Behavioral Finance and Economic Policymaking

Friday, March 4, 2016
Yuya Shino/Reuters
Paul A. Volcker

Founder and Chairman, Volcker Alliance; Former Chairman, Federal Reserve

Ernesto Ponce de León Zedillo

Director, Center for the Study of Globalization, Yale University; Former President, Mexico

Global Chief Economist, Citigroup, Inc.; Adjunct Senior Fellow, Council on Foreign Relations

Gillian Tett

U.S. Managing Editor, Financial Times

Closing Speakers
Michael Levi

David M. Rubenstein Senior Fellow for Energy and the Environment and Director of the Maurice R. Greenberg Center for Geoeconomic Studies, Council on Foreign Relations

Experts discuss behavioral finance and economic policymaking.

This symposium, presented by the Maurice R. Greenberg Center for Geoeconomic Studies, is made possible through the generous support of Robert B. Menschel.

TETT: Well, good afternoon, everybody, and welcome to the second part of the day’s event, which is entitled “Behavioral Finance and Economic Policymaking.” My name is Gillian Tett. I’m the U.S. managing editor of the Financial Times. And I’m absolutely delighted to be presiding over this panel, not just because Professor Shiller kindly just gave out a bunch of commercials for my book, my latest book—(laugher)—which I was watching from the Green Room so I didn’t need to blush, but thank you anyway. But I’m also delighted because I believe this is a crucial topic of the age.

As some of you may know, I have a Ph.D. in cultural anthropology, not in macroeconomics or quantitative physics or anything like that. And until 2007 I used to be very embarrassed whenever I spoke to people about my background because there was a presumption that if you worked in economics, if you wrote about economics, you really needed to have Ph.D. in economics or astrophysics to justify doing that. Having a Ph.D. in cultural anthropology was, as one bank CEO told me in 2007, all rather “hippy.” (Laughter.) That was before it was fashionable to be a hippy.

But I must say, since 2008, I’ve come out. (Laughter.) I tell people I have this weird background because if there’s one thing we’ve learned from the crisis in 2007, it’s that there is a reason why the roots of the word “credit” come from the Latin “credere,” which means “to believe,” which is that finance is fundamentally a social construct. We learned that in the credit bubble, when markets did not behave as people like Alan Greenspan expected. We learned that after the credit bubble, when there was a huge, great crash and panic took hold. I would say we’re learning that again now. In fact, I’ve just come back from Japan, where people are trying to puzzle about why the Japanese economy will not recover, why it’s in such a funk, why monetary policy does not work. And I’d argue a lot of that’s to do with psychology.

So we have a fantastic panel of people to talk about these themes today. We’re going to be talking particularly about the practical implications of what Professor Shiller was talking about before—namely, if you think that economics is about more than just numbers, what do you actually do about that? How do you respond if you are a bank or an economist or a trader—how do you respond if you’re trying to run a country, run a central banking policy, et cetera? What do you actually do in practice?

So the panel needs almost no introduction. But very briefly, on my far left, your right, is Ernesto Zedillo, the president—former president of Mexico, now director of the Center for the Study of Globalization. Next to him is Paul Volcker, the former chairman of the Federal Reserve and chairman of the Volcker Alliance. And on my immediate left, your right, is Willem Buiter, chief—global chief economist of Citigroup and a renowned academic economist.

So I would like to start with the economist, Professor Buiter, and ask you—(laughter)—you presumably spent the first part of your career crunching numbers. Am I correct?

BUITER: Actually, I didn’t do numbers; I just did math. (Laughter.) Numbers, data, I mean, that’s vulgar. (Laughter.)

TETT: Well, OK, models. Were you a model addict?

BUITER: Yes. (Laughter, laughs.)

TETT: Are you still a model addict?

BUITER: Well, it depends on the model. (Laughter, laughs.)

TETT: OK, well, talking about the thought that you didn’t have calculators—use of calculators—tell us, how have you seen economics change or not change over the last decade, say?

BUITER: Well, I wrote a sort of blog in 2008, I think it was. It was called—titled “On the Almost Total Uselessness of Conventional Macroeconomics.” And that was because, by that time, I had been adviser to Goldman Sachs in addition to professor at the LSE for—since 2005, and I watched the economy coming apart, financial markets going berserk, and I recognized that nothing I had learned, right, except possibly the sort of accounting I learned from James Tobin, was any good, any use in understanding what drove this crisis, and very little good in what to do about it, how to manage it.

Now, I think economics will forever be lousy at, you know, at predicting/anticipating crises. We are like doctors, right? We don’t prevent diseases. There’s social medicine for that, but we can sort of do something about it once somebody comes in with a bleeding nose.

But so what we learned, whether it was new Keynesian or, you know, or new classical, it was completely useless.

Then there was a collection, I discovered, of stories, which is behavioral economics, so anecdotes. No coherent theory or cohesive framework, but it shed light a little bit, little corners. I first got interested into it, actually, thanks to my wife, who, while starting as an even purer theorist than I ever was, ended up writing a number of papers on small group decision-making, including central banks, which relied heavily on the psychological and sociological literature.

