Why a Greek Departure from the Eurozone Might Damage Dollar

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This story is based on a radio interview. Listen to the full interview.

Audio Transcript:

Marco Werman: So, if Greece were to default and/or leave the Eurozone, how would that affect us in the United States? For that, we turn to Simon Johnson. He's a professor at M.I.T. Sloan School of Management. Johnson says even if Greece isn't officially expelled from the Eurozone, the damage to the dollar could be severe.

Simon Johnson: They may choose to leave or they may de facto and effectively leave, and then the big risk would be a financial sector impact. Not again directly from Greece itself, but the way in which the Greek events would impact countries like Portugal, Ireland, Italy which is a big country with a lot of debt, the way that would affect European banks and the way that would then affect our banks.

Werman: And so, there's kind of a contagion effect at play here. Do you believe that that contagion could spread across the Atlantic? Can contagion be prevented in any way?

Johnson: Well, there is certainly a significant contagion risk. It's a big risk. It's urgent that we deal with it and sensible preventive measures have not, unfortunately, been put in place by the authorities in the United States.

Werman: What do you think should be the biggest concern right now in Washington about what's happening in Greece?

Johnson: Well, the biggest concern is obviously the events are out of control and there's nothing really the Americans can do to sway it one way or the other. The Europeans are stuck in a very bad and unstable political dynamic. We need to firewall off as much of our financial system as we can. We need to build up capital in our own financial system. There should be an emergency suspension of dividends by large banks and other related financial institutions. They should be building up that equity financing the loss-absorbing capital in the event of a big storm coming in from the European direction.

Werman: Is Washington doing that right now?

Johnson: No, absolutely not. Unfortunately, policy makers in the White House, on Capitol Hill and I would emphasize particularly at the New York Federal Reserve Bank have buried their heads in the sand. They do not even want to talk about these issues seriously. The extent of official negligence on this issue cannot be overstated.

Werman: What about Washington lawmakers? What can they do?

Johnson: They can absolutely be holding hearings. There are some hearings going on this week and they should be pressing very hard on the responsible officials, in the first instance, the Federal Reserve, but we also have this newly created F.S.O.C., The Financial Stability Oversight Council which has overall responsibility for everything to do with potential financial collapse. All of the response officials should be appearing for Congress in public and hopefully behind the scenes explaining exactly how they are going to prevent the European troubles from impacting us. There have been some conversations and I know some of the details. It's really not impressive the way that our officials are responding.

Werman: Why do you think, Simon, heads are in the sand both on Capitol Hill and at the New York Federal Reserve? Is it fear?

Johnson: No. It's the power of the financial sector lobby. This lobby does not like to have a lot of equity. It likes to finance itself with a little bit of equity and a lot of debt. The danger of this massive downside scenario to them or as they see it is that it would require them to have more equity financing. It would require them to lower their return on equity which is the basis for their compensation and, as a result, they continue to push back, and to lobby hard, and spend a lot of money, and to throw money into presidential campaigns and so on and so forth in order to keep their capital levels, their equity financing as low as possible relative to their debt. It's good for them, very bad for the rest of the economy.

Werman: Briefly, what is equity financing?

Johnson: Equity financing is just like when you buy a house, you put down a certain amount of money. Maybe you put down 1% or 5% or 10% and you finance the rest of it with debt. It's exactly the same thing with banks. Banks like to have a little thin sliver of equity and a lot of debt, a lot of leverage that makes them very vulnerable to these big downside scenarios. To protect ourselves, we should have them finance themselves more with equity. More equity means stronger buffers against losses, means better able to withstand the storm that could well be heading our way from Europe.

Werman: And to extend the metaphor, Greece is the house that needs financing and that sounds like a handyman special right now.

Johnson: Ha-ha. Well, Greece is more like the storm. Somebody has set a fire in a forest near your house and the question is how much are you exposed to the risk that that storm, that firestorm will sweep through your community.

Werman: Gotcha. Simon Johnson, professor at M.I.T. Sloan School of Management. He's also a former chief economist at the International Monetary Fund. Thank you very much Simon.

Johnson: Thank you.