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Global Economic Trends: Lessons Of The Financial Crisis

Speaker: Martin Wolf, Distinguished Visiting Fellow for International Economics, Council on Foreign Relations
Presider: Barbara Matthews, Managing Director, BCM International Regulatory Analytics
March 27, 2009
Council on Foreign Relations

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BARBARA MATTHEWS: Well, if I could please ask everyone to settle down. I apologize for interrupting interesting conversations, but we will get started, because -- we will get started on time, because we will end on time. And we don't want to run out of the opportunity for people to ask very good questions.

And so with a little bit of housekeeping first: My name is Barbara Matthews. I'm here to -- pretty much to interview a journalist for the first 30 minutes of the session, which is something that of course, one takes with a certain amount of humility and trepidation when that journalist happens to be the distinguished Martin Wolf.

First, some basic housekeeping -- those of you who come to the council regularly know this -- but please turn off your phones. They interfere with the audio system. And as a reminder, this particular meeting is on-the-record. So in the event you ask a question, you can expect your question, your attribution, your name also to also to appear if it ends up quoted.

With that, we'll start the session. Obviously, we're meeting at a profoundly normative moment both in foreign relations and in international economics relations a few short days before the G-20 leaders convene in London. And the challenges that they face and that we face together, before our economies and societies, are awful and great.

In addition to the stunning complexity of the challenges at hand -- both in economics and in finance -- our elected leaders face very serious about how our economics systems have been functioning or not functioning, as the case might be.

At a core level, I think we're looking at how credit is mobilized in our financial system. Traditionally we financed innovation and economic activity -- job creation -- by mobilizing deposits into lending. Over the last 20 to 25 years, the security markets have become a much more important force in mobilizing capital toward productive activity -- something that has been very, very complex, done at a global level.

And at every step along the way, those of us who read Martin Wolf's column on Wednesdays in The Financial Times have someone to guide us through the globalization process, the financial process, the economic imbalances, the global imbalances that have occurred. And we're fortunate today to have some time with Martin to think through some of those issues in person.

And so from that perspective, welcome to you and let's just dig right in.

Let's start with global imbalances. Now, you have written for years about global imbalances, as has the G-7 and most recently, of course, the council chimed in, also talking about the importance of the global imbalances issues -- finding a solution for it. However, as the council report also notes, it's very difficult to get sovereign states to make domestic political decisions that would be very painful at home.

Is this a failure -- are we witnessing a failure of the IMF and the G-7 processes now, since we meet global imbalances problems -- whether we're talking about domestic demand in China, whether we're talking about more flexible labor markets in Europe and whether we're talking about the same situation here in the United States? You know, I'm not seeing any movement on any of those fronts -- except possibly savings in the United States and that's not really helpful right now.

Has the G-7 failed? Has the IMF failed?

MARTIN WOLF: Well, let's first of all, go back to the beginning on this issue on which I've been -- I should say boring for Britain -- perhaps that's a "Briticism" for many years now -- for eight or nine years -- and I still regard as a major contributory macro economic cause of this crisis.

It is important to remember that the issue, which is essentially about how demand and supply are balanced across a whole global economic system when many countries -- possibly for very good reasons -- de facto, or actually as a matter of deliberate policy --(inaudible) -- was an issue that greatly that greatly concerned John Maynard Keynes in the creation of the Bretton Woods system. Since we're talking about the IMF, it's a natural thing to remember that, because that's what led to the IMF.

He, of course, suggested to the Americans that there should be some sort of automatic system for rectifying this problem. And inevitably, the Americans -- then the world's largest surplus country -- said, "Get lost". And so I feel the Americans have sort of got hoisted by their own petard.

Anyway, the system never has had a way of dealing with this problem. In fact, I like to joke that there are classes of economies over which the IMF never has any influence. One is surplus countries in general and the other is a class of one -- namely, the United States. And therefore -- whether it's in surplus or deficit -- therefore it's completely predictably that a set of vast surpluses, which are counterbalanced predominately by U.S. deficit, will be utterly outside the IMF's control, influence, purview. They could write whatever they like, it would make absolutely not difference and it hasn't. So all you could do is -- (inaudible). That's what happened as far as this is concerned.

The second point I'd make is that -- and it is a theme of my book -- that there were very, very good reasons -- particularly for the emerging economies involved in this -- to move from allowing large current account deficits -- which many of them experimented with, as it were, in the '80s and '90s -- to move away towards their subsequent policies of extreme macroeconomic caution, accumulation of reserves and all the rest of it.

An essential reason was very simple -- and we're seeing a wonderful example at the moment -- that any emerging economies that have borrowed very large sums of money over long periods -- pretty well without exception -- and I stress borrow, rather than taking foreign-direct investment -- have ended up with very large financial crises -- very large macro crisis, and the pivotal one was the Asian financial crisis. And after that, basically all but one region of the emerging world decided not to pursue that path.

The one exception, of course, is Central Eastern Europe, which trusted very strongly in the principle of openness of Europe, the integration of Europe and all the rest of it. Poor fools! So they are now getting swallowed in the same way.

And my argument has been -- I'm trying -- (inaudible) -- into this and I'll just conclude it: that the U.S. quite naturally emerged being the sovereign country with the most desirable currency and one or two other countries with reasonably desirable currencies they could borrow and merge as the deficit countries in the global balance -- the macro balance -- the U.K. helped; Australia; Spain, within the euro zone; but principally the U.S.

And of course, the other point is that if you look inside the U.S., the deficit entities with the government and households -- and we know what the household deficits was fueled by and where we are as a result.

So the answer is we couldn't solve it through the international system. We didn't solve it. In fact, we sold it so badly that in fact, the problem became much, much worst than it's ever been in this decade and that's where we are now.

MATTHEWS: And where are we going?

