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McKinsey Executive Roundtable Series in International Economics: The Global Credit Crunch: What Should a Central Bank Do? [Rush Transcript; Federal News Service]

Speakers: Martin S. Feldstein, President, National Bureau of Economic Research, Inc., and Allan H. Meltzer, Professor of Political Economy, Carnegie Mellon University
Presider: David R. Malpass, Chief Economist, Bear, Stearns & Co., Inc.
November 19, 2007
Council on Foreign Relations


This meeting is part of the McKinsey Executive Roundtable Series in International Economics, presented by the Maurice R. Greenberg Center for Geoeconomic Studies and the Corporate Program.

DAVID MALPASS: Good morning, everybody. Hello. We'll go ahead and get started.

A very warm welcome on this cold Monday morning. I'm David Malpass. I'm here to enjoy the company of two of America's most prominent economists. We're going to talk about the global credit crunch and what should central banks be doing.

It's a true privilege to introduce both of our speakers today. Dr. Martin Feldstein, to my far left, is a professor of economics at Harvard University since 1967. He's also president and chief executive of the National Bureau of Economic Research, one of the premier economic organizations. So he announced he'll be stepping down in June 2008 from that post.

From 1982 to '84, Martin chaired the Council of Economic Advisers in the first Reagan administration. He's a prolific author and on many boards and has won many awards, which are maybe in your background material. He was educated at Harvard and Oxford. He was born in New York City, and we're privileged to have his wife, Kate, here this morning. She's also an economist.

I know -- I've had the good fortunate to get to know Dr. Feldstein through the National Committee on U.S.-China Relations, so one of the things we can ask Dr. Feldstein this morning is about China's monetary policy.

Mr. Allan Meltzer, to my left, is professor of political economy at Carnegie Mellon. He's also a visiting scholar at the American Enterprise Institute. He's the author of several books, most recently the first volume of a history of the Federal Reserve, 1913 to 1951.

Is the new book coming out?

ALLAN H. MELTZER: It's in the last stages of being sent -- just before being sent to the press.

MALPASS: So there will be a second volume; is it 1951 to present?


MALPASS: 1986. So that's short of the Greenspan years. But on other areas he's very outspoken. So we'll have a chance to enjoy that.

He's well known as the chairman of what became known as the Meltzer commission. They issued a report in March of 2000 on what should be done about the international financial organizations like the IMF and the World Bank. And Allan was co-founder with Karl Brunner of the Shadow Open Market Committee in 1973, which has watched U.S. monetary policy from a little bit of distance. He's been an adviser to the Bank of Japan and also had the privilege to meet with Lady Margaret Thatcher -- or work with her in the early stages of her economic policy development, as well as Ronald Reagan. He was educated at Duke and UCLA, born in Boston.

So it's a great privilege to have these two gentlemen here. Each will make a little statement on the general question of where do we stand on economics right now, and then we'll have questions and questions from the audience. Thanks again for coming.

Oh. Now I have very important announcements to make. This meeting is part of the McKinsey Executive Roundtable Series in International Economics. Happy to have Benn Steil here as the head of that. It's on the record. Please take a moment to turn off your cell phones. If anybody has them on, please, this is your opportunity to turn them off.

To Dr. Feldstein: How do we stand on the economy? What's important?

MARTIN S. FELDSTEIN: Well, when I thought about what what I wanted to say to this group today, David, I thought I would develop three points. First, that the U.S. economy now is very weak and could degenerate significantly in 2008; second, that the Federal Reserve should continue to cut interest rates; and third, that the declining dollar is an inevitable adjustment to the large trade deficit and it's going to be the primary source of aggregate demand and growth in 2008. So let me say a little bit about each of those, starting with the weakness of the U.S. economy.

The title of this session focuses on the credit crunch, but our problem is much more than that. In the housing sector, we have a triple problem. We have the problem of collapsing housing starts, down 30 percent from a year ago and falling at an accelerating rate.

We have house prices coming down nationally, an absolutely unprecedented change, reducing consumer wealth. Consumers own $20 trillion of assets in the form of owner-occupied housing. If housing falls by a cumulative 20 percent -- and many analysts are forecasting more than that -- that would be a fall of $4 trillion in household wealth, and that would trigger a continuing fall in consumer spending of about 1 percent of GDP.

Then on top of those two, we have the fact that mortgage refinancing and mortgage equity withdrawals that have provided that extra cash to allow households to reduce their saving rates -- indeed, reduce them to negative savings rates for a while -- that that's turning around, and we're now seeing a reduction in mortgage equity withdrawals and therefore less cash to stimulate consumer spending. So in short, quite separate from the credit crunch, we have a very serious housing set of problems.

Now, the credit crunch itself, in my judgment, is really very different from credit crunches that we've known in the past. The primary problem, this time around, is essentially a lack of confidence, a lack of trust. People don't know who to trust and they don't know what prices to trust. So there is a lack of confidence in counterparties, there's a lack of confidence in the market prices of assets, and so we're seeing a freezing up of transactions that would otherwise make the credit market a positive force for the economy.

And now there's a further problem that's developing in the credit markets, and that is as the banks are taking on to their balance sheets funds that were previously in SIVs or were commitments, that's using up scarce capital. And so we've moved from a traditional credit crunch to a confidence crunch to a capital crunch. Put all that together, and I think we have a very serious problem, quite apart from the fact that oil is heading at $100 a barrel.

