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A Conversation with Alan Greenspan

Speaker: Alan Greenspan, Former Chairman, Federal Reserve Board
Presider: Mortimer B. Zuckerman, Chairman and Editor in Chief, U.S. News & World Report; Chairman and Chief Executive Officer, Boston Properties, Inc.
September 15, 2010
Council on Foreign Relations



MORT ZUCKERMAN: Good morning, everybody. My name is Mort Zuckerman and I'm delighted to be able to be sharing a stage with Alan Greenspan, who needs no introduction. The last time I did this, which was several years ago, I remarked afterwards that was the best single lesson in economics I'd had in my entire life. So I clearly am look forward to it, and I know you all are too.

This meeting is a part of a C. Peter McColough Series on International Economics. Our next meeting in the series will take place on October the 22nd and will feature Ron Kirk.

I have to ask you all to take the -- cross the moral divide and completely turn off, not just on vibrate, your cell phones, BlackBerries and all wireless devices. I know some of you will go into shock, as did it, but try and live with it. We will have a very interesting conversation, undoubtedly.

I would like to remind the members that this meeting is on the record.

Now Alan Greenspan is seen as, as I said to him before, as being omnipotent and omniscient, so we are going to have an interesting discussion with somebody whose views remain extraordinarily important to the public dialogue on our national policy.

We have been through an extraordinary economic decline, the worst one perhaps in 50 or 60 years. We have had very, very aggressive government programs, both fiscal and monetary programs, and yet the response of the economy, two-and-a-half years into fiscal -- monetary policy -- (inaudible) -- fiscal policy has been quite limited.

So, Alan, I would like to ask you, what -- where do we go from here? What is a fiscal policy that you believe would be relevant, and what is a monetary policy that you would be -- you would think would be relevant to move this economy along?

ALAN GREENSPAN: Well, Mort, I think the first thing is to ask ourselves the question: Why, with this extraordinary surge of federal government activity, so little has come out of that? And unless you can answer that question, going forward is not something we can have any comprehension of, because unless you diagnose the problem, you're not going to get the right remedy.

And I'm increasingly of the opinion that what is happening here is that there is a connection that is increasingly credible between the issue of the amount of government stimulus -- and more, very explicitly, the size of the current deficit that exists, not over the long run, but just concurrently -- and, indeed, I'd say between that and the level of capital investment in this country.

For the statisticians who like numbers, it's a highly robust statistical relationship which sets the ratio of the deficit as a percent of GDP nine months earlier as a determinant of the level of capital investment -- investment in fixed capital, illiquid capital as a share of savings in the particular institution.

If that is accurate -- it depends, of course, on how robust it is, but also what the size of it is, and without getting through all the statistics, the numbers turn out to be that somewhere between a third and a half of the stimulus must be (debited ?) with the consequences of the rising deficit impacting on the level of non -- let's say nonfinancial corporation capital expenditures.

And if that is the case -- and, indeed, if it is the case that that measure of investment-to-savings is an excellent judge of what the degree of confidence in the system is, then the clear answer, as far as I'm concerned -- rather long, but I hope to the point -- because we have to find a way to simmer down the extent of activism that is currently going on and allow this economy to heal.

That is a very minority view in this country. I will argue that we have to let the facts show what they do. And I'm not saying that the stimulus is not working, I'm just saying it's working far less than anyone anticipates, and you can't explain the shortfall in economic activity from what we would otherwise expect it to be strictly by that relationship.

MORT ZUCKERMAN: Well, there is an argument that has been advanced recently that we will not get any kind of resurgence in the economy -- and have not -- without a preceding improvement in the housing market.

How do you anticipate that that housing market -- which has continued to plummet, where there are now 8 million homes where the equity is 5 percent or less; there are 12 million homes where the mortgages exceed the value of the equity -- how do we sort of -- and there has been, in a sense, an unbelievably limited response, in terms of housing, to the lowest interest rates -- the first time that, when interest rates have gone down, that housing sales have also gone down.

And when you multiply housing prices by the finance -- which takes up roughly 15 percent of family income compared to the conventional standard of 25 percent, which people have felt that they could afford. How do you deal with that particular issue of the economy, for example, if you're going to have that as a condition to a turnaround?

GREENSPAN: Mort, that's a very important issue, and I would say a necessary condition that we recover out of this without too much further damage is that home prices do not take a dip downward.

First, I think it's important to go back and ask ourselves what's causing the inability of all the government programs to work. And no matter how you look at the -- even with the 8 percent subsidy on home purchases, it didn't increase the net amount. I mean, it moved purchases --

(Cross talk.)

