Stephen C. Freidheim Symposium on Global Economics: Europe's Debt, America's Deficit: The Crisis of the Rich World

GILLIAN TETT: Well, good morning, everybody, and welcome to the second session of this fascinating debate.

Those of you who were in the first session will have heard Alan Greenspan say that he thought the major problem in the United States is Europe. Well, I think there are plenty of people in the U.S. today who might beg to differ a bit because America is not without its significant problems as well. Never mind that the economy remains at best stagnant or troubled, there's also the problem of rising budget deficits, rising debt levels and, of course, a political system which appears to be pretty dysfunctional right now in terms of dealing it -- with this. Not quite at Italian level, the dysfunctionality, but not far off, necessarily, at times.

And I can't think of a better person to discuss this than Jacob Lew, who is coming up for an anniversary. Next week he will have been director of the Office of Management and Budget for exactly one year. I don't know whether to congratulate you or commiserate -- you -- (laughter) -- perhaps congratulate you for surviving this far.

And those of you who have got his bio in your pack will see that there is scarcely anybody better placed to hold this position. In fact, much of his life, thus far, his career, has been a dress rehearsal for this position. You have already served in this position before, but you've been around in Washington since the late 1970s and as far back as 1983 were involved in bipartisan discussions to try and tackle the problem of Social Security. I'd like to ask you if you feel a certain degree of "Groundhog Day" about your job right now.

JACOB LEW: Almost every day. (Chuckles.)

(Laughter.)

TETT: (Chuckles.) Well, the good news is, you have plenty of training for this role. The bad news is that the problems look more insurmountable than ever before.

So I'd like to start by asking you: We are all awaiting the verdict of the supercommittee, which is due to report, I think, on November the 21st. How optimistic are you that the supercommittee will actually make any breakthrough in terms of tackling the mounting fiscal problems?

LEW: I have lived by the principle that if you become a pessimist, it's a self-fulfilling prophecy. So I am self-avowedly more optimistic than the norm. I think one of the diseases in Washington is that everyone is afraid that they're going to appear naive, so they predict failure.

There's reason to be cautious now. The substantive challenges the supercommittee has very substantial. The political issues that they're grappling with are very substantial. But I still think that the right bearing is that they have a couple of weeks, they have an important job to do, they need to be given the space to do it. I think you're seeing on a daily basis that conversations are continuing on very difficult subjects.

I wouldn't say we've seen the kinds of breakthroughs that would make me say it's 80-20 going to be a huge success. But I think it's substantially premature to write it off as having failed. I think if you look at complicated and controversial undertakings like that which is the mission of the supercommittee, it almost never looks like it's going to come together until the very end.

We're now in a critical period. I think if you look at the importance of what they're doing, the need to act is, I think, clear, and I think the need to act sooner rather than later is clear. The same action taken today versus a year from today would be much more powerful in terms of restoring confidence both in the United States and in the international economy.

So you know, the president spent much of the summer deeply engaged in negotiations; in the course of those negotiations showed that he was willing to go quite a substantial distance to reach a balanced, fair compromise, to do something quite big.

That obviously failed. I would contend it failed because there was an obstacle on the other side in terms of dealing with taxes as part of a balanced package.

I think that the supercommittee is now grappling with that same set of issues. I hope that all the parties are willing to move on these kind of core issues. I think we've seen some movement, some hints of movement. We will in the coming days whether they can -- they can close.

You know, the president submitted to the supercommittee in September his own unilateral plan of how we could reduce the deficit, the debt by $4 trillion. There were items in there that have been little noticed but in any other period that I've been in Washington would have been seen as acts of supreme courage to go out on your own and propose them.

So between the negotiations and the plan that the president submitted in September, we've tried to give as clear a signal as to where we think the lines are for a reasonable, balanced package. And we remain engaged in conversation, though this is really their job and they need the space to do it. And sometimes in Washington that means going into rooms and having private conversations, which is what they're doing.

TETT: So what for you would constitute a success on November the 21st? A clear-cut plan to get 4 trillion (dollars), 1 1/2 trillion (dollars)? You know, what for you are the benchmarks of success?

LEW: Look, the president made clear in the document that he submitted to the supercommittee that there's a path to $4 trillion that is achievable. There's no doubt that would be a powerful signal to the markets, to the economy, to the Americans who are looking to see: Can their government function?

I think realistically they have a mandate to do $1.2 trillion of deficit reduction in order to avoid having draconian cuts come in a year from January that would cut an enormous amount out of defense and domestic spending.

So I think that the (band ?) for the supercommittee is, can it take that minimum action to avoid what I think all parties agree is an undesirable set of policies? It was designed to be an undesirable set of policies, because it was meant to be a lever to focus Congress on acting, and replace it with a sensible, balanced package. A first step would be better than no step at all. You know, a big step would be better than a small step.

TETT: So 1.2 (trillion dollars) avoids the fail and 4 trillion (dollars) gets you a straight A?

LEW: I think 4 trillion (dollars) would be seen by almost everyone as a very substantial accomplishment. I would not hold out a high degree of optimism at the high end. I think that the question now is, is there something in the not-failing category that could both be accomplished and restore confidence.

I think if you look at the political debate in Washington, really this whole year, it has not been a good thing for the country and for confidence in our institutions to be hours away from a government shutdown in April, and really not necessarily, because the agreement that was reached should have been reachable without that kind of, you know, drama and brinksmanship.

July and August was very damaging -- the notion that there were a significant number of members of Congress who actually were arguing that the default of the United States was an acceptable policy option. Now, that obviously wasn't a view shared by the president; it wasn't shared by the responsible leaders, but we got right down to the wire. I think the fact that Congress is now beginning to try and find a way, you know, one way or another, to do its business in a more business-like way, both in terms of funding the government for the next year and in terms of dealing with the supercommittee's challenge, the small accomplishments would be a big reversal from what we saw earlier in the year. And I think that would, in addition to the economic impact, be quite important.

TETT: Right.

Well, I'm going to get granular in a minute and ask you a bit about defense and entitlements and taxes. Before I do that, though, I'd like to ask: The president is currently en route to Honolulu, I believe, which sounds to me like a vastly nicer place to be than in Washington and spending time hanging around the supercommittee. But at what point does the president actually get engaged in the supercommittee? I mean, is he going to stay on the sidelines (right the way ?) through? Do you think he'll come in and try and break any deadlock?

LEW: I think the president's engagement in the fiscal policy debate this year has been anything but on the sidelines. He spent months in March and April, in June, July, August, not engaged on a periodic basis but an almost full-time basis. The end result is, there is total clarity of his views on these subjects, an unprecedented amount of clarity.

Usually, you start a negotiation not knowing where the other party was willing to go. There is now a blueprint of what we would do on our own, where we would have gone in a true big bipartisan deal. And there is a political challenge for members of Congress to come together and do their work. So I think that being in the room and being on the sidelines are not the issue.

We have -- we have, I think, done the right thing by putting a comprehensive plan in front of the committee. I frequently refer members to that plan. I think it's actually been helpful to them as they've gone through the issues. They have some fundamental political challenges that they're working through. Subsequently, the administration has laid out a very detailed set of ideas.

And in terms of the president's kind of physical whereabouts, I think, you know, it's safe to say that the president is never out of reach. He can reach us whenever he needs to, and we can reach him whenever we need to. The president has a lot of responsibilities. You know, organizing a session like the one he was going to, where we get together with our trading partners and try to develop a future vision of Pacific trading that will grow the American economy -- that's also part of the president's job. And the president is doing his job, and it's really time for Congress to do its job.

TETT: Right.

And one other question on the president and the political climate. I remember talking to Secretary Geithner earlier this year when he was meeting with European investors and then the Asian investors, who were completely befuddled by what was going on and shocked by these threats of a government shutdown and default.

And the argument that was emanating from parts of Washington back then was: Don't worry. This may look completely bizarre to the rest of the world, but this is normal American politics. And this has been going on for decades. It's a game of brinkmanship. This is just how policy is made.

Given that you have been around Washington since the late 1970s, do you agree with that verdict in terms of what's going on now? Or do you think something has changed fundamentally in the political climate and the machine, which is making it actually harder than you've seen in your own career to get an agreement?

LEW: I would actually go to both ends of that, both what is happening in Washington and what is the context in which Washington's actions are playing out. And let me start with the second because I actually think it is the bigger factor.

You know, in a -- at a time when the economy is smooth and there's not a world that's on the edge of chaos in a number of important places, Washington brinksmanship is very deep inside the newspaper, and it may not be highly consequential. At a time when there is a recovery from the deepest economic downturn since the Great Depression, when there are very substantial challenges in Europe that all of us in this room and all of us in Washington follow on a day-to-day basis, there is an extra urgency for Washington to show that we can take the things that we control and that we can do it in a way that meets a standard of performance that the public expects. That's what the president was calling on Congress to do.

I think Congress did, in a way, handle it the way Congress normally handles things, which is you wait till the last minute. You don't make a concession that could be difficult until it was clear you had no choice. And you know, I, for one, was quite outspoken in cautioning members that this was not a time when that was a good way to proceed, that if -- accomplishing an agreement on the debt limit when we did had less value than accomplishing that same agreement a month before without the drama. Now, I think it is fair to say that that -- you know, debt limit votes have had that kind of last-minute quality before. I think it's more consequential now.

I do think inside, the system has become more polarized. There is, I think, the ability for a relatively small number of members with rather extreme views to kind of force issues into sharp focus and contrast that makes it harder to move to where the reasonable compromise is. Were there a willingness today to do things in a truly bipartisan way, as there were at moments in the '80s and the '90s, I think there's a broad consensus about some sensible things to do. But that requires leaders being willing to take action with part, but not all, of their caucus. I don't think we see that as much today as we have at some other points.

And ironically, in the end of the day, you look at how the votes have finally broken the logjam -- they've had that familiar pattern. You know, there have been, you know, 50 or 70, you know, extreme votes that wouldn't go along with a reasonable compromise. But it was just very difficult to get to the point of that being accepted as the reality. If you went in knowing that and said, what can we do that could get a majority on both sides, I think it would expand the scope of debate, and it would be a much more civil discourse because people would get out of their corners.

TETT: But in practice, almost the only time you've seen bipartisan agreement or action in the last years was in the autumn of 2008, when the markets were crashing so dramatically that it actually prodded Congress into passing the TARP. Do you think it's going to take a market crash, a real swing in Treasury prices to actually get that kind of gridlock broken in Washington? Because right now, of course, America is being giving -- given pretty much a free pass because everyone is watching Greece and Italy.

LEW: I think that if you look at the actions that Congress has taken this year, there were some moments of bipartisanship. The trade agreements -- they were very important economic policy, and they were passed on a bipartisan basis -- on, you know, some smaller issues, but not insignificant, like patent reform, things that are very significant to our long-term economic growth.

On these high-profile fiscal policy issues, in the end of the day, the votes were actually bipartisan. The funding bill that passed in April was passed in the House with Democratic votes. It couldn't have passed with only Republican votes. The debt limit increase ended up passing with bipartisan votes. What you did not have was a process of accepting the fact that we have to do this in a bipartisan way and negotiate so that's a victory, as opposed to the consequence of getting to the end. In the 1980s, in 1983, Social Security reform reflected that kind of coming together. Tax reform reflected that kind of coming together. In the 1990s the balanced budget agreement reflected that kind of coming together. I think it would be a good thing for the country.

That's what the president was engaged in in June, July and August. It was politically risky for him. He was engaged in negotiations where he was putting things that were considered sacred cows to most Democrats on the table. And his view then was that to do something big and to have the ability to stabilize confidence and the direction of the U.S. economy was worth taking that kind of political risk.

I think, quite unfortunately, the issue of taxes polarized the debate at the end. And, you know, I hope that that changes now. I hope the supercommittee, whether it's small or large, is able to get the kind of balance -- but that's going to mean, you know, both sides moving out of their corners; it can't be just one side. It won't be just by more spending cuts; it will require revenues and spending cuts.

TETT: Well, having been involved in the agreement of 1983 to look at Social Security and reform Social Security, do you think that it is possible for the supercommittee to do anything meaningful without addressing the entitlement issue? I mean, do you expect them to address the entitlement issue?

LEW: I think everything is a matter of degree. I think what would be in a small package, or the minimum package, would be different than what would be in the larger package. I don't think it's reasonable to have a view that: Let's start with savings and entitlement programs, and talk about revenues later.

If you look at the agreement on the debt limit, we essentially took one-third of the decisional areas and resolved them in the debt limit bill. We said that annual discretionary spending will be under very tight limits for the next decade. We saved a trillion dollars. I'm now putting a budget together in those limits. I can tell you, these are serious limits. It will mean choices; it will mean real restraint in spending. I think we can balance our priorities if we make the choices and live within it. But a trillion dollars in a decade has real impact.

We now have to move to the other pieces, entitlement savings -- and which are not just Social Security and Medicare. There's a broad list of things that are entitlement savings, many of which the president unilaterally put forward ideas for hundreds of billions of dollars of savings in September.

And there are revenues. I think in a package that actually addresses the $4 trillion challenge -- and just to be clear why $4 trillion, it's not a random number. It was the number that I think there was a broad consensus would bring us to, you know, primary balance in a reasonable period of time. That's not our ultimate goal. Our ultimate goal is to have a lower deficit, so we're buying down the debt; but you can't buy down the debt until you stop adding to it with new spending. And that's what the $4 trillion gets you to: It's a minimally sustainable place, so that you then can make the next set of decisions. One trillion dollars more doesn't get you there. The $4 trillion total -- which is $3 trillion more than we did over the summer -- would get you there.

The extent to which there are the difficult choices will depend on there being difficult choices on both sides of the ledger. It would be the right thing for the country for us to get the bigger package done. That's why the president spent July and August the way he did.

TETT: We were talking to some senior members on the Democrat side recently who were suggesting that they might be willing to compromise on the tax side, the revenue side, if there were significant defense cuts. Do you see that as a potential form of compromise going forward? And, you know, what would you define as significant defense cuts?

LEW: I think that the question of defense spending is a very important and complicated one. The agreement over the summer calls for very substantial reductions in defense spending -- almost $500 billion over the next decade. We're now engaged in a -- in a substantial strategic review with the Pentagon, with the secretary, the Joint Chiefs. And I believe we can come out of the review with $500 billion of savings and a defense posture that not only meets our national needs, but in some ways leaves us leaner and stronger.

I don't think there's an infinite amount we can reduce defense spending and still be able to make that statement. Defense reductions, like every other area, have to be driven by a strategy: What are our strategic requirements? The Defense Department even itself admits that the last decade, decade and a half, have basically been unconstrained. In an unconstrained environment, every institution behaves the same way: They forget the difference between the "need to have" and "nice to have."

This $500 billion of savings is forcing those kinds of decisions through, I think, a very clear, strategic lens. And it's actually one of the best strategic discussions I've been part of in my years in Washington, where everyone -- uniform, civilian, White House and military -- are coming at it with the same question: Where does the United States need to be in the world, and what can we do to put it there, while we're saving money?

The proposals to do almost double the savings --

TETT: A trillion dollars.

LEW: -- a trillion dollars -- I do not have a strategic frame to get there, you know, so I can't sit here today and say that you could achieve that level of savings consistent with meeting the strategic requirements.

That's not to say that we can't perform better than the 500 billion (dollars) in the summer. Certainly it would make my life a lot easier if the result of the strategic review showed that we had some more headroom. But I think it's dangerous to pocket what was accomplished and assume we're starting from where we were a year ago.

This is a serious exercise in cost reduction. You know, when the Bowles-Simpson commission came out, it had a substantially higher defense number. It was one of the things that we were concerned about. Not that we didn't want it to be true. You know, if we could save a trillion dollars instead of $500 billion, it would be a good thing. But we can't make the decision that we're going to save a trillion dollars and then find out that it leaves our national security exposed. We have to move the strategic review with it.

The secretary of defense and the president and I have all said the sequester, if it were to hit, the enforcement mechanism if the supercommittee fails, would be very damaging to our national security. That's an additional $55 billion a year for 10 years of cuts. So it can basically get you to just over the trillion-dollar mark. That's not the same as saying on the margins there's -- you fall off a cliff if you go from 500 billion (dollars) to 510 billion (dollars). And we're in a process now where it has to be policy driven.

TETT: And if you were a betting man or in the markets right now, what probability would you attach to the chance that the supercommittee will end up suggesting some tax increases?

LEW: I think that in order for the supercommittee to succeed, it will have to address taxes in some way. So I think it's really the same question as asking what do you think are the probabilities that the supercommittee would succeed. And I still think that there's a better than even chance that they can get something done.

TETT: OK. And then as offset, what proportion -- what probability will you attach to the idea the supercommittee will end up including tax increases for the wealthy?

LEW: Well, you know, tax increases for the wealthy are obviously a central part of the broad tax debate. You know, whether or not to extend the tax cuts in the top two brackets, we've taken the clear position they shouldn't be extended. It's a matter of some significance to the other party that they be made permanent.

I think that in the debate over tax reform, there is the useful reality that if you do tax reform, the current rate structure becomes less relevant, and the test is, is the system at the end of tax reform more progressive or less progressive than the current system? I think any tax reform coming out will have to be, you know, more progressive, not less progressive, than the current system, and in all likelihood it will be, if and when it happened, the rate structures that make this question of the old rates much less relevant perhaps irrelevant. If you'd lower the top rate, then -- and broaden the base by closing loopholes, then you've kind of addressed that issue.

So I think the question of progressivity is central. I think if you look at income distribution in this country, there's no secret that we have a kind of disparity of income distribution that is a serious concern.

The administration has taken the very strong positions that there has to be fair balance in what we do. If you look at entitlement savings, the numbers don't sound dramatic to a person, but a hundred dollars, $500, a thousand dollars, if you're living on $20,000 or $30,000 a year, that is a big sacrifice if you're seeing a few hundred dollars or a thousand dollars of lost income or benefits. You can't call for that and say we're going to allow people who have the highest incomes and have been the most successful to pay (low/lower ?) effective rates than people at much lower income levels.

The right way to do it is through tax reform, through base broadening. And, you know, I think the sooner we get on to that debate the better. I think that's where a lot of the conversation in the summer and in the supercommittee, as well, has been. That's obviously a very challenging undertaking, because it is a -- it's both complicated, and every decision you make changes the incentives in one or another part of our economy.

TETT: Well, I'm going to open up to questions in just a minute, but one other quick question from me. Are you worried that unless the supercommittee does come up with something sensible, between 1.2 (trillion dollars) and 4 trillion (dollars), then we will have the Italy/Greece situation play out in the U.S., namely a loss of market confidence in the government and a potential roller coaster ride in the markets?

LEW: I think it's very important to look at the fundamentals and to avoid treating all of the issues going on in the world as if they're the same.

This summer when the rating agencies took a look at the political debate in Washington, they fundamentally reached a political decision, a conclusion that there was political gridlock, that action would not be taken in a timely way; therefore, we're going to downgrade.

