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The Financial Turmoil and its Consequences

Speaker: Benn Steil, Council on Foreign Relations Senior Fellow And Director of International Economics
Presider: Sebastian Mallaby, Director, Council on Foreign Relations Maurice R. Greenberg Center
September 15, 2008
Council on Foreign Relations


OPERATOR: Excuse me everyone: We now have our speakers in conference.

Please be aware that each of your lines is in a listen-only mode. At the conclusion of the presentation we will open the floor for questions. At that time, instructions will be given if you would like to ask a question.

I would now like to turn our conference over to Sebastian Mallaby.

Mr. Mallaby, please begin.

SEBASTIAN MALLABY: Thanks, Operator.

Yes, my name is Sebastian Mallaby. I direct the Center for Geoeconomic Studies at the Council on Foreign Relations. And with me is Benn Steil, our director of international economics, who -- as well as advising on markets and market structure -- has just completed a great book called "Money, Markets and Sovereignty," which will come out in January. He's going to have some thoughts on how those issues link into what we've been seeing in the last hectic 24 hours.

Just to set things up, I would say that we're both willing to take questions on anything people would like to ask, but our perspective -- what we try to bring, which is perhaps a little bit different to other people who comment on this crisis -- is that we're looking at the Council on Foreign Relations at the interplay between international financial issues and U.S. power/U.S. foreign policy.

And in that regard, I would say that starting that from the fact that for Secretary Paulson, this is really quite a remarkable change in personality. He has spent about two years at the Treasury for most of the time, although he came to Washington saying he didn't want to just keep the seat warm at Treasury. He had a powerful job on Wall Street, he didn't want to come to Washington unless he was really going to make an on policy. And now he's done something which I think for the first time has really shaken people up, taken people by surprise -- the big gamble of not providing a taxpayer-backed assistance to Lehman Brothers to facilitate its takeover. Now, that throw of the dice is a change of heart for him.

And I think what Benn and I want to try and get across is that the stakes here go beyond the stakes for one or two financial institutions or even for the U.S. taxpayers' money that might have gone into the bailout. There are also issues at stake here which relate to U.S. power. And one linkage here is -- which has been commented on a bit in the commentary I've read -- is the fact of the U.S. model of free standing investment bank has taken a hit, while the more conservative European universal bank model has proven to be a bit more robust. Now, there are reasons for that, which we can go into later in questions if you would like. Let's just state that as a fact, that the European bank model has done relatively well.

Equally, the U.S. emphasis on innovating new types of financial instruments has clearly taken a massive credibility hit over the last 12 months or so and both securitization and over-the-counter derivatives trading is perceived to be a lot more risky than people had thought. And since that type of innovation emanated, to a large extent, from New York and from the U.S. financial institutions, it's sad to put these two things together and say that New York's position as the preeminent global financial sector is potentially at stake in the way that this shakes out over the next few months.

And that matters, because U.S. financial -- global financial centers -- there tend to be over history one that dominates, because there are huge economies to scale in a business like finance, just as innovation in an industry like software has congregated in Silicon Valley, because people who are ambitious and want to do great software go --
as young engineers, they move to Silicon Valley, because that's where hot action is.

So too, New York has become over the years the go-to place for finance, because that's where ambitious young financiers go to. And if you change that, and you lose your first-mover status to some other financial center, it can potentially be hard to win it back. And that, of course, if you lose -- if you think that economic competitiveness in the 21st century relies, above all, on keeping in your territory highly innovative industries such as software or finance or for that matter, pharmaceuticals, losing your first-mover advantage in a key industry like finance is not to be taken lightly. And I would say that there's something like that at stake in what's going on now.

Now, I want to hand over to Benn, because he's going to talk about another linkage between the crisis and U.S. power, namely the implication for the Federal Reserve and for the dollar status as a reserve currency.

BENN STEIL: Thanks, Sebastian.

