The Financial Crisis and Global Financial and Monetary Cooperation

Thursday, May 7–
Friday, May 8, 2009

This session was part of the CFR Symposium on the United States and the Future of Global Governance, which was made possible by the generous support of the Robina Foundation.

DANIEL W. DREZNER: (In progress) -- we're not used to this sort of thing. We're not used to other countries going around and creating, not necessarily competing arrangements, but possibly --

MICHAEL ELLIOTT: And at least shifting from being a rule tainter to wanting to be a rule maker?



DREZNER: I think there's no question that that's going on. And the interesting question is going to be, how does China manage to do this in a way that potentially doesn't arouse the ire of the United States; and also what are the -- you know, what is our reaction to this? It's that we've been spoiled. For the past 16 years, we're used to writing the rules of the game without really all that much influence by anyone else. We're going to have to change our expectations there.

ELLIOTT: I want Steven to come in a minute, but Sebastian, do you want to --

SEBASTIAN MALLABY: Two quick things. I think that actually this "downside hedge" idea is very instructive because, you know, I mean, in hedge funds or fund management more generally, the guys who become activist managers and start telling the management how to change are the ones who have such a big position in the stock that that they can't sell it. It's not liquid. They own 20 percent and they can't get out. Their only alternative is to say to the management, you should change that.

China is a bit like that. With a $2 trillion reserve position it has a locked-in stake, an illiquid stake in the international system. So now you have to be an activist. You have to get in there and say how it wants the thing to work, because it can't get out.

The other thing to say is that, you know, Justin Lin is the Chinese chief economist of the World Bank. Now, that's an index of China's rise, China's shifting world -- role in the world. It's a contrast, by the way, to the IMF where, you know, the current chief economist is the co-author of an MIT textbook with Stan Fischer, right. So, we've moved from the '90s to this decade and you've got the two authors in the same year being the dominant economists -- (inaudible).

But in the Bank, you have a real shift on the Chinese chief economist. And when I talked to him, as -- actually, I was on a panel with him in Washington maybe three weeks ago, and his takeaway from this crisis was, "What we need," he said "is growth without crisis. And the way to get growth without crisis is the East Asian model. We don't need all these financial markets; we don't want fancy bonds and cross-border capital flows. You know, we're just fine in our own system. Give us medium-sized banks that need to -- lend to medium-sized companies. Forget all this fancy finance." That was his -- that was his lesson.

And if you had said to him, as I did, well, maybe growth without crisis, when you take it from just the Chinese perspective, perhaps the consequences of your exchange rate policy is growth with crisis. What do you say to that? You know, luckily he didn't have time to answer, but. (Laughter.) So I think there's a bit of a confusion there, but I don't see them -- shall I put it this way, converging with a Western view of what went wrong.

ELLIOTT: The East Asian model has worked so well in the last 10 years for Thailand, Malaysia, Philippines, Indonesia anyway.

Do we need new institutions? I mean, there's been a -- there's been a flurry of academic and journalistic and other papers over the last year suggesting that the architecture needs to be supplemented -- there's the wise men's club, there's the club that advises on systemic imbalances, the "early morning club," that there's something, if you like, of the old IMF surveillance mechanism. Do we need anything like that?

MALLABY: There's always a lot of wise men saying we need more groups of wise men.

ELLIOTT: Yes. (Laughs.)

MALLABY: I also would remind you that, you know, as I said at the beginning, after the Asian crisis, one of the ideas was, gee, you know, these sovereign countries are going bankrupt. We don't have a bureaucracy court for sovereigns. So we need a -- (inaudible) -- mechanism where you can have an orderly workout of Argentina's debt, or whatever.

So Anne Krueger, number two at the IMF at the time, you know, made a big statement about this, and this was going to be -- she was really going to try and push it. And it took about, you know, 10 minutes for the Treasury to slap her down. And so, you know, when you talk about adding new institutions, I'm just not -- I agree with what Steve said, I think incrementalism, trying to fix the Fund at the margin -- (inaudible) -- how much of the margin is a much smarter course than, you know, pie-in-the-sky, big, new institutions.

ELLIOTT: Before I go to the audience, I just want to pick up one point that Sebastian made, but I actually want to get Steve and Dan to talk about it because they may have slightly different views.

We were talking over coffee about what -- I was actually stimulated by a piece I read by Dan -- I read by Dan last night about whether the U.S. -- I mean, let's just kind of talk about the U.S. now -- has the power to exert true leadership positions in the financial monetary system in the same way as it does as the politico-military system.

Dan, you'd sort of argued in the piece that it didn't. I think, Steve, you may disagree. But, Dan, do you want to go?

