SPIEGEL ONLINE: The European Commission has prescribed a strict program of austerity measure for Greece. The government in Athens needs to cut its budget deficit by 75 percent by 2012, and EU aid is not planned. But it is unclear whether Greece will be able to steer its way out of trouble on its own. Is Brussels risking a state bankruptcy?

Peter Bofinger: To the contrary. The tough stance against Greece is the only correct approach. A cash injection from Brussels would have set a dangerous precedent -- it would have signalled to other problem countries like Portugal or Spain that when the going gets tough, the European Union will rescue them.

SPIEGEL ONLINE: But isn't that precisely what is needed right now? The financial problems of the southern European members are putting pressure on the entire euro zone. Some of your fellow economists fear a crash would trigger a domino effect and cause a rapid plunge in the value of the euro.

Bofinger: Some of my fellow economists are going too far. Compared to other currency zones, the euro zone is doing a lot better than many claim. The national debts and new state borrowing is lower than in the United States. And in an emergency it could also cope with a Greek bankruptcy. The country produces just 2.6 percent of the euro zone's GDP.

SPIEGEL ONLINE: Still, the loss of faith in the euro would be massive. And regarding national debt, debt within the euro zone is currently about 88 percent of its GDP. You call that figure low?

Bofinger: It is not low, but it is lower than in the US. There, the national debt is 92 percent of GDP. In Japan, it is even 197 percent. And the United Kingdom's budget deficit is far worse than that of the euro zone. And as far as a possible loss of confidence is concerned, let me point out that the state of California has been on the verge of bankruptcy for months and its share of the US's GDP is about 13 percent. Viewed from that perspective, my fear of a domino effect is limited.

SPIEGEL ONLINE: That could have to do with the fact that you're a follower of Keynesian economics. As such, you believe in stimulating demand in order to increase production and employment and you support the idea of hefty government deficit spending to make that happen. But don't the exploding deficits make you uneasy?

Bofinger: After the Lehman bankruptcy,  there was no alternative to expensive bank bailout programs and very expansive financial policies. But now the key thing is to organize an exit that is both cautious and rigorous exit strategy. That's why in our new annual report (editor's note: provided by the panel of economic advisers to the German federal government), we propose a European consolidation pact under which all EU member states would be obligated in a transparent and credible way to once again achieve balanced budgets. The growing disquiet in the markets shows how important such action is. But equally as bad as the state deficits is the anarchic state of currency policies.

SPIEGEL ONLINE: What do you mean?

Bofinger: As the 1997 Asian crisis made clear, exchange rates are economic time bombs. They can also be used to conduct outright trade wars. China, for example, has kept its own currency artificially low for years, making China's goods cheap for the rest of the world -- a factor that has given a strong boost to exports in the People's Republic. But others feel the brunt of those policies, including the Europeans. The euro is stronger than the renminbi (the official name of China's currency) and goods from the euro zone are comparatively expensive in the rest of the world. But the often erratic fluctuations between the euro and the dollar are also problematic. Uncertainty over the value of the dollar destroys jobs. Take, for example the decision by Daimler to move production of its C-class sedans to the United States in order to safeguard itself from exchange rate fluctuations.

SPIEGEL ONLINE: Are exchange rates denigrating into a protectionist weapon?

Bofinger: Into a perfidious protectionist weapon. If China moves to shield its domestic economy through tariffs, the World Trade Organization intervenes. If China creates a global competitive advantage for itself by devaluating its currency, it is admonished and cursed by the rest of the world. But they cannot force China to do anything.

SPIEGEL ONLINE: That's why French President Nicolas Sarkozy is calling for a global body that would have the power to intervene if countries are abusing their exchange rate policies. Do you share Sarkozy's opinion that the free foreign exchange market should be eliminated?

Bofinger: I want to eliminate speculation related to so-called carry trades. Speculators borrow in currencies with low interest rates and invest that money in currencies with high interest rates. By doing so, they cause the currency of a weak country to appreciate rather than depreciate.

SPIEGEL ONLINE: What are the consequences of that?

Bofinger: The example of Iceland showed that if so much money flows into a country, the banks hand out loans like there's no tomorrow. But at some point the speculators wake up and start wanting their money back. By that point, though, it has long since been blown on unprofitable investments; and in the end the country is left on the brink of bankruptcy.

SPIEGEL ONLINE: Wouldn't it have been easier if Iceland could have simply devalued its own currency from the outset in order to prevent excessive capital flows into the country?

Bofinger: Of course. Each country can try to control the exchange rate of their currencies to prevent carry trades. The central bank in Iceland could have stopped the appreciation of its currency and sought a devaluation against the euro.

SPIEGEL ONLINE: Why did the central bank not take that step?

Bofinger: Probably because it didn't even occur to them. It is just not in keeping with the monetary policy consensus to devalue your own currency. Many central banks still believe in the free foreign exchange market -- even if it inflicts huge damage on their own economy. A global currency watchdog could ensure that governments are required to always make the most economically rational decisions.

'Monetary Policy Cannot Be a National Issue'

SPIEGEL ONLINE: There has already been one attempt to control global money flows. In 1946, the Bretton Woods system came into force. The dollar was then designated as the leading currency and all other currencies were pegged to it at a fixed exchange rate. The IMF oversaw the system, which ended up collapsing in 1973.

Bofinger: But it didn't fail because the basic idea was flawed: Monetary policy cannot be a national issue, it must be organized and monitored internationally. The Bretton Woods system failed because America did not fulfill its role as a reserve currency nation. The United States operated an extremely selfish monetary policy in the late sixties and early seventies. It took decisions which only benefited itself -- regardless of the exchange rates of other countries. And the IMF did not intervene. When the imbalance got too great, more and more states left the Bretton Woods system.

SPIEGEL ONLINE: But won't it inevitably end up like that? The idea that a single reserve currency can serve the monetary policy needs of all other states appears somewhat utopian.

Bofinger: That's why I suggest a tripolar system with the dollar, the euro and the renminbi serving as global reserve currencies. Instead of fixed exchange rates, the values of the three currencies should be strictly determined by interest rate differentials. For example, if the euro zone has higher interest rates than the US, the euro would have to be devalued against the dollar. If the interest rates in the euro zone then falls below that of the dollar, the euro would be revalued again. All other states could peg their currencies to one of the three reserve currencies of the tripolar system. The entire system would be monitored by the IMF, making selfish monetary policies impossible. Likewise, speculators wouldn't have a chance because should a particular currency have favorable interest rates, that would always be offset by a corresponding devaluation in the value of the currency (i.e. making carry trades unattractive). That would contribute massively to stabilizing the global economy.

SPIEGEL ONLINE: That sounds tempting, but it would be very difficult to put into practice politically. How could anyone persuade the Chinese to surrender their monetary clout to a global watchdog?

Bofinger: The Chinese are very interested in the yuan becoming more important internationally. Having a leading position in the global monetary system would be a good reason for them to give up their autonomy.

SPIEGEL ONLINE: But that's not a convincing argument for the Americans. After all, they already issue the world's reserve currency. For them, a tripolar system would only mean a loss of power.

Bofinger: Nevertheless, even the Americans would only benefit from such a project. At the moment, they do not control their exchange rate, with the result that the rest of the world takes over that role. The dollar then becomes the plaything of foreign governments whose main goal is to achieve a favorable exchange rate for their own economy. The price for that is paid by US manufacturing companies, especially automobile makers, who have come under massive pressure over the last decade. If there was a well regulated international monetary system, the Americans could put pressure on the Chinese much more effectively than under the current anarchic conditions.