They didn't make an economic judgment. They didn't say that the United States was out of control and that action couldn't be taken.

I think that that actually is a significant difference that sometimes is lost. You look at some of these other international challenges, and the underlying fundamental economics are much more challenging.

I think that if you look at the market reaction in the summer, it was actually also striking that when the rating agencies' downgrade came along, consumer confidence or the market confidence went the other way and the price of, you know, U.S. debt went down, not up.

Now I don't think we should sit back and say there's not a problem. I think that the display of political gridlock in Washington in July was one of the most corrosive things that I've seen in terms of American public debate in my career. At a moment when the public desperately wanted to see Washington able to just get its work done, it showed that inability. That was why the president went farther than most in his own party wanted him to go. But it takes, obviously, two to put that kind of approach together.

I think that -- I think that the members of that committee and the leadership of Congress understand that their success in meeting a measure of expectations that they can do their work is actually quite important.

That's why I'm kind of a little outside of the normal market assessment of the probability of success. I do not believe that a week from now, when those 12 members and the leaders get together, failure's going to be something that they want, because they're going to say we need to show we can do something.

Now they now may not succeed. One of the important things about the way this mechanism was set up that I think's quite important to keep in mind is that if they fail to meet the deadline in November or in December, in the full bodies, nothing actually happens until January 2013. So the enforcement mechanism, which is draconian across-the-board cuts in defense and nondefense, are set up to take effect in January 2013.

Well, in January 2013 it's also the time when the tax cuts that were extended last December expire. So it's kind of a perform storm that brews next fall into January, and I think it's hugely preferable for Congress to get its work done this year. But I think it's a mistake to think that if Congress were to fail this year, that therefore the -- you know, the seams split open and everything comes apart. I think what you see then is a national political debate, an election and action afterwards.

So I think there will -- I'm highly confident there will be action. I think it's highly preferable the action come now, but I think it would be a mistake -- and that has to do with public confidence and market confidence -- if it's understood that there will be action, that -- that that should be a factor that's taken into consideration.

TETT: Or to put it another way, we may get a bit of a break between the perfect storm in Europe and the perfect storm in the U.S. that way.

But I'd like to open up to questions now, please. I'd like to remind everyone that this session is on the record. I know there are many members who'd like to ask questions, so please keep your questions short and concise and to the point.

We have a microphone and we're -- aside from people in the room that are participating, do remember that there many members also participating by teleconference.

And lastly, it would be courteous but not compulsory to state your name and affiliation.

So, question over there and then one, two, three.

QUESTIONER: Thank you. Jamie Metzl with the Asia Society. As you know, President Obama called for the doubling of U.S. exports. And my question is, to what extent do you believe that China's policies on currency and intellectual property are impeding progress towards reaching that goal?

LEW: Yeah, I think we're actually making good progress towards reaching the goal. We've obviously made clear that we have concerns that there be both a fair balance of monetary policies and a fair treatment of intellectual property rights. We've made some progress on the intellectual property rights in discussions this year. It's an issue that I think is going to be ongoing. It's not something that we're going to be able to check the box and say it's resolved.

I think if you look at the balances of trade, the -- we are selling, actually, a good deal of services in China, raw materials in China. And I think that it is very important that globally, we stay focused on the -- on achieving the goal. And it's something that we are very much focused on as we put our resources to work in terms of trade promotion activities and the things that we can directly control that ease the trading relationships.

TETT: We have a question, I think. OK, there.

QUESTIONER: Good morning. My name is Andrew Gundlach, Arnhold and S. Bleichroeder. Obama might have done some courageous things on the fiscal front, as you say, but one thing that he did not do is get behind Simpson-Bowles at all. Many within his administration and many Washington insiders consider that his most important political mistake, even more important than pushing health care. Some even claim that he didn't even read the report. Those same people also believe that Simpson-Bowles will be enacted either -- and the only question is 2012 or 2013. Your thoughts?

LEW: Well, there are a lot of people who think a lot of things that don't have a lot of connection to what happened. So I'm going to address what happened.

You know, the Simpson-Bowles commission did an enormously important job, which we said at the time and we have said consistently since. In my conversations with both Alan Simpson and Erskine Bowles, I've said it to them. I've heard the president say it to them. I've been there with him. We embraced an awful lot of the approach of the Bowles-Simpson commission. If you look at the debate over the summer, the debate over the summer was highly informed by the Bowles-Simpson commission.

There are aspects to the Bowles-Simpson report that are challenging. Go back to the defense discussion that we just had. It calls for defense savings that are roughly twice what we know how to achieve. The president is commander in chief. The president is responsible for making national security decisions and not just fiscal policy decisions. And as his budget director, I'm responsible for balancing how would you do it, not what is the number.

I think that the balance between saying enormous progress was made putting a bipartisan consensus together, let's work with that to get something done, and signing on the dotted line are very different. So I think that there have been many who've tried to make it seem as if we did not embrace things that we did embrace. I can't sit here today and say I know how to achieve a trillion dollars of savings in defense without undermining our national security. So that's a challenge if the president is asked to sign onto a plan.

On the revenue side, you know, it was a hugely important accomplishment to get bipartisan conversation and agreement on the notion that base broadening would be a way to raise revenues that might be a place where the parties could come together. It has shaped the conversations that have gone on since. You know, I think the total number that was in there is one that probably would be more pleasing to me and to the president than to many Republicans in Congress. If that became the thing we demanded in order for there to be a deal, I think it probably would not achieve the kind of broad, bipartisan support that it would need.

I think if you kind of leave the position of kind of who said what to whom, which is the way, in Washington, things are often covered, the substance of Bowles-Simpson is very much behind what's been going on ever since, which is why it was such an important thing to do and a report that will have enduring value. The test of the value of a commission is not did it get picked up and voted on, but did it change the debate in the way that's going to change action going forward. And I believe it did, and it -- and it will.

TETT: Thank you. Any more questions? One and then two.

QUESTIONER: I'm R.P. Eddy from Ergo. Thank you very much for your time. A lot of cynics believe that at the end of this supercommittee, 14 months from now, if they haven't achieved a consensus, the draconian cuts won't actually occur because Congress will step in and sort of change the rules. Do you think that this is likely, or can you share any thoughts on that?

LEW: I think it is -- it is a challenge when there is subsequent action that could be changed by legislation to speak with certainty that nothing will happen to change events. So I understand that there is legitimate skepticism that hard things will happen if there's the opportunity to turn them off.

I would challenge that, though, in this case. I think if you look at the history of enforcement mechanisms like this, the threat of very unattractive policies is sometimes a very effective way of kind of concentrating political institutions to make hard decisions. In 1990, the Budget Enforcement Act came out of such a moment. There were, at the time, across-the-board cuts that were going to take effect if Congress failed. It was not, at the time, considered politically acceptable to just turn it off. I don't think it would be considered politically acceptable to just turn it off now, either.

I don't believe that it will be necessary for those across-the-board cuts to happen. That's a different question. If the reason they don't happen is because the fiscal discipline was turned off, that would be a very bad thing. If the reason it doesn't happen is because Congress comes together and reaches an alternative approach to accomplish the fiscal goal, that will mean that the mechanism actually accomplished its purpose. The purpose of the trigger was not to put across-the-board cuts in a way that would cause deep damage to our defense and domestic priorities. The reason for that mechanism was to say, it will be unthinkable to do nothing. Congress will have to make decisions. They will be hard choices. But when the choice is the hard choice of deep defense cuts and deep domestic cuts on the one hand and balanced mixes of spending and revenue proposals on the other, Congress will choose the balanced approach, which is what happened in 1990.

TETT: Let's hope that (work plays ?) out again.

Question there.

QUESTIONER: (Name inaudible.) Could you share with us the rough dollar amount or percentage of the domestic discretionary budget that is represented by pass-throughs to state and local governments? And would you agree with the often-expressed proposition that that's probably the part of the federal budget that's most vulnerable to the cuts that are inexorable in -- over the next few years?

LEW: I don't have the percentage off the top of my head, but you know, it is -- it is a (not insignificant ?) number. You know, between transportation and law enforcement and community development block grants, there are -- health care, the Medicaid program -- the dollars are quite large. I think they don't fall into the same categories easily, because you look at Medicaid, it is a very different kind of a system than a block grant which says you're going to get money to hire police or you're going to get money to do community development activities. It's very much tied to minimum standards of health care and state plans to accomplish that. So the biggest item is health care, and it is different in kind from the others.

In terms of their exposure in this process, you know, I think it's fair to say that everything is exposed in a process where you're not -- you're not just not keeping pace with inflation, but you're seeing nominal reductions in resources that are available. The grant programs, you know, are important in terms of the goals that they accomplish, but they compete against core federal functions in some cases.

And you know, we're going to have to strike the right balance. As I look at the budget for 2013, one of the things that I'm very sensitive to is that state and local budgets are going through a lot of stress right now. We're seeing reductions in local employment that are actually creating headwinds that are making it very difficult to bring down the unemployment rate. We look monthly at the unemployment numbers, the private sector is starting to produce jobs at a decent rate -- not high enough, but it's showing recovery patterns. And you have reductions in employment at the state and local level bringing that down so that instead of seeing unemployment drop, you see it hold constant for now a couple of months running.

I think we have to be very sensitive to that as we look at how we make these decisions. While it can't be that state and local issues are completely off the table, we have to, I think, be very mindful of the fact that a reduction today in state and local funding is more likely to lead to reduction in employment and service reductions, neither of which in the current climate are particularly desirable.

So it is -- the reality of a trillion dollars of savings against what would have been your baseline otherwise over 10 years means we're going through a decade of belt-tightening. It will feel like belt-tightening. How we make the allocation decisions is going to reflect kind of core values and what is dispensable and what is not. We're certainly not approaching it from the point of view that there's some big cushion of reserve out there that the states can absorb anything that -- or the local governments can absorb anything that comes with no impact. But I can't in any area of the budget say that it will beyond scrutiny.

TETT: Well, as you know, we have a number of members who are outside New York participating via password-protected teleconference, and one of those is Carlos de la Cruz in Florida, who is chairman of CCI Companies, who's asked a question which leads on very nicely from that, which is: Are you familiar with the sensitivity of the size of the projected annual deficit for 2012 and 2013 to different projections for variations in nominal GDP, unemployment, interest rates and inflation -- to which one might add, and the prospect of the eurozone collapse?

LEW: Budget projections are always made in the context of economic forecasts that, unfortunately, have to be made, you know, many months before a budget actually comes out. In normal times, making assumptions in November for a budget that's printed in February is not an interminable period of time. In an environment like we're in right now, you know, the world can change in significant ways from day to day and certainly from quarter to quarter.

You know, we have tried to maintain as much flexibility as we can while still making policy judgments to respond to our updated assessment of what we see as likely GDP growth, what we see as likely external economic factors. You know, to the extent that the world changes, it is not an uncommon practice for budgets to have to adapt to it later. You always do the best you can, either try not to be unduly optimistic or unduly pessimistic.

In the 1990s I'd say our budget projections were based on economic forecasts that were wrong every time, and the world was always better than we'd projected. That was a fairly good place to be. It wasn't so hard to figure out what do you do when the situation gets better. You try to avoid being in a place where the world deteriorates and you can't deal with it. You know, in an environment that could be rather volatile in terms of some of these indicators, I look to my colleagues, you know, like Alan Krueger at the Council of Economic Advisers more than I ever did before for constant guidance.

TETT: But do you have a sort of shallow set of projections for what things would look like if, say, the eurozone does go into a deep recession, if there is real financial turmoil in America?

LEW: Normally budget projections don't assume dramatic events occurring. The way budgets are traditionally done is that you assume there is a likelihood of dramatic events at some point in the window and you kind of average it out over the period, because trying to figure out in advance when dramatic ups and downs will happen is almost impossible.

So, you know, in the broad sense of there being kind of -- limits to growth that are a function of the environment having risk, that's kind of part of the long-term macro-forecast. We don't try to pinpoint what happens if to specific circumstances.

TETT: Right. Any more questions? We have time for one or two more questions, I think. We have a very active -- (word inaudible) -- group here. Any questions over this side before I -- OK, right. One in the back, and then come forward.

QUESTIONER: Do you think the supercommittee can reach -- a budget commitment, budget agreement is coming two weeks before the Thanksgiving Day -- has been scheduled? And what's the possibility to adopt the tax increase for the rates? And what's the influence from the Occupy Wall Street movement to the negotiations in the supercommittee?

Thanks.

TETT: OK. So is the holiday period going to disrupt the talks any more than anything else? And to what degree do you see the Occupy Wall Street movement or protest impacting on the debate about taxing the top 1 percent?

LEW: I think if you look at the history of decision-making in Washington, holiday breaks are often a very helpful action-forcing event. (Laughter.)

TETT: No one wants to go back to their family and say they're going to have a rush back to the office again tomorrow.

LEW: Deadlines matter. And you know, we were talking before about some of the brinksmanship. It would have been a good thing if there had been some intervening date that drove things other than when do you run out of money to -- you know, to run the federal government or when do you lose the ability to pay the federal debt. So I actually view things like Thanksgiving and holiday breaks as helpful, not hurtful to the process.

You know, and I think that the general sense in the country that we need to do something is pretty strong. It comes from right and left. You know, and I think that, you know, there's an aspect of the public's demand for action which is to do something specific, and there's an aspect of it which is to take control and make decisions and take charge.

I think the income, you know, disparity issues are quite important. I think that it's not because of one or another protest. I think if you look at the poverty statistics that came out, if you look at the trends over the last few decades -- I've talked to friends in, you know, the financial community who worry deeply about the polarization of American society. It's not just the top and the bottom, it's at the pressure on the middle. It's in their -- that ability -- it's not a good thing if middle-class families start to say, I don't know if I can send my kids to college.

And I think we're at a point right now where we need to address the anxieties that Americans have about the current economy and the very legitimate expectation that they want to have that the world in the future will be a world of opportunity for their children. And you know, you can call it class warfare, or you can call it the American spirit. I mean, the American spirit is if you work hard and play by the rules, you ought to be able to succeed. And that's what I think it's really about.

TETT: We have probably the last question over there. Oh, sorry, actually, the lady in purple, and then the man in -- behind her.

QUESTIONER: Hi, Sangeetha Ramaswamy with Eton Park. So one of the -- obviously, one of the big surprises that happened over the summer is that the U.S. had its sovereign rating get downgraded. And there has been some discussion that if these talks, you know, don't materialize in sort of reaching some sort of a conclusion, there's that potential again. So I was curious the extent to which the administration is, you know, obviously working behind the scenes to prevent that from happening, but also sort of what measures would you potentially take if it happened, you know, potentially now twice in one year?

TETT: So are you living in fear of Moody's? (Laughter.)

LEW: You know, I think that we actually have a commonality of interests in the sense that if you look at what we've stated to be the economic imperatives, they are the same as the economic imperatives that outside financial observers have seen: identifying the size of the problem, being on a path towards dealing with it. We're going to do the same thing. If it doesn't work in November, we'll still be at it. I mean, it's not as if the issue goes away if the deadline is missed.

I don't -- I -- it's hard to speculate on what happens -- if you look at the downgrade over the summer -- and it was certainly not something that we thought was a good turn of events. You know, you don't want to see a downgrade of the United States either for political or economic risk. But as I was saying earlier, it is very significant that the language in those reports was almost entirely focused on political risk in terms of the rationale for the downgrade.

So in a world where we know there are economic solutions -- and I'm rather confident that in a meaningful time frame we will make decisions in Washington in a timely way to avoid the kinds of adverse consequences -- I think that my political judgment is that whether it happens in November of 2011 or December of 2012, we will avoid the economic conditions that would give real reason for that downgrade.

I said earlier -- and I really believe it -- I think action now is, you know, worth a lot more than action later. And it's not because of the rating agencies. You know, when I -- when I hear people who are not in government -- you know, you go into a store in your neighborhood, and the shopkeeper is worried that things are out of control and they don't think that their government can get over this kind of political dysfunction -- that's a bad thing. It's a bad thing, and it's not -- it's not something that has to show up in a rating agency report for us to see that we need to do something about it.

Right now, you know, we talk a lot about confidence. And it's important that we in government do what we can do to show that there should be more confidence. The president's trying, in a world where Congress is gridlocked, to do as much as he can with executive actions to demonstrate that we're using the levers at our disposal in an effective way. I think it'll be quite confirming if Congress acts.

I think that there will be action taken in a meaningful time frame, and I hope it's this year and that it's soon and that it's substantial.

TETT: Well, I think we can all echo that. We are out of time now, so I just want to thank you for your comments.

My own personal takeaway -- perhaps three very brief one-sentence takeaways: One is that, having heard the challenges of creating a sensible fiscal policy, it's very clear to me that if the eurozone does go into significant crisis your challenges are going to be that much worse, and that's scary -- very pertinent for the next session.

Secondly, the sheer difficulty that the U.S. government faces and that the Congress faces in coming up with a sensible policy -- even though the U.S. economy is probably slightly recovering, and even though you haven't got the markets punishing you yet, and even though you've only got one government, not 17 -- is again extremely sobering when you look at the eurozone and think: How on earth is the eurozone going to put its house in order?

And just thirdly, the thing I always am very forcefully struck by every time I hear somebody like you speak is that, these days, it's not really just about the economy, stupid; it's about the politics, stupid, and above all else, about the sociology today which, as someone who trained in the social sciences for many years, I find fascinating. I think today really is the revenge of the political scientists and anthropologists over the number crunchers. (Laughter.)

So I just wish you the very best luck in finding a way through this sociology and these fiscal challenges. Thank you very much, indeed.

LEW: Thank you. (Applause.)

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THIS IS A RUSH TRANSCRIPT.

FRANK BROSENS: Good morning. Welcome to the third and final session of the symposium, the Stephen Friedheim Council on Foreign Relations Symposium on Global Economics, this one entitled "The Future of the Eurozone."

First, just a quick reminder -- two things: One, you've probably heard a few times today, but if you can turn off your electronic devices completely -- not just to silence -- to avoid interfering with the sound system. And second, a reminder that this is on the record.

We are fortunate today to have with us two -- not three -- Jacob Kirkegaard, unfortunately, got fogged in on his way from D.C. -- very prominent economists on the European situation; Thomas Philippon, the John Vogelstein faculty fellow and associate professor of finance at NYU's Stern School of Business; and Benn Steil, a senior fellow at the Council on Foreign Relations, whose recent book, "Money, Markets and Sovereignty," was awarded the 2010 Hayek Book Prize.

We're going to have a dialogue for about half an hour, after which I'll open it to the members for questions.

