The Crisis in Europe

... The Americans are urging more action, quicker action. They're frustrated. They feel the Europeans are putting Band-Aids on a big wound. What is Secretary [of the Treasury Timothy] Geithner saying to you?

It's not only the United States which is becoming irritated by the slow process taking place in Europe. The IMF is a big house, and it has many members, 187. And granted, the United States is the biggest member and the biggest shareholder in the institution, but it's a sentiment that is shared by many around the table, excluding the Europeans, of course -- you know, "What are they doing? Why is it so slow? Why can't they resolve the matter? Why is Greece, which represents only 2 percent of the EU GDP, why is it taking so much and so long? And why do they come up so late and so short?"

That's pretty much the sentiment around the table. And most then say, "Number one, Europe has to get its act together; number two, it has to build a firewall that can avoid contagion," because at that time there was already the fear, which developed a lot further in the middle of August, that other countries could be drawn into that. So there was a lot of impatience.

Italy, Portugal, Spain?

Yes. By then, don't forget, Portugal and Ireland were already under joint program, but the concern which was beginning to loom in the background was about Italy.

You went to Jackson Hole in August for the Fed's meeting, and you spoke and said, "We are in a dangerous new phase."

Yes.

At this point you're starting to feel things are --

Unraveling. Don't forget, this is the second half of August. From the beginning of the month, the situation has considerably deteriorated, at least from a market point of view. The spreads have widened significantly. Italy is borrowing on the 10-year bonds at roughly 7 percent, or getting close to 7 percent.

And it makes the whole situation extremely tense. The banks, the European banks in particular, are not trusting each other. The interbanking lending system is pretty much down. And the ECB [European Central Bank] continues to say: "None of my business. I'm not going to interfere and do any type of interest-rate monitoring."

So the month of August is a very difficult period, and one where I feel the necessity to actually publicly say a number of things like, "We are in a dangerous position"; like, "Austerity and deficit cutting is not the only panacea. We need to look at growth."

That message did go a little bit unnoticed at the time, because the third message was, "Banks have to be stronger to be able to actually do their job, which is finance the economy." That last message had a lot of echo and pushback.

From the banks?

Yes.

What was at stake here? Why should Americans be concerned?

The economies are strongly interconnected, and it's a good thing. If you look at the relationship between the U.S. and Europe, for instance, Europe is the largest trading partner of the United States. Half of foreign direct investment are made by European Union companies in the United States.

If you look at the financial sector, there is also there a very strong relationship with U.S. banks engaged on European markets and European banks having subsidiaries and activities in the United States.

So [there are] strong links between the economies, and if something goes wrong somewhere, it is going to have consequences -- we call them spillover effects -- in the rest of the world. But you can see, given the strength of the linkages, whether it's financial, trade, foreign direct investment between Europe and the United States, it does have an impact on the United States.

At the same time you're dealing with markets that remain in major parts dark, not transparent. I'm wondering what keeps you up at night during this period of time -- August, September, October, November -- as you think about all the things that might go wrong.

You know what keeps me up at night? Work, because during those periods, I didn't get much sleep because we were working pretty much on European as well as on U.S. times. ...

More seriously and to your point, during August and September, probably into October, we all feared that something was going to crack, that something was going to break, that an auction would not materialize, that this --

That a country would not be able to refinance.

And a country would not be able to refinance itself. So there was that constant attention paid to spreads, to yields, to how the auctions were going, to the timing of the refinancing, to all of that. And there was strong cooperation, collaboration, contacts between the European actors and the IMF and other key members of the institution.

How did banks behave during this period of time?

After my call to action, if you will, in my Jackson Hole speech, there was I think an element of resentment, an element of denial, and certainly very strong and vocal pushback about what I had said and a little bit about me, you know: "Who is she to say that? How does she know, and who has informed her of such things?"

To be clear, they're reacting to your call for new liquidity and capital rules.

What I said in my Jackson Hole speech was that banks, but European banks in particular, needed to be recapitalized in order to be just stronger so that we could avoid the vicious cycle that we were in.

And I added that they should go to the private market to raise the funds necessary to strengthen their capital, but if that was not available, there should be some public funding made available so that they do not deleverage; in other words, reduce their commitment to finance the economy in order to make their balance sheet look better, therefore avoiding the need to go and raise capital.

That's what I said. And there was strong pushback, particularly by the European banks, French banks noticeably, to say: "Oh, this is not needed. Absolutely not."

A lot of that will sound technocratic to some people, but what the banks really are objecting to is that you're going to crimp their ability to profit. Isn't that the bottom line for the banks? ...

Well, there are multiple ways to recapitalize, and one of them is clearly to reduce the volume of dividends that you pay to your shareholders, or to incorporate, in capital, the reserves that you've kept to the side. So that's a way that clearly was resented.

And in the same fashion, the banks did not like the idea of having to go to market, because at that time, September, October, there was a huge doubt about the future of the banking business, and there was a lot of uncertainty about the worthiness of investing in Europe because there was this turmoil out there.

So their fear was twofold: Am I going to have to cut on my dividends to my shareholders? If I go back to my shareholders, will they be willing to recapitalize me, given the doubts that are looming over the profession of banking?

Because the debate had started as to what the profession of banking should be in the future. Should it still be this financial-instrument creativity, or should it be much more so the financing of the economy and the sort of basic and boring job of lending to households, to entrepreneurs and to companies?