DREZNER: Yeah. I mean, I would say two things about this. The first is is that I think even in the economic sphere the U.S. is still first among equals -- you know, that it's first among equals more so than in the military sphere where, you know, U.S. power is so far and away greater than the, you know, rivals, that it's going to be at least 10 years before we're talking about truly any sort of peer competitor.

I think when you're talking about economics, you know, you can look at where the future is headed. And the U.S. is still powerful, but it's also a huge debtor. It clearly needs the goodwill of other countries, at this point, in order to be able to sustain its own economy. So, the U.S. can no longer act in a unilateral capacity in the same way that I think it could even, you know, 10 years ago.

There's something else, though -- and this is, in some ways what's more problematic about this I think. As much as the U.S. has more leverage on the politico-military side, it also can act with fewer domestic constraints on the politico-military side. When it comes to finance and economics, the fact is is that these are also the bread and butter of domestic politics.

And I think one of the interesting things is to contrast, for example, the cooperation that you have seen somewhat on, let's say, currency swaps between central banks. I mean, that's actually been relatively smooth since the crisis started. Contrast that with what's happened on trade, which is there's been no movement on trade. And the reason is is because to make any movement on trade you need the support of your domestic legislatures, and that requires a lot of domestic political capital and a lot of these leaders haven't had that much of it.

ELLIOTT: Steve, do you want to go?

STEVEN DUNAWAY: I think that I see the other side of the coin on this. You know, there's a lot of talk about how the world has changed economically, but I think it's a "G-1" world after all. Because, you know, if you look at the current situation and kind of gaze out at the near-term and how the world economy may evolve, it's all dependent on the U.S. and it's all dependent on U.S. consumption.

And I think right now that consumption is just not going to be there for two key reasons: One, a lot of the consumption through the first part of this decade was a financing phenomenon that -- owing to financial innovation, people could take money out of their houses. So the rise in housing prices created more equity that, in turn, helped to finance consumption. That's over.

Household balance sheets need to be restructured. They don't have room to take on more debt. So that's why we've seen the savings rate bounce back up. But there's a second reason why the savings rate is going to go even higher, and that is that the Baby Boomers, in particular, as they're facing retirement, they've just experienced a massive loss in their financial assets.

Now, back in the early 1990s -- and if -- as some of you remember, at the end of the '80s there was this discussion how the '90s was going to be a decade of slow growth because the Anglo-Saxon countries were going to have to boost their savings. But it didn't turn out that way. And, in part, the Boomers had two choices: They could raise their savings to meet their retirement needs or they could raise the rates of return on the assets that they already had.

And they chose to -- they chose the latter. They reallocated portfolios more towards equity holdings, boosted returns, savings didn't rise, and so that was one of the factors that helped to contribute to the boom in the '90s.

They can't repeat that. The only way for the Boomers to reconstitute those financial assets is to raise savings. That, coupled with -- you know, if you believe the administration's blueprint for medium-term fiscal consolidation, you're going to see a significant rise in the national savings in the U.S. and a decline in consumption.

Nowhere else in the rest of the world right now do you see, over the next three to five years, changes in policy that will generate enough domestic demand to move it along. So, that's why I say I think it's still a G-1 world.

Now, the U.S. doesn't -- and this is where I kind of deviate a little bit from Dan, the U.S. doesn't want to see it as a G-1 world. The U.S. realizes it's to its benefit that policies change in other countries to stimulate growth -- not only that China rebalances its economy as it becomes more dependent on consumption and domestic demand, but the same thing is true in Europe and Japan, that they remove the rigidities in their labor and product markets which have held back growth in those economies.

And I think that's where the big push on the U.S. side -- and the willingness of the U.S. to sit back and hold these discussions, is to try to push those policy reforms that boost overall world growth.

ELLIOTT: Dan, come on in, and then we'll --

DUNAWAY: It's not that they're -- it's not that I'm saying the U.S. is altruistic. It's in its own long-term best interest.

DREZNER: I'm a professor, so it's my job when asked any question, to answer "it depends." So I would want to --

(Cross talk.)

DUNAWAY: -- an economist. (Chuckles.)

ELLIOTT: Time alone will tell.

DREZNER: Yeah, exactly.

I mean, I would say two things. The first is is that one of the key questions, going forward is, you know, it's easy to sort of extrapolate from recent growth trends and assume, well, China is going to catch up with the United States, it's just an inevitability.

But I think Steve brings up an interesting point, which is, one of the relative comparative advantages of the United States' political economy -- for lack of a better way of putting it -- is it responds better to crisis than a lot of other systems. And the fact that you're seeing savings rates going up in the United States so quickly, you know, is actually encouraging because that's one of the necessary steps that has to take place.

So it'll be interesting to see whether or not, you know, over the long term the U.S. makes a quicker adjustment than some other economies which are hoping that the EU can resuscitate the previous status quo.

