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Symposium on the U.S.-Japan Partnership: Session Two: The Global Economy

Panelists: Roger M. Kubarych, Henry Kaufman Adjunct Senior Fellow for International Economics and Finance, Council on Foreign Relations, Benn Steil, Director of International Economics, Council on Foreign Relations, and Takenaka Heizo, Professor and Director, Global Security Research Institute, Keio University
Presider: Paul Sheard, Managing Director and Global Chief Economist, Nomura Securities International
December 1, 2008
Council on Foreign Relations

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This session was part of the CFR Symposium on the U.S.-Japan Partnership: An Agenda for Change, cosponsored with the Asahi Shimbun.

PAUL SHEARD: I'd like to begin the second session of this symposium today. This session will be on the global economy, instability and reforms. I'm Paul Sheard, global chief economist for Nomura Securities based here in New York.

Now, before I introduce the speakers, could I ask that everybody switches off their phones, BlackBerrys and mobile devices, and not just mutes them, as they do interfere with the sound system. I'd also like to remind members and guests that this session is on the record.

Well, today we have three very distinguished panelists who are uniquely qualified, I think, to address the topic of instabilities in the global economy and the necessary reforms, particularly in the context of the U.S.-Japan partnership and relationship.

From the far side of the room, Roger Kubarych is the Henry Kaufman adjunct senior fellow for international economics and finance at the Council and has written extensively on economics and financial topics, drawing on more than three decades of experience as an economist, a policymaker and investor.

Next to him, Heizo Takenaka is a professor at Keio University and the director of Keio's Global Security Research Institute. From 2001 to 2006, he was really the key person in the Koizumi administration in Japan, having a number of ministerial responsibilities, and notably for economic policy and structural reform, for cleaning up the banking system, and also for overseeing the privatization of the postal system. So he had all the tough jobs.

Benn Steil is the senior fellow and director of international economics, again, here at the Council. He's written and spoken extensively on international finance, securities trading and market regulation, particularly with a focus on the international dimensions of those issues.

So without further ado, I'd like to open up the conversation and perhaps start really with the basic question of how did we get into this mess. The financial crisis and the global market instability is still very much a work in progress, but let's first review how we got here. Perhaps you'd like to enlighten us on that, Benn.

BENN STEIL: Sure. Thanks, Paul.

I think, first and foremost, the crisis is a very sobering story about the cost of building up excessive leverage across the economy over many, many years -- individuals, financial institutions, even the government -- that went on over a very extensive period, particularly building up over the first half of the decade.

Now, who's to blame? Well, when millions of people do things that are certainly, with hindsight, reckless, there's usually some underlying reason for the collective madness. And what I would point to, first and foremost, is a very long period of negative real interest rates in the United States from 2002 to 2005. We haven't seen a period like that since the 1970s.

I think first the Fed needs to shoulder the blame for having instigated this buildup of leverage. There was good reason for people to be borrowing to invest and to speculate, because money was ridiculously cheap.

This was, however, amplified by many factors. On the macro level, we had what I would call a sort of reflexive dollar recycling, dollars going abroad, particularly to China and other creditors in Asia and the Middle East, and coming back here reflexively, usually invested in Treasury bonds or agency bonds, Fannie Mae, Freddie Mac.

This is reminiscent of the 1960s, when we were on a gold exchange standard, but the United States made clear that you should never ask for your gold back. So foreigners would take their dollars and immediately put them right back in a New York bank, which was wonderful for the United States for a period, but it obviously instigated a sort of credit pyramid. And we experienced the same thing in the early part of the decade.

On the micro level, I think it's important to emphasize that in the United States we give huge tax advantages to debt and leverage. That's across the economy. Interest deductibility, particularly mortgage interest deductibility, is a big incentive to own a home rather than to rent a home. And that's certainly played a major factor.

What about our financial institutions that were obviously complicit? Well, in the good days, in Wall Street terminology, our banks would tell you that they were generating alpha, meaning excess returns, above and beyond the risk they were bearing. But what we learned was, again, in Wall Street terminology, they were doing nothing more than leveraging beta strategies. In other words, they were just buying up the same assets as everybody else, but they were doing it with borrowed money. And you can make very good returns on this strategy in a rising market, but once the market starts coming down, your losses accelerate.

This strategy was really catastrophic, and it was no doubt fueled by, for example, executive compensation, formulas in financial institutions which very much encouraged that sort of strategy, because once the process began unraveling, there was really no mechanism for clawing back the bonuses that were inappropriate, because they were bonuses for bearing excessive risk, not for generating excess returns.

And what about borrower screening and monitoring? How did that break down? Well, I think many of us believe that the securitization process, particularly in the mortgage market, was going to be a good thing after the S&L crisis in the late '80s and the early 1990s because it would allow banks to get mortgages off their books and distribute the risk throughout the economy. But one thing that broke down was the screening and the monitoring of borrowers. That was entirely delegated to ratings agencies.

The securitization process became enormously complicated, talking about the construction of vehicles like collateralized debt obligations, mortgage-backed securities that often helped thousands of securities. And these were only value-based on credit ratings, nothing else.

And once these credit ratings began to lose credibility, there was really no way to go back, strip down these vehicles again and evaluate what they were worth, because they had been evaluated entirely based on the credit ratings, and the ratings agencies were shown to be compromised in that they were being paid by those who had a strong interest in ensuring that the assets that they held and were going to distribute received top ratings.

Once this process began unraveling and financial institutions needed to raise capital now, they found that it became excessively costly or indeed impossible to raise. And this raises questions about, for example, capital adequacy standards. They're pro-cyclical. In good times you can keep building up your asset base at essentially no cost. But when the bad times come and the assets need to be written down and you need more capital, it becomes impossible to raise it. So that's another huge problem with the process.

We also found that there were big problems in the sort of plumbing of our financial markets, the OTC derivatives markets, in particular credit default swaps, where AIG and Lehman Brothers turned out to be major vulnerabilities because counterparty risk was not being absorbed as it would have been on an organized exchange by a central clearinghouse, and counterparty risk had broken down entirely.

