The Federal Reserve Then and Now: Better Equipped to Avert Crises?

Monday, December 1, 2014

Event Description

Author Liaquat Ahamed, CFR Adjunct Senior Fellow and Citigroup Global Chief Economist Willem Buiter, and NYU's Professor of Economics Mark Gertler, join Sebastian Mallaby, CFR's Paul A. Volcker Senior Fellow for International Economics, to discuss the history of the Federal Reserve and its future. The panel looks at past financial crises and discusses lessons learned and unlearned, and offers reasons why forecasting future crises is difficult. They share opinions on capital requirements versus the cost of debt financing, and how to create stability in the financial system.

This meeting is part of the Stephen C. Freidheim Symposium on Global Economics: 100th Anniversary of the Federal Reserve System, made possible through the generous support of Stephen C. Freidheim.

Event Highlights

Liaquat Ahamed on the Great Depression and 2008 financial crisis:
“The financial crisis portion of this financial crisis was multiples what happened in the Great Depression. But in 1929, if you took bank assets, it was about 50 percent of GDP. If you took bank assets and shadow bank assets in the U.S., it was 150 percent of GDP in 2007. …So we're dealing with a gigantically different animal now. And I think we all agree that neither economists nor central bankers fully understand the way the financial system interacts with the real economy…what are the trigger points that make it so unstable? But they did do a better job than '29.”

Mark Gertler on fiscal policy and central banks:
“I think fiscal policy has made the life of central banks much more difficult. The debt ceiling fights in the U.S., the chaos in the euro area, and so the Fed is sort of left as the only institution kind of dealing with the problem of stabilization.”

Willem Buiter on communication and the Federal Reserve:
“…the Fed has really gotten into a mode that they're talking without knowing what they're talking about. They're confusing the daylights out of the market. …Accountability is very important. Ex-post, there has to be accountability. And especially in times of crisis, you want to know, ex-post, with a due lag of time to allow for confidentiality and commercial sensitivity… what the Fed board and central bank board, from whom, and on what terms. Because there were are a lot of problems in this country before that was finally acknowledged by the Fed. And it wasn't its proudest moment when it took a set of lawsuit to make that possible. So I think accountability, yes, but ex-ante communicating, no. When in doubt, say nothing.”

MALLABY: Welcome to the Council for the second session of today's Stephen C. Freidheim Symposium on Global Economics. We're taking an in-depth look at our 100-year-old central bank, and this second session is entitled "Looking Back and Forward: The Federal Reserve."

We've got a fantastic panel to talk about this. On my immediate left here is Liaquat Ahamed, who won a very well-deserved gold medal in the Council on Foreign Relations Arthur Ross Book Award for his book "Lords of Finance: The Bankers Who Broke the World," on the interwar central banking game not just in the U.S., but elsewhere. I believe you may have won a few other prizes, like the Pulitzer Prize, but we start with the Arthur Ross prize in this building.

Then, Willem Buiter, who is the global chief economist at Citi, also now visiting senior fellow here at CFR. And I think you were present at the creation of the newly reformed British central bank...

BUITER: Not the Fed.

MALLABY: No, no, the other one. The other Anglo-Saxon institution. After the Bank of England was sort of reconstituted, given independence in '97, you were the first independent member of the Monetary Policy Committee and a prolific commentator on all matters macro.

And then, far on my left is Mark Gertler, who is the Henry and Lucy Moses Professor of Economics at New York University, a member of the Academic Advisory Board of the New York Fed, a co-editor — former co-editor of the American Economic Review, co-author of Ben Bernanke on about twelve or so papers, and one of the most cited people in monetary economics.

So we're going to get started. And I'm going to go back to something that Stan Fischer said in a second. But I want to start with Liaquat and just sort of setting the scene a little bit. The Fed was created 100 years ago for reasons that were very different from what later became the central purpose of the modern Fed. It was really a reaction to the 1907 financial crisis. It was about being a lender of last resort. It was not about monetary policy, because there was a gold standard, so you didn't need a central bank for that. So it was really a different kind of central bank.

Can you paint the context, what people were thinking in the United States when they created the Fed?

AHAMED: Sure. I mean, the U.S. did have a central bank in the early 19th century, and because there was grave doubts about centralizing so much power in a financial institution, the Bank of the United States was closed down in the 1830s, so for sixty, seventy years, the U.S. did not have a central bank. Meanwhile, all of the European countries did have central banks, so there was the Bank of England, which was the predominant central bank in the world.

And the Bank of England took on the role as lender of last resort to the financial system gradually. So it was actually quite reluctant to become the lender of last resort. In the 1860s, it famously led — in a sort of Lehman-type event, it led a British financial institution, Overend Gurney, go under. And from that period on, it acted as lender of last resort, and Britain did not have a financial crisis for the last forty, fifty years, or did not have bank runs for the last forty, fifty years of the 19th century, and — while the U.S. had five. So it was — the Fed was created essentially to act as lender of last resort after a financial crisis.

MALLABY: And, Willem, I mean, part of the interesting turnaround we've had in the past century is that at the founding, when the Fed was set up to perform this lender of last resort function, it was assumed that this could be done without creating moral hazard. I mean, Bagehot's dictum was, so long as the central bank provides lending against strong collateral and at a penal interest rate, there won't be moral hazard. It's fine. There is huge moral hazard, meanwhile, if we have the central bank printing money, so therefore, we need gold.

So, in other words, the thinking today is basically the inverse of what it was 100 years ago. Today we worry about moral hazard around the lender of last resort bailout stuff, but we basically view the, you know, fiat currency can be done without moral hazard. In the founding, it was the other way around. Does that sound right to you? And is it inevitable that this shift then ensued in the next century?

BUITER: I think there's moral hazard associated with both dimensions of the central bank (inaudible). And, of course, under the gold standard, you can't really do much about anything. You can't be effective lender of last resort, because since you can't print gold, if the market decides to challenge you, they can always (inaudible) whatever gold reserves you have, so you're vulnerable. Everybody on the gold standard in principle is Iceland.

I think the Bank of England was very lucky that they got away with it for as long as they did. I don't know how they managed that. But probably there was no conflict between what they wanted to do in terms of interest rates for monetary policy reasons and what they wanted to do for financial stability reasons.

AHAMED: Can I just interject? They basically used to suspend the gold standard in...


AHAMED: ... and would get a letter of indemnity from the government saying, "We indemnify you, and you can follow whatever rules are necessary, and you don't have to obey the gold standard rules."

BUITER: That certainly is a solution. And — but, yes, I think that even today, moral hazard is especially, I think, in the field of financial regulation supervision, is still recognized, and especially when it's reinforced in the field of regulatory supervision by regulatory capture of the institutions that are meant to be preventing moral hazard. So the combination of inherent moral hazard and regulatory capture makes for great vulnerability fragility of the financial system, and that's not gone away. We haven't really addressed that yet.

