AUDIO-Transcript: C. Peter McColough Series'--After the Financial Crisis: Is the World Economy Now Safe? - Council on Foreign Relations

Mon, 27 Oct 2014 14:44

HomeFinancial CrisesC. Peter Mccolough Series: After the Financial Crisis: Is the World Economy Now Safe?Connect With Us: Speaker: Martin Wolf, Chief Economics Commentator, Financial Times; Author, The Shocks: What We've Learned'--and Have Still to Learn'--from the Financial CrisisPresider: R. Glenn Hubbard, Dean, Russell L. Carson Professor of Finance and Economics, Graduate School of Business, Columbia UniversityOctober 17, 2014

HUBBARD: Good morning, everyone. Welcome to this C. PeterMcColough lecture series discussion with Martin Wolf of the FinancialTimes.

I'll do the short Oprah Winfrey moment here at the beginning and hold up a copy of Martin's new book, "The Shifts and the Shocks: What We've Learned -- and Have Still to Learn -- from the Financial Crisis."

It is an absolutely terrific read, as anybody familiar withMartin's work could guess.

Just a short introduction, though he really doesn't need one.Martin is a recovering World Banker. He is a CBE in 2000 for hisfinancial journalism contributions, an honorary fellow of NuffieldCollege at Oxford and a World Economic Forum stalwart.

He is, of course, to all of us in this room, a regular andfeatured Financial Times columnist, whose pieces are must-reads. Ican say that from positions in academia and business and ingovernment, always having enjoyed talking with Martin and working withhim.

His writing is always extremely economics-oriented, which to aneconomist is a good thing, but also very cogent and well-written,which very few economists manage to pull off.

And "The Shifts and the Shocks" is no -- is no exception. It'snot really a review of what precipitated the crisis as much as it is adiscussion of shifts that are needed in thinking and policymaking.

So Martin, to get started, whenever I think about the financialcrisis, I often start at a place you do in the book, which is actuallythe Queen of England's question at the London School Economics.

The Queen of England actually asked one of the most cogentquestions in the financial crisis, and the question was this: "Whydid nobody notice it"?

The issue then in our profession that often gets discussed isthat it was a forecasting error. We simply blew it. Weestimated one thing, and it was something else.

But the issue that you talk about in the book is -- is actuallymuch deeper than that, and you hearken back to the idea that's -- that'smore terrible, that is, that we didn't even entertain the notion of afinancial crisis. And we all know that that kind of complacencywould've amused Hy Minsky, who famously wrote about financial crises.

How should we rethink our role or our conception of a crisis andthe role of finance in the economy?WOLF: Wonderful question.

First of all, it's a great pleasure to be back here. I've alwaysenjoyed my association with the Council, and it's a great opportunityto discuss the book here, so I'm very pleased to be here.

My starting point obviously is exactly with -- indeed, it was --it is the starting point of the book, because I start with -- I thinkit's in the preface -- with Hy Minsky's remark that economics -- anymacroeconomic theory, as it were -- macroeconomic view has to includethe possibility of great depressions. It's one of the possible statesof the world.

And I suppose it is true that for most economists, increasingly,as the Great Depression faded into the past and economic theoryevolved in the post-war period, as we knew it did -- though we coulddiscuss this further -- this possibility really disappeared from the-- the -- the way we thought.

Now, of course, people were very, very well aware that there'dbeen lots of financial crises in emerging countries. There'd been abig crisis in Asian emerging countries, for example, Latin America's(inaudible) Tequila crisis, the Latin American debt crisis.

Not that people aren't aware that crises have occurred, andthey'd also, of course, occurred in some developed countries.

But these were usually explained away by special features --crony capitalism, something like this -- some way in which thesecountries didn't really understand capitalism the way Americans andBritish people understood capitalism, so they -- they -- it was quiteunderstandable they made such a mess of it.

But of course, we really did. We were -- as I pointed out in thebook, this was seen, rightly, I think, as the -- London and New Yorkwere seen as the centers of world capitalism, financial capitalism andthe most sophisticated institutions and theoretically, the mostsophisticated central banks.

So it was sort of thought, I think, by most economists, that this just couldn'thappen.

Well, once we -- one realized -- and I have to say that I didn'tthink that it couldn't happen in -- that there couldn't be a financialcrisis, but I certainly didn't think, until it happened, that we couldthe financial crisis on the scale we did have in 2008.

That obviously raises profound questions. And in part of thebook, one of the chapters in the book is about the perspectives ofdifferent economic schools going back to the late 19th century. Istart with Wicksell--on the question of what makes financial fragility, how thefinancial sector interacts with the real economy, why one can'treally have any serious of macroeconomics which doesn't treat creditand money and the -- the role of the private sector in creating both acentral -- that -- that's a central part of my book. All seems prettyobvious now, but it wasn't very obvious before.

I don't want to make this invidious, but probably the mostinfluential living macroeconomist, Robert Lucas, has this famousremark, which, of course, I couldn't get away from, in hispresidential address, I think '94 -- I can't remember the exact date-- in which he says, "Well, of course, the problem of depressions hasbeen resolved, to intents and purposes, for all time."

So we have to, I think -- one of the lessons of the -- of theexperience and one of the things I grapple with in the book is what itmeans for economics.

HUBBARD: And of course, Lucas subsequently is awarded the NobelPrize in Economics...

WOLF: Indeed.

HUBBARD: ... on top of that, and draws on a rich tradition,because Arthur Burns, in his presidential address, said that thebusiness cycle was dead. So economists have a long history of thissort of forecasting.

WOLF: We do suffer from hubris rather badly, don't we?

HUBBARD: Yeah, I'm afraid that's true.

Well, your -- your book does talk a great deal about policyaction, and there's a lot there, but I want to focus with you on oneparticular area.

