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Bretton Woods II: Does The World Need A New Monetary System? [Rush Transcript; Federal News Service, Inc.]

Speakers: Lawrence H. Summers, Charles W. Eliot Univeristy Professor, Harvard University and Former Treasury Secretary, and Paul A. Volcker, Former Federal Reserve System Chairman
Moderator: James D. Grant, Owner and Editor, Grant's Interest Rate Observer
May 23, 2007
Council on Foreign Relations

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JAMES D. GRANT: Well, good morning, and welcome to the council's McKinsey Executive roundtable. The subject today is Bretton Woods II, which is not to be confused with Bretton Woods, Senior. And because our speakers need no introductions, they shall have none -- (laughter) -- though perhaps a word of preface on these recondite topics might be of some help.

Bretton Woods was a system devised after the close of the Second World War to reorder the world's monetary affairs. The idea was that the dollar would be the sun around which the lesser monetary objects revolved. The dollar would be convertible into gold for $35 an ounce, and the other currencies at length would be made convertible into the dollar. And this system lasted until 1971 when the Treasury got tired of paying out gold or of having the threat to pay out gold held over it.

There followed a most un-systemic system, which is -- has recently taken the name of Bretton Woods, Junior or Bretton Woods II, and the topic today is whether we need another one. These systems have succeeded each other since the fall of the international gold standard, at roughly generation-length intervals, and it's been, what, 35 years since the institution of our present system. So, do we need another one?

Larry, do you have a thought or two on this? (Laughter.)

Okay, Paul, do you have an -- (laughter)?

LAWRENCE H. SUMMERS: Life is -- you know, life's about choices, and I think one can give, in important respects, the democracy defense of the current international monetary system -- it's not that it's great; it's not that it's without risks; it's not that there aren't improvements possible, but it's far from clear that there is a better radical, comprehensive alternative that is either more economically desirable or more -- or at all political feasible in the current constellation.

And I think it's important not to lose sight of some of the positive features of our current system. We are living in a world of far greater price stability than we have in many, many years. We are living in a world of far more flow of capital than in many, many years -- for the most part, to productive benefit. We are living in a world where in the industrial countries, the business cycle -- which is what is more linked to monetary matters than issues of long-term growth -- appears to have very substantially moderated in volatility. So I think one has to be quite respectful of the Hippocratic Oath in contemplating proposals for radical reform.

That said, I think one has to look with at the minimum a quizzical eye at the fact that the dominant flow of capital is now from so-called "emerging markets" to mature industrial countries in a way that would seem quite perverse relative to the locus of opportunity. And I suspect the question of mercantilist exchange rate policy will loom larger in international monetary discussions over the next decade than over the last.

GRANT: Paul, when you got into the central banking industry, the dollar was a defined term. And because it was exchangeable or convertible into gold at a fixed rate, there was a limit on the capacity of this country to emit dollars into the world and to run up cumulative deficits. Now no such limits appear to prevail. Is there in fact a limit, or may we print as many dollars as we care to print?

PAUL A. VOLCKER: The limit's a little larger than I would have imagined some years ago, I must confess.

You know, I think -- if I can put this in a really long-term perspective -- if we have a world of entirely open markets -- a lot of small countries still, particularly open financial markets, which is something we didn't have before -- the ultimate evolution of the system is going to be toward a world currency. Now, we're way off from that, but it kind of struggles to give us stability in the system. And this usefulness of the dollar -- the widespread use of the dollar, which is beyond anything I would have imagined 30, 40, 50 years ago when the dollar was still the central currency -- but so in question because it had that moon around it -- the gold. You could always move in the gold, which put a limit on it, as you say.

That limit is gone. If there's confidence in the dollar, there's an enormous advantage in having a world currency. People hold dollars. They hold dollars partly because other people hold them, and the more other people hold them, the more convenient it is for you to hold them. And that has helped, I think, under-gird this enormous expansion in dollar holdings around the world, beyond the fact that China and Asia want to support their currencies and all the rest. There's something beyond it.

I think we're -- that may be creeping around the edges now. Every day I pick up the paper and see one country or another may be wanting to diversify or change their exchange rate or whatever. In the end, the glue that's going to hold this all together -- Larry already mentioned -- can we maintain price stability, not just in the United States but in other countries? If you have that core of solidity in the system, a lot of the rest that happens won't be too damaging, hopefully.

GRANT: Larry, price stability is something everyone -- to which everyone pays lip service, but that, too, is a defined term. And China has a measured rate of inflation that seems rather benign -- similarly, Kuwait -- and yet both seem to suffer from -- or enjoy, in the case of perhaps the Chinese speculators -- a kind of instability. In the case of China, it's the Shanghai stock market; in the case of Kuwait it is rip-roaring food prices and rental rates. Kuwait, only the other day indicated it would no longer hold its dinar tied to the dollar. And this seems to be at the margin, as Paul suggested, a trend in the world. These currencies -- in the case of Brazil, in the case of India, the currencies are breaking out to the upside. In the case of Kuwait, there is a move away from this dollar peg. Could it be that very quietly and without the release of a press -- issue of a press release, the world is in fact changing -- the currency system is changing right now?

SUMMERS: Well -- I mean, I'm not sure what it's changing from to. If you thought the world was on the dollar, and you chose to interpret the exchange rate regimes of these countries as being on the dollar, then you could argue that it was moving off the dollar.

It wouldn't have occurred to me to reach such a dramatic characterization of the current system. Certainly, you look at Brazil, which -- whose exchange rate has fluctuated quite radically over the last six or seven -- over the last six or seven years, as an example.

I think that what you are seeing is, in a way, the various tensions associated with efforts on the part of countries to maintain low effective exchange rates so as to maximize competitiveness, and the various external macroeconomic contradictions that that leads to and the various questions that that leads to for the global system.