MALLABY: So, Mark, I mean, so Willem is confirming that today we worry a lot about moral hazard with respect to the financial supervision and the lender of last resort stuff. I don't think that was so much there at the founding. But let's talk about the obverse for a second. So on the interest rate setting and monetary policy side, this is a fantastic story of successful public policy, right? You start with the gold standard, you think, we couldn't possibly do discretionary monetary policy without it being a disaster, and now we, in fact, do have it with a flexible inflation targeting regime, which most people accept. Is that right? Was this foreordained? Were there crucial tipping points?

GERTLER: No, I think the Fed has learned through experience. I mean, when you say successful, I would say mostly successful. There's been three pivotal periods in the history of the Fed, each associated with an economic disaster. The first was the Great Depression. What did we learn? We learned that the Fed shouldn't stand by the gold standard as it was forced to do during the Great Depression. In fact, the evidence is very clear that the countries that stuck with the gold standard experienced the worst depression, so the lesson is, when a crisis like that hits, you want central banks to intervene as quickly as possible.

The second disaster was the great inflation of the late '60s and '70s, and there we learned that the Fed had to step in to contain inflation. We also learned that the job of the Fed is a lot easier if there's a clearer nominal anchor, and hence the birth of inflation targeting.

And I would say the third pivotal moment was very recent, the Great Recession. There we learned that even though financial markets have become a lot more sophisticated, that doesn't mean they've become more stable, and that means that we have to be vigilant when it comes to regulatory policy. We've got to do a much better job of staying ahead of the game than we did in the past.

MALLABY: We still — Liaquat, we still hear people in the political debate sometimes advocating a return to gold. And if Rand Paul makes a run in the primaries, perhaps we'll hear some more about it. You do quite a good job, as I remember, in your book of explaining this sort of almost — I don't know what — emotional allure of gold. I mean, why do you think people always go back to it?

AHAMED: Well, I think it's rules versus discretion, so — and the problem with the gold standard is if the economy is growing — if the global economy is growing at 4 percent, that means the financial system is probably growing at 6 percent, and gold supplies only grow at 2 percent. So there's just going to be a progressive shortage of gold, unless you allow gold prices to go up steadily at 4 percent a year. So I think that's the fundamental flaw of the gold standard.

Can I come back to the picture you portrayed of a steady improvement in the conduct of monetary policy? And I want to go back to something Stan said, which is we actually unlearned some lessons. There was a period in the 1950s and '60s under William McChesney Martin where the Fed actually did a fantastic job of having low inflation and high growth by essentially following a sort of implicit inflation target, that every time inflation started going up, McChesney Martin, who was the one who invented the phrase "take away the punch bowl when the party gets going," would start tightening. And we actually got a period of stable inflation.

And so I think the interesting question was, you know, why did we unlearn that lesson in the late '60s? Was it because of the Vietnam War and the pressures — political pressures? Was it a sort of failed Keynesian attempt to exploit a Phillips curve that didn't exist? So we've actually come back full circle, back to the '50s.

MALLABY: And, Mark, in the mid-'90s, I think you had a paper which was entitled "Inside the Black Box," and what you were talking about was the way that the monetary transmission mechanism — you'd move policy rates — the Fed moves policy rates, and then some — it goes through some black box, and then it affects the real economy out there. You described it as a black box because it was hard to figure out how this thing worked.

Of course, I'm sure that your research has shed enormous light and now it's just a gray box. But I think it would be no disrespect to you to say still, precisely how long rates will react to short rates is — that's something the Fed can have a view on, but doesn't know for sure before it moves. And so we have this paradox, right, where monetary policy has stabilized prices remarkably well, and yet the mechanism used to achieve that is understood remarkably little. I exaggerate a bit for effect, but isn't there some truth in that?

GERTLER: Yeah, I mean, over time, I think central bankers have learned to be humble, and I think that's actually made them more effective in the way that they go about business. I think we've learned throughout time — and this idea goes back to Milton Friedman — that we just don't know enough to fine-tune the economy. But that doesn't mean to say the Fed should stand on the sidelines. It can still do something very useful, and I think the mentality of the modern central bank is to avoid disasters.

That is, we don't — even though we don't understand the precise details, qualitatively or quantitatively, we have a general sense of the direction of monetary policy, the way it works, how it affects the economy, and we can use that knowledge to contain disasters, like contain the double-digit inflation of the '70s, moderate how bad a recession could be. So I think the Fed is still very successful at that, so long as it keeps its goals modest.

MALLABY: So, Willem, as I understand Mark, he's saying even if you don't precisely know what the heck you're doing, you can still improve the world, because you understand enough about it...

GERTLER: Well, I make the — it actually goes to Robert Lucas. He made the analogy between driving a car along the road. I mean, you start to tilt off a little bit, you know which way to turn the steering wheel. You don't know exactly — you know, you can't calculate exactly.

BUITER: But the steering wheel only turns one way now. We're at a zero lower bound. So all these sophisticated central bankers managed to get themselves in a situation where they can only turn left. So that's not very good.

GERTLER: Well, no, no, no.

MALLABY: Did you choose left as opposed to right on purpose?

GERTLER: But, again, I think — OK, the problem is we're always good at solving problems in the past. I think we figured out how to solve the problems of the '60s and '70s and double-digit inflation. In fact, from '84 to 2007 did a remarkably good job. Where we missed out is we did not see the financial vulnerability that hit the system, and now we're kind of trying to learn how to deal with that.

MALLABY: I mean, so there is one view which is that the way you reconcile this apparent paradox of success in the outcome with respect to inflation but lack of clarity on how on earth that worked is to say, look, there are other things going on in the world. Globalization was driving down prices. Technological change was driving down prices. Productivity innovation stemming from deregulation in the 1980s drove down prices. And so to some extent, central banks got lucky in the period from, let's say, the early '90s to the crisis and delivered price stability because of stuff that was going on in the real economy. Is that...

GERTLER: I think there was — you can't dismiss an element of luck, but I think the knowledge involved in monetary policymaking has increased dramatically over the years, if you compare the '90s and 2000s compared to the way we're just mucking around in the '60s and '70s, like the growth of the idea of inflation targeting, the use of Taylor rules to guide policy. I mean, look, we're not omniscient. We don't know everything. But I do think we have something to offer about the way we should conduct monetary policy. Just the problem is, as we go through time, we get hit with new crises, and that's the challenge, being hit with stuff that's new.

MALLABY: Liaquat, Willem, you want to comment on the lucky man theory of central bank supremacy?

BUITER: Well, I don't think they've been very lucky. They find themselves in a position where inflation systematically undershoots whatever target they've set themselves. In the euro area, it's spectacular. Here, it's persistent, not spectacular. And the ability, I think, to respond aggressively should there be a major failure in effective demand either externally or more likely from a loss of animal spirits in the household sector or — is very limited. No, I think central banks have much to be modest about.

AHAMED: So I'm going to take the other view, which is that — rather than the lucky theory of inflation, the great man theory of inflation, which is that I don't think you're giving enough emphasis to how important Volcker putting the U.S. economy through the ringer was. I don't think you're putting enough emphasis on the fact that in '84, when we had started recovery, Volcker raised interest — real interest rates to 6 percent, and sort of cut off an incipient inflation. I think Greenspan at several points acted preemptively. And if we'd had a different person in that job, we might have had a different outcome. And I think that's throughout the history of central banks, that who is the chairman of the Fed is incredibly important.