You come into the job in June of '11 as the IMF chief. ... There are a series of EU [European Union] summits in July and September, and during that period of time the crisis is really ramping up, just as you step into office. There's riots on the streets of Greece. Describe that time, if you can, briefly.

Well, some would argue that I had to hit the ground running and that I was reasonably well equipped for that because I had seen it from the other side, sitting on the Eurogroup --

As a finance minister.

As a finance minister of France. Others would argue that it was just a lot to begin with, because when you join as a newcomer at an institution like the IMF, you have to learn the ropes and at the same time continue to hit the ground running.

So it was a very, very tense period of time, and one where we had to focus actively on how to push, how not to push too far, because we have to be equally concerned with the macroeconomics, with the fiscal situation of the country, but also with the social fabric of a country.

And all of that with the background of political challenges for each and every partner in this multidimension[al] equation given that there are 17 member states that participate in the debate.

You have a European central bank that was going to change boss and which had a very special doctrine about what it could and what it shouldn't do., and a European Commission that is the agent but also a strong proponent of the relationship between the partners.

It was in the summer of '09 when Greece revealed that it was running a budget deficit twice as high as what it had previously stated. ... What was your reaction? Were you aware this was coming?

No, and we felt betrayed, to be fair, because all of a sudden the public deficit that had been reported by the Greek authorities at the time suddenly ballooned on the occasion of the change of government. And it was very much to our surprise when Minister [of Finance Giorgos] Papakonstantinou, who tried to do as good a job as he could under the circumstances, reported the situation of the Greek public finances.

And then it went sort of downhill from there on, because there were successive revisions of those numbers on several occasions.

Did you call Papakonstantinou? Did you get him on the phone? ...

Well, we'd met.

What was your reaction?

But don't forget that when I was minister of finance, we had a monthly meeting, and it's on the occasion of one of those monthly meetings that he reported on the Greek numbers, so I didn't have to call him. He was in the room, and all of us, the 17 of us, were just appalled by the numbers.

Can you describe that meeting and that moment when he revealed that and how you reacted? What went through your mind? How serious did you think it was?

In the first place, there is always the suspicion that a new government comes into place and is as negative and as pessimistic as possible when it comes to power.

To set low expectations?

Well, yeah. You set low expectations, and you provision as much as you can so that if you actually work your way through and do a good job, you will look better.

That's a typical approach by any political group or political party or political leader. You want a clean plate to start from. So we had that suspicion, but it could not possibly encompass the entire massive revision that took place. And it was major disappointment.

So a bit of suspicion as to the reality of that revision and a huge disappointment, because prior to that we had been actually a little bit too relaxed with the previous government, because it was arguing that it was very, very much pro-Europe and that they were a strong supporter of the European integration.

What did you think would happen next as a result of this revelation from Greece? At the time, what were you thinking?

At the time I think we trusted the Maastricht mechanism, which was a European mechanism by which member states have to redress the situation and have to restore the deficit and debt positions. ...

To be fair to Greece, during the first year it significantly improved its situation, cutting the deficit by 5 GDP [gross domes

Now, little did we know at the time that Greece would require not only the Maastricht mechanism to work out, but the IMF [International Monetary Fund] to come and support the designing of a program. Little did we know that it was going to then entail the setting up of a bailout mechanism that was the European Financial Stability [Facility] [EFSF]. And little did we know that it was going to then lead to Ireland and Portugal to also be under very, very close scrutiny and in need of a program as well.

We've had over the last 10 to 15 years a tremendous amount of growth in the financial sector, and we were aware that there were a number of financial tricks used by governments to dress their balance sheets to get into the euro zone. How is it, with all that, that it seemed no one could see the trouble [that] was coming from Europe?

There has been a lot of growth in the financial sector, and that financial growth was very much out of control, very much off-site, because if you remember, the spirit prior to 2008 was very much about soft regulations, flexibility, financial creativity, sophistication of instruments.

I remember myself having had quite a few battles with some of my banking-sector interlocutors when I was minister of finance about precisely that. And that debate lasted quite a long time, actually the battle between those that were in favor of strong supervision and regulations and those who were eventually admitting that it was necessary but that we should, by all means, protect financial inventions and the creativity in the financial sector.

Now, that was clearly, in my view, at the root of the strong development of the financial sector. But that was the private-sector development; it had very little to do with sovereign credibility, with sovereign debt, and with the sovereign balance sheets.

In parallel -- and I think you're probably referring to a country like Greece, for instance -- there was some inaccuracy of data reporting. There was some shortfalls in the statistic agencies in that country. And possibly with the support of financial, highly reputable institutions, the actual portrait and landscape of the financial situation of a country such as Greece was inaccurate. I think there is no question in retrospect about that.

Now, at the time there was an element of "irrational exuberance," to quote Mr. [Alan] Greenspan, who was a very, very highly regarded and reputed central banker of the time. And that irrational exuberance also affected the way in which those data, numbers and statistics were looked at, because they were beautifully presented.

I was talking to a banker with JPMorgan who told me that it wasn't just Greece that was using derivatives to dress its deficit in order to gain admittance to the euro zone, but it was France, it was Germany, it was Italy.

Well, everyone was using derivatives, you know. Let's face it.

Everybody was using derivatives, but people were using them, and Eurostat was sort of looking the other way. Were you aware at the time of the kind of misuse of derivatives to dress balance sheets of governments?