You have a quite -- at least in my view, quite radical proposalto shift to narrow banking a la what you rightly refer back to in thebook as the old Chicago plan from the 20thcentury.

Do we really need to do this, and is it not possible that analternative of more contingent capital and a credible end to "too bigto fail" would do the trick?

And isn't the issue really more one of leverage and not this bankleverage? So is this solution really right?

Tell us about the narrow...

WOLF: Well, I think there's -- there're a whole set of veryinteresting issues about alternative proposals.

So I put forward -- discuss a number of possible ways forward to-- to deleverage the system and to make the financial system lessfragile.

And in fact, most of my focus is on raising capital. That's the-- the longest discussion in the section on financial sector reform.There isn't one chapter on financial sector reform, and since so manyhundreds of thousands of millions of words have been written on --obviously can't cover everything.

So it does seem to me that given where we are now, the naturalway to go is in the direction of raising capital requirements in bankstowards levels which would've been regarded as perfectly reasonable acentury ago.

And of course, that would have implications for neobanks, forentities that -- that essentially pursue bank-like strategies, whichare not called banks. These would emerge, so there're always going tobe some difficulties about that.

And I also talk about resolution regimes, which are relatedreally to your contingent capital or debt. If we pursue that, thatwill certainly be -- certainly be a big improvement, and it might besufficient to -- to help -- to help a great deal.

Now, my interest in the -- the Chicago plan actually has two aspectsto it, one probably much more controversial than the other.

The more obvious one is -- is simply the idea that if you have asystem who -- which creates most of our money, all (ph) our money, asa byproduct of its lending activities, the -- I describe this as essentially a public-privatepartnership in the creation of money, with the central bank backingthese entities.

Then the -- it's very, very likely -- and this is clearly whatthe Chicago plan people concluded -- that at some point, this will runaway with itself. There will be a point at which it will run awaywith itself.

When it does run away with itself, the elasticity of the systemis -- I mean Wicksell's great insight is that there is no stoppingpoint before credit collapse, you know, before mass bankruptcy. Itmust (ph) continue.

You have this insight -- let's think about it as if there's onebank. It's lending, creates money, and as long as people are preparedto -- to hold it and go on without limit -- doesn't need capital untilsuddenly, people are worried about the soundness of the loans, andthat takes a long time.

But if you move to 100 percent reserve banking or evenvery high reserve banking, you will curtail this elasticity very,very significantly, and you can give central banks much more directcontrol than -- than interest rate policy has given them in the pastover what they do.

And these banks would then be sound. There would no -- be noreason to run on them. Of course, it is absolutely true that youwould then have the question of what happens outside this core system.And one -- and we -- I discuss this to some extent. There areobviously a number of possibilities.

One, you would in -- in -- there will be -- you would not allowany other institutions to become very much like banks. And as soon asthey did, they would have come under the same perspective, the sameconstraints.

I won't go into all the details of this, but the -- my --my proposal here is these, I think, very, very interesting ideas, andI would like somebody to try experiment with it. So I'm trying to getthe Icelanders to do this at the moment...

(LAUGHTER)

... and -- and see what would happen. I think Iceland isperfectly suited. Now, there is another aspect to what I think, whichis much more radical than that. And it's not something I put forwardvery strongly, but I have become -- and I -- I genuinely think thisis, to me, a puzzle, a real puzzle. But we seem to find it very, verydifficult to create reasonably balanced and stable demand growth inour economies at the moment without credit bubbles. It seems tobecome a pandemic phenomenon.

Now, I have some views of why this has happened. Andmaybe people in the audience have better views than I do. But itdoes seem to me a feature. Well, if that's the case, then I supposeI'm increasingly tempted by the idea that the solution to that problem-- if that's the problem-- is Milton Friedman's helicopter money.

And that -- and that means government-created money is thesimplest way of financing expansions in demand if the only alternativeis crazy credit booms. And, of course, if you go that way, since youwant to contain the consequences, you want to manage that, well, then,you -- you end up with, inevitably, as we can see already with Dewey,huge reserves in the -- in the banking sector.

You can see the reserves, and I think we are going to end upin all arctic countries with much higher reserve requirements in orderto manage those. I think that's how that will probably end up. Because I don't think these balance sheets will be reversed. I may be wrong on that.

And I think it's possible that we will be forced to do more ofthat in the future. I stress possible. I don't say certain. But itis one of the puzzles about where we are that we have become socredit-bubble dependent.

HUBBARD: I want to come back to the credit bubble and theradical Martin in a moment, but I want to keep on this issue ofneobanking for a moment. So if one had neobanking, so no morefractional reserve banking, 100 percent reserves, which is the oldChicago plan...

WOLF: Yeah.

HUBBARD: ... what would you do about your banks? How would theFederal Reserve or any other regulatory entity assure itself thatleverage doesn't just simply move from commercial banks to somewhereelse?

WOLF: Well, the Chicago plan, as I understand it, had twoversions of this. The most important proponent of the Chicago planwas, of course, Irving Fisher, who was not at Chicago, I think.

HUBBARD: He was not.

WOLF: So it's not really a Chicago plan. Anyway, Irving Fisherwas...

HUBBARD: (inaudible)

WOLF: Yeah. Yeah, yes. Irving Fisher was the -- greatestAmerican economist. I think he was. And so...

HUBBARD: Although he, too, said stocks were the...

WOLF: Yeah, yeah...

(CROSSTALK)

WOLF: He got bankrupted by -- the failure to foresee stockprices is -- has devastated many individuals, and I don't there'sanyone who suggested that economists are necessarily particularly goodat that.

HUBBARD: That's correct.

WOLF: So...

HUBBARD: My wife would confirm that.