I find it hard to understand how the majority of forecasters -- indeed, almost all of the forecasters, are nevertheless saying that 2008, once we get through the first quarter, is going to be fine. I don't see anything in the recent statistics other than the fact that employment has held up in the last month. But other than that, it's hard to find anything that gives me confidence that 2008 is going to be a good year.

So that brings me to the Federal Reserve and what should the Fed do. Well, it should, of course, continue its role as a lender of last resort. But in addition to that, I think, it should be cutting the federal funds rate further. At the Federal Reserve's Jackson Hole conference at the end of August, I said that I thought the economy was weaker than it appeared to many participants, and that the Fed should be bringing the fed funds rate down by about 100 basis points over time. Well, we've now moved 75 basis points, and on December 11th, I hope they will move at least an additional 25 basis points.

But looking ahead, I don't think that's likely to be enough. Unless we see a stronger economy than now is showing up in the numbers, I think the Fed has to be moving the fed funds rate down to some number that begins with a three rather than a four.

Unfortunately, the lower fed funds rate is not going to deal with the specific problems that I've been talking about. It's not going to deal with the capital problems at the bank, it's not going to deal with the lack of confidence, but it can stimulate the economy in a variety of ways. People with adjustable rate mortgages will have more disposable income. Businesses that are borrowing and are able to get credit will get credit on more favorable terms. And perhaps most importantly, the continuing adjustment of short term rates will continue to add to the greater competitiveness of the dollar.

So let me conclude by saying something about the declining dollar. As you all know, the dollar has come down sharply relative to the Euro, relative to the Canadian dollar. Of course, it has not come down relative to the renminbi. It has come down very recently relative to the yen, but if you go back, not very far, we're back to where we were with respect to the yen.

A more competitive dollar helps our exports. A more competitive dollar reduces the temptation of Americans to spend their money on imports.

I'm puzzled by statements that the dollar is weak. I don't know how one defines weak. Is it weak if it's low relative to six months ago or two years ago? It seems to me the definition of strong or weak has to be in terms of the trade balance, and we have a $700 billion trade deficit, a trade deficit of more than 5 percent of GDP. And that tells me that the prices of American goods in world markets and of foreign goods in the United States translate into a dollar that is not weak, a dollar that is not competitive enough.

And so if we're going to shrink the size of that trade imbalance over time, we're going to have to see the dollar come down. And that should be seen as good news for the economy. The fact that the dollar is becoming more competitive means that we will see a stronger gross GDP in 2008 than we otherwise would.

Let me stop there and turn it back to David and Allan.

MALPASS: Thank you, and I hope we'll have a chance also for Allan to pick up on some of those points but to make his own. They both -- it's very interesting and good timing that we have -- for one, difficulties in the world -- but they both wrote Wall Street Journal articles, Marty's on September 12th, laying out some of these points, and Allan with a response on September 15th that kind of took the other side. So we're going to explore that in a collegial way here. (Laughter.)

MELTZER: Of course.

MALPASS: So, Allan, can you lay out your views? And I know many of them are the opposite. Why?

MELTZER: Yes. There are three problems -- three big problems facing the U.S. economy at the moment. The biggest of them all is the one that gets slight attention, and that's the price of energy. That's probably a big problem, bigger than people now seem to estimate. Manufacturing has reduced its energy. One of the things that is most striking to me is that, along with many other problems, the Congress, the president have been dealing with the problem of energy for 40 years and haven't really done diddly-squat about solving the problem. We still have the problem. It's bigger now and it's going to have a real impact.

What can the Fed do about the oil price? Nothing: That is, it doesn't produce oil; it produces paper. (Laughter.) You can't substitute paper for oil. You can print money and give the economy a little bit of a lift, but the oil shock is a reduction in the wealth and standards of living of the United States. And the only solution that we can have: We should think about it as a tax on American consumers and producers. And if we wanted to offset it, it requires a fiscal action, not a monetary action.

The Fed cannot do much about the price of oil. It realized that after trying in 1973 and 1979. It handled the last phase, the most recent phase of the oil problem, by largely ignoring it and trying to prevent it from spreading into other prices. It's a one-time lift in the price level, not the rate of inflation, and we do nothing. The prices will continue to rise at the rate that they've been rising, and that's nothing that the Fed can do much about.

Second problem is housing. We all know about the housing problem. We get talked to death about the housing problem. Most of that is in the market. They may overestimate the extent of the housing problem. But that's again a case of where we had a boom and now a contraction, and housing will be slow.

There isn't a lot that the Fed can do about housing. It can help to smooth the process of adjustment but then it's going to have to take out the additional money that it put in. It's not a problem that requires much action on the part of the Fed. People just have to accept the fact that there have been losses, and those losses spread to the financial market, and that's the third problem.

Now, the third problem, the financial problem, gets the most attention these days. And of course, there is great pressure from Congress, from market people, for the Fed to reduce -- and from Marty -- for the Fed to reduce interest rates. The fact is, what the Fed does has to do with the ability to smooth the path of the economy without creating inflation, and it has to serve as lender of last resort.

There is no, as far as I can see, no liquidity problem at the moment. When the Fed put out -- reduced the discount rate and offered to lend, there were very few takers. If you look at the federal funds rate on a daily basis, you find that most days it's below the rate that the Fed has set. It hardly ever goes above that rate. That's a sign that there isn't a great demand for our reserves at this moment. And bank loans, until the last week, had been rising at the same rate that they were rising before any of this crisis rose.