I heard a great anecdote this morning on the European situation from someone who, when asked what's going to happen to Greece, says, well, it's just going to follow the Greek precedent from 137 BC -- (laughter) -- where apparently the Romans heard that the Greeks were way overleveraged, and so they sent someone to Greece to find out the details and discovered that, in fact, it was true. The gentleman came back and said it's true but not to worry, the creditors all understand the situation perfectly; most of them are willing to take big haircuts, and those that aren't, we're going to pay them in installments over 10 years.

Unfortunately, over the last couple of years since President Papandreou took office and discovered and then announced that the fiscal situation in Greece was far worse than had previously been thought, the markets have bounced back and forth from greater and greater crises to greater and greater partial solutions. And the question now resolves not on Greece -- which is an economy of about 230 billion euros -- but on Italy, an economy over five times the size.

So I guess the question that I'll ask my two panelists to start is will it hold together.

THOMAS PHILIPPON: We'll hold together. So, for Greece, I think the issue is whether it's going to stay in the eurozone or not. And that's, I would say in the medium range, mostly for the Greeks to decide.

The real question is what's going to happen to Italy. And there I think that, in the near term, there are two issues; the near term and the medium term. In the medium term, it's all about growth. So the one thing you have to realize, the growth of Italy from 2001 to 2010 is 0.2 percent a year on that rate, almost no growth. It's such a low growth, it's hard to pay back your debt.

So any credible solution for Italy must involve some growth in the medium and long term. So these are the structural reforms. And then the big issue is whether the government is going to be able to do it. That, nobody can know in advance.

The near-term issue of, you know, the next two or three years for Italy, then it's really all about politics because the economic solution is, I would argue, quite simple. I think if and when the ECB decides to move, it can solve the debt crisis for Italy quite quickly. But it is not clear that this will be a load to move either by German politics or by Italian politics.

So I think the product is that the economics is actually quite simple and the politics is very complicated. So whether it's going to hang together or not depends on whether -- (inaudible) -- can put together a government that's credible.

The one thing I also will mention is we don't know yet for sure that Berlusconi is really gone. He's not gone -- (laughter). Anyway, if you wonder, you know, why is the -- why all the variety -- (inaudible) -- are very high. Well, there's still a lot of uncertainty. The markets interact very well to the announcement that Berlusconi would step down. Well, it's not guaranteed he's gone, and so that's why -- that's why there's still so much uncertainty.

BENN STEIL: But with Gadhafi gone in Libya, he's unlikely to get political asylum there. So his options are relatively limited. (Laughter.)

With regard to Greece, I do think it will need another -- the polite way to put it is restructuring sometime next year. But the eurozone as a whole can survive another restructuring, in my view.
The possibility of Greece leaving the eurozone is a heck of a lot trickier because there are so many webs of connections that go deep into the European economy.

Just to give you one example, if Greece were to leave the eurozone, you would have multitudes of cases like this where there's a German bank that's made a loan to a Greek industrial concern, if any of those exist. And there emerges a big question whether that loan is now denominated in euros and drachmas. And that's going to be replayed throughout the European continent. And that could give rise to a terrible contagion.

So a Greek exit from the eurozone is not, by any means, simple. It's very, very dangerous for Europe.

With regard to Italy, a restructuring, in my view, is out of the question without a breakup of the eurozone, but the problems Italy has, in my view, are manageable notwithstanding the current bond market. That's a big notwithstanding that I'll get back to in a moment.

Italy is solvent. Italy has a very high debt-to-GDP ratio, about 120 percent. But to date, it's been stable and even declining mildly. It has -- it's running a primary budget surplus, meaning that it doesn't have to borrow from the markets in order to fund its current expenditures just to pay debts on -- pay interest on its whole debt. Its current account deficit is much less than half of Greece's, and at least to date, it's had mildly positive growth. So those numbers are pretty good.

So then the real question becomes why did the bond markets disagree with me. And I'd point to one factor here that I am sure Thomas will agree is important because we had this conversation yesterday. The eurozone debt package that was put together for Greece a few weeks ago involved the plan to recapitalize the European banks. And they made what I consider to be a fatal mistake in how they set up the rubric.

They basically said that the banks needed to improve their capital-to-asset ratios. That gives the banks a choice whether to increase their capital or to shed assets. And they've been choosing to shed assets, and I think the timing couldn't have been worse because there's no doubt that Italian government bonds have been a big victim of this.

What they should have done is simply tell the banks you will have to raise capital irrespective of what you do on the asset side. And if you can't raise it, you'll have to take government capital just like they did in the United States back in 2008 when Hank Paulson told, I guess it was the 10 big banks, that you won't leave this room until you sign a thank-you card to Uncle Sam for the equity capital we're about to inject. That's what we're going to do in Europe, but that's not what they did. And I think we're reaping the consequences of that now.

BROSENS: Do the governments have the -- the U.S., when it did that, barely had the solvency to be able to inject a significant amount of its capital into the banking system without threatening its very solvency. It's less clear to me that the European countries have that same capability. There's more circularity between the sovereign risks and the bank risks.

You know, as you look at that issue, you know, is the capital that they're talking about raising enough? And do they have the capability to do it?

PHILIPPON: So in the case of -- for that question, the critical country is France, actually, because that's where the -- you know, the biggest exposure to Italy on the one hand, and that's precisely why that question of raising -- of using public money to recapitalize the bank was discussed. And it's clear that the view was that, if the French government was to do a massive recapitalization of its own banks, that would threaten its own fiscal position and its own -- essentially, its own credit rating. And so that's why that option was not chosen.

On the -- I totally agree with the -- the issue with recapitalizing the bank is you can tell the banks I want you to raise money or I want you to have a good ratio. If you tell them I want you to have a good ratio, they can raise money or shed assets.

And it looks like Europe has suddenly a second option, and not only that but also, of course, then the question is where do you shed assets. As you can imagine its bank in its own country is making sure not to shed its domestic assets. But the French banks are not doing a credit crunch in France. They're just getting rid of as much Italian paper as possible.

And I'm sure the Italian banks are doing the same as the French paper and so on and so forth so that, essentially, it's blocking their credit crunch in other countries. So that's a clear case of lack of coordination at the EU level.

So if you want to understand why is it that, you know, the U.S. has coped better with these kind of issues, well, you don't have that coordination problem because that -- (inaudible) -- and then you don't have this issue of California -- or actually, in that case -- yeah, California exporting its credit crunch to Texas. That didn't arise. That's the big issue.

On the specialty issue of the bank -- (inaudible) -- you have to realize one thing, which is there is no amount of capital that you could put in the bank that would protect them against a breakup of the eurozone. So today, for better or worse, that has become a second order issue. You know, the big issue is Italy. I think the eurozone would not survive restructuring -- significant restructuring of Italian debt. So that's it.

And so you think that-- or the whole game is over. It's not a little bit more capital in the bank that's going to solve the problem. The metaphor is: suppose you live next to a nuclear power plant and there is a leak. Well, you know, you could try to fix the power plant -- that's fixing Italy; otherwise, putting duct tape on your window, which is like putting capital in your banks, is not going to help you very much.

OK, so that -- unfortunately, that's where we are now. So I think that this issue of capital in the bank -- the banks have enough capital to withstand a normal recession, even a big recession. They don't have enough capital -- no bank would have enough capital if there is a break-up of the eurozone. So I think that's where the line is clearly at today.

STEIL: Recapitalizing the European banks is much more complicated than recapitalizing the American banks. A dollar in a U.S. bank is the same as a dollar in another U.S. bank, broadly speaking.

That's not the case in Europe. A dollar -- a euro in a Greek bank, however much the Greek government might want to insist that it's credibly insured, is not the same as a euro in a German bank. Those are, for all intents and purposes, two different currencies. And this is one of the things that's fueling the crisis right now -- that deposits have been fleeing the periphery countries, in particular, Greece, and going into Germany. We don't have that problem in the United States, thank goodness.

BROSENS: It seems actually there are a variety of circular issues with the eurozone that didn't exist in the U.S. When you think about the troubled assets in the U.S., they were unrelated to sovereign issues here.

They're related to sovereign issues, and therefore constrains the sovereign ability to help. The EFSF is guaranteed by all the various countries. You know, Italy and Spain actually represent 30 percent of the guarantee, and so you have the circular issue there as well.

Also, and we talked about this a little bit, the overall European banking system is over three times GDP, whereas in the U.S., it's about equal to GDP. Wondering how all of those play out in your view?

PHILIPPON: The two major differences between the U.S. and Europe, with respect to the current crisis, I think, A, the central bank; and B the growth prospect.

So no matter what we think, it's still the case that we believe the U.S. economy is going to grow over the next five years. Maybe not as much as we'd like, but something is going to grow. There is no question about that. That's less obvious for some -- for some (sovereign ?) economists in Europe. That's a big deal if you think about the credibility of your debt, because, you know, if you grow, it's a lot easier to pay back your debt. So that's one big difference.

The second big difference, of course -- and I think the main one today, for sure -- is the central bank. In a sense, if you look at it -- if you were to look at this -- (inaudible) -- and you would, like, ask yourself, who should be doing quantitative easing, well, the answer would not be the Fed. It would clearly be the ECB. And the one place where quantitative easing would have a huge positive impact would be Europe, right. And there it's the opposite.

So why is it that the Fed is doing it, even though the returns are much lower and the political risk seems to be even significant in the U.S.; where, in Europe, where the return would be very high, the ECB is not doing it? Well, the answer is because, to do that, you need a credible commitment to sensible fiscal policies going forward. If the ECB starts doing quantitative easing on long-term Italian debt (actually ?), that would certainly help a lot the economy to grow over the next two or three years.

The trouble is, if you get the Italian government off the hook, are they still going to do the reform that you would like them to do? That's the issue. And that's -- that is the main difference between Europe and the U.S. And you can see it very well in the data, doing some research on that. It's very interesting to see that the initial shock -- so think about, you know, 2007, 2008 the big shock happens. It hits everybody. And remember, German GDP fell more than U.S. GDP, right. So the shock was hitting all the countries.

Now, in the U.S. -- people think of the U.S. as one country, but in fact, if you look at different, say, U.S. states, you're going to see that Nevada, Florida, California got crushed, while Texas, New York, Pennsylvania were doing just fine, OK. And now imagine that you look at the collection of states in the U.S. and the collection of states within the eurozone. What you will see, almost exactly the same dispersion.

So employment -- the employment rate fell about 15 percent in Nevada, 12 percent in California. It was 12 percent in Greece and over 10 percent in Spain. And on the upside, Texas essentially had no significant recession, and neither did Germany. So the dispersion is very much the same.
So the idea that the U.S. has one business cycle, where all the states are hit the same, that's not true. There was also a lot of dispersion. And yet we don't have the second round where we start to worry about the solvency of Texas, versus California, versus Nevada. That doesn't happen.

Well, the muni market -- perhaps we can discuss that later on, but it's small anyway, relative to the federal debt market. And so that's, you know, that you can see it vividly, the reason that these issues don't arise in the U.S. is because the state don't have -- don't have their own debt, and therefore the solvency of the state themselves, that's not a big deal. And Europe is exactly the opposite. And so now the solvency of the state is a big deal.

And then second side, of course, which, as you said, is the feedback from the states to the banks. So I don't -- I don't think that the main issue is the size of the banking system per se. Just because, remember, in the U.S. you use the markets more to -- (inaudible) -- credit. But the bank branches are not that big, but then you have the money market fund, which is essentially backstopped -- you know, is a big systematic part of the system, and for all practical purposes, acts like a bank. And definitely eurozone is on the hook if there's a big run on the money market funds. I think we know that.

So if you add that up, that's not going to make a huge difference I think, in terms of the big picture. What is going to make a big difference is, again, the state law issue, which is Italian banks have Italian paper, and French banks have French paper, and so and so forth. So then, locally, all these effects, the feedback from the branches of the banks to the solvency of the sovereign, this feedback get together very quickly at the state level.

So imagine if California had banks, had a lot of debt, and all the Californian banks only hold the paper from California. Well, they would be in big trouble, and they would have spillover to their neighbors, OK. Fortunately, that's not like that. The banking market is completely globalized within the U.S., and so there is no sense in which a state being in trouble, even in a credit crunch -- (inaudible), OK. That's the main difference.

So I think, again, if you really go down to the basics, it's really about the different behavior of the states within the system. That's the fundamental difference, not the rest. At least that's my view.

BROSENS: (Off mic.)

STEIL: With regard to the ECB, I think its powers are much less than many people impute to it. For example, last week at Mario Draghi's first press conference enormous attention was given to the quarter-point rate cut. That will have virtually zero effect on the position of the periphery countries.

To put some numbers on it: Before the crisis -- even, in fact, up to mid-2010, the correlation between the ECB's policy rate and the Spanish three-month government borrowing rate was virtually 100 percent. That is, the ECB dictated the movement of the Spanish government's borrowing rates, and those rates in turn dictated borrowing rates in the private sector in Spain. That's how monetary policy works in developed countries in normal times.

The correlation today between the ECB's policy rate and the three-month borrowing rate in the periphery countries is zero. It has absolutely no impact. Investors are not interested in the ECB's policy rate. With regard to the periphery countries, they're only interested in default risk. Default risk is what determines the spreads.

Now, Mario Draghi made another comment that didn't get nearly as much attention as I thought it should have. He said, quite provocatively, that the European Central Bank is not a lender of last resort for eurozone governments, and indeed the eurozone didn't need the ECB to act as a lender of last resort. That was an extremely forthright statement. There are many dimensions to it.

I think, first of all, right now he's trying to have it both ways -- trying to be "a little bit pregnant" with regard to Italy, which is a catastrophic situation. It doesn't do any good to stabilize Spanish government borrowing rates at around 7 percent. You either have to go all in, or make it clear that this is beyond your capability here, and that the eurozone creditor governments need to act.

Now, I actually think that the eurozone creditor governments do need to act, and for this reason. The ECB only has 81 billion euros in capital. That could easily be wiped out with, say, just a 25 percent haircut in PIG debt -- Portugal, Ireland and Greece. That's it. Gone.

Now, a central bank can operate for a brief period without any capital. But eventually any central bank will have to tighten monetary policy at some point in the future. And in order to do that, they need assets to sell. And unless the market believes that the ECB is going to be credibly recapitalized, there will be a god-almighty run against the euro and it will, quite frankly, collapse.
That's not the same situation as the Feds in the United States. In fact, if you look at the Fed's reported capital, it's only $58 billion. They made good paper profits off the crisis, I should add, which is very good for them. But nobody doubts that the U.S. government is ultimately going to stand behind the Fed. But investors do doubt that the German taxpayer is ultimately going to stand behind the ECB. And that's a big, big problem.

And I think that's one of the underlying reasons why the ECB is so tepid with regard to the crisis. They don't want to make themselves a ward of Germany, because they don't know if they're ever going to get out of that poorhouse once they get in.

The German public may decide, at that point, enough is enough. That may be a bad decision, but it's still going to be a decision that they can take in a democracy. And I think that's a big risk.

BROSENS: Play devil's advocate a little bit.

I think Mario Draghi is viewed as much more pragmatic, I think, than (Trusche ?). And while he has a moral hazard issue, in terms of immediately coming into the support of Berlusconi -- and still Berlusconi-led government -- if in fact, Italy heads in a direction of a technocratic government led by Monti, and there is confidence that they're going to do the economic reforms and austerity measures that are needed, I'm not sure that there's much choice other than to come in, in a very significant way, and try and get rates down.

And I guess I'd challenge either one of you, in terms of why that wouldn't be the case.

PHILIPPON: I think it would work. I mean, I totally agree that the usual chain of monetary policy, where you fiddle around with a short rate. That's peanuts. That's irrelevant. And so that was completely irrelevant in 2008 and '09 in the U.S. as well, which is why the Fed went into what we call unconventional monetary policy, or also known as quantitative easing.

And quantitative easing, number one, was a huge success. I mean, I just recently discussed a paper at Brookings, doing a micro-estimate, looking at detailed data on all possible spreads you can think of in the U.S., looking at exactly what QE I did. And it's a huge success for all markets -- the corporate bond market; of course, all the mortgage-backed securities. That's completely unconventional. That had nothing to do with their policy rates. That's quantitative easing.

So I'm -- my presumption is, if they were to do it with the Italian markets, it would have the same efficiency. It would work. But I think -- and where we probably agree is, the paradox is if -- you know, if you're credible, you announce you're going to do it, and you're going to do it big, and without limits if necessary. And if that's credible, then the great thing is in terms that you don't have to do that much.

That's the paradox of it. If you're credible and you announce something big, you don't end up having to do a lot. And that's -- we had the -- (inaudible) -- scenario. That's the economy of Switzerland. But if you announce very little, and it's not very credible, you end up having to do a lot. OK, that's the product -- (inaudible).

The problem is, to announce a lot they need two things: They need credibility on the Italian side -- that is, they need to know -- and, of course, Draghi and Monti know each other very well and respect each other very well, so we can be sure they're going to be able to coordinate. But it's obvious that Draghi cannot move before Monti is in and with enough power to implement the reforms that everybody knows are necessary, OK. So they need that, on the one hand. That's on the Italian side.

And then they need the German side, because they need to be able to say, we're going to go in -- we're going to go all in, and we are backed by the rest of the eurozone, which essentially means Germany. If that's credible, that is not going to be very costly, and you can predict that the ECB is going to make big paper profits just like the Fed did. So I think that's the position we're in right now.

STEIL: Politics matters very much here. Ultimately Ben Bernanke is far less constrained by Ron Paul than Mario Draghi is by, say, Angela Merkel. That's not to say that Ben Bernanke can do anything he wants in terms of monetary policy innovations. Congress granted his body independence in terms of making monetary policy, and Congress can take it away. But we're not very close to that.

It's not surprising that the ECB is far more reluctant to engage in those innovations since its ultimate backstop comes from Europe's -- the Eurozone's largest creditor country, Germany. And the German public, the German political class, is very, very uncomfortable with these sorts of monetary policy innovations. And so the ECB's room for maneuver is ultimately limited.

As I say, politically I think it would be a disaster for them to have to be recapitalized. I think whatever independence they have right now would be permanently removed or they have to go down that route. So they're trying to avoid it.

BROSENS: One last question and then we'll open it up to the members. Two issues, Thomas, that would seem to present challenges to the ECB. One is so much credibility been squandered that it's going to be hard to get back. And the second issue is there seems to be, in a sense, a return to home bias. You talked about it in terms of some of the French banks divesting Italian assets. That's really from a capital perspective.

There is also a growing perception that financial institutions shouldn't own assets outside of their own country for risk reasons. So you look at the money markets in the U.S. owning European bank short paper, the problems that MF Global has obviously run into, the questions about Jefferies. You're seeing it in Europe as well in terms of questions about banks owning the sovereign paper outside of their own country. It seems like that's going to also prevent -- present a fair bit of -- a fair challenge to the ECB in terms of stoking up all of that supply.