We got both pushed into that because it’s the only thing that’s unique about me, actually. I am—well, no, two things. First, I’m the only person who has worked for a central bank whose father robbed a central bank, right? (Laughter.) That’s definitely new. But the other, second thing—I will explain that later, but—(laughter)—

TETT: That’s called narrative suspense. (Laughter.)

BUITER: But the second thing is, both I and my wife have served on the monetary policy committees of nations when we weren’t citizens. I did it in the—in the U.K., and my wife in Iceland.

Small group decision-making taught me so much about what’s wrong with economics. You put, you know, 10 people in a room, say 10 extremists in a room, the opinion that comes out is more extreme than the most extreme opinion of any of the people in the room. And similarly, you know, left or right, it doesn’t make any difference. So there’s these strange cognitive interactions that take place.

I mean, confirmation bias, right, just it takes a lot more, you know, to change your forecast than to stick to it, right? It makes no sense at all, but somehow we do this.

The going native bias, which I discovered later, that country economists invariably are more optimistic about their country than anybody else, and they’re always wrong. (Laughter.) All right?

So these were all extremely important, I think. The importance in the central bank of preventing groupthink, right—that we bring in regularly outsiders, don’t have people serve on a central bank committee, even the governor, for more than eight years, right, and bring in outsiders who have never before touched the inside of a central bank and are booted out after four years or so, simply to bring in new thoughts because groupthink is the end of common sense.

But none of that—economics didn’t help me with that. The main thing I learned about economics is that each country is open and the world is closed, this very important insight, that basically—(laughs)—application of Tobin, you know, flow-of-funds theory and balance sheet.

So the key thing about finance I had to learn in order to understand where the crisis came from is—broadening a bit on what you said—that finance really is trade in promises. And that creates an immediate problem, because it scales far too easily. If Boeing wants to double its capacity, it takes them years to build the plant, you know, and to hire the troops and, you know, get the assembly line going. If there is optimism, trust, confidence, faith—right?—(chuckles)—credibility, then the balance sheets—financial balance sheets can scale up, you know, by orders of magnitude in the space of days or weeks. That’s up. Down goes even faster, right? And the combination of this super-fast scaling up and scaling down, when there is scaling down it is lack of trust, lack of confidence, and pessimism, right? They can change spontaneously and in an unpredictable way.

It scales—well, and the big asymmetry in economics, which again learn very little about in conventional finance: bankruptcy, default. Right? You cannot be super-solvent, but you can be insolvent. There’s a big non-linearity there because of the private, personal, and social cost of insolvency resolution. So this is—this is what I learned.

So regulation was necessary. And then I learned you can’t have good regulators, because they invariably get captured, right? And there, again, turnover helps, right? Nobody should be a regulator for more than eight years, and they should definitely be banned from working in the industry which is regulated for life.

But these are—the problems that we are facing and the problems the banks are facing at the moment have very little to do with anything inward. But too big to fail, only one solution, right? End it, and then don’t try to regulate in detail. Just force everybody to hold 40 percent capital against their assets, and so you break it, you own it.

TETT: Right. Have you told your CEO that?

BUITER: No. (Laughter.) This is my—oh, yeah, I have told him that. Just my personal view, of course, yes, yes.

TETT: (Laughs.) OK. Right, this is not Citigroup policy.

Well, I’d love to come back in a moment and ask you about what you think could be done on bank trading floors or in bank regulatory areas to actually deal with these problems of financial markets being driven by, you know, emotion and things.

But before I do, I’d like to ask President Zedillo: When you were in office, did you listen to economists? (Laughter.)

ZEDILLO: Well, I happened to be—

BUITER: He listened to—

ZEDILLO: Yeah, I would stand in front of the mirror. (Laughter.)

TETT: And did you believe what you heard? (Laughs, laughter.)

ZEDILLO: No, no, no, I think I have to make a step back, you know. I think I went to school not with the idea that whatever I would be taught will be immediately applicable to real life. The school I went—and we went to the same school, and we had the same professors; he was two years ahead of me—but I think basically we were told, you come here to learn how to think. You come here, you know, to acquire some tools, to be analytic, how to pose a problem, and so on, and so forth. And I was very lucky that, of course, I had Tobin, but I also got good professors of economic history, and so on.

So when I was in office—and I started being in office in the middle of a terrible crisis in Mexico, which eventually we managed to overcome. And I remember that people will ask me two or three, four years later, OK, when you were in those very dark days of early ’95, what book did you look for? Well, I didn’t look for my basic macroeconomics, “Open Economy Macroeconomics,” or whatever. The book I looked for was a book I had read a few years earlier by Professor Kindleberger, “Manias, Panics and Crashes.”

BUITER: I looked to “The Bible.”

ZEDILLO: Because at some point very early I sensed that the game was quite different from what I had learned in the conventional macroeconomic—“Open Economy Macroeconomics.” And I think that was terribly useful because I realized very early on that we were going through a process of panic. And in that book, Professor Kindleberger described very well this Minsky process, you know, and it was extremely useful. So anyway, I used that.

And then I remembered on September 15, 2008, at four in the morning—I mean, I was not following the radio or anything like that, but in the morning I found out what happened with Lehman Brothers. At one in the afternoon, I had to teach my class at the university, at Yale. And we were due to see financial globalization later in the semester.

