0:36 Intro. [Recording date: November 28, 2011.] Situation in Europe. Taping will air one week from today; events may overtake this podcast, so we will do the best we can. Let's start with the problem. What is the problem facing Greece, and Italy and perhaps Spain, and what other countries you want to include in that problem group? The Eurozone is like the proverbial elephant. There are 17 different ways of describing the problem. And most of those ways are correct. But, which is the most important way depends on your point of view. Here's how I see it. The arrangement behind the euro, the common currency, was never workable in the first place. Principle 1). No monetary union without a fiscal union. Principle 2). No fiscal union without a common electorate. Europe is very far from having a common electorate. But that's it. The more practical question is: How did this all unravel? And if I may have just about a minute I'll run through what I think the problem is. Let's say that before all the trouble started, you are comparing two banks: The euro in a Greek bank in Greece, and a euro in a German bank in Germany. A few years ago the markets treated those two assets as basically equivalent in value. And in good times, they are. The Greek banks were solvent; the German banks were solvent; matters proceeded. But when times turn bad, they are not equivalent assets at all. The euro in a German bank is worth quite a bit more than the Greek bank. The Greek bank might fail, even if it's backed by the government. The Greek government might fail. It might be confiscated; it might be turned back into the drachma; there might be capital controls--whatever. So, as troubles approach, people start to realize that financial intermediation in Greece, it doesn't quite work any more. There's a slow and silent run on banks. And in general, what happens is a variety of different capital markets tend to be picked apart, and literally fall apart. Just as Carl Menger writes about how markets evolve, we are not seeing the opposite: the wholesale falling away and destruction of a lot of capital markets in a kind of horror, slow-motion process. And there's a lot more of what's going on--there are still 16 sides to the elephant which I haven't covered. But that's the one side I'll start with right now. To make that comparison vivid, let's contrast a dollar in a bank in Minnesota with a dollar in a bank in Mississippi. They are both worth the same--probably. Sure; they are backed by the same Federal Deposit Insurance Corporation (FDIC). Correct. So, there's no need to take your dollar out of the Minnesota bank and put it in the Mississippi bank or vice versa, because 1. There is an extremely high probability you can take it out whenever you want and what it will buy is the same once you get it out. What's different? What happened that caused the value of that euro in the Greek bank to not be worth--I mean, it's a euro. Why is it different from the German bank? The Greeks made many mistakes. A lot of them were fiscal policy. They spent too much money; they borrowed too much money; they have a very corrupt country; you can't trust the statistics. If you look at how Greece is rated on the World Bank's Doing Business Index, they are near the bottom. They are even below some of the African countries. So, the level of trust there is not high. And Greece has been in default about half of its history, since 1850 or so. So, ultimately: Should people trust the Greek euro and the Greek bank? I would say no. If I had money there--of course, I do not--I would have gotten it out a long time ago. So, there's a run not just on the banks but on the bond markets of the weaker countries. Let's talk about what you mean by that. So, Greece spends more than it takes in--that's the fiscal policy. By a lot. Which isn't unionized--there's no European fiscal policy. Each nation has its own fiscal policy, its own tax policy, it's own spending plans, its own tax revenue. They share a currency. And that's what you start off by saying it's probably not feasible from the get-go. But that's the way it was set up. What's going on in the bond market for Greece that making the life of politicians there difficult? At this point, everyone knows Greece will default, one way or another, whether it's legally called a default. If you are a bond holder, you will not get your money back. At first the talk was 30% haircut; then it was at 50% haircut. Some people even now are talking about 100% haircut. Meaning that if you lent money to the Greek government, you are not going to get any of it back. That's right. I would guess the best guess would be something like an 80% haircut. Meaning you get 20 cents on the dollar. So, how did that happen? Governance in Greece is extremely bad. There was this temporary myth that Greece had become part of the real Europe. There was a sense they would be taken care of. There was a sense they would grow more, that they would adopt political institutions similar to those in Germany, Netherlands, or the Nordic countries. Not all the way there, but that they would do enough of it to give it all a go. And expectations were very high. But in reality very few Greek sectors are competitive. Even something like tourism, which for Greece should be a no-brainer. If you compare what the Greeks have done for their tourist sector to, say, Turkey--hardly a previous paragon of efficiency--the Turks have done a much better job. You get a much nicer vacation in Turkey. It costs you a lot less. You are not paying euro-denominated prices. The [?] clubs are better, the foods are better--pretty much everything's better. And Greece just is not very much a competitive country any more. Yet, they were borrowing and spending money as if they were a wealthy European nation. And now it's turned out they are not.