PHILIPPON: So there is no question that ECB lost a lot of credibility with the way they dealt with Greece. In fact, it's quite striking that, not so long ago, at least early on in the financial crisis, the ECB was seen as the most credible central bank, ahead of the Fed, because they reacted better to the initial round of financial disasters, like, you know, in the fall of '08.. They were the first to have the credit lines open. They did some of the moves before the Fed.

And also there was the issue of the banks from the U.K. seeking liquidity in emergency, and the EC was much faster at doing that than the Bank of England. So in fact, there was a time when the EC was seen as, well, that's really impressive; they are successful. And they lost everything on the sovereign side. There is no doubt about that.

What is not clear in my mind is should we blame them or should we blame the politicians within Europe? That's a debate we can have. Is it the ECB? I mean, you know, I'm an economist. I don't know. We are not very good at making predictions.

There is one prediction that all -- the ones I talked to, at least, with me that the IMF or some of those places in Europe we all agreed on is Greece is not solvent. So that's not a liquidity crisis. Greece a year ago was not a liquidity crisis. It's a solvency issue. That is, take a big haircut and then get done with it, you know. Don't waste time. Don't waste a year and a half doing half-measures. It's obvious it's not a crisis of liquidity.

I think the ECB also knew that, and my sense is either they don't have the guts to say it or they have too many political constraints to say it. I don't know which one is true. But it doesn't matter. The outcome is they lost their credibility on that. So next time they're going to say this country shall not fail or they'll say, yeah, well, you said that for Greece. And so that's a big issue; I totally agree.

There's a separate issue of, you know, what's going to happen to -- are we going to move away from financial globalization? I don't think I can answer that in two minutes. I think there is certainly a tendency for that. I don't think it's going to be an issue just for the ECB, by the way. I think it will become an issue for the U.S. as well, for banks in Asia as well.

In the short term, it's clearly an issue for the ECB, just because the money market funds pulled out of funding U.S. dollars short term to EU banks. So now what happens is dollars flow from the Fed to a swap line in Frankfurt, and then that's given back to the banks in Europe. That doesn't sound like a good government solution.

And I -- you know, and as long as the crisis is going like that in Europe, I don't see the money market funds putting their money back into short-term EU banks' paper. So I don't think that's -- so that problem is here to stay. Whether it's going to disappear in the long run, I'm not sure. But there is a real chance we're going to see retrenchment from financial globalization, because it looks like this currency mismatch is an issue.

And the other one is, remember what governments do when they have to pay back their debts. That's financial repression, and that's something that has been going on for a thousand years. Every big episode -- and I'm talking really a thousand years, because all the historical periods of government having to, you know, reduce significantly their debt, every time it involved some form of financial repression, which just means forced saving at home. And so whether that's going to be part of the equation going forward, I think it's likely, at least; and not just in Europe, by the way. I think the same is going to happen here.

STEIL: I would be far harsher than Thomas on the ECB with regard to why they deny Greece's insolvency. They were a big Greek creditor. They were talking their book, just like Josef Ackermann at Deutsche Bank. He said it would be an utter catastrophe if Greece were to restructure. Charles DeLauro (sp), who represented all the big banks in Europe, said it would be a catastrophe.

The ECB was just another big creditor talking its book, saying it would be a disaster if it had to take a haircut. And I thought that damaged their credibility enormously. But I think the reason why they persisted in that position was that they were very concerned, ultimately, about their capital.

BROSENS: We can now open it up for questions for the members; if you can state your name and affiliation, please.

QUESTIONER: Rob Rosen. Do you think that any Eurozone solution would require significant -- I was going to use the word massive, but significant liquidation of gold reserves in order to provide leverageable liquidity to allow for the large solution that I think both of you suggested was required?

PHILIPPON: I think gold per se is not going to be a key issue. The issue is going to be inflation, which is, I mean --

STEIL: Things go together.

PHILIPPON: Yeah, exactly, to the extent it's going to influence inflation, then yeah, that matters. There are two scenarios. One scenario is you have some -- it's to convince Northern Europe to accept some degree of inflation. And then the rest -- that is, the southern part of Europe -- stays at zero wage growth, perhaps tiny bit of negative nominal wage growth, and then, you know, if you have a three-person difference between the north and the south, each year you gain 3 percent competitiveness. After 10 years you're at 30 percent. That solves a lot of the issues. So that's the growth and inflation scenario.

Then the barometer of that scenario is how much inflation is Northern Europe willing to tolerate? And my hunch is actually the answer is not much. And I think that it's not realistic to think it's going to be above 3 percent, and I don't think it's very realistic to think it's going to be sustainable above 2-and-a-half (percent), if I had to guess. That's my hunch. I don't have a -- I'll try to show that, but I think my understanding of people's preferences and the political realities in Germany is -- I don't buy the idea they're going to be willing to accept significant inflation.

OK, so that means what? That means that 2 percent is going to take a long time unless there is also deflation in the south, which is exactly what's happening now. The thing is, that's going to come together with big unemployment. And then the big issue is that makes it harder, at least in the short term, to pay back your debt. That's why this scenario is such an inefficient one.

But these are the two scenarios. You know, you're going to have either massive deflation in the south or some inflation in the north, together with either no inflation or small deflation in the south. And that's these are two scenarios that can keep the Eurozone together.

I don't think, actually -- I would be very bearish on the second one, because I don't think it's significant deflation in the south for a long period of time. I don't think it's going to be particularly sustainable. And therefore, I don't actually buy that scenario at all. I think that's not -- I don't buy that thing. I think that would not be sustainable. It would increase the debt burden too much and it would not make the -- it would make the political commitment to reform almost meaningless. That's why I think inflation is going to be the key.

BROSENS: But what you're saying is effectively austerity increases the deficits, decreases GDP, increases all of your ratios. And so the austerity that you actually have to perform is --

PHILIPPON: It's terrible.

BROSENS: -- is too big.

PHILIPPON: But the thing that's striking -- I mean, I don't know if I was very struck by that. I thought the IMF learned that from the Asian crisis, but they did exactly the same to Greece, I mean, literally. Well, that's kind of surprising in a sense, is that you would at least think that they would have learned from the Asian crisis. I think the politics is very different, so perhaps that explains some of it. But in terms of the economics, it looks like the same mistake again.

BROSENS: Another question? Yes.

QUESTIONER: (Off mic) -- Pace University.

What does it mean for a central bank to be backstopped by the central government? At the end of the day, doesn't the Fed print its own money? It doesn't have to borrow from the U.S. government.

STEIL: This is true. But if the central bank has no assets, then it can't tighten monetary policy. How does a central bank tighten monetary policy? It withdraws currency from the market, and it does that by selling assets; for example, the U.S. -- in terms of the Fed, usually it would sell treasury bonds. The Fed has to have treasury bonds. Likewise, the ECB has to have assets to sell in order to tighten monetary policy. Those assets ultimately have to be provided by the creditor member states.

Now, Thomas and I would agree completely that the ECB is not going to need to tighten any time soon. That's not the point. The point is, if the markets were to come to the conclusion -- for example, if the Bundesbank were willing to sell all its gold to fund the bailout and the ECB were to go down to zero or negative capital position, if the markets were to conclude that this institution is never going to be recapitalized because it has no credibility with its ultimate financier, Germany, then the Euro is finished. There will be a massive run on the currency, just the way we've seen with developing-market currencies in a financial crisis.

So that's the problem. Sure, they can print. That's the easy part. But you have to have credibility as a central bank that once the crisis is over, you're capable of reversing your expansionary policy. That credibility is central.

PHILIPPON: You know that Tom Sargent, who was my colleague at NYU, got the Nobel Prize this year. And among other things, he's famous for looking at this issue. At the end of the day, there is one -- (inaudible) -- from the government -- (inaudible) -- together. That's the one that has to hold. No matter what happens, it has to hold. But, yeah, this one could be on the money side or the fiscal side. There is one budget constraint.

And so if you remove entirely the fiscal side, then that means that you're going to have -- the only solution will be massive inflation. And that's probably not going to be a very good one -- (off mic).

BROSENS: Yes.

QUESTIONER: I'm Padma Desai, Columbia University.

If the European Central Bank will not and cannot play the role of lender of last resort in order to bail out EMU governments and banks, can the European financial stability fund be augmented from its current size of, what, 440 billion Euros, supplemented by IMF funding? Can it be augmented by liquidity flow from China? Or is this a nonstarter? And how do European leaders react to that suggestion?

STEIL: Politically, this is the most critical issue that's dividing Germany and France right now, whether that fund needs to be boosted and to what extent, also how to do it. There's quite naturally great political resistance to sinking more money into the fund on balance sheet. That's why there's been talk of, quote unquote, leveraging the fund, essentially turning it into a CDO, collateralized debt obligation. That could be extraordinarily risky. It means that that $440 billion that would be the equity tranche of the CDO, becomes far more risky than it is today. In other words, more likely to be depleted.

I think it's clear from the past two weeks of international discussions that China is not going to play a role through the EFSF. They might be willing to play some sort of role through the IMF but only at a price. They're going to want more influence in the institution, and I would contend that they would also make it a condition of their increased support that there shall be no more discussion in public criticizing the Chinese exchange rate policy.

So I think we're in a very difficult position right now. I don't yet see the political will in Europe, meaning in Germany and France, to boost that fund significantly and that money is not likely to be forthcoming from persons outside Europe.

PHILIPPON: I was always skeptical of this idea of China bailing out Europe. China is a complicated country. They have internal politics. People in China are not very keen on the idea of throwing money at Europe's problem. I think that's a non-starter politically in China. So they would only do it if they get really big political gain from abroad, mentioned like, you know, the extent of it in the IMF. So I never thought that would actually fly.

The biggest -- I mean, so if France wanted to turn the EFSF into a bank, which is very close to what the U.S. did. You have seen money which is physical money, if you want and then you lever it with monetary policy. That's pretty much exactly what the Fed and the Treasury did together. And you can solve all the -- (inaudible) -- on it. And again, that's the rational solution from an economic perspective. The trouble is, you do it in a country that has a fiscal union like the U.S. Then it's fine. But you should do it in a country where it's not a fiscal union then it's not fine. And Germans said no because they don't want to give a free blank check to the Italians. That -- it comes onto that.

The thing we have to remember, the eurozone as a whole doesn't have deficit. If you aggregate the eurozone together, it's actually probably more stable than the U.S. in the sense that its current account is balanced, it's not borrowing from the rest of the world. It's balanced and its debt-to-GDP ratio altogether looks very much like the one in the U.S. Whole package seems kind of similar.

So there is enough money in Europe to solve its own problem. It's all about politics. And that's so it comes on to that. That's why I don't think -- then when you read this -- I think what I'm trying to say is, when you read this news about outside involvement in Europe, don't think about economics as much as politics. That's the way to interpret it. Because we need a bad cop in Europe. That's the bottom line, OK. Because otherwise we're never going to get reform from Spain, Italy and Portugal. So we need the bad cop. The question is, who's going to be the bad cop?

When you know European history, you know Germans are not going to be great bad cops. And they don't want to do it, for good reasons. They say, you know, that's not the job we really want to do. Then who is going to be the bad cop? Well, A, the market guru -- (inaudible) -- Berlesconi? It's not like we haven't tried, but the market did it. And then the IMF because then you can blame Washington. That's great.

So involvement of outside creditors, you have to think of it as these are the guys who can be bad cops, you know. If the Brazilians say, well, you know, we've loaned you money; we want our money back, so you put your finance in order, that's more acceptable to the Italians than if the Germans say the same thing.

So it's not really -- the quality of money is not the issue here. If Europe had no political problem, it could solve its own problem. That's no problem. It's the politics that matter in that case.

BROSENS: Although the EFSF has gone in a direction -- while the Germans did not allow them to leverage it, they're heading in a direction of using a good portion of that 440 billion (dollars) in as a first-loss piece for the purchase specifically of Italian and Spanish debt. And whether that works or not is an open question.

STEIL: This idea, at least the way they've characterized it right now, I think it's foolish. They're talking about guaranteeing the first 20 (percent) to 25 percent of losses. But no sovereign is going to restructure 20 (percent) to 25 percent. When you're in default, you're in default, 50 percent-plus. So that's not going to calm the markets, 20 (percent) to 25 percent.

BROSENS: But it will lead to lower cost of funds. It may not make it a risk-free asset by any stretch, but if you --

STEIL: I personally don't believe it will if the markets still believe that there is significant default risk because they are going to know that any restructuring is going to involve a haircut that is much, much larger than what the EFSF is going to absorb.

PHILIPPON: But for Italy you could -- well, I think there are two issues. One is, this 20 percent is for the new bonds, not for the old ones. So that doesn't stabilize the Eastern markets. It's only for new -- borrowing. And then there are two issues. One is the one that we just mentioned, which is, you know, if you believe the haircut is going to be 80 percent anyway, 20 percent of that isn't that much. So it helps for medium restructuring.

But even there you have to be careful about, you know, are you going to be sure that this is going to be a real insurance policy? That is, these things are not going -- like when Germany or -- (inaudible) -- creditors lend money to these countries, if they lend senior, that can completely undo the 20 percent insurance you get, OK.

Now if you read the news from Europe, and if I tell you we have an instrument which is supposed to give you insurance against sovereign defaults, you should pay for that because if there is default, you are going to get some insurance back. Well, I don't think you would buy that insurance today because that's called a CDS and we made sure that they don't work. So the 20 percent is the same thing. It's precisely the same thing, if you think about it. So is that more credible? The same government would essentially try to get rid of the sovereign CDS market are now offering their own CDSs?

So again, you see that the issue is politics. I don't think that's completely credible.

BROSENS: Other questions? Yes. In the back.

QUESTIONER: Pierre -- (inaudible) -- from the French newspaper -- (inaudible). You have stressed the lack of coordination within the eurozone. I was wondering what do you make of the deficit of decision-making capability in the EU, and do you think the French elections could have an impact on the policy response in May? Policy response to the European debt crisis.

PHILIPPON: So there is no question that if there had been a better long-term working relationship between Sarkozy and America some of these issues could have been dealt with better. So that's a fact. So we are paying the cost of not having two leaders that are really on top of the game, and definitely not really on the same level one day. So they don't seem to be working very well together. Let's put it that way.

And so we would hope that -- and that's -- part of it is probably linked to the behavior of Sarkozy in some cases, so you would hope it would be marginally better if we have a different president. But deep down, though, you have to realize that I think the bargaining power between France and Germany has changed and is not going to be reversed any time soon, just because the fiscal realities are like that.

You know, Germany has the credibility, France does not. That is not going to change any time soon. So I don't -- in that sense I don't think it's going to have a very big impact. I think the key is more the German politics in and of itself than the interplay with the French politics. That would be my hunch.

BROSENS: Yes.

QUESTIONER: (Off mic) (RTHA ?) in Hong Kong. Along that same line, Mrs. Merkel yesterday spoke of more Europe as the solution, and wanting to do something, that there have been intense discussions with the French about something. It seems that this is moving rather fast in terms of Greece maybe choosing to pull out if they can't get a government, to say nothing of Italy.

I wonder if you'd say more about the implications of alteration of the system, someone leaving, northern zone, southern zone.

STEIL: I think the eurozone could survive the pull-out of a small periphery country like Greece. Would be touch and go because the financial repercussions in the markets would be enormous, but I think that's possible. If it goes beyond that, I don't see it persisting.

I mean, there's been talk about the reverse happening, that Germany and a few northerners would essentially leave the euro and the euro would be a sort of Club Med-like currency for the remainder. I don't see that as particularly credible. That currency wouldn't survive, and the deutschmark that would be reintroduced, whatever one might call it, would appreciate so radically that it would have a terrible effect on the German economy.

No one has an interest in seeing this unravel. But when we talk about more Europe, that has to be translated into certain concrete actions. One proposal has been, as you know, to create a Eurobond, not bonds issued by Germany, not bonds issued by Italy, but by the eurozone as a whole, and Germany is the one who is primarily resistant to this particular innovation. That's a significant political obstacle to moving things further in that direction.

PHILIPPON: I think there is no question that we're going to need more integration. You can read it both sides. You can see actually what we achieved over the last year and a half under intense pressure. It is a lot more than I would ever have expected. The fact that we have an active discussion about the Eurobond, even though the Germans are definitely against it as of now, and for good reasons. Again, I go back to my same point. It's not possible for a German chancellor to say yes to the Eurobond until they know for sure they can control deficits in the other countries. So then the question is what mechanism do you have in place to do that?

By the way, the same exact story played out in the U.S., 1840 (ph) in the U.S. You have nine states that are bankrupt, and big ones. And they all asked for federal bailout. And they were -- at that time loans were extended and U.S. was pretty big relative to federal debt. And it was actively discussed in Washington and the outcome is no. Go bust. And they did.

After that you have strict limits on the amount of debt that states can have and then it becomes clear that states don't have that much debt and all the debt is federal. So that a big -- (inaudible) -- the birth of the U.S. bond, OK. It didn't happen smoothly. It happened through big crisis with huge effort.

So in Europe of course the Eurobond is something that is required in the medium run. The question is how you get there. And the trouble that I have with EU policymaking is that they are not very good at tracing the path of how to get there. It's one thing to say, oh, it's hard. Yes, I know it's hard. But, you know, what are the concrete steps you could at least start so that we see how we would potentially get there? And with constraint you can put on a sovereign government on the spending side so that you could start by having some Eurobonds.

The Eurobonds -- one thing that's very important to realize is it's going to have to be some kind of -- either you put very strict limits on how much more we can -- and Italy and other guys, other countries can do. Or you have to have two types of bonds. You have a local bond which is backed by the EU, which it was proposed as blue debt, red debt. The blue debt is something which is issued at the EU level, backed by the entire eurozone, and that would of course would trade like goods, very low yield, very high liquidity. And so that's providing financing for the government. But then it's capped at some limit -- (inaudible) -- of that.

Beyond that limit then you're on your own, which means at that point you have the market price which prevents you from raising too much. So that solution has -- going back to my earlier point, that has the market being the bad cop because once you've issued your allocation, your quota of blue debt, well the next step is going to be not backed by Germany any more so you're going to pay the high price for that. And that's what prevents you from going crazy and borrowing too much, and that's the market being the bad cop. At least it's credible.

STEIL: Bank supervision and deposit insurance will also have to go pan-European. You remember the crisis didn't start just in Greece, which had a large sovereign debt problem. It started in Ireland and Spain, which had banking sector problems. So early on in the crisis Ireland issued a blanket guarantee on all the debt of its six largest banks and it's reaping the consequences of that now. We can't have a situation like that again in the future. That's why Ireland's in the position it's in now. That's why the ECB is so massively exposed to Irish sovereign debt. So banking supervision and deposit insurance will be a fundamental area that will have to be reformed on a pan-European basis.

BROSENS: I think that concludes our session. It's now noon. One thing that strikes me in terms of the comments have been made in terms of the limits of ECB is it's been said that the Fed in its actions are haunted by 1937, whereas the ECB is haunted by the hyper-inflation of Weimar, and they are still acting accordingly. So thank you. (Applause.)

