, as an imbalance, we have a huge advantage relative to other countries, which is, we are the reserve currency. we are able to borrow internationally. we have a credit line. we learned that credit line. however, we are in the process of wasting that credit line. we're not investing in the productive assets, upgrading our education system, boosting our growth. we're just spending and borrowing to finance consumption in excess of our income. that will end badly.

the pickle we are in could well end up being a very large one, maybe bigger from what other countries have had. we have an opportunity to fix it, and opportunity the europeans don't have right now. they are in a different place. we should take that as a cautionary tale and use it to fix our own budget today. i think we are all on the same page with regard to your general. spirit >> you touched on my next point. reserve currency. some countries are talking about maybe a basket currency. how long do we have? i realize you cannot answer that. is there really a concerted effort to move away from the u.s. dollar? >> i wrote a book on that a long time ago to keep close to it. it is critical to remember that the reserve currency role is -- it buys us more time, but that also means we tend not to have the pressure that we need to adjust.

even in fundamental terms, is it a good thing, it is ambiguous. once the turn happens, there are about $25 trillion of foreign- held dollars floating around the world economy. that is the sum of the accumulation of the years that let us run the deficit we are talking about. we used to call that a dollar overhang. it implies, correctly, that it could come cascading down. if it turns out and the markets begin to look askance at what we are doing, the reserve currency role in the dollar provides additional huge ammunition to intensify the pressure on us as people around the world sell those dollars they have accumulated over past decades. whether that happens depends on two things. is there an alternative to the

dollar? in underlying structural terms, the euro certainly is one. it meets the criteria. right now, it is not an attractive alternative. if they do get their act together, get the house in order, two or three years out, they could be. china is going to be the biggest economy. it is going to have the largest trade and foreign investment flows. once they decide to move off capital controls and make their currency convertible, that is another alternative. we are headed toward at least a three-part global monetary system. current system, dollar, and euro, and rmb over different time periods. and so, the non-alternative tha tadam pointed to does become

very different. people are not going to be compelled to put their money in dollars. the reserve currency role -- it certainly is in the short-run. that will be fading. it could become a huge liability. i would never rely very much on that one to deal with the sustainability of our situation over any reasonable period of time. >> senator, i said five years in argentina on debt restructuring. every schoolchild knows, because the ones who do not know this have been killed off by darwinian survival, every argentine school child knows there are only three solutions. you write down the debt, you raise the surplus to pay the debt, or you inflate the debt away. there are no other solutions. we have learned that over 200 years. the question of the reserve currency, u.s. question, should there be a basket as an

alternative? every person in the world can create their own reserve basket. if you'd like a basket of reserves and 20% yen and 40% euros and 30% dollars, and throw in the brazilian currency, you can create that herself. central banks do that all the time. the idea of creating an official reserve currency basket, such as the special drawing right was supposed to be, that is a very inefficient outcome. that is saying, we have decided what the optimal basket is. we set the weight, the percentage of each currency. i may like that. i may not like those ways. i want a different basket. the markets can create their own best. there's no purpose in creating a basket currency today. finally, as fred pointed out, the reserve currency can change

quickly. what has held us up and what has taken the pressure off the u.s. dollar to actually make the decisions it should have made years ago, is because there has been no viable alternative. the euro was a viable alternative. it now isn't for the moment. as fred said, if they come over the next three years, as i believe they do, put in place a stable system, it will be. you will see massive flow. the only thing that will surprise you more than the size of the flows as they move out of the dollars into the bureau will be the speed with which it will take place. >> this is about taxes and the effect on growth. during my lifetime, the highest marginal tax rate has been 90%, 7%, 50%, 20%, 39.6%, 35%. prior to 2008, the average amount of revenue generated or extracted from the economy has been 18.1%.

the variations have been tight around that. it goes too much, you end up with recession. i am not sure what the causes. look at the data. very tight around 18.1%. i am not sure what causes that. tax policy drives it. when you have high marginal rates, you have reductions. i have a suspicion as well that just like with capital gains taxes, when you raise them, people expose less of their income to that tax. i am highly concerned, we raise taxes, we will harm economic growth. i believe the number one solution is economic growth. if you can sort of speak to the effect of marginal tax rates, the ability of the u.s. government really to extract much more than the 50-year average over any kind of long time, and really speak to increasing tax rates to drive more revenue? i know that is kind of a big

subject. in 30 seconds or less. >> that is a huge and interesting subject. i think you and i may disagree on how to read the evidence and on the ability of the federal level to raise revenue. i take your point. there has been stability around federal revenues for a long time prior to the crisis. we should reflect on that. there is a stability to the future medical costs. that is the big solution if you look over 20 or 30 years. cap federaling to revenue at 19%, that has major consequences for what you're able to pay in terms of the health care costs of elderly americans. i think we should have that conversation. i would go on the side of covering more of the health care costs, personally. we should control the costs, obviously. those are tough to control. changes mean a possible in the increase. the cbo relative to the european commission was very honest about what future costs

