In the euro zone mess, so far the U.S. has largely played the role of an outsider, reiterating the urgency of dealing with the mess. On Tuesday, for example, the U.S. Federal Reserve’s second-in-command Janet Yellen urged European leaders to take “forceful action.”

But now a respected Washington economic policy shop is saying that Yellen’s bank itself should get involved directly. The Center for Economic Policy and Research (CEPR) is calling on America’s central bank to become a lender of last resort for the heavily indebted nations, to reduce their interest rates from unsustainable levels — Italy, Europe’s third largest economy is paying over 7 percent for its debt, a level at which other countries have required bailouts.

France, among others, has urged the European Central Bank to play this role. But Germany — which effectively has veto power — has resisted, fearful of inflation and of harm to its economy.

So why should the U.S. get involved? And what would it cost? GlobalPost spoke with CEPR Co-Director Mark Weisbrot to learn more.

Having accurately predicted, in 2002, that a housing bubble would cause a financial meltdown, CEPR is a key alternative voice on economics, and a widely-quoted resource for journalists. (The interview has been edited by GlobalPost.)

GlobalPost: You’ve called for the U.S. Fed to act as a lender of last resort for debt-laden European nations, such as Italy and Spain, to prevent them from having to pay unsustainable interest rates on their debt. Why interfere with the free market, and why is this the United States’ business when we have our own financial problems to deal with?

Mark Weisbrot: The problem is that Europe’s financial crisis is already slowing the global economy. The OECD just lowered its growth projection for the U.S. economy from 3 to 2.1 percent for next year, and estimated that the euro zone is already in recession.

To put the matter in perspective, we interviewed Dr. Victor Shih. An expert in Chinese politics and economy, Shih has been following the debt situation closely, and was among the first to warn of potential trouble ahead. An assistant professor of political science at Northwestern University, Shih holds a Ph.D. in government from Harvard. (The interview has been condensed and edited by GlobalPost.)

GlobalPost: When we spoke over the summer, you warned that the public debt level in China — including local and central governments, as well as state owned companies — held potentially staggering amounts of debt: between 80 and 150 percent of gross domestic product. At the low end, that’s similar to France, which currently has a perfect credit score but is under pressure from ratings agencies. At the high end, it’s nearly as bad as Greece. Do you still stand by that assessment, and how have things changed over the past quarter?

Yes, the low end — 80 percent — would be government debt alone. If you include debt that state-owned companies hold that the government is potentially liable for, the number would approach 150 percent of gross domestic product.

There’s been a slight improvement lately, in that the rate of increase in lending has slowed down a bit. Local governments are now having trouble borrowing from the banks. On the other hand, they are able to roll over existing debt. So non-performing loans in China remain low, because the central government has instructed banks to allow local governments — and I suspect a lot of state-owned enterprises — to roll over a lot of the existing debt.

Meaning that they get new loans to cover their old loans.

Shih: that’s right.

We’re hearing that business owners in Wenzhou are committing suicide or going into hiding because they cannot pay their creditors. Many have borrowed from relatives and friends, or used their homes as collateral, so they’re in big trouble both financially and socially. One woman who allegedly borrowed $45 million has now vanished. The situation has gotten so bad that Premier Wen Jiaboa recently paid a visit.

Are these debt problems happening elsewhere, and is it the beginning of a bigger problem — like a bursting Chinese credit bubble?

It is a serious problem, but I don’t think for the moment that it is a systemic problem. First, informal lending — by private individuals or unregulated credit companies to private companies or individuals — is still relatively small compared to China’s entire financial system. And of course, there are different estimates as to how large this informal lending is. It ranges from 5 trillion renminbi to 10 trillion renminbi ($786 billion to $1.52 trillion).

We have to remember that there is as much as 70 trillion renminbi ($11 trillion) in China’s banks. Moreover, this kind of lending tends to be relatively local, so while a cross-regional contagion is not impossible, the scale is not likely to be very large.

