Currency Wars, Capital Controls, and the Outlook for the International Monetary System

Wednesday, November 17, 2010

Experts discuss the the current global economy and their skepticism of effective capital control, as well as the future of currency pegging, fixed currency rates, and capital mobility.

This session was part of CFR's Stephen C. Friedheim Symposium on Global Economics which was made possible through generous support from Stephen C. Freidheim.

RICHARD HAASS (president, Council on Foreign Relations): Well, good morning. I'm Richard Haass, president of the Council on Foreign Relations, and I want to give a warm welcome -- and it is warm today -- to everyone here and thank you all for coming to what is the second annual Stephen C. Freidheim Symposium on Global Economics.

Let me begin by thanking Stephen for his support, without which this would not be possible, as well also -- and not -- let's be honest -- not simply for his generosity but also for his ideas. Steve is -- there are certain people who are generous enough -- and I'm happy with that -- to support what we do here. Steve, however, isn't content with that, and also is truly an intellectual participant. And you see the fruits of it today, which is going to be an extraordinarily rich day. So thank you.

I also want to thank the Council -- the Council on Foreign Relations' Maurice R. Greenberg Center for Geoeconomic Studies, led by the gentleman to my left here, Sebastian Mallaby, for all that they do as well and all the work they put into this symposium.

And subjects such as the ones we're going to be discussing this morning that focus on economic and political forces and how they interact and affect the world are at the heart of what we're trying to do both in this center and at the council. The interplay of the policy and the economic is what we call "geoeconomic," and what we are trying to do is mirror the world. Universities may have departments and silos; the world does not. And we do our best to approximate the world.

We've got an impressive lineup today, as you can see from your program. We start off with a panel on currency issues, followed by a conversation with Larry Summers, and we end with a panel on trade. And in the between the panels are breaks, to give you a chance to speak to one another, take in some calories, and there is a lunch afterwards.

Timing is a lot in life, and I think our timing is good. As the G-20 meeting in Seoul demonstrated all too clearly, the world as yet has no mechanism for solving currency issues. And the G-20 meeting came against the backdrop of charges -- or actually a near-consensus, I would suggest -- that China was manipulating its currency. Much less agreed upon was what the consequences were and what to do about it. But before the meeting was over, criticism of the Federal Reserve's decision to resume quantitative easing filled a lot of the political space. So all of this means we've got more than a little bit to discuss this morning.

The third panel -- the third session today, the second panel, is on free trade agreements and trade more broadly, and given, again, what happened in Seoul, what for many was the unexpected inability to come to closure on the U.S.-South Korea Free Trade Agreement forms the backdrop.

And obviously trade is a growing issue of both domestic and international concern. Lots of people are asking the question of what, if any, consequences the new Congress in this country will have. And as recent Wall Street Journal and Pew polls have shown, there are fundamental issues of what can be done to resurrect a consensus in this country that would support free trade. Indeed it's for that reason that one of the things we have started up here at the Council in Foreign Relations is a task force on exactly that issue: What should be American policy in this -- in this realm?

And again, all of this is against the backdrop of a moribund -- I think that's a fair word -- Doha process or lack thereof. So I think there's also the question of what, if anything, can be done to resurrect not simply the three languishing free trade agreements, but what can be done to resurrect global trade talks.

We'll discuss all these issues and more today, and I think the "more" is whatever Larry wants to talk about in between. The context could not be better in another sense. We've already had the brief -- well, the draft of the chairs of the deficit commission come out. Then I think today you've got the Rivlin commission's report that she and former Senator Domenici have put out.

So the air is filled with things economic and geoeconomic. And as a result, we couldn't do better than to turn things over to Sebastian Mallaby. Sebastian is the director of the Maurice R. Greenberg Center for Geoeconomic Studies here at the council, but he's also the Paul A. Volcker senior fellow for international economics, which makes him the person at the Council on Foreign Relations with the largest title and the largest business card. Sebastian is also the author of a recent book, "More Money than God: Hedge Funds and the Making of a New Elite," which is not only important, but it is truly interesting and readable.

So with that, Sebastian, over to you, sir.

SEBASTIAN MALLABY: Okay. Thank you very much, Richard. We'll get started right away on this first session about capital controls, currency wars, et cetera. We've got a great panel here to speak about this. I'll just quickly introduce Ajay Shah at the end, who is a professor at the National Institute for Public Finance and Policy in New Delhi and also visiting at the IMF research department right now.

In the center is my colleague over here at the council, Benn Steil, who wrote the book "Money, Markets, and Sovereignty," and is working on another book, which we'll get to in a second.

Then Alan Taylor, who is a senior adviser this year at Morgan Stanley, but also director for the Center for the Evolution of the Global Economy at the University of California, Davis.

So I'd like to start -- I mean, as Richard said, we've got a lot of stuff in the news, whether it's the European tensions, whether it's the controversy over the Chimerica deal and how sustainable that might be, questions in the background about the sustainability of the dollar as a reserve currency. All of this stuff is in the mix, but I want to start with some historical perspectives here because Benn is working on a book on the creation of the postwar monetary order, the 1944 Bretton Woods conference.

And I want to start with you, Benn, and ask if you could explain a bit, you know, when the framers, as it were, got together and thought about what they were trying to achieve in the monetary system, what were the objectives they were trying to satisfy, and what part of their thinking resonates today?

BENN STEIL: Well, today, of course, the phrase "currency wars" is much in the news, and the framers of the Bretton Woods system, the Americans and the British, were looking to create a new international monetary architecture that would address the problems that emerged from the so-called currency wars of the 1930s. The view was that it would be impossible to reestablish any sort of open international multilateral trading system without dealing with that issue, without providing some mechanism for stabilizing exchange rates.

The American and the British plans were actually quite different. The American plan was built around the idea of establishing the dollar as a unique surrogate for gold. All countries would be pegged to the U.S. dollar; the dollar would be THE international reserve currency, and countries would be offered inducements to maintain a fixed, pegged price for their currencies with the dollar. Now obviously that stands in marked contrast to today, where we're trying to get countries to de-peg from the dollar.

But where you stand depends upon where you sit. And in the 1940s, we were the world's largest creditor country. So we had a strong incentive to enforce fixed exchange rate, because it stopped others from devaluing against us, very unlike the situation today when we're the world's largest debtor nation.

The Keynes plan was entirely different. The Keynes plan wanted to replace both gold and the U.S. dollar with a new fiat international reserve currency. Keynes called it "Bancor." Actually, most countries at Bretton Woods at least quietly massively preferred the Keynes plan, but they were in no position to challenge the United States. So the so-called White plan, the U.S. plan, became the foundation of Bretton Woods.

And there's a lot of nostalgia today for Bretton Woods. But it's important to realize that the system as such, with convertible currency as it was envisioned by Harry White, only started in 1959. And by the mid-1960s it was already fraying, and by 1971 it was finished when Nixon closed the gold window.

And if I could just describe very briefly what the problem was, because this problem still exists today. Under the so-called classical gold standard that we had before 1914, if we were trading with China, if we sent a dollar to China, China would redeem the dollar (in ?) the United States for gold; U.S gold stocks would decline; we would raise interest rates; credit would tighten; prices would fall; U.S. goods would become more competitive and that would ease imbalances. And this system worked pretty well in the pre-1914 era. There were financial crises around the world, but they tended to be very short-lived and shallow by comparison to modern crises.