GERTLER: I don't think we can absolve fiscal policy from this discussion. I think fiscal policy has made the life of central banks much more difficult. The debt ceiling fights in the U.S., the chaos in the euro area, and so the Fed is sort of left as the only institution kind of dealing with the problem of stabilization.

BUITER: I agree with that, but that also created a real crisis of legitimacy, right? The Fed, like the Bank of England, like the ECB, was forced to take on quasi-fiscal roles that are probably illegal, certainly against the spirit of what the law meant in terms of, you know, fiscal actions require the consent of Congress or parliament or whatever, and it was simply because of a manifest political failure that the choice was we either, you know, have an economic disaster that makes the Great Depression look like the teddy bears' picnic, or we're going to do things that we should not be doing because this is not our — we were created for this.

So it was an egregious, impossible situation to be in. And so institutional reform is really what's required to cure this mess, because we still haven't changed it. We're still paralyzed.

MALLABY: I'd like to switch the discussion. So Stan has made this point that notwithstanding Willem's robust remarks, we have learnt quite a lot about conducting monetary policy with respect to interest rates. Flexible inflation targeting is a regime that people feel comfortable with, and it looks like it might be a lasting one. So if we leave that aside, we talk about the other challenge that central banks face, which he viewed as something very much more of a work in progress, namely, how do you achieve financial stability?

Maybe, again, we can go back to the pre-war period with Liaquat to begin with to set the stage. As we began by saying, it was thought initially that achieving kind of lender of last resort bailouts on Bagehot's principle could be done fairly straightforwardly, and yet it proved to be a disaster. Can you recreate that period in the '20s and '30s? Why did it go so badly wrong?

AHAMED: Well, first of all, on financial stability, I'd separate two issues. One is preventive. How do you prevent a financial crisis? And, secondly, what do you do in a financial crisis? So on the second, what do you do in a financial crisis, they did basically everything wrong in 1929. They lent to — they only lent to members of the Federal Reserve system, which accounted for a third of the banks, so two-thirds of the banks had no financial lender of last resort. They would only lend under very restricted collateral. And the Fed learnt the lesson this time. They lent to everyone, and they lent against almost every type of collateral.

So I think we know — we know they did the wrong thing then. We prevented a financial crisis this time, and it's not clear to me whether they went overboard and whether they, you know, in the — in the effort to prevent a Great Depression, we created a whole series of other problems.

On preventing financial instability, frankly, I don't think we have a clue. I mean, we have — we have the Basel capital rules which say that, you know, the financial system is stable as long as people have 3 percent — 33 to 1 leverage ratio. And we have other people who say that, you know, the maximum you should have is five to one, that you need 20 percent capital requirements. So somewhere between 3 percent and 20 percent is the answer, but we don't know where. So I'm afraid we — I really don't think we know enough about what are the requirements for a stable financial system.

MALLABY: So just to clarify, does that mean that, in fact, when Bagehot in the 19th century enunciated his principles, they might have been right for the 19th century, but by the 1929 and '30s, they were actually a problem, because they constrained the central bank's activity too much?

AHAMED: I mean, I think when Bagehot enunciated his rules, the typical bank had 20 percent capital. And so he was primarily focused on liquidity crises. There were very few occasions when the whole system was insolvent, which was what happened in the Great Depression. So I think the Bagehot rules were for a liquidity crisis with a large amount — with large capital cushions.

We're not in that situation anymore. We have small capital cushions, a financial system that is relative to GDP ten times the size. So I think we're dealing with a completely different animal.

BUITER: But maybe you've given us the solution, right? If 20 percent cushion did the job, then maybe we should go back to 20 percent cushion and apply it not just to banks, formal banks, but to anything that passes the duck test for being a bank. So anything highly leveraged with mismatch in duration and liquidity as liabilities, that's a bank. And so you — and the only reason not to do that is interest deductibility versus dividend non-deductibility. That's also easily solved in principle. You just end interest deductibility.

AHAMED: Try persuading the bankers in the room.

BUITER: Yeah, yeah.

MALLABY: I mean...

BUITER: But if that's the solution, I mean, if...

MALLABY: Well, I was just — so in Brazil, I was just hearing from Arminio Fraga — they addressed this issue partly by imputing an interest to the — to the equity side of the banks' funding, so that the advantage of debt is reduced. So there are — there are countries that are grappling with this. I'm sorry, Mark, go ahead.

BUITER: Abolishing the corporate income tax would also help.

GERTLER: My understanding, the problem this time was not so much with the initial capital ratios in the commercial banking system, but the problem outside the Fed's direct regulatory control in the shadow banking system. So it seems to me the challenge is to kind of extend the safety net and regulation to all systematically-relevant institutions.

BUITER: I think, as a description of the crisis, completely wrong. All the large Wall Street banks were woefully undercapitalized, tiny capital ratios. I mean, barely visible with the naked eye.

GERTLER: But the exposure was from the — initial exposure was from the investment banks. It is true. Once the crisis hit, the investment banking sector, the commercial banks did not have enough capital to absorb the assets of the investment banks, but the initial fragility was in the shadow banking sector.

BUITER: Wasn't it mutual?

GERTLER: Well...

MALLABY: Well, let me just push this story chronologically on. So Liaquat has addressed the interwar period. In response to that, you get deposit insurance and you get a new round of regulation, extending the safety net. And then in the postwar period, under sometime in the '70s, perhaps starting with Penn Central's crisis in 1970, you have this famously stable period in finance. People look back to that and they say, well, gee, that shows that a lot of regulation is a good thing and that really did stabilize the system.

As you and I have discussed, I wonder, you know, what is the regulation that is removed after 1970 that then destabilized things? Can you help us with that?

GERTLER: Well, I think there were two factors. One is easing on the restrictions on the types of assets that banks could hold. I believe in the crises in the mid- and late '80s, a lot of banks got into trouble with risky commercial real estate lending. The other factor was the growth of the managed liabilities markets, the large CDs, money market funds, and so on, and this led to the — increased the risk exposure of banks. So we had a more fragile system than we did at the height of regulatory tightness in the '60s and '70s.

MALLABY: Liaquat, could you imagine a different history, where we had foregone after the '60s — foregone some financial deepening, and not allowed the financial sector, as it were, to do the things that Mark is describing? If you prevented or capped commercial bank exposures to real estate, could there have been — would there have been things that might have given up a bit of growth in the short term, but brought more stability?

AHAMED: Yeah, I mean, I have to say, I think it would have been better to have focused on the liability side. So the way banks financed themselves, rather — banks have always done risky things on the asset side. But I think the big change was banks went to wholesale funding. The repo market became gigantic. Investment banks, you know, I don't know, Lehman was borrowing $200 billion, $300 billion every day in the repo market, and I think that was — that was the fundamental source of the instability, wasn't it?