The first point I'd make in this regard is that the Lehman Brothers collapse was very, very different from Bear Stearns. Bear Stearns unraveled much more quickly, and the Federal Reserve and the Treasury could make the argument that they really did need to step in very rapidly with a financial backstop in order to ensure confidence in the markets.

In this particular case, Lehman Brothers unraveled very, very slowly. This has played out over an extremely long period of time. And to the extent that there were any major players in the market that were not prepared for Lehman Brothers’ demise, that's the clearest possible signal that moral hazard had already begun to sink into the markets and really did need to be short circuited. So I think it was absolutely the right decision of the Fed and the Treasury not to step in with any sort of financial guarantees for Lehman Brothers and to let them go if that needed to be the case.

With regard to the future of the Federal Reserve, I do think that we need to be somewhat concerned about their expanding their lender of last resort activities. In the 1990s, in particular, we saw that central banks around the world -- Latin America, Asia in particular -- tried to reassure investors by standing behind financial institutions, guaranteeing deposits and the like. But that never worked, and the reason is that the local savers always withdrew their money and sold it immediately for dollars. And the reason is that these investors were never concerned that their governments would let local financial institutions collapse, but rather they were very concerned about the inflation and the depreciation of the currency that would follow from printing money in order to guarantee the financial institutions.

If the Federal Reserve takes too many unlimited liabilities on its books, it could be in the same situation. So it has to be exceptionally careful about what guarantees it offers to the market. If it needs to step in in the future, and it has already taken on too many responsibilities, we may see the same sort of reaction in the market here that we saw in the past in developing countries. That is, investors in U.S. assets will withdraw money from U.S. financial institutions and purchase euros and commodities -- perhaps gold -- as a safe haven, and the Federal Reserve will lose its abilities as a lender of last resort.

Although the dollar has rallied significantly since July, this was very much a flight to safety effect and I don't think we're by any means out of the woods yet. I think the dollar is still in a fragile state, and so I'm pleased, at least, the Federal Reserve did not, in this particular case, stand behind Lehman Brothers or any of its assets.

Having said that, the Federal Reserve has announced that it will expand its lending activities, taking a wider range of securities, including equities, as collateral for its loans. It's yet to be seen exactly how that will play out, but we do have to be concerned about the Fed’s balance sheet being littered by bad assets. The European Central Bank is already to some degree reversing course and is putting more restrictions on the type of assets that it's taking as collateral.

I'd just make another point, Sebastian, with regard to yours about derivatives and the importance of derivatives activities in the current financial crisis.

If you go back to the collapse of the hedge fund, Amaranth, it's remarkable just how little reaction there was in the market. And the main reason was that Amaranth was trading primarily in exchange-traded securities. These are securities for which there was a well-capitalized central counterparty called a clearinghouse, which was standing in the middle of all the trades. Lehman Brothers’ central position in the OTC credit derivatives market, however, emphasizes the critical importance of improving risk management in large OTC markets, in particular utilizing central counterparty services. These are services that would be provided by large well-capitalized clearinghouses, in particular in the credit derivatives area.

There are some welcome signs in the way the market is evolving that will help to address this issue. For example, all the world's major derivatives exchanges are now demutualized, meaning that they're no longer controlled by banks that have no incentive to see the emergence of these derivatives in standardized form on exchanges. So these exchanges, like Eurex, like the Chicago Mercantile Exchange, are competing extremely aggressively to get these contracts on exchange. I think that's welcome, but I still think we will need a prodding from regulators in Europe and the United States to ensure that we move more quickly to a situation where centralized risk-management services are provided in the OTC markets.

MALLABY: Great. Thanks, Benn.

Perhaps we should open up now for questions. Operator, do you have anyone?

OPERATOR: Yes, sir.

At this time we'll go ahead and open the floor for questions. If you would like to ask a question, please press the star key followed by the one key on your touch-tone phone. Questions will be taken in the order in which they are received and if at any time you would like to remove yourself from our questioning queue, press star two. Again, star one to ask a question.