Finally, I would raise the issue of the vulnerabilities we've seen in the international monetary system. In 1960, a famous American economist, Robert Triffin, in congressional testimony raised the issue of the so-called Triffin dilemma, which was the problem that he posited would always exist as long as the U.S. dollar and national currency was operating as the international currency. He said we would always go from one problem to another. If the U.S. did not run sufficient balance-of-payments deficits, or in the current context, without -- (background noise) -- current account deficits, the world would not be able to get enough dollar liquidity.

On the other hand, once the U.S. accumulated enough of these deficits year over year over year, supplying the world with dollar liquidity, eventually there would be a panic because people decided they had had too much of the stuff and it wasn't being sufficiently backed by hard assets.

And, in fact, this summer we went from one pole of the Triffin dilemma to another in a matter of weeks. In the early part of the year, confidence in the dollar was waning around the world. We had a global commodities boom. We had the Euro soaring, and there was real angst about the future of the dollar. Suddenly the financial markets seize up, no credit is available, and everybody is scrambling for dollars. And this is a major vulnerability in the international monetary system.

Japan, of course, has been whipsawed by this problem with the carriage rate. And this is going to persist. I think next year, as the credit crisis begins to subside, we're going to see the financial markets operate as they always do, meaning they're going to chase yields, which means to borrow in low-interest currencies and to lend in high-interest ones. And we're going to see these problems re-emerge.

SHEARD: Thanks very much, Benn.

Before we move on, Heizo or Roger, would you like to comment on anything to do with the causes and what led to this current crisis?

ROGER KUBARYCH: He's got it right. (Laughter.)

TAKENAKA HEIZO: Well, yes. When this crisis started as a subprime crisis, I thought this is quite different from what we experienced 10 years ago. We experienced a banking crisis. On the contrary, what's happening in the United States is so-called money market crisis.

In the case of Japan, the bank was heavily damaged. But in the case of the United States, its lending asset has been securitized and detached from the balance sheet of the bank. This was a very big difference, I thought. However, the situation is becoming similar and similar in my understanding at the same time.

The first time, this was a financial crisis. Now then, we face confidence crisis. Confidence is the base, as you know, as you mentioned already. So why we have the substantial confidence crisis? The market failure -- (inaudible). The government failure was added. So the politicians in Washington, D.C. underestimated or misunderstood the basic nature of this crisis, first of all. Then they denied the public money -- (inaudible) -- created by Paulson and Bernanke. And this created actually the confidence crisis.

And also, at the same time, once confidence crisis started -- (inaudible) -- the activism of the government is needed. Government activism is needed. And the symbol of this government activism is so-called capital injection. This was quite true for the case of Japan -- capital injection into the financial organizations. But based upon our experience in Japan, capital injection is needed, but it's not enough.

In 1999, the Japanese government invested huge amount of money, 7.53 trillion yen at that time to major banks. However, even after that kind of capital injection, financial crisis continued for more than four years. And then Prime Minister Koizumi created a new plan. The basic core of this new plan was to have accurate measurement or accurate assessment of the assets. Now the balance sheet of the corporation, balance sheet of the banks are not reliable. That's a really important point.

So first we should do is to have the accurate assessment of the capital and to make balance sheet viable. However, this time activism sometimes becomes over-activism. Once activism of the government starts, it's very difficult to stop that, right? Even the Big Three is demanding a capital injection. That's unbelievable, actually, but politically, sometimes, this kind of thing happens.

And the symbol of this overactivism will be maybe the change or changing the accounting standards. This will make balance sheets' viability much more worse. This kind of overactivism should be stopped -- (inaudible) -- important, let's say, in point on point, which we should demand from Cabinet experience. If, in the case of Japan, we had -- (inaudible) -- discussions, overactivism requirement, Koizumi very clearly -- Prime Minister Koizumi at that time very clearly denied that.

So anyway, in the year 2002, the ratio of non-performing loans in the banking sector reached 8.4 percent, but it has been declining to 1.5 percent. So anyway, overactivism could be stopped. This is the most important point regarding the U.S. current financial crisis.

SHEARD: Well, perhaps we could continue with the Japan theme for a moment. Obviously you were in the thick of things as the person given the responsibility to clean up the banking system. I think, coming into this crisis, many market participants thought that Japan was relatively immune, not really having very much exposure. But it does seem now that the impact of the financial crisis and the global recession is starting to hit Japanese shores, and I think the Bank of Japan is now convening an extraordinary meeting tomorrow to take some further measures.

What is your evaluation of the impact of this crisis on Japan? And then also perhaps you could come back to the issue of some of the lessons that perhaps can be gleaned from the Japanese experience for the way that it should be handled here, particularly in terms of the exit strategy from some of what may appear at the time to be excessive government intervention.

HEIZO: Okay, let me mention maybe about the current situation with the Japanese economy. As you mentioned, and also as I mentioned, the banking sector's balance sheets are relatively sound in Japan compared with those of the United States and the European countries. Still, the growth rate of the Japanese economy is now lower than that of the United States. And the declining of the stock price is much deeper than that of the United States. That's quite amazing when you think about it.

Last year the stock price in Japan declined 11 percent. What happened to U.S. stock price? It increased by 6 percent. Now maybe, from the beginning of this year, the U.S. stock price declined by 40 percent or so, 45 percent. However, the Japanese stock price declined by 50 percent or so.

We -- on the contrary, we had a very interesting year in 2005. In 2005, Japan's stock price increased in single year by 42 percent -- by 40 percent. What happened in the year 2005? At that time I was the minister for postal privatization, and I submitted this plan. And this was once -- (inaudible) -- in the Diet, and Prime Minister Koizumi developed it in the lower house, and we had general election. And Japanese people very strongly supported the privatization of Japan postal and this was approved in autumn. We decided the on privatization of Japan and also we decided on the privatization of some government banks.

At that time many people in the market had predicted Japan's economy would change and reform will advance. In such circumstances, the stock price increased by 42 percent. The statistics -- (inaudible) -- political meaning. Well the momentum of the reform was quite important to influence the Japanese economy. In case the momentum of the reform is high maybe, the people expected the rate of growth was high. However, in the past two years or so, we now have three prime ministers in the past two years, as you know. The momentum of the reform has been declining, and people -- the expected rate of growth had been declining and consumption and benefits is now very stagnant.