would be. the europeans, not so much. that is on the table. i would go a little bit more toward allowing revenue to increase. i think there are ways to do that. i think of the medium-term, we can do that without damaging growth. we can do that in a way that is pro-growth and quite reasonable. i don't expect you and i will agree on that. now is a good year to have that discussion into get these issues in the open and strategic and show people what is the menu. we give a recommendation from the menu. pick whatever you want off the menu, as long as you get on to what we have agreed is a path to fiscal stability and a debt-gdp level that is under control. >> two one-sentence response. i think it is more important to get the overall budget into sustainable balance than it is

to avoid an increase in government revenues as a share of the economy. point two, i think we can get a contribution to that outcome with higher government revenues without raising marginal tax rates, which used dressed, getting rid of a lot of tax expenditures, and finding a lot of base-broadening to go along with maintaining or possibly cutting some of the tax rates. i think there is a perfectly doable package here that addresses at least what seems to be your main concern, marginal rate. at the same time, increasing revenues as part of an overall budget package, which, to me, is the most important priority. >> i think you're concerned about tax rates is very well- focused. i think two things. one, we will have to pay for

what we have wasted the last 30 years. your chart showed our debt has gone up. someone has to pay for that. it was a mistake. we agree we should not have done it. we have to pay for it. that is going to require a rise in tax revenue, not in tax rates, that is right. the fact of the matter is that you raise marginal tax rates, especially on high-income people, you're not going to generate the revenue -- there's a question of how much more revenue will generate, and you will not generate anywhere near the amount of revenue you need to close the gaps significantly. you have to think of how you broaden the tax base. how'd you broaden the tax base without affecting economic growth, or with minimal impact? that is the issue. raising marginal tax rates can be politically attractive. it can be politically popular. in this country, 50% of u.s. voters don't pay any federal

income tax. 60 percent and receive more from the government than they pay in income taxes. raising taxes on the remaining 20% or 30% canopied -- can be politically wise. raising tax rates will not help. >> even though people don't pay, they pay payroll taxes. it is a historical accident that we make this distinction. some countries do not make that distinction. your funding social security and medicare out of payroll taxes. that is an important federal tax obligation that most voters do pay. >> one question. i view medicare and payroll taxes, those are pension funds and health care costs. those are not taxes to pay for general government expenditures. >> let me make this point. this is where we have a disagreement. when i look back at the five

years we have balanced the budget in the last 30 years, tax revenue was close to 20% of gdp, 19.7% one year, 19.8%, 20.6%. the years we have actually balance the budget, tax revenues have not been 18.1%. it has been close to 20%. we have the additional problem of the demographics of the country changing. an aging population. my personal belief is, we have got to be in the high-19% of gdp range to get a package. i agree entirely the way to do that is not raising marginal tax rates. if you look at somebody like martin phelps, a pretty credible conservative, he says, don't raise the marginal tax rates.

broaden the base. reduce, and in some cases, eliminate tax expenditures. i don't want to put words in his mouth. he says you should focus on tax expenditures because it is just spending by a different name. some of these tax expenditures, now we are running $1.10 trillion a year in tax expenditures, more money through the tax code than we are through all the appropriated accounts. it gets almost no attention. i am on the finance committee. i can tell you, we do not pay -- we pay much less attention to expenditures through the tax code than we do through the appropriated accounts. i don't suggest that we don't have to cut the appropriate accounts. we certainly have to have come as part of any serious package, a focus on entitlements. you know, 30 years ago, the share of our budget going for

mandatory spending was the smallest share. the biggest share was the appropriate account. now it is flipped. we are over 60% mandatory accounts, social security, medicare, the discretionary accounts are now the smaller shares. it is strange the way we operate around here. when we look at a solution, nobody wants to kind of talk about the elephant in the room. nobody wants to talk about the entitlements. we want to focus on discretionary spending, which i would argue is much less the problem. and you know, we all understand politics. >> i want to add one caution in terms of the percentage of gdp and revenue during boom times. that is when your percentage of revenue will increase, and in tough times, it goes down 15%.

we do not balance our budget because we increase taxes. it is because the economy was booming and allow that revenue to be extracted from the economy. it is all subject to debate. that would be my caution. >> here we are in a situation in which our spending right now is over 24% of gdp. our revenue is between 14% and 15% of gdp. so, spending as a share of the economy is at or near a 60-year high. revenue is at or near a 60-year low. no wonder we have gone record deficits. really, i don't know which one of you mentioned, if you look at the 10-year outlook here, on a realistic basis, we're looking at trillion-dollar deficits as far as the eye can see. you said that. i like to attribute it to the right person. thank you all. i know we committed to ending at

noon. somebody has to make a plane. we appreciate very much the testimony. i think it has been an outstanding hearing. >> thank you very much. [captioning performed by national captioning institute] [captions copyright national cable satellite corp. 2012] cable satellite corp. 2012]