The commercial paper market is in extremis. That's true, but we have -- and there isn't a lot that they Fed can do. What has to happen to solve the problems with commercial paper market is that people have to recognize the losses that have occurred. This is not a liquidity problem in the sense that banks are -- or that there was for example after the 1987 stock market collapse. Then, there was no money. People were holding on to their money, and the market wasn't likely to clear. The Fed could supply reserves at that point.

That's not the problem at the moment. The problem at the moment is that the people are, as Marty said, suspicious about all financial, especially asset-backed, commercial paper. The result is, even if it's good, they're not sure it's good and they're not willing to buy it.

Non-financial commercial paper continues to rise. Asset-backed commercial paper -- the people who have it have to take the losses, and that seems to be occurring. The agents who will come in at the end of the year to close the books are going to make them write down the value of the paper.

Now, no one knows what the value of the paper is. And so they're going to use something which is not a very good measure, the ABX index. And they're going to force them to write them down and probably write them down more, because the hedge funds are selling short on the ABX index, pushing it down even further and making the losses appear worse than they perhaps might be. So that has to happen. And when that happens, then the markets will come back. The commercial paper market will return.

Now, when do we have an experience like this with the commercial paper market? The one that comes to mind for me is 1970, when the Penn Central failed and the commercial paper market virtually closed. For about three months, there was virtually no commercial paper market.

Then, but what happens in the economy in that period? Not much. Why? Because there are very good substitutes for commercial paper. There are bank loans. And bank loans, as I said, have been rising. That's not a problem that the Fed can do much about.

If bank loans were falling, and there was a problem of a shortage of reserves, or a sign that at the current federal funds rate, people were -- bankers, business wanted to have more or less credit, there might be a case for reducing the interest rate. But there isn't much of a case at the moment. And there is a problem, not a great problem at the moment but there is a problem of inflation, as there almost always is. And that problem is bigger at the moment than it usually is.

So the best thing for the Fed to do is to try to encourage the adjustment in the banking and finance industry to accept the losses, and that's what the accountants are going to largely do, and to do as little as it can, to avoid the pressures that are coming to it from the marketplace, from the people who have losses, that they think the Fed could help them with, or from the Congress, which always is on the activists' side.

My guess is, like Marty's, that the Fed will, in the end, despite the statements that are being made by Randy Kroszner, Governor Kroszner and some of the -- my friend Bill Poole, that they should not cut interest rates anymore. Because I think they see things pretty much the way I do. The fact is that the market has priced in a cut in interest rates in December. And the Fed, if it's going to stop that cut from taking place, then the chairman or the vice chairman had better get out there and start telling the market, we're not going to cut or we don't think, at the moment, there's a reason for the cut. And otherwise, they're going to be in the position of having to not want to disappoint the market.

They finally learned -- it took them a long time to learn -- that they depend upon what the market thinks, just as much as the market depends on what they think. And if the market has priced in a large or another cut in the federal funds rate, then the Fed is going to be, in December, where it was in November. That is, it's going to be in a position where it won't want to deny that.

MALPASS: Thank you very much. You mentioned the vice chairman. Don Kohn will, I think, be speaking here at the council in a couple of weeks. So that will be interesting if they want to get the market to stop pricing in the cut.

Let me ask a short question. Do you think we'll have a recession? NBER, that Marty is the chairman of, decides when a recession has occurred. Do you think we're going to have one? (Laughter.)

MELTZER: I think the safest answer to that question is, it can't be ruled out but it is not the standard forecast. But most people who forecast now would say that you certainly can't rule out the problem, that things may get worse. And as I said at the beginning, I think the energy problem is probably the thing that's going to drive what looks like a recession. That's not really a recession in the true meaning of a recession; it's a one-time loss in wealth. That is, we don't recover -- income doesn't recover from that; it just stays lower and grows at the same path.

MALPASS: Marty, I know it's --

FELDSTEIN: The NBER doesn't predict recession. (Laughter.) We do date them after the fact. And when we do, we look not just at what's happening to real income but what's happening to production and what's happening to sales and what's happening particularly to employment.

And so the way I interpret the standard forecaster's answer to the question, "What's the probability of a recession," to which they usually say 30 or 40 percent -- I interpret that to mean they think there's a 30 or 40 percent chance that we're going to see declines in employment, declines in production, in addition to what may happen to real incomes because of the changes in import prices.

And that's my starting point for thinking about what the Fed ought to do. If you think that there's almost an even chance that the economy is going to be in a recession next year -- and by the way, I find it very hard to understand how people can say there's a 30, 40 percent chance of recession, but my forecast for growth is 2-1/2 percent. (Laughter.) Try to work that arithmetic out. It's not easy.

If you think there's going to be that much of a chance of recession, even though I agree with Allan that the driving forces causing it -- energy, what's happening in housing markets, what's happening in parts of financial markets -- are not things that the Fed can turn around, they nevertheless, by lowering interest rates, can stimulate the economy and perhaps avoid that downturn or modify the strength of the downturn.

MALPASS: Allan, can rate cuts reduce the chance of recession?

MELTZER: Yes, the can reduce the chance of recession. That is, if we make the rate low enough, we'll get stimulus in areas. We'll get a falling -- a more rapidly falling dollar, so we'll get exports. We'll get more short-term investment, things of that kind. People will take advantage of the lower interest rates.