So -- well, Japanese economy is, of course, influenced by the U.S. financial crisis. However, we further have domestic problem. This is mostly created by great confusion in politics, I think. So this is the one important factor to be considered regarding the Japanese economy.

Another factor is existing in the case of Japan. Now we call this compliance -- (inaudible). After Koizumi left, the bureaucrats had been gaining power, again, in policymaking process. Mostly everything was decided by the bureaucrats -- (inaudible). Under such circumstances, regulation has been increasing again.

For example, last year the so-called building code was changed. Under such circumstances, new housing starts, new building construction started to decline very sharply. And consequently, last year, housing investment declined by 10 percent, not because of subprime. This is because of the strengthened regulation by the government.

And also, as you know quite well, several months ago the government had some restrictions on falling investments to some company in Japan. (Inaudible) -- based upon this kind of increased regulation, the very dynamic free activities in the private sector is negatively influenced. So this is the reason we called for compliance we faced --in the name of compliance, in the name of consumer protection, the actual regulation is increasing.

So it is quite important to stop these kind of activities. So what is -- (inaudible) -- by the government is, first of all, to enhance the momentum of the reform, and second, to stop the compliance recession. However, what's now discussed in the government is to -- let's say, to increase government expenditures in many, many ways. This has hurt again the plan for fiscal rehabilitation. Very regrettably, the direction -- the reform is now going in a little bit different direction, compared with that those planning data under the Koizumi government.

But, anyway, for the time being, the Japanese economy will continue to be stagnant, very regrettably. However, sooner or later -- as was mentioned by Professor Tanaka, the political realignment will start. And many people in Japan are waiting for this momentum -- this timing of political realignment. So we -- 10 years ago we had a problem -- NPL, non-performing loans. Now we wait for another NPL, "new political leadership," maybe. (Laughter.)

So, finally, let me mention a little bit about the implication of the Japanese experience to the United States. Well, as I mentioned already, asset assessment should be done very properly -- correctly. Of course, we understand this is technically very difficult -- very difficult, but not impossible. So, based upon this assessment of the assets, capital injections should be done.

And also, I understand, since the macroeconomy is now becoming very bad, almost all countries are now increasing their government expenditures, even -- so the government -- the budget deficit is now expanding. This is necessary at this moment, however, we cannot continue this for a long time. So we have to stop this -- the current financial confusion very rapidly, otherwise we cannot continue the government expenditures.

And a typical case is maybe China. China will -- I expect that China's economy will grow -- continue to grow at the annual rate of 7 (percent) to 8 percent, based upon very strong government expenditures. In the case of China, the -- (audio break) -- GDP ratio is quite -- is very low. This ratio -- government-to-bond GDP ratio in the case of -- in Japan it's 150 percent or so; but, in the case of China, this ratio less than 20 percent.

Now, they still have a room -- the capability to increase their government expenditures. Actually, the Chinese government plans to increase government expenditures by 15 percent of GDP in the coming three years. This is a huge amount of fiscal stimulus. If supported by this kind of fiscal stimulus, the Chinese economy, for the time being, will continue to grow.

But this is not sustainable. (Inaudible) -- to stop -- to have a quick action to stop the current financial crisis, starting with a great assessment of the asset -- or a great measurement of the asset.

SHEARD: Thank you very much, Heizo.

Roger, obviously we've got a new political administration in the United States which carries with it enormous uncertainty, I think, for Japan. But, if you were to think about what the Japanese should be asking the U.S. policymakers to do, in order that perhaps they could also give some ground in response to some of the requests and pressures that will be coming from an Obama administration, what sort of things would you point to?

KUBARYCH: Well, they are going to face a variety of -- I don't know if they will be as strong as demands, but certainly the Obama team will have a lot to ask Japan to contribute to solve this crisis -- this global crisis, and it's going to require everybody's help. And I think probably the Japanese should be preparing a set of responses to that, and they'll have to make their own mind up about what to -- what they can live with and what they can't.

But, it wouldn't hurt for them to think about what to ask the U.S. for first, to make it as balanced a set of suggestions as possible. I'd be a little wary about marking-to-market the entire U.S. financial system any time soon. I think what you would find out is that an awful lot of institutions with famous names may have negative tangible net worth, and so it would be -- a little forbearance would be useful.

Let's put it this way, when things stabilize we should move to a more transparent mark-to-market system, but right now there's an awful lot of institutions that hold exposures that, at today's liquidation values, would make them unsustainable. So, that's a -- that's a little bit too-tough love, but it ought to be on the list for the next phase.

But, in the meantime there's a lot that can be done on the financial regulatory system, and Japan will have friends in Europe who are also pressing for the same thing. What are some of these things? Well, first, continue the support for the deleveraging process. Deleveraging is not over and it's going to continue for another year or two. And it's not going to be just the banks, it's going to not be just the hedge funds, it's going to be basically all of -- all of the private sector has too much debt, and so that's going to have to be wound down, and it can't be done overnight. So, support for the deleveraging process will require public funds.

Secondly, we've got to get to the origins, that Benn Steil has mentioned, of complex financial instruments -- I don't like the word "complex," let's put it this way, "misunderstood," and I would say dangerously misunderstood financial instruments which can be abused. On the face of them, they're not all -- they're not all bad but they are all capable of abuse.

So, on that list would be CDSs -- credit default swaps, and the requirement to have some formal oversight process and some collective effort to have modern, IT-based clearing and settlement systems. Absolutely essential. Too many of the big-time exposures and losses come from that overinvolvement in this almost-brand-new and easily-abused part of the financial system.

Along the same lines, it's -- the day for ignoring hedge fund exposure is over. We would not have had this fantastic volatility in commodity markets this year without the leveraging of hedge funds in the commodity area driving up the prices of all kinds of commodities -- just not oil. The oil one sticks in our mind because it's easy to remember 147 (dollars per barrel). That was the peak oil price, and it's down around 50 (dollars a barrel) now; and gasoline price is down at $1.92, having peaked at around $4.

And this would not have happened without the leveraging and then the deleveraging process. It's very reminiscent of early 1980s when we had the developing-country debt crisis then. And I was working for Volcker, and Sam Cross and Tony Solomon, and we were tasked to try to figure out who owed what. And we didn't know.