WOLF: OK, OK.(LAUGHTER)

Well, they had essentially two ideas. One idea, which is themost radical, is essentially Kotlikoff's. I mean, Kotlikoff hasresurrected this.

HUBBARD: This is Larry Kotlikoff who is...

(CROSSTALK)

WOLF: ... has produced a book, which is really -- I think herefers to the Chicago plan, but as far as I can see, it's identical.I mean, essentially, his idea was all other financial institutionswill be mutual funds or investment -- investment trust. That is tosay everything else -- there's a logic here, which is very brutal,that essentially says intermediation is dangerous if it -- if you takerisks on balance sheets, which are, in fact, not capable of takingthose risks. (inaudible) Ultimately, all equity is owned byhousehold, by definition, everything.

HUBBARD: Right.

WOLF: So one instance (ph) of financial sector is so fragile ifit has intermediation within it on the basis of very limited equity inthe system, and there's all these contagion of facts. So the simpleanswer to that is everything is mark-to-market on the asset side, and onthe liability side, it's far through to the -- to the investor.

So you get away from this pretense -- and it is a pretense in somedeep and obvious way -- that you can have a whole slew of very risky,uncertain price-varying assets on one side, and make guaranteedpromises in the other that you will meet your obligations at parinstantaneously.

And you could say, and I would say, that's essentially afraudulent promise. That is to say there are many states of theworld, not difficult to imagine, in which that promise cannot be met.And this is Larry's basic point. And if you build your financialsector on -- on a system in which many states of the world, thefundamental promise of the system -- that is to say you can meet yourliabilities at par perfectly liquidly instantaneously while you haveall this other stuff on the other side, you're asking for trouble.

So the answer Larry puts forward, and that goes back I think toIrving Fisher, is you just say you can't make those promises. They'reillegal. By the way, interestingly, this is the position taken by themost interesting contemporary Misesian, a -- or at least I found, aSpanish economist called, I think Jesºs Huerta de Soto orsomething like that. Anyway, he's written a huge book on money andcredit in which he say -- basically says the whole of Anglo-Saxonfinance is a fraud.

And the -- goes back -- and he goes back into the history of howwe got away with creating these entities, which may -- actually, Ithink it was invented by the Italians. But I won't go into the -- theorigins of the banking idea.

So one radical idea is essentially you make -- you makeinstitutions that make those promises illegal. And everything else ispassed through to the investor. And every day, your market moves upand down, and your...and if you want money, then you have to be backed by money.

The less radical alternative -- I really like that -- so if I were -- that's what I want Iceland to do.

(AUDIO GAP)

I know I'm not going to persuade it to happen in the U.S., but it's logical. It is logical. It is important to understand that if the main characteristic of your financial system is enormous balance sheets in the intermediation sector -- I'm sure this is many people here -- that make these promises, you're going to have trouble from time to time from panics.

Inevitable you're going to have panics. They're built into the system,and the only entity that can back you against the panic is agovernment entity, a central bank. So it's not really a privatesector. That's really important. It's not really a private sector at all.It's a solely public sector. This is why I make this crack in my book-- I think that you really should regard bankers as very, very highly paidcivil servants.

(LAUGHTER)

Because they are ultimately dependent on the public sector'sbalance sheet. That's why the Fed was created.

So the other alternative is, indeed, to say you can go and dothese things. But the regulators will go look at you, and wheneveryou start making promises that look bank-like, they will force youback into banks. And if you're not making promises that are bank-like, they will insist on high capital requirements and all the rest of it.

So -- and the regulators then will have to be very active inpursuing that. But the -- as I point out in my book, and that's oneof the central parts of the book, the regulators are being -- evenwithout doing that, the regulators are being insanely (audio gap) active.

One of the most important things in my book, I think, is to tryand spell out the nature of the regulatory response to the crisis.And the -- the fascinating thing, and this is derived from the work ofAndy Haldane, in particular, at the Bank of England, the paper hepresented at Jackson Hole in 2012, in which he points out that in ourresponse to the crisis, we have created, without any doubt, the mostcomplicated, incomprehensible, convoluted regulatory structuresimaginable, which nobody -- he doesn't understand. He's theregulator. He doesn't understand, and he's the cleverest regulator Iknow. Then it seems to me that it's not a very good system. That'snot a very good way to run things.

So I think the more radical ideas I put forward are not at allridiculous. They're just radical. And they're radical, becameradical, because where we've ended up now is that we have these hugeand highly (inaudible) financial sector, absolutely colossal, which makespromises that in states of the world it cannot keep.

We've lost confidence in it, a regulatory system, politicalsystem has lost confidence in it. And the way it expresses that lossof confidence -- just open the paper every day -- is evermoreintrusive rules on everything: what you pay people; how you paypeople; what risks you can take; what -- how much capital you needagainst this risk; and how much capital you need against that risk. Imean, it's micromanagement of the most insane kind.

I don't think anybody left, right, center can think this is verysensible place to be. It's unworkable. So that's a part, a radicalpart of my book. So I think we should be thinking about much moreradical alternatives.

This is one alternative, as I've said, these types (ph), isreally to go (inaudible) with -- with leverage reduced in all systemicinstitutions, and then you go around and decide what they are from thirtyto one to somewhere between three and four to one, to, at the most, tento one. That's the other way to go. I think they're the onlyrational ways to go if we don't want this, to my mind, insanemicromanagement, which can't...

HUBBARD: Yeah...

WOLF: Nobody can believe will really work.

HUBBARD: Yeah.

WOLF: Sorry. It's a long answer.

HUBBARD: Yeah, yeah, I -- no...

WOLF: But it's a very good question.

HUBBARD: ... and I agree with you that there's no way thatregulation is going to keep up with this. And the history offinancial regulation is (inaudible) it never -- it never does.