GREENSPAN: -- but remember that you cannot get an increase in housing unless you either get an increase in household formation or you get an increase in conversions -- or, I should say, a decrease in conversions, an increase in demolitions. In other words, there are a certain number of people in this society which must be housed. They either will be in rentals or they'll be in homes. And you can move things around all you want, you're not going to avoid that particular requirement.

And what the data show is after a dramatic rise in homeownership, in which 100 percent of household formation went into owned or occupied homes -- mainly single family, which, of course, is the cause of the huge boom in construction -- that stopped about 2005, 2006 and has since gone into reverse, so that we're actually losing a number of -- a number of homeowners. And as a consequence, we're getting housing starts for single-family dwellings down to unbelievable levels between 500,000 annual rate, which is barely the amount of demolitions that go on in the country.

I think that until we unload a very large amount of single-family homes for sale which are vacant -- these are largely held by investors and, fortunately for us, there is no evidence that they're trying to unload these, because were they to do that, prices would be under real downward pressure. But they're not doing that.

But nonetheless there's this big overhang of unsold homes on the market, and until we absorb that, there's no real solution to the recovery. And the way you absorb it, basically, is very low construction levels -- in fact, the lower the better, statistically -- and allow the normal increase in the labor force, and therefore in household formation, to absorb the excess.

That's actually going on. I mean, it's not as though we're stagnant. We are reducing this overhang. But it's going to take a year or so to get rid of it. I thought we'd be able to get rid of it a lot faster than we are doing it.

MORT ZUCKERMAN: Well, even a year seems to be optimistic given the amount of supply --

GREENSPAN: Yeah. Well, I --

MORT ZUCKERMAN: -- that is available in the house -- in the shadow inventory.

GREENSPAN: Yeah, I agree with that. But if you begin to get the prices continuing to stabilize, then the shadow inventory will gradually disappear because we are beginning to see foreclosure "starts," so to speak, peaking out at a very high level, but the real estate owned by the financial institutions is horrendous. And that stuff still has to feed into the market.

But it's been doing that for awhile and prices have sort of stabilized where they are. And if prices can hold -- and I'm not sure about that, I think they can, but it'll be -- a lot of forecasting they're going down, if prices can hold, we will gradually eliminate the shadow inventory and we'll turn it around. But I agree with you, it's a very critically important issue and, as you say, a year is a long time.

But I'd like to raise one problem that disturbs me more than anything else. In 2005 and 2006, there was about 8 million homes purchased with so-called conventional conforming mortgages -- you know, 20 percent down and the like. That's a very big chunk for the housing market. The home equity of that 20 percent downpayment is now gone.

So we've got a lot of conventional halt (ph) financed homes, as you put it, sitting right on the edge of going under water. Fortunately, they don't default very quickly, but -- (inaudible) -- there long enough, as you know far better than I, here they do.

MORT ZUCKERMAN: There are a lot of "strategic defaults," as they call it --

GREENSPAN: (Laughs.) Right.

MORT ZUCKERMAN: -- where people are basically not paying their mortgage payments. And the lenders are not foreclosing on them because they don't want to take on the home -- they'd have to show the losses on their books; and they don't want to maintain the homes. And if you have a vacant home, the value of that home drops anywhere from 5 (percent) to 10 percent as soon as it's empty.

But at some point there's going to have to be some sort of "moment of truth" here, where you have literally several million homes in this --

GREENSPAN: Getting assisted -- isn't it free rent?

MORT ZUCKERMAN: Yes, it's exactly -- it's what enables them to pay down their credit-card obligations. (Laughter.) And that's what's been going on. But sooner or later there is going to be some movement on that issue, and that's one of the great vulnerabilities.

The one thing, of course, that would save it would be an improvement in employment. I mean, in once sense, jobs really will help out the housing industry. And that's another area where we have seen a dramatic drop, and with virtually no response to the enormous fiscal and monetary stimulus.

You can say we saved some of the jobs, but the fact is we're looking at the highest levels of unemployment and partial unemployment that we've seen really since the end of World War II. And those numbers do not seem to be getting better. So what is it that we can do, in a sense, to have that primary driver of both confidence and the ability to maintain homes and to enhance and support consumer spending?

How does that change? And is it structural or is it just cyclical?

GREENSPAN: You know, I think at the moment it's a little bit of both. But the critical problem here -- if it's a problem, is that even as the economy was growing, employment wasn't, which is another way of saying that output-per-hour was increasing. But it's very -- that very output-per-hour increases, the productivity increases.

When you look, in terms, as I mentioned before, about non-financial corporations, one of the issues here that's creating a statistical concern on my part is we're getting this huge surge in corporate profits, which is the result, basically, of an improvement in productivity and a decline in unit costs, and that is not spilling over into new investment. Instead, it is showing up as a major increase in the size of liquid assets as a share of total assets in the corporate sector, the highest level in 50 years.