WOLF: Well, I think that -- okay, that's the second question: Where does this lead from now? I've actually talked about this, this few days.

It seems to be reasonably clear what's going on now is those problems are not going to be resolved at all. That is to say, while there is a global push for demand expansion and all countries with any degree of room for maneuver are now trying reasonably expansionary fiscal and monetary policies. They vary.

It is absolutely clear that what is not going to happen is that the expansionary policies on the demand side will be bigger in surplus countries that they will be in deficit countries -- far from it -- or at least the big deficit country, the U.S. And they certainly won't be so large, relative to potential output that underlie structural surpluses will diminish. Japan's surplus is collapsing at the moment, because everything's collapsing in Japan. Nobody knows what the structural surplus will look like at the end of this, but I expect it will remain very large.

So my view of the future is the U.S. is going to borrow like crazy. The fiscal deficit is exploding. It will be more structural than cyclical. That is to say it will be set up by this general environment. And what's going to happen in probability is that the U.S. government will replace U.S. households and the U.S. corporate sector as the borrower and you will see the same pattern of global macroeconomics, but with a long -- very long run of now completely unexpected fiscal (development ?) -- much less unexpected than they were.

One thing I can say with confidence -- because I have for several years been saying -- when the housing bust occurred, the U.S. will end up with fiscal deficits with at least 10 percent of GDP structurally and that is exactly where it is. And I can't see anything to change that. So the concern I would have from the U.S. perspective is that after private -- the household sector spent itself into bankruptcy, in sustaining the system it will now be the government that will do so.

Fortunately, the U.S. government's credit is very good and it will therefore be able to sustain itself like this in my view probably for quite a long time, but it's a very, very uncomfortable path. And the end game -- if there is an end game of nightmare proportions -- is one in which -- it's the sovereign credit that comes into question and that seems to be where we go next at the macroeconomic level.

MATTHEWS: Why don't we talk about the credit markets.

WOLF: (Inaudible.)

MATTHEWS: I know there will be more follow-up questions on that score. We have a very distinguished audience and I know some of them already are lining up to ask you follow-up questions.

WOLF: Tell me why I'm wrong. I do hope I'm wrong on this!

MATTHEWS: In an effort to cover a broad terrain, then, why don't we just shift to the credit markets. And for those of you that wanted to ask a follow-up question on those very dire -- but I think probably accurate -- predictions, think about them now.

The credit markets: Obviously, a lot of ink has been spilled on banking and on securitization and mortgages and for a lot of good reasons. It's for a lot of the personal pain that's felt in the economy.

I thought it might be helpful to focus a little bit on the other parts of the credit markets that have experienced a great deal of pain, have been frozen for quite some time and that tend to be underappreciated and that's in the other places where credit is traded in our economy. So it's not just securitization, it's not just credit default swaps -- as you know. It's also the money market mutual funds, which lent money to the corporate sector -- underappreciated to the tune of about $2 trillion, half of which tends to go to Europe -- the investors in those are in Europe -- and of course, the more traditional trade finance areas and such.

So if you look at where that is going in terms of retail money, in terms of traded credit, a very basic question comes up: Why does focusing on the banking system matter if so much of the credit in our system -- close to 80 percent of the credit in our system in the United States does not come from banks? Why do we care so much about the banks?

WOLF: I'd say the 80 percent -- it's not one I recognize. It thought it was about 50/50, but we could -- I'm not enough of an -- we'd have to go through the statistics and define it.

By the way, I fully recognize the picture, because -- and this is my stupidity -- but fortunately, I'm in the good company of the Bank of England and the FSA. We didn't realize that your money market funds, in essence, were completely destroying our housing finance system.

How did -- isn't this amazing? I'm being a bit facetious as to what actually happened, and is now is clearly exposed, but it wasn't clear to me at all at the time is that we -- Britain was a higher interest U.S., essentially. We had consistently higher interest rates than the U.S. We had a securitization process operating in our housing markets -- very similar to yours. And the predominate investors in those -- but they are a total mortgage market bubble as a result.

The dominate investors in those markets were in fact U.S. yield seekers, because the securitized assets they were getting here weren't high enough yield. So they got higher yielding British securities. That's what supported the immense expansion of the balance sheets of the former building societies like Northern Rock -- heard of that? Bradford & Bingley and all the rest of it; and then when the crisis hit in the summer of 2007, all this money went and the entire financing system imploded.

The interesting thing about that, which was clearly not appreciated by the banks, it is now quite clear to me that for all that period, higher interest rates in the U.S. -- in the U.K. were expansionary, not contractionary -- with the loan requirements for our building societies being the "indulgenous" element. So we completely messed up monetary policy, because we didn't understand what a mess this was. So you succeeded in exporting this wonderful system all over the world and we're very grateful! (Laughter.)

Now, I have been very --

MATTHEWS: There were willing buyers of those instruments --

WOLF: Well -- yet, the willing buyers were the U.S. investors. It was the U.S. investors that were the willing buyers and they all went.

But the core of the thing is it is clear in general -- in general, people thought that this was a true off balance sheet -- there were two mistakes that were made.

First, I think it is now clear that most governments didn't realize this and most commentators that I read didn't realize that this off-balance sheet system -- this -- (inaudible) -- was a fully-fledged banking system with all the attributes of a banking system -- term transformation and so forth -- with two exceptions. There was basically no capital in it and there was no regulation of it, or very little.

So it was the worst possible banking system. Of course, it evolved, because the existing banking system was regulated in the ways it was. So --

MATTHEWS: Well, it wasn't regulated as banking, but it was regulated in the securities markets --

WOLF: Yeah. But unfortunately, the banking-like elements of it weren't regulated. The fact, in other words, that when you had a run on the securities markets, it has exactly the same properties as a banking run, which is why when the money markets "broke the buck", quote-unquote, the central bank had to start treating it exactly as a banking system. And so the Federal Reserve suddenly discovered it was the central bank for everything -- not just a central bank for the banking system. That was a terrible mistake!

