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| Speaker: | Martin Wolf, Associate Editor and Chief Economics Commentator, Financial Times, Author, Fixing Global Finance: How to Curb Financial Crises in the 21st Century |
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October 15, 2008
Council on Foreign Relations
New York, NY
MODERATOR: We're going to have at the Q&A time our traditional way, the members can stand and identify themselves and ask questions.
And I'm going to start to interview someone here who I think you probably all know, Martin Wolf. He's the associate editor and chief economics commentator for the Financial Times.
I just asked him, did he start out as an economist or a journalist? And he looked at me with horror and said, "I'm a economist, of course." (Laughter.) He wound up -- having worked in economics at the World Bank, and moving into journalism at the age of 40 I thought. That's about 10 years ago, Martin, is it?
MARTIN WOLF: Yeah, if only. If only. (Laughter.)
MODERATOR: And he's had a very distinguished career, as I think you know. Some of the recent headlines of his columns -- and we wrote them because they're very appropriate, "It's Time for the Comprehensive Rescues of the Financial System" -- that's been done, Martin; "Congress Decided it was Worth Risking Depression;" "The End of Lightly-Regulated Finance Has Come Far Closer" -- I wanted to ask you about that later on; "Lessons to be Learned from the Financial Crisis;" "A Turning Point in Managing the World's Economy."
Many awards for this fine gentleman: The OBE (sic), the one three years ago. He won the AMEC Lifetime Achievement Award at the Workworld Media Awards in 2007; Commentator of the Year at the Business Journalists of the Year Awards in 2008. My favorite, he came in second -- equal, in the Royal Statistical Society's Award for Statistical Excellence in Journalism for 2008. Who came in first? (Laughter.)
WOLF: Fortunately, one of my colleagues.
MODERATOR: Okay. (Laughter.) And finally -- but, not finally, but the last we'll mention, placed among the World's 100 Leading Public Policy Intellectuals by the British magazine "Prospect," and the U.S. magazine "Foreign Policy," in May, 2008. Congratulations to that.
What we're going to do this morning is ask Martin, if he would, to summarize briefly his new book, "Fixing Global Finance." Very appropriate timing. I hope it's been read by everybody in Washington.
I'd just ask you an opening question first, Martin. The timing of this book seems extraordinary. When did you start it, and did you speed it up -- (to get it out ?) for this group?
WOLF: The timing, this one of those -- first of all, it's wonderful to be here. I am rather shocked by how many people are here, and I can't imagine you don't have all -- in the present circumstances, better things to do. But, nonetheless, it's very flattering.
The timing of this book is one of those fortuitous -- fortuitous events, in that the book is much more relevant, in the sense that -- of what's going on. But, unfortunately, the analysis is not of the subprime crisis. Let me make that quite clear. It's about the history of 30 years of financial crises which, in my view, have played a very big role in creating the conditions of vulnerability in the U.S. economy that led to the subprime crisis.
Though, let me be absolutely clear and honest, when I wrote this book -- and I wrote this book in two summers, mainly up to the summer of 2007, I write in my summers -- though I was very clear about the vulnerabilities the U.S. was generating, (but its ?) external and internal, and the links between those. That was a big theme of mine, and was a theme of my discussions here just a couple of years ago.
The scale of the errors made in lending -- the problems that were derived through the securitization process, and all that, were well outside my ken, though I do have, I think, quite an interesting chapter which summarizes all the reasons why you will expect financial systems to collapse periodically. And I think that's an important chapter of the book. But, the scale of this one is extraordinary.
Let me just say that the essential arguments of that -- and many of you will be familiar with this, is that after approximately two and a half decades of shattering financial crises, all serious emerging economies, with one exception -- namely those of Central Eastern Europe, for special reasons, decided they could not afford the run significant current account deficits and moved into pretty classic mercantilist (types ?) policies with enormous foreign currency reserve accumulations, very large aggregate current account surpluses. The biggest of these being, of course, China is, by far, equal to Japan and Germany together.
To that was added the oil surpluses -- you know about that; and there was, as a result -- and I believe Ben Bernanke was right on this, generated quite extraordinary global savings surpluses -- (inaudible) -- savings surpluses, which also showed themselves in these enormous current account surpluses.
A very limited number of economies, all of which, in fact, had one shared feature: low interest rates, easy monetary policy, and a massive housing booms, basically absorbed all these savings. The U.S. was the most important by far, but my own country, Spain and Australia contributed significantly to this (in aggregate ?) running current account deficits last year of about $1.1 trillion.
And it's all that mechanism -- which I describe at some length in this book, the mechanism for absorbing the world's savings into essentially household consumption -- (inaudible) -- by the housing boom, turned out to be even more dangerous than I thought it was, and it is now, sensationally, at an end.
And then that leads me to the last part of the book which is, how do we rebalance the world system, because it can't be rebalanced unless -- the U.S. is not going to get out of this, in my view, unless there's a very strong demand growth in the rest of the world. And the -- all the evidence we now have, unfortunately, is that the U.S. weakness is reducing demand growth in the rest of the world -- which normally -- (inaudible) -- the other way around.
So, that is the big -- this is a book really about the interaction between macroeconomics and the financial system, and about external imbalances and internal ones, which -- (inaudible) -- the household sector. And it does leave us in a rather depressing situation, because the particular solution -- which I think the world stumbled into, for managing the global macroeconomic system, which involved, among other things, these gigantic current account deficits in the U.S., has blown up pretty sensationally, and that's where we are.
Then there's, of course, these other questions about the financial system and how you heal this. Let me just say one final thing on where we are now. (As I repeat, ?) anybody who's reviewed any of my things -- (inaudible) -- will see, I believe that in the situation that evolved since Lehman's collapse, there was no alternative to the sorts of measures governments have now undertaken, which are a tragedy, of course, and will create huge problems for the future in many different ways.
I think they have probably -- probably -- stopped the heart attack, but that leaves -- (inaudible) -- metaphor I'm using, it leaves us with a very, very weak patient. And that weak patient is not just the financial system, it's also the economy, more broadly -- not just here but in the world.
So, that's I think the relevance of my book, what it's about, and I think it does describe at least some aspects of the agenda for the future, though it certainly doesn't -- it's tried to reconstruct the U.S. and world financial systems, a task well beyond my pay grade. (Laughter.)
MODERATOR: Well, that's well beyond anybody's pay grade -- (inaudible) --
Why don't we start with what really caused this to happen, and what might happen. I looked at a presentation you made on March 5th of this year -- pretty good, entitled "Why the Subprime Crisis was a Turning Point in the World Economy."
Now there are several theories about this -- or several ideas. My own view, and many others -- and I'm not sure that your book agrees with this, is that it was the housing crisis that's got us into this, and it's solving the housing crisis that will get us out.
To put that in perspective, there's 80 million houses in this country, 55 million have mortgages -- (inaudible) -- there are 25 million that have no mortgages. Of the 55 million that have mortgages, roughly 5 million have problems in one set or another. And of the 5 million, 2 or 2.5 million have very serious problems at the moment.
If you looked at it that way, the average value of a house is about $300,000; average mortgage, $200 (thousand.) You'd need about $500 billion, at $100,000 a house to freeze the financial problems of the 5 million houses. Then you'd have a concern about how to keep it from turning into 10.
Now, I guess the question I have for you: Do you agree that the housing crisis has gotten into this, and we need to solve it to get it out? And, how does that apply here and to the rest of the world?
WOLF: I'll make just one overarching comment on that before looking at the details. I see the housing crisis -- I think this is a correct description of where we are now, since we are in the collapsed stage of a massive bubble process. And in the collapsed stage -- many countries have been very familiar with this. You only need to talk to Japanese people, they will describe everything that's happened, and what's going to happen, in detail.