And, basically, people said, you can't know. Well, of course, you could know. When things failed everybody wanted to get repaid, and then we got hundreds of banks into a room this size -- it was quite a task, on that first Mexican debt crisis in '82. And basically the "powers that be" at that time decided to find out. And they tasked the Bank for International Settlements to set up a system, and it's been working well ever since, and we now have pretty credible international data on cross-currency lending -- cross-country, cross-currency lending.

We can do the same thing with hedge funds. All it takes is will. We -- but the apparatus -- the computer power is a lot cheaper now, and the apparatus is there at the BIS under the Financial Stability Forum. That should be something the Japanese should support, and push on the U.S. to support.

The rating agencies reform is absolutely essential. The SEC has been dragging its feet. They're part of the problem, and they've got to be part of the solution. And Japan is well within its rights, just as the Europeans are, that we'd clean up all the conflicts of interest, and the other very questionable practices of rating agencies. Not happy about them.

Corporate governance in the U.S. needs some significant improvement, and also in Europe. I'm not sure that the Japanese corporate governance system failed Japan during this crisis, but it surely failed us and the Europeans. Basically, we have to empower risk management, and we have to, basically, have a total new look at the internal and the external audit function of our companies -- in the banking sector, and beyond.

And finally, we have to reverse this supervisory laxity. Certainly, the Japanese, in cooperation with the Europeans, have to point out to the United States where the defects in our supervisory system were, and how they can be corrected. We have mountains of regulations. The notion that we have had deregulation is a canard. The mountains of regulations are still there. Only a couple have really been completely abolished. What didn't happen was the enforcement of the regulations. That was allowed to decay.

Then the Japanese could go on to suggest fixing the housing crisis by stopping the foreclosures -- helping the helpless. And that would not only be low-income companies -- low-income people, but also state and local government financing in the U.S. is in terrible shape and Japan has a vested interest in having that fixed -- and I'll tell you why in a second.

Certainly, Japan should support, and not resist, U.S. supporting aggregate demand. The one condition they should push for, however, is that it have a kind of a timetable; that it be reversible, or at least elements of the fiscal and monetary stimulus be reversible.

And then the final two points: All countries should be pressing the U.S. to remove impediments on purchases of U.S. stocks -- domestically, by reducing capital gains taxes, at least for awhile, or eliminating them for a couple of years; and internationally, by getting rid of impediments on sovereign wealth funds and every other type of, similar-type of institution, whether it's directly owned by the government or not, to buy U.S. stocks. We can agree on some kind of a livable list of industries or even companies that could be excluded, but this veil of concern has got to be lifted.

Now, why should Japan ask for all these things? Because the U.S. otherwise will be tempted, at some point, to impose trade restrictions. Because this recession is very deep -- Cory Highland is here, his company rarely provides the kind of really generous, juicy incentives to buy his company's cars. This tells me that there is a recession in the U.S. when that fine company has to give those kinds of incentives -- and they're not the only Japanese firm that has to.

So, there is going to be a lot of temptation for the Obama administration, egged on by a Congress, to at least threaten trade restrictions, and Japan should be pushing the U.S. to do these things to avoid having those pressures bubble up.

SHEARD: Thank you very much, Roger.

Well, I think we've had a number of interesting issues put on the table -- clearly, some points of agreement, but also I think some subtle nuances there when we talk about the compliance recession, as well about the appropriate level of regulation and deregulation.

So at this point, I'd like to open up to the audience to join in the conversation. Please wait for the microphone to come around, and speak directly into it. Also, please, if you wouldn't mind, please stand and state your name and affiliation. Also, please limit your question to -- or your interjection -- to one question, and make it as concise as possible. I'm sure we've got a lot of people who've got a lot of questions here.

So, who would like to lead off with a question for the audience -- for the panel?

QUESTION: Thank you very much. Henny Sender, the Financial Times.

I have a question both for you, Takenaka-sensei, and for you, Roger.

A lot of Japanese economists, led by Kano-san -- who, of course, was formerly Bank of Japan, have said that one of the lessons for the United States from the Japanese "lost decade" is the fact that stimulus -- fiscal stimulus does really work. And my theory had always been that it was the kind of fiscal stimulus that was the problem in Japan, and the reason there wasn't more of a multiplier effect.

I wondered what your advice would be on the efficacy of a fiscal stimulus for the United States now -- both of you? Thank you very much.

TAKENAKA: Well, your point is quite true. And from the viewpoint of economists, what's quite interesting at this moment is almost all industrial countries are now advancing the fiscal stimulus. Well, generally speaking, under the open economy, fiscal stimulus is not so effective. This is a very general theory. The monetary stimulus is much more effective under an open economy. It is true.

However, currently -- also in the case of 1990s, well, so-called "financial intermediation" function declined a lot. As you mentioned, the money multiplier, you know, quite low -- becoming low. So, in that sense -- in that case, the fiscal stimulus is the only possible way that we can take. So, based upon this recognition, almost all countries are now taking fiscal stimulus, I believe.

However, at the same time, the fiscal stimulus is not very effective under open economies, generally. And so the fiscal stimulus is a very temporary measure to rescue the economy. That's a very important point. This is the reason why I recommend it that this financial crisis should be ended quite promptly.

And so -- and also -- but one implication, if any, would be, well, now so-called negative asset effect, since the value of asset declines, then household consumption will decline. So in order to stop that, one way would be a tax cut. Tax cut would be important and necessary to some extent.

In the case of Japan, in the 1990s, the government mostly focused, not the tax cut for consumers, rather increased government public works. And this created a lot of -- (inaudible) -- vested interests in Japanese society. The companies, or general contractors, have a huge amount of benefit. They now increased their donation to government parties, and the very complicated Iron Triangle was created.

So, if the government is ready to take some kind of fiscal stimulus, well, I personally recommend a tax cut, a household tax cut, rather than government expenditures -- direct government expenditures in the form of public works.

KUBARYCH: Well, I think it's going to require both. I would see a combination of two-thirds government outlays, and one-third tax reductions. I think the tax reductions could be quite exciting.