6:55 So, they are going to default in some dimension. You say it as if it is a fact. Is there any possibility that things would get "fixed" and is there any sense of what they might possibly mean? Let me ask that a different way. Is Greece borrowing money right now, daily? They are getting money from the European Central Bank (ECB). Private citizens such as myself, we are reluctant to lend Greece money because the rate that we would require is so high that they are not feasibly in a position to be able to promise to pay it back. So that market has essentially collapsed; they are on life support. So, the only question remains: If with the aid of ECB money, which I assume--is it a loan? Is it an injection? Is it cash? Well, we'll see. In theory it's a loan. So, with the aid of that money they are covering their obligations day-to-day for now. They are not able to borrow additional money in the open market. There is a possibility in theory that through fiscal stringency, through so-called austerity they could cut back on their spending. I don't think that's possible right now. Right, but that would be a route to avoiding default. They could in theory "get their house in order," make a series of political decisions which are very unpleasant, which is very difficult for any nation to do, and particularly maybe this one. They would spend less, raise more money, show that they were responsible fiscally; and in principle they could then borrow money again to close the gap between what they borrowed in the past and what they owe. Correct? Had they started a few years ago, I think they could have done that. I think now it's too late. So, what will be the consequences of that outcome, if and when they do "default"--if and when they do not cover the payments they owe on past obligations? There are a number of different things going on. The first is belt-tightening in Greece has led to a lot of riots and a lot of political turmoil; and it's not clear how stable the basic situation is. That of course hurts the economy all the more. And bank deposits leaving the country hurts the economy even further; so it's hard to see them recovering without a complete implosion of some kind and just starting over again. But the key to understanding the crisis is not really Greece. Because the Greek economy is about 2% or was about 2% of the Eurozone economy. A shocking number, by the way. There are 17 countries in the Eurozone, so on average you should be about 1/17th, not 1/50th. They were a very small, well below the per capita size of the rest of the zone. But if Greece were the only problem, I'm quite convinced that the wealthier nations would be willing to pay the bill, plug the hole, call it a loss, and get on with business. Imposing, perhaps, some restrictions on future Greek spending. That's right. And no one would be happy with that. But it wouldn't be that big a deal. The problem is you have other, larger nations in the queue. And once Greece is treated or resolved a certain way, the question is: Italy, Spain, Portugal, possibly Ireland--do you treat or resolve them in the same way? And those are much bigger. That's the real problem. Italy and Spain are why we are talking about this. Greece is a small problem. So, the idea being that if Italy and Spain had some sort of catastrophic encounter with this failure to meet their obligations, economic consequences for the rest of Europe and possibly the United States would be much larger. And Italy and Spain are too big to bail out. It seems the resources simply aren't there. It's trillions. And the question is: Who is it now that's contributing to the bailout? Well, not too long ago we spoke of Italy contributing to the bailout of Greece. But now Italy needs a bailout. So, when you hear talk about the European Fund--11%-12% of that bailout fund is supposed to come from Italy. And what we see is more and more countries being shifted from one side of the ledger to the other. There is even some talk of France having some serious problems. I'm not sure that's true. But that there is even talk of it. And the notion that at the other end of the balance scale, you have Germany and the Netherlands, and maybe Finland, holding up the accumulated weight of the other countries and the fiscal problems--it's just not going to work. So, we need the Martian Central Bank to intervene--a suggestion I've made in the past. Which some suggest is not plausible. And I guess the Chinese would be a variant on that. Let's find someone who is just not related to this somehow who can help us avoid pain. If the Chinese and the Americans, the Brazilians and the Turks, were willing to put up some money and maybe lose it, you could have a short-run resolution. But of course, they don't want to, either. Per capita income in China is much lower even than in Greece. And to tell the Chinese: You should bail out the Greeks--they are not idiots. And so on. You tell the story a little differently than I've heard it, so I want to ask you about one aspect we haven't heard about. One of the things that is opaque about this crisis for me is who these nations owe money to. It's often discussed as if it's left out of the picture--or it's central to the picture. It's one or the other. And it's hard to know which way to think about it. So, in particular, in the early days in the Greek crisis, my understanding was that much of the Greek debt was held by French banks. Correct. So that the bailout of Greece--again for those of you who are listening to the program know I'm really focused on creditors, the people who finance leveraged activity, borrowed money--the creditors of Greece are not the citizens of Greece. They are some of course, I presume, who bought Greek securities, Greek Treasuries, whatever their name is. But they weren't the French banks. So that rescuing Greece isn't really about rescuing Greece. Which, after all, if Greece defaults, the theory is that they can't borrow for a while. Which is not pleasant. Not fun to have to live within your means. But that's manageable in theory. But that Greek default would mean French bank collapse, which would mean French collapse, which would mean the banks that had lent money to French banks might not get it back. And this systemic, contagious, fragility argument is the real reason we have to argue about Greece. What do you think of that argument? Well, it's become even stranger than that, because the French banks, and a lot of the other banks, have by now sold a lot of their Greek securities, a long time ago to hedge funds, who are doing this as a speculative play. It may end badly for them. So, the problem in that particular case may not even be about saving the French banks. It's about saving the impression that you are still able to bail out Italy, Spain, Portugal, and other countries. So, one could imagine, you could let Greece go. The banks already have sold off enough that, assume that's manageable. But then it's the credibility problem. If people think you are not going to bail out Greece, you are not going to bail out Italy. Which would be a reasonable assumption. And then all hell breaks loose. So, it's the interconnected nature of these different countries. If you could somehow settle them on a one-by-one basis, you would have a much better chance of doing well. But everything you do is a precedent, and that one big reason why things have gone as badly as they have.