Everybody was using derivatives. All agencies were looking somewhere else; all statutory auditors were looking somewhere else; all supervisors were looking somewhere else; many shareholders were looking somewhere else.

Were you aware of what the situation was when you took the job as finance minister in France?

I took the job as finance minister in July 2007. The first development of the big financial crisis hit the screen on Aug. 15. ... In those six weeks in the job, I had no idea of, number one, what was coming up; number two, the potential crisis of confidence that was going to hit all our radar screens in relation to the private sector, because don't forget that 2008 was really a crisis of the financial private sector, some portions of which had to be eventually nationalized in various corners of the world.

But the sovereign debt issues and the crisis of confidence toward sovereigns came as a second stage of that same crisis.

How much [are] derivatives responsible for magnification of the crisis in Europe?

I think it's not only derivatives. Derivatives play a part. The entire sort of transparency, financial instruments, the lack of traction by the supervisors -- as I said, a lot of people were asleep at the wheel. All of that contributed to the European developments.

But all of it originated, in the first place, from the U.S. financial markets being in total disarray as well.

Right. But it's said often that the financial crisis at its root was about subprime mortgages.

Yeah.

In Europe it's about overspending, fiscal irresponsibility.

It's about excess really.

It's about excess credit, but without the magnification and the increased leverage from the use of financial innovations, the crisis would not have been as great as it was.

That's correct.

... How much of the motivation for these bankers to take this significant haircut comes from the fear that many banks have some sort of exposure through credit default swaps? How much is this sort of a hidden bomb driving this?

It's very hard to say for sure. I think with a deal that we're trying to close, everybody has something to gain. It is clear that if at the end of this the debt becomes sustainable, the bond prices will go up. It is very hard to say to what extent credit default swaps and the positions of the various partners of the various institutions with swaps play in their decisions. Certainly for hedge funds it makes a huge difference [as] to whether they will participate in this or not.

This is why there are number of critical issues. Will the CDSs [credit default swaps] be triggered or not in [an] event? That's something that we do not know yet. We would like to avoid it. But we will see whether that can be avoided in the end.

So that's part of the problem. The CDS market is very opaque. We don't really know who holds the positions, how much, and who is about to gain and who will lose. Some of it is washing out. Some are gaining; some are losing. But there is a clear suspicion that there is an important element that is also driving part of this discussion.

... Did you have [Secretary of the Treasury] Tim Geithner or anyone calling you, trying to influence what happened here?

I was on the phone very often with my counterparts in the EU. I saw many times and talked on the phone with Tim Geithner. And there was a time just before the decision on the first bailout by the EU -- I don't like the term, but that's the term that people use -- where I was getting practically nightly phone calls from the U.S. Treasury.

Saying what?

Saying: "We're very worried. We've seen this before. This has Lehman written all over it. It is important for the Europeans to move."

The U.S. had seen what uncontrolled events can happen depending on taking or not taking a decision, and it was for them very important for Europe to get over its fear of moral hazard and decide to help Greece, at the same time demanding Greece to do certain things.

And they were very keen for this to close, this deal to be done, and for Europe to show that it would stand behind a weak member state as long as this member state would do the right things, but not let it go down and thereby destroy the euro.

They were, I think, instrumental in helping form the final decisions in certain European countries. And I think we all know that there were discussions between President Obama and [German] Chancellor [Angela] Merkel at critical times to make it clear that the U.S. also thought that for the stability of the world financial system, it was important for the euro zone to come to a conclusion on this issue.

What tools did the U.S. have to influence those decisions?

... One was its influence through the IMF. The U.S. is the biggest shareholder in the IMF and has a say in its running and therefore in its positions.

The second is the power of persuasion. We all live in the same global market, and it is very important for Europe to be on the same page with the U.S., because contagion can happen both ways. In 2008 it went from the U.S. to Europe. The U.S. was fearing that now it would go the other way and therefore was trying to avoid that.

... Some people listening to this could say: "OK, you know, in Greece they spent too much. People were paid too much in government. There were these artificial jobs out there. They need to cut back, just to get to normal." Is that what level the cutbacks are, bringing you to where you should have been?

... The problem is twofold. One is the physical aspect, and the other is the competitiveness problem, because it's not just that the state was running huge deficits. Also, the economy was losing competitiveness vis-a-vis its partners for years, and part of that competitiveness needs to be clawed back through structure reforms.

And when you do reforms, you are often against vested interests and people who, for example, don't want the profession to be opened and for anyone to exercise it, trade units that don't want their work practices to be touched, or people who participate in a pension system that came out in retirement at the age of 50, or even 45 sometimes, and think that this was normal where it clearly was not because it's not sustainable.

Whenever you're going through such a violent change, everybody's hurting, and there is no way that you can find a way to make it fair. You try. We increased taxes on the most wealthy. We increased taxes not just on high incomes but also on high wealth, property. We went after offshores. We went after tax evaders. For the first time, we put people in jail for tax evasion. In the U.S. that's normal; in Greece it was not. And we cut. Unfortunately, we cut horizontally. We cut public-sector wages horizontally. We cut pensions horizontally.

If we had time, we could have done it in a different way, but we were up against a clock. The clock was the bonds that had to be repaired and the willingness of the [EU] and the IMF to lend us, only if we agree to a certain package. So it's a very tough austerity package.