So yes, that will make a difference. But then there's a price to pay for that, as we found out with the 1 percent interest rates that Alan Greenspan had for several years. Then you have to do something about that later.

One of the problems that concerns me is, in writing the history of the Fed, there were countless times -- that is, almost every recession -- where before the recession began, the Fed members, the governors, would say to each other, "This time it's going to be different. We're going to stick to the anti-inflation policy. We won't deviate." And then two months later, they would say, "Well, we have to ease." And that's what they did.

And the day when you were going to do something about the inflation, caused in part by responding to the recession, that day never came. It didn't come until Paul Volcker reversed the priorities and said inflation is our number-one priority. That's what he told President Carter when he -- before he was appointed, and President Carter said, "It's my priority too." And so they agreed, and to his credit, President Carter never criticized his policy, and President Reagan not only didn't criticize it, he strongly endorsed it. And that -- we got rid of the inflation that way.

But we didn't get rid of it permanently, and as astute an observer of these matters as Alan Greenspan is out there predicting that there's going to be another inflation.

MALPASS: Let's stay on inflation for a minute. It's critical to central banking.

So can we predict inflation? How confident can we be in either the Fed's predictions or the market's predictions of inflation? And how can we use inflation, because it's backward-looking? The inflation that we have this year is the result of monetary policy two years ago. So how can it be helpful to a central bank?

I guess I'll start with Allan, because you raised it, and then hear Marty's thoughts on that.

MELTZER: A central bank -- central banks have learned in the last 30 years that they can have an influence on what happens a few years from now, and so they have developed long-term policies that -- that's what I believe inflation targeting is all about. It's a way of tying the central bank's hands, so that it looks ahead two years instead of being beguiled by the things that are happening today.

MALPASS: But the Fed's now making inflation forecasts of next quarter and the subsequent quarters.

MELTZER: Yes. Good luck. (Laughter.)

FELDSTEIN: But the Fed has also now said they're going to start giving us three-year forecasts, both on real side and on the inflation side. And in effect, that's a backdoor way of getting to an inflation target. In three years, what they forecast is what they think, and it's forecast conditional on their judgments about good policy, whatever that means.

But it is a way of saying this is where we want to be three years from now. So if the public believes it and if they themselves believe that that's what they're going to do, then I think what they are in a position to do now is to say: Look, we may have a short-run problem in 2008, we may provide more liquidity, and then we are telling ourselves that we're going to pull it back, so that we get back to that low inflation.

Now, will they really do it? I think there's been a lesson learned around the world. The world today is different from the world of the '70s, when inflation was allowed to rise and people treated it as a kind of minor inconvenience. I think we now understand the adverse effects of inflation, the high cost of inflation and the difficulty of bringing down high rates of inflation.

When Paul Volcker was facing inflation, he was facing inflation rates in the 10-plus percent range.

So I think the Fed is not going to let this slide, and I think if you look at who the members are of the Fed, the Open Market Committee today, they are people who really believe that they have a mission in terms of keeping inflation down. But it is a dual mission, and letting the economy fall into recession will not be an appropriate policy, in my judgment, for them when they have the opportunity to avoid it.

MALPASS: If the Fed had done an inflation forecast, say, in 2003, it would have been for inflation to stay at the 2 percent rate, and then by 2005 we had 4.7 percent inflation. The most recent data was 3.5 percent inflation, which surely the Fed wouldn't have predicted or assessed three years ago.

So you're giving us that -- the Fed is pretty credible because we've seen the alternative, and that was the 1970s. Is that it --

FELDSTEIN: Yes, and I think the Fed, perhaps incorrectly, has been focusing on the core PCE. The core PCE, in most recent numbers -- about half the headline numbers, about 1.8 percent.

MALPASS: And keeps getting revised up a year later.

FELDSTEIN: But it in any case is very low. And I think they've now come to accept that what the public cares about is the headline inflation, the overall CPI or they would say PCE. I think that's appropriate and that the role of the core number historically was a way of adjusting out short-term fluctuations.

Going forward, we see that food prices are scheduled to keep rising. It's not a bad lettuce crop that's causing food prices to increase. It's coming on the demand side from what countries, particularly in the developing world, want, and similarly for energy prices.

So it was a mistake, looking back, to focus on the core and think that that was going to track the overall price level that the public really cares about.

MALPASS: And so --

FELDSTEIN: And they have now said that they're going to move their attention to the full consumer price index.

MALPASS: Yes. And so this was a very important shift last week in Bernanke's technique. I'm going to use this to switch to the dollar, and that'll be my final area -- if people can think of their question areas.

But as you talk about energy prices, it seems to me that one of the things driving up energy prices is the weakness of the dollar, and so you're simultaneously holding the view that we can hold down inflation and yet have had the dollar weakened further. That's certainly going to drive up the price of energy and food, and the Fed isn't going to use the excuse of core inflation until much in the future. How does that match? Won't a weak dollar cause inflation?

FELDSTEIN: You know, the historic record on that is interesting. In fact, there's a piece in the journal today pointing out how little correlation there is between the changes in the exchange rate and changes in inflation, but --

MALPASS: That's the trade rate and exchange rate --

FELDSTEIN: Trade rate and exchange.

MALPASS: -- which many of us think is not really very relevant in measuring the value of the dollar because the currencies all move together. So if a group of countries all devalued their currencies, the trade-weighted dollar won't move, and yet inflation in all the countries -- we're right now seeing inflation in Europe, in China, in emerging markets because their currencies are weak as --

FELDSTEIN: They can't all be weak relative to each other.

