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World Economic Update

Speakers: James D. Grant, Owner and Editor, Grant's Interest Rate Observer, Richard C. Koo, Chief Economist, Nomura Research Institute, and Ronald Temple, Managing Director and Portfolio Manager/Analyst, Lazard Asset Management
Presider: Sebastian Mallaby, Director, Maurice R. Greenberg Center for Geoeconomic Studies; Paul A. Volcker Senior Fellow for International Economics, Council on Foreign Relations
December 8, 2010, New York
Council on Foreign Relations

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SEBASTIAN MALLABY: Okay. I think we can get started. Thanks for coming. This is the World Economic Update. I'm Sebastian Mallaby. I work here at the council.

Two quick housekeeping things:

This meeting, unlike some, is on the record. So if you quote people up on the panel, we want the credit. Don't just say it was your idea.

And please turn off those cell phones and those other things that go "Beep."

We've got a great panel. Over there is Ron Temple, who's a portfolio manager and analyst at Lazard Asset Management, has got a long track record of particularly investing in fixed-income markets. When James Carville said that if he was reincarnated, he would like to be the bond market, what he really meant was, he would like to be Ron Temple. (Laughter.)

Next to me is Richard Koo, who is the chief economist of Nomura -- of the Nomura Research Institute, based in Tokyo. He began his career at the New York Fed. He's become well-known recently for his book "The Holy Grail of Macroeconomics: Lessons from Japan's Great Recession." I notice that Paul Krugman, who used to be on a different side of the intellectual debate from Richard, has recently written an article -- written a paper entitled something like "Deleveraging: A Richard Koo Perspective" or -- I'm shortening it somewhat, but it does -- it does say a Fisher-Minsky-Koo perspective, I think. So clearly Richard's work is getting some traction.

And then here, James Grant, who is the founder and publisher/editor of Grant's Interest Rate Observer and has been that since 1983, surely one of the best-written pieces of financial commentary you can find anywhere. And he's the author of five books on financial history and also one -- a presidential biography of John Adams.

So let's start with fiscal policy, since that's very much in the news with the deal yesterday on tax cuts. Maybe we'll start with Richard. In your analysis of Japan and the lessons for deleveraging here, you've pointed out that Japan on the bad side took 10 years to get through the balance sheets' effects and the deleveraging, but it was able to grow in these 10 years because of stimulus. So would I be right in guessing that you welcome the congressional decision -- or the deal, which hopefully Congress will ratify, on tax cuts?

RICHARD C. KOO: Well, I think it's far better than nothing. Of course, we had a Bush tax cut in place when we fell into this recession. So having them back on the plate doesn't mean we'll come out of the recession. It just won't make it any worse.

On the Japanese point that you mentioned, there are many people who have a very poor opinion on Japanese fiscal stimulus -- roads to nowhere, bridges to nowhere, economy stagnating over this entire period -- but you have to put this in perspective. Japanese commercial real estate fell 87 percent nationwide. Eighty-seven. Just imagine what would this country look like with Manhattan prices down 87, San Francisco down 87, Los Angeles down 87. What kind of economy do you think we'd have left here?

And because of what happened, amount of wealth, Japanese loss was three years' worth of Japan's GDP, the largest loss of wealth in the history -- in human history, because even during the Great Depression, the amount of wealth Americans lost was one year's worth of U.S. GDP, 1929 GDP. We lost more than three years' worth. Everybody in the private sector was deleveraging. We still managed to keep the GDP from falling below the peak of the bubble.

And that was made possible because all the deleveraging the private sector was doing was taken up by the government and put that back into the income stream. So if I'm a -- if I may use a numerical example -- if I'm a member of the household sector, I have $1,000 of income, I decide to spend $900 myself and decide to save $100, the $900 is not a problem, it's already someone else's income. The $100 we decide to save, in the usual world, will go through a financial sector -- people like us -- and it will give it to someone who can use it and that that person follows and spends it, then you have $900 plus $100, you have $1,000 against the original income of $1,000 and the economy moves forward.

If you have too many borrowers, rates are raised; to few borrowers, rates are lowered; at the end of the day, the whole thing moves forward. That's the usual world.

But the deleveraging world that we found ourselves in starting around 1995, and the world that the United States is in at the moment, is that you bring rates down to zero, no one's borrowing money, because everybody wants to repair their balance sheets that are under water after what happened through bursting of the bubble. Then the person having $1,000 of income, spending $900 and deciding to save $100, the $100 gets stuck in the financial system because no one is borrowing money at any interest rates.

Then the economy swings from $1,000 to $900; the $900 is someone's income; that person, if he decides to save 10 percent, $810 are spent and $90 go into the financial sector; and that one gets stuck. And so the economy could move very quickly from $1,000, $900, $810, $730, even with zero interest rates, when the private sector is deleveraging with zero interest rates.

And you cannot tell the private -- if you are government, you cannot tell the private sector don't -- don't repair your balance sheets, because the private sector has no choice. If the private sector balance sheet's under water, they have to repair it. Then the only way to get the economy going is for the government to borrow the $100 and spend it. Then you have 900 plus 100 -- a thousand dollars -- against the original income of a thousand dollars and the economy moves forward.

And that's what basically Japan was doing the entire period trying to keep the GDP from falling so the private sector has the income to repair their balance sheets.

MALLABY: But -- so Ron, if the -- if the -- if the picture here is that when the private sector is determined to save, it's good if their government spends to prevent the shrinking spiral that Richard describes, nonetheless there are some risks. And one would be the bond market, which we reacted negatively to yesterday's news. Treasury's back up quite a lot.

I mean, speaking as a bond market vigilante -- (laughs) -- do you see some risks in this? Or are you also basically also in favor -- talking about growth, first of all, do you think this is a good thing?

RONALD TEMPLE: I think it's a good thing in the short term, but it's merely a bridge or plugging a gap. And I think the key part -- I agree with what's Richard's saying, but I think the second part of that discussion is making sure that the government has a credible plan to deleverage itself when this is all over. And I think the challenge we face right now is that we're not addressing longer-term issues, such as entitlements.