It's also got structural items in it that people tend to look more at the austerity and not on the other side. And it is fundamentally unfair because you cannot make it fair enough, because when you're living above your means and you have to somehow deflate this, everybody loses.

And unfortunately, not always [the] ones that should lose most are the ones that bear the brunt of this adjustment. We're trying to help the lesser paid, the lower paid, the ones on lower pensions. We have tried to cushion them more in all these cuts, but it's not easy. If somebody's in a low pension and you cut even a little, they hurt.

If somebody's low-paid, even if it's a public-sector employee, and you cut some, he's got mortgages; his kids need to go to college; he's paying health bills. He's in trouble, and as a result, the economy's in a recession. You cannot have a fiscal retrenchment without a recession. Recession puts people out of jobs, and that creates a multiplier effect.

And this is what we're paying politically, because the social price is very high. You find yourself in a difficult position as a politician, as a minister in the government, where you have two sets of constituencies. You have the people who vote for you, but you also have the bankers, and they're a more immediate vote of confidence than your constituents are.

Why did you change the Greek statistical agency? That's something that you all accomplished, that's a significant legacy of your time there. ...

Part of the problem we had in 2009 is because nobody believed us anymore, there was a serious credibility problem. ... So it was absolutely imperative to convince our European partners, to convince the markets that what you see is what you get, meaning that the numbers that the country uses are the real thing.

The only way to do so is to take the statistical agency outside the Ministry of Finance, because it was a secretariat of the minister of finance, and as in other countries, make it into an independent agency with fully fledged powers and absolute autonomy from the government so as to remove any fear of political interference in the running of the agents and the numbers.

We recruited somebody who had the track record from the U.S., a professional who was put in the position with a vote by [an] enhanced majority of the Parliament and who reports to Parliament, not to the government. As a result of the work that was done, Eurostat has fully verified all the figures from Greece for 2009 and 2010.

But that civil servant is now a suspect in a criminal investigation. What does that tell us?

Indeed. It tells us that there are absurdities in the system. That investigation has even led to investigation of the then-prime minister and then-finance minister -- that's me -- for allegedly blowing up the figures with a logic that borders on the surreal, because the logic says they increased the deficit on purpose so as to bring the IMF [International Monetary Fund] in and impose more austerity on the people.

Well, I'm a politician. I don't particularly enjoy inflicting pain, and I can tell you that my popularity ratings certainly don't enjoy the results of that. So unfortunately, rather than statistics being an issue of technical expertise, they have become part of the political football. And the reason why this story is now center stage is because there are two different ways of looking at the situation.

The way that we look at the situation, and I think the way that any logical person looks at the situation, is that Greece was in trouble. [It] was in trouble because for a long time we were spending more than [it] was earning, and because it hadn't done the right things in terms of structure reforms.

This came to a head. Difficult decisions had to be taken, which brought a lot of pain and suffering to many people, but they were the only possible choice. And as a result, we were able to finance our debt through the official loans from the U.N. and the IMF. And this is where we are.

There is an alternative story, and the alternative story is this should never have happened because the problem wasn't there in the first place. We are in the IMF because these bad guys bloated the figures and brought the IMF in because they want to sell off the country to the foreigners.

If you believe in this alternative conspiracy theory, then you will also believe that the official statistical agency and Eurostat, which has verified the figures, the European statistical agency, are all lying and that somehow some disgruntled ex-member of the board that has an ax to grind is correct. Well, I think that logic will prevail.

There were rules set up by the European community to try to limit the amount of deficit any country can have, a goal of 3 percent. One way [it's] been reported that that goal was reached was ... American banks came in with a version of these fancy financial instruments that had gotten us into trouble. And [they] actually worked, sold instruments to the Greek government that hid debt.

Two things. First of all, let's remember that the first country that actually breached the 3 percent rule was Germany. So once the large countries -- Germany, France -- breached the rule, smaller countries followed suit.

The kind of instruments that you're talking about to hide debt were used first and foremost by the large countries. Germany used them; France used them; Italy used them, because when they used them, they were deemed OK by the European statistical authority. So Greece used them as well.

But if you look at the numbers, those kind of fancy tricks do not account for a very large proportion of the debt or even of the increase in the debt. It is true that in critical moments, they managed to hide some percentage points of the debt, no question about it. And actually, after the European statistical agency had changed its rules in 2008, all countries bar Greece changed themselves and recorded on the debt the hidden figures.

At that point -- this was the previous, conservative government -- the government decided not to, at which point we had to do it, now to a cost of showing that the previous government was not being truthful with the figures.

So you had a period in the early '90s when most European governments were using those tools. Then the rules changed. Everybody became straight. Greece didn't until after we came to office and created an independent statistical agency which was audited by the European agency, came clean about all the figures. And finally everything has been recorded now in the official figures. ...

When one hears of excessive -- some would say corrupt -- government spending, you know, people on the payrolls that really didn't do anything, real patronage jobs, ... how much of the problem is related to inappropriate government spending in nonproductive ways for political favors?

I think it's a combination of the two. I am not one of those that say it was all due to corruption. If you strip away corruption per se, you are still left with the vast majority of the debt.

It was a very simple mathematical exercise. Expenditure on wages, pensions, social expenditure was growing much faster than revenues were. The economy was growing, but we were not reducing our debt. Our debt was growing even though the economy was growing as well.