It's essentially a reflection of the fact that the business community is extremely averse to the risk of investing in the long-term illiquid assets. And that is another way of saying that construction, generally, as you know, is under severe contraction basically because the higher the risk premium for long-term assets, the lower the market value of the properties. And so we're seeing that particular phenomenon basically crushing construction.

And construction has generated -- the loss in construction is the largest contributor of unemployment. I mean, if you look at the distribution of who's unemployed, what sticks out readily is the big construction-worker component. And I see -- I don't think the answer to the employment issue is to slow productivity growth. It's slowing by itself almost normally. But the answer here is to get the economy going again, and the only way I can see we can get that is to lift this pall.

Remember that we're getting all sorts of indications of what this pall is all about. For example, not only is there a contraction relative to cash flows in the issue of new fixed investment, but the nature of that investment is going increasingly to short-lived, less illiquid assets. In the sense that if you look at the ratio of equipment and software to total investment, it's going up straightaway as structures haven't even turned.

There's been a significant rise in capital investment in equipment and software, but, in total, it's nowhere near the rise required to absorb the amount of lost investment. I mean, I estimating the loss at something like $400 billion, which is not all that much different than the -- some of the estimates of the stimulus.

MORT ZUCKERMAN: We were building 1,600,000 units of housing. We're now building somewhere on the order of 4 (hundred thousand) to 500,000. Roughly, a million homes are not being built. The employment per home was generally anywhere from five to 10 people working on a home. Those jobs are simply not coming back for a good while, given what's happened to housing prices.

Now, that is a huge lump of unemployment that we're going to have a great deal of difficulty addressing. How does the government respond to that?

GREENSPAN: Well, I -- my argument at this particular stage is we'd probably be better off by doing less than more. There is an implicit judgment on the part of most economists that in order to stimulate the economy you have to do something.

But I think there's another choice here, which is -- basically gets to that old business of when you're digging a hole, sometimes you stop digging. And my view here is that I think we'd be far better off to allow the normal market forces to operate here because, one of the things that we have going for us is that the equity premium in the financial markets is at the highest level, according to JP Morgan, in a half a century. In fact, it's tracking these relationships that I've mentioned before about investment and savings.

You see the process of everything is 50 years -- the worst in 50 years at least. If you look at the study that just came out yesterday by a small -- by The National Association of Independent Businessmen, which is for small-business people, their capital investment is the lowest in the history of the survey, which goes back 35 years. We've got to get that coming back.

And to the extent that the evidence suggests that very large deficits do concurrently crowd out capital investment, there is a debit to the stimulus program which is probably somewhere between a third and a half of what the gross stimulus is. And that's where the problem is and we've got to remove that.

And I would say that because we have such a high equity premium, the upside of equity prices rising is very significant. As I've written and said for a couple years now, the most effective fiscal stimulus we could get with stimulus would be if the market value of equities rose. It does remarkable things for financial institutions and it is a very clear indicator of the impact of asset price changes on capital investment.

MORT ZUCKERMAN: Well, we had a considerable increase in equities, at least in capital stock -- stock market prices. We have not had that in the housing market. And what you are suggesting, if I understand it correctly, is to be very cautious about further fiscal stimulus. I don't know why this brings to mind the definition of a bartender who is a pharmacist with a limited inventory. (Laughter.)

I mean, we really -- we really have very few options, in a sense, at this stage of the game, given what we've been through both in fiscal policy and monetary policy, and that impulse to do something, you're suggesting, could be counterproductive.

GREENSPAN: I think that what we have to do is keep an open mind on what the facts show. I mean, this is a highly politicized and sensitive issue. I mean, for example, I've been strongly in favor of closing the deficit as quickly as we can because I think the deficit problem is a much more dangerous issue; I don't think we have time to wait.

So I'm coming out in favor, for the first time in my memory, of raising taxes. And the reason I'm doing that is essentially that I think that we're getting to the point, at this stage, that unless come to grips with the deficit problem very quickly, that we're fooling ourselves about how much time we have.

And I would love to see taxes go down. And I would hope that what we could do is, if we allow the tax cuts, the so-called "Bush tax cuts" all to lapse -- as they will, of course, legally on December the 31st, and then gradually bring the level of expenditures down, which is just -- it's not a question of affordability if we are committing more in the way of real resources in the public sector than we have.

And unless we start to do that, and then bring taxes down -- or, the way I put it, we should not have tax cuts with borrowed money, but we should have tax cuts. And the more, as far as I'm concerned, the better, but only in the context of bringing the deficit down because, unless we do that, I think we have very grave problems ahead and none of the issues we're discussing this morning will get solved.

