FM: Was it the wrong time to be austere?
PF: It is a challenge for fiscal policy to tighten in the face of economies that are this weak. That is the dilemma Europe has been facing and, frankly, we are facing here in the United States. What is desirable is if the politicians could just figure out how to act now to cut our long-term liabilities and not cut spending too much in the next year or so. They could get the time path right in a way that wouldn't hurt the economy now but could give confidence to credit markets and fixed income markets around the world. They are struggling to find a way to do it. You can see in the Italian government's efforts in their austerity budget, it is to change some of those long-term pension and health care liabilities to bring them down into line with the rate of revenue growth. The worry is [that] they tighten things too quickly in the short run. We have the same issues.
FM: We keep hearing that Europe is throwing good money after bad and eventually must bite the bullet and let the debt of these peripheral countries fail. Do you agree?
PF: Whether or not the peripheral sovereign countries in Europe need to restructure their debt is really up to how the countries want to choose to deal with the whole area. It is not necessary that all the countries restructure. Greece is probably an outlier. It will have a hard time meeting its debt obligations going forward. I don't know that the other countries have to restructure their debt. [There is risk] of [throwing] good money after bad in terms of just buying the debt while they tighten fiscal and monetary policy. That was not working. It is giving with one hand and taking away with the other. We have seen the ECB start to ease rates again, we've seen them do some bond buying, they're clearly trying to get a quid pro quo with the sovereigns cutting back on fiscal spending in order for them to feel comfortable doing any more bond buying. That might get you to a place where it is not throwing good money after bad. But clearly they both have to stabilize their banking system and they have got to come up with a pro-growth policy. These countries are going to have a very hard time stabilizing their revenues and their fiscal outlook if they now slip into recession. They have got to do something on the pro-growth side as well as something on the stability side.
FM: What would be the fallout if some European countries default?
PF: A lot of this is already priced into the market. These are small peripheral countries. They have had an outsized impact on confidence and you can see [it] wearing on the markets for the last year or so. But investors and markets are trading [this debt] at very low prices so markets already have reflected that. The principal impact it would have from a restructuring or default is the probability [that] it signals other defaults coming. That is why the authorities are so interested in their firepower. Can they ring fence the countries they don't want to have under threat? If there are further restructurings and downgrades, we'll be looking to see what we think the consequences of that are on confidence and the probability that other countries will follow.