You will have a long period of -- (inaudible) -- price decline; falling net worth of households; defaults -- though, the Japanese are incredible in their unwillingness to default at the individual level, otherwise their disaster would have been much bigger. And then if that filters into the banking system -- the banking system is essentially a Ponzi game. We all know that, obviously. If you told anyone, intellectually, that the entire financial structure of the world depends on institutions levered, on average, 20:1, you would obviously understand this is a pretty shaky thing.
So, it starts collapsing. You soon discover people start getting nervous about whether the banking institutions are solvent, and you have where we are. And there's nothing new about any of this. The only difference is the scale -- the scale, because it covers the whole of the U.S. and large parts of Europe as well.
And my book is particularly interested in how we got there. We don't need to go into that, but my argument would be -- I think it's fairly similar to Bob Shiller's, though I put it in an international context and he puts it more in national context. These bubbles arose, in my view, out of global environment -- a global circumstance, which created extraordinarily propitious circumstances for bubbles of this kind. And I try to stress -- and I've stressed a number of -- (inaudible) -- it is important to remember that the U.S. housing bubble is by no means special. There are about 20 countries that have had housing bubbles, many of them bigger. The only thing that seems to be special -- and I stress "seems" -- because the U.S. collapse is older -- it started in 2006, and ours were later -- that the quality of a great deal of the other -- the quality of more of the lending in the U.S. seems to be bad than in other cases. But come back to me in two years from now and I'll see whether that's true of the U.K. I wouldn't be terribly surprised if it turned out to be almost as bad.
So it's a global phenomenon of global collapse. Now, the question you're asking is, once this happens, what do you do? Well, the lesson of the spirit is you have to do a great many things. First you have to protect -- you have to sustain the capital basis of the financial system, which will become completely decapitalized in this sort of process, and that's what governments are now doing. And you obviously have to preserve confidence in the financial system, and that's why all these other things are happening.
The question then is, what else do you do? There's no question you have to do these things. There is a long-standing line of argument that says you should try and support the prices of the assets themselves that are collapsing, and -- in this case, the housing assets. I have to say -- it's clear that you would like to have some mechanisms and you can imagine mechanisms to put the floor under the house price falls because there's a danger of very big overshoots. I'm not in the least persuaded that house prices in the U.S., let alone any of the other countries with bubbles, are even at the equilibrium levels, let alone having overshot. I think adopting a general policy of trying to keep house prices above market clearing levels is a very, very bad idea -- and -- because you're basically trying to set -- the government in some ways would be trying to set the prices of vast parts of the asset base for an economy for the indefinite future. Unless you're really pretty confident you're above -- you've overshot downwards -- and house prices are still above long-term trends in most countries -- I think that would be a very bad idea.
What you can do -- and that becomes more interesting -- is what we did when we had a house price collapse in the early 1990s -- you could help some of the people who are affected. We did that through our welfare system, but you don't really have one so you can't do that. (Laughter.) That's a policy choice. You could obviously help with bankruptcy provisions, provisions above all that foster smooth renegotiation of the contract, no longer viable between the borrower and the lender. It helps a great deal if you don't have (long ?) recourse loans, and most of our -- in most other countries default, a default on a housing loan automatically means personal bankruptcy, and that gives a long, strong incentive for people to sustain payments.
But I really don't like the idea of interfering with the clearing of the market. A more necessary thing to do, it seems to me, is policies that do at some level sustain aggregate demand in this situation. I'm afraid -- and this is a position that I really don't like being in, as so many of my friends will know -- we are in a sort of Keynesian world now, and that means for sure we're going to have enormous fiscal deficits -- the fiscal deficit here is exploding and will get better, and the same is going to happen in Britain. And monetary policy of course will be dramatically relaxed, but won't turn out to be very effective.
My bottom line on this is I agree with your analysis that we are going to go through a pretty significant recession, and I'm not sure trying to fix the house price declines themselves is a good way of preventing this.
MODERATOR: Why don't we stay with this idea of fixing things and ask a two-part question? Part one is essentially your comments on the proposal and the actions taken in the last 24 or 36 hours. But I'd like to wrap into that the question for here and for the U.K., which is, as you read these proposals -- giving money to the banks and things -- there's very little about how to be sure that the banks will turn around and lend that money and help the people you're talking about -- lend them both, at least in my judgment, for mortgages and also for small business loans, which generate a high percentage of the jobs in this country.
So where do you come out on that, and would you contrast it and compare it with what's going on in the U.K.?
WOLF: My perception of what these sorts of measures are likely to do in our economies is reduce the rate of shrinkage of the credit outstanding to households and business, but it's almost certainly going to shrink anyway. These are very highly leveraged economies with very highly indebted households -- extraordinarily indebted households in both cases. By and large the ratios of household debt to disposable income is very rough, having doubled in the last 10, 12 years, and having the most leverage of all significant economies, and I think many households are either going to conclude or be forced to reduce that, often through bankruptcy.
Small business -- the situation is not so clear, but it is likely, obviously, in any (sub ?) situation, a lot of business is going to disappear, and they're going to see very bad (debts ?).
In normal circumstances, therefore, both the debtors and the lenders will see good reason to reduce their outstanding credit, and I expect that to happen. And it's part of the recession process we're in.
The -- what was going on in my view in the last few weeks was a crisis so severe in terms of access to funding for the banking system -- and of course, in America, even more significant perhaps, the long bank financial system, about which they've done -- managed to do very little -- that there was a risk that credit -- just rollovers would stop altogether. Everybody -- they weren't loans weren't being rolled over banks, or they weren't sure about that, so they weren't going to rollover bank lending to anybody else, and you'd have a catastrophic collapse in credit with -- precipitating the economy into an incredibly deep recessional slump.
The -- I believe the measures they've now taken -- (inaudible) -- with luck -- that's the range of measures, the recapitalization, liquidity provisions, guarantees and so forth for the banking system -- prevent that, though the U.S. -- I'm not an -- this is not an are I feel particularly expert on, but the U.S. clearly has an exceptionally large long bank financial system, and these measures as far as I can see really do nothing for that, and it will continue to contract very rapidly.
If they're successful, therefore, they will have a financial system that can do many things. But I just expect credit to contract. But if -- one of the striking differences -- I was just talking about this with colleagues out there -- is that when the U.S. is heavy-handed, it's more heavy-handed than we socialist Brits could even imagine. (Laughter.) I mean, the British government just went to the major banks and said, "Would you like some capital?" And three said, "Yes, we'd like some capital because we don't" -- (inaudible) -- and two, if I remember correctly, said no. My understanding is when Secretary Paulson went to see his nine banks he said, "This is the capital you're going to take," and that was that.
Now -- so it is possible for me to imagine that the next week, the Republican administration will have a wartime plan for credit allocation and expansion by the U.S. banking system. I would -- I must say that my residual libertarian propensities would find that a truly horrifying notion, but I'm -- wouldn't be surprised anymore -- nothing would surprise me anymore -- if that were to happen. But at that stage essentially the government will have taken over completely the running of the banking system on a wartime footing, and -- with all the inevitable consequences that will have for the medium and long run, and it seems to me something that one really doesn't want to do.
If the worst comes to the worst, however, and credit continues to collapse, governments have essentially two choices, and we've seen that again with -- (inaudible). They either do that and they tell the banks, "You're going to lend because we've given you all this money and it's not just to sit in your bank account," as it were; or -- and that has interestingly begun to happen in the U.S. in a very interesting way -- the central bank becomes the lender, and the central bank starts buying commercial paper, as it's done in a big way, and actually starts becoming a principal lender to business. And I don't find it impossible to imagine that 10 years -- a year from now, we'll find the Fed's balance sheet includes massive loans to a vast number of bad companies. And that -- and I don't need to read the list here because you know it better than I do. That's a fairly scary prospect. But let's be clear: we are in completely extraordinary territory.
MODERATOR: We'd like that list of bad companies, I'm sure. (Laughter.)
WOLF: I don't think you need the list. They're all in the newspapers. And they're being shorted, which is no doubt part of the problem. (Laughs.)