I think right now when you see the bond market yields back up -- and, frankly, they're up another 10 basis points this morning, as we speak -- some people translate that and say they expect more growth, and hence inflation fears are back. I think Ken Rogoff would say that's a different form of credit risk. And I think what the bond market is really worried about is the government keeps piling on more and more debt, and yet there's no strategy.

Right now, we're working in the world of tactics, of, how do we make it to next year two years out. And I think what the government needs to do is address that. So I think the good news is, if I went back six months ago, we had a long list of uncertainties that were weighing over business and over investors. What will health-care reform really look like after the secretary determines all of the secretary shalls which are in the legislation?

Two is, what will financial reg reform look like? What will Basel III look like? What will be the shape of Congress? And what will be tax policy in 2011?

The good news is, we're ticking off quite a few of these boxes and resolving uncertainty, which allows businesses to invest and investors to commit capital. The challenge is, we actually have to make sure that as a country, we can delever in a manageable way without the bond market forcing us to do that, as we're seeing in the euro zone right now.

I would make one other point. I think where Richard's on to something important is, we're seeing that at a certain scale, the financial system and the sovereign are effectively one in the same when it comes to credit risk. No country can allow their banking system to go bankrupt. And so in Europe we're seeing banking systems of a scale where the government is effectively bailing out Ireland but using a back door to bail out German banks. In the U.S., I think we have to realize that and say, okay, the banks are delevering, consumers are delevering. The government at some point will have to stop being the bridge and will have to delever itself. So I think this gives us a great opportunity to address long-term issues like those raised by the fiscal commission, Obama commission some months ago.

MALLABY: So, Jim, where do you stand on this tax deal?

JAMES GRANT: Yes, I do.

MALLABY: You stand on it? (Scattered laughter.) You bury it with contempt ?

GRANT: Speaking for the rich, or for the aspirational rich, I do welcome the opportunity to pay less. I wonder if Richard's description of the way out is the only way out. And it seems to me sometimes we forget that we live in time and not merely in the moment, and one sometimes is paid to look back and to ask why things are as they are at the moment and why are they so different from the way they were.

In particular, you know, the Great Depression in this country is 1929-'33, but the truly nifty depression, the wonderful depression is that of 1920-'21, in which the economy recovered.

Now, economies do recover from depressions, but to listen to our modern interventionists, one would doubt that this economy ever recovered from the rigors of the treatment it received from Washington in 1920, '21 after the First World War. During that episode, the Federal Reserve actually raised its discount rate. Market interest rates went up too. And the Treasury ran a surplus. And yet, that depression, brutal as it was, was sharp and it ended, and growth rebounded with a great flourish, and we were off and running on a pretty fabulous boom in the '20s, which, of course, ended as booms do.

But I look back on that and I think about that episode, and I compare that to Japan at the time. Japan, too, came out of the First World War as an inflated economy. What Japan did was wholly different than what America did. Japan dragged its feet, refused to let markets clear, and it suffered -- Richard, I think I'm right in this -- it suffered a great stagnation in the 1920s not unlike the subsequent stagnation of the 1990s into the aughts.

So I think it's -- I think we might consider the problem to be not necessarily one of inherent deleveraging, but rather maybe the interplay between markets and governmental entities that wish to stop market adjustments. It seems to me that the more dynamic an economy, the more free play is given to the price mechanism, the more markets are allowed to re-price errors fast. To that extent, we are closer to escaping this ever-so-dreary, gray threat of deleveraging and stagnation. It wasn't always thus, and I think we ought to reflect on why it is thus now.

MALLABY: But isn't there a logic to what Richard says, that if people want to save, their higher saving means less income for other people on the other side, those people have less income, they also want to save. So there's this spiral of -- (inaudible) -- consumption.

GRANT (?): Yes. But there -- you know, Allan Meltzer wrote this history of the Fed, and in it he considered this truly astonishing performance of the American economy in 1920, 21. In the Depression -- by the way, that featured unemployment so severe that Harry Truman lost his haberdashery and came back in 1946 and insisted on the employment act to remedy the terrible pains he and his friends suffered in 1921.

But so Allan Meltzer and this book about the Fed. You know, how did this happen? Why was the economy able to recover when everything went wrong in Washington? Interest rates went up, the budget surplus increased. And he said, well, the answer is what the economists call real balances. In other words, people holding cash felt richer because prices collapsed. With this cash, they found bargains. And what I would add, perhaps, to Richard's analysis is a dynamism that is characteristic of markets and of value-seeking investors.

So if values collapse in the New York Stock Exchange, they collapse in real estate, what happens next? Well, people seeking the main chance go out and buy the stuff that's cheap. And Japan is, I think, an unusual, if not unique, and certainly a flummoxing, laboratory in value-seeking because things there, for reasons we can perhaps speculate about -- Richard, I daresay, knows more than I. The reason -- but assets in Japan have stayed cheap. You can -- you can do screens -- analytical screens of stocks in the Tokyo stock exchange and you can find literally hundreds of companies that are trading below -- the shares are trading below the pro rata share of cash -- net cash in that company.

In other words, the company's business value is for free or is less than free. These companies were valued as piggy banks. The business value was negative. And there are hundreds of these companies, not all of them -- these dying construction companies that are subsidized by the Liberal Democratic Party all these decades. So there's something about Japan, it seems to me, that is different. And it was different in the 1920s, it was different in the '90s. So I am less inclined than Richard to draw lessons from Japan and apply them to this country.

MALLABY: Do you want to come back on this question of whether you can just let markets clear and -- you know, why do you not agree with that?

KOO: Well, as a former Fed economist -- and I had to deal with a large banking system when I was in -- at the New York Fed, 1982. For those of us who are old enough to remember, in 1982 we had a Latin America debt crisis, and I happened to be the syndicated loan desk officer at the New York Fed when that happened, so it was like my desk exploding in front of me, because it was all my responsibility.

That was such a bad collapse, equivalent to what we are going through now. Someone at the New York Fed told me seven out of eight U.S. money center banks are bankrupt, on August 1982. Only J.P. Morgan was above water; everybody else was under water, together with thousands of other banks.