14:40 So, I don't want to go too deeply yet into the American financial crisis of 2008, where the decision not to rescue Lehman Brothers was viewed by some as The catastrophic moment in the crisis. I view it actually as the Decision 2 Rescue of Bear Stearns of 4,5,6, 7 months earlier. But in this case, sticking with the current situation: Okay, so let's take the worst case scenario. Let's suppose that if we let Greece go that's a signal that we are going to let Italy and Spain to. Which, as you suggested a moment ago might be an unavoidable fact anyway. There's no secret as to how unhealthy Italy and Spain are. The magnitude of the asset/liability mismatch is large. It's maybe a trillion dollars for Italy--that's what I've seen--may be that for Spain, it's large. Everybody knows that. Everybody knows that it's very unlikely that a political compromise can be fashioned that would have, say, Germany, Finland, and the Netherlands, other third country on the pale of this enormous sum of money. Doesn't the world understand that already? And if indeed that expectation is realized, what would be so bad other than Spain, Italy, and Portugal, say, along with Greece, would be stuck with living within their means, and that people who lent their money would lose their money; and that would be a great precedent to the future that says: Don't lend money recklessly to dangerous places? We may see this a bit differently. I agree with a lot of what you said. But I tend to doubt if it would be a good precedent. Because if all of those countries go under, you have large numbers of banks in Europe being insolvent, and not actually a way to rescue them. So it becomes like 1929, where you have a very large deflation. You would have a second Great Depression, at least in Europe, possibly in other places. And I think the precedent people would take away is not: Boy, we showed them a lesson! They won't lend again! I think the lesson that would be taken away would be: Wow, that got so bad they'll never let that happen again. I understand that the political economy lesson could be uncertain, especially in how you interacted with voters and how others might behave. But let's take that dark scenario, that Great Depression argument. So, let's say all the banks go under. Let's say indeed it's not just MF Global, which is a player in this market that just went bankrupt, John Corzine's firm, perhaps with some alleged fraudulent activity. But certainly bad bets were made by that firm; they went under; they are going into bankruptcy, and that's that. Let's suppose it's not just firms like that--hedge funds with people who expected or which have a small chance of getting their money back--but rather large financial institutions, certainly in Europe, and possibly in the United States--so the French banks, maybe the German banks, maybe the U.S. banks, end up being, and this is not transparent, which is a huge part of the problem for me--but we don't know how much sovereign debt. Sovereign debt meaning issued by countries rather than companies. We don't know how much sovereign debt is held by these European and American banks. If it turns out to be a lot, and they don't get bailed out, there will be large losses; and those firms will become insolvent. And the next [?] we will decide to bail them out. And suppose we can't or the political will isn't there. And there would be a major depression, you said, in Europe. Because it will be like 1929, where bank failure leads to a contraction of the money supply. Can't the ECB counter that? Couldn't the Fed counter that here in the United States? Why is it? I do not understand why it is that the survival of individual institutions is central to our well-being. That's a key question. The United States is in a better position. So, let's focus on Europe here. It's quite possible that the ECB right now, legal issues aside, but quite conceptually, could pledge to support Italian banks, Italian debt, Spanish government, Portugal--whoever needed to be covered. And they would make a pledge. They would monetize whatever debts would need to be monetized to support all of those institutions. And if that were a credible pledge, and if you assume away some legal issues, that is the one thing that could potentially solve the crisis. But the problem is this: To pay for the mess, one way or another you need to transfer real resources. You could tax Germans and send the money. That's unlikely. You could do it through inflation. The ECB pledge is potentially an attempt to do the same thing to plug the gap by inflating. Now the people doing this, they sometimes doing this, they sometimes give the view that if the ECB is doing this and if they are credible, they don't actually need to inflate. They can keep the whole ship above water. Just by the expectation. Right. And there's some chance that's correct. But what you are asking Germany, Netherlands, Finland, to make a very large bet and back it and underwrite it; and it's far from obvious it's correct. I think at this point the ECB, the Eurozone, the European Union (EU), cannot credibly pledge anything. We don't even know if it will really be around a year from now. It will probably be around by the time this podcast comes out; but there's even a tiny chance there that it won't be. So, that's the only possible solution.