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THIS IS A RUSH TRANSCRIPT.

FRANK BROSENS: Good morning. Welcome to the third and final session of the symposium, the Stephen Friedheim Council on Foreign Relations Symposium on Global Economics, this one entitled "The Future of the Eurozone."

First, just a quick reminder -- two things: One, you've probably heard a few times today, but if you can turn off your electronic devices completely -- not just to silence -- to avoid interfering with the sound system. And second, a reminder that this is on the record.

We are fortunate today to have with us two -- not three -- Jacob Kirkegaard, unfortunately, got fogged in on his way from D.C. -- very prominent economists on the European situation; Thomas Philippon, the John Vogelstein faculty fellow and associate professor of finance at NYU's Stern School of Business; and Benn Steil, a senior fellow at the Council on Foreign Relations, whose recent book, "Money, Markets and Sovereignty," was awarded the 2010 Hayek Book Prize.

We're going to have a dialogue for about half an hour, after which I'll open it to the members for questions.

I heard a great anecdote this morning on the European situation from someone who, when asked what's going to happen to Greece, says, well, it's just going to follow the Greek precedent from 137 BC -- (laughter) -- where apparently the Romans heard that the Greeks were way overleveraged, and so they sent someone to Greece to find out the details and discovered that, in fact, it was true. The gentleman came back and said it's true but not to worry, the creditors all understand the situation perfectly; most of them are willing to take big haircuts, and those that aren't, we're going to pay them in installments over 10 years.

Unfortunately, over the last couple of years since President Papandreou took office and discovered and then announced that the fiscal situation in Greece was far worse than had previously been thought, the markets have bounced back and forth from greater and greater crises to greater and greater partial solutions. And the question now resolves not on Greece -- which is an economy of about 230 billion euros -- but on Italy, an economy over five times the size.

So I guess the question that I'll ask my two panelists to start is will it hold together.

THOMAS PHILIPPON: We'll hold together. So, for Greece, I think the issue is whether it's going to stay in the eurozone or not. And that's, I would say in the medium range, mostly for the Greeks to decide.

The real question is what's going to happen to Italy. And there I think that, in the near term, there are two issues; the near term and the medium term. In the medium term, it's all about growth. So the one thing you have to realize, the growth of Italy from 2001 to 2010 is 0.2 percent a year on that rate, almost no growth. It's such a low growth, it's hard to pay back your debt.

So any credible solution for Italy must involve some growth in the medium and long term. So these are the structural reforms. And then the big issue is whether the government is going to be able to do it. That, nobody can know in advance.

The near-term issue of, you know, the next two or three years for Italy, then it's really all about politics because the economic solution is, I would argue, quite simple. I think if and when the ECB decides to move, it can solve the debt crisis for Italy quite quickly. But it is not clear that this will be a load to move either by German politics or by Italian politics.

So I think the product is that the economics is actually quite simple and the politics is very complicated. So whether it's going to hang together or not depends on whether -- (inaudible) -- can put together a government that's credible.

The one thing I also will mention is we don't know yet for sure that Berlusconi is really gone. He's not gone -- (laughter). Anyway, if you wonder, you know, why is the -- why all the variety -- (inaudible) -- are very high. Well, there's still a lot of uncertainty. The markets interact very well to the announcement that Berlusconi would step down. Well, it's not guaranteed he's gone, and so that's why -- that's why there's still so much uncertainty.

BENN STEIL: But with Gadhafi gone in Libya, he's unlikely to get political asylum there. So his options are relatively limited. (Laughter.)

With regard to Greece, I do think it will need another -- the polite way to put it is restructuring sometime next year. But the eurozone as a whole can survive another restructuring, in my view.
The possibility of Greece leaving the eurozone is a heck of a lot trickier because there are so many webs of connections that go deep into the European economy.

Just to give you one example, if Greece were to leave the eurozone, you would have multitudes of cases like this where there's a German bank that's made a loan to a Greek industrial concern, if any of those exist. And there emerges a big question whether that loan is now denominated in euros and drachmas. And that's going to be replayed throughout the European continent. And that could give rise to a terrible contagion.

So a Greek exit from the eurozone is not, by any means, simple. It's very, very dangerous for Europe.

With regard to Italy, a restructuring, in my view, is out of the question without a breakup of the eurozone, but the problems Italy has, in my view, are manageable notwithstanding the current bond market. That's a big notwithstanding that I'll get back to in a moment.

Italy is solvent. Italy has a very high debt-to-GDP ratio, about 120 percent. But to date, it's been stable and even declining mildly. It has -- it's running a primary budget surplus, meaning that it doesn't have to borrow from the markets in order to fund its current expenditures just to pay debts on -- pay interest on its whole debt. Its current account deficit is much less than half of Greece's, and at least to date, it's had mildly positive growth. So those numbers are pretty good.

So then the real question becomes why did the bond markets disagree with me. And I'd point to one factor here that I am sure Thomas will agree is important because we had this conversation yesterday. The eurozone debt package that was put together for Greece a few weeks ago involved the plan to recapitalize the European banks. And they made what I consider to be a fatal mistake in how they set up the rubric.

They basically said that the banks needed to improve their capital-to-asset ratios. That gives the banks a choice whether to increase their capital or to shed assets. And they've been choosing to shed assets, and I think the timing couldn't have been worse because there's no doubt that Italian government bonds have been a big victim of this.

What they should have done is simply tell the banks you will have to raise capital irrespective of what you do on the asset side. And if you can't raise it, you'll have to take government capital just like they did in the United States back in 2008 when Hank Paulson told, I guess it was the 10 big banks, that you won't leave this room until you sign a thank-you card to Uncle Sam for the equity capital we're about to inject. That's what we're going to do in Europe, but that's not what they did. And I think we're reaping the consequences of that now.

BROSENS: Do the governments have the -- the U.S., when it did that, barely had the solvency to be able to inject a significant amount of its capital into the banking system without threatening its very solvency. It's less clear to me that the European countries have that same capability. There's more circularity between the sovereign risks and the bank risks.

You know, as you look at that issue, you know, is the capital that they're talking about raising enough? And do they have the capability to do it?

PHILIPPON: So in the case of -- for that question, the critical country is France, actually, because that's where the -- you know, the biggest exposure to Italy on the one hand, and that's precisely why that question of raising -- of using public money to recapitalize the bank was discussed. And it's clear that the view was that, if the French government was to do a massive recapitalization of its own banks, that would threaten its own fiscal position and its own -- essentially, its own credit rating. And so that's why that option was not chosen.

On the -- I totally agree with the -- the issue with recapitalizing the bank is you can tell the banks I want you to raise money or I want you to have a good ratio. If you tell them I want you to have a good ratio, they can raise money or shed assets.

And it looks like Europe has suddenly a second option, and not only that but also, of course, then the question is where do you shed assets. As you can imagine its bank in its own country is making sure not to shed its domestic assets. But the French banks are not doing a credit crunch in France. They're just getting rid of as much Italian paper as possible.

And I'm sure the Italian banks are doing the same as the French paper and so on and so forth so that, essentially, it's blocking their credit crunch in other countries. So that's a clear case of lack of coordination at the EU level.

So if you want to understand why is it that, you know, the U.S. has coped better with these kind of issues, well, you don't have that coordination problem because that -- (inaudible) -- and then you don't have this issue of California -- or actually, in that case -- yeah, California exporting its credit crunch to Texas. That didn't arise. That's the big issue.

On the specialty issue of the bank -- (inaudible) -- you have to realize one thing, which is there is no amount of capital that you could put in the bank that would protect them against a breakup of the eurozone. So today, for better or worse, that has become a second order issue. You know, the big issue is Italy. I think the eurozone would not survive restructuring -- significant restructuring of Italian debt. So that's it.

And so you think that-- or the whole game is over. It's not a little bit more capital in the bank that's going to solve the problem. The metaphor is: suppose you live next to a nuclear power plant and there is a leak. Well, you know, you could try to fix the power plant -- that's fixing Italy; otherwise, putting duct tape on your window, which is like putting capital in your banks, is not going to help you very much.

OK, so that -- unfortunately, that's where we are now. So I think that this issue of capital in the bank -- the banks have enough capital to withstand a normal recession, even a big recession. They don't have enough capital -- no bank would have enough capital if there is a break-up of the eurozone. So I think that's where the line is clearly at today.

STEIL: Recapitalizing the European banks is much more complicated than recapitalizing the American banks. A dollar in a U.S. bank is the same as a dollar in another U.S. bank, broadly speaking.

That's not the case in Europe. A dollar -- a euro in a Greek bank, however much the Greek government might want to insist that it's credibly insured, is not the same as a euro in a German bank. Those are, for all intents and purposes, two different currencies. And this is one of the things that's fueling the crisis right now -- that deposits have been fleeing the periphery countries, in particular, Greece, and going into Germany. We don't have that problem in the United States, thank goodness.

BROSENS: It seems actually there are a variety of circular issues with the eurozone that didn't exist in the U.S. When you think about the troubled assets in the U.S., they were unrelated to sovereign issues here.

They're related to sovereign issues, and therefore constrains the sovereign ability to help. The EFSF is guaranteed by all the various countries. You know, Italy and Spain actually represent 30 percent of the guarantee, and so you have the circular issue there as well.

Also, and we talked about this a little bit, the overall European banking system is over three times GDP, whereas in the U.S., it's about equal to GDP. Wondering how all of those play out in your view?

PHILIPPON: The two major differences between the U.S. and Europe, with respect to the current crisis, I think, A, the central bank; and B the growth prospect.

So no matter what we think, it's still the case that we believe the U.S. economy is going to grow over the next five years. Maybe not as much as we'd like, but something is going to grow. There is no question about that. That's less obvious for some -- for some (sovereign ?) economists in Europe. That's a big deal if you think about the credibility of your debt, because, you know, if you grow, it's a lot easier to pay back your debt. So that's one big difference.

The second big difference, of course -- and I think the main one today, for sure -- is the central bank. In a sense, if you look at it -- if you were to look at this -- (inaudible) -- and you would, like, ask yourself, who should be doing quantitative easing, well, the answer would not be the Fed. It would clearly be the ECB. And the one place where quantitative easing would have a huge positive impact would be Europe, right. And there it's the opposite.

So why is it that the Fed is doing it, even though the returns are much lower and the political risk seems to be even significant in the U.S.; where, in Europe, where the return would be very high, the ECB is not doing it? Well, the answer is because, to do that, you need a credible commitment to sensible fiscal policies going forward. If the ECB starts doing quantitative easing on long-term Italian debt (actually ?), that would certainly help a lot the economy to grow over the next two or three years.

The trouble is, if you get the Italian government off the hook, are they still going to do the reform that you would like them to do? That's the issue. And that's -- that is the main difference between Europe and the U.S. And you can see it very well in the data, doing some research on that. It's very interesting to see that the initial shock -- so think about, you know, 2007, 2008 the big shock happens. It hits everybody. And remember, German GDP fell more than U.S. GDP, right. So the shock was hitting all the countries.

Now, in the U.S. -- people think of the U.S. as one country, but in fact, if you look at different, say, U.S. states, you're going to see that Nevada, Florida, California got crushed, while Texas, New York, Pennsylvania were doing just fine, OK. And now imagine that you look at the collection of states in the U.S. and the collection of states within the eurozone. What you will see, almost exactly the same dispersion.

So employment -- the employment rate fell about 15 percent in Nevada, 12 percent in California. It was 12 percent in Greece and over 10 percent in Spain. And on the upside, Texas essentially had no significant recession, and neither did Germany. So the dispersion is very much the same.
So the idea that the U.S. has one business cycle, where all the states are hit the same, that's not true. There was also a lot of dispersion. And yet we don't have the second round where we start to worry about the solvency of Texas, versus California, versus Nevada. That doesn't happen.

Well, the muni market -- perhaps we can discuss that later on, but it's small anyway, relative to the federal debt market. And so that's, you know, that you can see it vividly, the reason that these issues don't arise in the U.S. is because the state don't have -- don't have their own debt, and therefore the solvency of the state themselves, that's not a big deal. And Europe is exactly the opposite. And so now the solvency of the state is a big deal.

And then second side, of course, which, as you said, is the feedback from the states to the banks. So I don't -- I don't think that the main issue is the size of the banking system per se. Just because, remember, in the U.S. you use the markets more to -- (inaudible) -- credit. But the bank branches are not that big, but then you have the money market fund, which is essentially backstopped -- you know, is a big systematic part of the system, and for all practical purposes, acts like a bank. And definitely eurozone is on the hook if there's a big run on the money market funds. I think we know that.

So if you add that up, that's not going to make a huge difference I think, in terms of the big picture. What is going to make a big difference is, again, the state law issue, which is Italian banks have Italian paper, and French banks have French paper, and so and so forth. So then, locally, all these effects, the feedback from the branches of the banks to the solvency of the sovereign, this feedback get together very quickly at the state level.

So imagine if California had banks, had a lot of debt, and all the Californian banks only hold the paper from California. Well, they would be in big trouble, and they would have spillover to their neighbors, OK. Fortunately, that's not like that. The banking market is completely globalized within the U.S., and so there is no sense in which a state being in trouble, even in a credit crunch -- (inaudible), OK. That's the main difference.

So I think, again, if you really go down to the basics, it's really about the different behavior of the states within the system. That's the fundamental difference, not the rest. At least that's my view.

BROSENS: (Off mic.)

STEIL: With regard to the ECB, I think its powers are much less than many people impute to it. For example, last week at Mario Draghi's first press conference enormous attention was given to the quarter-point rate cut. That will have virtually zero effect on the position of the periphery countries.

To put some numbers on it: Before the crisis -- even, in fact, up to mid-2010, the correlation between the ECB's policy rate and the Spanish three-month government borrowing rate was virtually 100 percent. That is, the ECB dictated the movement of the Spanish government's borrowing rates, and those rates in turn dictated borrowing rates in the private sector in Spain. That's how monetary policy works in developed countries in normal times.

The correlation today between the ECB's policy rate and the three-month borrowing rate in the periphery countries is zero. It has absolutely no impact. Investors are not interested in the ECB's policy rate. With regard to the periphery countries, they're only interested in default risk. Default risk is what determines the spreads.

Now, Mario Draghi made another comment that didn't get nearly as much attention as I thought it should have. He said, quite provocatively, that the European Central Bank is not a lender of last resort for eurozone governments, and indeed the eurozone didn't need the ECB to act as a lender of last resort. That was an extremely forthright statement. There are many dimensions to it.

I think, first of all, right now he's trying to have it both ways -- trying to be "a little bit pregnant" with regard to Italy, which is a catastrophic situation. It doesn't do any good to stabilize Spanish government borrowing rates at around 7 percent. You either have to go all in, or make it clear that this is beyond your capability here, and that the eurozone creditor governments need to act.

Now, I actually think that the eurozone creditor governments do need to act, and for this reason. The ECB only has 81 billion euros in capital. That could easily be wiped out with, say, just a 25 percent haircut in PIG debt -- Portugal, Ireland and Greece. That's it. Gone.

Now, a central bank can operate for a brief period without any capital. But eventually any central bank will have to tighten monetary policy at some point in the future. And in order to do that, they need assets to sell. And unless the market believes that the ECB is going to be credibly recapitalized, there will be a god-almighty run against the euro and it will, quite frankly, collapse.
That's not the same situation as the Feds in the United States. In fact, if you look at the Fed's reported capital, it's only $58 billion. They made good paper profits off the crisis, I should add, which is very good for them. But nobody doubts that the U.S. government is ultimately going to stand behind the Fed. But investors do doubt that the German taxpayer is ultimately going to stand behind the ECB. And that's a big, big problem.

And I think that's one of the underlying reasons why the ECB is so tepid with regard to the crisis. They don't want to make themselves a ward of Germany, because they don't know if they're ever going to get out of that poorhouse once they get in.

The German public may decide, at that point, enough is enough. That may be a bad decision, but it's still going to be a decision that they can take in a democracy. And I think that's a big risk.

BROSENS: Play devil's advocate a little bit.

I think Mario Draghi is viewed as much more pragmatic, I think, than (Trusche ?). And while he has a moral hazard issue, in terms of immediately coming into the support of Berlusconi -- and still Berlusconi-led government -- if in fact, Italy heads in a direction of a technocratic government led by Monti, and there is confidence that they're going to do the economic reforms and austerity measures that are needed, I'm not sure that there's much choice other than to come in, in a very significant way, and try and get rates down.

And I guess I'd challenge either one of you, in terms of why that wouldn't be the case.

PHILIPPON: I think it would work. I mean, I totally agree that the usual chain of monetary policy, where you fiddle around with a short rate. That's peanuts. That's irrelevant. And so that was completely irrelevant in 2008 and '09 in the U.S. as well, which is why the Fed went into what we call unconventional monetary policy, or also known as quantitative easing.

And quantitative easing, number one, was a huge success. I mean, I just recently discussed a paper at Brookings, doing a micro-estimate, looking at detailed data on all possible spreads you can think of in the U.S., looking at exactly what QE I did. And it's a huge success for all markets -- the corporate bond market; of course, all the mortgage-backed securities. That's completely unconventional. That had nothing to do with their policy rates. That's quantitative easing.

So I'm -- my presumption is, if they were to do it with the Italian markets, it would have the same efficiency. It would work. But I think -- and where we probably agree is, the paradox is if -- you know, if you're credible, you announce you're going to do it, and you're going to do it big, and without limits if necessary. And if that's credible, then the great thing is in terms that you don't have to do that much.

That's the paradox of it. If you're credible and you announce something big, you don't end up having to do a lot. And that's -- we had the -- (inaudible) -- scenario. That's the economy of Switzerland. But if you announce very little, and it's not very credible, you end up having to do a lot. OK, that's the product -- (inaudible).

The problem is, to announce a lot they need two things: They need credibility on the Italian side -- that is, they need to know -- and, of course, Draghi and Monti know each other very well and respect each other very well, so we can be sure they're going to be able to coordinate. But it's obvious that Draghi cannot move before Monti is in and with enough power to implement the reforms that everybody knows are necessary, OK. So they need that, on the one hand. That's on the Italian side.

And then they need the German side, because they need to be able to say, we're going to go in -- we're going to go all in, and we are backed by the rest of the eurozone, which essentially means Germany. If that's credible, that is not going to be very costly, and you can predict that the ECB is going to make big paper profits just like the Fed did. So I think that's the position we're in right now.

STEIL: Politics matters very much here. Ultimately Ben Bernanke is far less constrained by Ron Paul than Mario Draghi is by, say, Angela Merkel. That's not to say that Ben Bernanke can do anything he wants in terms of monetary policy innovations. Congress granted his body independence in terms of making monetary policy, and Congress can take it away. But we're not very close to that.