MORT ZUCKERMAN: There's a widespread feeling in the business community of a lack of confidence in this administration. It really does have an effect on the decisionmaking process. I mean, in part, I guess because the economic consequences of the fiscal stimulus and the monetary stimulus have been so limited, there is a -- and there is a sense that these issues get politicized.

What would you recommend, just on the intangible level of confidence, how would you suggest an administration sort of rebuild that confidence in the business community?

GREENSPAN: Well, I think that -- I think this president can do that. I think he is, very clearly, highly intelligent, as best I can judge, and he understands the issues. And I think that, politically, obviously, it's very difficult for him to turn. But I think it's feasible. In fact, I think it's necessary.

MORT ZUCKERMAN: Well, one of the issues that we have in this country is certainly that intellectual capital is at least as important as financial capital in a world of very rapidly changing technology. We have reduced the number of H1B visas from 95 -- 195,000 in the year 2000 down to 65,000 today.

Now, we are sending -- roughly, 50 percent of the graduate students, M.A.s and Ph.D.s in the hard sciences, are foreign students. Other countries are going around setting up offices around the world to recruit these people. We're sending them back to their home countries, where they can compete with us either from the countries or from companies in those countries. What should we do on something like that?

GREENSPAN: Well, I think, strangely enough, going back to your previous question, one way for the president to get started would be to press very hard to, I would say, list the H1B and require quotas; and essentially argue that anyone who gets a Ph.D. in the hard sciences gets a green card --

MORT ZUCKERMAN: Automatically.

GREENSPAN: The problem that we have is a very difficult political one. But it's not the self-evident one. It's the fact that that issue -- which I think the majority of Americans, and I think the electorate would approve of; in other words, if you don't have the skills coming through our educational system at home, you import them. And, indeed, we've seen the extraordinary proportion of entrepreneurs in Silicon Valley are foreign born.

The problem that we have is that we have two separate immigration problems. They really are distinct: One is in illegal immigration, heavily dominated by those with a high school -- less than a high school diploma; and the H1B, heavily dominated with Ph.D.s and advanced degrees, and a wide variety of skills that we need here.

These are two separate problems. And both are important, so I've argued -- I'm strongly in favor of immigration. I think that -- I don't know how you get the illegal immigrants out, but I bet you if we ever try to get them out, everyone would start screaming because nothing's going -- all the work that they do would not happen. So I would like to see us solve that problem.

But the pointed issue is that these are two separate immigration problems. We put the same name on them. They go into the same bill. And I think we have to decouple, if I may use a term everyone's using.

MORT ZUCKERMAN: There is going to be a lot pressure -- political pressure for another stimulus program. There certainly is a dialogue going on now between, is the employment structural or is it cyclical? Will a stimulus program help the employment issue?

Martin Wolf, a well-known economics writer for the Financial Times, described the last stimulus program as basically being too small, too wasteful and too ill-focused so that a lot of that stimulus was not stimulating. And, frankly, I think there was -- there were so many different programs put into that package -- the transfer payments, alternative minimum tax, things that really were not directed specifically to increasing employment.

If you had a stimulus program in a sense, almost as a political -- a part of a package that would be political, what kind of stimulus program would you recommend?

GREENSPAN: Long-term, infrastructure assets because under current conditions those are precisely the types of things which the market -- free markets will not give you because of -- the discount rates are much too high, and will remain much too high so long as there is a sense of malaise out there. So government stimulus, if it was put into the longer-term infrastructure assets would not be displacing the private sector so much, because they're already displaced in that regard.

MORT ZUCKERMAN: The other thing that we have heard sort of talked about -- at least seriously talked about is once again, having the monetary authorities look again at the issue of quantitative easing. Do you think that's appropriate in the current circumstance?

GREENSPAN: Well, I've refrained from talking about monetary policy since I left office. And I think it's -- I think I shall continue to do that.

MORT ZUCKERMAN: Well, why don't I now turn this session open to the audience and to questions from the audience. Just -- let me just read the usual things here. I'll invite members to join the conversation with their questions. Wait for the microphone, and speak directly into it. Stand, state your name and affiliation, and please limit yourself to one question -- not one speech, one question. (Laughter.) And keep it concise to allow as many members as possible to speak. Question back there.

QUESTIONER: I'm Ken Miller. I know you said that you won't comment on monetary policy, Mr. Greenspan, but could you just say in general whether a central bank is out of tools to increase the velocity of money. I mean, liquidity is just theoretical if it's part. Does a central bank have -- I mean, we now pay interest rates on deposits. And your prescription seems to be fiscal and laissez faire.