MODERATOR: Can we stay with this issue and move it slightly into the question of regulation, which as I skimmed your book didn't seem to play a big role? Now, one of the issues here is the creation of these securities -- securitized mortgages and the like. There's been a big contributor to this. We exported capitalism along with its sins -- this is one of its sins. And in fact banks went from being lenders of 30-year mortgages to 45 days because all they cared about was getting them on the books so they could package them and sell them.
So the question is, we have an SEC. It's very good at regulating stocks, but essentially debt and credit and derivatives are unregulated here and in the rest of the world. One, how much do you think that's contributed? Two, do you see a push for regulation worldwide?
WOLF: It's absolutely clear that -- when I wrote this book I wasn't thinking about it -- and in any case, in truth, it's not a field of my expertise. There are an enormous number of people who know vastly more than I do. I didn't look at the securitization question except in a very general and fundamental way, because what I describe in my chapter on the financial system, which I think I was quite pleased with because I thought in 20 pages I really described why financial systems are such dangerous entities and so necessary. But obviously the most important point that I made there is financial systems or information systems -- essentially what they are -- and their information about things -- that's much more problematic -- that we really don't know about, like the future. So it's quite easy to see why strange things happen.
Now, the reason -- clearly, ex post -- go back: I was one of the many, many people who thought that securitization sounded like quite a good idea, and the reason I thought it was rather a good idea is I really knew how fragile and weak banking systems were and how many problems they could create. So getting things out of the banking system with a proper matching of maturities and -- (inaudible) -- seemed very desirable. But two things went wrong with this, pretty clearly: One, the information content in the securitization process seems to have been massively distorted, corrupted, or made fraudulent to some degree; and the banks, two, didn't get out of it at all. They were in it in every possibly way, and that fragility was maximized.
So the securitization process clearly didn't work as I thought at that time it was going to work. I remain of the view, however, that it's a very desirable thing to have. I don't really want to go -- and when U.S. is almost instantaneous -- that was something I commented on yesterday with some colleagues -- the U.S. has jumped, it seems to me, in approximately three months into a classic European, oligopolistic, big bank structure. And these are very bad structure. And -- but of course it has some advantages. It's a nice, cozy oligopoly. It has advantages for the incumbents and it has advantages for the government. But that's what the U.S. has jumped into.
I would like to see the securitizing process restarted. Now, it is clear for that -- any such process to be possible, all the problems of conflicts of interest, adverse election, moral hazard and all the rest of it -- and above all information asymmetries, which became so obvious in the securitization process exposed -- would have to be fixed. I think that's first and foremost a market problem. I mean, markets are going to have to work out a way of doing that. I thought by now they would already have started; instead they've become completely toxic across the board. Regulators are obviously going to have to construct some way of doing that. There have been discussions -- for instance, one interesting -- (inaudible) -- bonds as the Europeans' sort of way of doing this, in which institutions are committed as well as the individual securities. So that's what I think about securitization, the problem, and so forth.
On the regulationary process more broadly, a few months ago when I thought this was not going to -- when I thought we would get through the financial crisis side without this sort of implosion, I played around a lot in columns with ideas I had for regulation, none of which seemed to me crazy, but now most of which seem sort of irrelevant. The -- it is pretty obvious to anyone who thinks about this carefully that pretty well every idea we had about how to regulate the financial system was wrong. (Inaudible) -- is irrelevant -- just nonsense. We're having huge problems with accounting. We don't know -- we've completely reconstructed the financial system, created completely new and in my view fundamentally unmanageable and unregulatable financial behemoths. We haven't even begun to think about the cross-border implications of this, the impact of what's going to happen -- what is happening now when you find banking institutions are collapsing in your jurisdiction and two-thirds of their depositors and two-thirds of their assets are abroad. Do you really want to guarantee all these people? How are we going to do that? We don't know yet in Europe.
So I think now, let's get through the cardiac arrest stage; let's try and rebuild the economies, go through the normal recession process we're going through, and then let's start thinking about the lessons of this for the regulatory system. All I think we now know is that nothing worked well almost anywhere, with a few exceptions -- the Spanish were famously -- the Spanish central bank told its banks that -- (inaudible) -- were not going to happen and if they did create them, they were going to have a take a full capital charge against them. That was pretty smart.
That very basic -- allowing a bank to operate outside the capital regime you created in order to control it -- is nuts. (Laughter.) So -- that's basic.
The -- but beyond that, I really do feel -- and I don't regard myself as -- (inaudible) -- why I focus on the macro side of this -- that the question of what all this means for the nature of the financial system, the regulation of the financial system, who the regulators should be is enormous.
There's one additional point to make, but everybody knows this. Everybody knows from the administration on down the regulatory structure in the U.S., particularly the historical reasons is, as we now increasingly say in the U.K., "unfit for purpose," and clearly has to be reconstructed. If AIG turns out to be pretty well the most important financial institution in the country, it has to be really part of the same regulatory network in exactly the same way as all the other ones.
MODERATOR: (Inaudible.) (Laughter.)
WOLF: (Inaudible.)
MODERATOR: Before we get to the Q and A, to go now from the creators of these securities to the buyers of the securities and get to the premise of your book, of the role of emerging economies: What's going to happen to sovereign wealth funds, their attitudes, their investments? How are countries going to invest inside, given all the things that are going on? What's your view --
WOLF: Let me -- well, let me -- what will happen --
MODERATOR: What will their role be in this crisis?
WOLF: Yeah.
MODERATOR: Not just tomorrow but in (the ?) term?
WOLF: Sovereign funds are big and getting bigger, and you should regard, I think, a large part of the foreign currency reserves of the world as more or less part of this, in the sense that they are excessive -- (their in excess ?) to short- to medium-term insurance requirements. The foreign currency reserves of the world at the moment are about $7 trillion, which is quite an impressive sum. And as I've -- (inaudible) -- frequently, the largest foreign aid program in the history of the world since it predominantly went into U.S. liabilities. The -- and over and above that, there are sovereign funds which don't appear as foreign currency reserves -- (inaudible) -- the Gulf states. Probably the aggregate is about $10 trillion.
These are enormous -- much larger than hedge funds or private -- (inaudible) -- and they are not, I think, going to go away unless you believe the oil price is going to collapse to $20 -- doesn't seem very plausible to me unless we have a true depression.
So it is -- there is a very big question about how are they going to use this money. They have a tremendous problem, and it is very relevant to the theme of my book. If you're going to invest that sort of money, doing it in other emerging economies is basically impossible. The markets aren't big enough, deep enough, liquid enough. The openness to that scale of foreign investment isn't there. And so they have tended to get driven into investing in the developed world because that's where the capital markets are.
At the same time, of course, as you know, recent experience of sovereign wealth funds and investing in the banking system of the West has not been entirely happy. That's a very gentle way of putting it. They got creamed, and confidence has clearly been shattered -- broken by that. And it's quite clear that they're very concerned now about what they're getting into. So I don't think they're going to play any useful role in helping with this crisis anymore, at least until it's well over. But in the end, they are going to have to invest in developed countries, I think, if they've got the sort of scale of money.
My optimistic view, which is clearly implicit in my end of my book, is that my -- I have a basic fundamental view that it makes sense for huge -- (inaudible) -- savings to go into investment, not consumer debt, and the investment should go into countries with the best opportunities. So they should go into emerging economies, which should of course be running some sorts of current account deficits to absorb them. That, as I'd stress, requires -- and this applies just as much to sovereign wealth funds as it does to private investors -- it requires enormous changes in attitude, institutions and so forth, in the emerging world, particularly in very big -- particularly in China. I think India actually is going to be a relatively straightforward proposition in comparison.