It's not surprising that the ECB is far more reluctant to engage in those innovations since its ultimate backstop comes from Europe's -- the Eurozone's largest creditor country, Germany. And the German public, the German political class, is very, very uncomfortable with these sorts of monetary policy innovations. And so the ECB's room for maneuver is ultimately limited.

As I say, politically I think it would be a disaster for them to have to be recapitalized. I think whatever independence they have right now would be permanently removed or they have to go down that route. So they're trying to avoid it.

BROSENS: One last question and then we'll open it up to the members. Two issues, Thomas, that would seem to present challenges to the ECB. One is so much credibility been squandered that it's going to be hard to get back. And the second issue is there seems to be, in a sense, a return to home bias. You talked about it in terms of some of the French banks divesting Italian assets. That's really from a capital perspective.

There is also a growing perception that financial institutions shouldn't own assets outside of their own country for risk reasons. So you look at the money markets in the U.S. owning European bank short paper, the problems that MF Global has obviously run into, the questions about Jefferies. You're seeing it in Europe as well in terms of questions about banks owning the sovereign paper outside of their own country. It seems like that's going to also prevent -- present a fair bit of -- a fair challenge to the ECB in terms of stoking up all of that supply.

PHILIPPON: So there is no question that ECB lost a lot of credibility with the way they dealt with Greece. In fact, it's quite striking that, not so long ago, at least early on in the financial crisis, the ECB was seen as the most credible central bank, ahead of the Fed, because they reacted better to the initial round of financial disasters, like, you know, in the fall of '08.. They were the first to have the credit lines open. They did some of the moves before the Fed.

And also there was the issue of the banks from the U.K. seeking liquidity in emergency, and the EC was much faster at doing that than the Bank of England. So in fact, there was a time when the EC was seen as, well, that's really impressive; they are successful. And they lost everything on the sovereign side. There is no doubt about that.

What is not clear in my mind is should we blame them or should we blame the politicians within Europe? That's a debate we can have. Is it the ECB? I mean, you know, I'm an economist. I don't know. We are not very good at making predictions.

There is one prediction that all -- the ones I talked to, at least, with me that the IMF or some of those places in Europe we all agreed on is Greece is not solvent. So that's not a liquidity crisis. Greece a year ago was not a liquidity crisis. It's a solvency issue. That is, take a big haircut and then get done with it, you know. Don't waste time. Don't waste a year and a half doing half-measures. It's obvious it's not a crisis of liquidity.

I think the ECB also knew that, and my sense is either they don't have the guts to say it or they have too many political constraints to say it. I don't know which one is true. But it doesn't matter. The outcome is they lost their credibility on that. So next time they're going to say this country shall not fail or they'll say, yeah, well, you said that for Greece. And so that's a big issue; I totally agree.

There's a separate issue of, you know, what's going to happen to -- are we going to move away from financial globalization? I don't think I can answer that in two minutes. I think there is certainly a tendency for that. I don't think it's going to be an issue just for the ECB, by the way. I think it will become an issue for the U.S. as well, for banks in Asia as well.

In the short term, it's clearly an issue for the ECB, just because the money market funds pulled out of funding U.S. dollars short term to EU banks. So now what happens is dollars flow from the Fed to a swap line in Frankfurt, and then that's given back to the banks in Europe. That doesn't sound like a good government solution.

And I -- you know, and as long as the crisis is going like that in Europe, I don't see the money market funds putting their money back into short-term EU banks' paper. So I don't think that's -- so that problem is here to stay. Whether it's going to disappear in the long run, I'm not sure. But there is a real chance we're going to see retrenchment from financial globalization, because it looks like this currency mismatch is an issue.

And the other one is, remember what governments do when they have to pay back their debts. That's financial repression, and that's something that has been going on for a thousand years. Every big episode -- and I'm talking really a thousand years, because all the historical periods of government having to, you know, reduce significantly their debt, every time it involved some form of financial repression, which just means forced saving at home. And so whether that's going to be part of the equation going forward, I think it's likely, at least; and not just in Europe, by the way. I think the same is going to happen here.

STEIL: I would be far harsher than Thomas on the ECB with regard to why they deny Greece's insolvency. They were a big Greek creditor. They were talking their book, just like Josef Ackermann at Deutsche Bank. He said it would be an utter catastrophe if Greece were to restructure. Charles DeLauro (sp), who represented all the big banks in Europe, said it would be a catastrophe.

The ECB was just another big creditor talking its book, saying it would be a disaster if it had to take a haircut. And I thought that damaged their credibility enormously. But I think the reason why they persisted in that position was that they were very concerned, ultimately, about their capital.

BROSENS: We can now open it up for questions for the members; if you can state your name and affiliation, please.

QUESTIONER: Rob Rosen. Do you think that any Eurozone solution would require significant -- I was going to use the word massive, but significant liquidation of gold reserves in order to provide leverageable liquidity to allow for the large solution that I think both of you suggested was required?

PHILIPPON: I think gold per se is not going to be a key issue. The issue is going to be inflation, which is, I mean --

STEIL: Things go together.

PHILIPPON: Yeah, exactly, to the extent it's going to influence inflation, then yeah, that matters. There are two scenarios. One scenario is you have some -- it's to convince Northern Europe to accept some degree of inflation. And then the rest -- that is, the southern part of Europe -- stays at zero wage growth, perhaps tiny bit of negative nominal wage growth, and then, you know, if you have a three-person difference between the north and the south, each year you gain 3 percent competitiveness. After 10 years you're at 30 percent. That solves a lot of the issues. So that's the growth and inflation scenario.

Then the barometer of that scenario is how much inflation is Northern Europe willing to tolerate? And my hunch is actually the answer is not much. And I think that it's not realistic to think it's going to be above 3 percent, and I don't think it's very realistic to think it's going to be sustainable above 2-and-a-half (percent), if I had to guess. That's my hunch. I don't have a -- I'll try to show that, but I think my understanding of people's preferences and the political realities in Germany is -- I don't buy the idea they're going to be willing to accept significant inflation.

OK, so that means what? That means that 2 percent is going to take a long time unless there is also deflation in the south, which is exactly what's happening now. The thing is, that's going to come together with big unemployment. And then the big issue is that makes it harder, at least in the short term, to pay back your debt. That's why this scenario is such an inefficient one.

But these are the two scenarios. You know, you're going to have either massive deflation in the south or some inflation in the north, together with either no inflation or small deflation in the south. And that's these are two scenarios that can keep the Eurozone together.

I don't think, actually -- I would be very bearish on the second one, because I don't think it's significant deflation in the south for a long period of time. I don't think it's going to be particularly sustainable. And therefore, I don't actually buy that scenario at all. I think that's not -- I don't buy that thing. I think that would not be sustainable. It would increase the debt burden too much and it would not make the -- it would make the political commitment to reform almost meaningless. That's why I think inflation is going to be the key.

BROSENS: But what you're saying is effectively austerity increases the deficits, decreases GDP, increases all of your ratios. And so the austerity that you actually have to perform is --

PHILIPPON: It's terrible.

BROSENS: -- is too big.

PHILIPPON: But the thing that's striking -- I mean, I don't know if I was very struck by that. I thought the IMF learned that from the Asian crisis, but they did exactly the same to Greece, I mean, literally. Well, that's kind of surprising in a sense, is that you would at least think that they would have learned from the Asian crisis. I think the politics is very different, so perhaps that explains some of it. But in terms of the economics, it looks like the same mistake again.

BROSENS: Another question? Yes.

QUESTIONER: (Off mic) -- Pace University.

What does it mean for a central bank to be backstopped by the central government? At the end of the day, doesn't the Fed print its own money? It doesn't have to borrow from the U.S. government.

STEIL: This is true. But if the central bank has no assets, then it can't tighten monetary policy. How does a central bank tighten monetary policy? It withdraws currency from the market, and it does that by selling assets; for example, the U.S. -- in terms of the Fed, usually it would sell treasury bonds. The Fed has to have treasury bonds. Likewise, the ECB has to have assets to sell in order to tighten monetary policy. Those assets ultimately have to be provided by the creditor member states.

Now, Thomas and I would agree completely that the ECB is not going to need to tighten any time soon. That's not the point. The point is, if the markets were to come to the conclusion -- for example, if the Bundesbank were willing to sell all its gold to fund the bailout and the ECB were to go down to zero or negative capital position, if the markets were to conclude that this institution is never going to be recapitalized because it has no credibility with its ultimate financier, Germany, then the Euro is finished. There will be a massive run on the currency, just the way we've seen with developing-market currencies in a financial crisis.

So that's the problem. Sure, they can print. That's the easy part. But you have to have credibility as a central bank that once the crisis is over, you're capable of reversing your expansionary policy. That credibility is central.

PHILIPPON: You know that Tom Sargent, who was my colleague at NYU, got the Nobel Prize this year. And among other things, he's famous for looking at this issue. At the end of the day, there is one -- (inaudible) -- from the government -- (inaudible) -- together. That's the one that has to hold. No matter what happens, it has to hold. But, yeah, this one could be on the money side or the fiscal side. There is one budget constraint.

And so if you remove entirely the fiscal side, then that means that you're going to have -- the only solution will be massive inflation. And that's probably not going to be a very good one -- (off mic).

BROSENS: Yes.

QUESTIONER: I'm Padma Desai, Columbia University.

If the European Central Bank will not and cannot play the role of lender of last resort in order to bail out EMU governments and banks, can the European financial stability fund be augmented from its current size of, what, 440 billion Euros, supplemented by IMF funding? Can it be augmented by liquidity flow from China? Or is this a nonstarter? And how do European leaders react to that suggestion?

STEIL: Politically, this is the most critical issue that's dividing Germany and France right now, whether that fund needs to be boosted and to what extent, also how to do it. There's quite naturally great political resistance to sinking more money into the fund on balance sheet. That's why there's been talk of, quote unquote, leveraging the fund, essentially turning it into a CDO, collateralized debt obligation. That could be extraordinarily risky. It means that that $440 billion that would be the equity tranche of the CDO, becomes far more risky than it is today. In other words, more likely to be depleted.

I think it's clear from the past two weeks of international discussions that China is not going to play a role through the EFSF. They might be willing to play some sort of role through the IMF but only at a price. They're going to want more influence in the institution, and I would contend that they would also make it a condition of their increased support that there shall be no more discussion in public criticizing the Chinese exchange rate policy.

So I think we're in a very difficult position right now. I don't yet see the political will in Europe, meaning in Germany and France, to boost that fund significantly and that money is not likely to be forthcoming from persons outside Europe.

PHILIPPON: I was always skeptical of this idea of China bailing out Europe. China is a complicated country. They have internal politics. People in China are not very keen on the idea of throwing money at Europe's problem. I think that's a non-starter politically in China. So they would only do it if they get really big political gain from abroad, mentioned like, you know, the extent of it in the IMF. So I never thought that would actually fly.

The biggest -- I mean, so if France wanted to turn the EFSF into a bank, which is very close to what the U.S. did. You have seen money which is physical money, if you want and then you lever it with monetary policy. That's pretty much exactly what the Fed and the Treasury did together. And you can solve all the -- (inaudible) -- on it. And again, that's the rational solution from an economic perspective. The trouble is, you do it in a country that has a fiscal union like the U.S. Then it's fine. But you should do it in a country where it's not a fiscal union then it's not fine. And Germans said no because they don't want to give a free blank check to the Italians. That -- it comes onto that.

The thing we have to remember, the eurozone as a whole doesn't have deficit. If you aggregate the eurozone together, it's actually probably more stable than the U.S. in the sense that its current account is balanced, it's not borrowing from the rest of the world. It's balanced and its debt-to-GDP ratio altogether looks very much like the one in the U.S. Whole package seems kind of similar.

So there is enough money in Europe to solve its own problem. It's all about politics. And that's so it comes on to that. That's why I don't think -- then when you read this -- I think what I'm trying to say is, when you read this news about outside involvement in Europe, don't think about economics as much as politics. That's the way to interpret it. Because we need a bad cop in Europe. That's the bottom line, OK. Because otherwise we're never going to get reform from Spain, Italy and Portugal. So we need the bad cop. The question is, who's going to be the bad cop?

When you know European history, you know Germans are not going to be great bad cops. And they don't want to do it, for good reasons. They say, you know, that's not the job we really want to do. Then who is going to be the bad cop? Well, A, the market guru -- (inaudible) -- Berlesconi? It's not like we haven't tried, but the market did it. And then the IMF because then you can blame Washington. That's great.

So involvement of outside creditors, you have to think of it as these are the guys who can be bad cops, you know. If the Brazilians say, well, you know, we've loaned you money; we want our money back, so you put your finance in order, that's more acceptable to the Italians than if the Germans say the same thing.

So it's not really -- the quality of money is not the issue here. If Europe had no political problem, it could solve its own problem. That's no problem. It's the politics that matter in that case.

BROSENS: Although the EFSF has gone in a direction -- while the Germans did not allow them to leverage it, they're heading in a direction of using a good portion of that 440 billion (dollars) in as a first-loss piece for the purchase specifically of Italian and Spanish debt. And whether that works or not is an open question.

STEIL: This idea, at least the way they've characterized it right now, I think it's foolish. They're talking about guaranteeing the first 20 (percent) to 25 percent of losses. But no sovereign is going to restructure 20 (percent) to 25 percent. When you're in default, you're in default, 50 percent-plus. So that's not going to calm the markets, 20 (percent) to 25 percent.

BROSENS: But it will lead to lower cost of funds. It may not make it a risk-free asset by any stretch, but if you --

STEIL: I personally don't believe it will if the markets still believe that there is significant default risk because they are going to know that any restructuring is going to involve a haircut that is much, much larger than what the EFSF is going to absorb.

PHILIPPON: But for Italy you could -- well, I think there are two issues. One is, this 20 percent is for the new bonds, not for the old ones. So that doesn't stabilize the Eastern markets. It's only for new -- borrowing. And then there are two issues. One is the one that we just mentioned, which is, you know, if you believe the haircut is going to be 80 percent anyway, 20 percent of that isn't that much. So it helps for medium restructuring.

But even there you have to be careful about, you know, are you going to be sure that this is going to be a real insurance policy? That is, these things are not going -- like when Germany or -- (inaudible) -- creditors lend money to these countries, if they lend senior, that can completely undo the 20 percent insurance you get, OK.

Now if you read the news from Europe, and if I tell you we have an instrument which is supposed to give you insurance against sovereign defaults, you should pay for that because if there is default, you are going to get some insurance back. Well, I don't think you would buy that insurance today because that's called a CDS and we made sure that they don't work. So the 20 percent is the same thing. It's precisely the same thing, if you think about it. So is that more credible? The same government would essentially try to get rid of the sovereign CDS market are now offering their own CDSs?

So again, you see that the issue is politics. I don't think that's completely credible.

BROSENS: Other questions? Yes. In the back.

QUESTIONER: Pierre -- (inaudible) -- from the French newspaper -- (inaudible). You have stressed the lack of coordination within the eurozone. I was wondering what do you make of the deficit of decision-making capability in the EU, and do you think the French elections could have an impact on the policy response in May? Policy response to the European debt crisis.

PHILIPPON: So there is no question that if there had been a better long-term working relationship between Sarkozy and America some of these issues could have been dealt with better. So that's a fact. So we are paying the cost of not having two leaders that are really on top of the game, and definitely not really on the same level one day. So they don't seem to be working very well together. Let's put it that way.

And so we would hope that -- and that's -- part of it is probably linked to the behavior of Sarkozy in some cases, so you would hope it would be marginally better if we have a different president. But deep down, though, you have to realize that I think the bargaining power between France and Germany has changed and is not going to be reversed any time soon, just because the fiscal realities are like that.

You know, Germany has the credibility, France does not. That is not going to change any time soon. So I don't -- in that sense I don't think it's going to have a very big impact. I think the key is more the German politics in and of itself than the interplay with the French politics. That would be my hunch.

BROSENS: Yes.

QUESTIONER: (Off mic) (RTHA ?) in Hong Kong. Along that same line, Mrs. Merkel yesterday spoke of more Europe as the solution, and wanting to do something, that there have been intense discussions with the French about something. It seems that this is moving rather fast in terms of Greece maybe choosing to pull out if they can't get a government, to say nothing of Italy.

I wonder if you'd say more about the implications of alteration of the system, someone leaving, northern zone, southern zone.

STEIL: I think the eurozone could survive the pull-out of a small periphery country like Greece. Would be touch and go because the financial repercussions in the markets would be enormous, but I think that's possible. If it goes beyond that, I don't see it persisting.

I mean, there's been talk about the reverse happening, that Germany and a few northerners would essentially leave the euro and the euro would be a sort of Club Med-like currency for the remainder. I don't see that as particularly credible. That currency wouldn't survive, and the deutschmark that would be reintroduced, whatever one might call it, would appreciate so radically that it would have a terrible effect on the German economy.

No one has an interest in seeing this unravel. But when we talk about more Europe, that has to be translated into certain concrete actions. One proposal has been, as you know, to create a Eurobond, not bonds issued by Germany, not bonds issued by Italy, but by the eurozone as a whole, and Germany is the one who is primarily resistant to this particular innovation. That's a significant political obstacle to moving things further in that direction.

PHILIPPON: I think there is no question that we're going to need more integration. You can read it both sides. You can see actually what we achieved over the last year and a half under intense pressure. It is a lot more than I would ever have expected. The fact that we have an active discussion about the Eurobond, even though the Germans are definitely against it as of now, and for good reasons. Again, I go back to my same point. It's not possible for a German chancellor to say yes to the Eurobond until they know for sure they can control deficits in the other countries. So then the question is what mechanism do you have in place to do that?

By the way, the same exact story played out in the U.S., 1840 (ph) in the U.S. You have nine states that are bankrupt, and big ones. And they all asked for federal bailout. And they were -- at that time loans were extended and U.S. was pretty big relative to federal debt. And it was actively discussed in Washington and the outcome is no. Go bust. And they did.

After that you have strict limits on the amount of debt that states can have and then it becomes clear that states don't have that much debt and all the debt is federal. So that a big -- (inaudible) -- the birth of the U.S. bond, OK. It didn't happen smoothly. It happened through big crisis with huge effort.

So in Europe of course the Eurobond is something that is required in the medium run. The question is how you get there. And the trouble that I have with EU policymaking is that they are not very good at tracing the path of how to get there. It's one thing to say, oh, it's hard. Yes, I know it's hard. But, you know, what are the concrete steps you could at least start so that we see how we would potentially get there? And with constraint you can put on a sovereign government on the spending side so that you could start by having some Eurobonds.

The Eurobonds -- one thing that's very important to realize is it's going to have to be some kind of -- either you put very strict limits on how much more we can -- and Italy and other guys, other countries can do. Or you have to have two types of bonds. You have a local bond which is backed by the EU, which it was proposed as blue debt, red debt. The blue debt is something which is issued at the EU level, backed by the entire eurozone, and that would of course would trade like goods, very low yield, very high liquidity. And so that's providing financing for the government. But then it's capped at some limit -- (inaudible) -- of that.