The world you described of higher capital does hearken back tothe 19th century when there were double-name commercial paper...

WOLF: Yes, yep.

HUBBARD: ... bank shareholders were individually liableagain...

WOLF: Yeah.

HUBBARD: ... for the amount of capital in the bank. Yet, therewere financial panics repeatedly in the 19th century. So itdoesn't...

WOLF: But you didn't have a...

(CROSSTALK)

WOLF: I agree. No, I -- only going to 100 percent reservebanking you eliminate the panic. But the -- the -- and you didn't --but you didn't have a central bank.

HUBBARD: Right.

WOLF: I've seen that the argument I've made, which I thinkfollows Mervyn King, which whom you probably have here because I knowhe's been involved, is -- let me go back in slightly different waysand good story. It's a -- it's a British story.

One of the good things -- one of the things about my book, whichI think is quite good, is that it does treat it as a global crisis,not just as a U.S. crisis. So we have Northern Rock. Northern Rockwas the first bank run that the British had had for more than acentury -- public bank run. So it was a big deal for us. We've hadfewer crises because we have a -- by the way, I should mention this.

WOLF: There is another way of running your banking sector. Ithink of it as the Canadian way. You get...

HUBBARD: Oligopoly.

WOLF: You have a nice tight, boring oligopoly, with most of therisk borne by the government. Nearly all banks now do mortgagelending, and more outside the U.S. than here, than the U.S., but youhave government entities to do this because you have a completely(inaudible) housing market, but the other countries -- in othercountries there is a sort of quasi-private sector, but it'sguaranteed.

That's another way of doing it. I think that's really the worstof all possible worlds. I wouldn't want to go into that boringoligopoly route. So that's not the way we go.

So where was I before I interrupted, just myself? What was thequestion you just asked?

(CROSSTALK)

HUBBARD: You were -- you were...

WOLF: Northern Rock, Northern Rock, good little story.

HUBBARD: And, by the way, we only socialized the housing losseshere, not gains, yet.

(LAUGHTER)

WOLF: That's the best sort of socialism, isn't it?

So, Northern Rock run, the Northern Rock run. Northern Rockcouldn't fund itself, once the crisis happened in 2007 because thewholesale markets froze. And, but Northern Rock had a lot of assetsthat it needed to fund, and also money was being withdrawn.

So the Bank of England was called upon to act as a lender of lastresort. And the Bank of England obviously wanted to pursue, to imposehaircuts on these assets, to devalue these housingmortgages in the U.K., whose values were highly uncertain.

And Northern Rock had next to no equity.

So the Bank of England's problem was really very simple. Itworked out that, as things were, as lender of last resort, it wouldend up funding at least a third of the balance sheet within a fewmonths. And if it applied a normal discount on the value -- this isvery important, why capital is so important for liquidity operations,for a central bank -- then Northern Rock would be insolvent.

That is to say, it will be funding an entity the value of whoseassets was below the level of its liabilities, including theliabilities to the Bank of England.

And the Bank of England's view was, our job is not to take on thecredit risk of this kind, therefore, we couldn't do it. And, in theend, that forced the government to nationalize the firm.

But, Mervyn's point is that if Northern Rock had had a, you know,capitalization of, let's suppose, even 10 percent of the balancesheet, let naught 2 percent of the balance sheet, then the solvency ofthe Northern Rock would have been much more unlikely.

It could have lent on the penalty rate on a much large scale,while being completely or at least much more comfortable about thecredit risk, and, therefore, operating as a genuine lender of lastresort, which as (inaudible) had always explained, was not abouttaking serious credit risk. It's -- it's -- that's why he wanted,among the reasons he wanted people to lend at a penalty rate, isimmensely much easier if banks are properly capitalized.

And if banks aren't properly capitalized, acting as a lender oflast resort involves taking huge credit risk and, in fact, of course,we know very well, though it worked out perfectly well in the end,that the Fed took a lot of credit risk in the 2008-09 crisis.

But in the more -- or that ultimately amounts to a pretty opensubsidy, not just on liquidity, but on capital values. And the -- Idon't want central banks to go there, so it's a -- it seems to mequite an important reason, if you don't go the really, really radicalroute, which we discussed, to have enough capital in the banks to getaround it.

There is another way of doing this, which is the classic way,which is that the banks pledge assets whose value, market value, is easy todetermine. There is a -- and you can impose a penalty simply on theassets, and so you don't need to worry about the balance sheet of theinstitutions.

But, given the sort of balance sheets that banking institutionshave nowadays, they don't have a lot of this -- they have much less ofthis very transparent, tradeable paper that used to be the case inbanks back in the 1960s, particularly British banks, so thatdoesn't seem a very realistic way to go.

(CROSSTALK)

WOLF: I mean, what haircut would you need to have imposed on so-called toxic assets to decide a value? I mean, central bank couldn'tdecide that in a sensible way.

HUBBARD: Right.

WOLF: So, that's my answer.

HUBBARD: Let me go back to Helicopter Martin for a moment.

WOLF: Helicopter Martin.

HUBBARD: So, is it your position that major industrial economiesare in what Alvin Hansen would have called secular stagnation,and that the solution to that, because Hansen's original argumentwas on the demand side, the solution to that is this permanent moneyfinancing of higher government spending? Is that a good way ofcharacterizing your position?

WOLF: My position is that this possibility seems more plausibleto me now than it has seemed in my professional lifetime. I havebecome increasingly concerned that -- and this is part of my analysisbefore the crisis, with the point that Larry his since sort ofcrystallized in his way, brutal way...

HUBBARD: This is Larry Summers, building on the Hansenargument.

WOLF: Yeah, that -- and I think a number of other economistshave made the same observation, that periods of what appears to berapid -- reasonably rapid and balanced growth in our economies havecoincided with -- not coincided with -- have been driven by whatlooked, certainly ex post, and looked, to some of us, ex ante, at thetime, to be obviously unsustainable credit booms.