And I said my students, stop the clock, we are going to move forward that topic. And the first thing that you need to do is to read the chapters that I have assigned to you of Professor Kindleberger’s book. And of course, I had some students who had been students of Professor Shiller, and really were very advanced, relative to the other students in understanding—(laughter)—actually, I had a student who was—who was a student of Shiller, but also had spent the summer working with Paulson—not at the Treasury, the other Paulson, you know? (Laughter.) So I had these incredible students.

So early in October we had a meeting here. And I remember there was this nice discussion with David Rubenstein and Alan Blinder. And they were asked what was going on, you know. And that night, I wrote to my students and I said to them, you know, you may never get to be as rich as David Rubenstein, and as famous as an economist as Blinder, but I think at this point you understand better what’s going on. (Laughter.) I made your read your Kindleberger and your Shiller. And you have also taken macroeconomics.

So I would say this eclectic attitude—I mean, nobody should go to school and say, OK, now I have my knowledge. I know this. And now I work at the central bank or the ministry of finance. That would be absolutely stupid. At the end of the day, you have to make decisions, you have to have solid foundations, but you have to, you know, have common sense. And I think—and that’s a lot of psychology too, right, and character. So you don’t train people just with knowledge.

TETT: Right. Chairman Volcker. I’m always fascinating by the Federal Reserve because—you know, because the Fed has built one of the most powerful economic models that are out there. And that’s been driving a lot of what the Fed’s done in recent years, never mind the fact it seems to ignore finance and ignore the rest of the world, both of which are quite important right now. So from your experience at the Federal Reserve, how do you look at economic now?

VOLCKER: Well, you know, a lot of questions get involved—we’ll get to the Federal Reserve—but I want the audience to understand, I have a comparative advantage. You have cultural anthropology, but I took economics—it was the last year undergraduate school at Harvard you could take economics without taking mathematics. (Laughter.) If you didn’t take mathematics you had to take French. I’m not very good at French either. (Laughter.) But I always considered that something of an advantage as time passed and I did not get terribly absorbed in the mathematical preoccupations of economists. And spending all this time at the blackboard and thinking that it reflected reality.

But I can remember when I was at the precursor of the Federal Reserve when I was in college and I took all these economics courses. And most of them seemed rather fuzzy to me—labor economics. I remember talking about the Labor Relations Act, and a lot of institutional stuff, or public finance and a lot of institutional stuff. And you know, money in banking. Ah, here, you get some certainty. You got a balance sheet. You got assets. You got liabilities. If you subtract the liabilities from the asset you know what the capital is. And we know what capital is, loans and whatever.

Now, my lifetime has been a long excursion into learning that balance sheets are not always what they appear to be on the surface. (Laughter.) But it took me a while to learn all that. But when I started at the Federal Reserve, I had the advantage of—and when I started, I’m talking about now 1950, a while ago. But I ended up at the trading desk for a while. And it’s not a trading desk in that we weren’t buying and selling to make money. But we were buying and selling to expand the money supply or whatever. But we observed the markets.


And I remember thinking of economics, you know, when supply and demand changes, prices change. People come in and buy and sell and all that stuff. You got a supply curve and you got a demand curve. My simple observation in the market is mostly when it changed nothing happened, except psychology. Something had happened maybe in the newspaper, very little here. Sometimes it was hard to identify what happened.

One little anecdote, as fresh as this morning. I was involved in a large fund and discussing the investment of money and so forth. And I was kind of observing, but the investment managers were explaining, you know, in a very complicated way what areas of the markets seemed better, or worse, or indifferent. And they presented some charts that showed the stock market. And they showed mean of the stock market over a period of years in terms of price earnings, ratios, and some other measures.

And they drew a nice fairly smooth line. And they said, well, you know, it’s very interesting to see how far we are from the mean. Maybe that gives us some indication as to where the market’s going to go. And then he finally said, yes, but you know, I have to tell you the characteristic of all these markets is the price is never at the mean. It’s always moving through the mean. And that’s what the chart showed, big ups and you can calculate the average, but the average is fairly meaningless in terms of trying to predict the market or whatever.

And I think the central banks, to some extent, got caught up in this business of they could develop some theories and some mathematical models. And when I—when I became chairman of the Federal Reserve, I think the general consensus was the Federal Reserve had the best-developed econometric model of the economy. And they presented this, of course, to the open market committee every month, or six weeks, or however often we met. And money was getting pretty tight and interest rates were very high. And what the model showed was we were either in a recession or we were going to be next month. It was not a great atmosphere for tightening money even further, but we went ahead and did it anyway.

And for six months, the projection was every month that we were going to be in a recession the next month. (Laughter.) And it came right against interest rates going to 20 percent, or close to 20 percent. Very tight market conditions. And the inability of what was presumably the most sophisticated econometric model that anybody had of the economy not being a very reliable indicator of where the economy was going was, I think, rather impressive in terms of maintaining a certain skepticism and some degree of common sense and judgement when you’re looking at the economy, whether you’re making investments or running monetary policy, or whatever.

I am of the view, which is not the normal view these days among a lot of people, that William McChesney Martin was at the central bank for more years than anybody else. And his favorite expression was, this is now 50 years ago, it’s very important to have economists in the central bank. But keep them on tap, don’t put them on top. (Laughter.) And we’ve rather deviated from that.