MALPASS: No, but they can all be weak in absolute terms relative to commodities and relative to the cost of living, relative to --

FELDSTEIN: Well that's not my definition of inflation.

Let me just mention what I think is the interesting historic fact on this. The last time we had a really big move down in the dollar was in the mid-1980s. The dollar fell by 40 percent over about a two-year period, and so you look at what happened to inflation in the United States before and after -- nothing, nothing. No significant increase. Why? Because there are a lot of things that influence inflation, and if the markets believe that the Fed is going to be serious about inflation going forward, if there are other factors at work that are depressing inflation, that can offset the impact of a falling dollar.

So I don't think we should overstate the impact that a falling dollar is going to have on inflation.

MALPASS: Alan, what causes inflation, and is the weak dollar a part of that or how do you think about these?

MELTZER: No, I don't think the weak dollar causes inflation. It may cause a rise -- a temporary rise in the price level here. It certainly will cause a rise in the price of foreign commodities.

But I think the talk about the weak dollar has to be put into context. The context is that the world economy doesn't seem -- seems to have lost whatever few mechanisms of adjustment that it had or at least a good adjustment that it had before because so many countries, just as you said, peg to the dollar, and if the dollar falls, China may raise its exchange rate 3 percent or so, but on a real basis, because they're pegged to the dollar, they actually are getting a lower real exchange rate. And so they're using that for internal purposes, which are much more important for them than what happens to the renminbi or the dollar. The same is true of many other countries -- they peg to the dollar.

So it's difficult to get the world to have stability in the exchange markets and low inflation at the same time. Stability in the world currency market requires that there be some give and take between countries. When there was an Asian crisis, the U.S. expanded to help the Asian countries get through the crisis. The trade deficit went from $150 billion a year to something like $450 to $500 billion a year. Who's going to give up those exports to let the United States adjust its trade balance? Not very many people, not very many countries want to do that.

So it's harder for us to adjust by actions, cooperative actions on the part of various countries. That leaves us to do it on our own and requires us to push the dollar down. The same system that's doing that is causing China probably to be overcapitalized, the United States to be undercapitalized. So we have lots of problems being built in because of the lack of an agreement or an understanding about how the world is going to adjust to imbalances in various places. It's going to be hard for the U.S. to get back to $150 to $200 billion, which would be a sustainable amount of current account deficit.

MALPASS: We're at $800 billion now.


MALPASS: So a big adjustment.

Now, if the -- if companies see that the dollar's going to weaken over a period of time, aren't they going to invest abroad rather than investing in the U.S., and isn't that part of our -- the weakness in our economic outlook?

MELTZER: That's part of the reason for the weakness, right. On the other hand, consumers will be inclined to buy more U.S. goods, and foreigners will be inclined to buy more U.S. goods. So we get some benefit on that side. But the investment side certainly companies will hesitate to come here thinking that they'd be able to make a better buy a year from now.

MALPASS: You both knew Ronald Reagan and Margaret Thatcher, and they both used strong currencies to stop the malaise that preceded them. Were they wrong in that, or what's different now?

FELDSTEIN: That's not factually correct.

MELTZER: Margaret Thatcher did.

FELDSTEIN: Margaret Thatcher may have, but the big adjustment of the dollar came in the middle of the Reagan term.

MALPASS: No, but in 1981, '(8)2, '(8)3, and '(8)4 it was very strong.

FELDSTEIN: And then it was very weak, so we gave up 40 percent in the value of a dollar relative to the currencies. And that turned around our trade deficit.

MALPASS: I was speaking, though, of growth. If the country was trying to achieve growth, the early Reagan years were characterized by dollar strength to attract investment into the U.S.

FELDSTEIN: I don't think -- I mean, I was there in the administration. I don't think that we really thought in terms of the dollar as a driving force in that. It was a combination of things. When the inflation came down, we saw real interest rates rise. We had very large fiscal deficit, again, as a result of the fall and fully unanticipated fall in inflation with a tax system that had built in tax cuts that were not yet indexed.

So for all of those reasons we saw a very large fiscal deficit and that attracted funds from the rest of the world through the high real interest rate. But it was the easier monetary policy, the fall in inflation, the fiscal deficit, all of that, which gave us the strong rebound. Of course, we were coming from a deep hole, too, so that helped, but it was that rather than a dollar policy.

MELTZER: A country has to make a choice between whether it wants to have an exchange rate policy or domestic inflation policy. It can't do both. At least it can't do both reliably. And the U.S., I think, during the Reagan years chose -- certainly the president chose low inflation as his objective. In my conversation -- Marty saw him more than I ever did, but I never heard him talk about the dollar. I never heard him talk about the exchange rate. He talked about inflation a fair amount, and he was concerned about inflation, and as late as 1986 or '87 he said something about, well, the inflation rate is still 3 percent, that's too high. So that was a concern for him and it was a concern for him throughout his presidency. I never heard him talk about the dollar.

MALPASS: Let's go to questions from the audience. I'll go one, two and then three. Yes, sir.

Thank you both. Very interesting.

QUESTIONER: Hello. Peter Fisher from BlackRock. Let me try to press Marty a little bit on a question of a burden of proof. You say you don't see why the economy will be strong next year. But what do you see in the credit channel that you see businesses -- otherwise healthy household and business balance sheets not getting access to credit, given the evidence in the non-financial commercial paper market and other places? So that's one part of it.