So, that's what happened in the early 2000s here. It's whathappened in Spain, which I argue had a lot to do with what happened in --which helped Germany. The -- it also, interestingly, is what -- it'swhat happened in Japan in the late '80s, it's what happened in Chinaafter -- interestingly, after your credit boom blew up -- or theWestern credit boom blew up.

Now there's an interesting question of why that is the case. AndI discuss in the book a number of possible hypotheses. The thingsthat I focus on here are changes in global imbalances, which I thinkis very important, mainly the perverse, but I think comprehensiblesituation, in which you're measuring economies that have become hugenet exporters of capital to the developed world, which we find verydifficult to use, changes in the behavior of the nonfinancialcorporate sector, both on the investment side and the profit side,shifts to profits, which are not matched in any way by increasinginvestments, very important macro economic phenomena, changes inincome distribution.

So in the Western world, not only have we become dependent oncredit booms, we've become dependent on very specific private sectorcredit booms, that is household-led borrowing.

It's quite interesting, because it seems quite new. When Ireread Minsky, his concerns were all about corporate sector leverage,not household leverage. That's a new invention. And it turned out tobe particularly destructive.

So I think the possibility that that's where we are is not to beignored.

It's -- now, there are a number of possible ways, one thinks-- one response might be, well, that's it. So that means that growthis just going to be slower. End of story. Just live with it.

Lots of friends of mine think you forget about it.

Another possibility is just to think about policies that affectinvestment, corporate savings, retained earnings, how they're used,distribution of income.

Of course, people on the left would start talking -- like JoeStiglitz would talk about redistribution of income as a core part ofthe solution to this strategy. That takes you all the way back, bythe way, to Marx's theory of the credit cycle. That's was what hebelieved was at the roots of this.

I don't actually have Marx in my book. No way. There we are.

But if we can't think -- and I'm agnostic about this at themoment, in the sense that I'm not saying that as a permanentstructural policy this is what we should do. But my friend, AdairTurner, Lord Turner, who was chairman of the FSA, he's putforward this idea, and I think that we may be driven to thispossibility.

It'll be very interesting to see how this upswing, which is avery feeble upswing, exceptionally feeble by U.S. standards, andnonexistent in Europe, will proceed. And I sort of hope that it willend up with balanced growth in the financial -- in the private sectorwithout another credit boom, but I'm increasingly concerned that inthe U.S. and U.K., the way we are, the way the banks, central banks,are operating, the way we are trying to drive ourselves out of this isto create another credit boom, and from the -- from the top -- fromthe position in which that we deleverage a little.

Take the U.S. simply. The U.S. has deleveraged. The financialsector's deleveraged. The household sector's deleveraged. But it'sonly back to 2002-2003 levels roughly, which is just four years beforeit blew up, so you've got four years of fun, and then it blows upagain.

If that happens, and I think it's quite plausible that it willhappen that way, that's what we're going to end up with, if it works atall, then we're -- then after the next crisis, we're going to have tothink of something new. And this is one possible thing we'll have tothink about.

And, as I said, it has very respectable Chicago Schoolantecedents.

But we are in a very strange place, in which I think theeconomy's had -- you know, we -- it doesn't look as though we get anequilibrium in our economies, growth, demand and supply matching in a-- what without ending up with zero rates, insane Q.E., and all therest of it, all this huge Q.E. phenomenon, without havingpotentially unsustainable asset price buckle and credit going with it.

And that's a pretty worrying situation.

HUBBARD: Before we open it up to the audience, I want to takeyou globally a bit, to talk about austerity, build on your comments.

It's clear, I think, to many of us, that there was too much near-term austerity in the United States and in Europe, but arguablythere's still a need for -- well, not arguably, I would say factually,a need for a great deal of long-term austerity.

How do we do this, given the discussion that you just had? Howdo we get long-term government budgets back in balance, or, since youborrowed from another radical in your book, Lenin, what is to be done?

WOLF: What is to be done?

Well, my first best proposal, which I regard as a medium- tolong-run proposal, is, well, it would go like this: Let's go back tothe late 19th and early 20th century's globalization, which had a muchmore natural structure of savings and capital flows.

So, which -- in other words, at that stage, you know, the richestold countries were Britain and France, to some degree. Britain was anenormous capital exporter. Actually, it exported abroad abouthalf its savings. That money was invested in the most dynamicemerging economies of the time, of which, of course, the U.S. was themost important, so the U.S. accumulated very large -- U.K. accumulatedvery large claims on these countries like the U.S., obviously thedominions, Canada, Australia, New Zealand, South Africa, Argentina.

And, actually, the U.K. went into the First World War with assetsroughly three times GDP, which had contributed very greatly to thedevelopments of these various countries.

WOLF: That would seem to be the natural process. Obviously,unfortunately, this wonderful treasure trove of wealth was completelyand utterly consumed in two world wars, but that's just one of thosethings that happens in life.

And the -- and our then subsequent principal predator of the U.S.as Benn has described so well in his recent book, drove somepretty hard bargains in the process. Now that's not important. So itseems to me if we are where we are, the aging economies, aging richeconomies, which seem to have in the private sector ex ante excesssavings. One of the symptoms of that is our interest ratestoday, should be exporting capital, not importing it. So Germany is,in fact, the future.

But Germany, for all of us, but that only works if the rest ofthe world is happy about importing capital. And you would think, ifyou look around the world, and most of the world is emergingeconomies, they have tremendous investment opportunities, why shouldthey save even more than they invest?

I mean, it's sort of really ridiculous because they'reforegoing consumption of opportunities now, in order to supporttheir investment. It would make much more sense if we invested inthem. So I do discuss both the rationale for this and theinternational institutions that might possibly support that then itwill happen.