On your point about the U.S. wanting other countries to contribute, I don't disagree with that. I think that's true. But, you know, just as China has been schizophrenic, the U.S. has been a little schizophrenic on this. We would like China to consume more. But on the other hand, I think we'd also like China to continue buying U.S. debt to keep interest rates low. And I'm not sure you can get both of those.

And, you know, just to end on a, sort of, a gloomy note, the history of macroeconomic policy coordination in the last 50 years is not really a terribly distinguished one. There have been a couple of key moments where you've had useful intervention -- like the 1985 Plaza Accord, for example. But, by and large, countries are going to do whatever their domestic constituencies want them to do. And if that actually works for a harmonious arrangement, that's great, but if you actually have very divergent preferences as a result of that, I'm not sure you're going to get a lot of international adjustment.

ELLIOTT: Time for questions. There are microphones floating around. Please state your name and affiliation.

In the back, Bill.

QUESTIONER: Bill Droesdiac (sp).

I wanted to raise the point -- how do you kill off the twitching corpses? The G-7 certainly has very little, if any, relevance left --

DREZNER: Oh, I thought you were talking about the banks. (Laughter.) Go ahead.

ELLIOTT: Oh, they're all fine -- they're all fine. (Laughter.)

(Cross talk)

QUESTIONER: -- (inaudible) -- 12 percent of the world's population, the advantage of the G-20 is that it represents 80 percent of the world's population, 90 of GDP. That's one thing.

Secondly, in terms of American leadership, I just want to take exception on this idea of a G-1. If that's the case, why didn't China or Europe follow the American prescription at the latest summit? I mean, China has gone with its own plan of vouchers; European Union wants better regulation -- didn't go along with the stimulus package. I thought that was one of the more remarkable results of the G-20 summit.

Anyway, if you could respond to those two points.

ELLIOTT: For those who weren't here last night, I should explain that at the end of the opening session of the conference last night there was a very illuminating and fun discussion on what international institutions were actually "twitching corpses" and should be -- and should be put out of our misery, hence Bill's question.

Who wants to -- who wants to take that?

DUNAWAY: I'll take the corpse question.

International organizations never die -- (laughter) -- they just don't. I mean, unless -- this is one of those tragedies of international politics. Usually the only way you get to wipe the slate clean, in terms of global governance, is through a great-power war. And let me stress that I'm not recommending that as a solution -- (laughter) -- for the current problems. But, I mean, you know, Bretton Woods was done under -- you know, during World War II. So, I'm very pessimistic with the notion that these things are going to go away.

Now, on the G-7, in particular, one way you can potentially make it useful -- I mean, the G-7 still actually has some uses. And here's the way you should think about it as useful: Don't think of it as an international organization -- which, by the way, technically, it's not, it has no independent secretariat, it has no, it's not a treaty-based body. It's just, sort of, an important grouping.

Think of it as an interest group, or it's like a Congressional bloc. Think of it like the Congressional Black Caucus, you know, in that way. And, in some ways, the G-7 can represent an interest, you know, group arrangement within a larger global governance structure -- be it the G-20, or be it the IMF, or so forth.

That might be a way in which it's still useful, because, I will say, from my own experience when I was at Treasury, the G-7 was useful even if it wasn't the final governance arrangement, because it did succeed in usually getting all the ducks lined up, in terms of a common policy position, within the Bank or within the Fund. So, that might be one way in which it retains its utility.

MALLABY: If we have ASEAN meetings, APEC meetings, should we really be against G-7 meetings? I don't know. I mean, it seems to me that -- and also, in the non-economic realm, when you're talking about who has the military power, as we've said before, you know, clearly, the G-7 still represents a very, very overwhelming share of (government ?) mililtary resources.

So, I think it's, sort of -- slightly depends on what the issue is. And I also think that, in the big picture, we lack global governance. We don't have an excess of it.

ELLIOTT: That international world secretariat, or whatever it is, I think --

(Cross talk)

ELLIOTT: -- (inaudible) -- I think we can do away with that.

If it's a G-1 world, why doesn't everyone follow the U.S.?

DUNAWAY: Well, because, you know, they're -- it's sovereign nations. They, in the end, determine their own policies. So, you know, the U.S. has ways to influence the policy decisions. One of the -- the one most powerful way right now, that I guess we're all afraid of, is using protectionism to try to force China off of its current approach to growth, which would not be in anybody's best interest.

So, the idea, in the end, is to try to sell countries. And this is a big part of what I did at the IMF. I was a salesman for good policy in various countries to try to convince them that the current array of macro policies were not sustainable in the long term and were not in the country's best interest.

But, at the end of the day, you know, at times that's a tough sell. It's an easier sell for the IMF when it's lending money, because it can impose conditions. And that's something that's lost in this debate about conditionality. These things are more -- aren't just tossed on willy-nilly. It's done in part to bring about necessary reform so that the country can become sustainable. There's also -- it's also done because the other members want it done. They want to ensure that the money is used responsibly.