BUITER: No, I still think it's too little capital. I mean, financial instability of solvent institutions can always arise when there's a mismatch between (inaudible) between asset and liabilities and liquidity but that's the nature of banking. That's what intermediation is about. So you want to have that. And that's how we make — what we have lenders of last resort for, right? The fact that Lehman didn't have a lender of last resort because it wasn't part — it couldn't go to the Fed was a real problem. The combination of much higher capital requirements and lender of last resort that deals with any entity that needs it is a principle they can.

But if you look at the (inaudible) they can just about go discount to the Fed, right? I mean, individuals, partnerships, I don't know whether it's individuals...

MALLABY: So why is it — if that's the answer, why is it that much higher capital ratios are not being demanded from the financial system?

BUITER: I don't know. And why do you impose higher liquidity requirements, when liquidity is a public good? Capital is the private good. That should be provided by the banks.

GERTLER: Well, banks don't like higher capital requirements, because raising equity is expensive. But the conundrum is, they know they're going to be protected in a financial crisis, and that's going to even increase the incentive to have lower capital ratios.

BUITER: Raising equities is only expensive?

GERTLER: Well, let me say one other thing. I think it's — again, look at the current crisis. The Fed didn't know what's going on. It couldn't see most of the vulnerabilities because most of it was happening outside the commercial banking sector. And in the pivotal moment in a crisis, as I look at it, was the day when Lehman was going under and the Fed didn't know about AIG, did not know the risk exposure of AIG.

And I don't think we want to find ourselves — if nothing else, we can all agree we like transparency. So the Fed — we can, you know, disagree on what the exact capital ratio should be, but I think we can all agree we'd like to — the Fed should know what the risk exposure of the system is.

BUITER: But there was fundamental ignorance not just on the facts, but of how the economy worked. In May or June 2007, I think it was, Ben Bernanke said that basically on balance subprime mortgages are a good idea, right? One or two problems with it, but...

GERTLER: Yeah, but...

BUITER: So they had absolutely no idea what was happening. The belief in self-regulation, right, which is a contradiction in terms, was inherited from Greenspan to Bernanke, right? The self-regulation stands the regulation...


GERTLER: But I take that as part of the point, is the Fed didn't understand the vulnerability of the system. No one understood that or saw the chain reaction that would happen once you had a series of subprime defaults.

BUITER: It's not mainly — it's not just transparency. It's a lack of fundamental understanding of how the economy actually works.

MALLABY: If we go back to your papers in the '80s and '90s on financial fragility, because I think you wrote several, I mean, did you foresee that financial fragility could have this high a price to grow?

GERTLER: Well, our goal — our motive for that particular research was to try and understand the Great Depression and the emerging market crises. We did not foresee the current crisis. But what we learned was, in a downturn, if credit markets are disruptive significantly, that's going to create an ordinary downturn into a severe recession or a depression, and it was incumbent upon policymakers to react quickly in a situation like that. I don't think anyone I know — except for a few people — foresaw the current crisis, because they didn't see the vulnerabilities.

MALLABY: But there is a paper which I don't think you were co-author on, but Ben Bernanke did a paper about the 1987 crash, and he wrote it a couple of years afterwards, and he looked at the futures broking system and the options market-makers in Chicago, who almost failed. And he observed that because the New York Fed was able to call up the banks in New York that were financing the options market-makers and tell them to keep on lending, that the system as a whole ended up being very stable, because you defined the system to include the central bank, which can twist the arm of the commercial banks, which can put liquidity in when you need it.

So it seems to me — and correct me if I'm wrong — but there was a view that ultimately crises can be nasty, but with a good central bank that understands the precedents of the 1930s...

GERTLER: No, this was the perverse effect — what Willem and I were talking about it before — the great moderation period of stability in 1984 to 2007. The economy was doing so well that we thought we solved all the problems and there was nothing a central banker couldn't do. That proved to be incorrect thinking.

MALLABY: So let's take one more historical crack at this question of financial stability. I mean, you could argue, perhaps, Liaquat, that right now, when people say macroprudential tools, there are those who would say — and I think Bob Rubin and Marty Feldstein wrote an op-ed in the Wall Street Journal about this — there are those who would say macroprudential tools — well, what does that actually mean? Can you please list these tools? Central banks don't appear to do that.

And so there's a kind of empty toolkit suspicion about these tools. But perhaps if we were to look back at the course of the use of monetary policy for a purpose of inflation, you begin with tools that people don't think you can work, you try them out a bit in the '70s and, lo and behold, they don't work, but after that you do get them right. Do you feel the same, that we're going to make a same sort of optimistic take on financial stability for the same reason?

AHAMED: You know, I think the inflation tools, which is raise interest rates somewhat preemptively when inflation is just beginning to emerge, so the question you ask — so is there an analogy there in financial — macroprudential? So can you imagine at the moment some central banks saying, god, you know, there's all this speculation in the high-yield market, and we should impose some drastic margin requirements on high-yield bonds. Now, that's the sort of thing it takes.

And I just — I don't see the political — I don't see the political system allowing central banks to act preemptively, because the system has the sort of stability of a bicycle, not the stability of a table. And, you know, when it's going forward, it all seems fine, that everyone's lending to all sorts of people at the moment, but there are other people saying that the high-yield market is in a big bubble. I don't know the answer, but I don't — I don't quite imagine the Federal Reserve Board getting around and saying, OK, we need to do something about the high-yield market.

MALLABY: Willem, could you imagine your former colleagues on the Monetary Policy Committee of the Bank of England sitting around the table and deciding to order British banks out of high-yield?

BUITER: No, but I can imagine the FPC doing that. They're doing it, right? They have been given at least a number of tools — markets that really matter are those fundamentally for the outside assets, ignoring that foreign assets, because America's a closed economy, as everybody knows. Basically, real estate, land, and equity, right? And there provided — now, you either have a variable land tax, which will be a fiscal instrument, or the kind of stuff that the FPC has, the Financial Policy Committee, which is variable loan-to-value ratios, variable loan-to-income ratios, and also the ability to move the capital ratios — the Basel capital ratios in a countercyclical way, and provided that you also have some margin requirements to think around this equity, if you think — that should be a good start. You may want to invent others, but...


MALLABY: But isn't, Liaquat...

BUITER: People use them. In Sweden, right, they are using the macroprudential instruments very aggressively. It may not be sufficient to prevent an implosion of the — of the housing credit market, because I think the houses are sitting on 200 percent worth of GDP of disposable income, I should say, worth of debt. It's an impressive number. But, yes, I think that would certainly go a long way. And you have to adapt the toolkit as new financial innovations occur. It's always chasing a moving target, but at least as long as you keep running after it, you don't get too far behind.

MALLABY: What do you think, Mark? So let me just sort of put the question this way. We've had a disagreement here, which is always nice and fun. You know, so — so imagine that the government, in whichever country, in the form of the central bank, comes to the financial sector and says, "We determine that you guys are overexposed to commercial real estate, and you should pull back, don't — not such high loan-to-value ratios and so forth." Won't the financial sector turn around and say, "Well, A, I know more about commercial real estate than you do, Mr. Government? And, B, if you pull me out of it, those five other guys — some of whom are foreign — who are going to come here and finance it, anyway, so you won't achieve anything"?