How did the system work under Bretton Woods? Well, the same way it works today. We would send a dollar to China. China would not redeem the dollar for anything; they would hand it back to us immediately in the form of a very low-interest rate loan. That dollar would get recycled through the U.S. financial system, creating more credit. And in the 1920s this turned up in the -- in various asset markets, like the stock market in the 1960s. It turned up in inflation. And of course, in the past decade, it turned up in places like the housing market. So it's a -- it's a problematic system.

Now, only two coherent responses to those fundamental flaws have ever been put forward, in my view.

One is the French response in the 1960s; that is, we should go back to the classical gold standard, which for all sorts of reasons is not likely, despite the fact that Bob Zoellick appears to have put it back on the -- at least on the international discussion level. Even Jean-Claude Trichet was forced to respond to this idea.

And the second is to adopt some sort of Keynes plan, a legitimate new international reserve currency. And in fact, the governor of the Bank of China, Governor Zhou, last year said that we -- perhaps we did make a mistake at Bretton Woods and that we should not have gone forward with the White plan and we should have gone forward with the Keynes plan.

MALLABY: Alan, do you want to add something to that?

ALAN M. TAYLOR: Yeah. I'm -- first I want to say I'm really looking forward to Benn's book, which I think is going to be very insightful.

But my one -- the one thought that resonated with me is that we know how the Bretton Woods framers thought about it. They thought that currency instability caused bad economic outcomes.

Now, even if that's the way they thought about it, and many people have thought about it since, that doesn't necessarily mean to say that was actually true causally, as an economist would say, you know, looking at the data or trying to assess the evidence. So there's an alternative interpretation out there of what was going on in the '20s and '30s, which is that economic instability were the real or financial causes -- currency instability. Right? And that puts a very different spin on how you look back at those events or later events -- so one can say about the collapse of Bretton Woods in the '60s and '70s, whether it was currency instability that caused real economic problems or the other way around.

Same thing today. We didn't have talk of currency wars until we had the worst economic depression since the 1930s. So economic historians and economists are very careful to try and sort out that causality. And it's not by any means a slam dunk. So if you look at, you know, is there any major difference between how economies perform under different exchange rate regimes, in terms of growth, in terms of crises, all kinds of other metrics, it's very hard to detect a problem there. So I think this sort of currency war, currency instability theme as, like, oh, no, we must try and avert that or put that genie back in the bottle at all costs, maybe that was a characteristic of Bretton Woods, though we should be careful about thinking that that's really the way things are being driven.

And, you know, I guess we might come back to this (theme ?) later, but a currency war isn't the -- or you know, currency movements aren't the worst thing in the world if they relieve other kinds of economic pressures. They are a substitute for a trade war, in some sense. And economic research on the 1930s by someone who's here today, Doug Irwin, who we might hear from later, supports the idea that if you can use the exchange rate as a release valve, it can help you avert more extreme measures of protectionism.

MALLABY: Well, that's a good connection to the third session today. Maybe we'd rather have currency wars than trade wars. But can you pick up also on this issue about what kind of reserves countries should be accumulating? Benn talked about the French idea of gold; you know, the bank or Keynes' idea of some kind of commodity-linked instrument. Right now, you don't have either of those, and you've got a world in which, since 1995, central banking reserves have gone from 5 percent of GDP to 14 percent. Is this sensible? Is it -- I mean, this brings us back up to the debate right today. In other words, the problems identified in '44 are at the core of what's going on in the last 15 years: huge reserve accumulation. Is this justifiable?

TAYLOR: So I think there were a number of questions embedded in that, which is a good way of framing it. So why have the emerging countries started down this track? Why are they accumulating what they're accumulating, and when will they stop? Or what is enough, right?

So I think we all know why they started. If you look at the trends in the data since the 1970s, it was kind of flat. Industrial countries, developing countries, they had, you know, a certain ratio of reserves to GDP, and it was kind of flat-lining; nothing much happened. Then we hit the sort of era of financial globalization and also commercial globalization in the '90s, and the emerging markets started to ramp up their reserve accumulation. And that only accelerated. In fact, it accelerated dramatically after the Asian crisis of '97.

So, you know, at some simple level, what's going on there, it's sort of political economy. Etched on the mind of all emerging-market policymakers, and etched on my mind, is that photograph of Suharto with Camdessus leaning over him, and he's signing away Indonesia's economic life and his political life. Right? And no emerging-market policymaker wants to be in that kind of photograph or that kind of position ever again.

So the message that they took from those events was: We must self-insure. It's not enough to rely on market access, being able to go into debt or borrow when you're in a pinch; or even go to a multilateral, which might come with nasty economic conditions or not supply you with enough credit on enough terms or whatever. Instead, instead of trying to run our wealth down into negative territory, we'll start with our wealth in really positive territory, and then we can draw it down when we need it. And it's kind of hard to argue with that, in terms of, like, countries pursuing their self interest and perhaps interpreting those events of the '90s as a caution. So I don't think there's anything surprising, or indeed anything wrong about that.

So how should you interpret the last 10 or 15 years when they ramped up this reserve accumulation? One temptation is just to panic and say, oh, no, this is global imbalances forever. That could be true and, you know, I'm not going to attempt to forecast it. It's hard enough to do economic history; I think forecasting is really beyond my pay grade. (Laughter.) But I think one way to look at it is we're in a bit of a step change. They knew they were under-provisioned, or under-reserved, in the 1990s, and so they had to take steps if financial globalization and integration and maybe the risks of a growing financial sector in their own countries and globally was going to pose more of a threat to them. So it made sense.

But maybe that step change is going to taper off, and so the public flows toward the -- you know, toward the rich world, driven by their accumulation of reserves, could taper down. So I think, you know, that's an optimistic view of how, you know, a more benign rebalancing could take shape in the years ahead: less of a reserve accumulation as they feel they've got into a sort of safe territory. And going in the opposite direction, I think part of the benign rebalancing will also be increased private capital flows towards them, so -- but that's maybe a separate issue.

As to what -- you know, what they're accumulating, you know, we're back to the Triffin dilemma which -- you know, bringing up Bretton Woods themes again, a hundred years ago, we had one real reserve asset, and that was gold. The problem was, it's in finite supply, or very inelastic supply. And we kept on making more stuff -- which is good; we had economic growth. But economic growth outpaced the stocks of gold, which would mean either inherent deflation if you kept the backing ratio and the price of gold the same, or you'd have to be constantly tampering around with how much backing and what the price of gold was -- which is basically like saying, "Let's float," or "Let's have a fiat system," which we kind of got to by various misdirections.

But along the way then we had a dollar system. And the dollar has this reserve currency status now, which is also kind of a path-dependent accident of history. The good news is: Dollar reserve assets are in seemingly infinite supply. (Laughter.)

But unfortunately that comes with other problems. It's -- you know, it's their reserves, but our problem. And we need to think about, you know, how we manage that. You'd think, you know, getting trillions of dollars at low-interest rates would be a wonderful position to be in, but it -- you know, it depends on an assumption that we have wise and efficient financial markets and households and governments and funds to allocate all of that.

MALLABY: And actually, let's get back to one thing Adam said, which, I mean, maybe I'll -- (inaudible) -- put words in your mouth, but you were saying that with reserve accumulation over the last 15 years, whilst enormous, has been natural and precautionary, and not about buying -- you know, not about managing the value of your currency. Do you agree with that, Ajay? Do you think that most reserve accumulation in the last 15 years can be explained in those terms?