And this idea of -- I have a hard time with this idea of an innocent victim, that that there's a country out there, that the financial crisis happens and it's just blindsided by that. There has to be something basically wrong in economic policies if it cannot cope with the impact of a crisis on its own. So, I'm troubled with innocent victims, and total lack of conditionality in lending.

ELLIOTT: The gentleman in the front here.

QUESTIONER: Donald Shriver, Union Theological Seminary.

The advice "save more and consume less," is deep as my religious tradition and that of this country, it's called "the Protestant ethic." If that had been implemented over the past 30 years we wouldn't be having all the problems that Pete Peterson has so ably called our attention to. At the moment, though, the idea of saving more and consuming less may not be the answer to our domestic economic crisis, so it sounds contradictory to what the government is hoping for.

My question is one which has been hinted at by all three of you. Who or what have the power in today's world to push the United States into consuming less and saving more? Who are you banking on to persuade us to a much more prudential kind of economic philosophy?

MALLABY: I think we are banking on basic economic reality. I mean, just to give you some numbers on this, right. So, in this crisis about $12 trillion of household wealth in the United States has been destroyed. And that's about a quarter of what households had -- just gone. They've got to resave money. Banks have probably lost something like, in the end they maybe lost maybe $2 trillion in the United States. That's money that's gone that's got to be rebuilt.

People are going to have to save. The government now has gone from a deficit of about 1.3 percent of GDP a couple of years ago, to something approaching 12 percent now. We have a World War II-sized federal deficit without the war. That is completely unsustainable. So there's no choice.

The logic of sheer sort of -- you, know, the math, is going to force the government to save more, households to save more, and it's going to push us back towards the (Protestant ?) ethic. What we need is for the Chinese to be less Protestant than they are right now -- (laughs) -- and to spend a bit more, and to offset that, because otherwise there will be a dramatic lack of demand in the world economy.

I mean, if you just look at some of these numbers. You know, McKinsey did a study that said if U.S. households today -- in 2007, just before the crisis, had saved the same amount of their income as they had in 1980, U.S. households in 2007 would have spent $1 trillion less. $1 trillion in a $50 trillion world economy is almost 2 percent of aggregate world demand, okay.

So, if they'd just tagged on -- (inaudible) -- same savings past, there would be a world economy (of) $2 trillion (more ?). And if you'd now -- you know, you've been through this crisis and destroyed all this wealth, and suddenly people have to rebuild savings above 1980 level, potentially, you've just got to get some spending going somewhere else.

And that's where I think -- you know, we understand that this debate about governance is no longer just about "how does the rich world stabilize the disorderly poor world." It's about "how do we get some confidence in collective global insurance for financial crises and balance of payments crises, so that the emerging world abandons this policy of an addiction to saving, because if they carry on being addicted to saving we are go to have a huge dearth of demand, and that's serious.


DUNAWAY: I don't think it's so much an addiction to savings as it's a reflection of reality in a lot of these countries. And China's is a great example. There a very high level of private savings -- of household savings to be precise, reflects (which) precautionary motives, okay. Because the government, over the past 10 to 15 years, has pulled out of the provision of a lot of services, and particularly in health care, education and pensions. And so Chinese households, as a result, save a tremendous amount to meet those three needs.

Now, the government could collectively perform the same role much more efficiently, as it does -- as it does in other countries, and that, in turn, would have a significant impact on the level of savings in China. So, that's part of the, kind of, package of measures, in particular, that we -- when I was at the IMF, that we suggested to the Chinese as part of this effort to rebalance the economy towards more consumption and less savings.

There's other problems and other distortions. The other key distortion in China is the cost of capital. The cost of capital is extremely cheap in China. We all think of China as having very low labor costs, well, it actually -- actually, capital is cheaper in China than labor. And then, owing to inefficiencies in the banking system, there's a tendency to focus -- to direct a lot of the Chinese savings towards large state-owned enterprises which tend to be capital intensive.

So, the net result is you have a situation where for every percentage point of real growth in -- GDP growth in China, you generate only a very small amount of employment. And so, the authorities are then preoccupied with keeping growth very high in order to generate sufficient employment.

China, over the past 15 years has averaged 10 percent real GDP growth; employment growth has been 1 (percent) to 2 percent. Industrial countries, over that same period, averaged 2 (percent) to 3 percent GDP growth, and 1 (percent) to 2 percent employment growth.

ELLIOTT: Before I get to other questions, just on your -- the points that both of you have made, of kind of making the Chinese less Protestant, if you like. Even if one wanted to shift to collective consumption rather than private consumption, as health, education and pensions, this would take a long time to set up and implement, right?