But I think we have a tendency -- and I certainly was guilty of this a couple of years ago -- to perhaps overemphasize the importance of what happens in the United States as the shaper of the way the global economy evolves. You know, there's a standard story, and it's got -- it's an important part of the story which emphasizes low U.S. savings sucks in the capital and creates these huge global imbalances. There is a tension with that story, as Ben Bernanke among others pointed out some time ago -- that if the dominant impulse in the world were low U.S. savings, one would expect the huge current account imbalances to be associated with unusually high world real interest rates. And it is more nearly the case that they've been associated with unusually low real interest rates, particularly a year or two ago.

And that suggests that in understanding what happens, one has to give very substantial weight to what's happening in the rest of the world. Whether a savings glut is the right way to interpret it or whether it has more to do with an investment shortfall, to what extent it has to do with imbalances between the demand for debt securities and the capacity to issue debt securities -- I think these are important analytic questions, but I think we make the mistake in seeing the driving impulse behind everything as always being what happens in the United States. And it seems to me the larger question for the next few years is what's the right monetary regime for themselves or for the world of the major developing countries?

And I'm much more skeptical, I think, than Paul of this whole notion of single currency dollar forever. It seems to me that the limited, to date, experience that we've had with the Euro suggests that a common currency with a fixed exchange rate for very diverse economies is somewhat problematic. And the range of country experiences around the world vastly exceeds any differences between Ireland and Italy.

VOLCKER: We shall join the issue at this point.

GRANT: Have at it.

VOLCKER: I -- you know, the monetary system is always evolving because it's responding to changing economic circumstances. And it's different today than it was in 1975 after we went off gold and had a lot of volatility.

But the principal change, which is I think symptomatic of the question and the problem -- the single biggest change by far is the euro, where you had -- how many currencies now -- 15, 20 -- all go into one. Fluctuations among the European currencies were a major source of monetary instability in the old days -- under the Bretton Woods system, after the Bretton Woods system. And for a tightly linked economic group like Europe, they concluded -- partly for economic reasons, partly for political reasons -- the political reasons were very important in catalyzing it -- but there was a very strong economic feeling that that unit could only hold together with a common currency and not with constant exchange rate fluctuations. Just imagine the last few years with all the concern about Italy -- if Italy had devalued, what would the franc have done? Where would that have left Germany, at that point with a sluggish economy? How would that have reflected on other exchange rates around the world?

I think the biggest single stabilizing factor we've had -- not the only one -- is the euro. And you go to Asia, all they talk about is whether there should be a common currency in -- of some sort -- or some kind of monetary integration -- in Asia. Well, they're a long ways from it, but the interesting thing is they talk about it with a sense of kind of urgency because the small countries in Asia feel vulnerable to a lot of exchange rate instability. And if you're an -- we forget how open those economies are. They have imports and exports -- 50 percent of their GNP, and they're not quite ready to adapt to a 50 percent change or a 40 percent change or a 30 percent change in their exchange rate very easily. So naturally there's -- "How do we stabilize? How do we stabilize?" And they may not be able to do it, but that is a constant preoccupation.

SUMMERS: Yeah.

Paul, there's a kind of test of your -- test of your view where we may not agree. The logic of what you just said, which I completely appreciate, would tend I think to suggest that a combination of economic misjudgment by Gordon Brown and perhaps misguided nationalism kept Britain out of the European monetary union, and it would be a better Britain, a better Europe, and a better world if Britain had gone into the European monetary union. It seems to me that unless you think that Britain clearly is better off in the monetary union, it's hard to be arguing that, sort of, all the world should be on a similar currency. Is that your view?

VOLCKER: I must confess, walking down here, I said, "What is Larry Summers going to say?" (Laughter.) And then I thought, "He's going to say, 'What about Britain?'"

(Cross talk, laughter.)

SUMMERS: God, Paul, I dread -- of all things -- being predictable. (Laughter.) That is -- when I left the Treasury Department, I sought to lose any image I might have had for predictability.

VOLCKER: (Laughs.) Well, I thought about the question because I thought it might be a difficult question.

Actually, I -- at the time the euro was beginning and there was a debate in Britain, I was very sympathetic to some of my British friends who felt very strongly that Britain should go and join the union and that they would suffer difficulties over time if they stayed out -- particularly that they would not become a kind of stable base, in some sense, for trade or for manufacturing industry. You know, Britain has escaped, I think, some of the difficulties because they have no manufacturing industry left -- (laughter) -- I exaggerate a bit -- but -- and they've had, you know, enormous growth in financial services side, I think. And the economy has prospered, at least in the south.

And so they've gotten by with it, and they've had, I think, a reinforced sense of strength in the central bank and in price stability, all of which has helped.

But whether in the long run they're going to be better off with the euro two to the dollar and --

GRANT: The pound two to the dollar, you mean.

VOLCKER: Pardon me?

GRANT: You mean the pound two to --

VOLCKER: The pound, yeah -- $2 to the pound. We've got to get it the other way around. But the euro's gotten stronger, too. But we'll see how much and how long they can stay out of line with the euro and be happy.

SUMMERS: You know, it's interesting, I would have had a -- I'm not -- I don't have any great confidence that what I'm about to say is right, but I would have had in a way almost the opposite view of the one you expressed as I think about the debates eight or nine years ago.

I thought the view eight or nine years ago was that if you were a manufacturer who was engaged in exports, it was really important to you to have a stable exchange rate and to not have it fluctuating all over the place. But if you wanted to be the world's financial capital, you couldn't be at the center of a country with its own little flaky currency.