So the idea was -- had been that somehow this made the banking system safer and that was completely -- was utterly wrong. What was the truth is, it had made all the rest of it more like a completely unregulated banking system and that has created tremendous problems for the authorities which are ongoing.

MATTHEWS: But do you think --

WOLF: Let me just -- the second element of this, which is obviously why the banks matter, the question is, what do we do with this now?

MATTHEWS: Yes, exactly.

WOLF: Can it -- in other words, can it be resurrected or should it be resurrected?

Well, there are a number of questions. The first, obviously, if it can be resurrected, the sorts of assets that are traded in it that can in normal circumstances be valued, priced and all that. That's also obvious. We don't need to go through that. It's not very bright to create a system in which, as it turns out, the underlying assets prices -- houses -- fall, you can't trade anything. That's pretty obvious.

But the other much more important aspect of it is that it is a bank-type system and therefore it has to be treated as a bank-type system with a lender of last resort -- which the Fed is now -- and with capital requirements and all the rest of it. So it can't be allowed to operate the way it was, because we know now, it seems to me -- that's my view -- that it is a bank-like system with all the characters of a bank-like system, because all these advantages go once it starts being treated bank-like system, essentially, the advantages that there were light regulation and no capital requirements, or next to none, it's future looks to me very dire.

And that comes to the very final point: Most people -- and I think it's implicit in almost any intelligent person's view of the future of the financial system -- is bank-type systems are going to grow now and that system it going to shrink. Now, some of that might be turning that system into proper banks and some of it might be expanding banks, but the core point of it is, there's going to have to be quite a different regulatory future. But much more important -- as I think Allan Greenspan pointed out absolutely correctly this morning -- we need much more capital in the system. And it's not just -- and this is, I think, the mistake a lot of people are making -- it's not just to replace/make up for the losses that have occurred. It's because investors want much more capital in the system. And the bank-type system -- including the banks themselves -- are going to have to expand to replace these non-bank entities that are disappearing.

So my answer to you is that was just a colossal series of errors and we now have discovered what a colossal series of errors it was. And we have a number of escape routes from them, but they're all rather painful. And part of it is much more regulation, unfortunately. The Federal Reserve is now the lender of last resort for the entire lot. And we need a lot more capital in whatever it is that emerges from this.

MATTHEWS: A lot of those failures were regulatory.

WOLF: Oh, indeed!

MATTHEWS: How can we trust the regulatory system to get it right when they got a lot -- again, people talk a lot about the market failures and the frauds and that's good, but in this context, we've got to focus on the fact that there were stunning regulatory failures in Germany, in France, in England -- of course, in the United States -- and elsewhere.

How do we trust the system?

WOLF: Regulators always fail and markets always go too far. So crises will always happen. I'm pretty clear about that.

I do think crises of this scale shouldn't happen to often.

MATTHEWS: I hope not! (Laughter.)

WOLF: And that would sound pretty obvious, because this is very large. But as we've been discussing, I mean, we've had massive financial crisis across the world at the rate of about one every decade -- a banking crisis, quite apart from the hundred-or-plus more local financial crisis. So there's a very, very big issue about how we make the system work better.

I actually think that we face some rather -- I have consciously not written about regulation for a year. And the reason for this is a year ago, I thought what the answer was. My answer then was the sort of the answers we're now getting from the regulators.

If you look at what I think are the most intelligent report by an official regulator -- which is Lord Turner's -- Adair Turner report for the FSA. What he's essentially saying, which I think is very much where the intelligent regulatory community will want to go, is we regulate everything that we think is systemic. We expand this envelope all the time, because it's not statistic, because of course, regulatory arbitrage means that we constantly will find things going on outside, because they want to evade regulations. So it's not static. It covers everything and we will be more and more aggressive in the way we approach this over time. And we will regulate every aspect of the business -- capital requirements, pay structures, counter-cyclical core capital structures, reserving policies, obviously -- the whole range of things.

And we will charge for some of our services. I mean, there's a lot of discussion about -- so that's one way to go. And I think it's the way that de facto the regulatory community will want to go and that means, of course, a lot.

Why do they think that this will fix it? I think part of the answer -- and I'm not persuaded myself, but I think it has an element of truth -- what they would say -- what one might say: Yes, the regulators failed, but they didn't fail merely because they're incompetent -- while that's no doubt true, underpaid, grossly underpaid dealing with the most well-motivated and well-paid people on earth.

That's all true, but there was also, they would say -- and I think this is right -- a philosophical view. And the philosophical view was -- and it was embodied mostly clearly in Basil II, but in many other elements -- that the markets and the market players could be trusted to do things right in the interests of their own institutions and of the system. And that view was clearly embodied in the viewpoint that many very senior regulators -- not the least of which who was the chairman of the Federal Reserve Bank of the United States -- now -- Federal Reserve Board of the United States, but many other had this view.

That basically meant that whenever there was a doubt and the supervisors or regulators met the banks, the banks would say, we know what we're doing. We're very bright, very smart, very well paid, very well motivated. Go away. And if you don't go away, we'll call our friendly politician or whoever it might be. And that's exactly how it worked.

The whole culture, in other words, was against the principle of regulation. I can assure you that whatever else we'll suffer from for the next few years, that won't be the case, because politicians have been frightened out of their wits. They really don't want to wake up every morning having to pay another check of several hundred billion dollars or pounds.

So I think the whole culture will change and it's going to move from a culture in which the financial system has been given the benefit of the doubt in all respects, to a culture in which the assumption will tend to be how are you stealing from us today?