GERTLER: I think realistically the best we can hope for is to get the long-run regulatory structure correct, that is, have capital ratios right, make of them broad and relevant to all systematically relevant institutions. Doing countercyclical policy I see as very tough, because it's very hard to identify clearly what you want to go after. You see a growth in housing prices, you know, is that a bubble? Is it appropriate? It's hard to say.

Now, the other thing besides long-run regulatory is to be doing stress tests so we can get a sense of what the risk exposure is, and so the central bank can be prepared. But it's sort of fine-tuning the way we do adjusting the funds rate, I think we're a ways off from being able to do that.

MALLABY: But just — all right. So...

BUITER: That has been a joke, right? I mean, in the...

GERTLER: Well...

BUITER: In the euro area, even the central bankers themselves are now saying that they once again missed the target.

MALLABY: But, Willem, will it always be a joke? I mean, don't these things always start with attempts that get criticized and then, because of that criticism, they get improved?


MALLABY: Isn't that how public policy gets better?

BUITER: I think you simply force institutions to hold enough capital so that if they do something silly, they can have a cushion to absorb it, rather than try to micromanage them. I think that is — I mean, read the Basel regulations. It looks like the U.S. income tax code, right? It's completely incomprehensible. And so that will not stabilize anything.

GERTLER: But the complexity is that to determine whether or not they have enough capital, we have to do something like a stress test. So we got to figure out how to do it better.

BUITER: Think of a number and double it.


MALLABY: I want to ask Mark one question before we go to your questions, which is the following. You've just said that realistically you need to get financial regulation right in a static way and trying to fine-tune it because of where you are in the economic cycle is too ambitious. Does that, therefore, mean — since we do have cycles, and cycles are bound up with finance — that it would be fair to use interest rates to dampen these credit cycles, excepting some more variability in inflation as a result?

GERTLER: Yeah, I think the problem with using interest rates is we have more targets than tools, at least we used to. In other words, we care about unemployment, inflation, and financial stability, and you want to put that on the interest rate.

Let's go back to the period 2001-2004. Everybody says the Fed should have raised interest rates over that period, but what they forget was the unemployment picture was very bleak, and had they raised interest rates enough to curtail the housing bubble at the time, it probably would have made the unemployment situation much worse.

And we've had another recent example about that. The Riksbank followed this logic. They raised interest rates because they were concerned about financial pressures. That further weakened the economy, and they had to reverse course.

Now, one possibility might be to come up with more tools. For example, the Fed has a mortgage portfolio now. Maybe if the housing market is — they feel it's overheating, they have some reason to believe, they could start selling mortgages. But using the funds rate to target asset bubbles, I don't think that's a good idea.

MALLABY: But just if you had to choose between avoiding financial instability or avoiding price stability — in other words, stable inflation — which really matters more? I mean, inflation that varies between 2 percent and 5 percent, is that a big deal?

GERTLER: They're not completely unrelated. I think one reason the crisis was not even worse than it was is the Fed was able to maintain its inflation target or keep inflation within target as opposed to have a big deflation. But I think, you know, these are not easy problems, but I think the best bet — if we had proper regulation, we wouldn't have found ourselves in the mess we did. If we didn't allow subprime lending to be — to go on, we didn't reduce lending standards, we didn't allow these loans to be securitized, we wouldn't have found ourselves in the mess we did. And it seems like you don't want to use monetary policy to undo the mistakes of regulatory policy.

MALLABY: OK. Well, let's go to questions from the members. If anyone's got a question, please raise your hand. I can see right over there, Jeff Schafer, microphone coming up.

QUESTION: Jeff Schafer. There was a lot of discussion about bank capital and banks think it's too expensive. There are a lot of professors out there who think it's free.

BUITER: No, it's just...

QUESTION: No more expensive than raising funds otherwise.

BUITER: ... (inaudible) a silly tax. Yeah.

QUESTION: What I wanted to get your sense of, how much more would it raise the cost of intermediation if — through banks if you went to Willem's 20 percent?

BUITER: Well, if you have interest deductibility, then it would raise it by...


BUITER: Yeah, no, I think it would have negligible effect.

MALLABY: Anyone want to debate that? You could raise capital requirements to 20 percent higher and it would not affect the cost of capital in the economy?

BUITER: No, because it lowers the cost of debt financing, of course.

MALLABY: Yeah, no, I understand the argument. I'm wondering if anyone wants to debate it. Do we have a consensus?

GERTLER: I don't think we know for sure.

BUITER: Yeah, but we also — it's worth trying. The alternative hasn't worked.

AHAMED: Yeah, it sounds as if we should go to 10 percent at least. For a start.

BUITER: Well, if you're Kotlikoff you go for 100 percent, right? Pure pass-through. Or a limited liability issue, want to do anything else.

GERTLER: Yeah, one can argue, though, that there is a subsidy to debt finance, partly the tax deductibility and also the implicit lender of last resort protection. So...

BUITER: Yes, but that can be addressed by — also — and by better bail-in arrangements, right, so that you really — so the last unsecured debtor is built in before the taxpayer walks up to pay. I think that has to be the norm. It has to be able to restructure any corporate at the speed of light, if necessary. And if you can't, then it shouldn't exist.

MALLABY: And another question. Yes, John?

QUESTION: John Macon, American Enterprise Institute and Cornwall Capital. Very stimulating panel, and I think — I sense the feeling of humility that crisis has brought to many of us, but I'm troubled a little bit by one thing that Mark said, and that is that nobody foresaw the crisis coming. I think a reading of the memos going around most hedge funds in 2007 that the Fed didn't show much interest in would disprove that. Counterparty risk was alive and well, and it was quite clear by the end of 2007 that what was going to happen to — if Bear wasn't enough of a warning, what was going to happen with Lehman was definitely there.

So I — and, you know, I — the Fed did a great job. They prevented a financial meltdown. But I would like to see a little more effort to communicate with people in the financial market and maybe a little more humility about "we didn't foresee it, so there's nothing we can do about it".

MALLABY: Anybody want to respond to that?

BUITER: I don't think that's right at all. I think that...

QUESTION: It is right. I'll show you the memos.

BUITER: A lot of people foresaw some, you know, financial kerfuffle, right? And people foresaw the subprime crisis, quite a few people did. People saw...

QUESTION: I don't think if you said a financial kerfuffle...


BUITER: But I'm talking now before 2008, right? Nobody foresaw that size, you know, cataclysmic, you know, North Atlantic financial crisis that materialized.

QUESTION: I'll show you some written material that does.

MALLABY: Well, maybe the answer here is exactly what Liaquat said earlier. In other words, it's one thing, if you're in a hedge fund, to be able to see that there's a 60 percent, 80 percent probability of something big and to adjust your positions. You don't have to be sure you're right. If you are the Fed and you're going to go and tell private...

QUESTION: Your capital is at stake. Actually, you do have to (OFF-MIKE)

MALLABY: No, because probabilistically in trading, you can decide that the best call for your own capital is to take risk off because you're worried, and that's — you don't have to be accountable to anybody apart from your own investors. If you are the Fed, the central bank, and you're going to go tell other private institutions to get out of certain positions, there's a much higher standard, I think, in the public square required of a — and that's Liaquat's point, is that one of the problems with hoping that a central bank can pull finances out of risky trades before the next crisis is rendered improbable by the fact that the standard of certainty that the government needs to have to do that exceeds the standard of certainty in a private investment house.