But we are not -- I mean, you go -- (inaudible) -- all the Gulf money go? In theory, from an economics point of view, it should be Asia. It shouldn't be coming to us because we can't absorb it. One of the most interesting -- I do make this point in the book: I think one of the most interesting sort of metafacts about the developed world -- and I think to my mind it's a very significant factor in the conditions that created the crisis -- is that the corporate sectors, the nonfinancial corporate sectors of nearly all significant developed countries are now, on trend, cash-surplus. Their retained earnings are higher than their investment. They don't need to obtain funds from the financial markets. That's one of the reasons why the financial markets have had to find so many clever ways to (households ?), in my view. That's not true for all companies, but it's true for them overall, and I don't see how that can change. We are mature, relatively rich countries with slowly growing or in many cases declining populations. There is no need for a huge investment boom in our countries. We can't therefore satisfactorily absorb these excess savings. The countries that can are all over the emerging world. And so the big challenge of my -- where my book ends up, and I would stress it's still relevant, is how do we create the monetary, financial and other conditions in which capital from the countries we're talking about ends up in the emerging world rather than in our world, because truthfully -- and I think this crisis demonstrates that -- we can't absorb this money productively.
MODERATOR: Yeah, that's true. The money market funds in the middle of this crisis went from 2.5 trillion (dollars) to 3.7 trillion (dollars) in this country, just to talk about liquidity.
WOLF: Yes. That's right.
MODERATOR: There would be much more to talk about, but now is the time to switch to the audience. I think you're all familiar with the way we like to do it. When you ask a question, could you please stand and identify yourself and your organization. We're going to limit each questioner to one question and hope we can have the questions be consistent with the track we're going down here.
You ready, Martin, for this?
WOLF: Yeah.
MODERATOR: Okay.
We'll get you a mike. (Inaudible.)
QUESTIONER: Richard Gardner, Columbia University. If the United States, as you have predicted, will now run huge fiscal deficits and easy money, what's the future of the dollar as an international reserve asset?
WOLF: That's obviously a very good question. When I look back at the -- I always am interested in the mistakes I make and -- probably everybody is. Fortunately my mistakes aren't as costly. That's the nice thing about being a responsible journalist. (Laughter.)
This book was written in the view -- which was actually standard -- that there were two, quote, unquote -- and I don't want to use this in any pejorative sense -- "imbalances" associated with the import of capital to the United States. There was an external one: the accumulation of current account deficits and net liabilities and all that sort; and an internal one -- that is to say, by definition if a country is spending roughly 8 percent more than its income, there must be sectors within the economy doing the same thing. And I analyzed the latter particularly because it's something the Europe-American economists don't seem to be so interested in -- never were very interested in. And I pointed out -- which, we're being very tedious, but again -- (inaudible) -- and what was so interesting about it is that the principal counterpart for most of this period was the household deficit, which was interesting because that's not the situation the U.S. household sector has normally been in.
But nonetheless, I along with most economists thought that the external side -- namely, the dollar -- would become a really big issue. But of course that led to huge debate on this, and there's a whole chapter which deals with this question.
Now, what is -- two things one can say about this: The dollar has experienced over the last six years, I think, a very, very steep decline. And if you look at the real trade-weighted exchange rates -- a J.P. Morgan calculation -- even with the recent blip upwards, it is basically as low as it's ever been. So there has been a huge depreciation.
Two, that has been sensationally good for the U.S. net liability position. And that's a very -- that's an important point in -- (inaudible). U.S. net liability position is less than 20 percent of GDP. And if you've just cumulated U.S. current account deficits -- i.e., which would imply nothing more than that, it would be now already about 50 percent of GDP, which is a large number for such a big country.
And the -- there are many reasons for the differences -- some of them statistical, which are -- which I'm not going to go into but which I discuss in the book. But the main reason, the single biggest reason, is the devaluation of the dollar. In other words, the U.S. has been engaged in a very successful, very -- (audio break) -- U.S. and world financial systems are a task well beyond my pay grade. (Laughter.)
MODERATOR: Well, that's well beyond anybody's pay grade, in fact.
Why don't we start with what really caused this to happen and what might happen. I looked at a presentation you made on March 5th of this year -- pretty good -- entitled "Why the Subprime Crisis is a Turning Point in the World Economy." Now, there are several theories about this, or several ideas. My own view, and many others -- and I'm not sure that your book agrees with this -- is that it was the housing crisis that got us into this and it's solving the housing crisis that will get us out. To put that in perspective, there's 80 million houses in this country; 55 million have mortgages. It's interesting to me that there are 25 million that have no mortgages. Of the 55 million that have mortgages, roughly 5 million have problems of one sort or another, and of the 5 million, 2 or 2.5 million have very serious problems at the moment.
If you looked at it that way, the average value of a house is about $300,000, mortgage 200 (thousand dollars). We'd need about $500 billion at $100,000 a house to freeze the financial problems of the 5 million houses. Then you'd have a concern about how to keep it from turning into 10 (million). Now, I guess the question I have for you: Do you agree that the housing crisis has gotten it into this and you need to solve it to get it out? And how does that apply here and to the rest of the world?
WOLF: Can I make just one overarching comment on that before looking at the details? I see the housing crisis -- I think this is a correct description of where we are now, since we are in the collapse stage of a massive bubble process, and in the collapse stage -- many countries will be very familiar with this. You only need to talk to Japanese people. They will describe everything that's happened and what's going to happen in detail. You will have a long period of actual price decline, falling net worth of households, defaults. The Japanese are incredible in their unwillingness to default at the individual level. Otherwise the disaster would have been much bigger. And then as that filters into the banking system -- the banking system is essentially a Ponzi game. We all know that obviously. If you told anyone intellectually that the entire financial structure of the world depends on institutions leveraged on average 20 to 1, you would understand this is a pretty shaky thing.
So it starts collapsing. You soon discover people getting nervous about whether the banking institutions are solvent, and you have where we are. And there's nothing new about any of this; the only difference is the scale because it covers the whole of the U.S. and large parts of Europe as well.
My book is particularly interested in how we got there. We don't need to go into that, but my argument would be -- I think it's fairly similar to Bob Shiller's argument, though I put it in the international context and he puts it more in the national context -- these bubbles arose, in my view, out of global -- environment of global circumstance, which created extraordinarily propitious circumstances for bubbles of this kind. And I tried to stress -- and I've stressed in a number of articles -- it is important to remember that the U.S. housing bubble is by no means special. There are about 20 countries that have had housing bubbles, many of them bigger. The only thing that seems to be special -- and I stress "seems" because the U.S. collapse is older; it started in 2006 and ours was later -- that the quality of a great deal of -- the quality of more of the lending in the U.S. seems to be bad than in other cases, but come back to me in two years from now and I'll see whether that's true of the U.K. I wouldn't be terribly surprised if it turned out to be -- (audio break).
So, it's a global phenomenon and global collapse. Now, the question you're asking is, once this happens, what do you do? Well, the lesson of the experience is you have to do a great many things. First you have to protect -- you have to sustain the capital basis of the financial system, which will become completely decapitalized in this sort of process, and that's what governments are now doing. And you obviously have to preserve confidence in the financial system, and that's why all these other things are happening.
The question then is, what else do you do? There's no question you have to do these things. There is a long-standing line of argument that says you should try and support the prices of the assets themselves that are collapsing, and in this case the housing assets. I have to say, it's clear that you would like to have some mechanisms, and you can imagine mechanisms, to put a floor under the house price folds because there's a danger of very big -- (audio break) -- in the U.S., let alone any of the other countries -- (audio break).
I think -- (audio break) -- asset base for an economy for the indefinite future. Unless you're really pretty confident you've overshot downwards and house prices are still above long-term trends in most countries, I think that would be a very bad idea. What you can do -- and that becomes more interesting -- is what we did when we had a house-price collapse in the early 1990s -- you could help some of the people who are affected. We did that through our welfare system, but you don't really have one so you can't do that. That's a policy choice. You can obviously help with bankruptcy provisions, provisions above all that afford a smooth form of renegotiation of the contract no longer viable between the borrower and the lender. It helps a great deal if you don't have non-recourse loans. Most other countries, a default on a housing loan automatically means personal bankruptcy. That gives a strong incentive for people to sustain payments.