Is there a point at which rolling over loans will no longer be possible, or is that not a risk, because China — as a centrally-planned economy — can simply print money?

That poses a problem to the economy. Of course when you print money — which not only China but the rest of the world is doing these days as a way to deal with financial difficulties — you can bail out financial institutions. However, China constantly enlarges its monetary base, and that causes persistent inflationary pressure.

So instead of having a steep crash in the financial system, residents and taxpayers in China have to pay for these financial difficulties through an inflation tax in the foreseeable future.

Which will essentially erode their wealth through inflation.

Exactly.

Many of loans — on the order of $1 trillion, you’ve estimated — have been made informally, essentially by loan sharks or by the “shadow banking” industry. Why is this so prevalent in China?

It’s prevalent because the banking system basically rations credit, channeling the vast majority of it to state-owned enterprises. That said, there’s still a large and quite vibrant private sector in China. They’re forced to seek financing some other way.

Now fortunately, the state owned enterprises have strong incentives to re-loan some of the money they receive to private businesses. In normal times, like last year, a state-owned enterprise could borrow from the banks at about 5 percent, and lend it to underground banks at 10 to 15 percent. So state-owned enterprises can get an upside of 5 to 10 percent a year on money they borrow.

In the U.S. when debtors can’t pay, they go to debtors court, declare bankruptcy, and they can got on with life. How are things different in China? Why are people jumping out of buildings?

People jump out of buildings when they’ve borrowed so much more than their assets, and they have borrowed from some very unsavory people. Or they’ve borrowed from mainly their immediate friends and family, and they have too much shame to go on living.

But usually, they don’t jump out of buildings. They go through the courts, as they do in the U.S. — of course, the courts are more corrupt, but the legal procedure is not that different from in the U.S.

Are there places other than Wenzhou where debt has become a problem?

A sizable informal debt bubble appears to be bursting right now in Ordos, Inner Mongolia. They’ve built a vast amount of housing there, even though the population is actually quite small. There were coal mines there that made a lot of local people rich. They didn’t know where to invest the money, so they first invested it in real estate, then in underground bank loans, and there have been a wave of defaults of these underground bank loans, which are causing problems.

Will this affect the US economy and the rest of the world?

The slow down in local government borrowing has led to a slow down in Chinese imports of construction materials. That mainly effects Australia, Brazil and other countries that export raw materials to China.

On the contrary, the U.S. has really benefited from food inflation in China. Farmers have been driven off their land, when it is converted into real estate. Chinese dependence on imported food, especially from North and South America, has increased quite substantially in recent years. I don’t see that trend reversing any time soon. So farmers in the U.S. have really benefited from Chinese growth and from rapid and artificially-driven pace of urbanization.

This week, French President Nicolas Sarkozy appealed to his Chinese counterpart, Hu Jintao, for financing to support the euro zone’s bailout. Does China have the money to do this? There are, after all, a lot of poor people in China, and development has a long way to go. And what are the risks of such financing for Europe and China?

China has the world’s largest foreign exchange reserves, and so strictly speaking they have the money to invest in whatever sort of bailout scheme Europe comes up with. At the same time, I think Chinese leaders are very careful not to publicly claim credit for saving Europe. That’s because, although in the short-term there could be some pay-off, there are still risks and we don’t know what really is going to happen to Europe down the road. If this bailout has to be followed by subsequent bailouts, then it’s not going to look very good for the Chinese decision makers. So I think they’ll go about it in a careful way, and it will largely go unseen by the public.

In a recent New York Times op-ed, Arvind Subramian of the Peterson Institute argues for a shift in voting status for loans that the International Monetary Fund makes to countries in trouble. He contends that China should gain the kind of veto power that the U.S. has, but that Europe should lose its veto given that it is now a debtor rather than a creditor. Do you agree, and what would this mean for the global order?

If China does indeed contribute a substantial amount of money to the IMF, it should probably get a higher voting share.