DUNAWAY: Yeah, but as I said, it's one aspect of the package of reforms. If you worked, if you worked on the side of dealing with the cost of capital -- and the key impediment there, what keeps the cost of capital low is a ceiling that's imposed on deposit rates in the banking system -- that if you eliminated that ceiling then you would get a lot of potential beneficial effects. You'd get better allocation of capital.

But, for the households, as well. If you look at household income over the last 10 years you see this straight decline. But, if you break it down, you see wages -- wages and salaries have been relatively flat relative to GDP. The big decline comes because interest income -- or investment income, relative to GDP, for the households has declined dramatically because of that -- because of that cap.

ELLIOTT: Yeah. Microphone coming.

QUESTIONER: Irene Meister.

I'd like to come to the heading of our session -- the cooperation that we all talked. And I'd like to come to two specific things: China and the intense cooperation that they are offering to the OECD. And that's very deep -- there are a number of studies coming up, with their full support and cooperation, both on political reform within China and also on some economic reforms.

Unfortunately, it's given very little attention. And, if you follow this work, you will realize that there is really the possibility of much greater changes and cooperation than appears on the surface. And I just wondered if you have given any thought to that, because that is -- we talked about OECD as, sort of, as a -- (inaudible). It isn't. They have done, at the staff level, extremely deep studies. And Chinese came willingly to it, come to the meetings -- write, send editions, and what not. So, I think there is something pretty promising there.

DUNAWAY: In March of 2007, at the National People's Congress, Premier Wen Jiabao made the pointblank state that growth in China was unbalanced and unsustainable. So, there is a recognition that they need to change and rebalance the economy away from being driven by investment and exports towards consumption.

Now, one of the key areas of disagreement in the end, though, is the pace at which they do that. The Chinese believe that they have a long period of time to bring about this transition. I think time has run out -- that they cannot continue with this model; that, on its own, assuming away any protectionist pressures, growth in China will have to slow after this year, okay.

Because, in order to -- in order to continue to invest at the rates that they have, to drive -- maintain a relatively high rate of GDP growth, then investment generates a lot of productive capacity, and that protective capacity is in excess of domestic demand. So, they need an outlet for it, and the outlet has been exports.

China now is the number two trading nation in the world. The only way that it can continue to expand its share of world trade -- particularly in an environment when world trade is growing very slowly, it has to cut prices, it has to cut margins. Margins go down; returns on investment decline; Chinese businesses, operating more on a commercial basis, should reduce their investment. Chinese banks also operating more on a commercial basis, they should begin to cut their lending to Chinese firms.

So on its own, even without external influences, the current Chinese model -- the growth has to slow.

ELLIOTT: Dan, yeah, come on in. I've got a couple of people coming in, but --

DREZNER: Two quick points on this.

First, I take your point about the staff cooperation. Again, this is the political scientist in me -- I always get very suspicious when there's cooperation at the staff level, whether that cooperation then continues when you get up to the policy principle level. And, I guess I'm a little more dubious about whether that's going to take place.

The second thing is -- this goes back to your first question in terms of what we learned from the crisis -- I do think one of the interesting things that's happened is that the BRIC economies -- Brazil, Russia, India, China 0-- you know, in the past six months you've actually seen behavior that makes the BRIC -- it's turned from a Goldman Sachs marketing term into something that resembles an actual coalition of countries when it comes to governance. And I think one of the interesting questions is going to be whether that continues over time.

ELLIOTT: The gentleman -- that's right, that gentleman first, then -- .

QUESTIONER: Thank you. Fred Tipson, with the U.N. Development Program.

Let me ask you about the poorest of the poor, or the bottom billion, whatever you want to call it, and how they fit into the -- or don't fit into this equation. Recognizing that the financial crisis is going to cause significant hardship, but also political problems for the developed world, can you leave out of the discussion what the approach needs to be for the poorest countries -- recognizing that so far it sounds like maintaining official development assistance is the answer that keeps getting mentioned, but we know that that's unlikely to happen; it isn't enough anyway; and it usually goes for things that don't affect short-term stimulus even in those economies?

So, I mean, what is the -- what is the thought process that ought to go on among G-20 or others about the --

MALLABY: Well, first of all, I think you're right to highlight this issue because, you know, on purely, sort of, Keynesian grounds, if you're thinking about stimulus globally, stimulus works when you give it to people who are going to spend the money. (inaudible) -- spend some money, poor people who really need it, right.

So, if you're giving the money to poor countries, you're going to get more stimulus. I think that that kind of overarching point, about why one shouldn't -- I mean, it's besides the moral imperative to prevent people from falling back into poverty, you're going to get a big global stimulus from more aid.