Now, that will be a big problem, because it will make life -- well, it will throttle probably a lot of very good innovation. But I think the regulatory failure was not just because these people are incompetent or regulators are incompetent, but that the whole culture of our societies -- and I was part of this, so I can take a little bit of the blame -- I never wrote, by the way, saying anything of these things, but I never wrote against them. The whole culture will change and therefore, we're going to have extremely intrusive regulations, because regulators will know that if it's on their watch that something even modestly like this happens again, they're going to be in desperate trouble. And that I think it part of the answer to what is going to happen. Not altogether very comfortable, but probably inevitable.

MATTHEWS: Well, I resisted the personal temptation to delve into some of the weeds on the regulatory front --

WOLF: Okay, well, I --

MATTHEWS: In the interests of covering a broader terrain, I'll close my set of questions with Central Europe and the G-20.

Central Europe were still talking about it. Prime Minister Rudd earlier this week in D.C., Prime Minister Brown the other day in New York all were making impassioned pleas for strengthening the IMF -- both its capacity and its authority -- in order to deal with the implosion in Central Europe.

And so you know, how much is it going to take for the IMF to ride to the rescue here? How bad is it and where if the money is going to come from? If these are countries in trouble that are funding the IMF to begin with, particularly in Europe, where they can exactly run the printing presses if they're in the euro zone?

And then finally, closing with -- and I think you're probably going to end up there anyway -- inside the G-20 we hear a lot about what the U.S. wants, what the U.K. wants, what the EU wants. There is surprising little attention paid to what South Africa wants, what Brazil wants, what India wants beyond free trade.

So if you could maybe provide at the back end -- before we open up to questions -- a vision of what the other major economies that are significant players in the G-20, you know, let's pay some attention to what they want out of this as well.

WOLF: Okay. The Central and Eastern European problem is actually, in terms of money, eminently fixable. These aren't big economies. I can't remember the aggregate size that the economies of Central and Eastern Europe probably can't be much bigger than the -- (inaudible) -- and it certainly wasn't much more than that a few years ago.

The problem is, of course, they really -- we have to understand what's happened. They opened themselves up to foreign capital. They allowed most of their banking systems to be bought by Western countries -- particularly Italy, Austria and Germany -- so their banking systems are no longer autonomous in most cases. Some have had fixed exchange rates and some have run extraordinarily large current account deficits, financed by huge capital inflows -- some as large in the small cases as 20 percent of GDP. So if you cut off the capital from these countries you get enormous recessions. In many cases there'll be -- in most cases where the currencies move, you have huge swings downwards in the currency. Given the large amount of foreign debt, you get mass insolvency. It's very familiar -- what happened in Asia. But unfortunately, in aggregate, these aren't -- well, we leave side Russia, of course, so I'm including Ukraine in this -- this isn't an enormous economic reach and it's imminently financeable.

Why it got so bad is because in the panic, everybody in Western Europe -- all the governments of Western Europe essentially guaranteed assets in their banking systems and liabilities in their banking systems so everybody started moving their money out of Central-Eastern Europe into the West, because it was safer. This is not something any of these countries could do credibly, because they didn't have AAA-rated governments -- very much not.

So it's a classic emerging market flight crisis with the flight-to-safety element, but fortunately a relatively modest one. If Western Europe wants to save them, it doesn't need the IMF anyway. It's mostly -- a lot of it would be Western European money. They can easily do so and I assume, ultimately, they will do so. And I assume that they will lean very heavily -- and are already leaning very heavily -- on their banks to sustain credit in these countries, because quite obviously, the alternative of letting them all collapse is impossible, since the integration of Europe -- in my view -- the integration of Europe is an immense strategic objective and strategic gain and of enormous vital national interest -- to put it mildly -- to the most important country in Europe, Germany, whose neighbors these countries are.

So I expect this problem, in fact, to be fixed in a very messy way -- probably not by accelerated entry into the euro zone. And anyway, I don't think that will be very sensible.

I still think -- and I've argued very strongly, that there's a very strong case for a very big increase in IMF resources, because of the general insurance problem, which these enormous reserve accumulations around the world over the last five, six, seven years demonstrate. Namely, no, this is not the only reason. The total stock of (foreign ?) currency reserves around the world has increased by about $5.5 trillion over the last 10 years -- and that is a desire for insurance in part, and clearly, it is much cheaper for us to provide it collectively, rather than individually, but I wouldn't limit that to the Central ad East European case.

Finally, the question of what these other countries want. It's actually quite difficult to work out. Trevor Manuel has written a quite good column -- well, it's an interest column -- in our series on the future of capitalism -- the finance minister of South Africa -- on the theme of making it a more moral and so forth capitalism.

I think broadly speaking there are the following demands -- though it depends on the individual country how much weight: First, a much bigger voice in the IMF. India's voting share is basically the same as Belgium's. Some of us think that's pretty ridiculous. Unfortunately, some of us include the Belgians -- (laughter).

MATTHEWS: Having lived there for two years and watched governments fall apart, I can understand.

WOLF: But obviously, the voting shares in the IMF are ludicrous -- absolutely ludicrous, completely impossible to defend.

And India, a rising power, considers that a particularly big issue. They are happy to have a larger IMF if it's more securely under the control of people who are actual or potential buyers, instead of just being controlled by countries who will never borrow. So that's a second big issue.

South Africa certainly -- and I think a number of others -- are very concerned about the support that will be given to the poorest countries -- particularly in Africa, their neighbors -- in this crisis. That's something we're not much discussing, but many of the victims will be people we're not even thinking about in the developing world. The commodity price collapse is relevant to quite a lot of them, though it benefits others. So that's another issue -- Bob Zoellick has talked very well about that, I think, and been quite a leader on that particular issue.

But I think the core -- and finally, of course, before they opened themselves up any more or indeed decide to open up less to the financial system, they want to be sure it's fixed.