And the other is, how can you compare and contrast post-'87 stock market collapse, when everyone forecast the world economy would slow down in 88, and it didn't? Now, the Fed responded, the Fed eased, and that was part of the response. But looking at the steep yield curve we have today, what is it in the existing response we already have that persuades you it's not enough? The Goldman Sachs Financial Conditions Index has eased a lot. The dollar's eased a lot. There's a lot of stimulus right here. So the second depart is, why isn't this enough already?

MALPASS (?): May I add to what you just said that the Fed allows -- that is, that the president decided to give up the Louvre agreement and to allow the dollar to fall. That was an important part of the adjustment.

FELDSTEIN: One way, Peter, to answer the question is to say let's look at the current Fed funds rate relative to inflation in comparison to where it's been historically, with a Fed funds rate of 4.25 percent, and then it's a question as to what inflation rate one looks at; but an inflation rate of around 2, 2.25 percent, that translates into a quite high real Fed funds rate, at least a Fed funds rate that by historic standards would be considered to be neutral. And that's consistent with the Fed's stated view that there's an equal risk on the down-side and the up-side.

So if I thought there was an equal risk on the down-side and the up-side, I would say the policy was appropriate at this level, but when I look at the factors that I talked about before -- what's happening in housing, you asked about the credit to households, the jumbo mortgage market is in trouble, certainly, and just the cost of funds that could come down to households and to small businesses if the Fed lowered.

So it's basically starting from a sense that -- this widely shared sense that there's a high probability of a recession, and a desire to offset that.


MELTZER: You know, the mistake that is often made is to pay attention to forecasts. Economists cannot forecast quarterly movements, and they should have recognized that by now. Short-term forecasts are not worth much. Who thought that? Well, Paul Voelker. Over and over again as I read the transcripts of Fed meetings, he said, you know, this is the greatest staff in the world, but they can't forecast worth a damn. That's true. And Alan Greenspan wasn't quite as dramatic but said very similar things. He made his own forecasts, some of which, when he was in the private sector, were not very good. When he was a staff at the Fed, he occasionally got it quite right.

The point is that it's a mistake to run the policy on the basis of forecasts. If there is a recession, then -- a real recession, not just an oil shock, but a real recession -- then we should do something about it. But we shouldn't do something about it on the basis of forecasts, because that's the way we get into trouble. We get into trouble because it concentrates the attention on the near term when we should have learned by now that what effects we're going to have happen over a longer term.


FELDSTEIN: That's where -- you know, you said in the beginning, David, that Allan I disagreed. As I listened to the conversation until now, we more or less agreed on everything.

MR. : Right.

FELDSTEIN: Where we disagree is on this last point, do you have a forward-looking monetary policy or do you wait for the problem to come and then treat it at that time.

MELTZER: Well, the forward-looking monetary policy I want is one that looks ahead a couple of years --


MELTZER: -- when what you do now will have an effect. So it's not forward looking, it's -- as I would put it, it's fine tuning, whether you think that you can offset expected shocks which have a low probability of being correct.

FELDSTEIN: Well, how low is low? I mean, you may be right that the forecasters have it wrong. I think if anything, they are too optimistic in talking about 2.5 percent growth. So if it were my call, I would say the economy has a high enough risk of a downturn, and we're doing it in a time when the inflation rate is relatively low, we have great confidence in the Fed, the Fed themselves is focusing on medium-term inflation, and therefore, having some easing below what I would call a neutral Fed funds rate today is called for.

MELTZER: So I think inflation may over the next three years average 3 to 4 percent headline CPI. You've got a more sanguine view of that. What would you say headline inflation will be over the next three years?

FELDSTEIN: Gosh. To forecast headline inflation, you have to forecast oil prices and food prices, and that's been so much of a driver of the difference between these two, I --

MELTZER: But aren't we saying the Fed's supposed to make monetary policy based on a forward-looking inflation forecast?

FELDSTEIN: Yes. And that's where they have this tension between how much do they weight headline information and how much do they weight the core.

So in effect, they may say, we like to see and our monetary policy is being set so that inflation will be under 3 percent, headline inflation may be 2-1/2 percent three years from now, but of course if oil goes to $150, if food prices and other commodities go up sharply, we're going to miss that forecast. And if, on the other hand, oil comes back to what we used think of as a very high number, like $70, then we're going to be doing better than our forecast, based on treating these variables as steady state while counting on the core not to increase.

MELTZER: The Fed can do nothing about oil prices, period, right? The Fed can do nothing about rainfall, so it can't do much about food prices, either. So a statement which says we're going to target the full CPI"is a statement that says we're going -- at least, should say -- we're going to try to push the other prices down so that we can make room for those prices to rise if that's what they're going to do. And conversely, then we're going to push the other prices up if those prices happen to fall. That doesn't seem to me to be a sensible policy.

I can understand why pressure from the public, that says, you know, "What is this core CPI? (Chuckles.) What we're paying is $3 at the pump. Why isn't the Fed doing something about that?" Well, the simple answer is, because it can't. But that's what people see. So they're not going to be satisfied with a statement that the core CPI is 1 to 2 percent. That puts the Fed under pressure, and particularly under political pressure, because Congress will respond to the voices of its constituents, who will say, "We want you to do something about the actual prices, not the core prices." But as far as its target is concerned, it has a pretty good chance of doing something about the core prices and not the other prices.