GREENSPAN: Well, let's remember what the nature of the problem that's raising the issue of quantitative easing. We have $1 trillion in depository institutions in the United States, which are so-called excess, overnight reserves, deposited at the 12 Federal Reserve Banks at 25 basis points. Federal Reserve data surveys show that there is available on a continuous basis -- because these markets continuously turn over -- commercial and industrial loans of fairly low-risks type of loans, its a term according to -- that the Fed uses which are yielding 125 to 150 basis points above what the depository institutions can get as -- at the Federal Reserve.

That means of necessity that they are foregoing that because they see credit risk. And that is an extraordinarily high risk premium for some short -- so short a timeframe of a loan. And what this implies basically is the issue I've mentioned before, namely that there is a heavy weight of uncertainty on the system such that, we are not getting the impact of the $1 trillion already on the books into the marketplace. In short, as economists like to call it, the money multiplier.

Because remember when you get excess reserves in the banking system, and the individual holders of those excess reserves start to re-lend them, there is a multiplier effect, which is showing up usually in an increase in the money supply. And until very recently, the ratio of the money supply to the so-called monetary base, which is essentially determined by the level of excess reserves, that has been at extraordinarily low levels.

In short, there's a clogging up of the system in the sense that -- and this is not true -- this is not only the United States. This is true pretty much throughout the developing world -- the developed world, I'm sorry.

And what is happening is, you're getting this huge amount of flow of central bank monies into the financial system. And it's caught, and it's just stuck there, it doesn't move. Kaines (ph) in 1936 described this process as a liquidity trap. And he described it exceptionally well.

Until you change the psychology, until you change the attitude towards risk, you will not get this system moving. And I think once it does, then we're going to find that that $1 trillion is going to begin to work very effectively in expanding commercial bank balance sheets, which as you know have been very stagnant recently. We're going to find that CNI loans, which have been coming down have just sort of bottoming, they will start to move back up. But unless and until that happens, our financial system will continue to be disabled.

MORT ZUCKERMAN: This suggests that given the lack of a sustained response to an extraordinary fiscal stimulus and monetary stimulus, that we -- and given the failure of money in a sense to -- because of confidence or what have you, that all these funds are sort of clogged up into the financial system. Are we in the midst of a modern day depression?

GREENSPAN: Well, I think the answer is no. And it's interesting that the answer is no because there is still sufficient vibrancy throughout the world that we're beginning to get the notion that we're about to get a double dip. The probability of that is clearly going down.

And one of the reasons is that the trigger of a double dip requires that something goes down. Well, our inventory accumulation is not at a level yet which suggests that a liquidation is going to create problems. You can't argue that we're going to get sharp declines in construction, which is usually what tips the thing down. You can't argue that motor vehicles are going to go through the floor, because they're already on the floor.

So what we have going for us is that the tinder for a double dip is not readily available. Now that doesn't mean it can't happen. If we get housing pricing down, then all bets are off.

MORT ZUCKERMAN: That's the biggest risk it seems --

GREENSPAN: I -- that to me --

MORT ZUCKERMAN: -- given the shadow inventory and the real inventory. And the shadow inventory will grow dramatically --

GREENSPAN: It has grown dramatically.

MORT ZUCKERMAN: Yes. There are millions of homes where people have not made any payments on their mortgages in two years. And the lenders are not throwing them out because they don't know what to do with the assets. But at some point, if you get another 5 (percent) to 10 percent drop in housing prices, that could really just transform that whole world.

GREENSPAN: I worry about that.


GREENSPAN: I'm more worried about that than I am of the double dip so to speak.

MORT ZUCKERMAN: A question back there.

QUESTIONER: Hi, I'm Lisa Chow from New York Public Radio. I just wanted to know what you think is driving gold prices to new highs -- new record highs.

GREENSPAN: Well, there are two schools of thought here. And there have been two schools of thought as long as I have been out of college, which goes back well into the last century. (Laughter.) And that is basically that gold is a supply and demand commodity, so like a whole series of commodities. And that to the extent that production goes up, prices go down. To the extent that demand for jewelry, et cetera goes up, prices go up. I don't think that's -- I don't think that's accurate.

Gold for reasons we don't fully understand is still the ultimate means of payment. And five monies have no place to go because five -- exchange rates of five currencies are a zero sum game. So if you begin to get a undermining of five currency values, you get the whole -- the whole structure go down. But the relationship between the dollar and the euro can stable, and the Yen and the Swiss franc can stabilize.

But they could all go down simultaneously. And the question is relative to what? And I think that what we are seeing is this extraordinary rise in the price of gold.