I'd like to add one point, which doesn't directly go to the question, but it's very important. I had the great privilege, never happened to me before, to be invited before the Senate Foreign Relations Committee to discuss this as a foreign policy issue for the United States. So since this is a Council on Foreign Relations, I'll say the main point I made.

The main point I made, of course, is this one, this is a very, very, very big mess of economic financial terms. And two, you should be aware that the rest of the world blames you. And this is a crisis for which they take no blame -- even when, though, I think that a few of the countries concerned, particularly China, is a part of the story, because of its role as a -- (inaudible) -- but that doesn't apply to anybody else on the same scale.

Therefore, if the U.S. does not come forward in this situation with one credible policy to get us out of the crisis -- and which they are certainly doing better at the moment than a few months ago; and secondly, generous assistance for those who are going to be hurt very, very badly. It's going to (rebound ?) very, very badly on the U.S., which has been seen -- to put it mildly, and I'm not going to put it more aggressively than this -- as having been the bull in the china shop of the world's system for the last 10 years.

MATTHEWS: And on that positive --

WOLF: With our -- I should say with British assistance, of course. But we are such a small little calf alongside the bull. (Laughter.)

MATTHEWS: And on that wonderfully provocative and positive note, we turn the floor over to questions. Please wait for the microphone, identify yourself and your affiliation.

First hand up, back there, the gentleman.

QUESTIONER: Thank you. David --

MATTHEWS: And remember, you're on the record.

QUESTIONER: -- Blue Orchard Finance.

I just wanted to ask the question that pairs with your earlier worst case scenario of what might happen going forward -- the U.S. government replacing the private sector as borrower of last resort and all of the imbalances continuing until a worse crash occurs.

What would be the best-case scenario with even so much fantastical hopes for good policy making from the U.S. and where it matters -- China, Europe, maybe Japan?

WOLF: Okay. Well, the best-case scenario is reasonably obvious. We have an absolutely credible commitment to maintain the open trading system. We have a very substantial replenishment of IMF resources, including in my view, at least during this crisis, SDR allocations in very quantitative -- special drawing rights of the reserve assets at the IMF. And that means countries don't need to earn reserve assets by running surpluses. They can require -- acquire reserve assets by the stroke of a pen.

In other words, they take some of the advantage that you yourselves have been able to do by simple printing money on an enormous scale, which is great for you, but not others can do. And I think that is a very important part of the answer. We get the IMF reforms we discussed, which together -- this is very important; this is not irrelevant to my store -- that creates the sort of environment in which people begin to think, if we run current account deficits or even allow maturity mismatch so we do borrow, to some extent short term, there is liquidity provision for us. We can get through the associated crisis and therefore, we can take greater risk steps.

And the big theme -- I've discussed much more about this in my recent book, the sorts of things you need to do to encourage emerging countries to take the risk, because after all, it is crazy that this is a world awash surplus capital and the only way we can fin to use it is to lend it to the U.S. government. That's simply balmy, isn't it?

So I mean, Keynes would have said that if he was sitting here. This is a crazy way to run the system. The only way you can do it is to lend all the surface capital in the world to the U.S. government to waste --

MATTHEWS: To waste?

WOLF: I'm sorry, I didn't mean that -- to use productively.

Now, but even so, this is the richest country in the world and it is ridiculous that the capital should end up -- so that's a big part of the story.

In macroeconomic terms, I do think -- and I'm with Keynes here -- that there are big problems in absorbing current account surpluses at the scale we've had -- demonstrably big problems. While we can clearly improve the system to make it possible for emerging economies to borrow more successfully, we're not going to absorb $1.5 trillion a year in that way very easily. Some of it will go into the surplus countries, but it seems to me -- at least in the case of China -- it is in China's interest -- and there are some other emerging economies in the same situation as well -- to absorb more of this at home.

And I also think the case of Germany, and in the interests of Europe and Japan, they should be thinking about domestic demand targets -- objectives, let's say -- and thinking about their policy system such that more of the potential output that they have is absorbed either at home or in productive investment abroad. And they should be contributing massively to the discussion of how these two objectives are to be achieved, because the status quo is demonstrably, in my view, not a stable one. It doesn't work, particularly as we're going to also clearly have to absorb more oil surpluses again when the price of oil goes up. And I say "when" -- as soon as we have this recovery that we want.

So those are, I think, broadly speaking, the elements I want to see. Serious understanding by the surplus countries there's a problem in absorbing their surpluses in the rest of the world. Demonstrably -- and a serious contribution by them to say -- understanding how that is to work. Serious reform of the international monetary system -- I'm not talking about going to gold. That's not going to happen, obviously. But I think we can improve massively the IMF as an insurance system and we should.

And I don't mind if it -- and by the way, I'm just using the IMF as a name. I don't mind if it's a new institution. I think we have this institution. We might as well make it work, as it was initially designed to do.

Finally, it also goes without saying in this good scenario we have to have a credible plan for the future structure, incentives and regulation of the financial system that makes one believe that one can trust it to operate with reasonable -- that's of course, a matter of judgment, so I'm putting quote-unquote "stability in the future." Otherwise countries can't -- they can't afford to let this happen.

My very last comment is to remind you of the big point in Carmen Reinhart and Ken Rogoff's paper, which I've often cited -- a very recent paper on the cost of financial crises -- financial crises are costly like wars. These are events that cost governments usually anything between 50 percent of GDP and 100 percent of GDP in additional debt, plus huge recessions. We can't go on living like this. It's intolerable. And that is really the background I think in which we have to approach thinking about the future of the financial system.

We shouldn't allow one sector of the economy to inflict costs upon economies which are comparable in these terms -- fiscal costs -- of course, it's not (withstanding ?) destruction -- but fiscal costs, broadly speaking economic costs, which are like having a significant war.