Personally, I've always felt that we should have a graduated progressive consumption tax to replace the Social Security payroll tax. I think that that's the one kind of thing where you can get complete bipartisan consensus. It's an old idea. It's been recommended by Democrats and Republicans over many decades, and this is the time to -- in a crisis atmosphere, it's the time to do something like that. The Social Security payroll tax is quite regressive, and it's an important part of what normal people pay in taxes -- low and middle-income people.

So, I'm in favor of tax cutting for the household sector. But, we have tremendous needs for infrastructure spending that are unmet, and not so many tremendous needs for new housing or new cars. And those -- having safer bridges, and roads that don't have huge potholes, and water systems that don't leak are worth a few billion as part of the fiscal stimulus, as well as a program for dealing with foreclosures.

So, I think there's plenty of unmet needs. And one comment about people taking tax cuts and repaying debt. It's a good trade. But, the government's borrowing money at about 2 (percent) or 3 percent; and people are paying 19 percent on their credit cards; and they can take a tax rebate and repay part of those 19 percent credit cards, society as a whole is a lot better off.

So, people who say, "Well, that wasn't much of an improvement to have the Bush tax rebates of last spring," I think, my gosh, we would have had a big -- deeper recession a lot sooner if people hadn't been able to repay a lot of that expensive debt. So, a little common sense is useful.

TAKENAKA: One short comment. Yes, I agree. Both are needed -- for tax cut and government expenditures. Both are needed, I completely agree. However, based upon experience in Japan, maybe this is very -- very special to the case of Japan, the tax cut will create smaller government, and the government expenditures will create big government. What would you prefer in the long-run, because that's another aspect to be considered?

SHEARD: Thank you.

(Cross talk.)

QUESTION: John Mbiti, from UBS.

As a result of the financial crisis, central banks around the world have effectively become investors of last resort. This has resulted in -- or is likely to result in increased budget deficits in a number of these countries. In order to finance these deficits, it is likely that these countries will have to issue additional amounts of debt.

Given the central banks are themselves large purchasers of other sovereign debt, and that they are currently constrained by their commitments to purchase distressed assets, who is going to purchase this additional government debt, and is this a concern?

SHEARD: Who wants to take that?

HEIZO: Well, according to the current statistics, the biggest holder of the Treasury bond of this country is China; 21 percent of total Treasury bond is held by China and 20 percent by Japan. And these countries are carrying huge amount of foreign (audio break) as you know.

And, for the time being, maybe, China and Japan will continue to play an important role to purchase assets from the United States. And so, let me repeat that this is not sustainable for the long term. So for the time being, well China and Japan will continue to buy bonds.

And personally -- (inaudible) -- that the government deficit problem will become a huge problem, not only for the United States, for all industrialized economies. And also, as you mentioned -- (background noise) -- thinking about it, extreme -- (inaudible) -- also, if the United States will become a country with, so-called -- (inaudible) -- interest rates, -- (inaudible) -- interest rates -- (inaudible). And interested countries also.

And at the same time deflation will continue. So, for the time being, we have to support the economy based upon this kind of scheme. So, we cannot continue this policy for a long time. That's a problem.

STEIL: In boom times, investors chase yield; and in situations of crisis like this, they flee risk. And the U.S. government is, right now, a big beneficiary of that fact -- that people are no longer looking for a free yield, they're looking to preserve their principal. And the safest investment in that sort of environment is the U.S. Treasuries, because the U.S. dollar is the de facto world currency.

And if the U.S. were to default on its Treasury bonds, obviously the problems globally would be so enormous that we'd probably not have much left to worry about. (Laughter.)

In the area of fiscal stimulus, because of the situation we're in the United States has much more leeway to raise capital than for, for example, Britain. I think the fact that Britain's having a different debate than we are about whether they're capable of borrowing enough money to make this stimulus package feasible, really illustrates a fundamental feature of the international economy.

If you were using a currency that is not globally used for international transactions, in an environment like this it becomes much more difficult, much more expensive to raise debt. So we're in a very privileged position.

My feeling is that if we don't move to regain control over the budget deficit in the United States, though, 2009's going to be a very, very difficult year. Because once the deleveraging process has mostly played out, we're going to start seeing an unwinding of some of the strange investments that we've seen going on.

For example, 10-year Treasuries are currently priced more aggressively than 10-year TIPS -- inflation-protected securities. This makes no logical sense. When this begins to unwind, the cost to the United States of raising debt abroad is going to go up enormously. And I think we could go back to the other pole of the Triffin dilemma extremely quickly; that is, there will be a run on the dollar; there will be a soaring of inflation again; and we're going to see a soaring of the U.S. cost of debt.

So I think the U.S. Treasury and the Federal Reserve are going to have an enormous new challenge next year once the deleveraging process has played out, because reversing the process that we've built up this year is going to be exceptionally challenging.

SHEARD: Roger?

KUBARYCH: Well, John is onto something here, because if you look at government guaranteed paper that is being issued in great magnitude these days -- I guess the latest issue was Goldman Sachs' three-year (less ?) -- (inaudible) --, you're looking at very substantial spreads on something that is government guaranteed.

Now, why is that? That is because it's absolutely clear that the world is buying U.S. Treasuries and pushing prices up to really unheard of levels -- two-year Treasury notes under 1 percent. But, at the same time, the government guarantee has lost its, shall we say, credibility, such that these spreads -- and you see the same thing in Fannie and Freddie paper, these spreads are widened out even though the U.S. government stands behind them.

So, clearly, once this immediate crisis is over -- and, I mean, I don't know whether it's 2009 or 2010, but it will be brought to an end within that kind of timeframe, then the government is going to have to move very quickly. I said in the earlier remarks, whatever we do has to be reversible, and reversible quickly. And that's the reason why, because otherwise -- this, shall we say, "suspension of full confidence" is palpable. We can see it in pricing. So I think we have to worry about that and we have to design fiscal policies that are pretty quickly reversible when things improve.

SHEARD: I have a question here.

QUESTION: Sheldon Kas, with Indus Capital Partners. This is a question for Takenaka-san.