AJAY SHAH: Right after the Asian crisis, it seemed like reserves accumulation was very strongly motivated by that iconic photograph of Suharto. But I think fairly quickly the motivations changed. There used to be this great debate, how much reserves should a man have, a bit like Abraham Lincoln's question of how long should a man's legs be. And different people used to have different views about how big the reserves needed to be. And the top experiment that you would have asked for is, let's have a really big flood, and then we'll see how much reserves you need. Well, we did have a nice, big flood.

And you get two camps, you get two stories. One kind of story is a country that will tell you no amount of reserves would have helped, that in 2008, you know, this was really not something that any reasonable, central bank would -- any unreasonable amount of reserves could have particularly made a difference to.

And then on the other hand, you have data of some countries where the amount of reserves actually used in intervention through the crisis is actually remarkably small. You get numbers like 2 (percent), 3 (percent), 4 percent of GDP. You don't get a very large amount of usable reserves.

So it seems like there are some countries where the amount of reserves required to have dramatically changed outcome was essentially infinite. And there were other countries where the reserves were pretty small. So I find myself hard -- I find it difficult to support the simple reserves as safety storage, certainly after around 2002. There I think it was more about -- (inaudible) -- mercantilism.

Many countries would say that because the Chinese are doing it, we have to do it, too. Maybe the story runs that because the Chinese are doing it, you get a domestic political economy where funds in your own country start pressurizing the politicians, saying because you are doing it, we need to do it, and you start sounding a bit like competitive argument in trade protectionism.

MALLABY: Yeah, you also get a Lockean process, right, where if China is running one type of exchange rate policy that favors its exporters, the exporters grow, they do better, they become more powerful, they have more political say. And then that becomes a political economy, sort of Lockean. Benn, you look as if you want to --

STEIL: You know, China is an interesting case because they've pursued essentially the same policy in terms of fixing their exchange rates since 1994. But their motivations have changed entirely. During the Asia crisis in 1998, there was enormous pressure on China to get rid of its currency peg and to devalue, and the U.S. Treasury showered enormous praise on China for maintaining its fixed exchange rate during the -- during the crisis. So China started this policy with very different motivations than it has now to maintain it. Clearly, its reserves are well beyond what it could possibly need for prudential purposes for dealing with a crisis like the one we've just gone through.

MALLABY: Ajay, let me get back to you since you're at the IMF at the moment. So, I mean, one could argue that even if a decent chunk of this reserve accumulation is understandable for precautionary reasons -- we have a world of big capital flow, so you need big self insurance -- that there are externalities from this reserve accumulation because as you do it, you are pushing capital into other economies, they don't want to necessarily absorb this stuff. And so therefore it would make sense to shift from countries self-insuring to collective insurance through the IMF.

You're sitting there in the IMF, but you're not owned by it since you're only visiting. So you're in the perfect position to tell us, you know, how plausible it is that some better-designed, larger, reformed, whatever IMF could remove this incentive to self-insurance, to get over that Suharto, Indonesia iconic photograph problem, and return countries to viewing the IMF as its friend?

MR.: It could be done.

MALLABY: Alan's even laughing at the mere suggestion of it.

MR.: Yeah. I think it could -- it could be done. But I really disagree on the extent to which that is the question we face today. I think the size of reserves in most emerging markets are way past precautionary motives today. So on -- it could be done, it should be done, and it will help one day. But I don't think it's going to make any difference today. Today we are in a world of exchange-rate mercantilism. I don't think the precautionary motive (binds ?).

MALLABY: Alan, do you want come back on this?

MR.: (So tell us what ?) -- and relate your argument earlier, specifically to China. I mean, before you said, in general, (this reserve ?) accumulation is precautionary. Do you believe that for China specifically?

TAYLOR: Okay. So, you know, frankly those -- the questions --separate.

So I think, you know, we can sort of sit here, and we can have a theoretical model or we could maybe construct some empirical model of do we think exchange rates are on target, above target, below target. And I think one of the problems there is just that there's a range of either theoretical parameters or the standard area you get there is so large that it's very hard to say meaningfully, well, that country has too many or too few reserves. So I'm not sure that's an edifying route to go.

I mean, I agree that we're in a second-best world. There must be better ways to insure. I'd like to, you know, sit here; we can link arms or we can wish for unicorns and the IMF to be nice. But we have to deal with the world as it is, and I think that's my sort of main point about the last 15 years. There were -- there were a lot of nasty threats that these emerging economies saw unfold and they reacted to. But yes, it would be better if there were -- there were alternative insurance mechanisms.

But, you know, it's hard. You've gone through the last, you know, two or three years. You take an example like Chile and its finance minister, Andreas Velasco, who's a friend of mine. And, you know, before the crisis he's being excoriated. He's got the worst, you know, approval rating of any politician and people are like, you know, insulting him on the street as he's taking his kids to school and, you know, it's all very unpleasant.

And then the crisis unfolds and he gets out the check book and spends the reserves on their social programs and things to support the economy, and people love him, right? And if you -- everyone suddenly understands there's a reason we did all of that savings, so that in a time of crisis we would have the flexibility to be able to support our economy. And his approval rates and that of Bachelet shot up to the highest levels ever.

And as someone who studies, you know, Latin American and Southern Cone economic history, I thought, wow, a countercyclical approval rating of a finance minister in Latin America. (Laughs.) Has that ever happened before? So, I -- you know, I just think it's a very powerful story both economically and politically as to why we're seeing this unfold. But I completely agree that there may be countries well above where they need to be in terms of reserve holding.

But in terms of motivation, some of it is planned; some of it is almost accidental; and -- but, you know, some of it may have intent. But I think it's loading too much on intent to sort of say, you know, you're a manipulator and this is mercantilism.

And I think the other thing that makes me a little bit uncomfortable there is an awful lot -- I mean, in the case of China, to bring it back to China -- an awful lot of this accumulation of reserves in the last six years has been through sterilization, so the issue of sterilization bond(s) that (require/acquire ?) reserves. So it's not really -- you know, it's not alternating the monetary base or monetary conditions in any significant way.

And I sort of look at that, and I can sort of separate their monetary conditions from their reserves. It's almost like they've got a separate policy. You know, the exchange rate peg, as you said, was -- it was set, you know, 16, 17 years ago. It's been fixed but adjustable, you know, that wonderful oxymoron we got from Bretton Woods, which is like "military intelligence" or something. (Soft laughter.) It's moving, but we think it's really fixed, okay?

MALLABY (?): (Inaudible) -- Council on Foreign Relations. Don't (make jokes ?) -- (inaudible).

TAYLOR: Sorry, I -- (laughter).

So that was -- (inaudible) -- ago, and then they kind of got into this task. But I just want to make the point that they got, whatever, you know, 120 percent backing for (N zero ?). They've got reserves of 3 trillion (dollars). Does anyone, you know, really think that suppose they got an extra 500 billion (dollars) of reserves tomorrow or they reduced reserves by 500 billion (dollars) -- which they could do very quickly through sterilization or other means just by moving the (leaders ?) -- does anyone really think that would change their ability to peg? You know, would it be so hard to peg with only 100 percent backing, as opposed to 120 percent backing? They're still so far beyond. I mean, they're really two separable issues.