20:27 Well, that's a different scenario than I had in mind. That's an interesting scenario; that's not what I meant. So, let me try to restate it. And I will now go back to the 2008 Crisis. The way that the United States, the 2008 policy makers, dealt with the 2008 crisis, is out of alleged worries that banks would collapse. They injected, they gave the banks money. They did a couple of other things, too. Obviously they guaranteed assets on the books of Bear Stearns; they allowed a bidder to come forward and take on the obligations that Bear Stearns had made so that those banks that had lent money to Bear Stearns wouldn't lose money, etc. But basically they decided to save institutions. What if they had not? What if they had let every institution fail--they had let Bear Stearns fail--of course Lehman might have changed its behavior, but let's say that would have been resolvable as well; Fannie and Freddie would have still gone under; AIG would have gone under. All these, maybe Goldman Sachs as a result, other firms connected to this concatenations and promises. I understand why that's bad if you are shareholder for those firms. Why do I, on Main Street, care about that? And the standard answer, I thought was: Well, this shadow banking system, these failures, would freeze up the credit market. Interest rates would spike. Commercial activity would go down. The money supply would shrink. We would be in a major deflation, and that would have a devastating impact on the United States. The Fed could counteract that. Instead of counteracting that ex ante by making sure it didn't happen to start with, it could let it happen, let the dominos fall, and inject liquidity into the system generally rather than in specific banks who have lousy management and should have been punished. Why wasn't that option--should that have been an attractive option? And in turn, should the European Central Bank, the ECB, shouldn't they now have the same situation? Let Greece fail, let Italy fail, let all these countries fail, which is a political mismanagement? The banks that lent them money, whether it's their fault or not, they are going to go out of business. Some might still be solvent--we don't know. Some hedge funds, a lot of them might go out of business. Too bad, not a big deal. Let the ECB counter that with expansionary monetary policy. Which is the lesson I thought we learned from the Great Depression. We didn't learn the lesson: Don't let banks fail. We learned the lesson that when banks fail, make sure the money supply increases. There is a difference here between credit and currency. So, if all these European banks are failing, you are talking about injecting liquidity into the system. But that system is collapsing. Loans aren't being made, loans are being sold, margin calls are being made; so everything is collapsing into this vortex of the black hole. The central banks or the ECB, they still could just print currency. But currency is no substitute for, say, what we call M2. Currency is not credit. To have a world where credit is gone and you have a lot of currency, you have a weird mix, a total collapse of economic activity, including the ability of firms to meet payroll; and maybe even some odd hyperinflation. But I don't even think you get that far. The key point here is the United States has a credible Federal Deposit Insurance Corporation (FDIC); but a lot of the European nations do not. We do right now. We did in 2008. So you have everyone essentially in a lot of countries, maybe not every country, losing their bank deposits. And even if one thinks there is something the ECB could do to equalize that in terms of the flow of nominal income, nominal GDP, I'll just predict the political equilibrium is that those banks will be nationalized rather rapidly, before we even get to these extreme scenarios. And this indeed may be what happens: That Europe moves from what it is now, to when association, when the weaker countries, have nationalized all their banks and keep their banks afloat with some kind of wealth tax. To me, that's a pretty ugly ending. But that may be what happens. That's what we are looking at. Not that there is some kind of even process of adjustment, that some banks go under and you keep up the flow of nominal spending. Credit markets are already collapsing in these countries, and we are not even at the worst part of the crisis yet.