As Paul mentioned in his opening remarks, at the start of this crisis, a year and a bit ago, markets were pleasantly surprised to discover that Japanese banks did not hold large amounts of subprime or -- or other collateralized debt obligations. Having said that, recently markets -- or those of us who watch Japanese markets closely -- were not surprised to also see that Japanese banks had to start raising capital mostly to offset the losses on their equity market -- Japanese equity market portfolios.

When you were in the government, you and other policymakers were quite successful in getting that system of cross-shareholdings to finally break down, and banks, and therefore corporates reduced greatly their holdings of Japanese equities and cross-shareholdings.

Do you think this latest episode has finally kind of put the bullet in that old system? And is there likely to be anything near-term to get banks to reduce their holdings, and corporates who -- banks obviously have a capital issue, corporates have a capital efficiency issue at best and it destroys capital at worst -- is that system likely to finally breakdown, given this latest need to raise capital? Thank you.

TAKENAKA: Thank you very much for a very interesting point.

Well, as you mentioned correctly, for example, 10 years ago or so the cross-share holdings were prevailing, and under such circumstances the stock price went down. And many people discussed, "Well, we should change this kind of system. The banks should sell the stocks -- the equity that they hold." And, actually, this has been advancing given my understanding.

However, for example, five years ago or so the Japanese economy came back at 2 percent, 2.5 percent growth came back. Under such circumstances, we didn't understand quite well. But, anyway, the banks -- Japanese banks, again owned huge amount of stocks. We were honestly also -- also surprised to find, wow, they are coming -- they're coming back again, this cross-shareholding.

Again, now they are changing the system. The fact -- this is indicating what's happening to corporate governance in the Japanese companies. We're still -- corporate governance -- we have a very serious corporate governance problem.

Also, as I mentioned, the Japanese balance sheet -- banks' balance sheets are good. However, this is -- is this a good thing or bad thing -- (audio interference) -- not the trend in the United States. And, consequently, the balance sheet is good. But, this is not indicating the corporate governance of banking sector is good. Maybe this is not indicating that way. So, in that sense, we still have a corporate governance system. And the worst case will be, temporarily, they will sell -- they will sell off their stock. Then, if the economy comes back they will practice again. This kind of thing could be repeating. That's the worst case, I'm afraid.

So based upon the experience I really hope the corporate governance system will be improved. Essentially, I don't expect this story for the financial sectors in Japan. Well I really appreciate if the market people -- the business people would respond to this issue from the floor -- I personally expect that.

SHEARD: Thank you.

I have a question down here.

QUESTION: Hi, I'm Tony Holmes, from the Council on Foreign Relations.

In his opening remarks, Roger raised the very ugly specter of growing American protectionism. President-elect Obama has been able to step away a little bit from the more protectionist positions he had to take during the Democratic primary season, but I'm wondering what our panelists -- how our panelists see the possibility for renewed multilateral trade negotiations and if the two sides -- both Japan and the United States, are willing to make the difficult decisions necessary, in terms of agricultural trade?

TAKENAKA: (Inaudible, laughter.)

KUBARYCH: Personally, I think the best we can hope for is no action over the next four years. That would be the best-case scenario. The worst-case scenario is that President-elect Obama does decide to move forward with some of the trade positions that he enunciated during the campaign -- for example, reopening NAFTA.

It's important to remember that when the Smoot-Hawley Tariffs were passed there was really very little concern in the United States about what the reaction would be abroad. It was only once we saw the reaction that we began to realize that this is a budding disaster, and unless we move to rein it back in we're going to have a global crisis.

So, I'm hoping that the president-elect is savvy enough to realize that this is certainly not the time to reopen that, because every country around the world has a beef on the trade front and if we all decide to reopen this can of worms now we're going to take a huge step backward.

Having said that, with regard to the Doha Round, I really don't think President-elect Obama has enough political capital within his own party right now in order to push that agenda forward.

TAKENAKA: Well, let me explain it from economic and political aspect. First of all, economically. Japan's export-to-GDP ratio has been very stable in the past -- around 10 percent or so. Japan's export-GDP ratio is around 10 percent. However, in the past five, six years, this has been increasing very rapidly, and currently this ratio of export-GDP is, amazingly, 18 percent, almost 20 percent.

So this is indicating we do have a very strong incentive to promote a free trade. And if protectionism advances in -- especially in the United States, the damage on the Japanese economy would be very serious. That's the story from economic side.

However, on the contrary, politically, it is quite -- in order to realize this free trade very strong leadership -- political leadership is needed; however, we do not have that kind of political leadership. The politicians are becoming very much populist type of politicians because elections are coming close - that's one reason. And -- so domestically, protectionism is now enhancing also in Japan, regrettably.

As I mentioned a little bit, compliance recession -- this is a part of protectionism, I think. So from now on, maybe, economically we have a strong incentive to cooperate with the United States to have the free trade. At the same time, some backlash type of trend will also occur. So in essence also, we are expecting a new political realignment. We have, even in LDP, even in the Democratic Party we have strong forces who support free trade, who support the reform. So these powers get together and new political power will be created. This is the story of political realignment.

So again, this is also -- your point is also very much dependent on the trend of the Japanese politics -- political alignment will occur or not.

SHEARD: I guess one saving grace is the fact there are so many scholars of the Great Depression in the administration. That presumably will help! (Laughter.)

I think we have a question over here.

QUESTION: Chris Faulkner-MacDonagh with Ziff Brothers Investments.

This is a question for Takenaka-san: One of the legacies of Japan's financial crisis was a large stock of debt. And I was wondering if I could get your insights on what you think of the possibility of increasing the consumption tax over the next several years to begin addressing that stock of debt -- say within the next three years or so?

TAKENAKA: Well, this must be a very controversial issue in Japan. I am strongly supporting the -- well, structural reform should be done, then the growth rate will be increased. Under such circumstances, well, the need for the tax hike will be reduced. This is a so-called riding-the-tide scenario.

However, some other groups are insisting a little bit different story. We cannot increase the potential growth rate of the Japanese economy. So it is important to raise tax as soon as possible.

What's happening in the government would be like that. Now, government is again increasing government expenditures. And when the prime minister said the government expenses should be increased, at the same time, he said the rate of (inaudible) -- tax will be increased.