And I think they could quite safely back with perhaps half the level of the reserves they have now. You know, think back to the gold standard, when countries were backing the gold standard with, like, you know, 10 (percent) or 20 percent backing in emerging countries, maybe a bit more, 50, 60, 70. So I really think that we ought to separate the currency and exchange rate question from the reserves, because I think mechanically and practically they are separate.

MR. : (Inaudible) -- and I just point out that Keynes did not believe that it was possible to have a nice, friendly, helpful International Monetary Fund. He was very concerned about White's plan. His idea of an international clearing bank was going to be completely passive. And throughout the Bretton Woods process -- the British emphasized this with the Americans -- we want a passive institution. We don't want it interfering with national autonomy.

We just want it to be a mechanism to produce this international reserve currency that would have a very elastic supply. So it was more a mechanism than an actual fund with technocrats that were going to make the sort of decisions that would produce the Suharto photo.

TAYLOR: I mean, I think, again, this is like (first best ?): If we could have a way for both surplus and deficit countries to coordinate and cooperate and adjust in those ways, the world would be, you know, a much happier place, and we'd all be -- we'd all be very happy with that.

But can we make it work? I think, you know, we need -- we need a guinea pig and a sort of controlled experiment, a small region which claims to have political cohesion where we could try out such an experiment. Umm -- oh, well, Europe. (Laughter.)

I don't want to divert our discussion, but I think, you know, that's obviously a question that's in the air as to can countries that are -- you know, when you have a group of countries with asymmetric shocks, surplus and deficit, and they want to get along -- I don't know. I'm -- at the moment, I'm not getting such positive vibes out of that. But it could be --

MALLABY: Right. I mean, the Ireland reaction to the prospect of a European bailout is only a little bit different to the Indonesian one. I mean, they don't seem to want the money, just like Suharto didn't want it.

TAYLOR: I mean, right, it comes with conditions, saying, oh, it might come with some very unpleasant conditions, some that might even threaten the development model, such as, you know, the corporate tax structure and so forth. And they want to sort of hold on for the best deal possible, which is understandable. And they know that the moment they sign it that it's almost irreversible, and it'll be politically something hanging round their neck for a long, long time. So yeah, I can understand why they -- why they are balking at it, yeah.

MALLABY: Well, Benn, or actually whoever wants to get this -- but I mean, you know, you could say -- there's a lot of criticism right now about the global monetary regime, a lot of disquiet about it, because this combination of fixed and floating, open and not open seems to create a lot of tension. Europe is another model, as Alan said. Right now it seems to be in a mess. Should we draw from this the lesson that even in a fairly politically cohesive bloc of countries, fixing is just too difficult and is not the way to go? I mean -- Benn, actually, whoever wants to --

STEIL: Well, let me start on Greece. There's this myth out there now that somehow if Greece had not joined the euro zone they never would have gotten into this problem. I find this storyline rather remarkable, since a few -- just a few years ago, when Iceland went into crisis, everybody was drawing the opposite conclusion, that clearly if Iceland had euroized, they wouldn't have gotten into this problem.

It's important to remember that, if you go back to 2000, right before Greece joined the euro zone, already 80 percent of their total debt stock was denominated in euros. Irrespective of whether they joined the euro zone, they were going to issue debt in euros because it was cheap. So had they not actually joined the euro zone, they just would have gotten into this crisis sooner.

So it's far from clear to me that this is -- this is a problem created by joining the euro zone. You can make an argument that it's a problem created by the creation of the euro itself, because it induced countries to borrow in this country when -- in this currency when the rates were cheap.

But I don't think we should draw the conclusion that joining the euro zone was a mistake. I don't think you will see countries having any real incentive to consider leaving the euro zone, because once you've actually defaulted on your debt, the whole logic of leaving the euro zone in order to alleviate the pressure goes away. You don't need to do that anymore.

MALLABY: Ajay, on -- let's switch topic a little bit to capital controls. So one response to a world of abundant capital flowing out of reserve-accumulating countries has been for the recipients of these inflows to try to erect barriers. So Brazil, Taiwan, Thailand, all these countries that have -- you know, there's been a kind of return of the fashion towards capital controls. The IMF, which used to be extremely hostile to controls, is now willing to say that they're a good idea in some cases. You know, maybe from the Indian perspective, you've had a long tradition of using controls. Do they work? Are they a good idea? Is it -- is it a sustainable swing of the pendulum of fashion that capital controls are now being smiled upon?

SHAH: There used to be an old wisdom, mostly rooted in the Latin-American experience in the '70s and the '80s, that controls were messy and controls did not work, and you give it enough time, the lawyers and the financial engineers will show you how to get past any controls. I think we are going to rediscover the wisdom of that in a painful way.

So I continue to be skeptical about the usefulness of controls. Controls are far less effective than many policymakers think. I think people have just spent too many years away from those experiences of the '70s and '80s to get to the point where you feel that controls will actually deliver the goods.

There is only one class of situations where I think there is a case for doing something different: It is a country where there's a very low level of development and the country really does not have much of a financial system, the country really does not have financial supervision or the human capability to put together some kind of financial supervision. Maybe an autarchic (ph) approach is more appropriate there, but for most significant countries participating in the global system, I really find myself skeptical about controls.

STEIL: I'd point out that just at Bretton Woods, both under the American and the British plans, capital controls were absolutely fundamental. In fact, the Americans were much more hard-line than the British about it. White insisted not only that countries should have the right to implement capital controls, but countries should have the obligation to assist those countries in preventing inflows into their markets from those countries.

MALLABY: But, Benn, the question, surely, about that is that it's one thing to argue that in 1944. And now we have a world of, you know, hugely expanded trade flows, hugely expanded global supply chains; multinational corporations, which raise capital in different jurisdictions and can move capital internally through their networks by under-invoicing, over-invoicing, all these tricks. Surely it would be plausible to say that capital controls were a useful policy option 66 years ago, but they're not anymore.

And, I mean, India, as I understand it, Ajay, I mean, is a -- is a case study in this, where theoretically the bond market is closed to foreigners, but in practice, after Lehman Brothers went down, India -- Indian interest rates reacted rather dramatically. Isn't that right?

SHAH: Yeah, I -- I've written a lot about this, but on that weekend when Lehman failed, I have to confess that I was more curiously looking at the world, that oh, what a spectacle, rather than thinking that something interesting is going to happen in India. But lo and behold, on that Monday morning, the money market in India opened before London and before New York, and that money market had choked right there in the morning of Monday morning. So it was a lesson for me on financial globalization.

In theory, the rules say that Indian funds cannot borrow abroad with a maturity of less than three years. So in theory, there was supposed to be no money-market borrowing going on. But in practice, that didn't work, so I think we really should question the extent to which capital controls make a difference.

MALLABY: Alan, what do you think? Do you think capital controls can be useful policy tools?

TAYLOR: Well, I think the discussion so far -- I just want to back up what's been said. Fifty, 60 years ago, we were in a different world after World War II, given that this, you know, fundamental trilemma: You can't have fixed exchange rates, capital mobility and autonomous monetary policy. Countries wanted their autonomous policies, but they wanted to sort of stick with the barbarous relic of the gold standard, or the dollar standard, as it became. And so they had to give up capital mobility. Everybody was on board with that. The Washington consensus of 1945 was, you know, kill finance, basically, and restrict financial globalization. It was a very different world.