And so I thought the consideration eight or nine years ago was that the financial services folk thought it was crucial to go in -- thought it was crucial to go in, and the manufacturing folk were more worried about going in. So I would have taken the experience where -- I think the one thing that's been established is that you're not harmed in your ability to succeed in financial services by being located in your own currency. I would have said the single empirical fact that is almost unarguable today but was very much in doubt eight years ago was, can you succeed as a financial center without having a major world currency? And I think the answer -- we now think we know the answer to that question is yes. And I would have thought that as Bombay thought about its future or Shanghai thought about its future, those were relevant observations.

So I would have read the post -- whatever you thought in 1999, I would have read the euro experience to date as tending to lead you away from the "common currency for the whole world" view.

GRANT: Well, enough of this (eco-banter ?). (Laughter.) I think it's high time the audience had its say, and I would welcome as many as four dozen questions starting right about now. (Laughter.)

Do I see a hand? Peter Fisher probably has one. (Laughter.)

QUESTIONER: Thank you, Jim.

Peter Fisher, BlackRock. Let me quote something to the panel, which is, reserve currency status --

MR. : Wait -- wait for the microphone.

QUESTIONER: -- oh, microphone.

Reserve currency status is not really about the unit of account; it's about the asset. And when I hear monetary theory discussed or global monetary regimes, it's all about the unit of account: the euro, the dollar, sterling -- just the dialogue you were starting to have. When markets really behave, it's about an asset. It's about what could -- reserve currency status -- the monetary regime that the capital markets live in -- it's about the asset. And one reason the euro still lags a bit, even though there are lots of notes now in circulation, is those capital markets aren't integrating at the pace that some of us might have hoped. Let's talk about the capital market side of this, the reserve asset side, what people put their money in.

Another historical example: In the 1970s, a lot of people thought the (Swissi ?) was going to be a reserve currency, but it turned out there wasn't really an asset there for anyone to hold.

VOLCKER: I'll give you a little story about the use of a currency as an asset. I asked a Russian friend or acquaintance of mine a few years ago -- I said, "In the long run" -- Russia wasn't looking so strong, but -- "are you going to use the dollar continue to be the street currency and the currency of account in Russia, or will it be euro? Is the euro developed?"

She said, "Oh, it's the euro."

I said, "Why?"

She said, "They're printed in larger denominations." (Laughter.)

SUMMERS: We actually -- we actually sought, with no success, when I was in the Treasury Department, to shame the Europeans out of the issuance of the issuance of the 500-euro note because we thought the question of what the largest bill was was not unimportant with respect to questions of ease, of bad guys storing value outside of any system that could be traced and was not altogether irrelevant for seniorage. We thought the United States had taken the right decision many years ago by eliminating notes above $100. So we saw that as an -- we saw that as an unfortunate development.

You know, turning to the reserve question, Peter, there are two cliches' that are in some tension with each other, it has always seemed to me. One cliche' is that sterilized intervention is irrelevant. And what is that statement? That is the statement that if you change the supply that the market has to hold of the bonds of one country for the bonds of another country in a world with mobile capital, that will have no effect on anything because they're relatively close substitutes and people will trade back and forth.

The other is that if there's a change in the concept of reserve currency status -- and so people change their demand from dollar assets -- desiring to hold dollar bonds to desiring to hold foreign bonds, that will in some way be catastrophically expensive for the United States because the assets will not prove to be substitutes.

Those views are frankly flat-out contradictory. And people don't tend always to recognize the contradiction. And it has always been my instinct that the sterilized intervention fact teaches us something and that the change in reserve holdings is less catastrophic than is supposed by many for exactly that reason. And I hesitate mostly because -- I hesitate to express the view with too much conviction mostly because it's the kind of view that if it turns out to be wrong, it will somehow be too late to recover the situation after -- after one has acted on it. So I don't mean it as a basis for lack of concern, but I think there's a tendency to overexcite around these matters. And I think it's revealing that -- as least as I read the market evidence -- the degree of excitement that surrounds a Bloomberg announcement that, you know, Thailand is going to further diversify its currency holdings, is rather less in the marketplace and the market impact was much less than would have been the case 20 years ago. And I think that's not unrelated to the fact that the major central banks have stepped back substantially from sterilized intervention reflecting greater patterns of capital mobility.

GRANT: Peter, apropos of a development of a European -- or the euro-denominated capital markets, it strikes me as nothing short of miraculous that people are willing to lend at 50 years in a currency that has not yet had its -- blown out their candles on its ninth birthday cake. So it seems to me that the development is proceeding pretty swiftly.

I would like to read something by way of priming the inquisitive pump in the audience. And this has to do with a quotation from Jacques Rueff, the great French critic of the preceding monetary regime, Bretton Woods, in which the dollar was the center of things and the dollar was convertible into gold, and anything else was convertible into the dollar. And Rueff saw this as inherently unjust and destabilizing, despite the apparent stability of it. And he said that this regime produced, quote, "the secret of a deficit without tears: it allowed the countries in possession of a currency benefiting from international prestige to give without taking, to lend without borrowing, and to acquire without paying."

And mind you, this was in the day when the dollar finally was exchangeable into gold at the option of the official foreign holder. Nowadays, of course, there is no anchor, there is no collateral. The dollar is purely faith-based, and we are emitting about 850 billion of these greenbacks a year into the world payment stream.

So does anyone think this is -- (inaudible)?

Yes, sir?

QUESTIONER: Well, I have a question --

GRANT: Well, good.

QUESTIONER: -- relating to it. I don't know if there's any engineers or scientists in the room, but every engineer and scientist knows that any system that doesn't have a negative feedback loop blows up. And today, carrying on with your quote, there is no market-based self-correcting mechanism on increasing financial leverage.

So I'd like to ask Dr. Summers and Mr. Volcker, what contingency plan do you have, does the government have, does anybody have, when the dollar finally blows up? (Laughter.)