And our first question comes from Sarah Winchell with the Dow Jones.

QUESTIONER: Oh, yeah. It's actually Sarah Lynch. Thank you. Thank you very much.

I just wanted to follow up with the comment you just made about the need for centralized clearing in the OTC market.

The other day, the CFTC in its release of its (ops ?) report on Thursday, talked about this in its list of recommendations. But I noticed that in that area it was nothing -- they discussed the need to quote-unquote "encourage" clearing of OTC, but they didn't talk about any kind of action that would require congressional approval or anything like that. I was wondering what you thought about their list of recommendations and if they should be strengthened in light of this new emerging crisis?

STEIL: Yeah, well, the CFTC is not in a position to force OTC trading on exchange, as it were, to force the utilization of central counterparty services.

Having said that, there are other regulatory authorities that are in a position to mandate that, or at least provide much greater encouragement to market participants to do that - for example, in terms of the capital charges that they would have to bear for certain activities.

I think it's already sunk in, in the markets, that the current status quo -- at least in the credit derivatives markets -- is unsustainable, and that there will have to be some sort of centralized clearing model utilized. It remains to be seen whether that will involve really migrating the market onto existing exchanges like the CME, for example, like Eurex, or whether they'll use the central counterparty services of an existing independent clearing house or indeed, a new one that might emerge. But I think there is growing realization that the current situation is unsustainable and very dangerous, in the case of the collapse of a major OTC market participant like Lehman Brothers.

QUESTIONER: Thank you.

OPERATOR: Thank you for your question.

Our next question comes from Ruuben Barrera with Notimex.

QUESTIONER: Yes, good morning -- I mean, good afternoon.

Even though both candidates, McCain and Obama, made comments today about what's going on in the financial sector, I wonder if you see any implications in the -- I'm sorry -- to what point this event could force both candidates to focus more of their campaigns on the economic issue, and maybe offer more precise policies to deal with to deal with these and other issues related with economics.

STEIL: Sebastian, do you want to start with that one?

MALLABY: Sure. I think for both the candidates the political calculation is that you don't want to look as if you are indifferent to this crisis that's unfolding. But at the same time, if you start proposing specific remedies, such as the one that Benn was talking about -- moving OTC trading onto exchanges -- the voters are going to roll their eyes and you'll lose them totally.

It's tough to get policy debate into the last two months of a presidential campaign, and this is a particularly technical and difficult area of policy. And I think what you're going to see the candidates doing is sort of sounding concerned, trying to sound responsible, as if they understand it and they would be able to take charge in a crisis. But insofar as you see specifics, it's more likely to be talking about the real economy consequences of financial distress for your average voter. And so you're more likely to hear something about the need for a fiscal stimulus to get households through the crunch, rather than -- you're more likely to hear something like that then you are about the deregulation of OTC derivatives.

STEIL: I think there's one area where the current financial crisis may help at least to sharpen the distinction between the candidates on some significant economic issues. And that's the placing into conservatorship of Fannie Mae and Freddie Mac.

John McCain, for example, has long been opposed to the status of these two institutions. He's been clear that he wants them privatized, hived off entirely and no longer given their current government supported status. Barack Obama has been a little more ambiguous about that. He has acknowledged that their status is unusual and gives rise to significant regulatory concerns. But there's already a sharp distinction in Congress between what Democrats would like to do with Fannie Mae and Freddie Mac and what Republicans, who are more likely to support McCain's view, would like to do.

Broadly speaking, you have the Democrats who would like to expand the range of activities in which Fannie Mae and Freddie Mac are involved, in particular doing more to support low-income housing. And on the other hand, you have Republicans who would like to close down these organizations, spin them off, privatize them -- however you want to put it -- as quickly as possible.

And this issue is likely to come to a head around the midpoint in the next administration -- irrespective of which candidate wins. By that time the housing market would, hopefully, begun to have stabilized. And the question of Fannie Mae and Freddie Mac's future will have to be addressed directly, because right now they're accounting for about 70 percent of all new mortgages originated.