24:28 Is it imaginable that Greece could nationalize its banks without having any meaning, without leaving the Euro? Wouldn't they have to effectively do that? Most likely. And right now, the Greek government is itself such a bad credit risk, the idea that the Greek government has nationalized the bank is maybe a step backwards. Maybe you'd rather have the bank nationalize the government. So, that's not an answer for Greece. And Greece is also not running any kind of primary surplus. What do you mean by primary surplus? They are borrowing just to pay back just a lot more borrowing. So, if they were cut off from credit markets, cut off from the ECB is a better way of putting it at this point, they would have to cut government spending by another 8-10%. And again, I think that's not possible. No matter what one thinks is the proper role of government. There would sooner be a coup or riots; somehow that process would collapse before we got to the end game. So there is not some easy scenario of Greece being cut off and just toddling along. It would be very ugly. It's a strange thing, really, when you think about it. If you or I had to take a pay cut, which is unlikely being tenured here at a state university--it's possible, not likely but it's possible; we've had some semi-versions of it recently here in Virginia. But let's say we had to take a pay cut, or we lost some outside source of income; and our expenditures might have to fall by 10%. Ten percent would be some unpleasant set of circumstances, we'd have to make within our family; we'd sit down with our family members, talk about what we cared about. A 10% cut probably wouldn't require me to move. Which would be a dramatic change. You'd eat out less. You'd cut back on extravagances. Ten percent is unpleasant. But it's not even life-changing. Because you wouldn't have to move to a different house, in a different school system. Those would be dramatic changes. We're well above the median, of course. But governments don't work this way. That's what's fascinating. Because an 8% cut is not a big cut. A 10% cut. And yet, I agree with you--I think the political mechanisms to achieve that might not exist. Not for Greece. I'm not sure they exist just for us in the United States. It's interesting to compare some of these countries to Iceland. Iceland had a very bad financial crisis, and they took a different route. They didn't do bailouts of the banks; and they could get away with this because Icelandic banks are so small in the global scheme of things, you don't knock down any larger house of cards. And I think Iceland, within the country, there was enough trust that they could do this; and the Icelandic government could tell the people: You are going to have a hard 3-5 years, not be buying so many fruits from abroad; there will be capital controls; the exchange rate will be a problem; but you need to trust us that this is best. I don't agree with everything they did in Iceland, but in fact they managed to do it. There are not riots in Reykjavik. It's not in that sense a political problem. It's a very small, homogeneous country. With a high level of trust. There are governments which can take radical steps which other governments cannot. And I do not think that Greece could do its own version of Iceland. Not at this point. Let's compare for the moment England to the United States. I find it fascinating--we're in the middle of a debate over what to do with America's fiscal deficit. The Supercommittee has just given up in the last week or so. I find it remarkable that in a time when nominal spending, measured in actual dollars, not corrected for inflation, has risen something like on the order of 50%--50% in the last 3-4 years--that a 10% cut is considered shocking. We're trying to get a cut in the rate of increase; we're trying to close the gap with taxes. Many people are arguing that we should not cut spending; we should increase tax revenue. Of course, many people have many agendas. But a 10% cut would be a real cut--a cut in actual spending, not the growth in spending--is somehow seen as Draconian, in a time when we've just had a massive increase. Which is a fascinating real aspect of our political system. And yet in England, have they had some actual cuts? They call it austerity; I don't know what they actually did. Did they really cut anything? Did they cut the rate of increase? And why might there world be politically different from ours? In England, they've done some of the cuts; others are in the works; they are scheduled. They may not follow through on all of it. But keep in mind, their system does not have the same checks and balances which ours does. You govern through Parliament; you can't quite do what you want, but you can try to do what you want and then there will be a referendum on it at the next election. So, England continues to get itself into trouble first; and they tend to get out of trouble first. Thatcher came before Reagan. British socialism came before a lot of the U.S. interventions. So, they go in and out of trouble more rapidly, both ways. Our system has a lot more inertia. But inertia right now is not a good thing. Most of our history it's been our friend, but it's not right now.

30:24 What's your best guess, which maybe is an unfair question, as to how this might play out in Europe, going back to our PIGS scenario--Portugal, Italy, Greece, and Spain. Maybe a second double "I" in there for Ireland. What might happen? Here's my most likely guess. But when I say it's most likely, it doesn't mean I think its probability is 50%. I just think it's the most likely of all the different scenarios. Greece, there's simply no way out. There's nothing really to discuss there. It's all about Italy and Spain. My guess is that Germany will not step up to the plate. Those countries will be in informal default by Christmas time. At some point, to pay their bills, not right away, but as more credit markets unravel, as more economic conditions unravel, as aggregate demand weakens, they will be faced increasingly with the option of: Do we go back to creating our own currency to pay our bills, to pay our state employees, to get things back in order? And as that talk increases, there will be further runs on Italian and Spanish banks, which will force their hand. There will be capital controls introduced suddenly. And a return back to earlier currencies; and they will leave the Eurozone; and they will have 3-5 years economically speaking of being a total mess. For Portugal, Spain, Italy, I think that is likely. For Greece I think it is nearly certain. For Ireland I am genuinely unsure--I think they have a real chance of sticking it out in some way. I'm not sure. And that in my view is the most likely scenario. Let's continue to unfurl that story. So, they reinstitute the Lira, the Drachma, the Peseta, etc. and they are not going to very happy places economically, politically. Because there is going to be a lot of uncertainty about the reliability of that currency outside of government employees. All the contracts written in Euros for international trade--how are they honored? External debts in Euros--how is that honored? A lot of legal messes that won't be cleared up very well or very quickly. Correct. So the joke used to be: When America sneezes, Europe catches a cold. I would suspect that when Italy, Spain, and Portugal sneeze, Europe gets pneumonia and we are going to get a really bad flu. Right? That story, which you suggest is, although not likely, is maybe the most likely, is a very depressing story. Correct. I think it's not well understood what would be the implications here. Keep in mind it at least seems that European banks are significant net suppliers to our shadow banking system. To a very large extent. It may be more important than the so-called savings glut coming from China and Asia. So, to the extent European banks have trouble, have to sell assets, need to raise capital, need to scale back, they will presumably be restricting a lot of their activities. They may shrink in size; they may be partially or totally insolvent. That will be a negative shock to our shadow banking system. By shadow banking you mean investment banks--things other than FDIC-insured. Short-term lending among financial institutions. Now, if European banks are pulling out of that, can U.S. or other banks step into the gap and keep that running smoothly? It's possible. But again, this is not something happening during calm times. This would happen with a lot of other uncertainty being carried along as baggage, and I think there's a pretty reasonable chance it would be a very negative financial shock for us, quite possibly larger than Lehman Brothers or you would say Bear Stearns, however you wish to slice that cake.