When the problem was that big, we had to think very, very differently. Until August 1982, we at the New York Fed were telling American banks to pull the money out of Latin America because at that time Latin America was all run by military dictators, huge trade deficit, a huge current account deficit, inflation that was three digits or four digits, whatever the case may be. But American banks kept on lending money. Our warnings went -- was completely ignored.

So when it happened, those of us at the New York Fed said: Yes! Finally we're proven correct. We're going to bring those guys back up, slap in the face, kick them you know where.

And then we got a call from Paul Volcker, says: Do everything possible, legal or -- he didn't say illegal, but -- (laughter) -- legal, illegal, paralegal, do whatever possible to make sure that we continue lending to Mexico; that any bank with exposure of more than $1 million will have to continue lending to Mexico, knowing full well that Mexico is bankrupt.

And we were shocked when we got this request, but when you think about for -- about this for 10 minutes, you figure out why this is necessary. When the problem is small relative to the entire economy, you can have an operation, let the market clear, let the prices go where it may be; and then there will be other buyers who will take over the assets, make good use of it, and the economy will move forward.

So if the problem is 5 percent, and the healthy part is 95 percent, you can do this operation. But if the ratios are reversed -- 95 percent sick, 5 percent healthy -- and then you try the solution, the whole thing will come crashing down because there will be no buyers; everybody will be a seller. And Paul Volcker immediately realized that, and he took all these measures to make sure that the whole problem will not come to surface. And did such a beautiful job that, even though this was a banking crisis equivalent to the one we're going through now in size, the average American never felt the pain. It just kept on going, took us about 12 years to clean this whole thing up. And -- anyhow

(Cross talk.)

TEMPLE: And then what -- and then what happened? In 1990, they were broke again.

KOO: Well, that's for a different set of reasons. (Laughter.)

TEMPLE: But I go with American banks. I know -- I know James started by saying spokesperson for the wealthy. But I think that is a prescription for the wealthy, what you just described, which is a great way to concentrate wealth in a depression. And I think if you think about the goal of government, and the goal of the Fed is to maximize the welfare of society, not a narrow segment of society -- and I think what you need to look at is productive capacity of a country when it goes through a depression and what happens.

If you look at GDP from 1929 to 1933, it fell from $97 billion to 57 billion (dollars).

It took 10 years to get back to where we started.

Now, I appreciate that people like to focus on GDP, but there's also an element of human health, human welfare, education and future productivity. And I think what the government is doing is actually trying to bridge a gap that's very different than one in a normal environment. I think there's a certain point where the rules get turned on their head when the entire economy is dislevered. And, as Richard pointed out, when you're at zero interest rates, you require certain unorthodox moves. The key point is to make sure you know when you know when to stop those unorthodox moves and allow the economy to function to again as it normally --

MALLABY: Well, that -- that's a good segue. I mean, so we talked -- we began with monetary policy -- I mean with fiscal policy. Now let's talk a little bit about monetary policy.

When Ben Bernanke went on TV on Sunday, he made the interesting comment that he wasn't printing money. He also said he wouldn't necessarily stop printing money -- (laughter) -- beyond the 600 billion (dollars) he's now announced. He said there might be QE3.

Ron, at what point do you think you get diminishing marginal returns with this kind of policy?

TEMPLE: It -- it's -- it was not intellectually inconsistent, but I think the Fed had to do QE2, but it probably won't work. And -- but -- on the surface, it won't work. I think it's interesting to realize that the U.S. not only has the reserve currency of the world, but it might be the only central bank in the world that can create inflation in other countries.

And if you think about what the U.S. is about to do, I think, with QE2, we already have an inflation issue budding in India, budding in Brazil, budding in China. Having just been in India meeting with the Reserve Bank of India, they're very concerned, as they should be, in terms of what inflation rates are doing. In China they're very concerned.

And I think what's interesting is by creating this supply of money in a world with free flows of capital, we basically create more money chasing growth. And a lot of this money is moving straight to emerging markets. It's driving commodity prices higher -- I mean, partly on some of the concerns I would think James would have as well, I mean, in terms of the value of the currency; but also as the demands for those inputs go up, also drives up labor costs in countries like China.

So it makes Chinese products more expensive in the end.

At the same time I think the feedback loop, where I say it might not work, is that as commodity prices go up in the U.S., consumers -- who have very little pricing power for their labor -- these staples get more expensive; food gets more expensive; energy gets more expensive. And ultimately their discretionary spending power may actually be squeezed by quantitative easing. So you might argue it's a devaluation of American labor relative to non-American labor, but I would argue that's part of getting to a long-term equilibrium and competitiveness. It's just something that will be less painful to the consumer than allowing markets again to act quickly and have a 15 percent unemployment rate to drive down nominal wages.

Again, important to realize: Stability of a financial system is based on nominal debt, not real debt. Consumer living standards are real. So there is a asynchronous element here of real versus nominal in the U.S. economy.

MALLABY: So, if what you're saying is that the QE2 amounts to an act of currency war and that basically it's going to work through a devaluation, therefore there are potential negative effects on the rest of the world.

Richard, how do you see it affecting the U.S.? I mean, is there a benefit to the U.S.? Does monetary policy work in an environment where balance sheets are under pressure like this?

KOO: Well, they only work through the exchange rate, I think, in this kind of environment, because there's a perception in the foreign exchange market that everything else -- if everything else stays the same and if one country tries to do QE while others don't, then that country's exchange rate is likely to fall. And that's how dollar fell when talks of QE came onto play.

But I'm very unhappy with the QE2 in the following sense, and that is that the rebalancing of the world economy and getting the economy to recover are two different goals, two completely separate goals.

And we -- we have to decide which one you want to chase, because I don't think the world economy is strong enough to get both at the same time. Sure, United States has the right to devalue its currency, running a trade deficit. It's correct for a trade-deficit country to have a weaker currency. But if United States tries that, there will be other countries who will have to retaliate. And if that happens, we're back in the 1930s all over again, the competitive devaluation scenario.