MALLABY: Right. And I would just add to that -- Benn is quite right -- that there will be a lot of these debates that come to the fore in the next administration. I would add that the debate, as of the structure of regulation on Wall Street -- the centering of regulatory authority amongst multiple different overseers -- that's bound to come up as well. And I think that getting that right and rationalizing some of that is part of the equation for returning New York's health as a global financial center.

Equally, doing something about the rise in the cost of litigation that has -- if you look at a chart of litigation costs for financial companies and companies that seek listings, New York has become an increasingly expensive place to do business because of tort costs. And one would expect that there would be a whole raft of new losses arising out of the current bankruptcies and turmoil. So that will bring that to the fore.

And getting all that right will be very important. The only point is that it won't necessarily surface in the campaign in any detailed fashion.

Shall we move to the next question, Operator?

OPERATOR: Thank you.

Our next question comes from Peter Clottey with Voice of America.

Mr. Clottey?

MALLABY: Perhaps we should move on.

OPERATOR: Okay. We'll move onto the next question.

Our next question comes from Tom Curry with MSNBC.


I think you've already partly addressed this, but I just wanted to see if there's anything additional you wanted to add. And that is on the proposals from either McCain or Obama -- have they -- from what you've heard, have they said anything about ways they would try to regulate the innovative financial engineering that Wall Street has done over the last several years?

From what I saw from McCain, for example, today, he talked about things that are a little simpler, maybe, for most people to understand like stopping severance payments or payouts to CEOs who are leaving some of these companies. But have you heard anything from them on regulation of financial engineering?

MALLABY: Benn, you may know more than I. I have not seen anything detailed. It's possible that I've missed something. But what one sees more is the debate taking place amongst people who may plausibly be part of the team on either side.

And so you know, when you hear an authoritative figure such as Paul Volcker make the argument a few months ago that financial engineering had failed the test of the market, quote-unquote, and that basically this sort of innovation has more costs and risks than it has benefits, then I think it's fair to assume that people in the policy circles around both candidates are hearing that, thinking about that and debating that. I just don't think it has surfaced in a very crystallized way in the actual stump speeches of the candidates. But if somebody else wants to point out something I've missed, I will defer to that.

STEIL: I haven't heard of anything specific on that front either.

There's no doubt that the proliferation of complex derivatives presents a welcome target for politicians. And I wouldn't be surprised to hear it come up in some sort of, say, very primitive form over the course of the campaign.

I do think, however, that focusing just on financial engineering is really to miss the fundamental problem, which I think is leverage. Homeowners in the United States have become overleveraged, of course. The investment banks that have failed -- like Lehman Brothers, like Bear Stearns and the ones who are threatened with demise such as Merrill Lynch -- were significantly over-leveraged.

And part of the problem I think we need to address is that to some extent, the regulatory system that we have in the United States did encourage this sort of over-leveraging. For example, getting loans -- in particular mortgages -- off a bank's books in order to ensure that the institution did not have to bear a high capital charge for holding those assets on its books. So it naturally fueled the use of financial engineering in order to securitize assets and get them off the books.

And of course, those institutions that were the most heavily leveraged have been the ones that have been hit the hardest in this crisis.

MALLABY: Should we go to the next question, Operator.

OPERATOR: Thank you.

Our next question comes from Peter Clottey with Voice of America.

QUESTIONER: How will this impact sub-Saharan African financial market? And secondly, how should those markets address this problem?

MALLABY: Well, I could take a first crack at that and Benn could come in too.

It seems to me that by being open to flows of capital, African economies -- as well as other emerging economies around the world -- have been feeling the effects of the ups and downs of finance in the U.S. and other developed markets. So at a time when commodity prices were high, mobile, global capital flowed into Africa and forced asset prices up. And that made capital cheaper to come by in those African economies and fueled growth. And now you're seeing something of the opposite cycle as commodity prices come down and that effect goes into reverse.