AHAMED: And also, I'm not — if they had decided we were going to get a major financial crisis in 2007, was it too late? I mean, the size of the financial system was gigantic by then. The undercapitalization was enormous. The liquidity mismatch between their liabilities and their assets was gigantic. I'm not sure there was anything they could have done at that point.

BUITER: And the fact that investment banks had no lender of last resort, right? Which...


MALLABY: You couldn't stop the bicycle without falling off the table or something?

GERTLER: Yeah, let me — there...

AHAMED: Mixed metaphor.

GERTLER: There were people who saw that there were potential vulnerabilities in the system, and certainly we have to give a lot of credit to Ned Gramlich, who first warned about the subprime crisis. What I had in mind was that nobody saw how everything fit together, just partly because it was so large and partly because it was so hidden. And nobody saw how the transmission mechanism would play out.

There were people like my colleague, Nouriel, who warned against, you know, that housing prices could collapse and this could create a crisis, but if you go back and look at the crisis that he described play out, it was quite different than the one that actually did — did play out. And so — and, also, the other point is, I don't think the Fed uses this as an excuse to — you know, I think they feel bad about it.


AHAMED: And in the initial — in the initial few months, the Europeans were congratulating themselves on having weathered the storm, and no one foresaw the sudden stop in capital to all of the peripheral countries which then occurred, so there was a sort of second dimension crisis.

BUITER: In 2010.


BUITER: Yeah, yeah. Yeah. And they're not foreseeing the 2015 crisis, either.


MALLABY: Another question. Matthew Klein?

QUESTION: Thank you, Financial Times. I'm wondering — it seems to me that the way the Fed and other central banks work — adjust their targets and adjust their metrics for hitting inflation depends a lot on forecasts about what the real economy is going to do and how their interest rate policies affect the real economy and how that flows through inflation. How is it that they've at least apparently managed to be very successful or relatively successful in that and yet don't think that they can have the same level of confidence in forecasts about asset prices, leverage, and other activities in the financial system, and the way their tools which affect the financial system more directly than they would the real economy, in any case, how that works? It seems to me that there's a disconnect between the confidence, relatively speaking, that they can make projections about the real economy and inflation and the humility about the extent to which the Fed and other central banks can affect financial markets and financial stability.

GERTLER: Well, I think, first of all — first of all, it's a great question. Now, the Fed actually has a comparative advantage in forecasting the macro economy, inflation, output. They have good data; they have a great staff. Go to the private sector, they lose that comparative advantage. You have all these brilliant financial economists pricing assets, and it's not clear that you — you know, that the Fed — the Fed is certainly not better than it. The question is how much worse they are. So that's one consideration.

The other is, financial markets are much more volatile objects. You know, there's lots of stuff that goes on that we just don't completely understand. There's behavioral issues, market psychology. You know, output and inflation are pretty slow-moving relative to what goes on in financial markets. So the short answer is, it seems that the private sector is better at pricing assets than the Fed is, and the Fed's better at understanding the macro economy than the private sector is.

AHAMED: I mean, I would add a second one, which is — or third one, which is that there's sort of a discontinuity in finance, which doesn't seem to occur when you're just tracking inflation and the economy, that there are sort of smooth curves and you can respond, whereas when leverage gets — you know, nothing happens as leverage goes up to a certain level, and then suddenly, you know, everything happens. And sort of those sorts of tipping points are much harder to forecast.

BUITER: That would be an argument then for — versus using interest rates for financial stability purposes, for raising them when leverage — either the non-financial private sector or in the banking sector, whatever — it's too high, and that affect them favorably. I think the Fed's notion that — well, the Fed's version of macroprudential policy, which is very much like what Mark described here, which Janet calls "across the cycle", which basically means structural strength, right, the ability to resist shocks, so that crises are, A, less likely, and, B, if they happen, do less damage. And we're all in favor of that.

But even then, I think leaning against the wind of rapidly rising leverage or rapidly rising asset prices is, I think, desirable and necessary, partly because it is simply implied by regular inflation targeting. The reason that — I think that the Fed believes there's a conflict is that the Fed is inflation targeting over two to three horizons, right? If you let a financial bubble run (inaudible) against this, inevitably you're going to have a crash in the period of undershooting, it may be years from now. But I think if you take inflation targeting long-run perspective, the financial stability is simply a precondition for price stability.

MALLABY: But so you think that leaning against the wind should take place with interest rates, as well as leverage requirements? Or...

BUITER: Or everything you can add, because as Jeremy Stein pointed out, you know, any — basically macroprudential is regulatory, ergo can be arbitraged, will be arbitraged. The only thing you can't get away from is interest rates. They go into every — you know, every pore, so to speak. And so, yes, you need definitely interest rate — the interest rate instrument in addition to the macroprudential. I wouldn't use them both, right? But I think the Fed is far too reluctant to use interest rates for what I would call macroprudential reasons.


GERTLER: But the challenge of a situation like the current one, where the economy still hasn't completely recovered and inflation is running under target, so...

BUITER: Life is difficult. So that's what you get paid for.

GERTLER: But the Riksbank just tried that, and it didn't work so well.

BUITER: No, that's right. And then you try again. I mean, you have to learn, right? There's no reason for saying we shouldn't do it. Yes, life is a mess, and central banking is very, very difficult.


MALLABY: Fundamentally, Mark, isn't it a question about which are you more scared by? Are you more scared by the fact that there's inflation below target...

GERTLER: That's a good way...

MALLABY: ... or are you more scared by the fact that asset prices may be bubbly? Which can do us more damage?

GERTLER: Sure, that's right. What I'm more scared about is a lost decade, another lost decade like Japan. And, you know, you look at — even though the labor market is showing signs of improvement, we are still way below the old trend that we started out on before the Great Recession. The employment to population ratio has not recovered. It's recovered maybe a quarter of where it was before, so right now — I think you put it well. It's what you're more scared of. And right now, I'm more scared of...

BUITER: But do you believe you can do anything about — I mean, the notion that the Fed has a serious handle on the long-term ratio of employment to population, it's possible, but it's by no means obvious, right? You have to really believe it is the reason...


GERTLER: But the fact the inflation is running below target tells me that there's still weakness in the economy.

MALLABY: Let's have a question on the aisle there, Ben.

QUESTION:  Benn Steil, Council on Foreign Relations. Throughout my adult life, there's always been some dominant theory in central banking indicating that the central bank operating wholly on its own could stabilize the economy. This theory today appears to be market monetarism, the idea that the central bank should do what it takes, potentially, for example, limitless asset purchases, to keep nominal GDP growing at a rate of, say, 4 percent to 5 percent. I'd be particularly interested in Mark and Willem's thoughts about this, the growing popularity of this idea.

BUITER: No, only if the central bank can engage in helicopter money, but overtly fiscal would that be the case, yes. And if they can also reverse it, in other words, take it out, hoover it up, right? So that — otherwise, no. You need fiscal for it to be effective, a combination.