It's clearly a perverse situation that we have now. Why shouldChina be a huge exporter of capital, when it's already got this --it's much lesser now, but still the emerging world continue to be asubstantial exporter of capital. A lot of that has to do with ofcourse the failures of policymaking, emerging developing countries,failures of institutions, legal institutions and all the rest of it.

But that's the natural solution. And I give some arithmetic andsome ideas in which we would solve our problem quite easily, if webecame net exporters of capital. So the U.S. wouldn't be runninga current account deficit anymore, it would be running a surplus of,say, three, four percent of GDP. This is not an unreasonable view ofthe world.

Unfortunately, it doesn't seem to be available. We seem to bedriven and it's a central part of my argument how that happened. Weseem to have been driven to a situation in which we are forced, Ithink, by choices elsewhere, in large measure, particularly inemerging country choices and particularly East Asian choices toactually run our economies in a way that our total expenditure exceedsour output.

And in the -- in that run-up to the crisis, that excess wasenormous. And that creates tremendous problems for policymakers,because if you don't want the government -- coming back to your point-- to run the fiscal deficits, that means that the private sector mustrun large financial deficits and for the private sector to runfinancial deficits, as far as we can see, that -- particularly whenthe corporate sector is so cautious, that means that we end upwith this household problem.

In that context, doing the things you want on fiscal policy isvery difficult. If we want to -- and I discussed that actually in mycolumn today about the UK, if we want a balanced budget and to drivedown our debt over time, so -- in our case, it would probably take twentyyears -- twenty-five years of normal growth to get our public net-debt ratioback to 30 percent of GDP, which is where we started. Now it's 80percent. So we have to run a balanced budget.

For that to happen, given that we seem to have, again, a largestructural current account deficit, which doesn't change very quicklyor easily, but I assume that's the case, then we have to have a hugefinancial deficit in the private sector. And I think that's going tobe impossible to do without destabilizing the economy again.

So what we would want to do is to move into surplus on theexternal account -- re: not have these excesses. But thatmeans the rest of the world has to adapt. It's a huge globaladjustment problem. And if the whole developed world does this, notjust Germany, it's a very big -- to my mind -- a very big global macroadjustment problem.

So getting your fiscal position where you want it to be, whenyou're talking about the West as a whole -- so not just individualcountries -- really does mean thinking about how the rest of the worldeconomy will adjust to that situation.

And I think the only way therest of the world economy adjusts to that situation, plausibly, givenwhere we are, is if the developed world becomes really large netcapital exporter. And that's a complete transformation of a situationwe've been in for the last twenty years. And it's not a situation, Ithink, that will emerge naturally, because I think most emergingeconomies just don't want to be there.

HUBBARD: Great. So we've gone from Simons and Friedman to Lenin all in one morning. But now the floor is yours for any questions. Yes. Please wait for the microphone and identifyyourself.

QUESTION: I'm Sam (inaudible). Good morning. Actually before myvery brief question, the notion of our bankers becoming publicservants, does that also imply they be paid as public servants?

WOLF: Well...

QUESTION: I know you don't have to answer the question.

WOLF: ... the implication is that they should be, but I don'texpect them to be.

QUESTION: No. But my question, is if we had some majorterrorist event in one of our major Western countries, here, WesternEurope, how would that affect the extraordinary thoughts given to usthis morning about how we fix our problem?

WOLF: I suppose, it must depend, in part, on what you meanby a major terrorist event. The -- so let me give you my idea of what a major ...

(UNKNOWN): (Inaudible).

WOLF: Well, yeah -- what I think of as a major terroristevent, as opposed to a minor one, would consist of two things -- oneor both of two things. And somebody here may have more imaginationthan I have. One, somebody lets off a nuclear device in a downtownof a major city, like New York or London. And a device sufficient tokill hundreds of thousands of people and destroy a substantial part --this is a Graham Allison's nightmare, right. And you've allfollowed, I am sure, what Graham Allison's work in this area. Sothat's one major event.

And the second major event that people talkabout is the ability to infiltrate very porous cyber-security systemson vital utility grids, most obviously, the electricity system, andcloses it down. Well, I can't just the plausibility of the latter. Ijust can't. I'm told it's possible. I don't know for how long this isgoing to go on.

Well, either of those events would be -- how does one puts it,in the most delicate way, game-changers. And we would -- if they -- Ihave no sense of a plausibility in such scenarios. But if either ofthose events, and particular the former were to work out, well, firstof all, far from the immediate impacts of a devastating nuclearexplosion in the town, in the center of New York or London, apartfrom those -- the simply immediate effects, it would change everythingabout our world. Globalization, it seems to me, will be over. Themovement of people would become controlled beyond belief. Therewould almost certainly be massive military consequences of, I think,an imperial kind. This is -- how did the Roman Empire expand. TheRoman Empire expanded every time you bounded across the border. Butthere were some uncontrolled place with some nuisance trying toattack them. So expanded.

So in this world, I wrote this in -- twelveyears ago --at the time immediately after 9/11, one of the things we learnedat 9/11 is that our borders in the modern world are with everybody.So the only solution in this world is control everybody. This is areally scary possibility. The -- or to close up completely. Thatbecomes one of the two possibilities. So my assumption is if we'retalking about an event of that type, that's what you mean by amajor terrorism event, we are in a different world.

So let's not hope -- let's hope it doesn't happen.

QUESTION: OK, so we're choosing between Caesar and Hadrian'sWall, but yes.

WOLF: Yes, exactly.

QUESTION: Yeah.

WOLF: Perfectly defined. Caesar -- neither strategy workedin the long run, by the way, but that's normal in life.