Why did it unravel? For reasons you were pointing to, in part. As world trade grew and commercial ties between countries grew, there were ways around. The controls were leaky, the countries could mess around with their invoicing of exports and imports to move capital surreptitiously, and there were other ways in which leaks developed over time. So Ajay's point is that, you know, you can't really make controls absolutely watertight, and they can be evaded.

So I think we have to be just pragmatic here and understand that we're not going back all the way. On a continuum from zero to 100 percent, we're not going to back to the 100 percent, sort of early 1950s way of the world here. And that's -- I don't think that's what's being talked about. Just as, you know, when people talk about currency war, they're really talking about actually quite small currency movements. It's nothing like, you know, Zimbabwe or even the 1930s.

So what we're likely to see is some movement from zero and, you know, complete freedom of capital movement towards some restrictions. Perhaps the most important ones we will see. And to, again, bring the great example of Chile to bear, I think like the Chilean "encaje," where there's a tax on short-term flows. And I think studies at the IMF and elsewhere have shown that won't necessarily significantly damp down the total volume of capital flowing in your country, but it might change the composition more towards long-term FDI and away from the kind of hot portfolio flows.

And on the margin, that's maybe something that gives you a little bit of a breathing space and takes away some of the downside risk with these countries looking back at, you know, recent experiences where they were subject to capital outflows or runs. And you know, that's something we can cope with. Even the IMF came out this year and said, you know, maybe capital control's all right. You know, everyone probably fell over and said: What did they just say?

And I think we can sort of live with a world like that, but it won't change the fundamental, deep, you know, real forces that drive the capital flows in the long run but force countries to have adjust their real exchange rates and, you know, cope with living in a globalized world.

So you know, I think pragmatically we'll just follow a fairly moderate course here.

MALLABY: Ajay, we've been talking mainly about reserves in terms of just the extraordinary pace of accumulation. There's also of course the issue of, you know, the currency that it's denominated in, and 60 percent of reserves are denominated into our dollars, but the U.S. economy is 24 percent of global GDP. Do you think that, you know, emerging markets such as India -- are the central banks going to move to something else? When Zoellick talks about gold as a reference point at the World Bank, is there something behind that? Is there -- you know, could you see central banks moving towards some alternative to the dollar on a five- to 10-year horizon?

SHAH: Well, in two parts:

First is, you can act actually be very separate and distinct in your decisions about how to peg the exchange rate and what reserves portfolio you to own. So in principle, a central bank could say that I'm going to peg to the euro, and its investments could all be in hedge funds. So the currency composition of reserves, a large part of it, can be in something that's very different from your pegging strategy. So we don't have to think that the two go together.

In principle, the whole world could choose to peg to the dollar, but that doesn't mean you have to hold all your assets in U.S. government bonds. You could diversify. There's just a small liquid portion that you need to keep in dollars. Large parts of the $3 trillion could go into something else.

The second point I do want to emphasize is that we should not phrase the choices that the world faces as between that (Barbados relic ?) or the U.S. dollar, because there are very nice alternatives as well. Let's not lose sight of the fact you could choose to float the exchange rate; that here is another anchor other than gold -- that is, the CPI basket, so to speak -- so inflation targeting is an alternative system in which any country can create fiat money. And it actually works very well. It -- Andy Rose at UC Berkeley has emphasized that it is actually the best-performing system in many ways; it is durable, it adjusts to shocks and so on. And it's a nice framework, a mechanism through which we can create fiat money.

It does need a little bit of an institutional capability in the country, and Benn Steil and Robert Litan have emphasized that in many countries you don't have that kind of institutional capability. So I respect the difficulties in a certain class of countries where you could not do it.

But for a large part of the world, we actually have a very clean, well-posed alternative, which is inflation targeting plus floating exchange rates.

MALLABY: Well, I want to bring members and guests in, in a second, but I want to give Benn and Alan just a chance now to wrap up this part of the conversation. If -- so, you know, Ajay is saying that after all is said and done, fiat currencies perform better than the alternative of -- I mean, Benn, do you agree with that and, I mean -- and also, as you think about this discussion, do you regard this period of tension over currencies, capital controls, et cetera, as something that we'll just get through and it won't seem significant in five years' time? Or do you think this is the beginning of some tipping point in the system?

STEIL: I think it is the beginning of a tipping point. Alan brought up the problem with the so-called Triffin dilemma earlier. Robert Triffin in 1960 gave very famous congressional testimony where he said: Well, look, this system that we're operating in -- under right now is inherently unstable. The United Sates will always create one of two problems. Given that the U.S. dollar, our national currency, is THE international reserve currency, the U.S. will either produce too little liquidity for the world, which will cause a crisis, or they'll produce too much of it, which will cause a crisis.

But the regime would always oscillate between the two crises until you changed it. And Triffin's solution was to go to the Keynes idea of having an international fiat currency. His chief intellectual nemesis at the time was the French economist Jacques Rueff, who said: No, nonsense. The whole idea of a Bancor he described as nothingness dressed up as currency. We had to go back to the classical gold standard.

And both those concepts are indeed extremely radical, but I don't believe that anybody's ever identified a coherent system that lies somewhere in between. So I think there are ways that we, as the issuer of the international reserve currency, can mitigate the likelihood of crises, like we're going through now, in the future. But I think the system is inherently prone to the sort of problems that we're experiencing.

MALLABY: So we've -- we're living in an incoherent world, but it's been 50 years since the incoherence was pronounced in (Congress ?). Will we carry on, Alan, or will it -- are we reaching a tipping point on the system?

TAYLOR: I'm thinking very deeply. And my wife is a medievalist, so I'm always reminded that it's been an incoherent world for, like, a millennium or more. (Laughter.)

But, I mean, there's a -- there's a serious point here, which is, you know, is there a system? Should there be a system? Can there be a system? You know, we like to teach our courses to undergrads saying, you know, this -- the gold standard system, Bretton Woods and, you know, the idea that someone or -- you know, someone's in charge, whether they have a black helicopter or not. It's the lifeblood of, you know, our courses, (mainly ?) at the Council on Foreign Relations.

But in some sense, you know, countries will pursue self-interest. And it might be difficult, as we see from Europe and other instances, to actually make some kind of coherent system work. What we really want, though, is, like, something that's stable and durable, isn't prone to crises and permits, you know, exchange and trade and other good things to happen.

And the present, quote, "system," i.e. nonsystem, has done a decent job of doing that for the last 30 or 40 years. People thought, when Bretton Woods collapsed: Oh, no! Floating exchange rates. It's going to be the 1930s. We're going to have another Great Depression. And then, you know, life went on and trade kept on growing, maybe even accelerated, and economic growth resumed and we have the new industrializing economies and -- (inaudible). Maybe that was overblown.

So, you know, I think we need to be cautious about thinking we absolutely have to solve this and this is some great crisis. Clearly there are tensions. The -- if -- the main tension is if the emerging markets want to go on, you know, accumulating infinite dollars and -- the Triffin dilemma is there, is sort of behind that -- we may have a problem. Those imbalances may continue in a way -- in a way that's problematic.

But I -- but I do see, you know, trends pushing in the other direction. We don't really know how countries will graduate from emerging (states ?) to developed. Another factor pushing in the direction of fear of floating and lots of reserves 10 or 20 years ago was that they couldn't issue bonds in their own currency. And they had a huge mismatch in terms of the currency, the liabilities and assets. Well, the currency mismatch is moderated, partly because of the accumulation (of/on ?) official reserves, which, you know, creates other issues. The reserves are mostly in the public sector, while a lot of the liabilities are still in the private sector.