But I really don't like the idea of interfering with the clearing of the market. A more necessary thing to do, it seems to me, is policies that do at some level sustain aggregate demand in this situation. I'm afraid -- and this is a position that I really don't like being in, as so many of my friends will know -- we are in a sort of Keynesian world now, and that means for sure we're going to have enormous fiscal deficits. The fiscal deficit here is exploding and will get bigger. The same is going to happen in Britain. And monetary policy of course will be dramatically relaxed but won't turn out to be very effective.
But my bottom line on this is I agree with your analysis that we are going to go through a pretty significant recession, and I'm not sure trying to fix the house price declines themselves is a good way of preventing this.
MODERATOR: All right. Well, why don't we stay with the side of fixing things and ask a two-part question? Part one is essentially your comments on the proposal and the actions taken in the last 24 or 36 hours, but I'd like to wrap into that the question for here and for the U.K., which is as you read these proposals -- giving money to the banks and things -- there's very little about how to be sure that the banks will turn around and lend that money and help the people that you're talking about, lend them both -- at least in my judgment -- for mortgages and also for small business loans, which generate a high percentage of the jobs in this country. So where do you come out on that, and would you contrast it and compare it with what's going on in the U.K.?
WOLF: My perception of what these sorts of measures are likely to do in our economies is reduce the rate of shrinkage of the credit outstanding to households and business, but it's almost certainly going to shrink anyway. These are very highly leveraged economies with very highly indebted households -- extraordinarily indebted households in both cases. By and large the ratio of household debt to disposable income is very rough, having doubled in the last 10 to 12 years, and the most leveraged of all significant economies, and I think many households are either going to conclude or be forced to reduce that, often through bankruptcy. In small business the situation is not so clear, but it is likely -- obviously in any funding situation a lot of business is going to disappear and they're going to see very bad bets.
In normal circumstances, therefore, both the debtors and the lenders will see good reasons to reduce their outstanding credit, and I expect that to happen, and it's part of the recession process we're in. What was going on, in my view, in the last few weeks was a crisis so severe in terms of access to funding for the banking system -- and of course in America even more significant perhaps the non-bank financial system about which they've managed to do very little -- that there was a risk that just rollovers would stop altogether. Everybody -- loans weren't being rolled over to banks, or they weren't sure about that so they won't going to rollover bank lending to anybody else, and you have a catastrophic collapse in credit, precipitating the economy into an incredibly deep recession or slump.
I believe the measures they've now taken, nurtured with luck -- the range of measures -- the recapitalization, liquidity provisions, guarantees and so forth -- for the banking system prevent that, though the U.S. -- this is not an area I feel particularly expert on, but the USA has an exceptionally large non-bank financial system, and these measures, as far as I can see, really do nothing for that, and it will continue to contract very rapidly. If they're successful, therefore, they will have a financial system that can do many things, but I expect credit to contract.
Now, one of the striking differences -- I was just talking about this with colleagues out there -- is that when the U.S. is heavy-handed, it's more heavy-handed than we socialist Brits could even imagine. The British government just went to the major banks and said, would you like some capital, and the three said, yes, we'd like some capital because we don't meet any reasonable -- (inaudible) -- said no. My understanding is when Secretary Paulson went to see his nine banks he said, this is the capital you're going to take, and that was that. Now, so it is possible for me to imagine that the next week the Republican administration will have more time planned for credit allocation and expansion by the U.S. banking system. I must say that my residual libertarian propensities would find that a truly horrifying notion, but I'm certainly wouldn't be surprised anymore -- nothing would surprise me anymore -- if that were to happen.
But at that stage essentially the government will have taken over completely the running of the banking system on a wartime footing and with all the inevitable consequences that will have for the medium and long run, and it seems to me something that one really doesn't want to do. If the worst comes to the worst, however, and credit continues to collapse, governments have essentially two choices, and we've seen that, again, in the Japanese case. They either do that and they tell the banks, you're going to lend because we've given you all this money and it's not just to sit in your bank account, as it were, or -- and that has, interestingly, begun to happen in the U.S. in a very interesting way -- the central bank becomes the lender and the central bank starts buying commercial paper, as it's done in a big way, and actually starts becoming a principal lender to business.
And I don't find it impossible to imagine a year from now we'll find that the Fed's balance sheet includes massive loans to a vast number of dud companies. And I don't need to read the list here because you know it better than I do. That's a fairly scary prospect, but let's be clear: We are in completely extraordinary territory.
MODERATOR: We'd like that list of dud companies so we can short them. (Laughter.)
WOLF: I don't think you need the list. They're all in the newspaper, and they're being shorted, which is no doubt part of the problem.
MODERATOR: Can we stay with this issue and move it slightly into the question of regulation, which, as I skimmed your book, didn't seem to play a big role.
WOLF: No.
MODERATOR: One of the issues here is the creation of these securities, mortgages and the like. It has been a big contributor to this. We exported capitalism along with its sins. This is one of its sins. And in fact, banks went from being lenders of 30-year mortgages to 45 days because all they cared about was getting them on the books so they could package them and sell them. So the question is, we have an SEC. It's very good at regulating stocks but essentially debt and credit and derivatives are unregulated, here and in the rest of the world. One, how much do you think that's contributed? Two, do you see a push for regulation worldwide?
WOLF: It's absolutely clear that when I wrote this book and was thinking about it -- in any case, in truth, it's not a field of my expertise; there are an enormous number of people who know vastly more than I do -- I didn't look at the securitization question except in a very general and fundamental way because what I describe in my chapter on the financial system -- which I think I was quite pleased with because I thought in 20 pages I really described why financial systems are such dangerous entities, and so necessary -- but obviously the most important point that I made there is financial systems are information systems -- that's essentially what they are -- and they're information about things, and that's much more problematic, that we really don't know about, like the future. So it's quite easy to see why strange things happen.
Now, the reason, clearly, ex post -- go back. I was one of the many, many people who thought that securitization sounded like quite a good idea. And the reason I thought it was rather a good idea is I really knew how fragile and weak banking systems where and how many problems they could create. So getting things out of the banking system with a proper matching of maturities seemed very desirable. Two things went wrong with this, pretty clearly. One, the information content in the securitization process seems to be massively distorted, corrupted or made fraudulent to some degree, and the banks, too, didn't get out of it at all. They were in it in every possible way, and that fragility was maximized.
So the securitization process clearly didn't work as I thought at that time it was going to work. I remain in the view, however, that it's a very desirable thing to have. I don't really want to go -- and the U.S. has almost instantaneous -- it was something I commented on yesterday with some colleagues -- the U.S. has jumped, it seems to me, in approximately three months into a classic European oligopolistic big-bank structure, and it is a very bad structure. But of course it has some advantages. It's a nice, cozy oligopoly. It has the advantages for the incumbents and it has advantages for the government, but that's what the U.S. has jumped into. I would like to see the securitizing process restarted.
Now, it is clear that for any sort of process to be possible, all the problems of conflicts of interest, adverse selection, moral hazards and all the rest of it, and above all information asymmetries, which became so obvious in the securitization process ex post, would have to be fixed. I think that's first and foremost a market problem. I mean, markets are going to have to work out a way of doing that. I thought by now they would already have started. Instead they've become completely toxic across the board. Regulators are obviously going to have to construct some way of doing that. There have been discussions -- for instance, one interesting discussion has been about covered bones, as the Europeans' sort of way of doing this, in which institutions are committed as well as the individual securities.
So that's what I think about securitization, the problem and so forth. On the regulationary process more broadly -- a few months ago when I thought this was not going to -- when I thought we would get through the financial crisis side without this sort of implosion, I played around a lot in columns with ideas I had for regulation, none of which seem to me crazy but now most of which seem sort of irrelevant. It is pretty obvious to anyone who thinks about this carefully that pretty well every idea we had about how to regulate the financial system was wrong. Basel II was irrelevant, just nonsense. We have these huge problems with accounting. We don't know -- we've completely reconstructed the financial system trading -- completely new and, in my view, fundamentally unmanageable and unregulateable financial behemoths.