VOLCKER: I never had to face that contingency, so we'll turn it over -- (laughter) --

SUMMERS: I'm -- I think the history of the extrapolation of engineering lessons to economics -- (laughter) -- is at a minimum mixed. So I would resist rather strongly the basic implication of your question that we're automatically headed for doom.

I think what your question does raise is how to think about -- it does raise an aspect of how to think about certain kinds of adverse shocks. And there is in all modern economies a safety net to at least some extent under a certain kind of financial problem, which is that if liquidity dries up in a world where there is a printing press, the central bank does have the capacity to provide liquidity, and that can be enormously availing, as it was after October 19th, as it was in 1998 and 1999, as it was in the immediate aftermath of -- in the immediate aftermath of September 11th. And for very good and very conscious reasons, that process is surrounded with a certain amount of mystery and uncertainty, which is that it has a little bit the character of paying ransom. On the one hand you want everybody to believe that it will never happen and rely on the fact that it's not going to happen so that they're very careful. On the other hand, once the adverse event has happened, you actually do want to fix it in the best possible way. So that's one part of the answer.

But there is a very serious potential contradiction, which I think will increasingly be at the root of the most serious financial crises and which in many ways we saw in Asia in the late 1990s, and that is if a country has two problems -- one is all the foreigners are trying to take their money out because they've lost confidence and they don't believe in the sustainability, and the other is that the domestic banks are failing and that the assets are coming out -- then the central bank has two problems. It has an external problem, which is that people don't want to hold your money -- you should print less of it; and there's an internal problem with the banks failing. You can't very well -- contracting liquidity can be catastrophic, as it was in the United States in 1929 and 1930. And with a single instrument, it's very difficult to hit two targets. And so the most serious risk in the system is the kind of crisis that arises when there is a simultaneous failure of both internal and external confidence. And that's why people will debate forever what the Bank of Indonesia or the Bank of Korea or the Bank of Thailand should have done, should have been encouraged to do by the IMF and so forth, because there was no very good answer in the face of that internal contradiction.

And that's why certainly one of the risks in the current situation does lie in the magnitude of the U.S. current account deficit and the buildup of foreign claims on the United States. And it's a very difficult question to know whether those who are now holding a large portion of those claims -- foreign governments and central banks -- are, in the market parlance, strong hands, who will continue to hold all the way through, or weak hands, who will tend to liquidate at the first sign of trouble. Both what are they, and what are they perceived as being, because if they're perceived as being weak hands then others will find ways to liquidate even if they don't. And I've said at another point that in important respects, today's system relies on a kind of financial balance of terror, that the incentive isn't there to liquidate because if you liquidate, the value of all the stuff you own goes way down in value and that it's hard to know how to think about a system based on a financial balance of terror. On the one hand, as we saw, systems based on balances of terror can often have tremendous stability. On the other hand, as the term "balance of terror" suggests, there's good reason for them to make one feel uneasy.

GRANT: Is there a -- yes, a question from right there. Yes, sir? Yes.

QUESTIONER: John Beatty from UBS.

I'd like to discuss the role of the IMF in the world financial system. Currently, rich countries routinely ignore the IMF Article 4 consultations when it suits them; middle-income countries already have access to international capital markets. And secondly, they can -- they're contemplating setting up regional initiatives, such as the Chiang Mai initiative to deal with regional currency crisis. And finally, poor countries are routinely looking to countries such as China for financing.

So, given all this, is there a need for an IMF?

GRANT: Paul, do you need an IMF? Not you, but does the world?

VOLCKER: Well, we need someplace where we can get together and have a meeting once a year and have other meetings, and I think that's all very useful. But I think the implication of the question is, does the IMF have real authority in the system and the capability of itself stabilizing. I think the answer is, unfortunately, no.

And its real (pull ?) and authority comes from its ability to lend, and if people feel some need to borrow, neither of which -- well, it takes some ability to lend, but small relative to private markets, and people don't feel any need to borrow and they don't want to borrow, so they protect themselves by building up big reserves.

There still will be a need if there's -- when that big crisis comes, if and when it comes for the small countries, I think they will have a role to play in coordinating a reaction. But -- (inaudible) -- our consultations and any other consultations (are going to ?) reflect the actions of the United States or the Euro or the European central bank or China or Japan, I think it's demonstrable that the influence is limited, to say that most generously, which is a big question for the institutional future.

If I may just revert a bit to what Larry said earlier, I think that he describes, for the -- (inaudible) -- and the Thailands and the Indonesians and so forth, is precisely the problem for a small country with a violent (change ?). It's very hard to cope because it will undermine its banking system and its interest rates, and so forth and so on, where a big country, a really big economic unit, can more easily, maybe with difficulty, ride out the storm.

When you get the big regional currency units, as I think you're going to get over time, and they themselves have a lot of potential volatility between them, where we have an institutional structure that hopes to at least limit that range of fluctuation in the interest of the world development system, that is the goal of, I think, international financial architecture in a big sense, to which we don't have the answer.

It didn't used to be the IMF, to put it bluntly. It was the United States, back in the Bretton Woods system and the immediate thereafter. Without the United States being able to play that role anymore, without it having the respect and confidence of the rest of the world, you haven't got it. Nobody else is going to step in there, not -- (inaudible) -- organization sitting in Washington.

SUMMERS: I would say three things. First, I think the IMF right now is a bit like the dentist after the rise of fluoridated water. (Laughter.) Fluoridated water was a terrific thing. It was a very good thing. People had cavities much less. It was a better world with less pain. But there was less for dentists to do. And that's how -- it was challenging in some ways. If you were a middle-aged dentist, it could be a daunting prospect. But the fact that it was a daunting prospect for you shouldn't blind you to the fact that it was a very good thing for the world that fluoridated water had been invented.

And I think all this tendency to worry about the future of the IMF needs to be put in the perspective that there's a huge private capital market. Countries that were once tremendously unstable, short on reserves, had massively unstable currencies, today are on the brink of being investment-grade. This is good, not bad. And the IMF problems are largely a casualty of the world's success, not largely an autonomous matter of concern.