But another thing that's ameliorating the problem is that many countries can issue domestic currency bonds now in international markets. And, you know, every morning I'll go to meetings at Morgan Stanley and we're hearing -- Peru has just issued, you know, a domestic currency -- Peru has issued a domestic currency bond, with overwhelming demand for that bond, right? And that's helping these countries get away from needing quite so much in terms of precautions. Just like a few weeks ago, you -- it wasn't -- it wasn't a peso bond, but you had Mexico issuing a 100-year bond -- 100-year bond. You know, I -- my head starting spinning as I thought back over Mexico's 200-year history and what Reinhart and Rogoff and others have pointed out.

But, you know, in some sense that's progress, right? And so we're taking away some of the roll-over risk and other problems. So, you know, one can be optimistic and think some of these countries are graduating; that to some extent they're taking responsibility for their own problems through self-insurance. They've learned from their mistakes of the past just as we did. We're now -- we're all -- we're all emerging countries, right? We just had a massive financial crisis and learned -- you know, we got -- we got some sort of comeuppance and learned that history doesn't -- that it doesn't sort of go away.

So, you know, I'm kind of optimistic there, that we'll just -- that we'll just progress down this track and the imbalances will ameliorate and our system, such as it is, will continue to function without massive intervention. We'll just have the sort of, you know, amusing moments when people panic and say "currency war." And it's entertaining to get the newspapers going, but that's just, you know, part of the great rich tapestry of economic life.

MALLABY: Okay. Well, so we're going to muddle through happily.

At this time, we'll open it up to members and guests. I should have said at the beginning that this is on the record, so sorry I didn't say that before. So if you have a question, please put your hand up and wait for the microphone, speak directly into it.

Do we have any questions? We have one right here in the front, I think.

QUESTIONER: Thank you. Marcus Mabry from The New York Times. So I suppose I could be accused of being one of those newspapers that benefitted from it all. (Laughter.)

I'd like for you to take the opposite view, though, and tell us what do you see, though, as the genuine shocks here in the short term -- because obviously, we do make some money talking about those. (Laughter.) But which ones do you think are really valid? Because I assume there are some you do find valid -- valid risks in the short term.

MALLABY: Well, if it bleeds, it leads. Please provide some blood. (Laughter.)

No, seriously, what -- if you had to predict what the flashpoints might be in the next six months of monetary diplomacy, I mean, how do you see -- how do you see the Financial Times headlines?

TAYLOR: For me, the main downside risks are the European problems are not contained in a -- in a sensible way, and a trade war. I would say those are the two major downside risks. They're hard to quantify, but I think they're definitely there.

MALLABY: Let's go over there.

QUESTIONER: Steve Robert.

I'm intrigued by Alan's somewhat sanguine outlook toward -- to all this, in that we might just sort of muddle through it without needing too much change. But the one country that's become the poster child for currency manipulation, and takes an enormous beating in the press and in other places, is China. So to what extent do you think this is a valid criticism and to what extent do you think the rest of the world should put more pressure on China to let their currency adjust?

MALLABY: Do you -- Ajay, do you want to take a crack at that, and then --

SHAH: I think China matters more than meets the eye, not just because of the size of the Chinese current account deficit, but because there's a whole bunch of political responses across the world that are being shaped by the Chinese exchange rate. Exporters in lots of countries turn around to their governments and say, "Look at those guys. We need you to do the same." So I think that's the real significance of China; that if we could see some important changes in China, it would change the politics of exchange rates and trade protectionism in lots of places, and that's important.

MALLABY: That, by the way, is an issue which I think comes into the third session as well, where, you know, if the Chinese government is assisting Chinese companies in exporting, with key credit or near-free infrastructure support, tax breaks and so forth -- you know, they decide they want to take over the soda industry, and so there's huge government backing for soda companies; it does change the dynamic internationally, where other soda companies are going to their governments and saying, "Hey, you help us, too." And so you get a sort of -- but that -- so I think there's a linkage across our sessions there.

Did you want to say something, Alan?

TAYLOR: Yeah, I think the criticism of China is a little unfair, and I -- you know, they've had a fixed exchange rate for 16 years, and we didn't criticize them for much of that period. And we -- the criticism seems to go up when we've got problems of our own. So some of that is endogenous and reflects other features.

And I think going forward, you know, they are letting the currency appreciate -- not as fast as other people might wish. They do have inflation pressures. We know when a developing country grows, its price level in dollars will rise. That means either domestic inflation in their own currency, or an appreciation. And, you know, the Chinese leadership and economic advisers are aware of the laws of economics and that this is an almost ironclad rule and that it will happen. And I'm sure they want to contain inflation, and they will find a mix.

But I don't -- I don't think it's, you know, beneficial or wise from a sort of economic or financial statecraft point of view, if I can use that term, to really browbeat them about it. I think -- I think it's -- you know, that they have their place on the world stage, and we need to deal with it diplomatically. And I'm not sure we've always accomplished that, especially in recent weeks, heading up to the G-20.

And, I mean, there's sensitivity there, when other world powers -- you know, there's a perceived slight -- or even former world powers. I remember when the British delegation was there last week. It was Remembrance Day, and the Conservative ministers were wearing poppies. And this was taken as a huge insult by the Chinese that some -- you know, that -- (laughter) -- so, you know, if that's going to cause trouble, you know, then saying a few harsh words about their currency is going to lead to explosions.

But my sense is, if cool heads would just prevail, I think the adjustments are taking place in the right direction, and QE2 is part of that. And, you know, there'll be a letting off of steam from various quarters, but eventually the reconfiguration, you know, will occur.

QUESTIONER: But if you go back 15 years ago, China was a very -- if you go back to 15 years ago, China was a very small economy. Today it's the second-biggest economy in the world.

MR. : Yes.


TAYLOR: Ajay's point about the macro weight is important. It's --

QUESTIONER: Yeah, so isn't that -- isn't that a great imbalance, to have the second-biggest economy in the world with 3 trillion (dollars) of reserves, I think he said, manipulating their currency, not letting it basically float like all the rest of the big countries are doing?

MALLABY: Benn, do you want to attempt --

STEIL: Yeah. Bringing up Keynes again, Keynes -- Keynes's biggest gripe about the international monetary system was that there was never any fundamental pressure on a creditor nation to adjust. I think he unfairly tarred the gold standard in that regard, because under the gold standard the creditor nation was supposed to adjust, but the point was that they never HAD to adjust. And if he were here today, there's no doubt that he would support some mechanism to force China to adjust. Under his plan, for example, creditor nations would actually be fined by his version of the IMF for building up excessive credit.

Now, as a matter of financial statecraft, I don't think we're ever going to get to a world where we can -- we will have that sort of institutional pressure on a creditor nation to adjust. The pressures in the financial markets are always on debtors to adjust.

TAYLOR: Just think -- I mean, in Europe, are we going to get a system where Germany taxes itself for running a surplus? Or is it just going to be we must tax and have penalties like in the Stability and Growth Pact for the naughty deficit countries? Is there going to be any sense that the surplus countries have some role to play?