We haven't even begun to think about the cross-border implications of this, the impact of what's going to happen -- what is happening now when you find banking institutions that are collapsing in your jurisdiction and two-thirds of their depositors and two-thirds of their assets are abroad. Do you really want to guarantee all these people? How are we going to do that? We don't know yet in Europe.
So I think now let's get through the cardiac arrest stage. Let's try and rebuild the economies, go through the normal recession process we're going through, and then let's start thinking about the lessons of this for the regulatory system. All I think we now know is that nothing worked well almost anywhere, with a few exceptions. The Spanish famously -- the Spanish central bank told its banks that the FIBs (ph) were not going to happen, and if they did create them they were going to have to take a full capital charge against them. That was pretty smart, but very basic. Allowing a bank to operate outside the capital regime you created in order to control it is nuts. So that's basic. But beyond that I really do feel -- and I don't regard myself as in way an expert; that's why I focus on the macro side of this -- the question of what all this means to the nature of the financial system, the regulation of the financial system, who the regulators should be is enormous.
There's one additional point to make, but everybody knows this. Everybody knows, from the administration on down, the regulatory structure in the U.S. particularly for historical reasons is, as we now increasingly say in the U.K., unfit for purpose and clearly has to be reconstructed. If AIG turns out to be pretty well the most important financial institution in the country, it has to be really part of the same regulatory network in exactly the same way as all the other ones.
MODERATOR: You have strong views. (Laughter.)
WOLF: You're goading me.
MODERATOR: Before we get to the Q&A, to go now from the creators of these securities to the buyers of the securities and get to the underlying premise of your book of the role of emerging economies, what's going to happen with sovereign wealth funds, their attitudes, their investments? How are countries going to invest inside, given all the things that are going on? What's your view on --
WOLF: Well, let me -- what will happen --
MODERATOR: What will their role be in this crisis?
WOLF: Yeah.
MODERATOR: Not just tomorrow, but in the near term?
WOLF: Sovereign funds are big and getting bigger, and you should regard, I think, a large part of the foreign currency reserves of the world as more or less part of this in the sense that they are in excess to short- to medium-term insurance requirements. The foreign currency reserves of the world at the moment are about $7 trillion, which is quite an impressive sum, and as I've joked frequently, the largest foreign aid program in the history of the world since it predominantly went into U.S. liabilities. And over and above that there are sovereign funds which don't appear as foreign currency reserves, particularly in the Gulf States where the aggregate is about $10 trillion. These are enormous, much larger than hedge funds or private equity funds and so forth, and they are not, I think, going to go away, unless you believe the oil price is going to collapse to $20. It doesn't seem very plausible to me unless we have a true depression.
So there is a very big question about how are they going to use this money? They have a tremendous problem, and it is very relevant to the theme of my book: If you're going to invest that sort of money, doing it in other emerging economies is basically impossible. The markets aren't big enough, deep enough, liquid enough. The openness to that scale of foreign investment isn't there. And so they have tended to get driven into investing in the developed world because that's where the capital markets are.
At the same time, of course, as you know, recent experience of sovereign wealth funds of investing in the banking system of the West has not been entirely happy. That's a very gentle way of putting it. They've got creamed and confidence has clearly been shattered -- broken by that, and it's quite clear that they're very concerned now about what they're getting into, so I don't think they're going to play any useful role in helping with this crisis anymore, at least until it's well over. But in the end they are going to have to invest in developed countries, I think, if they've got the sort of scale of money.
My optimistic view, which is clearly implicit in the end of my book, is that -- I have a basic, fundamental view that it makes sense for the huge surplus savings to go into investment, not consumer debt, and the investment should go into countries with the best opportunities, so they should go into emerging economies, which should of course be running some sorts of current account deficits to absorb them. That, as I've stressed, requires -- and this applies just as much to sovereign wealth funds as it does to private investors -- it requires enormous changes in attitude, institutions and so forth in the emerging world, particularly in very big -- particular in China. I think India actually is going to be a relatively straightforward proposition in comparison.
But we are not -- I mean, you can ask where should all the Gulf money go? In theory, from an economics point of view, it should be going to Asia; it shouldn't be coming to us because we can't absorb it. One of the most interesting -- and I do make this point in the book -- I think one of the most interesting meta facts about the developed world -- and I think, to my mind, it's a very significant factor in the conditions that created the crisis -- is that the corporate sectors, the non-financial corporate sectors of nearly all significant developed countries, are now, on trend, cash surplus. Their retained earnings are higher than their investment. They don't need to obtain funds from the financial markets. That's one of the reasons why the financial markets have had to find so many clever ways of getting money to households, in my view. That's not true for all companies but it's true for them overall. And I don't see how that can change.
We are mature, relatively rich countries with slowly growing, or in many cases declining, populations. There is no need for a huge investment boom in our countries. We can't, therefore, satisfactorily absorb these excess savings. The countries that can are all over the emerging world, and so the big challenge of -- where my book ends up -- and I would stress it's still relevant -- is how do we create the monetary, financial and other conditions in which capital from the countries we are talking about ends up in the emerging world rather than in our world because, truthfully -- and I think this crisis demonstrates that -- we can't absorb this money productively.
MODERATOR: It's true that money market funds in the middle of this crisis went from $2.5 trillion to $3.7 trillion in this country, just to talk about liquidity.
WOLF: Yes, that's right.
MODERATOR: There would be much more to talk about, but now is the time to switch to the audience. I think you're all familiar with the way we like to do it. When you ask a question could you please stand and identify yourself and your organization? We're going to limit each questioner to one question. I hope we can have the questions be consistent with the track we're going down here.
You ready, Martin, for this?
WOLF: Yeah.
MODERATOR: We'll get you a mike and get started here.
QUESTIONER: Richard Gardner, Columbia University. If the United States, as you have predicted, will now run huge fiscal deficits and easy money, what's the future of the dollar as an international reserve asset?
WOLF: Obviously a very good question. When I look back at -- I always am interested in the mistakes I make, and probably everybody is. Fortunately my mistakes aren't as costly -- that's the nice thing about being a responsible journalist. This book was written in the view, which was absolutely standard, that there were two, quote, unquote -- I mean, I don't want to use this is any pejorative -- "imbalances" associated with the import of capital from the United States. There was an external one, the accumulation of current account deficits and net liabilities and the rest of it, and an internal one; that is to say, by definition, if a country is spending roughly 8 percent more than its income, there must be sectors within the economy doing the same thing. And I analyzed the latter particularly because it's something the American economists don't seem to be so interested in, never were very interested in.
And I pointed out -- which has been very tedious but, again, what was so interesting about it is that the principal counterpart for most of this period was the household deficit, which was interesting because that's not the situation the U.S. household sector has normally been in. But nonetheless, I, along with most economists, though that the external side -- namely the dollar -- would become a really big issue. But of course there was a huge debate on this, and there's a whole chapter which deals with this question.
Now, what is -- two things one can say about this: The dollar has experienced over the last six years, I think, a very, very steep decline, and if you look at the real trade-weighted exchange rate, say the JP Morgan calculation, even with the recent blip up it is basically as low as it's ever been. So there has been a huge depreciation. Two, that has been sensationally good for the U.S. net liability position, and that's an important point. The U.S. net liability position is less than 20 percent of GDP, and if you just accumulated U.S. current account deficits, which would imply nothing more than that, it would be now already about 50 percent of GDP, which is a large number for such a big country.