Beyond that limit then you're on your own, which means at that point you have the market price which prevents you from raising too much. So that solution has -- going back to my earlier point, that has the market being the bad cop because once you've issued your allocation, your quota of blue debt, well the next step is going to be not backed by Germany any more so you're going to pay the high price for that. And that's what prevents you from going crazy and borrowing too much, and that's the market being the bad cop. At least it's credible.

STEIL: Bank supervision and deposit insurance will also have to go pan-European. You remember the crisis didn't start just in Greece, which had a large sovereign debt problem. It started in Ireland and Spain, which had banking sector problems. So early on in the crisis Ireland issued a blanket guarantee on all the debt of its six largest banks and it's reaping the consequences of that now. We can't have a situation like that again in the future. That's why Ireland's in the position it's in now. That's why the ECB is so massively exposed to Irish sovereign debt. So banking supervision and deposit insurance will be a fundamental area that will have to be reformed on a pan-European basis.

BROSENS: I think that concludes our session. It's now noon. One thing that strikes me in terms of the comments have been made in terms of the limits of ECB is it's been said that the Fed in its actions are haunted by 1937, whereas the ECB is haunted by the hyper-inflation of Weimar, and they are still acting accordingly. So thank you. (Applause.)

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THIS IS A RUSH TRANSCRIPT.

GILLIAN TETT: Well, good morning, everybody, and welcome to the second session of this fascinating debate.

Those of you who were in the first session will have heard Alan Greenspan say that he thought the major problem in the United States is Europe. Well, I think there are plenty of people in the U.S. today who might beg to differ a bit because America is not without its significant problems as well. Never mind that the economy remains at best stagnant or troubled, there's also the problem of rising budget deficits, rising debt levels and, of course, a political system which appears to be pretty dysfunctional right now in terms of dealing it -- with this. Not quite at Italian level, the dysfunctionality, but not far off, necessarily, at times.

And I can't think of a better person to discuss this than Jacob Lew, who is coming up for an anniversary. Next week he will have been director of the Office of Management and Budget for exactly one year. I don't know whether to congratulate you or commiserate -- you -- (laughter) -- perhaps congratulate you for surviving this far.

And those of you who have got his bio in your pack will see that there is scarcely anybody better placed to hold this position. In fact, much of his life, thus far, his career, has been a dress rehearsal for this position. You have already served in this position before, but you've been around in Washington since the late 1970s and as far back as 1983 were involved in bipartisan discussions to try and tackle the problem of Social Security. I'd like to ask you if you feel a certain degree of "Groundhog Day" about your job right now.

JACOB LEW: Almost every day. (Chuckles.)

(Laughter.)

TETT: (Chuckles.) Well, the good news is, you have plenty of training for this role. The bad news is that the problems look more insurmountable than ever before.

So I'd like to start by asking you: We are all awaiting the verdict of the supercommittee, which is due to report, I think, on November the 21st. How optimistic are you that the supercommittee will actually make any breakthrough in terms of tackling the mounting fiscal problems?

LEW: I have lived by the principle that if you become a pessimist, it's a self-fulfilling prophecy. So I am self-avowedly more optimistic than the norm. I think one of the diseases in Washington is that everyone is afraid that they're going to appear naive, so they predict failure.

There's reason to be cautious now. The substantive challenges the supercommittee has very substantial. The political issues that they're grappling with are very substantial. But I still think that the right bearing is that they have a couple of weeks, they have an important job to do, they need to be given the space to do it. I think you're seeing on a daily basis that conversations are continuing on very difficult subjects.

I wouldn't say we've seen the kinds of breakthroughs that would make me say it's 80-20 going to be a huge success. But I think it's substantially premature to write it off as having failed. I think if you look at complicated and controversial undertakings like that which is the mission of the supercommittee, it almost never looks like it's going to come together until the very end.

We're now in a critical period. I think if you look at the importance of what they're doing, the need to act is, I think, clear, and I think the need to act sooner rather than later is clear. The same action taken today versus a year from today would be much more powerful in terms of restoring confidence both in the United States and in the international economy.

So you know, the president spent much of the summer deeply engaged in negotiations; in the course of those negotiations showed that he was willing to go quite a substantial distance to reach a balanced, fair compromise, to do something quite big.

That obviously failed. I would contend it failed because there was an obstacle on the other side in terms of dealing with taxes as part of a balanced package.

I think that the supercommittee is now grappling with that same set of issues. I hope that all the parties are willing to move on these kind of core issues. I think we've seen some movement, some hints of movement. We will in the coming days whether they can -- they can close.

You know, the president submitted to the supercommittee in September his own unilateral plan of how we could reduce the deficit, the debt by $4 trillion. There were items in there that have been little noticed but in any other period that I've been in Washington would have been seen as acts of supreme courage to go out on your own and propose them.

So between the negotiations and the plan that the president submitted in September, we've tried to give as clear a signal as to where we think the lines are for a reasonable, balanced package. And we remain engaged in conversation, though this is really their job and they need the space to do it. And sometimes in Washington that means going into rooms and having private conversations, which is what they're doing.

TETT: So what for you would constitute a success on November the 21st? A clear-cut plan to get 4 trillion (dollars), 1 1/2 trillion (dollars)? You know, what for you are the benchmarks of success?

LEW: Look, the president made clear in the document that he submitted to the supercommittee that there's a path to $4 trillion that is achievable. There's no doubt that would be a powerful signal to the markets, to the economy, to the Americans who are looking to see: Can their government function?

I think realistically they have a mandate to do $1.2 trillion of deficit reduction in order to avoid having draconian cuts come in a year from January that would cut an enormous amount out of defense and domestic spending.

So I think that the (band ?) for the supercommittee is, can it take that minimum action to avoid what I think all parties agree is an undesirable set of policies? It was designed to be an undesirable set of policies, because it was meant to be a lever to focus Congress on acting, and replace it with a sensible, balanced package. A first step would be better than no step at all. You know, a big step would be better than a small step.

TETT: So 1.2 (trillion dollars) avoids the fail and 4 trillion (dollars) gets you a straight A?

LEW: I think 4 trillion (dollars) would be seen by almost everyone as a very substantial accomplishment. I would not hold out a high degree of optimism at the high end. I think that the question now is, is there something in the not-failing category that could both be accomplished and restore confidence.

I think if you look at the political debate in Washington, really this whole year, it has not been a good thing for the country and for confidence in our institutions to be hours away from a government shutdown in April, and really not necessarily, because the agreement that was reached should have been reachable without that kind of, you know, drama and brinksmanship.

July and August was very damaging -- the notion that there were a significant number of members of Congress who actually were arguing that the default of the United States was an acceptable policy option. Now, that obviously wasn't a view shared by the president; it wasn't shared by the responsible leaders, but we got right down to the wire. I think the fact that Congress is now beginning to try and find a way, you know, one way or another, to do its business in a more business-like way, both in terms of funding the government for the next year and in terms of dealing with the supercommittee's challenge, the small accomplishments would be a big reversal from what we saw earlier in the year. And I think that would, in addition to the economic impact, be quite important.

TETT: Right.

Well, I'm going to get granular in a minute and ask you a bit about defense and entitlements and taxes. Before I do that, though, I'd like to ask: The president is currently en route to Honolulu, I believe, which sounds to me like a vastly nicer place to be than in Washington and spending time hanging around the supercommittee. But at what point does the president actually get engaged in the supercommittee? I mean, is he going to stay on the sidelines (right the way ?) through? Do you think he'll come in and try and break any deadlock?

LEW: I think the president's engagement in the fiscal policy debate this year has been anything but on the sidelines. He spent months in March and April, in June, July, August, not engaged on a periodic basis but an almost full-time basis. The end result is, there is total clarity of his views on these subjects, an unprecedented amount of clarity.

Usually, you start a negotiation not knowing where the other party was willing to go. There is now a blueprint of what we would do on our own, where we would have gone in a true big bipartisan deal. And there is a political challenge for members of Congress to come together and do their work. So I think that being in the room and being on the sidelines are not the issue.

We have -- we have, I think, done the right thing by putting a comprehensive plan in front of the committee. I frequently refer members to that plan. I think it's actually been helpful to them as they've gone through the issues. They have some fundamental political challenges that they're working through. Subsequently, the administration has laid out a very detailed set of ideas.

And in terms of the president's kind of physical whereabouts, I think, you know, it's safe to say that the president is never out of reach. He can reach us whenever he needs to, and we can reach him whenever we need to. The president has a lot of responsibilities. You know, organizing a session like the one he was going to, where we get together with our trading partners and try to develop a future vision of Pacific trading that will grow the American economy -- that's also part of the president's job. And the president is doing his job, and it's really time for Congress to do its job.

TETT: Right.

And one other question on the president and the political climate. I remember talking to Secretary Geithner earlier this year when he was meeting with European investors and then the Asian investors, who were completely befuddled by what was going on and shocked by these threats of a government shutdown and default.

And the argument that was emanating from parts of Washington back then was: Don't worry. This may look completely bizarre to the rest of the world, but this is normal American politics. And this has been going on for decades. It's a game of brinkmanship. This is just how policy is made.

Given that you have been around Washington since the late 1970s, do you agree with that verdict in terms of what's going on now? Or do you think something has changed fundamentally in the political climate and the machine, which is making it actually harder than you've seen in your own career to get an agreement?

LEW: I would actually go to both ends of that, both what is happening in Washington and what is the context in which Washington's actions are playing out. And let me start with the second because I actually think it is the bigger factor.

You know, in a -- at a time when the economy is smooth and there's not a world that's on the edge of chaos in a number of important places, Washington brinksmanship is very deep inside the newspaper, and it may not be highly consequential. At a time when there is a recovery from the deepest economic downturn since the Great Depression, when there are very substantial challenges in Europe that all of us in this room and all of us in Washington follow on a day-to-day basis, there is an extra urgency for Washington to show that we can take the things that we control and that we can do it in a way that meets a standard of performance that the public expects. That's what the president was calling on Congress to do.

I think Congress did, in a way, handle it the way Congress normally handles things, which is you wait till the last minute. You don't make a concession that could be difficult until it was clear you had no choice. And you know, I, for one, was quite outspoken in cautioning members that this was not a time when that was a good way to proceed, that if -- accomplishing an agreement on the debt limit when we did had less value than accomplishing that same agreement a month before without the drama. Now, I think it is fair to say that that -- you know, debt limit votes have had that kind of last-minute quality before. I think it's more consequential now.

I do think inside, the system has become more polarized. There is, I think, the ability for a relatively small number of members with rather extreme views to kind of force issues into sharp focus and contrast that makes it harder to move to where the reasonable compromise is. Were there a willingness today to do things in a truly bipartisan way, as there were at moments in the '80s and the '90s, I think there's a broad consensus about some sensible things to do. But that requires leaders being willing to take action with part, but not all, of their caucus. I don't think we see that as much today as we have at some other points.

And ironically, in the end of the day, you look at how the votes have finally broken the logjam -- they've had that familiar pattern. You know, there have been, you know, 50 or 70, you know, extreme votes that wouldn't go along with a reasonable compromise. But it was just very difficult to get to the point of that being accepted as the reality. If you went in knowing that and said, what can we do that could get a majority on both sides, I think it would expand the scope of debate, and it would be a much more civil discourse because people would get out of their corners.

TETT: But in practice, almost the only time you've seen bipartisan agreement or action in the last years was in the autumn of 2008, when the markets were crashing so dramatically that it actually prodded Congress into passing the TARP. Do you think it's going to take a market crash, a real swing in Treasury prices to actually get that kind of gridlock broken in Washington? Because right now, of course, America is being giving -- given pretty much a free pass because everyone is watching Greece and Italy.

LEW: I think that if you look at the actions that Congress has taken this year, there were some moments of bipartisanship. The trade agreements -- they were very important economic policy, and they were passed on a bipartisan basis -- on, you know, some smaller issues, but not insignificant, like patent reform, things that are very significant to our long-term economic growth.

On these high-profile fiscal policy issues, in the end of the day, the votes were actually bipartisan. The funding bill that passed in April was passed in the House with Democratic votes. It couldn't have passed with only Republican votes. The debt limit increase ended up passing with bipartisan votes. What you did not have was a process of accepting the fact that we have to do this in a bipartisan way and negotiate so that's a victory, as opposed to the consequence of getting to the end. In the 1980s, in 1983, Social Security reform reflected that kind of coming together. Tax reform reflected that kind of coming together. In the 1990s the balanced budget agreement reflected that kind of coming together. I think it would be a good thing for the country.

That's what the president was engaged in in June, July and August. It was politically risky for him. He was engaged in negotiations where he was putting things that were considered sacred cows to most Democrats on the table. And his view then was that to do something big and to have the ability to stabilize confidence and the direction of the U.S. economy was worth taking that kind of political risk.

I think, quite unfortunately, the issue of taxes polarized the debate at the end. And, you know, I hope that that changes now. I hope the supercommittee, whether it's small or large, is able to get the kind of balance -- but that's going to mean, you know, both sides moving out of their corners; it can't be just one side. It won't be just by more spending cuts; it will require revenues and spending cuts.

TETT: Well, having been involved in the agreement of 1983 to look at Social Security and reform Social Security, do you think that it is possible for the supercommittee to do anything meaningful without addressing the entitlement issue? I mean, do you expect them to address the entitlement issue?

LEW: I think everything is a matter of degree. I think what would be in a small package, or the minimum package, would be different than what would be in the larger package. I don't think it's reasonable to have a view that: Let's start with savings and entitlement programs, and talk about revenues later.

If you look at the agreement on the debt limit, we essentially took one-third of the decisional areas and resolved them in the debt limit bill. We said that annual discretionary spending will be under very tight limits for the next decade. We saved a trillion dollars. I'm now putting a budget together in those limits. I can tell you, these are serious limits. It will mean choices; it will mean real restraint in spending. I think we can balance our priorities if we make the choices and live within it. But a trillion dollars in a decade has real impact.

We now have to move to the other pieces, entitlement savings -- and which are not just Social Security and Medicare. There's a broad list of things that are entitlement savings, many of which the president unilaterally put forward ideas for hundreds of billions of dollars of savings in September.

And there are revenues. I think in a package that actually addresses the $4 trillion challenge -- and just to be clear why $4 trillion, it's not a random number. It was the number that I think there was a broad consensus would bring us to, you know, primary balance in a reasonable period of time. That's not our ultimate goal. Our ultimate goal is to have a lower deficit, so we're buying down the debt; but you can't buy down the debt until you stop adding to it with new spending. And that's what the $4 trillion gets you to: It's a minimally sustainable place, so that you then can make the next set of decisions. One trillion dollars more doesn't get you there. The $4 trillion total -- which is $3 trillion more than we did over the summer -- would get you there.

The extent to which there are the difficult choices will depend on there being difficult choices on both sides of the ledger. It would be the right thing for the country for us to get the bigger package done. That's why the president spent July and August the way he did.

TETT: We were talking to some senior members on the Democrat side recently who were suggesting that they might be willing to compromise on the tax side, the revenue side, if there were significant defense cuts. Do you see that as a potential form of compromise going forward? And, you know, what would you define as significant defense cuts?

LEW: I think that the question of defense spending is a very important and complicated one. The agreement over the summer calls for very substantial reductions in defense spending -- almost $500 billion over the next decade. We're now engaged in a -- in a substantial strategic review with the Pentagon, with the secretary, the Joint Chiefs. And I believe we can come out of the review with $500 billion of savings and a defense posture that not only meets our national needs, but in some ways leaves us leaner and stronger.

I don't think there's an infinite amount we can reduce defense spending and still be able to make that statement. Defense reductions, like every other area, have to be driven by a strategy: What are our strategic requirements? The Defense Department even itself admits that the last decade, decade and a half, have basically been unconstrained. In an unconstrained environment, every institution behaves the same way: They forget the difference between the "need to have" and "nice to have."

This $500 billion of savings is forcing those kinds of decisions through, I think, a very clear, strategic lens. And it's actually one of the best strategic discussions I've been part of in my years in Washington, where everyone -- uniform, civilian, White House and military -- are coming at it with the same question: Where does the United States need to be in the world, and what can we do to put it there, while we're saving money?

The proposals to do almost double the savings --

TETT: A trillion dollars.

LEW: -- a trillion dollars -- I do not have a strategic frame to get there, you know, so I can't sit here today and say that you could achieve that level of savings consistent with meeting the strategic requirements.

That's not to say that we can't perform better than the 500 billion (dollars) in the summer. Certainly it would make my life a lot easier if the result of the strategic review showed that we had some more headroom. But I think it's dangerous to pocket what was accomplished and assume we're starting from where we were a year ago.

This is a serious exercise in cost reduction. You know, when the Bowles-Simpson commission came out, it had a substantially higher defense number. It was one of the things that we were concerned about. Not that we didn't want it to be true. You know, if we could save a trillion dollars instead of $500 billion, it would be a good thing. But we can't make the decision that we're going to save a trillion dollars and then find out that it leaves our national security exposed. We have to move the strategic review with it.

The secretary of defense and the president and I have all said the sequester, if it were to hit, the enforcement mechanism if the supercommittee fails, would be very damaging to our national security. That's an additional $55 billion a year for 10 years of cuts. So it can basically get you to just over the trillion-dollar mark. That's not the same as saying on the margins there's -- you fall off a cliff if you go from 500 billion (dollars) to 510 billion (dollars). And we're in a process now where it has to be policy driven.

TETT: And if you were a betting man or in the markets right now, what probability would you attach to the chance that the supercommittee will end up suggesting some tax increases?

LEW: I think that in order for the supercommittee to succeed, it will have to address taxes in some way. So I think it's really the same question as asking what do you think are the probabilities that the supercommittee would succeed. And I still think that there's a better than even chance that they can get something done.

TETT: OK. And then as offset, what proportion -- what probability will you attach to the idea the supercommittee will end up including tax increases for the wealthy?

LEW: Well, you know, tax increases for the wealthy are obviously a central part of the broad tax debate. You know, whether or not to extend the tax cuts in the top two brackets, we've taken the clear position they shouldn't be extended. It's a matter of some significance to the other party that they be made permanent.

I think that in the debate over tax reform, there is the useful reality that if you do tax reform, the current rate structure becomes less relevant, and the test is, is the system at the end of tax reform more progressive or less progressive than the current system? I think any tax reform coming out will have to be, you know, more progressive, not less progressive, than the current system, and in all likelihood it will be, if and when it happened, the rate structures that make this question of the old rates much less relevant perhaps irrelevant. If you'd lower the top rate, then -- and broaden the base by closing loopholes, then you've kind of addressed that issue.

So I think the question of progressivity is central. I think if you look at income distribution in this country, there's no secret that we have a kind of disparity of income distribution that is a serious concern.