And I think if you can't achieve that kind of Keynes-type plan within the superstructure of the -- of the EU or the euro zone, to imagine it at the global level is --

QUESTIONER: (Off mike) -- deficit on -- (off mike) -- countries. That's different than getting -- (off mike).

MALLABY: Well, let's -- I want to move to another question, but let's just give Ajay one chance on that, because he said something before we walked onto the stage about, you know, is it true that 10 percent or 20 percent misalignment in a currency really has a big effect on trade outcomes?

SHAH: I don't work in that field. But the people who are very closely studying the trade data and asking questions about aggregates and (stabilities ?) of trade through exchange rates are really not finding a whole lot there. The effects are remarkably small. So I see a certain gap between the evidence and the political rhetoric. I think the politics is very real. In any country you go to, you will have a bunch of people screaming at the politicians that, oh, this exchange rate is not good for me. But the evidence over a large number of countries for large numbers of years shows fairly modest effects. So I think that the magnitude of the impact of exchange rates on trade is a bit overstated.

STEIL: In fact, I'd just throw in that Keynes actually agreed with that. He argued in the 1940s that, given the so-called "terms of trade" effect, that Britain would get virtually nothing, if anything, out of devaluing. So he was not in favor of a floating-exchange-rate system. He was in favor of a fixed-exchange-rate system, with adjustments when there was a quote-unquote "fundamental disequilibrium." Would he have declared the current status quo in the world as a fundamental disequilibrium? Absolutely yes, he would have. But he would not have supported floating exchange rates on that basis.

MALLABY: We have a question over there.

QUESTIONER: Deryck Maughan, KKR. Is it China's fault that we've only had a current-accounts surplus once in the last 30 years? Is it China's fault that we have deficits with more than 60 countries, not just one? Is it China's fault that we're on a fiscally unsustainable path and critically dependent on capital inflows to keep the economy going? Do we owe a vote of thanks to the world's central banks, who now own more than half of the U.S. Treasury debt, recognizing that they'll -- they will very likely take very large capital losses simply to keep us afloat? Would you agree that the United States is the largest systemic threat and it's time to stop blaming China?

MALLABY: Okay, so we've talked enough about China, but that is a -- (laughter) -- cue to talk about QE2. I mean, I take the question to be really about quantitative easing, which we have not addressed. In other words, is the U.S. to be blamed for -- more than China for any potential instability to the U.S. economy, I guess is what the question -- (inaudible).

MR. : I love the way you turned that question around. (Laughter.)

(Cross talk.)

TAYLOR (?): Yeah. And in terms of truth in advertising, to directly answer the question, yeah, it takes two to tango. But QE2 -- I mean, Ajay's point is absolutely valid. And I was talking to Dick Burnham, my colleague at Morgan Stanley, and, you know, people have run the various models.

If you think about just the magnitude of depreciation that people would like to ask China to do, it's probably outside the realm of reality, and then you crank it through the models, how much of a change in trade balances or current accounts is that really going to deliver, it's not that huge. So QE2, you know, it's going to work through various channels, and it's kind of the last, best hope, because what's happening in terms of fiscal and other policies that can turn around the United States economy right now; not so much. Even the Fed is now coming under attack, which is obviously very worrying, for someone like me, at least.

So, you know, we have still a broken financial transmission mechanism. Banks are not lending. Many of them are still repairing their balance sheets. Households are repairing their balance sheets. You can ease financial conditions a bit more. You can move the yield curve at the long end a little bit more. Maybe that's partly signalling just saying I really am committed to low interest rates for been longer than you thought. And then you can hope for help from the rest oF the world. It is marginally going to weaken the dollar. I guess that's the hope. but it's the unintended, or at least unspoken, consequences, as Bill Dudley (sp) pointed out in remarks this week.

So there's a direction. However the U.S. is just issuing very conventional monetary policy like in the textbook. You know, you have an asymmetric shock, you're in a worse position than other countries, you're going to have more expansionary monetary policy; and as a, quote, "side effect," the currency will weaken, and you hope that will stimulate aggregate demand. It's just unfortunate we're in a position where many of the transmission mechanisms through which that will work are just somewhat impaired. but it may be the only game in town.

STEIL: There is another perspective. Certainly that's the one that's shared by the Fed and the administration, but there's another perspective that I would characterize through this analogy. Say you turn on your shower in the morning and there's very little water coming out. You call the plumber and he says, well, the problem is you have a hole in your pipe. And you say, well, how much will it cost to repair it? And he says, $10,000. And you say, well, forget about the hole, then; just turn up the water pressure.

And that's what we're doing. We have, in my view, a broken credit transmission mechanism. The problem is not that the Fed is not providing too much liquidity; it's that it's not translating into credit for the businesses that need it. Small and medium-size enterprises in the United States are overwhelmingly dependent on small and medium-size banks for their lending. These banks still have very seriously impaired balance sheets.

So the fact that in principle they can borrow from the Fed at virtually zero interest rates is not, for them, an incentive to expand their balance sheets by making loans. And until we address that problem, we are going to be dealing with all the side effects from turning up the water pressure.

What are those side effects? Well, bubbles. And we're seeing the possible emergence of some serious bubbles now, for example in various commodities markets and in emerging markets.

I agree with you, Alan, in principle that it's a good thing if Peru can legitimately and sustainably issue bonds in their own domestic currency, but I would suggest that this is an effect of yield chasing because of the fact that credit is so cheap now and yield is so low on conventional assets, and that this is probably not sustainable.

And so that's the potential downside of QE2, in my view.

MALLABY: Another question. Anybody else. Okay, one over here.

QUESTIONER: Jorge Mariscal (ph) from the Royalton Group. I think maybe parts of this question have been answered, but if the final mix for U.S. recovery entails a weaker dollar, and if this is -- the final mix is required, then the world will just have to adjust to that, and the tensions we're living today are part of that adjustment.

I figure that if there is no weaker dollar, what is you're going to see is deflation in the United States. Real wages and the price of things are going to go down anyway, so they either go down nominally or they're going to go down really. And so the fight here is to prevent or to smooth out that path. But I guess my question is, concretely, do you see a weaker dollar as part of the solution, in the end, despite all the screaming and kicking that you're hearing from other nations?

MR.: Ajay, do you want to take a crack at it?

SHAH: So, I think that the dollar's -- I think that the weaker dollar is a part of the solution and that a weaker dollar is the way we are headed. And I guess the interesting feature of the Chinese question is how that weaker dollar is played out in respect of the counterparties. So how much will happen at the euro? How much will happen in the Korean won? How much will happen in the Chinese renminbi? I think that is the interesting dimension.

So that's a story that is being played out in the currency wars.

MALLABY: To some extent, you could get this adjustment by having not deflation here but low inflation, but then really quite considerable inflation in emerging markets, which you're -- which you're seeing. And you're nodding on that.

TAYLOR: Yeah, I mean, in the long term, we know, just as a, like, ironclad law, that when countries develop, their price level goes up in dollars. So in real -- in terms of real exchange rates relative to the emerging markets, we're going to see the dollar weaken. Relative to other developed markets, not so clear to me.

In the short term, though, because the U.S. is -- economy is in a weaker position, I'd expect that a weaker dollar in real and nominal terms in the short term to be part of the likely recovery strategy. But as was pointed out, whether that plays out through the price level or nominal exchange rates, I don't know. There's considerable uncertainty around any of these forecasts because a lot depends on, can the Fed pull out an exit strategy from this large balance sheet without igniting inflation? I personally don't think we're going to see double digit or anything scary, but it will have to manage it, possibly, within a wider range than would have been previously, you know, anticipated.