So, you know, that's a dilemma. And the solution that they have come up with for the moment is not a good one, nor is it one that they're going to be happy with for very long, but it's going to be hard for them to get out of it because of something that one always has to think about -- as I read the history of monetary policy -- write the history of monetary policy -- and that's called the Congress.

And the Congress -- the Fed is scared to death of the Congress at every point because the Congress can always change the law, and on occasion -- 1982 is one such occasion, when Senator Byrd got 31 people to sign on to a statement which said we want the interest rate to be fixed at its historic range and brought down to that quickly.

You know, that was headed off, but there's always that pressure and the Fed is under that pressure and it's aware of that pressure and it responds to that pressure, and that's why I'm dubious about policies which say we're going to do something now to help the economy get over what may be a recession, and we'll take care of the inflation later. That's how we get into trouble.

MALPASS: Very good.


QUESTIONER: Thank you. I do agree that confidence --

MALPASS: Could you state your name, please?

QUESTIONER: Mahesh Kotecha, Structured Credit International.

MALPASS: Thank you.

QUESTIONER: I happen to follow the subprime markets, as I'm sure many people do here. The confidence problem, it seems to me, comes from exactly what you said; one, not being confident about counterparties, and second, not being confident about prices, pricing to model versus marking to market and so forth. And if you look at the fundamentals, you don't see -- I don't see that the priority is out there in terms of where the losses are going to be for another year, a year and half before we know where the '06 vintages and the '07 vintages will peak in terms of their expected trajectories or on cumulative default rates.

Housing price appreciation also, so we don't know whether it's going to reach the trough a year from now or two years from now or when. So given this interregnum when we don't know, and we will not know, how do we restore confidence, which really relates to who is at risk, how much are they at risk and will they fess up to it, and will we find out where indeed the problems are.

I don't think the interest rates do it. They don't address the issue of confidence. They address the issues of liquidity, and frankly, there's too much liquidity, not too little. Internationally -- we have not discussed what's happening internationally -- all that money's still sitting out there. So my question is really, how are we going to address confidence?

MALPASS: Thank you. So, broader than monetary policy, any other suggestions policymakers right now? Marty first of all.

FELDSTEIN: I agreed with you until the very last part of your statement. We agree about the problem of confidence and we agree that the Fed cannot really change that. And it's going to take time until all of this unwinds and becomes clear. What the Fed can do is to provide some confidence to the economy as a whole that the probability of a downturn is not so large. If the Fed says, we're finished cutting, then I think the forecasters, for whatever they're worth, are going to say to the American public, we've just revised up our probability of recession.

And if the Fed says, look, we have a dual mandate, we're going to be medium term inflation targetters but we're going to try to avoid economic downturn and therefore we're cutting another 25 basis points in December and may cut more as we move into 2008, I think that will build confidence, not about a counterparty risk and not about pricing risk for asset-backed commercial paper, but it will build confidence about the economy as a whole, which will keep spending up and will keep employment up and will reduce the risk of a recession.


MELTZER: I agree with a lot of what you said. The one thing that I think you omitted that I believe will be important, especially in the next three months, are the role of the auditors. The auditors are going to make them write the stuff down, and that's going to make the market look a lot better than it does now. It won't provide perfection, but it will increase confidence.

I think there are several other things that I think need to be done long-term. After all, this is not the first financial crisis that we've had in recent years. It's probably the third in the last 10 or 12 years. Why do we get into them? Why did people -- my students, Marty's students, people who were trained in finance, why were they buying this terrible paper? (Laughter.) Why did they do that? They were not trained to think that you could buy a no-downpayment loan with no information about the borrower and think that that was somehow going to be good. Why did they do that?

They do it because I believe in what economists call the principal agents problem. That is, they do it because if they don't do it, they get marked down because this is a good year and all the other banks, institutions are making money. And therefore, why aren't we making money? Well, it's because our guy won't buy this paper. So he gets to say "I told you so" from the unemployment line. (Laughter.) That's not a good system and that's a system which gets us into crisis.

The second thing which I think we have done, which I think is terribly wrong, is we've adopted Basel II. Basel II says we mark -- require reserves if you put this paper on your balance sheet. So we don't put it on the balance sheet, right? We put it -- we used to have a banking system that we monitored, and we could see where the losses might be. We didn't do a very good job at that, but it's a better job than we do now when we don't know where the losses are, right? That's the result of Basel II and pushing it -- at least, largely the result of Basel II and pushing the stuff of the balance sheets of banks and into goodness knows where. That's another mistake.

Now, Congress won't do much about that. They'll look for scapegoats. Who are the bad people who did these things? That's what it did in the housing, with the savings & loan institution.

That's what it usually does. It tries to satisfy the public's concern by hanging somebody. That's not the way that we're going to get out of the repeated crises that we get into.

MALPASS: Good, thank you.

Number three and then number four and number five, and then short questions, if we can, please.

MELTZER: Short answers too.

QUESTIONER: Margaret Cannella from JPMorgan.

One of the reasons investors have tended to buy structured credit is they've been -- they depend and they rely on credit ratings. And if we look at when the credit market really fell into crisis, it was in the week of June 11th. And during that -- you know, at that time, we already knew we had a housing crisis and we already knew that our leverage deals were priced too low, and they needed to be repriced. And what triggered, I think, the credit market crisis was the Bear Stearns hedge fund situation and the downgrades of the CDOs which followed: one day from S&P, the next day from Moody's.