So there is a tendency today to say, "Well, that isn't really ours; it's because of the politicians being corrupt." I think it's much more complicated than that. I think as a society -- and that of course is expressed by its politicians, its political system -- we spent more than the economy was able to handle.

We spent more by creating a large public sector to an extent because of patronage, but not corruption per se, ... and because we didn't tackle some of the big problems in Greek society, namely tax evasion, we allowed tax evasion to become endemic, not just in the last few years but before that as well.

By doing so, we allowed tax revenues to be much, much lower as a percentage of GDP than in most other European countries. And then, if year after year you have this fundamental imbalance, then your debt piles up.

Why was tax evasion allowed to exist at the level it existed at?

Because it was never easy or convenient for political parties to have a head-on approach to it. I think we only started doing this in the last two years because people were kind of happy with the situation that was perpetuating itself, and not many people were willing to go against the grain, and because tax evasion -- let's face it -- was very widespread.

Greece is a country of professionals, of small businesses, and this is when a lot of tax evasion exists. You don't find tax evasions among pensioners or wage earners that have steady jobs as employees. You find most tax evasion in the free professions and the small businesses as well as in large businesses. So the fabric of the economy was evading, and if everybody's doing it, it's much harder to tackle it.

... When did it really dawn on you, the magnitude of the problem? Was there a particular day? Was there a particular moment? Was there a particular report you got?

... I remember we took office -- we won the elections on Oct. 4. We got a vote of confidence from Parliament on the 20th. The day after that, I had to go to the Eurogroup for my first session as finance minister, and I had to tell them that the deficit was twice as big as they thought, twice as big as the previous government had told them, and six times as big as was originally planned, because the deficit in the budget was planned to be 2 percent of GDP [gross domestic product], and I showed up to tell them it was 12.5.

Actually, once we were finished with looking at all the data, it landed at 16 percent. So it'd been 2 and [now] 16. You have a huge difference, ... and it was clear to me from the reaction that we were unleashing a certain chain of events.

There was no way or desire on our part to do anything but say what the numbers really were, and those numbers became apparent to us once we took office. Before that, we knew that the deficit was heading to double digits. We had been told so by the governor of the Bank of Greece. We had said so publicly that we thought the deficit was bigger than what the government was saying it was.

But [it was] not until we sat down in the General Accounting Office with all the people there that knew the national accounts and slowly stripped the layers of expenditures that were due but not really being recorded or declared, the projections of revenues that were completely unrealistic, and the numbers that were simply put aside and not officially recorded for a variety of reasons, not until that time did we realize that what we had was a very, very serious problem.

I would say that's the first realization of the problem. The second realization, which took a bit longer, was the realization of how swift the market reaction would be.

If you went back to New York, and you were explaining to ... your friends what's happened here in Greece, what's the simple summary that you'd give them? How do you make them understand?

I would say that this was a crisis that was overdue in a certain sense. It was coming. We failed to see it coming. And at the certain point, the economy stopped growing as it was, at which point the debt became unsustainable.

We, for a very long time, were running huge deficits. Unfortunately, in the last two years before we took office, so before 2009 and in 2009, the deficits skyrocketed. We were spending in 2009 36 billion [euros] more than we're earning. That number doesn't sound big for a large economy, but for an economy like Greece, it's a huge number.

So the markets woke up to the fact that they were not willing to finance this any longer. The markets thought that because Greece was a member of the euro zone, it was safe to lend to Greece at very low rates. But at some point they realized that this kind of dead dynamics were quickly becoming unsustainable. So they got scared, and they pulled off.

Once they did that, it became very clear that the cost of borrowing would be way too high for Greece to be able to sustain its debt, to be able to service its debt. So what we call the "spreads," the difference from the German rates, increased very quickly and very much.

Then the rest of the euro zone woke up to the fact that here was a euro zone member that would probably be shot out of the markets and scrambled to find a way to save it while maintaining incentives for it to reform and put its finances in order.

This created attention, because the rest of the euro zone had to help Greece but do it on terms that it would not create a precedent. And it would not go against one of the basic tenets of the euro zone, which is the famous "no bailout" clause for countries that are in difficulty.

So we passed -- and this was the beginning of 2010 -- a few months of trying to create out of thin air basically a mechanism that would help countries in trouble while putting them in a straitjacket, which is what we are in [in] the moment.

In doing so, the emphasis was more on the straitjacket to convince national parliaments in Germany and the Netherlands and France and others to vote to give money to Greece. That made for a program that if it were to be redesigned now, it would be different. And it has been redesigned in a different way -- longer time for repayments of the loans, etc.

And then slowly it also became apparent that Greece was not alone, that this was not just a Greek issue, that there were other countries that had similar problems. After Greece came Portugal, Ireland, and then we started talking about the center of euro, countries such as Italy.

So what was originally perceived as an isolated problem, it became apparent that it was a systemic problem for the rest of the euro zone, meaning that the euro zone was created on certain premises but that when we created it, we did not put in place all the right mechanisms of common economic governance to be able to deal with shocks such as this one. And that's what we are.

So it's really a twofold problem. You had the credit problem that then ran into the euro and the fact that the euro was not fully developed and formed.

You had an outside crisis, the world financial crisis, impacting a country which already had serious structural and fiscal problems, and a country that was moving on a knife's edge of debt sustainability, just being to able to serve its debt and go long, overlong.