Because gold -- I've been trying to understand why gold has the fascination it has for generations. And I've come to the conclusion since -- for example, in 1944, Germany could not import anything except with gold. And when we landed in North Africa during World War II, in order to bribe the various potentates around, we needed -- only gold would do it.

In other words, it's the only means of payment which is accepted without endorsing it. The question is why human beings are so attracted to that, I've struggled with for years. I don't understand it. I've now accepted the fact that we do. (Laughter.) And once we -- once you do that, then the question is, it's the ultimate means of payment. And it is a signal that there is a problem with respect to currency markets globally. I don't think it's a serious problem unless you short gold. But it strikes me that it's the canary in the coal mine to keep an eye on.

MORT ZUCKERMAN: Another question over there in the corner.

QUESTIONER: (Off mike.) before I give you a comment on the --

GREENSPAN: Why don't you just hold for a minute to get the mike.

QUESTIONER: Okay, Elizabeth Bramwell. I wonder if you could comment on the impact of low interest rates on those who do save. And, you know, it seems to me that, you know, the housing market is affected by the fact that it's really hard to save for a downpayment if you're buying your first house. It has an enormous effect on saving for education. It has an effect on our pension funds. And, you know, to me, you know, the interest rates are artificially low.

GREENSPAN: Well, I can basically say nothing more than you've raised the issue as it should be raised. You cannot have the extraordinary amount of liquidity that we have in the system without rates doing down. And choices have got to be made because clearly you always look at low interest rates as galvanizing investment or purchasing and the like, which of course it does.

But there is double entry bookkeeping in this world. And as the other side of the transaction, you cannot have -- without extraordinary fluctuations in the profit margins of financial institutions a breaking in the tie in interest perceived or rate perceived. And the rate of payment -- the only way that I think that the restoration of interest paid on deposits would be as we unwind this extraordinary -- and I use the word advisedly.

We are still partial because financial institutions are now still partially disabled, and will continue to be disabled until we restore a level of capital in the system which enables the average lender to a depository institution to feel secure. But the capital rates that we have now are not something which would make anybody feel very comfortable with an investment.

MORT ZUCKERMAN: But how do you feel -- how do you assess the significance of the financial world -- the world of finance in the United States both as a part of our domestic economy and as a part of our competitiveness in the world?

GREENSPAN: You mean, how do I assess where we stand in terms (ph) generally?

MORT ZUCKERMAN: And how do we support the financial world in a sense as compared to what's been going on?

GREENSPAN: Well first of all, I think that one of the issues that I raised in a Brookings paper -- am I allowed to say that?

MORT ZUCKERMAN: Oh, absolutely. (Laughter.)

MORT ZUCKERMAN: Do you know what my name was before I changed it from Brookings. (Laughter.)

GREENSPAN: In the Brookings paper which I wrote and it's just been finally published, I raise a very interesting problem, which I don't know the answer to. And that's -- we have seen a very dramatic rise in the share of national incomes, going to finance and insurance. For example, in the United States, it was 2.3 percent of national income -- of I should say gross product originating in 1947. It's now up to 9 percent. And it raises the interesting question, is this extraordinary rise something that is required as the division of labor increases?

I mean, if you get the -- because remember the basic purpose of finance is to direct the scarce savings of a society into the most effective, productive goods. And there is a form of creative destruction that goes on, which you basically phase out obsolescent capital in the system. And the depreciation from that capital plus the net new savings of the community gets invested in cutting-edge technologies with high output per hour. And that's -- the increase in one and the decrease in the other, which continuously creates an increase in productivity growth, standards of living and the like.

But there is this very (gnawing ?) question. Does that increasingly complex process require an evermore, ever higher rate of value added or income originating in finance? And it is not a U.S. phenomenon, the same trend exists in of all places China. And you can't argue that the same forces are replayed (ph). It is something that is going on which we don't fully understand, but I think we need to.

And we are -- if we cut back very substantially on the extent of the intermediation in the United States, I'm a little concerned that we will find ourselves in an increasingly less competitive position. But I don't know that. In other words, I know what the data show, and what hypothesis you can make about why it's happening, but there is no direct evidence that says that ever increasing share of the gross domestic product going to finance is a necessary condition for increasing the standards of living. And the reason basically is that this trend did not exists prior to World War II. And so, it's something odd here that requires explanation.


QUESTIONER: Jacob Frank (ph) at JP Morgan. Over the weekend, the Basel Committee has issued new standards that raise significantly the minimum capital ratio that financial institutions should hold. That's intended to improve the safety and soundness of these institutions. Of course, if all banks are going to build up their capital immediately, this will create a credit crunch. Recognizing this, the Basel Committee has allowed a very long period of phasing in -- very, very, very long.