QUESTION: Mr. Wolf, there's an interesting trial going on in NewYork, as I'm sure you know.

WOLF: I am aware of it.

QUESTION: Yes, I bet.

WOLF: You know much about it, I'm sure, than I do.

QUESTION: Oh, yes, I used to work for AIG, so I have a self-interest.

WOLF: OK.

QUESTION: And Greenberg is suing, on behalf of Starr, for $25billion. And any shareholder who wanted to participate can, and I did.What have I got to lose? I think he'll lose, but that's beside thepoint. It could go all the way to the Supreme Court. As a littleclause there that that nobody knows about that he made, or that AIGmade with the Fed, that if he were to win that it's AIG's problem. So thatmeans, of course, AIG would go out of business. Having said all that,you criticized our regulatory mechanisms. How do you think theregulators back in 2008 handled it?

WOLF: By the way, when you said -- I -- I must be precise. Ididn't criticize specifically your regulatory procedures. Icriticized our regulatory procedures, so that includes everybody else.I'm not, in any way, trying to suggest that there's anything specialabout U.S. regulatory procedures. The rule book we're creating inEurope is even worse that yours. So (inaudible) very aware of that.

So on the AIG case, I find it very, very difficult and I've read a lotof literature, but I wasn't there. I wasn't a participant To second-guess the decisions taken by the authorities in the autumn-fall of2008 and early 2009, as it were, in real time, it's very, very easy.I think you call it Monday night quarterbacking here?

QUESTION: Monday morning.

WOLF: Monday morning, I apologize. Yes, we've got -- so Sunday.

QUESTION: You've got...

WOLF: Monday -- whatever, whatever. It's very easy after theevent to argue that they made a great many mistakes in the way theyhandled specific cases. And there's still an ongoing debate aboutLehman, about whether they were right to let it fail or let it fail inthat way and whatever. AIG is obviously a very big case -- about thedeal, how they fully paid off all the AIG obligations.

So there are lots and lots of -- there's lots and lots ofsecond-guessing here. And the -- but it seems to me that if you're inthe middle of a world-class panic, which we were, with the economydeclining very, very rapidly and no real idea of how -- when thiswould stop, they had to go in with overwhelming force.

That is something I agree with Tim Geithner oncompletely. You have to stop this. And you -- AIG had been asurprise for them. They didn't understand before it happened howcentral AIG's activities, London activities had been in providingwhat I'd call a pseudo-credit -- or pseudo-capital, sorry, as that'scapital to the system, because, essentially, everybody was riding onAIG's AAA, which couldn't be actually used for this purpose by -- theregulators wouldn't allow it to be used for this purpose -- in orderto allow all the other institutions not to have as much capital asthey really needed, and, because they could get credit default swapsfrom AIG.

So, this was a really, to put it mildly, dubious activity thatAIG had been involved in.

So I have to say, I find the case complete chutzpah. I mean, Ithink it's sort of amazing that this case could be even brought, giventhe activities of AIG that played such an extraordinary role indevastating -- a devastating role.

But I think the authorities didn't understand how important ithad been. They were surprised by how devastating it might be. They were concerned what would happen if all AIG's credit default swaps weren't met in full. They thought that -- even thoughit's very controversial, a lot of the benefits, of course, went toEuropean banks. We all know that.

But I sort of feel, well, maybe there was some better path, butsince I wasn't there, I wasn't exhausted, I wasn't having to make thisdecision over weekends in extreme pace, and they had to prevent thecredit -- the panic from spreading.

I find it very difficult, and certainly didn't try in my book, toargue, well, if only they'd done this or that or whatever else, andthen it would all have been much better.

I think the big -- to me, the bigger question was the Lehmanfailure. Though I still feel, tend to feel, that if they hadn'tlet that happen, if some such event hadn't happened, they would neverhave come to grips with the crisis at all.

But, so I would take the view -- the British view would certainlybe, if this was a British case, you know, there are extreme situationsin which the sovereign has to act -- has to make discretionarydecisions to save a country from a severe threat of panic. That'swhat we have sovereigns for, that's what governments are for inextremis. They're insurance agencies, as far as I'm concerned, at thecore.

And in extreme crisis, the sovereign has to have discretion. Andit's not for the judicial authorities later on to go along and say,well, actually, they should have exercised this discretion in someways.

There's absolutely no way this case will get within anywhere inthe U.K., anywhere, it would be just inconceivable.

But the U.S. legal system is a wonder of -- all of its own.

(CROSSTALK)

WOLF: And I may -- and I want to say, (inaudible), but I thinkin the end I'm not going to second-guess these people. They dealt withthe panic in a messy way, but it was a very messy panic.

HUBBARD: You've channeled Abraham Lincoln very well.

WOLF: Oh, yes. He would have taken that view, wouldn't he?

HUBBARD: Exactly.

QUESTION: Maurice Templesman. May I shift from policy desirability to policy achievability, andthat leads us to the intersection between economics and politics. Ina system such as we have it, unfortunately, where it's governmentby consent and persuasion, how do you create political will amongpoliticians? How do they get re-elected while proposing remedieswhich in effect negatively affect their constituency in order to bepreventive, really, than actually reactive, to the motivation that thecrisis provides?

WOLF: Well, I think the short answer is in your question, youdon't. And that's why we are where we are.

The -- in my book, I describe what we've done in this essence, iswe've re-created, resurrected, that's not the right word, but, mainlythe old system. You know, we haven't had the strength to be veryradical about the financial system or economic policy-making.

But we've done -- we've combined that. So, that's theconservative side, because there are very, very powerful forcespreventing any profound changes, and that's what happened even in the'30s, though it's more radical, because it's a bigger change.

So, we've done that. So that's one side of the politicaloutcome, the conservative one. Essentially, it's the same system asbefore, more concentrated than before, obviously.

