Ezra Klein: A bit over a year ago, when we first spoke, you said Greece was like Bear Stearns, and behind it were a lot of potential Lehmans. Have you become more optimistic since then?
Desmond Lachman: No. What has occurred over the past year is that the situation with Greece has clearly been untenable. It is only a matter of time till Greece has a hard default. Since then we have had real problems in Portugal and Ireland. But what is of most concern is the crisis has spread to Italy and Spain, and even the French banks have trouble funding themselves. This isn’t just the European periphery. It’s the heart of the European banking system and the whole European experiment. What makes matters worse is that the American, French and German economies are slowing. That means that if the troubled countries in the periphery had any chance to export their way out of their problems before, they don’t have that option now.
EK: And if some of these dominoes fall, how bad are things likely to get?
DL: What’s really at stake here is the European banking system. These countries might be relatively small, but if you just look at Greece, Ireland and Portugal, that’s $1 trillion in sovereign debt. If you add Spain, that’s another trillion. If you add Italy, that’s another $1.9 trillion. If the European banks take the hit, that could really cause another Lehman moment. It would be a credit crunch that would throw the European economy into a meaningful recession.
EK: What would that mean for us?
DL: The United States should get no schadenfraude out of this. We are very exposed to the European banking system. Our money market funds have loaned out more than a trillion dollars to European banks, for instance. If we see real problems in Europe, that will hit the United States much in the way the U.S. financial crisis in 2008 impacted the rest of the global financial system.
EK: My gut sort of seizes when you mention money-market funds, because I remember how one “broke the buck” in 2008 and that set off a massive panic. But aside from them, what are really the channels through which you could see the European crisis contaminate America?
DL: There would be three channels. First, you have to remember the European economy is a third of the global economy. If Europe goes into recession, that’s not good for our exports. Second, if we get defaults in Greece that impacts the European banking system and we aren’t sure who will stay in the European Union, that’s hugely negative for the euro currency. That means the dollar would appreciate massively and our exports would become more expensive. But the main way it would effect us is through the financial system. In these circumstances, investors become risk averse and they take all their money out of equities, out of lending to corporations and the like, and they put all their money into U.S. Treasuries and Swiss Francs and gold.
EK: Put aside political constraints for a moment. Is this a situation that the European Union has the fiscal and financial capacity to solve? Or is it now beyond their capabilities?
DL: They could solve it. But what’s involved is a transfer from the rich countries to the poor countries. It would be a transfer from the Germans to the Greeks and the Portuguese and the Irish. If Germany would just write them a check, that would solve the problem. But the German taxpayer is asking, ‘why are we using our hard-earned tax dollars to prop up these profligate countries?’ Seventy percent of the German electorate is against bailouts. It’s not like the United States where there’s a commonality of purpose and a vision of national unity.
So the Germans are grudgingly lending to the periphery but they’re lending to the periphery with conditions that are causing the deepest of recessions and much higher unemployment. The Greek economy has contracted by seven percent in recent months and unemployment is up to 16 percent. And now the IMF is saying to Greece, ‘you need to tighten your belt even more.’ And there’s no way that can happen for another six months. The Greeks are saying, ‘this is economic suicide.’
EK: But there’s another side to this too, right? Part of the problems in Greece and Ireland and elsewhere were driven by bad loans from German and French banks, and part of the difficulty these countries are having getting back on a growth path is that they’re trying to keep their membership in the euro zone, and that has meant abiding by a tight monetary policy and a strong currency that countries in these sorts of situations would usually have abandoned long ago.
DL: I agree with you. It’s like the housing bubble in the United States. You couldn’t have had a bubble without the financing. In Europe, the debt bubble was financed by German and French banks. So for them to throw all the blame on the profligacy of the Greeks or the Spanish housing bubble is ridiculous. So just in terms of the blame game, it’s unfair just to blame the Greeks. But in terms of a solution, that’s a big part of the problem. Once you’re in a fixed exchange rate and you have these huge imbalances, they can’t be redressed without economic collapse. So the Germans and the French don’t want the Greeks to default because that will force French and German banks to recognize losses and then they’ll have a banking crisis. It’s easier for them to keep these countries afloat than to bail out the banks. But this is not a sustainable situation. Something has to give.
EK: And what do you think that will be?
DL: I think they have reached the conclusion that Greece is insolvent. According to the IMF, Greek debt will peak at 172 percent of GDP, and a dangerous level of debt is 80 percent or 90 percent. So to think Greece won’t have to write its debt down by 50 cents on the dollar, you have to be smoking something. I would be surprised if the Greeks don’t default on their debt within six weeks, and at that point, they will probably leave the euro. But a Greek default would be the largest sovereign debt on record. And the concern is that if Greece defaults, there will be a contagion to Portugal and Ireland and Spain and Italy, so the Europeans are trying to get this $2 trillion bazooka ready so they can ring fence Greece.
EK: And what are the chances that this leads us back into a recession?
DL: If you want me to depress you some more, let me tell you what really worries me. If we do go into recession this time around, what will be different from 2008 and 2009 is even if the recession isn’t as deep, we either don’t have the policy ammunition to fight it or we have convinced ourselves that we don’t have the policy ammunition to fight it. So what will the policy response be? Bernanke just showed you he thinks he has very little ammunition left. There’s no way Congress will go in for another big stimulus package. And the Europeans are tied up in the belief that they need to balance their budget.
EK: Thanks for a really depressing interview.
DL: Put an asterisk on it for me. Please tell your readers, ‘don’t shoot the messenger.’