Sure, that would impact the way the IMF goes about its business, because China — just like the U.S. and Europe — has its own strategic priorities. The U.S. and to some extent Europe have used the IMF to further their own strategic goals, so if China were to gain influence in the IMF it would probably use it to further its own strategic goals.

It’s possible that Gadhafi died of wounds that were inflicted before his capture. Mortal wounds inflicted in battle do not violate international law.

But emerging evidence suggests that he may have been killed while in custody. If so, that would constitute a serious war crime, human-rights advocates say. It could also tarnish the new government’s standing, especially if other crimes are revealed, and if the perpetrators are not held accountable.

Gadhafi was “found alone in the drain pipe, surrounded by the bodies of his guards who had been shot as they tried to flee Sirte,” reports GlobalPost’s Tracey Shelton citing anti-Gadhafi combatants. He had “injuries to his legs, torso and head,” she writes, but he was clearly alive.

An exclusive iPhone video obtained by GlobalPost shows the immediate aftermath of his capture. At first he walks under his own control, before being seized by an armed mob. Violence ensues. Libya’s longtime leader is kicked and punched. A gun is pointed at his head. Cries of Allahuh Akbar (God is Great) are punctuated with the staccato of gunfire — although in the scuffle it’s not clear whether the shots are aimed at Gadhafi. A knife is held to his neck, but the camera jolts away. Ultimately, a very bloodied but still apparently-walking Gadhafi is led to waiting vehicles.

Later, the NTC confirmed that Gadhafi was dead.

The matter is attracting international scrutiny.

“We believe there is a need for an investigation, and more details are needed to ascertain whether he was killed in the fighting or after his capture,” says Rupert Colville, spokesperson for the United Nations High Commissioner for Human Rights. An independent Commission of Inquiry for Libya, established by the United Nations Human Rights Council, “is very likely to look into this,” says Colville.

“There’s clearly blood on him” early in the video, notes Fred Abrahams, Special Advisor to Human Rights Watch, an expert in armed conflict fact-finding. “The question is, did he die of wounds inflicted before or after capture.”

“If Gadhafi was executed in captivity and that goes unpunished, it sends a message that Libyans can take justice into their own hands,” notes Abrahams. “Whether they’re senior officials, security officials or the neighborhood spy, people who committed crimes over the four decades should be tried in a court, and not lynched by their neighbors.”

He points out that arbitrary justice is exactly what Gadhafi exercised for 42 years. “The goal of the revolution was to break from the past, not to repeat it.”

Muammar Gadhafi’s death is not alone in raising questions. His son Mutassim was also killed yesterday under murky circumstances.

In Mutassim’s case, a three-second video posted on Facebook, purportedly taken after his capture, shows him sitting upright. He takes a drag from a cigarette, and begins to speak. His shirt is bloodied, but no wounds are visible. Later, photos show him dead with a wound in his neck. (The Facebook video’s date and authenticity could not be immediately confirmed by GlobalPost.)

Human Rights watch is calling for an independent inquiry into the death of Gadhafi and his Mutassim. “A lot of faces on the [Gadhafi] video are clear, so they should be able to speak with some of the people who participated in his capture. And we think that the investigation should have an international element, including an internationally supervised autopsy,” to provide that extra layer of transparency.

Meanwhile, Human Rights Watch is also concerned about the fate of others captured on Thursday, including Mansour Dow, a senior Gadhafi security official. The identity and number of captives remains unknown. “We’re afraid that these people will be mistreated or killed in custody.” Their treatment is essential not just for their well-being, Abrahams says, but for their value in future trials for crimes committed under Gadhafi.

European stock markets, meanwhile, hit their lowest point in two years Tuesday.

While Europeans take their August vacations and leaders prevaricate, investors are growing increasingly concerned that the continent’s common currency could collapse, and that one or more countries could default on their debt, leading to another global economic crisis.