Once the outside crisis threw it off balance, the debt became unsustainable. The structural problems, which were there, became apparent for all to see. And it became the lightning rod, if you will, of a broader chain of events that unfolded in the rest of the euro zone.

What's it like to be at the center of that?

Interesting. I do not wish it on anyone. It was an experience that I certainly did not regret, because I think that we took the right decisions in the right moment. And Europe took the right decisions, with delay, but it did. I am paying personally a political cost for it. My party's paying a huge political cost for it.

But if that's the price to pay to be able to say that we did the right thing at the right time, we'll take it. The moment was difficult, but I always felt that collectively, obviously, this was not just a question for the finance minister; this was first and foremost an issue for the prime minister and for the whole government, even though the finance minister lives it on a daily basis much more than anybody else.

We all felt that even though we were forced to take decisions which were impossible and that we hadn't even dreamt of in our worst nightmares, we were doing the right thing. Mistakes we made -- there is no question about it. We may have delayed decisions. We may have taken some wrong decisions, but the basic direction and brunt of what we took was inescapable and necessary given the circumstances.

I think this was proven by the fact that other countries followed us, countries that had for many years undertaken austerity, for example, countries that thought they had a much healthier situation. Portugal, Ireland had to go through the same thing and go through the same mechanism. Even stronger countries such as Spain flirted and hopefully avoided the bailout mechanism. Italy had to go through savage cuts at the moment with a new government ... to avoid Greece's fate.

So we were not alone, and in that sense, discussing with your European partners makes an impossible situation much more bearable.

Rarely does one get a chance to talk to somebody who's at the epicenter of something like that. We talked about the economics of it, but just from a personal point of view, who's yelling at you loudest in the moment? ...

The first time that I went to the IMF, there were about 150 registered press, accredited press, and I had a press conference. The interest was such that there were about 145 of those 150 that were in my press conference. We thought that the whole world is looking, and the whole world was looking.

It was very strange, but Greece being 3 percent of European GDP was able to influence, by its actions or inaction, the rest of the world. Unfortunately, there was a disconnect between the necessity of your actions and how they impact also the rest of the world [and] sometimes the way that society follows this.

And in a country with a political system with a lot of populism, unfortunately with an opposition that while we're responsible for most of the mess was not willing to rise up and take responsibility, it became increasingly difficult to defend what we're doing as the austerity bit deeper and deeper, as unemployment kept going up, and as wages kept being cut and taxes going up. It became increasingly more difficult for people to realize that this tough road was the only one that could guarantee that this house would not go bankrupt.

And at some point they start saying: "Well, where's the end to this? Is there an end to this?" This is why we're hoping that the deal that is now being discussed and will hopefully be closed with a shaving of the national debt by 100 billion [euros], which is a very big number for Greece, ... and at the same time a new loan with a new program, we'll be able to count things down, and people will start seeing that at the end of this very difficult road, there is a better future where the economy starts picking up again. Jobs are being created, investment flows, and you have an economy which is much more viable and robust and much more competitive than what we had before. But the distraction in between is severe.

But when it comes to a country like Greece, participating in some dodgy derivative trades helps them get under the Maastricht level. So in that sense, had they not been provided that opportunity to dress their books, Europe today, it seems, might not be dealing with a Greek debt crisis.

It's possible. I was there at the time. I have an idea what European policy-makers were thinking, and European policy-makers wanted Greece inside the euro.

So the Germans wanted to sell them Mercedes for euros.

Sell them Mercedes or have a friendly country on the border of the Muslim world, or who knows what the motivation was. But I find it hard to believe that a continent that can figure out pretty precisely how many centrifuges Iran is running at this moment enriching plutonium and uranium couldn't figure out that the Greeks were cooking their books doing currency transactions with Goldman Sachs. I think they knew. In fact, I know they knew, and they just didn't care.

How do you know they knew?

Because I talked to them. They knew. The Greeks had a constant dialogue with Eurostat. Now, doesn't mean that they didn't play a few tricks along the way that Eurostat didn't know about, but the Eurostat knew the big ones. And Eurostat also knew the French were cooking their books by reclassifying their pension obligations with a parastatal organization called Cades, and they knew that the Germans were cooking their books with gold transactions.

This was the time when Europeans were generally cooking their books because they couldn't imagine what's actually happening today could ever happen. ...

Do you think that was widespread, and that was the abuse of derivatives, right?

There were abuses. In every market there are abuses. There were abuses in the derivative markets because of the opaqueness of derivatives. It was probably easier to abuse in some cases.

What does that say about the profession?

It obviously doesn't cover the profession in glory. And I think when you go through a period like we all did in the 1990s and the 2000s, where really large amounts of money were available to individuals on the condition that they performed well and performed honestly --

We're talking compensation.

We're talking bonuses. The incentive to cheat is very high. It's very high. And as a manager of those organizations, policing of prospective cheating becomes very difficult when there's huge amounts of money at stake. And there were cheaters.

I don't think the industry was full of cheaters. I don't think every firm was riddled with cheaters. In fact, I don't think most of the business that was done was cheating. I don't think most of the mistakes that were made can be chalked up to somebody cheating someplace. I think most of the mistakes that were made can be chalked up to incompetence. ...

But don't the banks have a fiduciary responsibility in this case to advise the governments about what they're getting into?