The second thing I'd say is I have -- to be clear, I have a different bet than Paul does on whether we'll see lots more regional currency unions 15 years from now. If you had asked me a decade ago how much dollar there would be in Canada and Latin America in 2020, my estimate would have been considerably greater than what my estimate would have been today, because I think what we're seeing is that -- I would have thought that there was a reasonable chance that Latin America would conclude that it was unable to manage fiat money successfully and would therefore fall back to the dollar.

If you look at the experience in Mexico today, you look at the experience in Brazil today, it gives more encouragement. So I think this argument that we're going to move towards regional currency unions is somewhat -- is quite problematic.

The third thing I'd say is if I'm wrong, which could easily be the case, and the world does move to regional currency blocs, the key officials of those limited number of regional currency blocs will work out their deal and will do the important thing in a room at which people from international institutions will struggle to be participants but will not be leaders or directors of that effort.

And it seems to me there's very limited experience of international institutions driving change rather than international institutions being the vehicles through which the desires of major countries are carried out and activated and serve as tools of persuasion and instruments of legitimacy. And I'm not sure that that's a terrible thing.

GRANT: Well, maybe the conjunction of those answers is now the rise of bottled water -- more cavities. (Laughter.)

In the back.

QUESTIONER: Hi. Josh Harris from Apollo Management.

Could you talk about your concern, or lack thereof, of the large twin deficits of the United States of America, in particular as it relates to China? And secondly, if there was a pretty significant fall in the dollar, what would your view be in terms of the impact of that on the U.S. and on the global economy?

VOLCKER: Well, I think we both said the same thing. (Laughs.) I don't know many economists who, four or five years ago, would have said the United States could run a current account deficit of 6 (hundred billion) or $700 million (sic/ billion), rising indefinitely, and the amount of dollars held by the rest of the world -- Japan, China, other Asian countries, now the oil-producing countries -- would go along indefinitely in such tranquil circumstances.

But we have gone along in relatively tranquil circumstances for a long time, because it suits everybody's convenience at the moment. We like to buy oil and spend, and the rest of the countries want to produce and save. The monetary system reflects that.

Now, you raise a question, what happens if that ends? I'm a little less certain about it ending very promptly with a great collision than I was a few years ago, because it does suit everybody's convenience. But I think at some point it does get so top-heavy that it comes down or something happens, and you'll have some kind of an adjustment.

And the only question is whether that happens relatively benignly and gradually or it happens with a big crisis. And I don't think anybody knows the answer to that question. As I say, I think the strong points are we've begun to return to the basic themes, so long as the United States is growing, seems stable, and particularly maintains confidence in its own price stability, I think the chances of dealing with this in a relatively constructive way, as the adjustment happens, are higher than otherwise.

It would be, I think, a real problem if there was a sense that we were losing discipline and internal policy. That happens in the small countries rather easily, as Larry was just talking about. It's not going to happen so easily in the United States, but it could happen. And it's very important that we maintain confidence in the dollar at home.

SUMMERS: Paul and I are chastened prophets of gloom. And that's a complicated role to have, because, on the one hand, your reasons for concern have, if anything, increased; on the other hand, you're chastened by the fact that your prophecy hasn't come true yet.

VOLCKER: Yet. (Laughs.)

SUMMERS: I -- yes, exactly. And I am struck -- I am chastened that I agree entirely with the way Paul expressed, and I am struck that in a way there were more people who were confident that the NASDAQ was overvalued at 25,000 -- 2,500 than there were who were overvalued -- confident that it was overvalued at 3,500 precisely because they had been chastened, and there were more people who were confident that the NIKKEI was overvalued at 27,000 than there were at 35,000. And so it's a mistake just because these expressions of concern don't come as fast as one would like, to be serene.

My great friend, the late Rudi Dornbusch, used to say there's one thing to understand about economics and finance -- things always happen slower than you think they will, and then when they happen they happen faster than you can imagine they would. And I think that's quite worth our keeping in mind, and I think the dilemma -- and I'm just repeating what Paul said -- the -- I think the dilemma is this dilemma of if there is an incipient fall in the dollar and incipient rise in interest rates, what do you do? Do you tighten because of the need to add confidence to the dollar and to resist the incipient inflationary pressure, or do you loosen because of the financial strains on the United States, and in the absence of a good answer to that question you can't be confident as to how well the outcome will play out.

GRANT: I'd like to add just a couple of words on current events that might prompt another question or two. There has been a project underway in the Persian Gulf through an organization called the Gulf Cooperation Council to institute a regional currency among the oil-soaked nations of that region, and the idea has been that the dinar, that the Saudi currency, that all manner of the half dozen currencies are pegged to the dollar, and the central banks of these countries and these principalities absorb dollars at such a rate as to hold this peg in place. That's been going on for a while. The news was, as I said before, that Kuwait has opted out.

Over the weekend it said it would no longer do this because inflationary pressures were becoming intolerable. Now, in these countries money supply growth is running at 20 percent a year, and inflation either suppressed or manifest is becoming problematic -- very much so. So it seems to me this is a little microcosm of Bretton Woods II. Central banks absorb dollars with local currency printed for the purpose. That is, there's a huge amount of credit creation in the world simply to hold the dollar at desired levels, and it seems stable until such time as inflation as defined wells up and becomes intolerable for the relevant authorities. So perhaps the little -- very little publicized drama over the weekend in the Persian Gulf is an augury of what might happen if the world decides it's too full of dollars.

Yes, sir -- question?