The administration has taken the very strong positions that there has to be fair balance in what we do. If you look at entitlement savings, the numbers don't sound dramatic to a person, but a hundred dollars, $500, a thousand dollars, if you're living on $20,000 or $30,000 a year, that is a big sacrifice if you're seeing a few hundred dollars or a thousand dollars of lost income or benefits. You can't call for that and say we're going to allow people who have the highest incomes and have been the most successful to pay (low/lower ?) effective rates than people at much lower income levels.

The right way to do it is through tax reform, through base broadening. And, you know, I think the sooner we get on to that debate the better. I think that's where a lot of the conversation in the summer and in the supercommittee, as well, has been. That's obviously a very challenging undertaking, because it is a -- it's both complicated, and every decision you make changes the incentives in one or another part of our economy.

TETT: Well, I'm going to open up to questions in just a minute, but one other quick question from me. Are you worried that unless the supercommittee does come up with something sensible, between 1.2 (trillion dollars) and 4 trillion (dollars), then we will have the Italy/Greece situation play out in the U.S., namely a loss of market confidence in the government and a potential roller coaster ride in the markets?

LEW: I think it's very important to look at the fundamentals and to avoid treating all of the issues going on in the world as if they're the same.

This summer when the rating agencies took a look at the political debate in Washington, they fundamentally reached a political decision, a conclusion that there was political gridlock, that action would not be taken in a timely way; therefore, we're going to downgrade.

They didn't make an economic judgment. They didn't say that the United States was out of control and that action couldn't be taken.

I think that that actually is a significant difference that sometimes is lost. You look at some of these other international challenges, and the underlying fundamental economics are much more challenging.

I think that if you look at the market reaction in the summer, it was actually also striking that when the rating agencies' downgrade came along, consumer confidence or the market confidence went the other way and the price of, you know, U.S. debt went down, not up.

Now I don't think we should sit back and say there's not a problem. I think that the display of political gridlock in Washington in July was one of the most corrosive things that I've seen in terms of American public debate in my career. At a moment when the public desperately wanted to see Washington able to just get its work done, it showed that inability. That was why the president went farther than most in his own party wanted him to go. But it takes, obviously, two to put that kind of approach together.

I think that -- I think that the members of that committee and the leadership of Congress understand that their success in meeting a measure of expectations that they can do their work is actually quite important.

That's why I'm kind of a little outside of the normal market assessment of the probability of success. I do not believe that a week from now, when those 12 members and the leaders get together, failure's going to be something that they want, because they're going to say we need to show we can do something.

Now they now may not succeed. One of the important things about the way this mechanism was set up that I think's quite important to keep in mind is that if they fail to meet the deadline in November or in December, in the full bodies, nothing actually happens until January 2013. So the enforcement mechanism, which is draconian across-the-board cuts in defense and nondefense, are set up to take effect in January 2013.

Well, in January 2013 it's also the time when the tax cuts that were extended last December expire. So it's kind of a perform storm that brews next fall into January, and I think it's hugely preferable for Congress to get its work done this year. But I think it's a mistake to think that if Congress were to fail this year, that therefore the -- you know, the seams split open and everything comes apart. I think what you see then is a national political debate, an election and action afterwards.

So I think there will -- I'm highly confident there will be action. I think it's highly preferable the action come now, but I think it would be a mistake -- and that has to do with public confidence and market confidence -- if it's understood that there will be action, that -- that that should be a factor that's taken into consideration.

TETT: Or to put it another way, we may get a bit of a break between the perfect storm in Europe and the perfect storm in the U.S. that way.

But I'd like to open up to questions now, please. I'd like to remind everyone that this session is on the record. I know there are many members who'd like to ask questions, so please keep your questions short and concise and to the point.

We have a microphone and we're -- aside from people in the room that are participating, do remember that there many members also participating by teleconference.

And lastly, it would be courteous but not compulsory to state your name and affiliation.

So, question over there and then one, two, three.

QUESTIONER: Thank you. Jamie Metzl with the Asia Society. As you know, President Obama called for the doubling of U.S. exports. And my question is, to what extent do you believe that China's policies on currency and intellectual property are impeding progress towards reaching that goal?

LEW: Yeah, I think we're actually making good progress towards reaching the goal. We've obviously made clear that we have concerns that there be both a fair balance of monetary policies and a fair treatment of intellectual property rights. We've made some progress on the intellectual property rights in discussions this year. It's an issue that I think is going to be ongoing. It's not something that we're going to be able to check the box and say it's resolved.

I think if you look at the balances of trade, the -- we are selling, actually, a good deal of services in China, raw materials in China. And I think that it is very important that globally, we stay focused on the -- on achieving the goal. And it's something that we are very much focused on as we put our resources to work in terms of trade promotion activities and the things that we can directly control that ease the trading relationships.

TETT: We have a question, I think. OK, there.

QUESTIONER: Good morning. My name is Andrew Gundlach, Arnhold and S. Bleichroeder. Obama might have done some courageous things on the fiscal front, as you say, but one thing that he did not do is get behind Simpson-Bowles at all. Many within his administration and many Washington insiders consider that his most important political mistake, even more important than pushing health care. Some even claim that he didn't even read the report. Those same people also believe that Simpson-Bowles will be enacted either -- and the only question is 2012 or 2013. Your thoughts?

LEW: Well, there are a lot of people who think a lot of things that don't have a lot of connection to what happened. So I'm going to address what happened.

You know, the Simpson-Bowles commission did an enormously important job, which we said at the time and we have said consistently since. In my conversations with both Alan Simpson and Erskine Bowles, I've said it to them. I've heard the president say it to them. I've been there with him. We embraced an awful lot of the approach of the Bowles-Simpson commission. If you look at the debate over the summer, the debate over the summer was highly informed by the Bowles-Simpson commission.

There are aspects to the Bowles-Simpson report that are challenging. Go back to the defense discussion that we just had. It calls for defense savings that are roughly twice what we know how to achieve. The president is commander in chief. The president is responsible for making national security decisions and not just fiscal policy decisions. And as his budget director, I'm responsible for balancing how would you do it, not what is the number.

I think that the balance between saying enormous progress was made putting a bipartisan consensus together, let's work with that to get something done, and signing on the dotted line are very different. So I think that there have been many who've tried to make it seem as if we did not embrace things that we did embrace. I can't sit here today and say I know how to achieve a trillion dollars of savings in defense without undermining our national security. So that's a challenge if the president is asked to sign onto a plan.

On the revenue side, you know, it was a hugely important accomplishment to get bipartisan conversation and agreement on the notion that base broadening would be a way to raise revenues that might be a place where the parties could come together. It has shaped the conversations that have gone on since. You know, I think the total number that was in there is one that probably would be more pleasing to me and to the president than to many Republicans in Congress. If that became the thing we demanded in order for there to be a deal, I think it probably would not achieve the kind of broad, bipartisan support that it would need.

I think if you kind of leave the position of kind of who said what to whom, which is the way, in Washington, things are often covered, the substance of Bowles-Simpson is very much behind what's been going on ever since, which is why it was such an important thing to do and a report that will have enduring value. The test of the value of a commission is not did it get picked up and voted on, but did it change the debate in the way that's going to change action going forward. And I believe it did, and it -- and it will.

TETT: Thank you. Any more questions? One and then two.

QUESTIONER: I'm R.P. Eddy from Ergo. Thank you very much for your time. A lot of cynics believe that at the end of this supercommittee, 14 months from now, if they haven't achieved a consensus, the draconian cuts won't actually occur because Congress will step in and sort of change the rules. Do you think that this is likely, or can you share any thoughts on that?

LEW: I think it is -- it is a challenge when there is subsequent action that could be changed by legislation to speak with certainty that nothing will happen to change events. So I understand that there is legitimate skepticism that hard things will happen if there's the opportunity to turn them off.

I would challenge that, though, in this case. I think if you look at the history of enforcement mechanisms like this, the threat of very unattractive policies is sometimes a very effective way of kind of concentrating political institutions to make hard decisions. In 1990, the Budget Enforcement Act came out of such a moment. There were, at the time, across-the-board cuts that were going to take effect if Congress failed. It was not, at the time, considered politically acceptable to just turn it off. I don't think it would be considered politically acceptable to just turn it off now, either.

I don't believe that it will be necessary for those across-the-board cuts to happen. That's a different question. If the reason they don't happen is because the fiscal discipline was turned off, that would be a very bad thing. If the reason it doesn't happen is because Congress comes together and reaches an alternative approach to accomplish the fiscal goal, that will mean that the mechanism actually accomplished its purpose. The purpose of the trigger was not to put across-the-board cuts in a way that would cause deep damage to our defense and domestic priorities. The reason for that mechanism was to say, it will be unthinkable to do nothing. Congress will have to make decisions. They will be hard choices. But when the choice is the hard choice of deep defense cuts and deep domestic cuts on the one hand and balanced mixes of spending and revenue proposals on the other, Congress will choose the balanced approach, which is what happened in 1990.

TETT: Let's hope that (work plays ?) out again.

Question there.

QUESTIONER: (Name inaudible.) Could you share with us the rough dollar amount or percentage of the domestic discretionary budget that is represented by pass-throughs to state and local governments? And would you agree with the often-expressed proposition that that's probably the part of the federal budget that's most vulnerable to the cuts that are inexorable in -- over the next few years?

LEW: I don't have the percentage off the top of my head, but you know, it is -- it is a (not insignificant ?) number. You know, between transportation and law enforcement and community development block grants, there are -- health care, the Medicaid program -- the dollars are quite large. I think they don't fall into the same categories easily, because you look at Medicaid, it is a very different kind of a system than a block grant which says you're going to get money to hire police or you're going to get money to do community development activities. It's very much tied to minimum standards of health care and state plans to accomplish that. So the biggest item is health care, and it is different in kind from the others.

In terms of their exposure in this process, you know, I think it's fair to say that everything is exposed in a process where you're not -- you're not just not keeping pace with inflation, but you're seeing nominal reductions in resources that are available. The grant programs, you know, are important in terms of the goals that they accomplish, but they compete against core federal functions in some cases.

And you know, we're going to have to strike the right balance. As I look at the budget for 2013, one of the things that I'm very sensitive to is that state and local budgets are going through a lot of stress right now. We're seeing reductions in local employment that are actually creating headwinds that are making it very difficult to bring down the unemployment rate. We look monthly at the unemployment numbers, the private sector is starting to produce jobs at a decent rate -- not high enough, but it's showing recovery patterns. And you have reductions in employment at the state and local level bringing that down so that instead of seeing unemployment drop, you see it hold constant for now a couple of months running.

I think we have to be very sensitive to that as we look at how we make these decisions. While it can't be that state and local issues are completely off the table, we have to, I think, be very mindful of the fact that a reduction today in state and local funding is more likely to lead to reduction in employment and service reductions, neither of which in the current climate are particularly desirable.

So it is -- the reality of a trillion dollars of savings against what would have been your baseline otherwise over 10 years means we're going through a decade of belt-tightening. It will feel like belt-tightening. How we make the allocation decisions is going to reflect kind of core values and what is dispensable and what is not. We're certainly not approaching it from the point of view that there's some big cushion of reserve out there that the states can absorb anything that -- or the local governments can absorb anything that comes with no impact. But I can't in any area of the budget say that it will beyond scrutiny.

TETT: Well, as you know, we have a number of members who are outside New York participating via password-protected teleconference, and one of those is Carlos de la Cruz in Florida, who is chairman of CCI Companies, who's asked a question which leads on very nicely from that, which is: Are you familiar with the sensitivity of the size of the projected annual deficit for 2012 and 2013 to different projections for variations in nominal GDP, unemployment, interest rates and inflation -- to which one might add, and the prospect of the eurozone collapse?

LEW: Budget projections are always made in the context of economic forecasts that, unfortunately, have to be made, you know, many months before a budget actually comes out. In normal times, making assumptions in November for a budget that's printed in February is not an interminable period of time. In an environment like we're in right now, you know, the world can change in significant ways from day to day and certainly from quarter to quarter.

You know, we have tried to maintain as much flexibility as we can while still making policy judgments to respond to our updated assessment of what we see as likely GDP growth, what we see as likely external economic factors. You know, to the extent that the world changes, it is not an uncommon practice for budgets to have to adapt to it later. You always do the best you can, either try not to be unduly optimistic or unduly pessimistic.

In the 1990s I'd say our budget projections were based on economic forecasts that were wrong every time, and the world was always better than we'd projected. That was a fairly good place to be. It wasn't so hard to figure out what do you do when the situation gets better. You try to avoid being in a place where the world deteriorates and you can't deal with it. You know, in an environment that could be rather volatile in terms of some of these indicators, I look to my colleagues, you know, like Alan Krueger at the Council of Economic Advisers more than I ever did before for constant guidance.

TETT: But do you have a sort of shallow set of projections for what things would look like if, say, the eurozone does go into a deep recession, if there is real financial turmoil in America?

LEW: Normally budget projections don't assume dramatic events occurring. The way budgets are traditionally done is that you assume there is a likelihood of dramatic events at some point in the window and you kind of average it out over the period, because trying to figure out in advance when dramatic ups and downs will happen is almost impossible.

So, you know, in the broad sense of there being kind of -- limits to growth that are a function of the environment having risk, that's kind of part of the long-term macro-forecast. We don't try to pinpoint what happens if to specific circumstances.

TETT: Right. Any more questions? We have time for one or two more questions, I think. We have a very active -- (word inaudible) -- group here. Any questions over this side before I -- OK, right. One in the back, and then come forward.

QUESTIONER: Do you think the supercommittee can reach -- a budget commitment, budget agreement is coming two weeks before the Thanksgiving Day -- has been scheduled? And what's the possibility to adopt the tax increase for the rates? And what's the influence from the Occupy Wall Street movement to the negotiations in the supercommittee?

Thanks.

TETT: OK. So is the holiday period going to disrupt the talks any more than anything else? And to what degree do you see the Occupy Wall Street movement or protest impacting on the debate about taxing the top 1 percent?

LEW: I think if you look at the history of decision-making in Washington, holiday breaks are often a very helpful action-forcing event. (Laughter.)

TETT: No one wants to go back to their family and say they're going to have a rush back to the office again tomorrow.

LEW: Deadlines matter. And you know, we were talking before about some of the brinksmanship. It would have been a good thing if there had been some intervening date that drove things other than when do you run out of money to -- you know, to run the federal government or when do you lose the ability to pay the federal debt. So I actually view things like Thanksgiving and holiday breaks as helpful, not hurtful to the process.

You know, and I think that the general sense in the country that we need to do something is pretty strong. It comes from right and left. You know, and I think that, you know, there's an aspect of the public's demand for action which is to do something specific, and there's an aspect of it which is to take control and make decisions and take charge.

I think the income, you know, disparity issues are quite important. I think that it's not because of one or another protest. I think if you look at the poverty statistics that came out, if you look at the trends over the last few decades -- I've talked to friends in, you know, the financial community who worry deeply about the polarization of American society. It's not just the top and the bottom, it's at the pressure on the middle. It's in their -- that ability -- it's not a good thing if middle-class families start to say, I don't know if I can send my kids to college.

And I think we're at a point right now where we need to address the anxieties that Americans have about the current economy and the very legitimate expectation that they want to have that the world in the future will be a world of opportunity for their children. And you know, you can call it class warfare, or you can call it the American spirit. I mean, the American spirit is if you work hard and play by the rules, you ought to be able to succeed. And that's what I think it's really about.

TETT: We have probably the last question over there. Oh, sorry, actually, the lady in purple, and then the man in -- behind her.

QUESTIONER: Hi, Sangeetha Ramaswamy with Eton Park. So one of the -- obviously, one of the big surprises that happened over the summer is that the U.S. had its sovereign rating get downgraded. And there has been some discussion that if these talks, you know, don't materialize in sort of reaching some sort of a conclusion, there's that potential again. So I was curious the extent to which the administration is, you know, obviously working behind the scenes to prevent that from happening, but also sort of what measures would you potentially take if it happened, you know, potentially now twice in one year?

TETT: So are you living in fear of Moody's? (Laughter.)

LEW: You know, I think that we actually have a commonality of interests in the sense that if you look at what we've stated to be the economic imperatives, they are the same as the economic imperatives that outside financial observers have seen: identifying the size of the problem, being on a path towards dealing with it. We're going to do the same thing. If it doesn't work in November, we'll still be at it. I mean, it's not as if the issue goes away if the deadline is missed.

I don't -- I -- it's hard to speculate on what happens -- if you look at the downgrade over the summer -- and it was certainly not something that we thought was a good turn of events. You know, you don't want to see a downgrade of the United States either for political or economic risk. But as I was saying earlier, it is very significant that the language in those reports was almost entirely focused on political risk in terms of the rationale for the downgrade.

So in a world where we know there are economic solutions -- and I'm rather confident that in a meaningful time frame we will make decisions in Washington in a timely way to avoid the kinds of adverse consequences -- I think that my political judgment is that whether it happens in November of 2011 or December of 2012, we will avoid the economic conditions that would give real reason for that downgrade.

I said earlier -- and I really believe it -- I think action now is, you know, worth a lot more than action later. And it's not because of the rating agencies. You know, when I -- when I hear people who are not in government -- you know, you go into a store in your neighborhood, and the shopkeeper is worried that things are out of control and they don't think that their government can get over this kind of political dysfunction -- that's a bad thing. It's a bad thing, and it's not -- it's not something that has to show up in a rating agency report for us to see that we need to do something about it.

Right now, you know, we talk a lot about confidence. And it's important that we in government do what we can do to show that there should be more confidence. The president's trying, in a world where Congress is gridlocked, to do as much as he can with executive actions to demonstrate that we're using the levers at our disposal in an effective way. I think it'll be quite confirming if Congress acts.

I think that there will be action taken in a meaningful time frame, and I hope it's this year and that it's soon and that it's substantial.

TETT: Well, I think we can all echo that. We are out of time now, so I just want to thank you for your comments.

My own personal takeaway -- perhaps three very brief one-sentence takeaways: One is that, having heard the challenges of creating a sensible fiscal policy, it's very clear to me that if the eurozone does go into significant crisis your challenges are going to be that much worse, and that's scary -- very pertinent for the next session.

Secondly, the sheer difficulty that the U.S. government faces and that the Congress faces in coming up with a sensible policy -- even though the U.S. economy is probably slightly recovering, and even though you haven't got the markets punishing you yet, and even though you've only got one government, not 17 -- is again extremely sobering when you look at the eurozone and think: How on earth is the eurozone going to put its house in order?

And just thirdly, the thing I always am very forcefully struck by every time I hear somebody like you speak is that, these days, it's not really just about the economy, stupid; it's about the politics, stupid, and above all else, about the sociology today which, as someone who trained in the social sciences for many years, I find fascinating. I think today really is the revenge of the political scientists and anthropologists over the number crunchers. (Laughter.)

So I just wish you the very best luck in finding a way through this sociology and these fiscal challenges. Thank you very much, indeed.

LEW: Thank you. (Applause.)

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