TETT: Well, I was going to ask you some practical point about what could be done, and there is one. Although, of course, it’s very noticeable, if you look—for my last book I actually went back and looked at the employment record of people who were being hired by central banks. And really started from the 1990s it began to be absolutely dominated by B.A.s and Ph.D.s in economics. And nothing wrong with that, but it was very much a single tribal group that came to the fore. But do you have any other—any other thoughts about what can practically be done to try and recognize that models can be useful, but not the only thing that can be—

VOLCKER: Well, I don’t think it’s already been said here, I don’t think behavioral economics—I like that phrase, because it reflects, I think, reality. (Laughs.) Behavior has something to do with it and behavior is not so stylized as economists have in the past thought. But how do you take advantage of that in a practical way? I don’t think it’s been developed. As Willem said, it’s kind of a series of anecdotes, in a way. And I decided I would prescient my mind. I know vaguely what behavioral economists were doing. But I wondered whether there was some theorizing going on here and some model building that I wasn’t familiar with, and I was going to appear very ignorant in this panel.

So he sent me—my grandson, who had taken behavioral economics—sent me a little stuff. Called him said, said big emergency. He said, well, here’s the best stuff I can give you in the short run. And what I looked for, and what was said, is, by people who were involved in this, that they haven’t been able to develop and didn’t know whether you could develop a kind of model of behavior in the economy that took account of all the vagaries of expectations and understanding or quirks of personality that human beings have that aren’t reflected in the economic modeling. And I think that’s true.

If we ever had this perfect model, it wouldn’t work because then that would affect people’s expectations, and they’d have to think of a different model that took account of the expectations. They might change that, then they’d have to take account of the expectations of what would happen to those who were thinking about the future expectations. (Laughter.) So I think we’re going to be left with a certain amount of uncertainty.

TETT: Right. President Zedillo, do you have any advice for people who are running emerging market countries about what do with the economists?

ZEDILLO: I no longer give advice. (Laughter.) Well, I have opinions. No, let me again step back a little bit to the question you made to Paul. And it’s about whether or not, you know, these relatively new field—although, Bob explained that it goes back to Adam Smith, the theory of moral sentiments, and I fully agree. You know, how does it apply? And I think it’s very important.

I mean, we may say that it is a collection of anecdotes or experiments, but I think it’s useful first to prove that some of the models that have been used in the recent past as if they were, you know, incredible absolute truths, you know, can fail and can fail very seriously because they have an inherent construction that probably will make them fail. You know, these ultra-rational man that takes brilliant decisions, you know, as if everybody were a Paul Samuelson, or something like that. I mean, it’s simply not possible. And there are these biases that you have to take into account if you are trying to figure out what is going on in the world. But still, you know, a good part to the profession wants to think like that.

I took a—I was reading the speech by Bill Dudley, who is somebody I admire a lot, because he is not only a good economist, he’s a great public servant. But he gave a speech last week in China. And he says: Adam Smith in “The Wealth of Nations,” introduced the concept of the invisible hand. Smith argued that individuals acting in their self-interest can collectively promote the public interest. This concept, I believe, also often applies to international monetary policy. The biggest problems that countries create for others often stem from getting policy wrong domestically. Recession or instability at home is often quickly exported abroad. Equally important, growth and stability abroad makes it easier to set policy at home.

Well, this is wrong. I mean, and I say it with incredible respect, first, because as Bob said, well, you know, Adam Smith also said other things. But the problem here is that you do need macroeconomic policy coordination at the international level, otherwise you can be in deep trouble, as we are today. And this is not an irrelevant consideration, because by not having that coordination we are paying a high price. And what is described here is that, well, if countries just care about themselves, we will have a nice equilibrium. Well, I think we are going to have a phishing equilibrium, in a way, and that takes to me to emerging countries. You know, I think emerging countries are suffering and are bound to suffer a lot simply because we are having faulty policies at the international level. And I think this is too bad.

Now, perhaps what is missing here, you know, in all these discussions, when I listen to Bob Shiller and other behavioral economists, what is really missing in the other part, the macro. We speak about all these questions of asset markets and we speak about the crisis, and today the crisis is still presented as a problem with the bankers, problems in financial markets, and we have forgotten about the previous story. The previous story is poor macroeconomic policies that allow global macroeconomic imbalances to get out of control so that some countries got too many resources with perhaps too few investment opportunities. That was the United States borrowing a lot of money from China and others, with a current-account deficit of 7 percent of GDP.

So the question is, yes, you have to be watching financial markets, but you have to be watching your macroeconomic policies too. And you have to watch it nationally, but also you want to live in globalization. And with interdependence, you have to accept a significant degree of coordination of macro policies. Otherwise you are going to pay a very high price, even if you have, by the way, very good, very clever financial policies or instruments in which you have, by means of perhaps super artificial intelligence, incorporated everything that Bob Shiller is teaching. If you have poor macro policies, then you are in trouble no matter what.

TETT: Right. Well, that’s a very sobering point.

Willem, in terms of—I mean, you work in a bank these days. You’ve seen how bankers behave, how central bankers behave as well. I mean, what do you think it means for financial institutions in practical terms?