QUESTIONER: What you're describing is a world without hegemon -- that is, you're -- it's something that we've all seen -- a series of blocs developing. And the last time I can remember -- before I was born or about when I was born, but you were alive -- is a world in the 20s when there was no hegemon and there were various blocs, and you all know what happened then. Both of you have been in the chair of the hegemon at the time of a crisis, and I wonder if either one could say what you would do now if you were faced with what Paul has hinted at and what -- I'm sorry, Larry, when you get older you'll go to the dentist more than you think. (Laughter.) I don't know whether or not anybody has an answer, but having sat in that position what would you do now if faced with it? I don't know if there's an answer to it, and maybe that's what worries me, and maybe what worries a man from Apollo Management too.

(Laughter.)

SUMMERS: Not sure it was intended this way but it was not -- it was a fairly powerful question thought of as a rhetorical question. I'm not sure how much the issues involved -- the political consequences for the United States of all that's happened in the last six or seven years -- how much the consequences involve the magnitude of U.S. indebtedness and the U.S. current count -- the deficits. The crises that took place when I was involved in government were never centrally crises of the United States as distinct from international crises to which there needed to be an international response. So I'm not sure I'm in a position to quite predict how it is that one would react.

VOLCKER: Well, I do think it's more difficult to take the lead if the political and economic position of the United States in the world is weaker than it was, and if there's certain amount of antagonism toward American leadership, and it depends upon nature of the crisis obviously. But I think the ultimate danger would be that -- would be -- the outcome would be a tendency for Europe and the United States and Asia to some degree go the wrong way and you would get protectionist pressures, and instead of a very harmonious kind of regional cooperation in maintaining some stability, you get a breakdown politically as well as economically between big regions. Now, is that the worst thing in the world? That may not be the worst thing in the world economically but it doesn't have very savory implications politically, I think.

QUESTIONER: (Off mike) -- 1930.

VOLCKER: Pardon me?

QUESTIONER: It was pretty bad in 1930.

VOLCKER: Yeah. Well, I don't disagree. That's why we don't want it to happen.

GRANT: Sir?

QUESTIONER: Looking at the institute -- institution today -- the IMF and where we are today -- not -- I'm not talking long-term, I mean now -- and the reform program that they have instituted over the last year or so, and getting away from the issue of whether we should have the IMF or whether we shouldn't have it or abolish it or so forth and all of the consequences of that, what do you think of the reforms that are being proposed today? You know, the multilateral surveillance, the reserve augmentation line and so forth. Is that -- are these reforms moving in the right direction, assuming that we have the fund -- we need the fund, and we're looking toward some kind of evolution -- some change that will make sense as opposed to simply saying, "Well, either we, you know, get rid of it or we don't." And if we do get rid of it -- and the ancillary question is who would take its place in times of crisis management? The G8 or some other -- I mean, who would do it? The private sector? But getting back to the immediate thing, what are your reactions to what's going on with Dorato (ph) and what they're proposing now in terms of the, you know, in terms of a trajectory toward some place where we would like to be a few years from now?

SUMMERS: Look, I think they're doing the three things that are probably the right thing to do -- broadening the governance to include the newer, more powerful actors, trying to put more emphasis and more meat and content into the surveillance, and accelerating the evolution from IMF means that's mostly fiscal towards being engaged with the financial kinds of developments that are likely to happen. But I think it's a mistake not to recognize that it's all relatively (small beer ?) compared to the fact that Brazil's accumulated more reserves in the last five months than the largest program in IMF history ever was. And that's a kind of fundamental reality that no amount of reform programs at the IMF can really engage with.

QUESTIONER: Ricki Tigert Helfer. Paul and Larry, could I ask you what impact you think the rise of the private equity market and the huge volume of capital held in private hands largely outside any regulatory structure, meaning both securities regulation or banking regulation, means for purposes of addressing any future severe world financial crisis?

VOLCKER: Well, I don't -- I hadn't thought of it in that light. I'm not sure it would have great implications for the financial crisis. I think it's a little puzzling in terms of not just the rise of private equity and that stuff but all this complicated financial engineering that goes on as to whether in the long run that's going to be stabilizing or destabilizing. I think it does have the effect of reducing the potential pressures in a crisis on the institutional structure -- the traditional institutional structure. The banks have all floated all their loans and spread them all around. The banks aren't so vulnerable. And if they're huge and very diversified they're not so vulnerable.

But a lot of these risks have been passed around in a way the consequences of which we're not quite sure. A lot of the risk been pushed back to the individual, which I guess is a good thing in retirement plan -- I don't know it's a good thing or a bad thing but it's a good thing in terms of the crisis -- that the institutions don't fall before consumer falls -- (laughter.) -- whether that's a great advance but it's -- my own sense is that we're probably more resilient against small crises and small pressures but if this big crisis came along that people are hinting about I'm not so sure, and it may be exacerbated. That's not a very helpful answer but that's about the conclusion that I come to, which it's fine when things are relatively equable and the basic structure isn't at risk, but if the basic structure becomes more at risk then we're in trouble.

Let me just make a comment on a somewhat related subject -- talk about the IMF and its role -- so forth. What's interesting I think is that so much of the international financial architecture, if that's the right word, is taking place outside these official institutions. It's taking place in accounting I think of because I was involved in it. We're suddenly getting pretty good prospects for international accounting system with no official direct participation. You've got auditing internationalized with some official stimulus but nonetheless it's going on. You've got bank capital and the banking regulations being coordinated through the BIS, which we haven't thought of. I mean, they're a kind of informal grouping of central banks, not through the IMF or the World Bank. You've got IASCO straightening out security regulation and clearance arrangements and all that stuff, and it takes place outside the established -- what we think of as the main pillars of the financial system, which says something about adaptation to the world as it is and internationalization. And I think all that stuff is constructive, but it's interesting that it takes place outside the IMF, the World Bank, the ITO and so forth.