In an environment like the one we are in now, I think it's better to get individual economies to recover through fiscal stimulus first, and then once the world economy is more or less stable, then we can talk about rebalancing it through exchange rate and other adjustments instead of chasing two rabbits at the same time.

MR. : I would generally agree with that point. The challenge is when you have a fixed exchange rate as a policy. I think the U.S. has used the policy tools at its discretion or at its -- you know, that it has at its hand.

I think actually the interesting part will be to see how this plays out in terms of what Chinese policy does in response. I mean, the strategic response, in my view, would increase the gradual movement or revaluation of the renminbi, takes inflation pressure off in China, basically decreases the demand for end goods in China, raises their cost, takes a lot of political pressure off and actually moves toward the free market that Richard describes. The challenge right now is, we don't have that free market.

MALLABY: Jim, so we have two people here criticizing QE2 in some respect. You've written elegantly about gold, which is to say that, you know, these guys are "Johnny-come-latelys" to this event. You think monetary policy is unseemly at all times, not just now. Is that right?

GRANT: I can clarify QE2, and I can clarify QE2 by quoting a letter to the editor of the Times of London that appeared last year. I think I mentioned this before; I'm going to mention it again. The correspondent is from Midlands of the U.K., and he wrote approximately as follows.

He said: Now, I do understand quantitative easing -- he wrote to the editor. What I don't understand is the meaning of the word "money."

And that to me is the essential question of the moment. So Mr. Bernanke gets on the tube, and he says we don't print money, which, by the way, he did say in a previous "60 Minutes" interview the year before. He said we print money. He's changed his mind.

What the Fed does do is conjure money. It electronically materializes it through the technique of acquiring earning assets, so it goes out and buys Treasury bills or bonds with money that didn't exist before it called it into being for that very transaction. On the liability side, the Fed's balance sheet is dollar bills. We call that money, Mr. Bernanke. The asset side is Treasury securities. It grows and grows.

Ron a moment ago said that the remit of the Fed was to essentially improve the human race. No. The Fed was founded in 1913 without reference to the following things, without reference to price stability, without reference to employment, without reference to interest rates. It was founded to furnish liquidity to the banking system during cyclical and seasonal times of stress. That was it.

The Fed's remit has expanded in such a wonderful way as to make it the greatest institutional example of mission creep in the District of Columbia. It is an extraordinary institution, and I think it is on balance a hugely dangerous and damaging one, because it is daily in the business of manipulating prices that ought -- in a more perfect world that I would administer, if I were administering the universe -- would be free to set themselves.

Now, the Fed, among other things, has taken it upon itself now -- this is one of the new things -- has taken upon itself to improve our lives through lifting up the prices of stocks, bonds and mortgages. Now, why does it do that? What does it think -- does it imagine there might be unintended consequences of that set of actions? No, it does not. It admits none, at least. It seemed to see none when it set out in the early aughts to lift up the prices of houses by suppressing the mortgage rate.

So you said, Sebastian, that I suspect that -- or I hold that monetary policy is unseemly. It is -- it is simply unworkable. And now QE. QE -- what a very anodyne phrase. The Fed knows, I'm sure, that it can pick its poison. It can set a quantity, or it can set a price. It has set out to set a quantity. It's announced, we're going to buy $600 billion worth of stuff. And now interest rates are going up.

But you notice that in an October 15th conference call the Fed batted around the idea of fixing a long-term interest rate, as it did during World War II. And during World War II, for 10 years, until 1951, it fixed the long-dated Treasury bond at 2-1/2 percent. And they talked about that as a serious policy option in October. And if things keep going as they are, I daresay they will talk about it again and perhaps implement it.

Because, you see, there is no theory. The French are wont to say, it's all very well in practice, but what's the theory? (Laughter.) With the Fed, there ain't none. There's no -- the theory is print and print and print and the crisis will go away. If there's a new crisis, print some more. That's it. That's our central bank. And it bears watching.

MALLABY: One of the ironies in the world economy right now is that if you look at surveys of loan officers and so forth, you see that in the U.S., the demand for credit is soft from companies.

And so it would appear that trying to push down interest rates may not stimulate loan growth, because people don't want to borrow.

In Europe, by contrast, there is demand for credit, but the ECB has been maybe less aggressive than the Fed about pushing money into the system. I mean, do you think that the Europeans are really at the tipping point now of insufficient policy aggression in response to their crisis?

TEMPLE: Europe to me feels very much like the fall of 2008 in the U.S., when Congress voted down TARP and we saw the ramifications in the capital markets generally. I appreciate that Trichet wants to establish the ECB as a strong central bank supporting a strong euro, but I think, unfortunately, Europe will need to stare into the abyss, much like the U.S. did, before it responds as it should.

I mentioned earlier that, effectively, the decision for Germany and for a number of other banks, if you look through the BIS data -- talking about bailing out a different sovereign is convenient because you're able to scold the sovereign and say, "You were irresponsible." Think of it much like parents having given their children a credit card and co-signed for it. Effectively, creating the euro zone, Germany co-signed the credit card for Greece, Ireland, Spain and Portugal, and now they can scold them. The reality is the banks in Germany were largely responsible for funding the children's credit- card spending, and so for these countries they can actually respond in this way.

The fear I have is, whether it will be Irish elections and a decision perhaps to throw out the budget that's being agreed today, or if it's Spain hitting the brink and people recognizing the EFSF is insufficient to cover Spain, or if people look at the IMF and realize the IMF actually does not have the funds at its disposable -- at its disposal to fund its own commitments and then has to call up for more capital -- something will give, and Europe will stare into the abyss.

And I think that's when the ECB will get more aggressive in terms of its response, much like the Fed has been. And then I think what that will lead to is a European reevaluation of the structure of the euro.