34:33 So we learned or are continuing to learn, unfortunately, of a wide variety of activities the Fed took in the 2008 period that not only subsidized American institutions by a significant amount, but foreign banks as well. If you are sitting in the chair of the Federal Reserve Chair, what kind of decisions is he going to have to try to make in that scenario? They are not very attractive. It's a bad place to be, if you are Ben Bernanke. Vacation, probably--stress on the job, more time with the family. Well, here's one thing he could do; one could debate if it's a good thing or not--but basically, buy up all of the bonds of the weak European countries which are currently on the books of the U.S. banks. And support their value that way, and also protect U.S. banks. Like the original TARP plan, which was to buy up toxic assets to keep the balance sheets of banks solvent. It would not be comparable in size or directness. It would be one way of aiding a bailout, but I'm not sure it can be enough to matter. And then there's the very real issue of if those countries are going under, the Fed is holding the bag. The buying they did in this country worked out fairly well. Well, so far. But it's less clear that loading up on Italian periphery debt is going to work out as well, or be as popular if it doesn't go well, because citizens are aligned between helping out Americans and helping out foreigners, rightly or not. Who would pay a price for that if it didn't work out well? Right now, one of the things that bothers me when the Fed guaranteed the assets of Bear Stearns, $29 billion, later $32 billion, to get JP Morgan Chase to buy up the obligations of Bear Stearns and "own" them, it was said at the time: We might even make money on these. They are at a depressed value now, because the markets are illiquid and it's a thin market and people are scared, but we don't know what these are really worth. They might even be worth 100 cents on the dollar. That turned out to be probably not true; they weren't worth 100 cents on the dollar. Do you think it's strange that we don't know what those are worth? We don't know, the Fed has bought about I think $2 trillion of Fannie and Freddie obligations. How am I doing on that as a taxpayer/investor? I have no idea. You can't look that up anywhere. There's no transparency; it's kind of a secret. If it's not a secret it's close to one. So, let's say they do what you just said--they buy up all this paper from Europe; everybody breathes a sigh of relief; there's a lot of bloggers and pundits who say this was really risky and we're going to lose a lot of money. Who is going to pay a price for that? Where would the political costs of that be? It seems like there would be a lot of political pressure to do that. I think on this issue we disagree. The ECB has been much slower to buy things than was our Fed. Our Fed can act more or less immediately. You need to make a few phone calls, get a few people in a room; but things would run very quickly. You sit down one Sunday, everyone's panicked, and things happened. The ECB cannot really work that way. But I'm saying, the Fed, if they do that, wouldn't that turn out well politically for the Fed because the price, I don't know how it would get paid or who would get upset if it didn't turn out well. Isn't there going to be essentially pressure for the American Central Bank to do something like that? What's the downside, politically? Well, the downside is if those securities really do not pay off, the Fed to some extent needs to be recapitalized with taxpayer money. That's the potential downside. And who would care, besides the taxpayer? So, Ben Bernanke would lose face. Would the President of the United States at that time, whoever and whenever it is--I don't even know when it is. I'm just thinking about the political forces. It would be very unpopular. But it may be better than risking a second European Great Depression, which would also be bad for the U.S. taxpayer in a number of indirect ways. But I doubt if our Fed right now has the political capital to do enough to make a difference. I think you are probably right.