MORT ZUCKERMAN: Eight years.

QUESTIONER: In many years, indeed. And the question is what is the assessment about the forces that will actually shorten the period significantly? If I am a bank and I know that all my competitors are going to try to raise capital by the end of five years from now, I will try to beat the crowd and do it today, especially with interest rates are so low.

And I assume that they will think the same. And if all of us are doing the same, aren't we going to find ourselves creating a credit crunch just from that point, at a time where this is the least desirable part?

GREENSPAN: Jacob, I doubt it. And the reason I doubt it, is that, if that were true about the overall demand for all equity in the world, then I'd say there is an interesting problem here. But we're talking about the amount of equity in finance, not in the total system. And there is an arbitrage that goes on between equity financing in the financial system and in the non-financial system.

And the non-financial system is still sufficiently large that even if you very significantly increased the equity requirements in U.S. finance, it's a very small part of the global, non-financial equity availability. So I'm not terribly concerned about that. I do think that we need more capital because I -- you know, it's hard to realize this, but if we had adequate capital -- remember, if you have enough capital in a financial institution, by definition it cannot default. If it defaults the capital is inadequate. So if you have adequate capital, you don't have defaults, you don't have contagion. You don't have any crises that emerge as a consequence of debt.

And so the question that you've got to get to is -- the hypothetical ones, I mean -- I don't want to talk about Bear Stearns, but Bear Stearns if they had adequate capital would be thriving at this particular stage. And Lehman Brothers would still be -- and I'm seeing the two senior people of both these organizations sitting side-by-side here.

It's -- we lost two prominent institutions in this country because they ran out of capital, because all of a sudden they decided that tangible capital of 3 percent was adequate for a financial intermediary, which it is not. And so we have to build this back up, and I'm -- I think the sooner the better. And I thought the -- the nature of the regulations that were promulgated by the Basel Committee made sense to me.

And I don't think eight years is a real problem because it's inconceivable to me that we can get another type of crisis of the type that we're trying to protect against in the next eight years. We first have to go through the absolute reverse. I mean, the issue of irrational exuberance emerging in today's environment sounds like a contradiction in terms.


QUESTIONER: Pete Peterson (sp). Mr. Chairman, I think there is a tendency in some quarters to believe that the situation in Greece is unique and that one need not be particularly concerned about the future debt outlook in other countries. And yet, as you look at the factors operating -- declining birth rates, longevity, unfunded programs -- I looked recently at some projections of an official agency on future debt-to-GDP ratios in other developed countries.

And I was quite stunned, and I fully appreciate that the forecasts aren't perfect, but they are so large as a percent of GDP that as you aggregate these for the world as a whole, you're left wondering in relation to the capital pool that is available, is what is the effect of this? And what are -- and to what extent are you concerned about some kind of, what you might call a global debt crisis?

GREENSPAN: Well, Pete, that's a real serious problem. And I think it's most evident in the United States, where we talk as though -- well, let's keep the stimulus going for the next two years, then, we will address the problems. I find that extraordinarily risky as a notion.

People have to remember what happened in 1979, as you well remember. That in the summer of 1979, the 10-year Treasury note I think was yielding 7 (percent) or 8 percent and inflation was rising. But there was a general view that the United States was not an inflation prone economy. And that therefore, you could not get significant rises in inflation premiums embodied in long-term interest rates.

Within a couple of months, the rate increased by 400 basis points. The psychology broke and the illusion broke. And I think that we have got a fiscal situation sitting out there in which, if we don't curtail it sufficiently quickly, I think we're in trouble.

And I certainly will argue that if we allow the tax -- the Bush tax cuts to lapse, that there are risks out there that is unquestionably -- even with the arguments I'm making namely that there is a relationship between the deficit and the other levels of private spending. Even with that, there is a risk out there that if you allow rates to rise as much as they are going to rise automatically on tax rates -- on December the 31st, that there are risks.

But our choice is not between good and bad, it's between terrible and worse. And the issue here is we have to recognize that we cannot take the risks. I just don't visualize how we're going to get through next February's budget program, because there is no question that anybody who has looked at the data closely, as Pete I know has in very great detail. We have essentially put on the books a level of commitment to the real resources of this economy, which I don't think we physically can meet. I'm not talking about financially, forget finance.

And it's fundamentally that we do not know, and we cannot forecast what the size of Medicare is going to be. And it's -- one of the reasons is that the technology is so extraordinary and improving so rapidly, that when you put that into a fee for service, subsidized type of economic structure, it means that demand will get fulfilled irrespective of what it is. And if you end up with X percent of a GDP as medical expenditures, I guarantee you will find that X percent of total employment will be in the medical profession. And that means less to produce cars, less to produce agricultural products, less education, less everything else.