Structurally, this is a currency that has some major flaws. There are penalties, in theory, for violating the Maastricht Treaty in terms of your deficit levels on an annual basis or total debt accumulated. Unfortunately, those aren't realistic. So there needs to either be a way to take the credit card away from the children -- apologies for the demeaning analogy for Greece -- we need to take the credit card away and send them out of the house to go work, or frankly to be able to impose a budget on them. And I think where Europe will ultimately end up is a more federal approach to the structure. As you're aware, there is more veto authority for the other members of the community.

The alternative, frankly, is politically somewhat unpalatable for most of Europe, and that's: It's the end of the euro as we think of it today.

MALLABY: Richard, let me just ask one last question before we go to the members for questions. So we've got the U.S. sort of muddling through with a -- with a policy response that's probably enough to avoid a double dip, but nonetheless growth is not exactly going to be fantastic, especially given that we're coming out of a recession. We've got Europe, which is trying to sort out how to treat the kids, and is in this kind of policy paralysis because it's sort of federal and sort of not federal, and it -- and that creates a paralysis of policy.

What about Asia? You've had fantastic growth in China coming out of 2009. Does that spill over, do you think, into geopolitical results, that the Chinese are growing this fast? Does that -- you go to China a lot. Does that change how they see the world?

KOO: Well, my analysis of the Japanese economy, that in spite of this massive collapse in asset prices, Japan was able to keep its GDP from falling with government borrowing and spending the $100 that I mentioned earlier, that was fully studied by the Chinese government and very well implemented every step of the way, because they had a bubble also.

And when Lehman Brothers collapsed, Chinese house prices were also collapsing. And stock market was doing poorly. House prices were falling. They were in for a -- they were a perfect candidate for what I call a "balance-sheet recession," like the rest of us.

But they took the lesson from the Japanese experience and put a massive fiscal stimulus, November 2008, that was 4 trillion renminbi, 17 percent of Chinese GDP, three times larger as a percentage of GDP than the one we were able to put in through Obama administration. And it was implemented very, very quickly. And as a result, even though China was headed to a perfect "balance-sheet recession," it bounced off. And they maintained the fiscal stimulus, which is the key thing to do in these things. And so now the economy's booming.

And because it is a dictatorship, it can maintain the fiscal stimulus. The key lesson from Japan -- there are actually two parts to it. One is that when asset prices collapsed and everybody started to delever, we were supposed to put in the fiscal stimulus to keep the economy going. But the second part of the Japanese lesson is that fiscal stimulus will have to be maintained until private-sector balance sheets are repaired, so when the private sector becomes forward-looking again. Until that time, you have to maintain fiscal stimulus, because if you don't, the 1,900, 810, 730, that process will start all over again.

And we had two experiences like that in Japan, 1997, 2001. Every time we pulled the plug, they come and start collapsing. And same thing in the United States, 1977.

MALLABY: But that was when the stimulus was withdrawn prematurely.

KOO: Right, right, when the private sector was still deleveraging.

Now, in democracies, however, it's extremely difficult to maintain fiscal stimulus during peacetime, because if one side is focused for stimulus, the other side is always for fiscal conservation. And you go back and forth, back and forth, and you can -- it's very difficult to maintain a fiscal stimulus in a consistent fashion. So if the private sector knows that you have a fiscal stimulus, income will be stable, and they can repair the balance sheets in such a short time.

Dictators don't have that problem. I mean, dictators -- if someone complains, you can -- (inaudible) -- put him in jail, and that's the end of the story. So Chinese are able to maintain a fiscal stimulus, and that's why they are about the only winner in this global economy.

And this situation where the dictator is doing the right economic policies and getting the economy moving, people more confident, more confident, they become more nationalistic and so forth -- is somewhat akin to what we saw in Europe during the 1930s. And that part worries me a lot, because if you look at what Hitler did from 1933 to 1938, from this perspective -- the private sector was deleveraging, and government was taking the money and putting it back into the income stream -- he did everything right.

And German unemployment rates went from nearly 30 percent -- people were starving in Germany in 1933. By 1938, unemployment rate was 2 percent. And industrial production, GDP, both doubled from 1933 to 1938, whereas the other countries -- Poland, U.S., U.K., France; they're all democracies -- they were going back and forth between this fiscal stimulus, no fiscal stimulus, fiscal restraint -- economies doing very poorly, and Germany doing extremely well, more tax money to pay for defense, for more -- for fighter planes and so forth. That probably led him to say, hey, maybe this time, we can do something.

And, of course, we know what -- the tragedy that followed after that.

There's some -- after the Senkaku island problem with Japan, I'm beginning to feel that maybe Chinese, they feel the same way; that look, Obama is going to cut fiscal stimulus -- or the U.S. will cut fiscal stimulus, the U.S. will be weaker going forward, less aircraft carriers, less marines; Japan the same thing, South Korea same thing; U.K. cutting budget deficit -- defense spending by, what, 20 percent or something? Massive number. And if you are the only one increasing your military standings because the economy can support it -- and economy can support it because you have the right economic policies, you know, you could get -- you may get into a situation where, maybe I can do something with these -- with these new toys.

And if that's the direction they're going, I'll get worried. But the solution to that is not to prod China to do some incorrect policies. The solution is for us to have the correct policies so that that kind of gap won't develop.

MALLABY: I should mention that Rich is on the advisory board to the Japanese Defense Ministry.

Let's go to member questions. Anybody got a question? Right here in the front.

QUESTIONER: Thank you. (Name inaudible) -- of Pace University. I wonder if the panel has a comment on the following question. The panel has obliquely referred to it. The crux of the problem, in my opinion, is that the Fed has increased high-powered money, or base money, by almost three times, whereas M1 and M2 growth have been at the low teens.

So why is the Fed not doing something like charging interest on reserves to increase M-1 and M-2, which at the end of the day are the monetary aggregates that will cause economic growth. I was wondering what the panel's thought on that is.

GRANT: Sir, if I understand this right, you're asking why the Fed doesn't take action to induce not merely the buildup of idle balances, called bank reserves, but rather the mobilization of those reserves in the economy by, as it were, pushing Fed -- pushing commercial banks to lend.

QUESTIONER: Right.