I think they do. And one of the criteria for any deals that we did with Greece -- would have been before the Goldman Sachs incident or after -- was that anything that they do be outlined specifically and in detail to Eurostat. Eurostat is the EU [European Union] organization that was tasked with determining whether a transaction complied with the European rules. So that would have been one of our requirements.

Another requirement would have been that the minister of finance personally signed off on the transaction and that somebody in a position of responsibility at JPMorgan spoke to the minister of finance and was sure that he understood what he was signing off on.

These are quite burdensome obligations, which meant that lots of times JPMorgan didn't do the business, as it were.

Those were burdensome obligations to make sure that your client understood what they were getting into. Do you think all banks went through that?

No, of course not.

Of course not? But that's a remarkable thing to say.

Well, perhaps. For me it's remarkable, and of course that's why we set the rules that we did. I think somebody else might have said it doesn't have to be the minister of finance. If you'd got somebody that runs the Treasury, that's fine. Doesn't have to be the elected official. It can be --

Or as long as they sign the paper, we're OK with it?

I think some banks might have set that criteria as well. ...

... You're saying that investment banks would sell derivative products to governments, whether it be a municipality or a federal government, that they knew the governments didn't understand?

Yeah.

You knew of deals like that?

I know of deals like that.

Did you ever raise that? Did you ever go to a regulator? ...

Yeah, I did, and so I'll give you a couple of examples. In terms of government entities dealing in derivatives, some of the worst abusers of the product, both on the government side but also in terms of banks dealing with governments, were the municipalities in Italy.

The local authorities in Italy in the '90s dealt very actively in derivative markets. They had no business dealing with derivative markets. They didn't understand the product, and they didn't have the underlying risk. They weren't risk management transactions. They were speculative transactions designed to generate income to fill up the government coffers.

Like interest rate swaps?

Interest rate swaps or currency swaps or commodity swaps or credit derivatives. ...

So the Italian Treasury was concerned enough about [it] that they came to us and other banks that I think they considered to be responsible and said, first of all: "We would be quite disappointed if you were participating in these markets. Confirm to us that you're not." And of course we said we're not.

Were you?

No. No. The transactions that we did with Italian municipalities were entirely bona fide as far as I'm concerned.

You bought Bear Stearns--

Uh-huh. (AFFIRM)

--in 2008. And they had done some famous deals in the town of Cassino, outside of Rome?

Uh-huh. (AFFIRM)

Are you familiar with those?

Yeah.

Was that a clean deal?

I don't know. At the time that the deals were entered into, hard to tell. Would JPMorgan have done those deals? No. No. Too complicated, too small a counterparty.

So in this case you're holding banks responsible for leading less sophisticated municipal officials down the wrong path?

I would hold banks responsible for that.

So you started looking at Europe; you started seeing opportunity there.

We looked at Europe because the logical corollary of the overextension here had been Europe. ...

European banks were also much more highly leveraged in terms of assets to equity even before the crisis than the American banks and have a fundamental difference in their deposits.

Most American banks have more deposits than loans. Most European banks have more loans than deposits. That means they're very dependent on what they euphemistically call the wholesale funding market. To me, that's the hot money market.

A lot of the problems you're seeing with Europe now were that American money market funds, who formerly were putting money into these banks short term, because they'd make 20 basis points more or 30 basis points more, now are withdrawing it. ...

Everybody looks at Europe right now and sees disaster. You look at it and see opportunity.

I just don't think it's the end of the world, and if it's truly the end of the world, I've got bigger things to worry about than just Europe. ... To me, the idea of Europe truly blowing up is as flawed as the idea that Bank of America, JPMorgan, and Citicorp would be allowed to go down.

But who's going to bail them?

I think what's going to happen -- and nobody else so far seems to agree -- I think it'll take a combination of the ECB, the European Central Bank, the EU [European Union] itself, the countries, the EFSF [European Financial Stability Facility], that's the stabilization fund, and the IMF [International Monetary Fund].

But they have meeting after meeting after meeting, summit after summit.

But they're moving in the right direction, because what is needed are two things. One is a big check. That's part of why I think IMF would be needed. But the other thing that's needed is a policeman. Right now, they don't have a mechanism for enforcing fiscal austerity on anybody. IMF has a long history of serving as the policeman.

So what I think is ultimately going to happen is IMF will come into it in some way, shape, or form, and that probably will mean that China and some of the other emerging countries will end up with bigger shares in the IMF.

That's something they've been wanting to do. They have the ability to write a big check, and so I think you're going to start to see a real change in global financial structure as the result of this, not just of the European structure. ...

You can't take away monetary policy from the individual countries, which they have, and yet leave fiscal policy in the hands of the local governments. Think what a mess the U.S. would be if every state could run a deficit as big as it felt like. That's the equivalent of what's the European structure right now. It's illogical. Not going to work.

How much of what happened in Europe with sovereign debt can be laid to bankers here in the U.S.?

They might've prolonged the period before which you had the crisis. That's the most that it could've done. But take Greece. This is something like Greece's fifth default in the last 100 years, so they don't need Goldman Sachs to teach them how to operate in a profligate manner.

But it didn't help that Goldman got in there in the last 10 years and helped them do a little bit more window dressing.

I'm not intimate enough with the facts to know who did what, but I don't think it's a fundamental problem.

The fundamental problem was Europe was setting itself up to be the leisure society, and many of the European leaders were trumpeting that theory.