So that is going to give rise, I would have thought, to a sort of new version of the debate that happened 10 years ago in the wake of the 1997-1998 emerging market crisis when economists argued that, look, trade is a great thing and trade globalization is good, but financial globalization -- we don't quite see that the costs are justified by the benefits. In other words it might be that the instability you get as capital flows in and out of your economy is just too high a price to pay for any theoretical benefit of greater access to capital that you might get by opening up to foreign capital.

And that debate as I said was pretty prominent 10 years ago in the wake of the emerging market crisis. The interesting thing is that although people debated it, if you actually look at the measures of how much emerging economies opened up to global financial flows, what you see is they did open up -- despite the strong argument that they perhaps shouldn't or should think twice about it.

And the reason they've opened up is that when you are open to trade, and to foreign direct investment and to global supply chains, it's almost impossible to be closed to global capital flows. You find that if a subsidiary of a multinational corporation is setting up its operations in your country and low and behold, it can use that subsidiary if it wants to move capital in and out and evade your capital controls by under invoicing or over invoicing to move money in and out. And plus, you've got more movement of people, the growth of remittance by migrant workers around the world means that money flows go up when human flows go up.

And so for all of these reasons, the world just is becoming inexorably more integrated in terms of capital flows. And it's pretty tough -- whatever the theoretical arguments that governments might want to make about the need to protect themselves from these gyrations, it's pretty tough to actually do it.

Perhaps Benn wants to comment on that.

STEIL: I think the sub-Saharan market -- sub-Saharan Africa, as well as other developing markets -- are going to be hit particularly hard by the recent developments in this financial crisis.

You are seeing a flight to safety. You are seeing investors in Europe and the United States retrenching, capital coming back to the home markets. The fall in commodities prices, obviously, is not going to help at all. I think countries that were seen as being in a particularly strong position just say, six to nine months ago -- like Brazil -- are now seen as being vulnerable again. So I do think this particular crisis will not be at all good for emerging markets.

I do think there are some countries who are in a position to weather this crisis much better than they might have in the 1990s. I'm thinking in the European context of countries like Greece and Portugal and Slovenia that have adopted the euro as their currency, an internationally traded currency, so their current account situations are no longer of concern to the markets.

In the case of Central America, interestingly enough, I think El Salvador and Ecuador are somewhat protected from international turmoil by the fact that they no longer have vulnerable domestic currencies, as they are using the dollar as their currency.

MALLABY: Okay, Operator. Next question.

OPERATOR: Thank you.

Our next question comes from Suzy Khimm with The New Republic.


You mentioned earlier that there is the danger that the U.S. might follow the financial crisis in the developing world should there be failing global confidence in U.S. institutions and in America as the world leading financial institution, that the dollars don't -- (inaudible) -- and so forth.

Is there evidence that global confidence in U.S. financial markets and the U.S. economy is already on shaky footing? And if not, what are the warning signs that we should be on the lookout for in the upcoming weeks and months?

STEIL: We saw some rather powerful signs of it late last year and earlier this year in statements from particularly high-ranking Chinese officials that they were very concerned about what they considered to be exceptionally loose U.S. monetary policy. And their concerns are really motivated by the fact that they import U.S. monetary policy directly through fixed and pegged exchange rates. And the main reason that they do so is that the vast bulk of their international trade -- I'm thinking in particular of our major creditors in Asia and the Middle East -- the vast bulk of their international trade is actually denominated in U.S. dollars. So importing U.S. monetary policy is sensible.

The problem is for them that their foreign exchange reserves are currently heavily concentrated in U.S. dollars -- about two-thirds of it. If they wish to diversify it, they risk assisting in driving down the dollar further and thereby undermining the value of the assets that they've already built up. So far we have not seen any significant diversification of reserves, which is good news for the U.S. and the Federal Reserve -- at least so far.