GRANT: Perhaps the Fed asks itself what is the cause and what's the effect. In other words, if it were -- if it decided to raise -- to charge banks for leaving these balances sitting around gathering dust in the Fed's vault, would that action really increase the willingness of banks to lend? And furthermore, would it activate latent borrowers to step up and borrow? And I can see the argument against that because, you know, there seems to be a lack or there has been a lack of demand for borrowing, as Richard and Ron have indicated as well as -- I don't think it's on the supply side. So perhaps for that reason, the Fed says, you know, it's not the way to go.

I don't know if that's the answer.

TEMPLE: I would just echo Sebastian's comment. From my studies with the Federal Reserve, senior loan officer studies, et cetera, the demand isn't really necessarily there for the loans, except in the small-business segment. And I think the challenge we have in the small-business segment is the banks have been too loose in their underwriting historically and had underwritten small business almost like an unsecured credit card loan, and they've actually realized that was unwise. I do not think you want the Federal Reserve to encourage lending that's not prudent.

I mean, that would basically just create another problem thereafter.

I do think there are other moves you can make, though, to encourage productivity. I mean, again, I mentioned that we have a window of opportunity here. I think one thing's very important. Anyone living in this region knows we were looking at another tunnel across the Hudson River, but the states can't afford it. I think some ideas, like an infrastructure bank that President Obama has floated, there might be ways to have public-private partnerships to encourage actual investment in infrastructure, which enhances our long-term -- long-term productivity, facilitates growth and actually gets private- sector dollars involved. I think if you look at corporations, they have large amounts of cash they're sitting on. It's only the small business where I think you have a facilitation issue around credit.

MALLABY: A question on the aisle here.

QUESTIONER: Thank you. Jay Gelb from Barclays Capital. Can you give us your outlook for inflation as well as your thoughts on stress going on in the municipal markets?

MALLABY: Maybe Ron?

TEMPLE: I think the key thing to think about and the backdrop is, we're in an era of deleveraging in the United States, and deleveraging in and of itself is disinflationary or deflationary. And I think part two of the discussion of inflation is looking at the composition of the CPI basket in the United States. And basically about 15 percent of the CPI calculation is related to food at home and food away from home, and then another less than 10 percent related to energy, either directly or indirectly.

So my base case view is that you will see inflation in commodities as a result of the QE moves and the growth in emerging markets, et cetera, keeping in mind commodities are priced globally. But if you look at the underlying cost of goods sold in the United States, about 65 percent of the cost of goods sold is labor. And Bernanke actually referenced this on Sunday night. If you look at the stratification of unemployment rates by level of educational attainment, you can see that most of America has very little to no pricing power. Seventy-one percent of Americans over the age of 25 do not have a college education.

So 29 percent of Americans actually have a college degree or better. I think it's 18 percent bachelor's; 11 percent master or beyond. Twenty-six percent will have an associate's degree, or some college. So if you look at the unemployment rate by those people, about 70 percent of the population has very elevated unemployment rates, very low pricing power. And my view is that's going to lead to low, benign inflation rates over the next three to five years, in spite of commodity price increases; so back to what I said earlier about staples getting more expensive. So in that regard, I think we don't have as much of an inflation issue to worry about, and you'll see a devaluation to some degree of labor rates.

On the municipal issue, I think that is the big challenge. And actually, having met with some clients from outside the U.S. in the last few days, they brought it up. They said: It's easy to throw stones at Europe, but you have this thing called California. (Chuckles.) And so I think the U.S. does have some serious issues at the state and local level.

Bankruptcy codes don't exist for state governments, but I do think we actually have some serious challenges where as a country we have to decide again about are we going to invest in future productivity and assist the states. I mean, if you look at what being done -- what is being done to university budgets nationally, we're gutting our educational infrastructure -- which, frankly, I think the universities are one of our core competitive advantages. So I think there will be challenges on the municipal level and we will see more defaults, but I can't give you a precise -- you know, percentage of a rate of default we expect.

MALLABY: We'll take another question --

GRANT: Well, a quick comment on municipals. Municipal bonds are mainly held by individuals. And one thing to think about with regard to the municipal market, the structure of that market, is that there are a lot of bonds held in open-end mutual funds, and these funds hold very little cash. The municipal market is not very liquid.

Furthermore, the municipal market is priced as if there were no problem. Interest rates generally, of course, are very, very low. Municipal rates have come up, but still perhaps not enough to compensate one for the looming credit risks.

So when you're looking at a yield that perhaps is too low given the risks, and we are looking at a structural market in which so much is held in funds in which there is very little cash for redemptions, there is a possibility of some thunderclap and a run on these funds, and suddenly very much lower prices for munis, very much higher yields, which might introduce a buying opportunity.

KOO: If I may add one more point on inflation, you know, this idea that if you do all of these QE, the inflation will somehow pick up because there's all this new money in the system assumes that money multiplier is positive. But when the private sector is deleveraging, even with zero interest rates, money multiply is actually negative at margin. So no matter how much money you pump into the system, the private sector is not taking the money out of the banking system and putting it into the real economy.

And so inflation is almost impossible to happen, except for some of the points that were mentioned here. In Japan, we increased base money by nearly five times. Required reserves in the Japanese banking system was about 5 trillion yen. BOJ increased to 30 trillion yen, but inflation did not pick up. It just kept on disinflating, because the money supply just won't grow. And whatever the growth that we saw in the Japanese money supply is entirely due to government borrowing.

So someone has to borrow money to increase bank assets. And it was their government borrowing that kept the bank assets up, which kept the money supply from shrinking, because if only private-sector sorts are borrowing and spending money, and if private sector decides to delever, money supply actually stops -- starts shrinking, no matter what the central bank does.

And during the Great Depression, that's exactly what happened. Private sector was all deleveraging.

And as a result, U.S. money supply declined by 33 percent.

And from 1933 to '36 and onwards, U.S. money supply starts increasing again, but if you look at who borrowed that money to put the bank assets up -- because money supplies the banks' liability, so something has to happen on the asset for money supply to grow -- it's all government borrowing. So during the New Deal process, Roosevelt government was issuing a lot of bonds. American banks bought those bonds, and that's what allowed the money to move out of the banking system into the real economy, and that's how U.S. money supply was increased from 1933 to 1936. It was not private-sector borrowing at all. Private-sector borrowing actually fell from 1933 to 1936.