It's real resources, you don't have to get to finance, it's just the question that we have. In this country, we are at the cutting edge of productivity growth. That means we cannot increase output per hour at a rate over a protracted period by more than 3 percent, at least that's what the data show.

Since we know what the size of our labor force is, we know in general what the outer limits of the real resources of our productive system is capable of turning out. All I say is, if you look at those comparisons, we are running out of resources. And it is reflecting itself in a gradual reduction in the cushion between the public debt held -- I should say the federal debt held by the public as a share of the ultimate capacity to borrow.

That is closing, it has never closed at this rate previously. The last time we were even close to it was during World War II. But then we knew that when the war ended, the demand for the military would collapse, that the deficit would disappear and that we needn't worry about the longer term, and that's indeed exactly what happened.

That's not the case today. And unless we come to grips with this issue quite soon -- and Pete has devoted a huge amount of his time and resources to focusing on this issue, and I think that it's one of the few investments in this country which I think may start to -- which may be working at this stage.

QUESTIONER: Hi Chairman Greenspan, David Malpass with Encima Global. The yen has been strengthening, and it's gaining momentum. The Chinese are buying JGBs for example. Does that create a problem because Japan's economy is not a very productive user of that capital. So it seems like that's -- that's creating yet another pool of idle capital.

So what would you recommend to Japan? And could intervention be useful at this point -- they're discussing it.

GREENSPAN: I know they are, and I think that they stopped intervening, I think -- what was it in 2004. And I remember when they stopped intervening they were purchasing something like 50 -- I think the number was a small number, it was very large at the time, like $50 million a month or something of that.

Well in any event, there is a concern about when they -- what would happen when they stopped. And when they stopped nothing happened. And the reason is that there is a global market that arbitrages out there.

So that I think intervention is -- it never works unless you are an intervener, as I was for awhile. The way we used to intervene was to wait until a particular currency was net short, then we'd go in. And we'd look very smart.

But that was -- it was never a permanent sort of issue. Japan is a very different issue because remember that the reason the Yen is as strong as it is, the reason why you can sell JGBs for 10 years under 1 percent, is that there is this extraordinary yen bias in Japan where as you know, vast -- nobody holds JGBs outside of Japan, except in index funds. And the reason essentially is that the demand for Yen issues domestically by Japanese is so strong that it keeps the interest rates low. It keeps the exchange rate strong.

But I don't think it has a very significant international effect largely because there is still true -- there is heavy arbitrage going on between all the currencies. And there is a Japanese problem. And the Japanese problem that's going to emerge is not there yet, which is essentially when the population ages sufficiently such that their consumption rises relative to savings. And eventually, their current account surpluses turn negative. At that point, they're going to start to have to borrow in international markets at very much higher rates.

That's where the real problem, I think of the Japanese fund problems exists. And we're not there yet, we've still got a way to go. But it's something which we ought to be wary of because it's going to happen.

MORT ZUCKERMAN: Alan, we're at the end of this session. I want to ask you one last question which is, we've had the most stimulative fiscal and monetary policy to try and address the downturn in the economy, perhaps since the end of World War II. It has had much less of an effect on the performance of the economy than almost anybody expected. We had a relatively small decline in output, but a much larger decline in employment.

There is a -- just a -- at this stage of the game, no sense of any momentum in the economy really. What could we have done different? What went wrong? What lesson do we get from this really unhappy experience?

The government predicted we would stop the unemployment rate at 8 percent. We're way, way above that. I could go on and on.

GREENSPAN: Well, first of all, let me just say that as one of the things I discussed in this Brookings paper is that central bankers for the last decade or so have been aware of the possibility of a type of crisis which eventually happened. We hadn't a clue when it might happen. But that it was theoretically probable -- possible, was there.

And as I pointed out in that piece, and as I wrote -- I made a speech actually a decade ago. When that happens, you find that there is no alternative but to substitute sovereign credit for private credit to keep the financial system and intermediation going, which is a necessary condition to keep the economy going.

So I was very strongly in favor of, quote, "the bailout," because I think the act -- TARP actually was very effective in maintaining a degree of intermediation, which we would not have had. And the Fed supporting the commercial paper market, and money market mutual funds. These were all crucial actions to stabilize what is essentially a once in a 100 year -- as I put it, once in a 100-year flood.

And you have to do that, and I think it worked. And I think it was very useful. I think to extend beyond that has, certainly in retrospect, not been a very useful endeavor.

MORT ZUCKERMAN: Well I thank you on behalf of everybody as always. (Applause.) That was great, Alan.






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