And, but, the other side, as I've said is we've also a wholeother slew of political pressures say we've lost confidence in thefinancial sector. And so, channeling that side of the public'sattitude, we get all the regulatory stuff.

So the political equilibrium, which is not surprising, is, on theone hand, the system is strong enough to survive as it was, and toprevent any profound change in the way the system worked. And on theother side, we are incredibly angry and we're not going to allow thesystem to get away with anything.

And so, that's the equilibrium, political equilibrium I thinkwe've reached, which is fantastically over-regulated, but stillhypertrophied and essentially still highly leveraged and unstablefinancial system. This is a very undesirable place in my view to haveended up.

But, as you imply in your question, it's exactly what you wouldpredict from a political point of view. I can't do much about that,except describe it.

QUESTION: Benn Steil, Council on Foreign Relations.

Martin, one of the consequences of the crisis for our professionis that the various schools of macro thought have been to a test in away they hadn't been previously.

Broadly, to caricature -- somewhat, at least. The Austrianliquidation school, looks very very weak. The Keynesian, it's allfiscal school, looked extremely strong, I would argue until 2013, whenthey were saying that the fiscal multiplier in the United States was avery high number, at least 1.5, probably over 2, yet we had a largefiscal crunch and no recession.

That led to a victory lap being taken by the third school, whichis really sort of a post-crisis phenomenon, the market monetaristschool, that argues essentially that fiscal policy is just socialism.It's the job of the central bank to stabilize the economy bystabilizing nominal GDP, and then it -- that, in fact, the centralbank has all the tools to do this.

Where do you come down on this?

WOLF: I think that's really very interesting. The -- OK --the -- I divide economics, perhaps a bit like you. There are two bigschools and then there's sub schools. The two big schools are, one,to be very, very (inaudible), supply creates its own demand, forgetabout demand. Just doesn't matter. And there's the sort of rationalexpectations version of that and the Austrians are sometimes there.

Austrian macro I've always found very difficult to get my mindaround, and I've tried quite hard. I mean, I do understand what Hayek is trying to say, I just don't think -- see how it all fits together.

I think when von Mises is really interesting to me, he's justlike Minsky, so -- on his view on credit and money.

So there's the supply creates its own demand school. And thenthere's the demand matters state.

And I think the supply creates its own demand theory gets prettywell destroyed in crises. So put that to one side.

So then you've got the demand side. Now, in the -- onemight describe is as the Hicksian synthesis -- of course, he wasthe great synthesizer -- the conclusion was reached that monetarypolicy, and I think it's been the dominant subsequent view, thatmonetary -- though it's changed from time -- that monetary policy is,in normal times, the best way of manipulating demand, adjustingdemand, so it's market monetarism.

But in severe crises, when you get to the zero bound, monetarypolicy becomes less effective, and therefore, you have to use fiscalpolicy.

And the -- and I feel at the moment, in response to what you say,that what has happened so far gives enough support to both sides.That is to say, we haven't had a knockout conclusion between the two.

In a severe panic such as 2008, '9, I think -- I really do thinkthe evidence suggests that relying purely on monetary policy ispushing-on-the-strings type of stuff, the famous Keynesian idea, youneeded direct demand and the decision effectively to allow governmentsto go massively into deficit and even have a modest stimulus but above all to gomassively into deficit in 2009, '8, '9, which they all did as revenuescollapsed and -- and public programs, welfare programs increasedspending it was just automatic, was incredibly important, and that had beenpart of Minsky's view.

Now, in the subsequent developments, my view is slightlydifferent from Benn's, but I don't disagree with this.

The -- the evidence, to my mind, looking at what has happened inthe way monetary policy's interacted with fiscal policy, is thatfiscal tightening, which has been substantial everywhere, hascurtailed demand growth. It has had negative effects. It's one ofthe reasons demand growth has been so modest.

But monetary policy has turned out to be more effective at thezero bound than many Keynesians thought. And -- and the -- so in thatsense, the -- the market monetary school's (inaudible) and so forthhave some support.

And that was very much Friedman's view, though I'm not persuadedthe right way of thinking about that is in strict quantity terms. Imean, that's not -- not that helpful.

The -- the - the question then arises -- and this is where I getmy usual sort of in-the-middle sort of way -- is what is the mosteffective way of using monetary policy when you've got a situation ofchronically deficient demand, because of deleveraging and all the restof it? What is the best way to use it?

And it seems to me that what we've actually done after the worstof the crisis was over -- so forget that crucial period wheneverything was working together and I think quite effectively -- webasically used -- beyond having very low interest rates, we basicallyrelied on Q.E. as a mechanism for purchasing predominantly governmentbonds.

And I don't think that has been a very effective policyinstrument. It hasn't been hopeless, but I don't think it's been avery effective policy instrument.

What would've been the most effective policy instrument? Well,we come back to helicopter money, the use of money to finance fiscaldeficits, larger ones, if necessary.

So I tend to see the zero bound, in this situation, that it's thecombination of the two instruments that is probably the mosteffective.

But since nobody really tried that ruthlessly -- nobody triedthat ruthlessly -- and nobody really managed a reasonable recovery, Ithink it's fair to say that the test hasn't been -- yet been made.The full test has not yet been made.

But so -- but my basic conclusion in this is that you use whatyou have, which is both of these things, which is effectively whatwe've done. But I do agree with Benn that after the panic stage,monetary policy turned out to be more effective than I thought itwould be.

By the way, I do expect that the next time around -- and therewill be a next time -- the liquidationists are going to have their go,and then we will see what that does to us.

HUBBARD: Well, I'm going to have to come down on the side ofmonetary policy and take the punch bowl away while the party is stillgoing, because we need to wrap up.

But please join me in thanking Martin Wolf.

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