38:44 Let's turn to an optimistic scenario. Can you imagine a scenario that isn't as bad as the outcome you think is most likely, and what might that scenario be? It's hard to think of it, but I bet you can. Here's the most optimistic scenario. Again, Greece--write that off. They are basically in default, even though they are not in a legal sense. The optimistic scenario is Germany gets its 'druthers together and sits down with a few other countries and says we are going to reform the ECB. Probably in the meantime the ECB has to act illegally and the ECB will guarantee a lot of markets and it will be credible and there will be an absolutely strong pledge; and it will be believed; and you will have countries like Italy, Spain, still with a lot of growth problems, a lot of capital market problems; but the bleeding will be stopped. There won't be any big implosion or explosion. And then you could deal in the longer term with the structural problems and grow your way out of it. I don't believe in that scenario, but it's logically possible. There's some chance it can happen. I don't think the Germans are willing to try it, and also if they tried it, it would work, but it could possibly work. And if they tried it, though, the people of Germany paying a price--it's very hard for them to extract anything in return. They would have to get some sort of ECB governance change, European Union governance. Because what we are really talking about here is a loan that can't be paid back. Essentially it's saying: We're going to give you something now in hopes that you'll get healthy; and you'll do something for us later. And right now the only thing they can do for them later is to say: We won't get sick. That's not so good. There was a recent poll on Eurobonds. This is not exactly a Eurobond but it involves a similar kind of commitment. And the German citizens were against that something like 4 to 1. There's also an issue whether this way of committing resources is Constitutional. It may be illegal for the ECB; it may be unconstitutional for Germany. You have 17 nations, each one of which has some degree of veto power. We saw this with Slovakia and the European Fund. It's like 17 different branches of government, each one has typically a coalition ruling and its own branches of government. And they have to in sufficient numbers, sufficiently rapidly, agree to something decisive. It's not like Ben Bernanke and Tim Geithner and Barney Frank getting together on a phone call downtown here. I just don't think it could happen. And if you tried to get it to happen, you could get the worst case scenario, which is that you start doing it; you get some of its bad effects in terms of moral hazard, cutting off reforms, inflation; but you can't see it through and you postpone an even bigger explosion when at some point the German taxpayer stands up and says: Enough is enough; we're not going to do this any more. And the support for the policy vanishes. And that, of course, is why Germany is reluctant. With all these obstacles they just have to doubt whether they can see it through, even if they were willing to pay the price. Which is why you don't put that as your most likely scenario. But it is possible.

42:01 Germany recently tried to borrow some money in the open market and it required a higher interest rate than the previous entry by Germany. It was a small increase; it went from something like 2.63% to 2.81%. You view that as quite significant. You were joined this morning in a Bloomberg column by Simon Johnson, co-author who argued that this is the end of the Euro. Period. It's over. What information did that "failed auction" as some have described it--what's your analysis of what that tells us and what are its implications? Of course, it's still a low rate. I wish I could borrow at that rate. So, I wouldn't quite call it a failed auction. Here's how I took that number. The market is not saying: We are afraid about Germany. The market is saying: We're afraid the whole deal collapses, and when the whole deal collapses, if you've bought Euro-denominated bonds, even if backed by Germany, there's something messy; there's a re-denomination issue, there may be legal judgments, there may be tie-ups, there may be a period of interim uncertainty. And it's not that you are doubting the Germans will pay you back. But I think some parties are just saying: For the time being we want to stay away from the whole mess, because we've actually begun to doubt that it's going to be around in its current form. That's how I read that. And some of that is just pure inflation risk. It could be inflation risk; it could be Germans' underwriting someone else's credit risk. But I think more likely than not it's simply the risk that there will be a lot of chaos in a way which is hard to quantify, hard to plan for. Like Knightian uncertainty [Frank Knight], in Austrian economics lingo. I don't need to buy more German bonds today; I trust Germany, but I'm going to buy something else today. And that's not unreasonable. Or, if I'm going to get a low return, I'd rather get a low return holding a U.S.-dollar-denominated allegedly safe asset rather than this one. But once that kind of thinking kicks in, even if there is no mistrust of an actual repayment from Germany, if you are Merkel leading Germany, you have to take that into account. You can't just play games with your country's credit rating and bond auctions. And I think it's a sign to the Germans, also to the Netherlands, saying: Look, are you really up for this? And what must they be thinking? Nothing they can say in public, but I think to us it's obvious. So, part of the unsustainability of this situation, which you argued and others have argued again on day 1, which was a currency union that was not coordinated with fiscal policy and a unified electorate. So, you didn't create a Europe. Right. A Euro of the currency of something called Europe, had a governing body, a European Parliament, European spending activity, European tax revenue. Instead we have these 17 different nations. The public choice aspect of this, the political economy, is pretty stark. There's