MATTHEWS: The first row.

QUESTIONER: Arnaud de Borchgrave, CSIS.

Martin, peering into your crystal ball, what do you see down the road replacing economies based on conspicuous consumption at a time of growing world shortages?

WOLF: Ah, right. Well, right at the moment -- this is the long-term problem. Right at the moment we have growing world glut. Right at the moment, you know, a very simple way of thinking about what is happening this year -- if we think of sort of the economic language in terms of what's called output gaps, which is the difference between potential output of the world and the actual output of the world -- the output gap of the world is going to grow this year alone probably by about 5 percent.

That is to say the difference between the potential growth of the world economy, which is probably 3 percent or so, and the actual growth will be 5 percept. Last year it was already significant. Next year it will be the same. So what we're actually going to move into is a world of very large, excess capacity. And that world -- which is just a definition of a slump. That world -- a very large excess capacity, my guess would be, will be with us for quite a few years.

And therefore, in this situation -- which is not a normal situation, which Larry Summers has pointed out. It's not a general point situation, but it is a situation now. We're in a Keynesian world. I know the name -- we're not allowed to use this too often in the U.S., I remain unreconstructed in this context, as does my colleague Samuel Briton, as I'm sure you've all been reading, who is basically liberal in orientation in the classical sense.

We are in a Keynesian world so the immediate issue is demand it will remain demand for quite a long time. In the longer term, we clearly have -- will have a world of significant supply issues, of which incomparably the most important, I think, are the ones we know about -- energy and climate change. I don't want to get into the water and other such issues. I have views on that too

But I think it is obviously right. One of the things I admire about this administration's objectives is that it's put those issues firmly on the table. They are the right medium-term to long-term issues to concentrate and I hope that over the next two or three years we will be putting in place policy systems in our countries -- and therefore in the world, ultimately -- to deal with these two huge underlying resource constraint issues, energy and climate, sensibly. I don't think they're going to be -- you know, that those aren't -- (inaudible) -- tomorrow, but I think one of the nice things that I like about this administration is that it's been prepared to be ambitious enough to look at long-term issues as well as the short term.

But the issues that dominate in economic policy for the next few years are clearly going to be demand issues. We are in a world now of chronic deficient demand, which is quite general and basically, demand has gone off a cliff. We all hope this will stop. There are tentative signs it's slowing, but no more than that. And you will have noticed -- just a completion to that -- the IMF has downgraded its forecast for world economic growth by between 1 and 1.5 percentage points in just two months.

So we are still, you know, in a real slide. And if somebody told me that we were going to find that global GDP shrank 5 percent this year, I wouldn't find that inconceivable.

MATTHEWS: In the blue jacket.

QUESTIONER: Thank you. My name is Sonia Short (ph). I am with the (TPA ?) Agency.

I would like to know what is your perception regarding Latin America? Before the crisis, everybody was thinking about, okay, Latin America is doing well. After the crisis, everybody was wrong. So if you can spend some comments on that and what will be the future of the free trade agreements.

Thank you.

WOLF: Okay. I don't know which free trade agreements you're referring to, because there are so many.

QUESTIONER: (Off mike.)

WOLF: The Latin America -- oh, you mean the bilateral agreements with the U.S.?

QUESTIONER: Yes.

WOLF: So you're not --

QUESTIONER: And in general, the Doha Round regarding --

WOLF: Okay. Well, I'm afraid I have nothing good to say on the Doha Round. As things stand it won't be completed. That may change. I'm assuming that the United States is not going to rescind NAFTA, which will be the most significant one. There have been moments I've wondered, but I am assuming they're not going to do that. I think the chances of new free trade agreements seem to be very, very poor.

On the -- my hope for the trading system is we hold ground. I think that's possible, provided largely hold ground -- largely holds ground for the trading system as a whole. I think that's perfectly possible if we have a reasonably credible recovery towards the end of next year -- or certainly not later than 2011.

I'm not sure we can hold ground if this sort of condition lasts three or four years, because we're going to be talking about a situation in which the unemployment rates in most developed countries -- and I'll leave out the emerging countries, because it's more difficult to measure -- will all be north of 10 percent, in some cases north of 15 percent. This is not an environment in which sustained and opened trade is going to be, to put it mildly, easy. And I can't see that we're not going to be in bad if we don't have a very brisk recovery.

In terms of the Latin American economy, first, I don't consider myself expert, but I -- (inaudible) -- to make a fool of myself on everything.

The commodity boom is very important to a lot of Latin American countries and clearly, that's gone -- at least temporarily -- and I would guess that would be gone for some time, even if we're moderately successful with its recovery. And it might be even more gone if, as is possible, the Chinese development path changes as a result of this to become less resource intensive.

China's development path has been astonishingly resource intensive on a whole range of areas. I don't have the time to go through that. And therefore, despite the fact that it's a relatively small economy -- it's still not much bigger than Germany -- its impact on resource markets has been staggering and that may not continue. So that's a qualification.

A lot of Latin American countries seem to have rather sound debt positions at the government level. And it turns out -- which I must say I wasn't aware of that in some very important cases, corporations have again borrowed an enormous amount of foreign currency, rather like the Russia story, and that create tremendous problems in the situation. It's one of the ways in which they've turned out to be much more vulnerable. That seems to be true of Mexico and Brazil in particular.

But in general, I'll just make the general point: this is an open region. Like it or not, it is dependent on the world economy; it always has been. Its savings rates are still relatively low, so it's always going to be dependent, to some extent, on capital inflows. And in an enormous crisis of this kind, it's actually inevitably vulnerable.