GERTLER: That's right. I mean, what the Fed can do is contain damage, which I think it did in the last recession. But you need the cooperation of the fiscal policy. Right now, the Fed is fighting the fiscal authority.

MALLABY: Right in the middle there. Yeah.

QUESTION: Hi, Andrew Huszar, Rutgers Business School, formerly Fed, formerly Wall Street. There was some celebration of Paul Volcker early in the panel, his heroic raising of interest rates back in the '80s and '70s. And, you know, if you look at the Fed today compared to then, I'd argue the challenge facing Chair Yellen is much greater. The Fed's balance sheet is now 5.5 times the size it was in 2008. It used to operate only on the short end of the curve now. It owns basically 30 percent of U.S. government debt from a duration perspective, 10 percent of the housing market. The Fed used to release interest rate decisions weeks after meetings. Now we have press conferences on FOMC days.

So my question is for the panel, do you think that what Paul Volcker did is even possible in today's Fed? Obviously, we have 2015. We have this discussion of even a small rise in interest rates, which is eliciting huge nervousness in the financial markets. You know, can the Fed get back to where it was? Or are we living in a new world?

MALLABY: Maybe I can just also — I mean, frame this in the following way, since this is a historical panel. We've had this big shift in central bank openness from a period of minimal communication to sort of maximal communication. And Stan Fischer was saying on the previous panel that the Sunlight rules about needing to release information about a meeting are such that he can't talk to his fellow governors, five of them, without everything being minuted. So he feels that's a constraint on efficacy. Maybe, Liaquat, you could start and put it — give us a little bit of — you know, we began from a period when people didn't communicate, right?

AHAMED: Well, that question was asking, I think, can — given the size of the balance sheet, if inflation started ticking up to 4 percent, would the Fed have the courage to raise interest rates sharply? And, frankly, I think they would. I think the view that inflation, when it gets out of hand, is now well entrenched. I don't think we're going to go to the — try an experiment a la 1960s. So I think they could there.

On communication, look, I think this forward guidance stuff is — I mean, if you don't know what you're going to do, how can you communicate what you — you know, what you don't know? So I think there's a fundamental problem. It sort of works in models, but it doesn't work in practice. And so I think we've exaggerated the efficacy of forward guidance. But that's, I think, a separate question to the one that was...

BUITER: First of all, central banks can live comfortably with any size balance sheet relative to GDP, right? They have the instruments. If all else fails, if you're a monetarist, to say, when it doubt, sterilize. If the banks get a mojo back, when they start lending again. If that doesn't work, raise reserve requirements, turn excess reserves into required reserves. If you don't like that, because it's not nice to the banks, raise the remuneration rate of excess reserves, right? You can — I think there's absolutely no problem there. The Swiss National Bank has 83 percent of GDP balance sheet. It makes the Fed look like Scrooge, right?

And on the communication, I think there's far too much of it, right? And that is not the same as  accountability, right? But communication in advance, right, this avalanche of increasingly incomprehensible written and verbal statements from the Fed and other central banks is — and then there's communication by committee, which is impossible. You can deliberate by committee, make decision by committee. That can work. There are some problems there, as well, but that can work, but communication by committee, no. At most, one person should talk, and preferably nobody, right?

So the Fed has really gotten into a mode that they're talking without knowing what they're talking about. They're confusing the daylights out of the market. And I don't think that's good. Accountability is very important. Ex-post, there has to be accountability. And especially in times of crisis, you want to know, ex-post, with a due lag of time to allow for confidentiality and commercial sensitivity, blah, blah, blah, what the Fed board and central bank board, from whom, and on what terms, right?

Because there's a lot of — there were are a lot of problems in this country before that was finally acknowledged by the Fed. And it wasn't its proudest moment when it took a set of lawsuit to make that possible. So I think accountability, yes, but ex-ante communicating, no. When in doubt, say nothing.

MALLABY: Mark, yeah, so the academic fraternity has evinced some enthusiasm for open communications, forward guidance, and...

GERTLER: Well, let me go back — I first want to second the point that Willem made about the balance sheet. I mean, one thing we should have learned from the experience in Japan, the U.S., the U.K., and the euro area — there is no connection between the inflation rate and the size of the balance sheet. Look at the data. In fact, I'm constantly dumbfounded that people keep talking about inflation exploding, when you see no connection.

And the reason is, this stuff — these liabilities — this is stuff you can pay interest on. There's tools you can use to avoid inflation and have an exit and drawing down...


BUITER: It's a sovereign wealth fund.

GERTLER: Yeah. So — yeah. It's a hedge fund. Essentially, what happened...


GERTLER: ... is the private hedge funds tanked, the Fed went into the hedge fund business to kind of prop up the flow of credit. So the balance sheet — you know, I think that's the — maybe one of the least of Janet Yellen's problems now, if I dare say.

On communication, I mean, I'm sympathetic to what my fellow panelists are saying, but with one important caveat. We're at the zero lower bound. So the only game in town for manipulating interest rates is through communication and somehow giving the markets a sense of which way rates are going on, so the markets will price rates in a way that will be consistent with the Fed's accommodation goals.

Now, unfortunately, that's not an easy thing to do. And there are many people that want to weigh in, and that makes it more complicated. But I think given we're at the zero lower bound, we can't abandon communication.

MALLABY: But this presumably is a game you can't play too many times. I mean, in the early 2000s, when the U.S. was worried about repeating Japanese-style deflation, this was the first time when forward guidance became fashionable at the Fed and there was more — there was certainly I think talk about it then, because you were near — you were not at the zero lower bound, but you were approaching it.

So then it kind of has this moment in the sun. It goes away a bit. It comes back with a vengeance after the crisis, because you are at the lower bound. But surely people have by now figured out that the Fed goes yadda, yadda, yadda, yadda when it can't act and cut, because it's at the lower bound.

BUITER: But it's also not right (inaudible) even if you're not at zero lower bound, the next rate decision means nothing, right? It's only the future costs of rates, right, that matters. And that's true at the lower bound or away from the lower bound.

MALLABY: But the fact that you're not...


GERTLER: You have to say something about what you're going to do.

BUITER: But in that case, you want to get markets to get some sense of your reaction function. But to just — just blab, right, and then have to reverse yourself and to unblab, right — you remember these physical — these thresholds? What was it, the 6.5 percent and the 2.5 percent? Right? No sooner were they announced than the unemployment rate went right through them and, oops, they went. Same happened to Carney, right?

MALLABY: Mark Carney.


GERTLER: But the — what they're struggling with is the following. You have a weak economy. You're worried about a lost decade. And the worst thing that can happen now is if rates preemptively rise because the market thinks they're going to rise, you start pricing this in, you have high interest rates, that slows the economy.

So the trick is, how do you deal with that? What's the right way to accumulate the path of accommodation you like in a world where there's lots of uncertainty?

MALLABY: Another question? Yes, right here.