SUMMERS: You know, Paul and I don't disagree on enough to make this really interesting, so nothing I'm saying is in disagreement with anything he said. I think in important respects the private equity boom is made in Beijing and the Gulf -- that you have a huge number of new actors with a lot of money who want to hold debt securities and whose orientation is very much to debt securities, and that creates a natural incentive to create debt securities and -- for them to hold and then to buy equity securities. I think that's the deep driver behind the private equity boom. I suspect it is reinforced by a tendency to confuse lack of price discovery with lack of volatility, and that the risks inherent in private equity are rather greater than is often supposed because you don't see prices bouncing around like you do in stocks, though in fact the underlying volatility is that much greater. And I think there is room for concern about what the reverberation will be the first time the debt associated with a totemic private equity deal goes bad, and that day will surely come. But as a fundamental matter, changing the environment for responding to a crisis, I doubt that it is incredibly highwater.

VOLCKER: I must say I -- just inject a little personal concern about today's modern accounting. Apparently you can consider when you're a private equity firm, you buy a company, you say you expect it to be sold at a profitable rate three years from now, so we'll put the profits on the balance sheet right away, and put it in the income statement. Now, that is creative accounting but apparently it's quite acceptable in the new --

GRANT: See a somewhat diffident hand up there. It's not quite all the way up. Yes?

QUESTIONER: Not the first time I've been called diffident. Tony Malkin-- a question. I want to go back to this issue of what happens if there is a meltdown of sorts, and let's assume for a moment that \there's a lot of private equity out there but the bottom line is it's nothing compared to what the issues are in the United States and our twin deficits. Let's assume for a moment that an awful lot of our obligations are held by others who may have an interest in -- some might have an interest in seeing us melt down and be humbled a bit but also that they would not like to see their investments deteriorate to the point that they have significant losses. Under that scenario, who might you see taking a leadership role in coordinating a response to a serious fiscal crisis for the United States from outside the United States? Who might lend a hand in that regard -- take a leadership role?

VOLCKER: All the candidates raise your hand. (Laughter.) I don't think there are going to be many hands raised. There it is. (Laughter.)

GRANT: Yes, sir?

QUESTIONER: I'm Richard Whalen. I'm a writer and I'm concerned that in this room of rich insulated people, of one I'm whom, there has not been mention of the word deflation, which is rampant in today's popularly priced real estate markets. The weakest holders of debt in the United States are homeowners, whether they know it or not, and they're losing their major assets at a rate that is terrifying if you aggregate them and extrapolate them. The United States faces the challenge that was faced in the 30s. Do we defend the currency or the economy, and Arthur Burns always told me we defend the political economy. That means massive inflation in order to keep homeowners from being put out on the street. How does that sit with the rest of the world?

SUMMERS: Look, I think yours is a reasoned but not prevalent view on the magnitude of the house price problem. It would not correspond to most people's sense of how that's going to evolve. It doesn't mean you're not -- doesn't mean that you're not right but it means it's not where I think most of us would bet. I think you just posed in a sharp way the contradiction that I've emphasized several times around one instrument to target. Is it the currency or is it the domestic economy -- the matter to be debated -- but I think that most readings of the 1920s -- 30's experience suggests that a little more emphasis on the domestic economy would have served monetary policy well through that interval, and I think one does have to be impressed that, for example, the euro has moved from 80 to 135 without it being a titanic event in the economic life of Europe. And so a first obligation to the domestic economies is something for which there is much to be said. I think one of the reasons why becoming as extended as the United States is is problematic is that it becomes that much more difficult to give first emphasis and reliance to the U.S. economy in setting monetary policy as you become more like a small country floating in the international economic ocean.

VOLCKER: No, I don't think we're going to face that stark a dilemma as suggested but when you talk about inflation I -- you're talking about a generalized inflation, which was not the situation in 1930s where you had a generalized deflation of some proportion. Obviously, then, it's tilted toward doing something about the deflation. If you're talking about a generalized inflation, letting that -- (rip ?) -- isn't going to help the situation in my view -- it will aggravate it. I don't think it's going to happen but --

SUMMERS: To just clarify two points -- I agree completely with what Paul just said. My -- I was responding to a question that was framed in terms of the currency or the economy --

VOLCKER: No, the currency.

SUMMERS: -- I would have given a very different answer to a question that was framed in terms of the price level or the economy. I think there's one other point that's worth emphasizing. There is in modern economies, including at the government level, a very large amount of essentially daily rolled over short-term debt. It is the nature of very short-term debt that you can't inflate it away because if you try to inflate it away the relevant interest rate increases, and so it is a mistake to entirely -- to fail to recognize that there is rather more discipline provided by borrowing costs, which react quite quickly to inflationary tendencies than some of the discussions that suggest that in the absence of gold there's no anchor of any kind. And I think that's worth keeping in mind when considering these questions relating to inflation credibility.

GRANT: Back there -- yes, sir?

QUESTIONER: Hi. Art Kleiner, Strategy in Business. You haven't mentioned factors like the emerging middle class -- if it is emerging or productivity or -- do these kinds of factors play a role in the stability amidst turbulence or are they not the -- not major factors?

SUMMERS: I'm not certain I understand the question. I think there's a very broad, profoundly important question -- probably more important than the questions we're discussing this morning -- of what all of this economic change means for the 180 million Americans and several billion people on planet Earth who are neither capable of leveraging the remarkable change in the emerging markets, nor prepared to envision themselves competing with people in India and China on the basis of wages. And how their lives are going to play out and how our system is going to work for them is a huge question but not our question today. I think with respect to the developing countries in emerging markets one of the great and likely sources of strength and stability in the years ahead is the emergence of connected middle classes, and the fact that that's happening I think is one of the things that gives one some very considerable optimism with all the problems about how the future's likely to unfold.

GRANT: Yes, ma'am?