So the point is, in this kind of an environment where private sector is deleveraging, both the size of the money supply and the GDP end up becoming dependent on government borrowing because government is the only borrower left.

MALLABY: Okay. Let's go to the back on the aisle there.

QUESTIONER: My name is Chandrakant Pancholi from Overseas India Weekly. U.S. dollar is an anchor for world currency since a long, long time. And if it keeps declining, are there alternatives that will come up? Because euro is not an alternative; it -- it's lying on the floor with its one leg up. (Laughter.) And do we think we will have a currency in Eastern Asia like Japan, China; you know, Australia, New Zealand coming up with; or are we going to go back to gold standard and it will be the only answer?

MALLABY: Jim.

GRANT: Well, yes. (Laughter.) Bless you, sir. It seems to me that we are in a phase of our monetary history that historians may one day label the "bonfire of the currencies."

The United States dollar is the -- kind of the Coca-Cola of monetary brands. It is the -- it is -- it is, in fact, the greatest triumph in the history of money, considering that it is a piece of paper of no intrinsic value that is nonetheless held to be value-laden the world over. When you have a $20 bill on a street corner any place in the world, people recognize that as something hopeful. (Laughter.)

But the Fed is the steward of this dollar, and the Fed is the central bank only of one country, this one. And it resolutely refuses to consider in its deliberations the consequences of monetary-policy actions on the great constituency of dollar-holders the world over.

So I agree with the premise of your question: The dollar is in difficulty as a reserve currency. I further agree that there is no obvious successor. The euro -- euro's very existence is now being called into question in the daily press. Gold is -- gold is a wonderful thing if you happen to own it; I -- the trouble is they say there's not enough to go around. There's not enough to go around, certainly, at this price. There would be enough to go around at a much higher price.

To move the world in the direction of a gold standard requires, it seems to me, a great deal of philosophical discussion. The gold standard's not merely a mechanism of fixed exchange rates, but it was part and parcel in its day of an almost purely libertarian worldview. Under the gold standard, central banks monetized no government debt. That was anathema. Governments themselves were small and not intrusive. Intervention was a nightmare for the future, not a reality of the day.

So the -- some arrangement -- and Richard (sic) Zoellick himself -- a member not of the fringe but of the great establishment -- suggested -- on point five of a five-point program, he kind of mumbled this -- gold might have a role as a unit of value or a reference point.

So I think that the idea is out. And I think people are coming to grips with the notion that our mandarins who run these central banks may not have the answers, do not in fact know what the future holds and are looking for something like stability. And perhaps gold will play a role in that in ways we don't yet know.

TEMPLE: Actually, if I could chime --

MALLABY: Sure.

TEMPLE: Actually, if I could turn the question on its head, A, I've been very thankful that the crisis hit when there was no alternative reserve currency, because this would be a very different discussion if there had been an alternative; but two is, I think we have a choice. We're at an intersection where the Fed has done as -- about as much as they can do, and it's really up to Washington, from a fiscal policy perspective, making the right decisions -- and I'm sure we all have our views of what those are -- but the -- where we as a country actually can make decisions to address long-term fiscal issues and prove to the world why the dollar is the reserve currency.

I mean, if you compare it to Europe, we have the ability to react. The Fed has flexibility. They have their mandate. It's clearly codified in terms of employment and inflation. The federal government, in theory, knows its role. And if the country actually addresses this properly and resumes growth and begins to delever the sovereign, I think that will be evidence that this was the right currency to choose as the reserve currency.

The thing I worry about is the political will and the ability to make the tough choices that actually should reaffirm that role. And I do think we have a window, because as you point out, there is no alternative right now. And again, I'm hopeful that the country will recognize this opportunity and embrace the opportunity to continue to be the economic power that we've been for quite a while.

MALLABY: So, in other words, an enormous amount hinges on medium-term fiscal consolidation.

TEMPLE: Yes.

MALLABY: Let's go here in front.

QUESTIONER: Byron Wein, Blackstone.

We've in the -- a little over the past month, we've seen the 10-year Treasury yield rise by 60 basis points. I wonder if we're all too complacent. I wonder if we're headed to a more serious financial crisis than the Christmas season would allow.

My concern is that this deficit is being financed by the kindness of strangers, and the strangers are getting a little apprehensive about the fiscal policy in the United States and the accumulation of debt. I think that the crisis would be precipitated by Treasury rates rising very substantially. And it looks like they're on that path now.

So are we headed to another crisis that will be indicated by a rise in Treasury yields, let's say, to 6 (percent) or 8 percent? Is that in the cards?

TEMPLE: I would just say I think the -- you highlight a very good point. So I tend to have what sounds like a relatively benign view. We have a window of opportunity to address issues. The challenge is the longer we go without addressing those issues, the higher the probability of that tail risk.

I mean, effectively as a country, we have socialized the problem, right? We've socialized the leverage problem of the banks, of the consumer. And by the way, by of reference, I think the challenge in Europe is they're being asked to cross -- to socialize on a cross- border basis, which is even harder. If we do not address these issues, I think there is a chance that longer-term there will be an alternative reserve currency, that the kindness of strangers will be reaching fatigue, and where those strangers might decide that it's better to bite the bullet and make changes sooner. I don't think we're there yet. But if we go -- and again, there's no one here with enough of a crystal ball to say precisely when it will be. We have a number of years, I think, not decades to get our house in order until we actually could face that kind of risk.

And even on the inflation topic -- I say three to five years with low inflation -- over time if we do not address these long-term fiscal issues, I think we increase the probability of an expected spike in turbulence that none of us would necessarily anticipate.

And maybe 6 (percent) to 8-percent Treasurys would be a good story at that point.