There are many reasons for the differences, some of them statistical, which I'm not going to go into which I discuss in the book, but the main reason -- the single biggest reason is the devaluation of the dollar. In other words, the U.S. has been engaged in a very successful, very well-managed default, okay? There's been quite -- that's what's happened. And the result of that of course is if you look at it from the point of view of the reserve holders and you look at the interest rates they've been getting on T-bills, they've been having very significant negative real returns. So this has not been a great investment for them.
Now, the question -- the reason I put this background in, is there a point at which they say, enough already, and dump this? And my conclusion, which is not what I thought a year or two ago, is it seems extremely unlikely, but there's one circumstance in which I think that would change. It's unlikely I think because they don't really have satisfactory alternatives other than the euro, which they clearly have been shifting into because we've seen the exchange rate, but there really aren't satisfactory alternatives. So I think the U.S. may well get away with its default, and it can continue, as the Fed has been doing, to ignore entirely the issue of the international holdings.
There is a qualification to this, and I think it will work out, but it is a risk. There is clearly going to be a very large increase in the visible vet of the United States because of these operations and because of the deficits. I will be extremely surprised -- and somebody can come back and shoot me about this five years from now -- if four or five years from now the U.S. government's combined government's debt-to-GDP ratio didn't look at a bit like Italy's, about 100 percent. It's already well over 60. Certainly 80 or 90 seems to me quite plausible.
Is this a level at which people will really start getting frightened about the solvency of the United States? I suspect not, but if in that circumstances you elect a president who decides to cut all the tax rates you might. So the only point I would make is this is a situation in which the vulnerability of the United States is increasing -- it's clearly increasing -- but it is probably, given the lack of alternatives and assuming that the U.S. has a credible plan for reducing deficits subsequently in the recovery, when it happens, it will probably get away with it. And I think that remains the most encouraging feature of the whole situation. There has been no dollar panic at all. It's just been -- it has remained the reserve currency of choice more or less, and I suspect now that that will probably last.
MODERATOR: All right. Yes, second row. And then I'm going to take one question from our national members after this.
QUESTIONER: Jacob Franken (sp). First, I fully agree with you about the fact that the story did not start with the subprime but rather with a long-term deficit, et cetera, but I can also tell you, as you know, that there is absolutely no recognition of this fact in the policy arena and everyone thinks of it as a financial crisis.
WOLF: That's why I wrote the book.
QUESTIONER: I understand, but it's the reality.
WOLF: Are you (going to ?) publicize your thesis?
QUESTIONER: Number one. Number two -- and that's really related to your remarks -- if you look at the balance sheet of the Fed, or for that matter of the combined government, a Martian coming down to Earth will never believe that that's what he sees, and the changes during the past month have been so dramatic and they are coming more, and more and more assets and types of assets that were never there. I understand that that's what is to be done during a fire that you have to extinguish. If you had to reflect about an exit strategy, namely how does the balance sheet of the Fed and of the public sector come back to a normal balance sheet that you would like to see -- how many years, what needs to be done, what announcements, what clarity?
And related to it, Lehman -- you mentioned Lehman, can you reflect a little bit how the world would have been different, and if there is a mistake, is it fully recognized and internalized?
MODERATOR: See if you can do that in about one or two minutes. (Laughter.)
WOLF: Okay. Well, my views on Lehman now are conventional. They weren't the view used at the time -- I knew really nothing about this and I didn't claim to. I wasn't involved in these discussions, but clearly in retrospect it was a catastrophic mistake, and I don't think anybody can really deny that unless you -- no, I said there are -- I still get lots and lots of e-mails from the liquidationist school, basically says the U.S. deserves the depression it's going to have, and it should have it. And so I think you have right views, and obviously all the interventions by the government were a mistake. And it's a completely consistent libertarian position; it doesn't happen to be mine.
The balance sheet of the Fed, well, you're right; it's unbelievable and it's going to get more unbelievable because the Fed has in fact taken over a very significant part of the intermediation function of the financial system, and that's what happens when the financial system has a heart attack. My memory -- but somebody may correct me -- is that the Bank of Japan was pushed in some degree in the same direction, though it resisted it manfully.
How do you get out of it? Well, you need the economy to recover within a whole range of measures which are -- as we go through this mess at some point house prices will bottom out, oil prices are falling. That will be very helpful. Monetary policy will continue to be eased, though its effects will be limited, and normal prices in capitalist economies will generate recoveries. In addition, you will hope -- and this is a more disturbing thing -- that a more capitalized financial system will emerge, people will begin to see huge opportunities in restarting intermediation because so many assets will be so cheap, and the financial system will reemerge, and though it looks to me increasingly like as though it will be a bank-based megabank sort of system. And when you've got the two together, a reasonably well capitalized and robust financial system and a recovering economy, the Fed, I presume, will be very happy to resell all these assets back into the market and over time it will get rid of them.
If you look at other comparable exercises -- and nothing can ever be comparable with what happens in the U.S. because of its scale, but if you look at the Swedish example to know a little bit about -- where the processes are very similar, if my memory is correct -- and somebody can -- they managed to sort of dispose of the assets over about five or six years. So I would assume that five or six years from now the Fed will no longer be a huge commercial bank and the assets will be back in the private sector, though a very different private sector from the one we have. That's the optimistic view and it's the only sensible view, and one has to assume that's what's going to happen. Otherwise we have much bigger problems than just this. It will mean the U.S. economy is flat on its back.
MODERATOR: Well, maybe this is good for a question from the national members: Is the United States entering a lost decade like that of Japan in the '90s after the end of its real estate bubble -- a decade-long slump where even zero interest rates and massive public works projects could not revive the economy?
WOLF: If I had been asked this question three months ago my answer would have been an unambiguous no. I'm not quite so sure now.
MODERATOR: Why?
WOLF: I tend to think that the recovery process will be long because there are some very big -- I believe the household savings rate will rise, the financial -- the housing sector will be moved into surplus, the corporate sector will remain in surplus, and that means the U.S., in balance, must reduce dramatically its current account deficit. That must mean for its recovery, because it's so big, a very strong external demand, and we're not going to get that for a while. People outside in the rest of the world are really going to have to get used to the idea that U.S. demand is not going to be the engine, so they're going to really have to change what they're doing. That will take a while to think about.
But I do think they have a few -- the U.S. has a few advantages: Its saving surplus is very small compared to Japan; the asset price collapse is going to be much smaller. I mean, it's worth remembering land -- I mean, if you add land -- I mean, this is very rough and ready, but roughly speaking, nominal asset prices in Japan -- I'll leave aside real prices because in fact they're worse, but nominal asset prices fell about 70 percent across the board -- equities, housing. I mean, the truth is that Japan got through this with nothing much worse than stagnation in 10 or less years, one of the greatest miracles in macroeconomic history. It ought to have had the biggest depression imaginable. It's quite an achievement, and they did it because they were a surplus country. But the U.S. won't have that sort of collapse unless something horrendous happens. I don't see asset prices, either equities or land prices, anything like that overvalued, and so I don't see why that should be anything like that scale.
The thing that does worry me a bit more is the international side is more difficult for an economy of this scale to -- you know, export-led growth is mostly what's keeping the U.S. going at the moment, as I'm sure you know, and this is a very big economy to run on export-led growth. But I expect the U.S. to get through this in three or four years and to be back to its vigorous best, but I really don't see how people can imagine the U.S. will be back to normal by 2009 or -- or never mind, even by 2010. It will be a longish process because there are big corrections going underway, but I really can't see the circumstances as bad as Japan.
And anyway, quite apart from that -- I know this is a lengthy answer, but the action finally -- finally the U.S. policymakers are seized of the moment fully. The Republican administration has done things I could not imagine a Republican administration doing, and I think it's just the start.
MODERATOR: I think that's right. You had a question, in the row back there, and then over there.
QUESTIONER: Daniel Wagner from GE. There are a variety of theories, economic theories, about what went right and what went wrong in the Depression. The Bernanke view obviously is that interventionism wasn't done enough. Just curious what your view is there and whether you subscribe to the Jim Rogers view that those companies that should fail should fail, and whoever is left standing should pick them up and we should start over again.