This is a very interesting -- it's a funny story, actually. If you are a consumer, you increase your expenditures -- maybe no, right? If you are -- (inaudible) -- increase. So I predict it's quite difficult politically to increase consumption tax in two or three years. First of all, government should return to the position to reduce the government expenditure as much as possible. Now the necessary part of the deficit will be covered by tax increase. This kind of story should be presented before the people.

At this moment, very regrettably, the government leader or political leader in Japan is very reluctant to show this kind of solid story. And so very regrettably, for the time being, the economics ratio will be slightly increased. However, the people do not agree, you know, agree. People do not agree with the government tax increase -- at least if you say two or three years. That's impossible, I think.

QUESTION: Hajime Matsuura of Nikkei News.

Recently Japan -- the Japanese government made an announcement -- the willingness to provide liquidity to the global economy -- $100 billion through IMF.

In my opinion, I'm not really sure whether a troubling country has the luxury to provide one-tenth of its foreign reserve.

So Takenaka-san, if you're in a position to run the foreign reserve -- a limited, but 1 trillion yen strong fund -- how do you run it? And do you think the idea of creating a sovereign wealth fund is a good thing?

TAKENAKA: Well, first of all, as foreign reserve issues, that's quite interesting.

I was in the middle of the government. Even minister for economic and fiscal policy couldn't understand where -- this mechanism of foreign reserve. This foreign reserve is managed only a small number of people of the ministry of finance. Even the minister of finance, even the chief of Cabinet of secretary -- maybe even prime minister of Japan -- were not informed about that system.

That is a very strange system. So I'm not sure why at this time in the ministry of finance, ministry of treasury announced this. This is an announcement of the ministry of treasury, not a statement of the prime minister, I mean.

So my point is, first of all, this size of the foreign reserve -- this size of the government assets should be reduced first. There are a lot of -- amazingly, the balance sheet size -- the size of balance sheet of the Japanese government is about five times as that of the United States. The size of the GDP about half in the case of Japan; however, the size of the balance over five times. So reality of size is 10 times maybe. A huge amount of assets is held. So this must be reduced.

The part of this asset should be sold out in the market. This is the first process. And some necessary part should be, you know, invested in a much more effective way. In that sense, I personally support sovereign wealth fund issues.

Now in Japan we have the largest sovereign wealth fund in the world in the name of pension fund -- public pension fund. And up until last year, we have much larger sovereign wealth fund in the name of Japan Post. This is now privatized. The privatized Japan Post is not a sovereign investment in a strict sense.

So anyway, privatization so -- you know, saving out a part of the asset is an important strategy. Now then, let's create sovereign wealth fund to invest -- investment much effective. Well, investment to the IMF -- I do not deny the need for that in the current situation. However, a much more comprehensive strategy -- how to make use of this huge amount of asset is necessary.

SHEARD: If I could perhaps just broaden that point out a little bit, before you come in Roger, and just go back to the bigger macro picture here. That if you take the view that behind this crisis is a problem of global imbalances, which perhaps has been exacerbated by the nature in which various countries were managing their exchange rate against the U.S. dollar -- particularly the Chinese; of course, they've got even more foreign exchanges than Japan.

What are the panelists' thoughts on how the international monetary regime will have to change or may change in the process of working ourselves out of this current crisis. Are there some lessons to be learned on that front as well?

KUBARYCH: You really can't change savings investment imbalances easily or smoothly or in the short run. The financial markets exist to essentially patch things over until you can have these more far reaching adjustments over a period of time. And those periods may be 10 years or 20 years.

So you can't really devise a program beyond very near-term stabilization programs to influence that savings investment imbalance, which is, of course, another way of talking about current account surpluses and deficits.

Nobody should want the U.S. to get rid of its trade deficit overnight, because what would be required would be so disruptive to the world economy that it would be a crazy thing to ask for. But what you can do is you can look at what's happened here in a period where the dollar was quite weak -- particularly against the euro and against commodity-producing countries -- don't forget, it was only a few days ago, literally, where the Canadian-U.S. exchange rate was one-to-one. It's now what, 1.25.

So these things -- and I can remember back when it was 1.60. So these rates have changed a lot and we haven't gotten a whole lot of true permanent realignment of current account balances from what by any historical standard has been a period of 10 years of huge changes in exchange rates. So I'm not too much of an optimist on that.

So in the meantime, you've got to deal with the financial repercussions. And there's one big headline written on the board of what we need. We need more risk taking! We've had a collapse of risking taking in this world. And it's not just limited to the U.S. As Takenaka-san said himself, the Japanese stock market has been battered more than ours in the United States.

Go to Europe! You can find worse stock market performances there too. There's a global lack of confidence in the future of private enterprise and we've got to do something about that and we've got to do it collectively. And that's going to require a lot of give and take and it's got to be done relatively soon.

SHEARD: Benn.

STEIL: The most important thing to say about the current international monetary system is that no one chose it. It landed in our laps in 1971 when President Nixon closed the gold window, and suddenly there was no longer a global monetary base. It used to be -- at least in principle, gold; and the dollar was tied to gold at a fixed exchange rate. That's gone.

So, the world had no rules after 1971. And what we settled in on, gradually, is a system whereby the U.S. dollar replaces gold. And countries build up reserves of dollars because they need it to pay, first of all to pay their bills -- that's the global currency; and secondly, they need it as a war chest precisely to deal with crises like this.

I think South Korea, in particular, took the lesson from their last crisis that the only effective way to avoid having to go "hat in hand" to the U.S. Treasury and the IMF was to have a huge war chest of dollars. They built up that war chest. They're still in trouble.

Once we come out of this crisis, I think we've only reinforced the message to the world that you need global imbalances. You need a big war chest of dollars -- at least in the short-term.

There are a few alternatives to it. We may see central banks rebalancing their reserves perhaps a bit more towards euros in the future. If they become very concerned about the future of the fiat monetary system perhaps they'll start rebuilding their gold reserves.

I mean, we've already seen tentative moves in that direction, in that central banks, which used to earn a steady income in lending out their gold to the private sector, are now hoarding it. They won't even lend it out to the private sector anymore, which, in fact, is supporting the gold price.

I'm not -- I'm not particularly sanguine about the future of international monetary system right now. We're not having any serious talks about the fundamental instabilities.