But the important point, nonetheless -- it is clearly vulnerable, very vulnerable and will be adversely affected -- but it's not in the sort of crisis that it has been in all the previous massive downturns. So in that respect, the accumulation of reserves that has occurred, the strengthening of the current account positions that have occurred has probably reduced vulnerability somewhat. But in a crisis of this kind, particularly in North America, it's inevitable Latin America -- and particularly countries closely integrated into North America like Mexico -- will be adversely affected. It's unavoidable.

MATTHEWS: The gentlemen in the red tie. Second -- in the middle -- second row in the middle.

QUESTIONER: Robert Solomon, Brookings Institute.

Martin, read your columns with interest and I've never disagreed. May I make one observation and a question?

I'm surprised that you're comparing the financial crisis with a war. It seems to me, as you know very well, a financial crisis dealing with credit and maybe creating money, but it doesn't require purchasing goods and services, as does a war. So it seems a little odd to me to make that comparison.

Let me ask you my questions: How can we get Western European -- continental Western Europe -- to recognize the need for a macro-economic stimulus, which doesn't seem to have happened yet, but if I'm not mistaken is badly needed if the world is going to recover properly.

WOLF: Okay, let me be clear -- you've given me the opportunity to clarify. I tried to be clear, obviously, I wasn't successful.

I mean by this something very precise: The fiscal impact of a -- the impact on the public finances of a major financial crisis in terms of the increase in the debt burden going forward turns out to be similar to the impact of a significant war.

And to make it more precise: I think it is very plausible, and it's not even very far from what the IMF is now projecting, that by 2015, the general government-debt ratio in the United States will not far from where it was in 1945. So that is all I meant.

I am not suggesting, of course, that it is anything like as destructive, though there is an extraordinary capacity to build things nobody needs -- like however many empty houses you have at the moment, which is also a waste. But of course, there's no other comparison, but the fiscal impact is similar. And the reason that's important is that it means you can't do it too often. You can go from 60 percent of GDP debt ratio to 150 percent once, but you don't want to go to 300 percent. So this is something you want to do briefly.

Now, the European view of a stimulus -- well, there are -- first, I think they're getting a bit of a bum rap. And I think it's fair to say this, as they point out -- and I've got some charts in one of my columns that showed this quite clearly -- the so-called automatic stabilizers are much -- it is true they're much stronger in Europe than in the United States, because of having welfare states, which means that automatically expenditure increases very rapidly in a downturn with rising unemployment, rising poverty and it does increase very rapidly. And fiscal systems are quite progressive -- though, actually, not more progressive than here. Your fiscal system's surprising progressive, because you have no sales tax at the national level. But the result is that there's no question that automatic stabilizers are significantly stronger, and that is why a lot of European countries are in fact going to deficit very quickly.

Second, it is true that the discretionary stimulus in most cases is smaller, but even in a very cautious country like Germany, the stimulus, as I see it, is very close to the 2 percent that the IMF is calling for. It's not as ambitious as the U.S. yet, that's true. But I think we have to say the U.S. fiscal stimulus ambitions this year are pretty extraordinary and will have pretty extraordinary results. And I think they're completely right. In fact, I would be even tempted to do more, but we have to say that.

And most European countries cannot be as -- except possibly Germany -- cannot be as confident of getting away with the sort of fiscal position that you see here. Lots of already under considerable fiscal stress and they don't have access to the capital markets that the U.S. has. That's true of the U.K. now and it's even more true of members of the euro zone, which of course, don't have a central bank that will credibly bail them out. It might, but it won't credibly. And there are some extraordinary increases in spreads in Europe, which suggest real worries about the longer-run solvency of the number states. So they can't just expand.

Could the Europeans do more? Yes, particularly Germany. I do think -- and I've made this point often -- that it is very difficult for the European economy to be stabilized -- and this is very important for the world if the most creditworthy and largest country in the union runs a current account surpluses, because Germany has recently been doing between $250 and $300 billion a year.

The reason is by definition that means others are running deficits. The counterpart to that are either private sector deficits or government deficits. Private sectors are mostly bust now. The governments are already less creditworthy than the German government. The essentially the problem is this: is that it creates a very deep death trap for all Germany's significant problems. For the moment, the country that is most -- the country that is deepest in this trap at the moment is Spain, because of the scale of its internal deficit. So I think there's a problem.

Will they change their mind? Very slowly, but they will, because the alternative is to bad to imagine. And my guess is that three or four years from now we'll find deficits in Europe are much larger than anyone now imagines. And we will find the European Central Bank pursuing monetary policies much more aggressive than they can possibly imagine doing, because however unreasonable they may seem, actually allowing a slump to continue for a long period, which I think is what they face, is not something they can actually allow to happen.

But it will always be reluctant, because I suppose in the end, they do genuinely worry about the long-term consequences of these policies. The U.S. has the happy self-confidence of a nation that believes it will always recover from serious mistakes, because history has ensured by its virtue of its size, location, resources that it will do so. For the very reasons you know better than I do, there are good reasons why Europeans don't have this happy confidence.

MATTHEWS: We have time for one more questions. And this gentleman had his hand up first.

And while you're getting the microphone, it also --

WOLF: I'll make it brief and then we can have to.

MATTHEWS: And the thought on the transatlantic relationship, then, obviously comes to mind. But I won't ask the question; I'll let you ask your question.

QUESTIONER: Thank you very much, Martin.

Adam Siemenski from Deutsche Bank.

The drop in oil prices from about $100 last year to maybe $50 this year has injected something like $1.5 billion into consumer spending -- by my calculation.

WOLF: Trillion.

QUESTIONER: One-and-a-half trillion.

WOLF: Trillion-and-a-half. Yes.

QUESTIONER: Trillion. Thank you very much.

WOLF: That's my estimate.

QUESTIONER: (Laughs.) I'm glad you raised your eyebrows.

So the two biggest exporters in the world are Russia and Saudi Arabia. Do you think this was -- how do you think they feel about this and what do you think they intend to do -- looking out over the next year or two?