QUESTION: Niso Abuaf, Pace University. Vice Chair Stan Fischer mentioned that the New York Fed has a very complex map of the various relationships among the various players. My question is, does anybody understand that? And can anybody explain the various feedback effects, both adverse and non-adverse, that can happen in the system? The best example being in 1987, when an initial shock in the stock market was amplified because of portfolio hedging. There are such adverse feedback loops obviously in the system. Does anybody understand them? Thank you.

MALLABY: Who wants to take a crack at that? Stan was saying that the New York Fed has created this map of interrelationships in the system. I don't know whether you have heard that from colleagues in the Fed or...

BUITER: It's a laudable enterprise. And...

MALLABY: But will it be successful?

BUITER: I hope it's complete.


GERTLER: I mean, we didn't understand it well enough before the crisis — that's for sure — because AIG wasn't on the map.

BUITER: That's what they should be doing, but it's really chasing, you know, the blind man chasing a black cat in a dark room and the cat isn't there.


MALLABY: So this is — this is a highly encouraging "one can but try" answer.

GERTLER: I think they're — you know, under Dodd-Frank and so on, the goal is to move in that direction, to, you know, have the Fed more directly engaged in...


MALLABY: I saw another question back here in the middle there.

QUESTION: George Weiksner, Credit Suisse. Looking back, I haven't heard discussion of maybe Glass-Steagall erosion was part of the problem and separating the too-big-to-fail deposit insurance institutions from those who want to play roulette in the capital markets. What does the panel think of looking back of re-establishing a Glass-Steagall separation, simple, not as complicated as Volcker?

MALLABY: Take a crack.

AHAMED: I mean, my view is that the crisis — the crisis occurred in investment banks which had no commercial banking activity. There were other commercial banks that went under that were heavily involved in real estate, but that had no investment banking activity. So I'm not sure that sort of coalescence of investment banking and commercial banking was a source of the problem.

BUITER: Yeah, in the U.K., again, the first victim of the war was Northern Rock, which was, you know, pure mortgage — mortgage-backed securities and housing loans.

GERTLER: That's right. I agree. I mean, I see that what we learned is the problem is dealing with highly leveraged, systematically relevant financial institutions...

BUITER: Whatever they are.

GERTLER: ... complicated by the fact that often we can't see the leverage exposure.

BUITER: Especially with the derivatives. You really have to crawl inside the minds of the traders, almost, before you know what's done.

MALLABY: For those who believe that Glass-Steagall ought to be brought back, I think the most convincing contention is that bringing multiple product lines into one institution creates a managerial challenge that means it's more likely that you'll have people making — you know, banks themselves will make mistakes, because they're trying to keep their tabs on too many different activities and it becomes too complex and...

BUITER: My local grocer can sell apples and potatoes. So I don't — I really don't think that is obvious. You have to judge that one case — there are these economies of scope.

MALLABY: But the question was more about your local employer...


BUITER: Yeah. But I would think — one way to solve it would be do away with deposit insurance, right? You don't really need it, except sort of a de minimis amount to protect granny, right, if you have a lender of last resort. You don't need belt and braces, right?

MALLABY: Question here.

QUESTION: Jason Tepperman, Promontory Local Credit. A question for the panel. In terms of bank regulation and the impact of the Basel rules on macroprudential policy, there's an argument that part of — or one of the sources of the last crisis was the ability of banks to take assets with high-risk weights, securitize them, and then hold them on their balance sheets with a much lower risk weight. The new regulations we have in Basel III are much more complex than the old ones. Does the panel think that this is additive or negative for financial stability? And what might be done going forward?

MALLABY: Anyone want to make a guess about whether Basel III is better?

AHAMED: You know, I mean, I have to say, I've been skeptical about risk weights just because that sort of preempts that — if you like, prejudges the problem, so — and it's particularly a problem in Europe, where government bonds continue, I think, to be low-risk-weighted, when we know that's one of the principal risks. So I've never believed in risk weighting as an effective mechanism.

BUITER: If you're going to have risk weighting, you definitely should attach the risk weights to — and for the matter concentration, exposure limits to sovereign debt, as well as to commercial debt. But I agree that we basically haven't got a clue what they should be, and if they have to be left to the banks themselves, right, that is like asking a bank how much capital you want to hold, right? The answer's always rather less.

And so I don't think it's very meaningful. Now, I think you have to move away from that, and Basel — well, I don't understand Basel, right? I've tried to — I've tried to understand it. But I find it completely incomprehensible. So, I mean, we find out with the next crisis whether it has improved things.

GERTLER: Yeah, I mean, I don't think anybody can pretend that they have the answer to what the optimal risk rates or capital ratios are, but, again, I'd go back to this idea to making sure that the application is sufficiently broad across financial institutions, because what happened when the old Basel was tightened in response to the banking crisis of the '80s and the '90s, the problem was a lot of the stuff was not only securitized and held on balance sheet, but then it was sold. So the bank got the profits from the origination and then you had these investment banks holding this stuff, and they proved to be vulnerable. So at least you want to make sure that you broaden the regulatory oversight sufficiently.

MALLABY: So I'm going to give the last question to Byron Wien, and everyone can take a crack at it, and we'll wrap up.

QUESTION: Liaquat, in your book, "Lords of Finance," you established the fact that they — those bankers were facing a similarly complex situation, and there was quite a variability of understanding of the situation and what to do with it. And one of the reasons they didn't act effectively is because of disagreements among themselves.

Now, if you were going to write a similar "Lords of Finance" book, let's say, ten years from now, looking back at the pre-2007 period, I would think that they — those people had less of an understanding of what was happening to them than the people in the 1920s. Is that a fair assessment?

AHAMED: Well, I mean, we didn't get a Great Depression, so that's a fact. So they did some things much better than the previous group of people. The financial crisis portion of this financial crisis was multiples what happened in the Great Depression. But, you know, in 1929, if you took bank assets, it was about 50 percent of GDP. If you took bank assets and shadow bank assets in the U.S., it was 150 percent of GDP in 2007. In Switzerland, it was 600 percent of GDP. In — you know, in Britain, it was 450 percent of GDP. So we're dealing with a gigantically different animal now.

And I think we all agree that neither economists nor central bankers fully understand the way the financial system interacts with the real economy and what — what makes it so — you know, what are the trigger points that make it so unstable? But they did do a better job than '29.

MALLABY: Willem, final thought?

BUITER: I would also say they did — well, anticipation and prevention, complete rubbish, right? So probably as bad as anything in '29. But in terms of dealing with the financial crisis, preventing it from destroying the financial system completely, I thought they were very effective. And also, then, in terms of just the monetary policy, the expansion of monetary policy to get out of the Great Recession, to the extent it was possible without active fiscal support, I think they did as well as could be expected, except, of course, in Bundesbank, right? That's the '20s still.

GERTLER: I'll just end with the following thought. I think we've forgotten, one of the great coincidences of history that the person who happened to be at the helm of the Federal Reserve at the time before the crisis was the world's leading expert on the Great Depression. And I firmly believe that's an important reason we didn't have another one.


MALLABY: So the next session will begin in fifteen minutes, at 3:45, with a panel made up of former central bank leaders. But I want to thank Liaquat, Willem and Mark.


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