MALLABY: But I guess the question here is, you know, should the tail risk wag the policy dog? In other words, you know, you're saying, you know, it's good to have more fiscal expansion right now, and that your policy prescription is, this is a good thing. But if there is this embedded tail risk that we won't address the medium- term -- (word inaudible) -- and therefore suddenly Treasurys will collapse, and that's the reserve currency for the whole world -- every portfolio around the world is based around the Treasurys as a risk- free asset -- this is like Lehman on steroids. You know, are we underweighting that tail risk in our policy recommendations?

GRANT: Well, maybe it has nothing to do with policy at all. I mean, interest rates have fallen since September 30th, 1981. On that date, the long bond -- the Treasury 30-year bond had peaked at 15 percent or thereabouts, and interest rates have been moving down, irregularly but steadily, since 1981. And now perhaps they're going back up again. Since the late 19th century, writes Sidney Homer in his page-turner called "A History of Interest Rates" -- (laughter) -- these cycles have moved at generation length. So 30 years up in rate, 30 years down. We have had about 30 years of falling rates, and now it might just be time, people might be reappraising the risks.

You can on the New York Stock Exchange find good companies that are yielding what they call a free cash flow basis in the trade. That is to say they are generating cash equivalent to 10 percent on the price of the stock. It's pretty good. You have dividend-paying companies that are yielding 2 and 3 and 4 percent. These are Fortune- 500-quality companies. Some of the price ratios of price-to-earnings are the lowest in 20 years.

And at the margin, perhaps, Byron, people are looking at these adaptive corporate animals and saying: Why not, in a world of uncertain monetary prospects, invest in companies that can adapt to either inflation or deflation, on the one hand, or -- that's one choice. Another choice is to buy these unguided missiles called bonds. These are contracts, purely inert contracts, between lender and borrower. They pay dollars, that's it -- the very currency that the Fed is working overtime to print, as Bernanke does not say now.

So it seems to me perhaps rates going up have nothing to do with the city of Washington, D.C., nothing to do with policy deliberations here or elsewhere; but rather, with a generational reappraisal of risk and rewards. Stocks have been going down for 10 years; bonds have been rising for, let's call it 30. Things get overdone.

TEMPLE: I think actually you highlight the specific challenge facing Bernanke, in that he's not a magician, right? So I think -- I operate in a world of probabilities and severity given a certain probability. Not acting I think has a highly probable negative impact. I don't think we're at the point where the tail risk offsets that, but I think you always have to think about that extreme negative outcome.

I think as it relates to equities, I could argue quite a long argument of why you want equities over fixed income at this point. It is much more attractive, for many of the reasons James has mentioned. But I would argue also there's a fallacy that corporates are above the sovereign. If the sovereign gets bad enough, corporate taxes will be high enough that you will have no pre-cash flow left as a corporate. So I think we have to be aware of that kind of --

MALLABY: I want to give the last word to Richard Koo.

KOO: I don't think inflation is in the cards, because money cannot flow out to the private sector if private sector is still deleveraging. And if that's the case and if all of these savings are generated, not just in this country -- I mean, if you look at the flow-of-funds data in the United States correctly -- correctly -- (chuckles) -- the amount of savings generated in this country is absolutely massive.

And I think that explains why bond yield is down to 3 percent -- I mean, slightly above 3 percent today, but for those of us who are in this business long enough, remember where budget deficit was 8 percent during President Reagan's days, it was 14 percent. Now the budget deficit is 10 percent of GDP and it's down to 3 (percent). How do you explain this huge gap? Well, it's largely because America -- this country is no longer a low-savings country. It's actually a pretty high-savings country compared to where we started three years ago.

The -- this jump in savings from where we were three years ago is just massive. And that's what's keeping the bond yield from rising, and that's what happened with us in Japan. We were -- because of the size of the public debt, Japan -- Japanese government bond was downgraded, downgraded, downgraded; downgraded to the level below that of Botswana in Africa. But the bond yield -- of course, every time those things happen, bond yield jumped up a bit, but pretty soon everybody realized that, wait, we have this excess savings in the Japanese system because everybody's paying down debt. Nobody's borrowing money even as your interest rates -- government is the only borrower. And in these kinds of situations, financial institutions are also in very sad shape, as we found out in this country as well.

So even if they want to lend to the private sector, they can't because they don't have enough capital. So for those two reasons, the macro reasons and the micro reasons of financial institutions, the money ends up going to the government bond market. And that's how -- (inaudible) -- that's why -- that's how governments are able to procure funds at ridiculously low rates during what I call balance- sheet recession. And that was true in the 1930s through now. And for bond yield to really go up and stay up, someone has to pay that interest.

And I don't -- if Americans suddenly decided that after two tequila drinks, they forget about everything that happened in last two years and start borrowing money again, then, of course, yes, bond yield can go back up, and we're back to the textbook world, with large budget deficit, high bond yield, and investors worried and so forth.

But I don't think we are anywhere near there yet. Japanese rates remain low for all these years in spite of all attempts by American hedge funds to dislodge that thing. (Chuckles.) Every one of them failed, because at the end of the day someone has to buy government bonds now globally. Because private sector in Europe is not borrowing money. Private sector in Japan is not borrowing money. Private sector here is not borrowing money. So these investors, at the end of -- at the end of the day, you have to buy government bonds of some country. And I don't think U.S. -- I think U.S. is one of the more primary beneficiary of that.

Now, you talked of a kind of foreigner -- this argument of kindness of foreigners. Chinese are very much against QE2, as we all know, and they made that very clear. China is not against U.S. running a large budget deficit, because they themselves are doing the same thing with their balance-sheet recession. Large budget deficit, Chinese clearly understand, are absolutely essential for a country in a balance-sheet recession.

So China -- Chinese are very unhappy with QE2 because U.S. is trying to -- because U.S. does not want to run a budget deficit. They want to devalue the dollar. That's how Chinese view at what the U.S. is doing.

But instead, if U.S. is keeping the value of dollar but running the fiscal stimulus to get the U.S. economy going, then I think China will be fully supporting the U.S. effort.

MALLABY: Okay. With that, we'll call it a close. Thanks for everybody's coming. Thanks to the panelists. (Applause.)

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