BUITER: Well, you start with central banks and make them recognize something that was forgotten to varying degrees in most advanced economies’ central banks in the years leading up to the great financial crisis, during the so-called—whatever, the great becalming—that the first responsibility of the central bank is financial stability, right? Whether you have a dual mandate, a triple mandate, or a single mandate, you know, price stability, prices, and maximum employment, that’s all secondary, right? The key thing is financial stability.

And the lender of last resort in a bank-dominated economy role of the central bank is its most important one. In a capital-market-dominated economy, it has to be market make of last resort as well, you know, to intervene and make market when market liquidity dries up, act as a buyer of last resort most of the time.

And to—I think you have to ensure, to the best of your ability, that there are no entities that cannot fail without creating a systemic disaster, all right? And if that means breaking up entities between different activities or even within an activity, then so be it. Because if you do make things too big to fail, the moral hazard and very classic economic incentives on the sort of—(laughs)—even the behavioral kind, of the—of the—you know, of the everywhere kind will make sure that, you know, you have an endemic source of instability there.

Other lessons. Once you have no entity too big to fail, right, you have no need for CCARs and stress tests and all these other fighting of the last wars, right, and failing to address the likely next source of financial instability.

Incidentally, on that—on that ground, learning does not take place. This is a fact that has to be remembered. I was shocked out of my mind when, a couple of weeks ago, I discovered that ABS—asset-backed securities—in fact, technically CLOs—backed by subprime residential mortgages were again being pushed. I thought we would never see these things again, right? These are instruments which should never have existed because it suckers people that cannot really afford to take the exposure of a classical mortgage, right, into assuming liabilities that they really can’t afford. And it is—I think it’s just a crime against humanity. But yet, it’s back, right? Why? Well, because, for political reasons, politicians are pushing to let—to get people who are desperate to climb on the property ladder, to give them a foothold there. It’s tragic. So learning does not take place.

Don’t rely on internal risk models, right, in regulation. If it cannot be verified independently easily by outsiders, don’t rely on it for calculating the risk rate of a source of capital.

Central banks should spend as much time looking at macroprudential instruments as at the interest rate. They need both, I think, to manage financial stability. One of the real problems at the Fed is that it has no macroprudential instruments. It has one, actually. It is the—it’s a margin requirement for stocks. It hasn’t been changed in 40 years, right? But it doesn’t have countercyclical capital requirements. It doesn’t have countercyclical loan-to-value or loan-to-income ceilings. It doesn’t have countercyclical leverage ratios, liquidity requirements.

When Mrs. Yellen talks about no macroprudential policy, she means across the cycle macroprudential policy—not countercyclical capital ratios, but high capital ratios. And I’m not in favor of that, because it makes it as likely that a crisis will happen and, if it happens, that the impact will be serious. But it is not leaning against the wind, and that’s—we need more of that.

And so I think these are the obvious lessons, right? First, get central banks to focus not primarily on price stability and then employment. That’s secondary. These are important as well, but only subject to the goal of financial stability, because without that you can neither have price stability nor full employment.

So one final thing: There are real cognitive obstacles sometimes to central monetary policy. The response, for instance, to a negative nominal interest rate, negative policy rate, cannot be understood, I think, rationally in a conventional economic model, right? There’s a cognitive problem here that I think one has to live with and hopefully educate the masses on. We’re going to be, in the foreseeable future, in a world where the risk (reveal ?) rate, at long maturities even, and the risk—(inaudible)—rate are going to be close to zero, close enough—

TETT: Right.

BUITER: —to revisit the zero lower bound on a regular basis, right? But it means it will be extremely desirable to remove the effective lower bound and allow, you know, interest rates to be symmetric around zero, as easily at minus five as plus five. And that’s not difficult to do. There are at least three ways of doing it—you know—(inaudible)—way, taxing currency, abolishing currency, or having a variable exchange rate between currency and deposits, right?

But the arguments that you—that you get, literally, are that this is an immoral, a perverse policy, right? Negative rates are called, very emotively, a tax on savers and on creditors, or a confiscation of the wealth of creditors. But by the same token, of course, positive interest rates are a tax on borrowers and the confiscation of the wealth of borrowers. At some point you have to move cognitively to a world where minus-3 (percent) is no more usual than plus-3 percent. And the sooner we get there, the better.

TETT: Right.

OK. Well, I’m going to jump in here, because I’m conscious that we have a lot of people sitting in the room who have strong views and who have a lot to contribute to this discussion. And we’ve heard a lot of ideas about what can be done. They include focusing on macroeconomic coordination; keeping economists on tap, not on top; and if you’re about to do an epoch-changing event like raise interest rates very high, don’t necessarily believe your economic models. That seemed to be one of the messages from Chairman Volcker. And we’ve got from Willem talking about macroprudential regulation at central banks; essentially, that banks need to think about whether they’re going to be stable in a crisis—break up the banks, perhaps. And then, of course, look at economic history, look at economic psychology. I would argue try hiring an anthropologist. (Laughter.) All of those can be useful.

BUITER: We’re not that desperate.

TETT: Not all that desperate, OK. (Laughter, laughs.) All of those can be useful for dealing with the shortcoming of economics, if not models.

But I’d like to bring the audience in at this point and see if anybody in the audience has got any suggestions, comments, questions about how to deal with this. I would argue, please—I have to—I should say I’m not allowed to talk to you as the audience. You’re members, not the audience.