Having said that, the U.S. dollar is really unique in the international marketplace along two dimensions, and there seem to be some warning signs that might be breaking down. There are two relationships that hold for virtually every currency in the world, with the exception of the U.S. dollar -- at least over the course of this decade. One is a positive correlation between depreciation and inflation. That is, when depreciation goes up, the national economy imports inflation from abroad. The U.S. had been largely immune to that over the course of this decade. It was not until the dollar began declining precipitously late last year that you started seeing depreciation be positively correlated with inflation. So that's a worrying development.

The second one is actually considerably more worrying. Around the world you see a positive relationship between depreciation and interest rates. And what this means is that central banks around most of the world are not in any meaningful sense sovereign. That is, when their currencies depreciate, capital begins to flow out of the country very, very rapidly because people become concerned about inflation, and interest rates get driven higher domestically in order to attract it back. The U.S. has not been subject to that effect, which really does make it quite unique on the international stage.

But as I pointed out earlier, if the Fed begins littering its balance sheet with bad assets, if it begins to take on unlimited liabilities, that will worry the markets. And when the Federal Reserve tries to reassure markets by backing financial institutions or some of their assets, they may in fact trigger a massive outflow of dollars into alternative investments. I would think that they would be particularly denominated in euros or alternatively in gold.

MALLABY: I'd just like to add that for those of you who want to pursue that argument at greater length in the future, Benn makes this extremely well in his book, "Money, Markets and Sovereignty", which will be out early next year.

And also, on the point that the caller made about the relationship between perceptions of the U.S. dollar and the willingness of foreign central banks to hold the dollar, and whether this is a vulnerability for the U.S., our colleague, Brad Setser, has a new Council on Foreign Relations paper about that question, which is on our website at -- cgs like Center Geoeconomic Studies.

After that commercial break, we'll go to the next question, thank you.


OPERATOR: Thank you.

Our next question comes from Chris Brookover (sp) with Associated Press.


Actually, to sort of follow up on that and particularly on the reference to the Setser paper, I was wondering if you guys wanted to comment on just the bailout from last week in terms of Fannie and Freddie and whether or not some of the talk that the selling or the stopping of the buying of Fannie and Freddie did by international -- by foreign central banks -- what kind of role that played in triggering that bailout and is that nay kind of precursor of what might happen as the U.S., you know, continues to pile up its trade deficit?

MALLABY: I think it just added an extra element of risk. I mean, in the absence of foreign buying of Fannie and Freddie debt — especially buying by foreign central banks such as China's -- you would have had the fact that lots of other players in the U.S. financial system had bought this debt and if the debt had been defaulted on, you would have had systemic consequences within the U.S.

So I think the logic of bailout -- it would be too much to say it relied entirely or even mainly on the fact that the foreign governments were owning this debt. But it is nonetheless, the case that foreigners did hold this paper and foreign governments, which were in a position to call up the U.S. government and talk about it held the paper. And they clearly did not want to see a default and they clearly had the power, even without saying it, to threaten to cease buying U.S. assets into the future -- or at least to sort of slow, and stand back from purchases of U.S. assets into the future.

And given the large U.S. current account deficit and the reliance of the U.S. on continued purchases of U.S. assets by foreigners, that's a threat that cannot be dismissed lightly. And indeed, even if the purchases were to stop because by some miracle, the current account deficit disappeared tomorrow, it would still be the case that foreigners have accumulated enormous stock of U.S. assets. And the threat of selling those, Brad Setser argues, does have the potential to be a foreign policy lever.

If a foreign government says we will inflict turmoil in your financial markets by dumping dollar assets -- or even shifting from type of dollar asset, and not U.S. Treasuries, into a different type of dollar asset such as equities, just causing disruptions by moving around within dollar assets -- you know, just as cyber warfare is part of the architecture of 21st century security, so too this kind of financial warfare I think is something we all need to get our minds around.

STEIL: I think there's absolutely no doubt that the way the bailout took place -- putting Fannie Mae and Freddie Mac into conservatorship rather than putting them into receivership -- was designed precisely to address this particular problem.