But there are similar issues like for the euro zone, right? It's bought a lot of Greek and Irish and other countries' debt. Is it going to have a hole on its balance sheet? It's been supplying a lot of liquidity to Irish banks. There are all kinds of facilities there that might need to be unwound. Some of them have been sterilized, but still, they've got to manage a big balance sheet. The Bank of England has pursued QE. Japan has been trying, you know, all manner of things for 20 years, to variegated effects.

So I think in terms of nominal exchange-rate movements, all of the G-4 and the big countries have, like, question marks over them in terms of what kind of volatility you will see, but I'm pretty sure we'll see volatility.

MALLABY: Any more questions? Yes, Steve.

QUESTIONER: Steve Fried (sp) -- (inaudible) -- Capital. You touched on the euro and the potential risk there. To the extent that you do have some players in the euro who have not been able to meet their mandated deficits, to the extent that it doesn't look like they're going -- it's going to be possible, to the extent that they've misrepresented their current position, what do you think should be done with these players, and what do you think will be done, and how will this ultimately unravel?

TAYLOR: Sir, I mean, I think the great conundrum or problem for the euro zone right now is that they've set up a common currency and also wanted to have a no-default zone. And the realization in recent weeks has been that we can't have a no-default zone. And one can imagine the political economy behind that, which is we want to be taken seriously as a new currency, have credibility; can't we just get everyone to play by sensible rules and not have bad outcomes?

But unfortunately, given both public- and private-sector behavior -- the public sector in Greece, Portugal; private-sector bubble in Ireland and Spain in housing and so forth -- they ended up with countries that, you know, went off the rails a bit in terms of sustainability and borrowing.

So I think that's one of the big unknowns about Europe, is how will that be resolved? There's talk of this crisis-resolution mechanism. They went far down the road in terms of wanting to have haircuts. They're backing off a bit now and thinking about how they will restructure some rules about how a country can go into some kind of structured or organized default.

But I think, eventually, you know, history says occasionally, you know, debtors default, and that's like life, and we have to come up with a way to just manage that in a reasonable way. And I think that's where the euro zone will end up, and you know, that'll be okay. I mean, we talk about the Peru bond. You know, it'll have risk. All credits have risk, and just because we're living in a savings glut world doesn't mean that everyone's chasing yield now in the naive -- the naive view that yield is always safe. It comes with risks. And, you know, we've just grown up a bit, or maybe we learned a lesson we should never have forgotten. And those same lessons will apply to the euro zone too.

MALLABY: Benn, you wrote a nice piece about the lessons from the financial crisis in terms of domestic regulation. And it strikes me there's a parallel here, which is that orderly resolution mechanisms are extraordinarily hard to implement, because in a time of panic, the systemic risk consequences -- that the risk of contagion from actually making people take a haircut, take a loss, is so big that people often just blink.

And so you can have an orderly resolution mechanism; in the case of American deposit-taking banks, it's called the FDIC. But whether the Treasury in the moment of truth was willing to actually use that mechanism after Lehman went down with WaMu and actually make the bondholders of WaMu take a haircut, the truth is we know that they were ready to flinch and to have public money go in to facilitate the rescue. So that was an example where you had a resolution mechanism but you didn't have the guts to implement it.

In other cases you don't have a resolution mechanism. For example, in Long-Term Capital Management in 1998, there was no resolution mechanism for hedge funds. But, you know, the government didn't put public money on the line because it was an environment where they actually did resolve it by convening people at the New York Fed. Without there being a mechanism to do it, they did it.

And aren't we seeing the same thing now in Europe, where, you know, you can talk about a resolution mechanism, you can theorize about it, but when you actually are confronted with Ireland and you try to use it, everybody panics, the Portuguese start screaming, and you can't -- you don't have the guts to do it?

STEIL: Absolutely. In fact, the EU is trying to have its cake and eat it too on this particular issue. They're saying, "Right now don't worry; we're not going to let anybody fail. But just you wait: In the future, in a few years' time, private investors are going to have to take a haircut." And of course that caused a panic in the market, because investors say, well, those countries are asking us to buy their bonds now, which they're planning to pay back in the future, and you're saying that we're going to be at risk in the future. So we're not going to buy the stuff now. So creating an orderly restructuring mechanism -- it can -- exceptionally difficult to do.

My personal view is that you've got to have what we economists call a corner solution. You can't -- you either have to say that the public -- the private sector is at risk and caveat emptor, or you have to say that we're not going to allow any failures. Why? Well, consider the Northern Rock bank run in the U.K. The U.K. had deposit insurance, I believe, on, what, 90 percent of the deposit(s)? Well, depositors are going to run for their 10 percent. So if you're going to have deposit insurance as a mechanism to stop bank runs, it has to be a hundred percent, at least up to a certain deposit amount. Otherwise you may -- you might -- may as well not have it at all, because it doesn't achieve the purpose.

So the -- what the EU is trying to do now in my view is exactly parallel to the U.K. deposit insurance scheme before this crisis. And they're going to be forced to revisit it.

MALLABY: Let's take one last question. I think there was one right here.

QUESTIONER: Thank you. I'm Vincent Lauerman from Energy Intelligence. I've heard a lot about economics today, but not a lot about politics. I'm just kind of curious: The House of Representatives passed a bill before the midterm elections in which a countervailing duty would be imposed on countries that were perceived to have a(n) undervalued currency. I guess, really, this is a two-part question. The first part is, is it likely that the Senate will pass a similar bill? And if so, would it be veto-proof? And at the same time, what would that -- and this -- the second question's for Alan, and that is, what would that do to this gradual improvement in global imbalances if the Senate did pass such a bill?

MALLABY: Okay, well, on the -- on the political thing, I think the Senate prediction is that they would not pass it, although the corollary to that is that after the tea party -- I mean, the tea party's views on foreign policy, including trade policy, are pretty obscure.

So I think it's -- but you want to give a last comment? I mean, it sort of dovetails to what you were saying earlier about would we rather have a currency war than a trade war. Maybe the currency war would lead to the trade war. That's a good thing to end the session on.

TAYLOR: Yeah, I hope we don't get to a trade war, and I think the -- as I understand it, the political equilibrium at the moment suggests that it won't clear all the hurdles, which, you know, I think would be a good thing. But if we start going down the route of imposing those kinds of protectionist measures, it will just open up a big can of worms.

Even, I mean, the Brazilian finance minister himself -- you know, he's quite a media star. He got on the front page once saying it's going to -- that we're in the middle of a currency war. Then he got to come back the next day to sort of explain himself. And in the -- in the second press conference, he said: Well, what I really meant to say was the currency war is bad, but what would be really bad would be a trade war.

So everyone understands that that's like where we don't want to go. And I think at the -- at the international level, we're kind of fortunate that, unlike in the 1930s, it can't really be such an unrestrained free-for-all, because now we do have the WTO, we have mechanisms and institutions in place that will try and protect, you know, the status quo and try to prevent countries departing and just doing unilateral stuff.

But, you know, Washington is Washington, and anything could happen.

MALLABY: Okay. Ajay and Alan, thank you very much. We're going to stop you there.

We're coming back at 10:00 a.m., for the Lawrence Summers session. Thank you. (Applause.)







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