For insights on the current state of the crisis, GlobalPost turned to economist Yannis M. Ioannides, the Max and Herta Neubauer Chair at Tufts University. Ioannides is an authority on Greece’s economy. He has served as a research associate at the National Bureau of Economic Research in Athens, and is currently on the academic board of trustees at the Athens Institute of Economic Policy Studies in Athens. He also co-chairs the Greek Study Group at the Center for European Studies at Harvard University.

GlobalPost: In mid-August, German Chancellor Angela Merkel and French President Nicolas Sarkozy proposed initiatives to deal with the euro zone crisis, but investors viewed these as weak. Global equities plummeted. One of the Merkel-Sarkozy ideas was to bolster euro zone governance, which is a step toward greater fiscal union for Europe — essentially, toward a common budget and government-spending policy. Some people have compared this to a United States of Europe. Would this work, and is it needed?

Yannis Ioannides: There’s no doubt that better governance would help solve the crisis, but the real issue is whether the European Union is ready to move closer to the kind of political union that has to undergird a fiscal union. I think that both Sarkozy and Merkel were motivated by a desire to appease the markets by making a political statement. But I think that their ideas are really ideas of the past.

We know very well that what is needed now is growth. Yes, it is important to have surpluses in order for lenders to be prepared to lend to different countries. At the same time, everybody understands that there are times when deficits are inevitable, just as there are times when surpluses appear because of growth. The key thing is growth, and the markets did not see any growth ideas in the meeting last Tuesday. The markets went down basically because of a lack of ideas from Merkel and Sarkozy’s summit. It’s a political failure of the European Union.

Jacques Attali, the former head of Europe’s development bank, told the Council on Foreign Relations recently that Europe needs to create a federation — with a central budget, central “euro bonds” and strict restrictions on national budget. If they don’t do this soon, he warned, the euro will disappear. Would you agree?

He’s right. The idea that you could have a common currency without a fiscal union is patently failing, and people can’t come to terms with that. The question is, how do you construct the United States of Europe? There is no way, because of low labor mobility, the lack of political uniformity across the euro zone and many other factors.

European leaders are currently doing the minimum necessary to get by, as opposed to putting on the table bold proposals about things that are going to appeal to the public throughout the 17th member euro zone or the 27-member European Union. They keep talking, but at the end of the day, the market is unconvinced, and the public is unconvinced.

If you can’t have a currency union without a fiscal union, and we don’t have a fiscal union now, how likely is it that they will be able to put together a fiscal union in the necessary amount of time?

The problem is, leaders in major countries — Germany, France, Italy — won’t tolerate subsidizing other countries, especially when those other countries are not behaving in a like manner.

Compare that to the U.S. Massachusetts, for example, subsidizes people in Arizona on a regular basis, and people in Arizona subsidize Massachusetts. That happens automatically, through our tax money, our social-security contributions, our contributions to the federal unemployment fund and the like. When fewer people draw from those funds in Massachusetts, the surplus is available for people in Arizona to draw from. This cross-subsidization goes on without you or I debating it. It’s part of the U.S. fiscal union.

In Europe, people keep talking about the European Union, but they forget the simple fact that the entire E.U. budget is less than 2 percent of E.U. gross domestic product. In the U.S., it’s much higher, (as high as 40 percent, by some estimates.) There is little scope for stabilization-type activities with a 2 percent budget. A fiscal union would mean having a budget of 20 percent of GDP, ten times larger. Is the European public ready for that? I don’t think so.

There’s been a lot of talk about whether the European Central Bank should issue euro bonds — essentially, debt that would pool the credit of euro zone member countries, thereby making it more difficult for credit-worthy countries to borrow. Would this help, and what would the risks be?

The problem with the euro bond idea is that it won’t solve the more difficult problem, namely, fiscal discipline. Countries that are not doing well fiscally, like Greece, could no longer be forced to stand by their promise to be more prudent _the way the European Financial Stability Facility requires them to be, before freeing up bailout funds). There’s nothing in the euro bond mechanism that allows you to do that. In the U.S., we don’t have this problem because the states are allowed to issue bonds for investment projects, but not to cover deficits. Only the federal authorities can do that, because they have control of the money supply.