That is, the debt was guaranteed. Foreign governments that have invested in Fannie Mae and Freddie Mac debt securities have done so under the assumption, which the United States did absolutely nothing to undermine, that these were a higher-yielding version of U.S. Treasuries -- that is, that they were guaranteed by the U.S. government. I think Treasury came to the conclusion that it was far too dangerous in the long-term, in terms of the U.S.'s ability to attract capital from abroad, to allow default on some of these contracts.

Having said that, obviously those who held stock in Fannie Mae and Freddie Mac have taken a big beating. They will have most, if not all, of their stake wiped out. So the way in which this bailout took place was clearly designed to send a signal that the U.S. recognized the importance of continuing to attract large-scale capital inflows from abroad -- particularly from foreign governments.

MALLABY: Operator, next question.

OPERATOR: Thank you.

Our next question comes from Caille Melner with The San Francisco Chronicle.


I have a very basic question, but it's the one that people have been filling up my inbox with today.

It's just: How is this going to affect people, as you called it, the real world? Is it just going to be about loans getting tighter -- people not being able to get credit cards, car loans, housing equity loans? What are people going to be looking at in the next few months?


STEIL: Well, no doubt that all financial institutions are going to be much tighter on their lending practices. They've got less capital available to loan out, so obviously they're going to be looking for lower credit risks.

Someone who goes out to get a mortgage these days is probably going to have to put down at least 20 percent, maybe 30 percent in order to get a mortgage, whereas in the past, of course, even nothing down was enough. So we are going to see significant changes.

Having said that, putting Fannie Mae and Freddie Mac into conservatorship does mean that those institutions will be able to continue borrowing at preferential rates, and that will help bring down mortgage rates in the market. Indeed, it already has.

So those consumers who do have good credit, who do have enough capital to put down, say, 20 percent when they go out to buy a house, will actually find mortgage rates significantly lower than they were a few weeks ago.

MALLABY: Next question.

OPERATOR: Thank you.

Our next question comes from Jim Landers with The Dallas Morning News.

QUESTIONER: Just to take this international thing a little further, why would China want to buy U.S. paper right now, given the turmoil in our marketplace? I mean, I've heard a lot of people argue that because they want to keep their own currency from appreciating too much in value, but it doesn't look like the soundest investment right now.

STEIL: A few points in that regard: First of all, everyone right now -- not just China, but even the man on the street -- is primarily concerned with credit risk. They're very concerned that the principal on their investment is safe. And at least when you buy U.S. Treasury securities, you can be reasonably assured that the principal on your investment is safe -- at least in the sense that the U.S. government can always print the dollars that it needs to pay off its debts. So that's the main reason.

There's a very good question to be asked about why China and others -- particularly in Asia and the Middle East -- are not diversifying their foreign exchange reserve holdings more rapidly into euros and other assets. And indeed, we may see that. No doubt, a part of the reason to date has been the fact that they do not want to contribute to the perception that the dollar is on an endless spiral downward, because that will obviously undermine the value of the assets they currently hold.

But if they are convinced that, longer term, the dollar is not a good store of value, indeed you will see them begin to diversify their holdings. So even if they continue to be concerned about credit risk, they will invest in other government bonds -- non-dollar-denominated bonds. I think particularly eurozone debt will prove attractive to them.

MALLABY: I do think that in a way, the caller's answered the same question to some extent, when you said that people say China continues to buy dollar assets, because it's managing its currency vis-a-vis the dollar, it doesn't want it's dollar to appreciate too much. And I think that is basically right.

I mean, the Chinese regime knows that its legitimacy is fragile. People don't really believe in communism anymore. To some extent, the regime can invoke nationalism, but that creates its own instability if that boils over. And so really, what the regime is offering as a kind of legitimizing principle for its continued grip on power is the ability to create jobs and prosperity and make people feel better off.