BUITER: What kind of audience consists of members? I didn’t understand that. (Laughter.) I mean—

TETT: (Laughs.) I think maybe we’re being promoted to be members.

I have to remind you this meeting is on the record. I have to remind you that you have to wait for the microphone and speak directly into it. I would ask you to please state your name and affiliation. That’s courteous if not compulsory. And above all else, please limit it to one question and keep it very brief. Otherwise I will cut you off. (Laughter.)

So who would like to ask the first question? Let’s start there and then go to the back of the room over there.

Q: Thank you. This is Ebrahim Rahbari of Citigroup.

We heard about the importance of international policy coordination. We, of course, have Chairman Volcker here. That’s been a popular topic of late as well. So if I could ask you perhaps to recall the circumstances, both economic and in terms of the political economy, that led to international policy coordination in your time and what you would think would have to happen for that to exist in the near future again.

VOLCKER: Well, I guess that question is relevant in two times in my experience. Let’s go back to 1971, where the dollar had been under some pressure. Our gold stock was diminishing. The balance of payments, after being in surplus for years and years, was going into deficit, had been in trade deficit.

It seemed to me and others that we were going to have to get an exchange-rate change. How are you going to get an exchange-rate change? Were we going to call together the other major central banks and say, gentlemen, I think we need an exchange-rate change; who wants to volunteer for changing 15 percent, let’s say, and make it meaningful? The volunteers are not very evident.

We knew that was going to happen. So we said the only way to change this, ever, as an interim step, we will unfortunately have to stop the gold price fixation, let the dollar float. Then other currencies are going to float too. And presumably, if it all went well, we would move toward a sustainable equilibrium, whatever that means.

The fact is there was no great desire to move. And yet they’d been complaining about the dollar for years. We’re running a deficit. They’re running a surplus. OK, let’s get an exchange-rate realignment. And with the possible exception of Germany, which had done some on its own, everything was quiet.

Well, we finally had a negotiation and we did agree to a change. But before that negotiation, the suggestions from some of our European partners were, all right, we’ll change by 2 percent or 3 percent. And they were, you know, numbers that seemed totally inadequate to the possibility of any change in the equilibrium.

Well, we finally negotiated somewhat larger changes than that. We would say it was 10 percent if we left out Canada. And since Canada didn’t move much, it was less than 10 percent. But, at least to me at the time, it seemed inadequate. And we did not agree to restore convertibility, which upset everybody, because we didn’t think we could sustain it.

We went through a prolonged negotiation. We made up the first committee of 20 to have this negotiation. It was very difficult to get a consensus. And we finally did make a further devaluation. But that set off speculative processes, and it broke down. So there was an agreement that for a time being at least will help to float everybody.

I don’t think the success of that was very great. It helped set off very large fluctuations in the dollar and other currencies. It helped create a big inflation in the United States. But the theory was that it would settle down in the long run, the not-so-long run, and floating rates were the way to go.

We ended up floating rates because it was impossible—maybe the inadequacy of the negotiators—to get an agreement on the kind of suggestion that President Zedillo was talking about.

Now I’ll come back to another embarrassing—it’s not really embarrassing, but now I’m chairman of the Federal Reserve Board instead of the undersecretary of the Treasury and we had an inflation problem, big inflation problem, in my judgment. It’s affecting psychology. It’s affecting the mood of the country. Everybody was unhappy. There was no confidence in the restoration of price stability and we went at it hammer and tongs.

That was not a terribly helpful development from the standpoint of many developing countries that had gotten increasingly heavily in debt in dollars. And the suggestion which somebody made: Didn’t you take that into your account? And my answer there was: Not much, because there wasn’t much I could do to help that situation when they were already getting desperately in debt. And to, at that point, say we will try to—are going to coordinate policy in a way that undermined our anti-inflation policy seemed to me counterproductive. Again, we didn’t do it.

Now, there have been incidents here and there, a year or two following that actually, where there was, in the short run, some accommodation. You saw it in the Plaza agreement. And I must say—and then the Louvre agreement. And there was a lot of talk about coordinating exchange rate policies. There was a lot in the communiqué about adjusting economic policies. The part about adjusting exchange rate intervention with a certain purpose had some reality.

All those words in the communiqué about adjusting domestic economic policies were words in a communiqué that had no influence, that I’m aware of, on actual policies, because that’s pretty tough stuff. I could repeat—

TETT: Right.

VOLCKER: —the same kind of story in the Louvre. But it’s just an illustration of the practical difficulties, even in areas where the incentive might have been quite strong to get that kind of coordination you’re talking about.

TETT: Right.

VOLCKER: But should I shut up?

TETT: No, no, no. (Laughter.) No, I was going to go to the next question in a second.

VOLCKER: The other incident I can remember is the practical political problem. We talk about behavioral economics. You need behavioral political systems for this.

Shortly before—when did I become chairman—’79. Seventy-eight they had this great bond conference where there was a feeling the system was falling apart. And the finance ministers all met and agreed upon some exchange rate changes and presumably some policy changes.

Helmut Schmidt, who was very outspoken, said: That was the most serious mistake Germany ever made because we adopted some economic policies that we didn’t think were in our interest as part of an effort to be cooperative and all it does is mess things up over a period of years, in his view. And he may have been right because the forecast upon which those changes were suggested were not very valid anyway.