WOLF: Yeah, well, that's the liquidationist theory.
MODERATOR: Yeah, lifting duds.
WOLF: What is one of the most fascinating things about our time is we're rerunning the debates of the '30s. We've not got quite as high an intellectual level, it may be said, when you think of who -- (laughter) -- the protagonist -- I mean, the debate you describe was a debate between Hayek and Keynes, and then Fisher added in brilliant and incredibly important insight much too little ignored and -- much too much ignored until the 1990s in Japan of debt deflation. Hayek basically said this was the result of excesses when -- a long period when the interest rate was kept below the natural rate -- familiar, right? -- in the '20s, and all these excesses have to be eliminated and then we'll have a recovery. And this is essentially the liquidationist school.
And of course in the -- if you imagine a completely hands-off government, you let the banking system disappear, sound banks will emerge -- which they will in the end -- every business that is bad will go, and of course with it will go all the good businesses that sell to it, and the excesses should be purged. And Keynes's view, which I share -- which is probably the British corruption -- though I'm very sympathetic to Hayek in many ways, is you really can't tell ordinary people in a democracy that a depression is good for them. So, strangely enough, they're going to elect a politician who doesn't think that. (Laughter.) So my answer to Mr. Rogers is, get elected president.
The truth is it's an irrelevant question. You have to let the really bad stuff go, and a hell of a lot of bad stuff has gone. Most of the financial sector that existed a year or two ago won't be around. A lot of other businesses won't go, but actually the government, in my view, is the ultimate insurance agent for society. One of its functions in the modern era is to prevent depressions, and they're not necessary, in my view, anymore than people dying of bubonic plague is necessary, so I don't agree with Mr. Rogers. And anyway, he has to get elected.
MODERATOR: Sir?
QUESTIONER: (Inaudible) -- JP Morgan. Martin, thanks for your remarks. You mentioned that in the next coming years we're probably going to see a step up in regulation around the world, you know, trying to prevent the repeat of the problems of recent times. Are you fearful that actually there may be overregulation in the coming years, that NSPs (ph) are basically killing financial innovation, constraining credit supply, and in the end, in the next stage, we end up with lower growth? And if so, do you think that that's a bad thing given the need to reduce the global imbalances that you also refer to?
WOLF: I'm sure we're going to end up with overregulation. We'll end up with failed regulation. Intermediation is going to be considerably more expensive for quite a while, for a whole host of reasons, and it's going to be rather unpleasant. I spoke to somebody very senior yesterday in the financial industry who said that essentially we're making a choice -- and I think he was referring to the U.S. but not just the U.S. -- of stability over growth. How much growth will be sacrificed? How successful will it be on the stability side will not be clear, but I think that's clearly in the instinct.
The simple truth is policymakers know -- but I think, even more importantly, the people who run the institutions know they really can't do this again in a hurry. Actually I don't think the dangers are very great. I mean, I imagine -- I haven't worked in these institutions -- that it will be engraved on the heart of everybody working in these institutions, from a 20-year-old upwards, that you really don't wan to go there. It's very unpleasant. That means the management of these institutions for the next 25 years will be these people, and they will be very cautious.
So I do agree that regulation will probably be redundant. Excessive regulation may well be redundant. The really big point is that we're going to have much more cautious financial systems because of this shattering experience, and the regulation pendulum will swing far too far on the opposite side, and I suspect there's nothing we can do about that except argue on specific cases as it goes along.
In the world as a whole where the intermediation process is still very primitive, what worries me particularly is that some of the worst aspects of unreformed financial systems -- say in China for example -- will remain like this because people will say liberalization is too dangerous. I don't think the consequences for us are going to be that serious. It's not going to disappear. Basic intermediation functions will continue in developed countries, but I think for the developing world, the consequence of extreme caution may well turn out to be very unfortunate, but I think it's a consequence of this breakdown because nobody anymore has the moral or intellectual authority to say, this is how you do it because it works. That's what we said three years ago. Now it's a joke.
MODERATOR: We have time for one more question. There was someone in the back, but if not, right there. And I have a closing question for you.
QUESTIONER: Herbert Levin. What role do you see for the existing international financial institutions, as distinct from these financial fire brigades that are summoned?
WOLF: I'll presume for the moment -- I'll just talk about the IMF if I may. I don't want to get into the BIS because it takes too much time. I think the IMF has two roles in this crisis. First, it's going to do a lot of crisis lending again. There are lots of emerging economies, fortunately most of them small, which are already sucking from very -- which do have current account deficits to finance, which are losing trade finance, but basically they've been cut off like everybody else, and they're going to have to be financed in the intermediate period by the IMF, so IMF lending is clearly going to increase. I think they're very clear about that, and one of the encouraging things is they're very clear that this is going to be very, very low conditionality lending, as it should be in this circumstance.
That's exactly what the IMF should be doing. One of my views in my book is actually the -- I know this is a controversial view, but I think the IMF has become far too small as a financial institution. Its total assets are smaller than the foreign currency reserves of about six or seven emerging countries. Its total lendable assets are about a sixth of China's reserves alone. It's just too small, but we're going to have a lot of emerging countries in terrible distress in the next year or two as a result of these shocks, and they're going to have to deal with that.
The second side is the IMF remains a repository of, substantially, information and knowledge, not least on reconstructing past financial systems. And as they happily told me when I was there, you know, we didn't know several months ago what they were going to have to do, but nobody came to ask us. So I think they remain a moderately useful source of advice. There's a public good of surveyance; there's a public good of external advice. There is a tendency in developed countries to assume we can't learn from the experience or anybody else. That's a mistake because we've stumbled into the right position after trying all the alternatives, as it were, and much of this information was available.
But that is, I think, all the IMF can do, but I do think actually it needs more resources, and of course its government structure has to be changed in the process, but everybody knows that.
MODERATOR: We've only got about two more minutes; then we can close with this question --
WOLF: Okay.
MODERATOR: -- Ben Bernanke is going to be in New York today speaking at the Economic Club.
WOLF: Poor man.
WOLF: And two questions for you: How do you assess what he has done so far, and if you were up there today in the podium getting to ask the questions and provide advice, what would you say?
WOLF: I think that -- I think actually he's done rather remarkably well, and I don't -- and I'm afraid that I was wrong and he was right on something very important. It's clear -- it's absolutely clear that he missed, as almost everybody did -- there are a few very distinguished exceptions but they weren't in these sorts of positions, and wouldn't have been -- the significance of what was going on in the subprime area in the early part of 2007. There are well-known speeches of that.
In August 2007 he realized the significance of what was happening before any of the other central bank governors -- chairman governors -- it depends on the country. He acted more quickly in cutting rates, in some ways I think -- sometimes very unfortunately for these emergency rates, but he responded fairly quickly. He's been unbelievably -- one might say incredibly imaginative about use of the Fed's resources and balance sheet. At various stages in this I've been inclined to the view of our own governor that this is really excessively risk taking, moral hazard and all that stuff, but actually in retrospect that was clearly wrong. He understood more than we did -- perhaps because you were across the Atlantic -- just how big a mess this was, and he -- and I think a lot of the mistakes were not made by him but made in the Treasury. So I think he's done impressively well, and he's trying to stick to this very famous promise he gave to Milton Friedman -- the famous remark about the Depression: Yes, we caused it and we won't do it again. And I think he's done that.
Now, the question I would ask is I think very much what Jacob asked, is what's the end game? I mean, how do you unwind this extraordinary position the Fed has now got into, which clearly no one in the Fed wants, which has potential very significant institutional dangers, not least if the Fed ends up losing a vast amount of money and needs to be recapitalized, which seems to me a possibility. But on the whole -- I know this is a controversial view with some, but I actually think Ben Bernanke's done pretty damn well.
MODERATOR: Well, on that note we will end the meeting and thank you very much.
WOLF: Okay. (Applause.)
.STX
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