I don't see what's wrong with the prescription of sustaining aid and increasing aid in this crisis. That's the policy tool that we have. It would be nice if we could say, you know, well, we'll give more trade access, or something. But, that's not going to happen quickly and it takes time for countries to respond to open markets. So that's not a quick solution.

ELLIOTT: But isn't the real chokepoint not government-to-government development assistance or multilateral government assistance, but private capital flows to the developing world?

MALLABY: Right. It is, actually, unbelievable on that point. If you look at cross-border capital flows, cross-border bank lending, and you look at the chart, which started in '95, right, and you go through the Asian financial crisis, you see this tiny little undulation -- a little bit up, a little bit down, it looks like nothing. Then you come to 2005 to now, you see this unbelievable spike up in cross-border lending to emerging economies, and then a big crash. It's a much, much bigger effect than anything before.

But I think that's largely a sort of emerging-economy issue, with, you know, counting in Eastern Europe and so forth. I think for the poorest of the poor, you know, if remittances are somewhat of a deal, so if you look in aggregate, you know, I think the numbers are on the order of a 5 percent decline -- 5 (percent) to 8 percent decline this year in remittances projected by the World Bank. The total amount of remittances is, I think, like $300 billion. It's not a huge number.

There's quite a locally focused -- specific countries, like Guatemalan, and the Philippines --

ELLIOTT: Philippines --

MALLABY: -- that are going to be quite -- going to feel the effect.

So, I think you're right, private capital flows do matter. But the policy tool that we have -- we can't affect the remittances, right, but what we can do is talk about foreign assistance. I think the World Bank, which is now talking about upping lending to the poorest countries, you know, should have said that 12 months earlier. It should have said, look, we have an -- (inaudible) -- window which is replenished over three years for financing for the poorest countries. Normally, we spend it over three (months). Guess what? Now we spend over 18 months, and the donors have to come up faster with the new funds -- something radical like that. And, they've, sort of, gotten to it, but rather slowly.

ELLIOTT: The gentleman here, yeah.

QUESTIONER: (Off mike.)

ELLIOTT: We'll wait for the phone, please -- for the phone, mike.

(Cross talk.)

QUESTIONER: We seem to have forgotten Japan. And you guys probably know the math better than I did, but I do remember a point in this discussion where people were asking, will China pull us out of our crisis through their growth? And they everyone said, well, actually, when you look at the math, no. They're not that big.

And Japan is, as I understand it, a huge economy and has seemed to have some of these same export-led growth model issues that you're discussing with China, so I'd be interested in how you fold that into your equation. And if you could comment as well on whether we're getting anywhere with Japan in terms of convincing them to adjust their model.

ELLIOTT: Well, I was there a couple of weeks ago, but Dan, you --

MALLABY: A couple of things. I mean, one is, I think, the big three savings countries are China, Germany and Japan -- I think in that order. Those are the guys with the capacity to really spend.

The Japanese government has been the most forthright in saying, yes, you know, there's a lack of demand in the world economy, and we want to do something. The problem is that if you look at debt to GDP, Japan is off the charts. I mean, you know, it's like over 200 percent or something. And it's just -- there's not much capacity in the Japanese government to do more fiscal stimulus just because of the level of their debt already.

So they're talking the talk, and they're trying to deliver, but I think we can't leave Germany and China out of it because that -- you know, there's more capacity for a stimulus -- (inaudible).


DUNAWAY: Well, the problem is the private sector in Japan. You know, you just reached the point where you're beginning to see some pick up in consumption when the current crisis hit. So, you know, you face more of a risk that Japanese consumers are just going to retrench again. So, even if you pour in this extra government stimulus you're not going to get much out of it.

Japan's on the verge of probably slipping back into deflation again. So, in the near-term I don't see any way out for them except through an export-oriented growth model. Although, that being said, you know, I still think -- and there's no discussion in Japan about dealing with particularly the rigidities in the profits -- in the product markets, which would lay a foundation later for much sounder and balanced growth in Japan.

ELLIOTT: And you have an absolutely logjam political system -- which is going to last at least until the fall of this year.


DREZNER: I mean, in the short-term, actually I think Japan actually has a -- (inaudible). I mean, they're now running a trade deficit, I think, for the first time in decades, I think. So, I mean, it's very small, but they're -- I agree, they're not going to be the engine for growth.

I can't think about Japan without the word "demography" running through my head over and over and over again. And this is one of the problems with this, which is, as time goes forward, they're going to be a smaller economy.

And the truly appalling thing is how they responded to the crisis. They're actually kicking -- there was a great The New York Times story, on the front page about a month ago, they're responding to this by kicking out guest workers, ethnic Japanese workers that were based in Brazil and are actually do things like construction, the Japanese won't actually do.