They are the ones who created the pension fund mess. They are the ones who created the early retirement. They are the ones who created the terrible labor laws that make it almost impossible to fire people, which means you can't really hire people. It's based on the local government's problems and on the original flaw in Europe, which was not taking control both of monetary policy and fiscal.

What kind of work are you doing vis-à-vis Europe?

Actually relatively little. The Europeans are figuring it out for themselves. ...

They're taking in Treasury Department officials on the planes back and forth a lot.

There is consultation with Treasury. How much they're really listening to Treasury, I don't know. But we certainly are advising clients elsewhere in the world as to potential ramifications of what is going on in Europe. …

So is this batten down the hatches, pull down the sails, ride out the storm? What are you telling them?

What we are trying to tell them is that we have to have as many lines of communication open as possible and to be as innovative as possible. Because the idea of a fortress America, if you go back in history, that's sort of the position the United States took after the First World War economically as well as politically and militarily. And the economic pullback from the rest of the world, whether it was the Smoot-Hawley Tariff or whatever, was equally damaging as the political withdrawal.

So anybody who thinks that we're going to be able to withstand with minimal damage a collapsing Europe, I think, is taking an enormous risk. ...

How do we think about what's happened in Europe and where we are today?

I think there were two pieces in the way in which Europe has been affected by what's going on in America.

One is that Europe bought a lot of our toxic mortgages. Some estimates put it at close to 40 percent. ...

Why did Europeans buy so many toxic mortgages?

They bought so many toxic mortgages for a little bit of the same reason as American banks. They were taken up in the deregulation movement in the same way that America was. These toxic mortgages yielded a little higher return. The rating agency says these are fantastic, AAA.

A basic law in economics is there's no such thing as a free lunch, but they thought they'd found something that gave them a higher return without greater risk. ...

The second thing of course is that when the American economy went down, it had global consequences. You have financial troubles and real troubles on both sides of the Atlantic, global economic downturn. But in Europe, there is a stronger social protection system -- better unemployment insurance, sometimes called a safety net, better health insurance -- so that when the economy went down, the deficit, the government went up. ...

Does austerity by its imposition ensure these countries are going to sink deeper into debt and deeper into recession and more likely default?

Almost surely austerity will mean that these countries' economic position is going to get worse. ...

Why not just break it up and let these countries go back to their own currencies and forget the euro? ...

The process of going from here to there is going to be very painful. Argentina tells us a little bit about what might happen. When Argentina left this economic arrangement where its currency was fixed to the dollar, it caused an enormous amount of trauma. ... Unemployment went up in excess of 20 percent. It was really a very difficult, traumatic problem for the country. ...

In the case of the break of the euro, the consequences in the short-run are likely to be even more traumatic. Contracts have to be rewritten, reinterpreted. There will be legal disputes of enormous magnitude.

But I think for many of the countries, if they manage their economy correctly, they will work their way through this problem and it will provide the basis of a longer-term economic growth. ...

And what will the consequence be for the United States?

... The consequences for our financial system are very hard to determine, partly because our financial system is very nontransparent, very interlinked with that of Europe. ...

You can see the volatility in bank share prices as the travails of Europe go on that say the markets are really very worried about the impact on our financial system. An economic downturn of the magnitude that might occur in Europe will inevitably have a very serious impact on our economy.

Our economy is not yet out of the woods. In fact the CBO [Congressional Budget Office] study that recently was published suggests that we will not be back to full employment, to fully realizing our potential, until 2018. And that's assuming no European crisis. If there's a European crisis, that becomes a rosy scenario. ...

... The story broke [in 2003] that Goldman had helped Greece dress its books, hide its debt. What was the reaction at JPMorgan?

I think there were two dimensions to that story. First was that the Greeks had entered into risky transactions to effectively hide their debt, and the second is that they'd lost a lot of money on those transactions. They'd made it much worse. What they ended up losing was much more than what they originally sought to hide.

But Goldman had assisted them.

I don't know exactly what Goldman did, but Goldman certainly was the counterpart to the trade. ... Did the Greeks devise a structure that was going to allow them to get around the Maastricht criteria and just go out to Goldman to execute the transaction, or was it cooked up in the halls of Goldman Sachs and sold to the Greeks? I don't know.

The issue from my perspective was that the Greeks had a very risky transaction on their books that could cause them to lose more money in the future, and they also needed to finance the losses that they had already incurred. So our first thought was, how can we help them solve this problem?

And how did you help them?

We worked for days and days and days on ways that they could offset the existing risk, so eliminate a risk that perhaps they never should have had in the first place, and effectively put an arrangement in place to satisfy their obligations to Goldman Sachs or whomever. ...

You talked to the Greeks, and they had been through this horrible experience during this Goldman deal. Did you not learn what had actually happened with Goldman?

No. As always happens when you're dealing with governments, if there's a problem, the guy that did the transaction is not there anymore. ... You're working alongside the person that's tasked with solving the problem.

I talked to [Claudio] Costamagna, the co-head of Goldman in Europe, and he said that there were lots of these kinds of deals that were going on, where investment bankers were helping governments of one type or another in Europe hide their debt.

Now, I'm sure that's right. ... The Germans, the French, the Dutch, all the people of course that are now paying for the Greek mistakes, were they aware of what Greece was doing with Goldman Sachs? I don't know for sure. I suspect they were.