So my question is, how important is the restoration of confidence in structured credit and securitization to the health of the economy? (Cross talk.)

MELTZER: Yeah, I think it's important. And I for one like the proposal, of Mr. Prince and the other bankers, to set up an agency to buy that paper. That was Herbert Hoover's idea in 1931, and he tried to get the banks to do that. It didn't work, and we got the RFC out of that. That is, the idea was to have somebody there who will buy the good paper, separate that from the bad paper and write off the bad paper. That's what has to happen.

Now, this proposal from the bankers is one way to get that done. It's not the only way to get it done, but it's one way to get it done. It's to bring other people into the market who will buy the good assets and open up that part of the commercial paper market.

And the commercial paper market, for example, for non-financial commercial paper, is going up every day. And that paper is being bought and sold without too many problems. It's the asset-backed paper that's a problem, and we have to clean up the asset-backed paper.

So somebody has to come in to buy it and to do the job of separating out the parts of that that are good from the parts that are bad. Because the reason the market is doing what it's doing, which is nothing, the reason is because no one is certain that the stuff that you're trying to sell them is good. And you may not know that yourself, but certainly the buyer doesn't know that, and so they just don't want to buy it.

And we need to do something about that. Writeoffs are going to be one solution to that problem. The proposal from Mr. Prince and his fellow bankers is another.

MALPASS: Marty, anything to add there?

FELDSTEIN: Well, I would agree with the thrust of Allan's remarks, but that doesn't solve the problem going forward about the newly created stuff. So you may have a mechanism for taking things off the hands of Citi and B of A, but it doesn't solve the problems of things that are yet to be created.

MALPASS: Though we may end up in a system where banks hold the lot of the loans that they make for a while. That can work. Basel II provides an incentive for them to go a different direction. But for a while, they may just --

FELDSTEIN: What the banks had discovered is that they could increase their return on capital by not holding things, by initiating and then spinning it off to somebody else. Now, we see the troubles that that created.

MALPASS: Yes, sir, did you have a question? Yes.

QUESTIONER: (Name inaudible) -- from UBS.

You talked a little bit about the issues regarding, you know, investors not being able to understand exactly what they're buying, and I think -- (inaudible) -- mentioned the issue of mark to model versus mark to market. I wonder, as an issue -- as a way of restoring confidence, whether, you know, central banking regulators and accountant regulators will propose methodology to value these assets which are more consistent across the board so investors can actually understand how to price these securities as opposed to different institutions marking them differently.

FELDSTEIN: There's a real problem in that at a technical level we don't know how to do those things. There isn't agreement. For example, when you look at the past history in order to think about valuing the security, you look back 10 years or 12 months and economists in general say we have to look back over a long period of time. Market analysts doing the same kind of calculations typically have a much shorter window. So I don't think the Fed has a basis for coming in and saying here's what best practice ought to be. I think we got in trouble because a lot of these securities were valued based on a period of rapidly rising house prices in which the falls were less likely to happen. So if we'd been looking at a much longer period of time or at sort of stress-testing them against markets where prices fell, a different kind of number would come out.

But should the Fed really be in the business of saying how to do that kind of analysis? I have my doubts about that.

MALPASS: We'll have to make this the final question. I'm sorry all the others.

QUESTIONER: John Brademas, New York University, 3rd Congressional District of Indiana. What --

MALPASS: Here comes a microphone.

QUESTIONER: John Brademas, New York University, 3rd Congressional District of Indiana. What do you see as the political implications for next year's elections of your analyses?

MALPASS: Very good.


MELTZER: Well --

MALPASS: So if there's a -- let's say there's a recession or not a recession, you could start with that. Does that help one party or another? You're both very astute in the political to and fro of Washington.

MELTZER: Well, if there's a recession, it really won't help the current administration or its Republican --

MALPASS: So you say it would hurt Republicans.

MELTZER: It'll hurt Republicans --

MALPASS: They'll argue we need growth people in to save us from recession.

MELTZER: Yes, but -- (laughs) -- that won't -- I mean, when people -- we should have learned in the Clinton-Bush election that the fact that the economy was doing better didn't do much for Mr. Bush because the Democrats were able to make the case it's the economy, stupid, and they'll make a similar case now. And the fact that they have a Democratic Congress and all that, that it didn't do what it might have done and all that, those arguments may carry weight in a few places, but they won't carry the bulk of the public, who will look at the facts and they'll say the facts are not very good. If there isn't a recession, then the arguments will be elsewhere and health care and such things as that.

The fact that in a country which has a 50 or 60 trillion-dollar long-term deficit in its health care funding is talking about how it's going to increase the amount of health care spending without providing much of an answer to how they're going to pay for the health care funding -- if you don't believe that that's a long-term problem for the United States -- (laughs) -- come up and explain to me why.

MALPASS: Marty, this will be the last word.

FELDSTEIN: I agree about the political effect. The public will look in the spring and summer of next year, and they'll say what have they done for me recently. And if recently they've delivered 1 percent growth and rising unemployment rates, the public is going to be unhappy. And if they see falling GDP and more rapidly rising unemployment rates, an outright recession, they're going to be very unhappy, and that's going to be taken out on the incumbent.

MALPASS: Well, thank you, Dr. Feldstein, Dr. Meltzer, for a very interesting -- (off mike). (Applause.)











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