The only way Japan's going to ever be able to, you know, to maintain its economic size, as time goes forward, is to become an immigrant nation. And yet, if you look at the political realities, that's never going to happen. And the fact that they're kicking out the few immigrants that might ethnically actually be able to fit in, it's pretty appalling.

DUNAWAY: But, there's another group within Japan that are probably more important than immigrants for the future of Japan, and that's women.


ELLIOTT: Women, yeah, exactly.

DUNAWAY: That if something were done, you know, to provide support -- particularly, in terms of child care and elderly care in Japan, to make it, to make it easier for women to go back into, and stay connected with the labor force, that would help Japan tremendously.

DREZNER: In some ways, Japan is the only -- the one useful thing about Japan is that you can go to China and say, do you really want to become like that -- (laughter) -- because that really is -- I mean, the scary thing is, in some ways, that's where China could wind up if they don't have more state provision --

ELLIOTT: Let's not -- one of you -- I remember -- or, maybe it was the gentleman there, but someone mentioned Germany. Let's not let Germany off the hook. Let's not --

DUNAWAY: Well, all of Europe.

DREZNER: Yeah, okay.

ELLIOTT: Okay, all of Europe.

(Cross talk)

ELLIOTT: Go ahead, Steve.

DUNAWAY: No, no, it's the same thing. The Europeans seem to be content to just basically grind themselves into the ground, which I don't understand, and particularly the attitude, with respect to fiscal policy, in this crisis. To me, it's comparable to, you know, you've got this raging inferno; the fire company comes up; it sprays a little bit of water on it; and then they sit back and say, well, let's see what that does. And if that takes care of it, then everything will be fine.

You know, in a situation like that you don't -- this, you don't do that, because of all the potential damage that it can create. And, if at the end of the day all you're talking about is a few percentage points additional debt -- government debt to GDP, that doesn't have a huge, huge short-term economic impact and it can always be made up in the future.

Now, that's the short term. But, the longer term is there's no discussion in Europe whatsoever about dealing with particularly the rigidities in the labor markets, and the lack of competitiveness of the countries within the area.

There's a lot of preoccupation with Eastern Europe, but Southern Europe is where I think there's much more difficulties. And Southern Europe, at the end of the day, may test whether or not the euro survives.


DREZNER: Well, I want to bash the EU on the governance issue, which is --

(Cross talk)

ELLIOTT: Okay, go ahead -- (inaudible) --

DREZNER: Well, no. One of the great ironies that I think about -- you know, we're talking about reforming the international financial architecture and global governance, is that the EU, which has been the biggest, sort of, booster of, you know, global governance as a solution to the world's problems, is now the biggest impediment to reforming these institutions. And the reason is is that if -- you know, international institutions, where the distribution of power within those institutions don't correspond to what the distribution of power actually is in the world, usually become ineffectual relatively quickly.

And the fact is, if you take a look at any of the major international economic organizations, if you were to rejigger the balance -- you know, the distribution of power within these organizations, it's the European countries that are vastly overrepresented. There is -- you know, there is no reason why Belgium should be as powerful as China in the IMF. That doesn't make any --

(Cross talk.)

DREZNER: -- you know -- exactly. (Laughter.)

DUNAWAY: Well, don't forget, the ECB has an observer at the Fund's executive board, as well, who like to chime in.

DREZNER: And the problem is, you know, you know, not shockingly, people who have power don't like giving it up voluntarily. And so the Europeans aren't going to be terribly, you know, willing to do this. And, as a result, that's been the biggest impediment to any sort of serious global governance reform of these institutions.

MALLABY: This is a pretty revealing moment for not only Europe's participation in global institutions, but its own building on its own, you know, European project. Because, when the Hungarians and the East Europeans came and said, hey, we've got a financial crisis, how's about --

(Cross talk.)

MALLABY: -- helping, the answer was, no.

And, you know, if there -- there was talk at that time of, you know, issuing an EU bond, right, which, if they had done it would have been a new instrument of European integration. And they could have financed assistance for Eastern Europe and, thereby, showing the Eastern Europeans that "if you're on the way to being part of the euro, you are already part of the EU, you are part of the club, we are here to help you."

Instead of that they said, no. Okay, so what does that mean? That means that, going forward, the East Europeans are going to be tempted to take the same view as all other emerging economies and say, we've got to self-insure, to heck with these collective arrangements, massive reserves, export surplus. And it will basically mean that they run a cheap currency; flood Western Europe with cheap imports. The West Europeans will go crazy about this. It's going to have big explosive effects within Europe.

ELLIOTT: Great point.

DUNAWAY: The one other aspect of this where I kind of disagree with Sebastian a little bit. You're right that they couldn't reach agreement among themselves. So since they couldn't reach agreement among themselves, they went for the next best thing, and that was to use other people's money. So the Europeans were the ones that were the major impetus behind increasing the funding available to the IMF.