TETT: Right.

VOLCKER: But it’s a very difficult process. So how do we get, realistically, an international monetary system that has enough flexibility so it’s not going to break down in the short run, with some limitation on the volatility of markets? That’s a very difficult thing to do. We obviously haven’t succeeded.

TETT: I think it’s still a very, very big challenge even today. I mean, now more than before.

BUITER: The only thing we have is what the U.S. put in place under Bernanke during the crisis, the swap lines, right? That’s hardly coordination. That was a unilateral act of sort of intelligent self-interest, right?

VOLCKER: Oh, I hope so.

BUITER: And we should be expanding that of course, I would say now, and extend it to key emerging markets. If the IMF won’t do it, right, then the U.S. might as well do it. After all, the U.S. has the only reserve currency in the world.

TETT: Right.

We have a question right at the back, over there on the—yes.

Q: Herbert Levin.

Chairman Volcker, the effect on the American economy and the world economy at present and in the near term of the evolution of the Chinese economy, what effect do you think that has?

VOLCKER: Well, it has a big effect. (Laughter.) We can avoid the—

TETT: Now, we have quite a few more questions so we need to keep the answers quite short.

VOLCKER: Pardon me?

TETT: We have quite a few more questions—hands waving, OK?

VOLCKER: What effect does—

TETT: In one minute—one or two minutes.

VOLCKER: The Chinese economy is someday going to be as big as the American economy. By some measures it’s almost there. And their external trade I guess is bigger than America’s external trade. And we are learning that they can have business fluctuations in their planned economy just as we can in our market economies, and they’re struggling with a partial market economy.

So to be practical, I think the suggestion can be made, recognizing the force of the changes in the Chinese economy, recognizing the size of the American economy in particular—this may be not a very politic thing to say, but if you’re going to make some progress toward the kind of thing Ernesto is worried about, you’ve got to get the two biggest—two biggest economies more or less involved. If you can’t do that, the rest of it isn’t going to fall into place.

Now, when and how the time is appropriate for that kind of involvement between China and the United States is interesting. It used to be if there was some anchor or cooperation in the world 20, 30 years ago, it was between the United States and Germany as the next-biggest economic policy before the euro, and their hope would be with the euro, but before the euro. And Germany was—I expressed some concern that they had earlier, but they were more flexible in terms of the kind of cooperation that’s necessary, as we saw it and most other countries. And I think it helped stabilize things for a while.

TETT: Right. We’ve got a question over here.

Q: Thank you. Ricki Tigert Helfer, the Grameen Foundation, U.S.

President Zedillo, how are you? Nice to see you. The question is, there’s a lot of emphasis now on inequality, the haves and the have-nots. Some would say the U.S. election currently may, in fact, be an evidence of that. But what do you think the likely effect of continuing exclusions of large percentages of people in a number of developing and developed economies in the world—what effect could that have on financial stability over time and what can we do to deal with it?

ZEDILLO: Well, we will have to—and this goes a little bit the sequence. I think financial—lack of financial stability or insufficient supply of the global public good of international financial stability will make it harder, or will postpone the process of economic convergence that we had been observing up to very recently.

The idea was three or four years ago that a large group of developing countries, emerging countries, were making a lot of progress in converging. Now that idea is gone because the commodity boom, or supercycle, is over. The emperor has no longer clothes. And countries, some emerging countries, are discovering that they are in trouble. One of them, unfortunately—well, several of them, but given its size it has to be mentioned, is the case of Brazil, and that’s a terrible disappointment.

Now, of course that is going to have political consequences in countries that the population gets frustrated in the sense that they’ve got some expectations that are not being fulfilled. And this of course gives rise to explanations that are wrong, to populist postures. And we Latin Americans invented populism, in a way, unfortunately. So that’s a big issue.

So again, I think there is a great need of recognizing that this is a common problem and that somehow we need to have—I would insist on that, on coordinating policies to—if not going back to the very high rates of growth that we had before the crisis, and in some cases right after the crisis in the cases of emerging countries, we need higher growth in the world. And we are not going to have it with the way in which we are doing things, in which we are basically in a prisoner’s dilemma.

I don’t know how sustainable this situation is. I don’t know—let’s say the United States continues to do so-so or well. Is that sustainable while other countries are not doing so well? I think eventually there will be some disequilibria here that will stop the process. Is it sustainable for Germany to have a current account surplus of 7 percent of GDP and other Northern European countries? Is that going to be sustainable for the European monetary union? Absolutely not. So this is a mess.

So the examples that were used by Chairman Volcker, while it was a little bit like the Greenspan putt: You know, OK, there is a bubble. Let it break and then we’ll go and fix it. Well, in ’71 you were fixing a mess that had been built in the previous 10 years when you did the Plaza Accord. Again, you know, it was almost a desperate situation.

I’m talking about something fundamentally different. I’m talking about—and, you know, in 2006, when we knew that there were these significant disequilibria, well, the IMF tried to do an exercise to do proper surveillance and push countries to adjust in the right direction. There was a proposal and they put it in the drawer.