QUESTIONER: Henny Sender -- The Wall Street Journal. In your opening remarks, Dr. Summers, you referred to the somewhat counter intuitive flow of capital from the emerging world to the developed world. A lot of that capital is in official hands as opposed to private sector hands, and recently there's been a lot more talk of moving from considerations of safety and liquidity in investing those reserves to opting for higher returns. So in a very messy question I'd like to ask you what the implications of that shift to official hands is and a more sort of proactive aggressive management of reserves, both in terms of the dollar, interest rates, and all kinds of financial assets worldwide. Thank you.

SUMMERS: I'm going to focus on the second part of your question. I think it is -- I think it should happen and it will happen, that as countries' reserves come to far exceed any need for a liquidity buffer, they will come to see the right investment strategy for those reserves as being oriented to the country's long-term interests rather than the maintenance of short-term liquidity.

And the patterns of investment will be increasingly like those pursued by defined-benefit pension plans or even nonprofit institution endowments. And those will mean being prepared to accept short-term risk with the very confident but not certain expectation of higher long-term return. And Singapore was a pioneer in this regard many years ago, to its very substantial benefit. Norway has been active in this sphere for some years from now. And there are more and more countries that have made decisions to pursue this.

I think it is in their interest and I think it is potentially in the global interest in raising the supply of risk capital as long as it happens in a less than precipitous fashion. And given the kind of bureaucracies involved, I think there's very little risk that it will take place in a precipitous fashion. I don't anticipate that this should be a jarring event in any way for the U.S. treasury market or for the world's capital markets.

I think you do -- I think there will be a number of issues that the world will have to address as this trend unfolds, including the challenges raised by governments as shareholders. And I think there are very large and very fundamental questions for developing countries about domestic versus international investment.

I think it is easy to make the case that if you're going to invest internationally and you have reserves of 30 percent of your GDP, that a substantial portion of those reserves are better invested in riskier assets than in short-term financial instruments.

Whether it would be better still to invest more of those assets in infrastructure in your own country and to accept the exchange-rate consequences of making that move is, I think, a much more difficult question and one that's likely to be debated over time. And that goes back to the question of mercantile exchange rates, with which I began my remarks.

VOLCKER: I don't disagree with the economic analysis. I think this raises some very large political issues, for better and worse. You've got a reaction in the United States already to rather marginal, in the big scheme of things, of investment by some foreign countries in the United States.

But look at Africa, where there is clearly a push by China in particular to make strategic investments, not just for economic needs -- profitable needs, but to hedge their energy supplies in particular or to gain political advantage. And it's not clear that it all goes on strictly economic criteria.

But it came to mind the other day -- everybody talks about Darfur and why don't people do something about it. The only leverage you've got, according to some analysis, is oil production in the Sudan, and maybe somebody ought to start an oil-for-food program in Sudan. I don't think that would be very popular. But it comes to mind, the oil production in Sudan is all controlled by China, and that raises interesting questions about how you deal with that situation.

GRANT: We have time for one last really terrific question.

Yes, sir.

QUESTIONER: Dick McCormack from Merrill Lynch. If, in fact, we do have a different kind of investment from those in Asia having reserves, isn't this going to result in potentially higher interest rates in the U.S.? And isn't it going to result in a potential higher return on their capital, which would then add to current accounts problems for the U.S.?

SUMMERS: The logic of what you say is impeccable. I think if you do a reasonable calculation of the likely consequences of a shift of plausible magnitude spread out over seven or eight years, it's very hard to get excited about the impact on treasury rates relative to whatever you thought the uncertainty about treasury rates was before. You are talking perhaps in the tens of basis points, perhaps -- not, I think, a major impact.

Look, I think the question of will they earn higher returns and will that be bad, that depends in important ways on how you think about the world. Another way to say it would be, will they provide entrepreneurs and reduce the price of risk in the United States to the benefit of the U.S. economy? And I think the answer to that is yes. And so I think if you believe in mutually beneficial exchange, even mutually beneficial exchange that's good for the other guy, you should be inclined to regard this as benign.

I agree with Paul very much on something he said. You know, in a way there are three levels of investment that one can consider. There's standard sovereign investment, which is it's really ambitious to buy Fannie Maes rather than to buy U.S. treasuries -- you know, fixed income, liquid instruments. If we outperform by four basis points, that's a fantastic thing.

There's broader portfolio investment and investment in alternatives of the kind that's contemplated by defined-benefit pension plans or by nonprofit endowments. That's a second level. And there's a third level which is strategic investment to achieve political objective. And I am very much supportive, both in a prediction of what's likely and in a normative sense, of the evolution from one to two.

I agree with Paul that the third is, it seems to me, problematic from everybody's point of view. We had at Harvard -- and Jack Meyer insisted on this, and he was absolutely right -- a very strong policy that the Harvard endowment was managed to maximize risk and return -- maximize return relative to risk. (Laughter.) I mean, there are some who would question that, but the objective was to maximum return relative to risk.

And he was absolutely insistent and absolutely right that if somebody thought it was a good idea for the university to own property near it or to make an investment in the future of science or to do something else that was strategic, that was fine -- and that's why the university had a budget and that's why the university had a set of special reserves -- but that it was a serious mistake to conflate financial management with the achievement of strategic objective. And I think that's very right.

And I think countries would be well-advised, to the extent they wish to pursue strategic direct investments or to take another issue that I don't think Paul mentioned that's also important; they want to engage in domestic financial policies with respect to their financial institutions. I think they should think of those as being from quite different pots, managed in quite different ways, than wealth pots that are directed at maximizing risk and return.

GRANT: Well, I think you've agreed that we've solved the question -- that, if not today, then sometime in the future we'll get to that.

Meanwhile, thank you, audience. Thank you, McKinsey. Thank you, Hank Greenberg Foundation. And we'll see you soon, I hope. (Applause.)

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