The euro bond would allow the European Central Bank to be more like United States Federal Reserve Bank. But at the same time, the issuing entities would still be looked upon with suspicion by the markets. Why would Greece have an incentive to be prudent? That is not addressed in all of these discussions. In principle, the Eurobond is a good idea, and it would make the European Central Bank a more standard central bank, but I haven’t heard anything about the moral hazard problem.

On the other hand, the euro bond would help Europe take action quickly, without convening a summit (and dealing with the complex politics).

If the euro zone is unlikely to adopt one of these policies that brings countries’ budgets together — such as issuing euro bonds or creating a fiscal union — is it inevitable that some countries will default? And will we see countries leaving the euro zone as a result?

Whether the obvious inescapable outcome of a failure to introduce euro bonds is that countries will default, I don’t see that link. I think countries run a risk of defaulting if their economies fail to grow, rather than if leaders fail to issue euro bonds. We see that Portugal is picking up, Portugal is doing much better, already in a few months of its rescue phase.

Are defaults inevitable? I think the issue is growth. If they can implement pro-growth policies, then we will see the end of the tunnel, and more importantly, the markets will see the end of the tunnel.

Right now, governments are pursuing an approach which appears to restrict growth. They’re pursuing austerity, which promotes deflation, slows growth, and increases unemployment. Is this the right strategy?

Austerity is needed to reduce budget deficits, but they need to cut the senseless stuff that they spend money on, and move some of the spending on infrastructure investment, job creation and subsidies to certain businesses.

By senseless stuff, what do you mean? Salaries for too many bureaucrats?

Yes. I’m very familiar with the Greek public sector. It’s staggering what the Greek state pays, and gets nothing in return. It’s just pure waste.

And what would they invest in?

They basically have to slash the state sector by discontinuing activities that do nothing except eat up tax revenue, and have a system where they can screen people, and reallocate them to different activities that are more productive. That’s not happening. They keep talking about it, but it’s not happening.

If Greece, Ireland or Portugal were to default, what impact do you think that would have on Spain and Italy? Would it increase their borrowing costs and would they be able to handle the result?

Whether or not there is contagion, strictly speaking, it’s an empirical question that has not been addressed fully. I would want to see a serious study that establishes cause and effect, that Greece, Portugal, and Ireland are impacting Italy and Spain. For me, contagion is a lot of talk.

What I believe is the issue, especially as it pertains to Italy, is the political crisis. Yes, early in the summer the Italian government very quickly passed measures controlling its budget. But traders believe that a clown is running Italy, and that Finance Minister Giulio Tremonti is the person who needs to take the lead. I think this is a very important factor regarding Italy.

As for Spain, the prime minister decided to call early elections in November instead of next spring. So it’s natural that the public and the markets perceive political instability.

Finally, what about inflation? Debts are denominated in nominal amounts, and inflation tends to erode them by making it easier to come up with cash to make payments. Some in the French media have suggested that inflation could help the situation, more or less the way houses purchased in the U.S. in the 1960s became very easy to afford for the people who held mortgages once the inflation of the 1970s came along.

There’s no doubt that inflation would erode the real value of the debt, (making it easier to afford). But that’s tricky business. It seems to me that nobody is going to go for inflation. The parties that argue in favor of fiscal prudency: Germany, the Netherlands, the Scandinavian countries, Austria and those people, will not go for inflation. The most frightening thing to the German public is inflation.

Because it helped fuel the rise of Hitler?

Yes. They have not forgotten that.

Although details remain murky, the measures appear to take a baby step toward one of the euro zone’s two potential destinies: full-scale fiscal marriage (the other being a messy breakup).