WOLF: First of all, that is the single most important reason for optimism that we may get a reasonable recovery next year. Though, I think the problem with it -- and that comes to your second part -- is what happens next. That, plus the extraordinary aggression of monetary and fiscal policy here.

Well, you know how they feel about it. (Laughter.) The difference is, Saudi Arabia is astonishingly -- in my experience, and I don't count myself in anyway expert -- sort of relaxed about this in the sense that they expect it to happen. It's what they've experienced. They don't like it. They rather hate it, but they know oil prices are volatile. They believe they can manage their social system. They to have been able to to an astonishing degree, even in long period when real spending declines. They've just come off a very good period, which has replenished their coffers very satisfactorily, after what was really quite a bit problem for them.

So I suspect they will feel -- we're an oil producer for the long term. It goes up; it goes down. We are, of course, cutting back a bit in OPEC now -- and it will cut back, because everybody has an incentive to do so. But the oil price has got to come up. They can read the IAEA reports as well as you can, and everybody who thinks about this for three seconds knows oil prices are going to go back up if there's a serious recovery. We know what's happening to supply. So I think they're relatively relaxed.

The Russians can think that, of course, thought, they're not -- from what we know, as I understand it, they're not a producer for quite the long term as Saudi Arabia is. Certainly, it's more vulnerable. But in the short turn, this has created some very, very big problems for Russia and we know about this. Large parts of their private sector -- quote-unquote "private sector" -- is clearly bankrupt. There is a big pressure on the government to bail them out. And you can read as well as I do the conflict this has caused. It's going to squeeze the budget. Russia has got a very large country and it's got a pretty strong central government, but still, squeezing the budget is not popular. If it goes on for many years -- though they've been pretty prudent in managing reserves in the budget -- it will start squeezing real spending. And Russia's ambitious, as of course is obvious, which is to return as a great power -- serious great power -- is going to be, to put it mildly, handicapped if the principle resource on the basis of which that is plausible, declines permanently or even temporarily in value.

So for Russia, I think this is a strategic problem of some significance. I don't wish to be offensive to anyone in this audience, but I will still say, you know, every cloud has a silver lining. (Laughter.)

MATTHEWS: We actually do have three more minutes, so we can take one more.

The lady there in the --

QUESTIONER: Karen Johnson (sp), independent consultant.

One of the features of the run-ups to this crisis was a huge expansion in financial sectors that just got bloated and tremendous compensation increases that meant more of gross national income was being generated within the financial sector and so forth. Now, of course, there's been a big bust.

Perhaps the country that experienced this more than any other was the U.K. We now have to go through an adjustment in which financial sectors shrink. How do you see the U.K. succeeding the structural adjustment?

WOLF: That's a very good question. It's a perfectly accurate description. Indeed, I'm reasonably confident that a significant part of the GDP we reported and that you reported -- though to a lesser degree in the last few years -- was illusory. That is to say, it was credit creation counted as income. And when they recalculate GDP back -- (inaudible) -- periodically do, it's going to look different and worse.

One of the great difficulties with the financial system, since it creates its own income, that it's quite difficult to distinguish -- it's always been very well known to distinguish its income from its balance sheet activities. It's pretty obvious if you triple the balance sheet and pay 10 percent of that as fees to yourself, that's income, right? And you know this very well -- so that illusory.

The answer to your question of how are going to get through this structural adjustment is I have no idea, but it's going to be very interesting -- in the Chinese sense.

We clearly made a pretty large bet on this sector. And one can't exaggerate. It's about 8 percent of GDP, but it's much more significant if we look at it in terms of its contribution to the balance of payments, and that's already reflected very well, I think, in the movement of the pound.

I tend to be modestly optimistic that provided the economy's -- the country's political stability does not disappear completely -- always possible, but unlikely -- provided the world economy recovers, which is very important; and provided that the real exchange rate remains roughly where it is now and we have no inflation associated with it, that we will find quite a large range of other activities. Design activities associated with manufacturing -- some manufacturing -- it's not quite as disappeared as some have supposed; lots of other service-type activities non-finance, which will expand in that environment. And over a period of five to 10 years we will get through it -- probably 10 years rather than five, but I would guess from what I am seeing that we have permanently lost -- that our GDP was really about 4 percent less than we thought it was and that's the basis on which we are growing, so that's gone. And that means we have a huge structural fiscal deficit, which will have to be closed with a lot of public spending cuts and a lot of revenue increases -- I would guess 5 percentage points of GDP minimum over time. Again, it can be done if we have time.

Britain's been reasonably good historically about managing fiscal positions like this, but it will be -- it will be a fair amount of pain. In addition, the trade in growth rate was certainly lower than we thought and is probably now closer to two than the two-and-three-quarters we thought. It's still positive, but in the aggregate, we're poorer than we thought -- quite a bit poorer than we thought, but still probably not as poor as we were let's say in 1995.

Well, I think countries should cope with this. Some of what I said -- though not to the same degree, the numbers aren't as large -- will apply here. The structure fiscal position is much worse than it looks. There's going to have to be big tax increases. Nobody wants to talk about that here, but it's going to happen -- particularly if you want universal health and so forth.

So there are very big structural adjustments in our economies. And I would guess in our case it will be 10 pretty miserable years. And that's what countries have to endure.

I mean, I tend to think very big rich countries, which have done pretty well for a couple of centuries, ought to be able to cope with this. I am actually much more worried about what's going to happen to a lot of emerging countries in this crisis. But it's going to be tough and we will have several government changes in the process -- for sure, starting with the next election.

MATTHEWS: Thank you very much.

Please join me in thanking Martin Wolf. (Applause.)

WOLF: Thank you very much.

MATTHEWS: Very well done. Thank you.

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