And they perceive and people debate whether they are right in this perception -- I personally don't think they are right -- but they have perceived for the last few years that the best strategy is to keep the currency cheap so that the export sector booms and they can continue to create the jobs that they need to absorb a very, very fast migration of people out of the countryside into the towns where they're looking for work. And if they can't keep that job creation machine growing, and keep pace with internal migration from the countryside, their own legitimacy is very much under threat.

Now there are counter arguments to do with the fact that managing your currency at an artificially low level for an extended period causes you to build up these enormous foreign currency reserves, because you have a constant current account surplus, therefore a current constant flow of capital into your own country. And in the end, that's both expensive, it's a bad allocation of your money, because you're taking the national savings and tying it up in various dollar assets rather than building roads and infrastructure and stuff that you need for still a relatively poor population back home. And it also creates questions of inflation pressure within China.

So there are arguments against this, but that's been the calculation for the last few years of the Chinese government, that they need to carry on managing their currency, keeping it low against the dollar, and they are willing to take losses on their investments in dollar assets, because they're okay with portfolio losses so long as they get the cheap and competitive currency.

STEIL: To go back to the 1960s, which I think has some interesting parallels with today -- General de Gaulle's primary economic adviser, Jacques Rueff, came up with this analogy when referring to the privileged position of the United States. He said, "If I had an agreement with my tailor whereby every time I bought a suit from him, he immediately gave me back my money in the form of a loan, I would have no objection whatsoever to buying more suits from him."

And China plays the role of the tailor for the United States. U.S. consumers buy goods from China. They pay with dollars. China immediately turns around and loans us back the dollars at exceptionally low interest rates. So this never provides any mechanism for unbalances to become unwound. In fact, it encourages them to build up further and further and further, and that's the problem with the situation we're in right now.

MALLABY: Next question, Operator.

OPERATOR: Thank you.

Our next question comes from Gerry Mulero with The National Journal.

QUESTIONER: It's actually Eugene Mulero.

Do you think U.S. voters will associate this financial crisis with the Bush administration? And if so, how will that affect John McCain?

MALLABY: This is a question for a pollster more than people who watch the financial system.

I would have thought that there's always a risk for the incumbent party -- particularly an incumbent party which has held the White House now for more than seven years. That this happened on your watch -- particularly to the extent that people blame a lack of regulation for what's gone wrong, they are potentially going to identify that with the Republican Party.

Having said all that, I don't think that would be particularly fair. I mean, a problem like the Fannie and Freddie bailout had its origins -- as Benn was saying earlier -- in a long-standing arrangement, which allowed Fannie and Freddie to grow on the basis of a taxpayer-backed implicit guarantee. And this was an arrangement which not only predated the Bush administration, it was also prominently supported -- and probably more supported -- by Democrats than by Republicans.

And furthermore, the idea that regulations or the lack of regulation is to blame for what's gone wrong is suspect. I mean, on the one hand, Fannie and Freddie were highly regulated, and they're still into bailout. Regulated banks, such as Citigroup, lost huge, huge amounts of money. Meanwhile, rather lightly regulated hedge funds -- which is something I follow a bit since I'm writing a book about them -- have had some trouble, but relatively less trouble than the more regulated parts of the financial system.

So the idea that one should blame Republicans because they say that deregulation -- and deregulation is to blame, would be wrong. But it may nonetheless have some legs politically.

STEIL: It's interesting, Sebastian, that if you go back a year ago there was speculation that hedge funds would be hit very, very hard by a downturn in the U.S. housing market, because banks would be much more reluctant to lend to them.

In fact, what we've seen is that hedge funds are now much pickier about which banks they do business with. They're concerned about their own assets -- the safety of their own assets.

MALLABY: That's right.

Next question, Operator.

OPERATOR:Thank you, Mr. Mallaby.

At this time, we have no further questions.

MALLABY: Okay, good.

Well, it just remains then to say thanks very much to Benn Steil for doing the call and thanks for all of you for making time in a hectic day to be part of this conversation.

Thanks very much.

STEIL: Thank you.







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