In brief, “Merkozy,” as the two leaders have become known, proposed the following (which obviously will need to be considered by lawmakers before they can be implemented):

• taxing financial transactions, to raise much-needed revenues;
• harmonizing German and French corporate taxes, to take effect as early as 2013;
• electing a euro zone head to “shore up governance of the monetary union,” as the Wall Street Journal put it.

They also announced that the rescue package currently in place is adequate, and that euro bonds — which would ease pressure on member states by borrowing under the creditworthiness of the European Central Bank — may be issued eventually, but not any time soon. (For more on the details of the announcement, see Tom Mucha’s blog hit.)

In other words, Merkozy is advocating a gradual shift toward the type of unified fiscal policy — basically, a United States of Europe — that many economists have argued is essential, if not inevitable.

Sound like good news? The markets didn’t think so. The S&P was down by 1.9 percent Tuesday afternoon, before recovering somewhat. The euro slid as well.

“It’s hugely disappointing and what they say is not going to work,” Marchel Alexandrovich, an economist at Jefferies International Ltd. in London told Bloomberg. “They think they have all the time in the world and they don’t.”

Apparently aware that the announcement was underwhelming, even by the standards of a European August, Merkel struggled to defend it — particularly the decision not to embrace euro bonds.

“People always seem to have the feeling that there is one method that will spring us out of the crisis and in this context there seems to be that the last resource we have is euro bonds,” Merkel said, according to Bloomberg. “I don’t think Europe has come to its last resource and I don’t think we can solve the problem with a single big bang.” Rather, “we need to work steadily and step by step to win back confidence. I don’t think that euro bonds will help us now with this.”

The real problem is that the initiatives aren’t bold. They don’t go far enough. They won’t stanch the financial bloodletting threatening the euro. Instead, they rely on the same wishy-washy, ineffective governance that is at the heart of the zone’s troubles.

Europe already has a sprawling government, and the euro zone has long “regulated” its member states. That hasn’t worked, largely because eurocrats lack real enforcement power, and have a habit of looking the other way when faced with economic realities that might ruin their vacations.

For example, euro zone members are forbidden to let their debt exceed 60 percent of gross domestic product — a restriction enacted to prevent profligacy among members tempted by the relative ease of borrowing in euros. But that restriction has been meaningless. Italy’s debt weighs in at about 120 percent of GDP. It didn’t get that way overnight, but discipline was never imposed. Greece’s debt is even worse, in part due to a currency swap arranged by Goldman Sachs that hid billions in debt. Regulators have known about the shenanigans for years, but chose to hope for the best.

In other words, the euro zone is based on a gentleman’s agreement that’s widely flouted. To rescue it, something far more powerful and effective is needed.

Jacques Attali, the founder and first president of the European Bank for Reconstruction and Development, told the Council on Foreign Relations this week that the zone will have to convert itself “from a confederation to a federation” soon, or the face extinction. He said the zone has “twelve months” to make “real progress [creating a] federal budget, euro bonds, and strict coordination of nation-state budgets, [or] the euro will disappear; Germany will get out.”

That’s a tall order for the continent. Citizens haven’t been all that enthusiastic in recent years about European integration. Its constitution was rejected by both the Netherlands and France, for example. Moreover, greater unity will no doubt be quite costly for the wealthier, more industrious nations. But a collapse of the euro zone would be painful as well.

And so, as with so many initiatives meant to address the crisis, Merkozy’s announcement today fell short of what’s needed to avert possible collapse. Perhaps the heat will have to rise faster before the leaders gain the political courage (and cover) needed to take such meaningful action.

For now, the euro zone contagion is migrating from the periphery to the core economies. In Spain and Italy, interest rates are rising and the governments are tottering toward a possible debt trap. In France, investors are dumping shares in banks, which hold a fortune in dubious debt, and the government’s credit rating is rumored to be at risk of a downgrade (although credit agencies deny this). And the economy of Germany, the motor of the euro zone, is stalling, reporting only 0.1 percent growth in the past quarter.

It may be only a matter of time before that heat rolls in.