When the crisis exploded a couple of years later—well, in ’08—they created the G-20. The first paragraph of the declaration: We are here because we have had uncoordinated, incoherent policies, so now we promise that we will have a mechanism to coordinate policies. And you reconstruct the history of the G-20 and it’s the most—one of the most disappointing exercises.

So we cannot have it both ways. We want to enjoy the fruits of interdependence but we are not willing to pay a price for interdependence, and that is to say to agree on some—at least some directions in policies.

TETT: Right.

ZEDILLO: So that’s my point. If we don’t do that, then your inequality problem will be—that’s also my problem.

TETT: Right.

ZEDILLO: And everybody’s problem will get worse.

TETT: We’ve got hardly—

VOLCKER: May I make a—

TETT: We’re going to take one more last question quickly, but yes.

VOLCKER: I want to make a brief commentary on this because I think the euro and eurozone is an interesting case. Germany is out of equilibrium with the rest, quite clearly.

Now, all kinds of political reasons why they want to hold the euro together and hold the European Union together. It’s being tested and it will be interesting to see how this test works out. If they hold them together, that disequilibrium within—the economic disequilibrium within the euro has to be taken care of. If it’s not, it will disintegrate. Which is more likely?


VOLCKER: (Laughs.) As a practical matter, will you—

TETT: In 10 seconds. Then I’m going to bring in Professor Desai.

VOLCKER: —will you get—even with that pressure through coordination?

ZEDILLO: Well, then we will go to disintegration, and that will be the beginning of what, because if the monetary union breaks down, I don’t know what will happen with the common market. And if the common market breaks down, then I don’t know what comes next. And here we go back to 1914.

TETT: To go back to an era of politics, not economics.

Professor Desai. It will be the last question because we’re almost out of time.

Q: A question for Dr. Paul Volcker.

Do you think that policy making in the U.S., especially during the current years of the recession, has been entirely dependent on monetary policy, because fiscal policy and budgetary issues have been caught up in Congress as a result of contentious party politics?

VOLCKER: It’s obviously been heavily dependent upon monetary policy in recent years. There was more or less effective fiscal policy in the midst of the crisis. We did have a big budgetary action. We had deficits that I never would have imagined. It was close to 40 (percent) or 50 percent of the budget was deficit, 15 percent of the—over 10 percent of GDP. I don’t remember what it was.

But after that, when we had the initial recovery, obviously the U.S. has been left with a roadblock in Washington about any kind of sensible policies about anything that—fiscal policy has been frozen, and so monetary policy has been pretty much—the full load—it’s a dangerous situation because people look to monetary policy to create some miracle that isn’t within the capacity of monetary policy, in my view, to create. There are limitations, probably, at the rate of speed of growth of the American economy not very different from what’s actually happening. And to expect the central bank to have something in their hat that’s suddenly going to change the growth rate I think is mistaken.

TETT: All right. Well, sadly—I mean, I think we could have another hour talking about this. Sadly, we are, indeed, out of time. It’s been fascinating.

I mean, my main conclusions are, one, everyone agrees to agree that economic models alone are not a great guide. Everyone agrees that the have lots of great stories about how economic models are not a great guide. But trying to find a practical solution to what to do about a world where economic models don’t always work remains incredibly hard.

But thank you very much, indeed, for sharing your thoughts. It’s been very challenging. And I think we’re now going to hand over to Michael Levi, who is going to close the—today’s event.

LEVI: Thank you. And first, please thank—join me in thanking this fantastic panel. (Applause.)

I’m Michael Levi. I lead the Center for Geoeconomic Studies here at the Council on Foreign Relations. Bob Rubin said at the beginning that this is the first in an annual symposium, and in the coming years we’ll go between these sort of broad takes like we’ve had today, and deep dives into particular areas to see where a behavioral perspective and awareness of irrationality and crowd behavior can help us develop better insights.

But the thing that I’m really excited about for this entire series is that—and today has demonstrated it—we’re going to talk as much about what we don’t know as about what we do, and that’s unusual for the Council on Foreign Relations. So this is a big of an exercise in humility—(laughter)—and in learning. We’re good at learning here. We’re going to improve on humility. (Laughter.) And I’m really thankful for this opportunity to do it.

Before we close, I want to thank Carrie Beakey (sp), Stacey LaFollette, Katie Lowry, who did an enormous amount of work to bring this together, and a much bigger team of folks who have been working throughout the day today. So please join me in thanking them. (Applause.)


This is an uncorrected transcript.

Top Stories on CFR

Middle East and North Africa

CFR experts Steven A. Cook and David J. Scheffer join Amnesty International’s Agnes Callamard and Refugee International’s Jeremy Konyndyk to discuss the humanitarian crisis in Gaza.


The highlights from Kishida Fumio's busy week in Washington.

Genocide and Mass Atrocities

Thirty years ago, Rwanda’s government began a campaign to eradicate the country’s largest minority group. In just one hundred days in 1994, roving militias killed around eight hundred thousand people. Would-be killers were incited to violence by the radio, which encouraged extremists to take to the streets with machetes. The United Nations stood by amid the bloodshed, and many foreign governments, including the United States, declined to intervene before it was too late. What got in the way of humanitarian intervention? And as violent conflict now rages at a clip unseen since then, can the international community learn from the mistakes of its past?