Last question, gentleman right there -- yeah. Wait for the mike. There you go.

QUESTIONER: (Off mike.)

ELLIOTT: No, microphone.

QUESTIONER: -- (inaudible) -- and I'm from Germany, so I like --

(Cross talk, laughter.)

ELLIOTT: Hope you've enjoyed the last five minutes?

QUESTIONER: I enjoyed them tremendously, but I think it's -- lots of stuff that I share. But, it's not actually a question but it's just European is a complicated institution, so things are a lot more difficult.

And I like the provocation you just made, but just taking out one or two points that you just mentioned -- euro bonds. First of all, it's not that the Europeans said we're not going to help Hungary, or Luxembourg, or Spain, or whoever it's going to be, no matter what homemade crisis they have -- may have, or otherwise imported. But, they said we're not going to have euro bonds because we don't have a mechanism for that in place -- number one.

If we were to have the mechanism in place we need to look at what kind of mechanism do we want, because we still have -- as was just said, 27 countries -if you take the euro countries, each country having one vote. So, what a euro bond would mean, for Germany, for example, to be on the international market and have higher interest rates for itself that it doesn't have to pay now. So, it would actually hamper its possibilities to help out other countries, in a way, and itself, first of all. I agree with that.

Number two, it would let some countries off the hook -- to do the conditions, to do their homework back home, if the Europeans were to hand out bonds. Now, you may say, well, why don't they put on some conditions? Well, because Europe is Europe, and it's not like the IMF. You cannot, within 27, or less, countries, tell one country to do its homework, as specifically as the IMF does --

ELLIOTT: Well, you could.

(Cross talk.)

QUESTIONER: And why doesn't it work that way? Because we're different than the United States. Why is it that way? Because everybody's going to look at one or two countries who will insist on saying, "Do your homework." But, public pressure, frankly speaking, is going to be so great that that will be difficult the maintain publicly, in policy.

So this is why the G-20 meeting -- specifically, Germany, but other countries said, for the time being let the IMF help out in some of the European countries, because, you know, this is the way it works. It's a fact of life that some countries within Europe -- you know, you have solidarity, and solidarity means also to give in to some of those conditions and soften them up. That was one point.

Okay, they're the --

ELLIOTT: Now, I think we've -- we've got to draw it to an end. And, frankly, I want to do a very, very quick last question to these three, because it's something that we haven't covered except in a very quick point that you made Sebastian.

Yesterday was stress test day. Six months ago, enormous conversation about global private financial institutions needing new sorts of regulations -- almost gone away in the discussion over the last six months. Will it come back, and should it come back?

DUNAWAY: Certainly it'll come back. It's still there. It's not on the front burner as much as it was six months ago. There has been some discussion of it.

In the U.S., you know, the initial proposals were in terms of changing the whole system, because the U.S. system is basically a nightmare. That no one would set out to invent the mixed regulatory regime that exists.

I think, at the end of the day, though, that they'll focus on the key part so the system, because it's going to be too hard to change the whole system. And, to me, the key part of the system that really needs changing is insurance, that you cannot any longer allow insurance to be regulated in the United States --

ELLIOTT: That's 51 states.

DUNAWAY: By 51 states.

ELLIOTT: Sebastian, do you want to come in?

MALLABY: You know, I think that if you look at the Basel II in our cross-border norm-setting for capital for banks, what happens is that you spend almost a decade talking about this thing and then it gets implemented anyway at the national level.

And national regulators are lobbied by the national banks and Deutsche Bank says to the German authorities, "If you make us hold this much capital then we're going to be losing out to the French banks and the other banks."

And so each regulator is bid down to a more permissive (than if ?) -- But, the point anyway, is that when it, you know, occurs there's public money standing behind these institutions with implicit guarantees. It's always going to be national governments that set the rules, because they're on the hook financially if it goes wrong.

And so I think that although their -- you know, the financial standards --

(Cross talk)

MALLABY: -- (inaudible) -- you know, and we've upgraded that, and extended the membership, and there will be important norm-setting discussions about financial regulation at an international level. The actual norm imposition into rules will always be national.

ELLIOTT: Dan, last word?

DREZNER: Yeah. Political scientists love to talk about tough tests -- you know, situations where, you know, we really see if our theories hold up. If the financial sector in the United States manages to ward off, you know, more intrusive regulation over the next year, at what really should be their weakest moment, in, you know, in decades, then I think you have -- you know, Simon (sp) dropped an interesting piece to The Atlantic, which I would recommend reading, that argued that, you know, that financial interests in the United States basically run the government.

Well, I'd have to give a little more credence to Jonathan's argument if that actually happens in the next year.

ELLIOTT: Steve Dunaway, Dan Drexner, Sebastian Mallaby, thank you very much, and thank you all for coming.









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