an enormous tragedy of the commons/free rider problem here. The Prime Minister of one of these relatively healthy countries--Germany, Netherlands, Finland--you certainly don't want to impose costs on your own citizens to bail out people who have been irresponsible. The famous example--I think it's true--Greeks retire at 52, which is much lower than the German retirement age; the idea that you are subsidizing the pensions of early retirement Greek citizens is not a political winning strategy. And tell this to the poor Slovakians, whose standard of living is well below that of Greece. So, there's no political incentive to do that. And yet, the bus you are all on is going over a cliff. You don't have your own parachute. You may end up less damaged, with fewer limbs lost than the other folks, but as a politician, that's not much consolation. You are going to get thrown out of office. It's a rock and a hard place. What might those conversations, if we could listen in, between Merkel and her colleagues in the stronger nations--what are they saying to each other that could possibly be productive? I think they are going through every possible scenario. But one thing you see with all of these developments is the way things used to be done in the EU is Germany and France would get together, have a two-nation phone call, possibly with some preparation with some other countries, and then present it to the others, not quite as a fait accompli, but: We're in charge here. In this matter, it seems you have Germany and France on opposite sides. French banks are extremely vulnerable and France is in danger of losing its triple A rating. It probably will lose it. Germany is seen as someone who can pick up the bag for France. So it's not that France and Germany can get together and plot out the answer in advance and shove it down the throats of the other countries. They are on opposite sides, and the customs and conventions for resolving the disputes when Germany and France are not working together are just not there.

47:39 So, in another time, and maybe this time, these kind of stories wouldn't just lead to a really bad year for an economy. They'd lead to revolution and a war. We assume that France and Germany, because they've been at peace now for 65 years, that that's what we're used to. They don't have a great history before that. A series of brutal, horrifying wars. You want to get dark on me and tell me a worse scenario than the likely one that could end that way? On that question, I'm not at all a pessimist. I think in France and Germany, certainly all of the smaller countries, there's a real belief in the European project; and if this in some way collapses, which I think it will, within 5 years' time I think there will an attempt to pick up the pieces and do it better. They still then may not get it right. The only country where I see a chance of a politically nasty outcome is Greece. And that wouldn't matter very much for Europe as a whole. And the other countries--I don't want to call myself an optimist, but I think in the medium term they'll be okay. They used to have their own currencies; there's a very bumpy road to get back there. Once they are back there, they've lived with that world; it will be fine. They'll need a little bit of time to get over the split, but I think a lot of European integration will continue. It makes too much sense. I'm more worried about the transition period. We don't know how ugly it will be, if that's indeed the way it plays out. I look at the United States which has now a fairly long history of Constitutional governance; and yet when I look at the inability to find common ground in the current political map at least for the impending train wreck of Social Security and Medicare, it's a bit demoralizing. I don't see the mechanisms for compromise and muddling through that have worked in the past. We see, in the United States and in these countries as well, European countries, a set of promises made by the governing class that are not sustainable. The normal way you deal with that is you change your promise. That's the way nations deal with that. I don't see the political will, the structure, to deal with that in a way that isn't going to lead to the kind of situation we saw in Greece with the riots. We see it in France every once in a while over labor issues. In the United States we've seen Tea Parties and Occupy Wall Street folks on the opposite ends of the political spectrum showing a lot of displeasure with the way things are going. There's a little bit--it's a real test for democracy, democratic government in general. It's not clear that they're going to make it. Again, I'm much more optimistic. The two key countries are France and Germany. For a long time both have had a real rule by consensus. Not always on good policies, I would add. That governments in those countries are trusted; maybe in some ways trusted too much. Also in Germany there is a sense of sacrifice having been necessary to reunify the country to recover after the war. So, if there are outcomes where France and Germany need to take hits and have lower standards of living, I'm really pretty confident they will manage that. Of course, it will be painful. But I think European government is extremely stable. No non-democratic force has a credible way to solve the problem. Come along and say: After fascism we won't cut your benefits. It's just not there. And if France and Germany are on board, it's not as if the Netherlands will launch a war against Austria. So, I think Europe will remain liberal Europe--at least the Western part. The counterpart is fascism wouldn't be that or whatever the alternative would be wouldn't be that rational. They'd appeal to nationalism as it has in the past. I would worry most about Hungary on this account, because they are in a very bad financial crisis themselves. They would be caught in the fallout. They are not in the Eurozone. They would be like their own podcast, I suppose. But can I imagine a country like Hungary or other countries in the East going fascist--I absolutely can. I'm not predicting it, but I think that's entirely imaginable.