TAKENAKA: May I add one thing?

SHEARD: Sure.

TAKENAKA: One aspect would be, well, please compare the financial system with the trade system. In the case of trade system, we have a global approach of the WTO; and the regional approach, APEC; and bilateral approach, which are the agreement, et cetera, et cetera.

However, in the case of a financial system we have a global system in the form of IMF, and we have some bilateral agreement, the swap agreement, et cetera. However, we cannot find some regional approach. A regional approach would be quite weak at this moment.

Of course, -- (inaudible) -- initiative of the part of -- (inaudible). For example, in the case of Asia monetary crisis. So, we Asian people discussed the need for Asian Monetary Fund. This is a tentative name, of course -- Asian Monetary Fund. This kind of approach -- a global, regional, bilateral. So, a triple-track approach should be considered.

Some people are against -- the global approach is the most important. It is understandable to some extent. However, very constructive potential system work among these three approaches in the case of trade.

So, some regional agreement, regional approach, Asia -- including the idea of an Asian Monetary Fund, since we suffer from the lack in liquidity. So, now is the time to consider that.

I understand in the United States some disagreement -- there exists some agreement on that issue, but now is the time to discuss this kind of regional approach.

STEIL: Presumably, the primary reserves of such a fund would be dollars. (Laughter.) This is a problem, is it not?

TAKENAKA: That's one issue. That's one issue.

However, in the case of Asian countries, where at this moment it is very -- it is not realistic to create, for example, some kind of special currency. So, for the time being, the dollar (growth ?) quite important.

At the same time, I quite understand the Triffin dilemma -- (inaudible) -- dilemma. So, in order to support this kind of -- in order to -- I want to say, make up with the kind of problem, some kind of additional approach, like regional approach, is needed I think.

SHEARD: Question in the back?

QUESTION: Susan Shirk, University of California, San Diego -- this year at The Asia Society.

President Hu Jintao, when he came to Washington, made a statement about anticipating -- a statement about the long-term goal of having the renminbi, as well as other currencies, join the dollar as a reserve currency. This was quite a remarkable statement of Chinese ambition. There are a lot of reasons why nothing like this can happen in the short term, but do any of you think this is a realistic prospect for the long term?

KUBARYCH: Well, Japan's got a lot of reserves. Takenaka-san probably has more -- (laughter) -- stature in this discussion.

TAKENAKA: Wow. (Laughter.)

KUBARYCH: You going to diversify into renminbi?

TAKENAKA: Well, the -- (inaudible) -- renminbi. Renminbi is very important, and would become much more important. In that process, we should discuss that kind of scheme, President Hu suggested.

But still, I -- in my understanding we need much more intellectual level of discussions for this issue. Well, political leadership is very much important. At the same time, as far as financial issue is concerned, we need very solid base for -- by intellectuals. So, I do not disagree that we start this kind of discussion among intellectuals. Based upon that process, we would have much more concrete and much more constructive discussion I believe. I do not disagree, so.

SHEARD: Benn, did you -- ?

STEIL: I would just point out that the Japanese -- the Chinese financial system is very, very tightly controlled. Interest rates don't work in China as they do in Japan or the United States. The bank lending rates are set by the government. The deposit rates are set by the government.

So, we have a long way to go before the renminbi even could conceivably fulfill such a role. So, I don't -- I don't see that as a realistic option into foreseeable future.

SHEARD: We're drawing towards the end here. I think we've got time maybe for one last question, and I'll take the prerogative of the chair to ask it.

I think when you look at the recent financial crisis, I think many economists would conclude that the U.S. policymakers have learned one of the key lessons of the Japanese crisis, which is that you have to intervene very aggressively, in huge size -- in a forceful way. We've seen that from the Treasury; we've seen it from the Fed in a dramatic expansion of its balance sheet.

One question then becomes, how is the U.S. going to extricate itself -- the exit strategy? Clearly, nobody in this country has an appetite for permanent financial socialism. Japan spent many years trying to extricate itself from financial socialism over there -- and Mr. Takenaka, of course, was leading the charge at the end. But what are the thoughts on the panel about how the U.S. policymakers will be able to manage this very difficult conundrum of having to deal with the crisis; having to extricate themselves as soon as possible to return functions to market? But, at the same time, presumably to make some fundamental changes in the whole nature of the regulatory machine that underpins the capital markets? And briefly. (Laughter.)

KUBARYCH: I would venture a guess that they can go a long way by just doing something in that direction next year. And my guess would be AIG. That when we can essentially get a little bit more stability in the markets, there are lots and lots of insurance companies that would like to buy bits and pieces of this incredible company and transform the, sort of, open-ended exposure of the U.S. taxpayer to something a little bit less daunting. And that will set up a better mood.

So, you've got to do -- you've got to do something tangible next year. And then people will say, well, there is an exit strategy, it's basically selling this stuff back into a marketplace. So, let's see that there is a marketplace. And AIG is my favorite candidate for doing that first.

TAKENAKA: Remedies from a political point of view. Based on my experience, it is difficult, almost impossible for politicians to understand the financial issue. (Laughter.)

This is the most important experience that we have. So, the more freedom to be given to, for example, minister -- secretary of the Treasury, or the chairman of the Federal Reserve, Larry Summers, for example. So, this is most important point, I think. So, that U.S. can manage the situation.

SHEARD: They'll be pleased to hear that.

Benn -- last word.

STEIL: For me, the key turning point will be when we split up and privatize Fannie Mae and Freddie Mac. I'm very, very worried about the U.S. government basically controlling the entire mortgage market in the United States.

Now, I understand completely that right now we have no choice. But, once we begin to return to some degree of normalcy, it becomes critical to prevent this housing bubble from recurring. And remember, the politicians had a big role in it building up in the first place, and where we were pushing Fannie Mae and Freddie Mac to move into low income housing.

And certainly, now that we own them, the temptations to continue to do that will be utterly enormous. So, for me, the key sign that we've learned our lesson will be when we finally split up and sell off Fannie Mae and Freddie Mac.

SHEARD: Well, thank you very much. (Applause.) It's been a very informative panel. And I think we'll take a 15 minutes break now. Thank you.

.STX

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