Globalization and the Contours of the Recovery

JOAN SPERO: Good morning. Good morning.

My name is Joan Spero and I'm presiding today, and I'm delighted to welcome you all to the Council on Foreign Relations Meeting. It is part of the C. Peter McColough Series on International Economics, and I've been told to tell you that the next meeting in the series will be on April 26, 2010 and we will have Jean-Claude Trichet, who is the head of the European central bank. So Richard is the warm-up act or something like that.

Other announcements. Please turn off your cell phones or BlackBerries or whatever it is you carry around. I want to remind everybody that the meeting is on the record.

So with those formalities aside, I want to say what a special pleasure and honor it is to welcome Richard Fisher here. He is the President and CEO of the Federal Reserve Bank of Dallas, and I'm not going to go into a long intro because I, along with everybody else, am going to keep my questions short so Richard can speak more.

But I just want to say, he's a man of many talents. He was a Naval officer. He was a highly successful banker and entrepreneur, a public servant who served both in the trade representative's office at the Treasury and now in the Federal Reserve system. I said I wasn't going to say this, Richard, but he even had a brief spell as a politician, running against Kay Bailey Hutchison for the Senate seat from Texas. Today, he had to say that.

I met Richard when we were both whippersnappers. He was working with Bob Rosa at Brown Brothers and I was an Assistant Professor at Columbia University, and we have been colleagues and friends ever since.

Richard is knowledgeable. He is thoughtful. He's been known to be outspoken and he's been a wonderful leader at the Dallas Fed. So we're fortunate to have him with us today. Let's welcome Richard Fisher. (Applause.)

RICHARD W. FISHER: Thank you, Joannie. We have been friends a long, long time. And even one of the great joys, if you'll forgive me, audience, making this personal, but not only are we close friends, but our sons are two of the best of friends. That's how long we've been around.

I know you all celebrated Texas Independence Day yesterday, the 174th anniversary of our freedom from Mexico, and if you try to understand the Texas elections, which I will not try to explain to you today, that might give you some insight. The mood against Washington, and where I come from, is not enormously favorable.

But I want to speak about a subject here and then we'll talk about the issue of globalization and its impact on monetary policy and the current recovery. Every time I come in this building, I'm reminded of a little bit of my past. I paid my way through college by working for a man named Irving Pratt, who grew up in the Harold Pratt House, long before it became the headquarters of the Council on Foreign Relations and the bete noire of conspiracy theorists. He brought me here one summer day in 1970 to show me his boyhood home. He told me that, and I remember this, "Richard, if you apply your talents, someday you'll have a home just like this." As if. Actually, mine is larger. No, I'm just kidding. (Laughter.)

Then in the next breath, and this is a memorable phrase that I've never forgotten, he warned me of the perils of the health -- of the wealth he had inherited and he invoked to Prime Minister William Gladstone's famous dictum that "Not even love had made so many fools of men as contemplating the nature of money." So I was thinking, as I was preparing for this speech, Mr. Pratt's wisdom was somehow lost on me because here I am, 40 years later, making my living as a central banker, contemplating the nature of money.

It would have all been a fool's errand, all this background that you mentioned, Joannie, if I hadn't come away from decades as -- of experience as a market operator and the last five years as a central banker and a monetary policymaker without some lessons learned, especially against the background of the financial crisis that we have just gone through and are just coming out of. So I thought, very quickly, while I had the podium here, I would share with you this morning some of the lessons learned, or at least some convictions acquired, before we have our dialogue about globalization and the contours of the recovery.

I come away from my career of contemplating the nature of money with four basic convictions. I'm more convinced than ever that the financial markets require a healthy dose of regulation to function efficiently. I'm more convinced than ever of the importance of regulatory and supervisory authority to the proper conduct of monetary policy. I am more convinced than ever that too big to fail banks are dangerous and should be contained, if not dismantled. And I'm more convinced than ever that central bankers operate most efficiently when they're insulated from political passion. So let me just touch on that very quickly.

I'm a fierce advocate, as everybody knows, or at least those that know me well, of free markets. I believe in the magic of the invisible hand. That's not to say that the hand is always steady or that it is not given to occasional loss of control or spastic bouts. I'd like to remind people that capitalism wasn't designed to be stable. Asset prices overshoot during booms and they overcorrect during busts; as we say, "Panic happens."

Nearly 170 years ago, Charles Mackay, writing in his "Memoirs of Extraordinary Popular Delusions," wrote this, "Men think in herds and they go mad in herds." He didn't say women, Joannie, men think in herds -- (laughter) -- and they go mad in herds; an insight that must have been overlooked by whoever wrote the copy for Merrill Lynch.

Writing in the fifth and last edition of his book, "Manias, Panics and Crashes," Charlie Kindleberger noted that the madness of the herd had intensified in modern times. He wrote, "The conclusion is unmistakable, the financial failure has been more extensive and pervasive in the last 30 years than in any previous period." And he attributed this, in fact -- in part, rather -- to the fact that, quote, "There are more countries in the international financial economy and in part because data collection is more comprehensive," end of quote.

Now mind you, this was written before the herd turned decidedly lemming-like in the lead up to 2008. Even if we accept that markets will always be given to volatility, we know from repeated experience that market failures roil the financial system and can have dangerous repercussions, setting off an adverse feedback loop of contracting credit flows, declining economic activity and sustained high unemployment.

This reminds us of the vital role that money and credit play in maintaining a healthy economy, and I liken it to a cardiovascular system. In an economy, the central bank is the heart, money is the lifeblood, and financial markets are the arteries and the capillaries that provide critical sustenance to the muscles that are the makers of goods and services and the creators of employment for our people. A properly functioning cardiovascular system fosters healthy growth. The system fails, the body breaks down and the muscles atrophy. This is exactly what happened during the recent crisis.

Elaborate statistical models and complex securitization products created the illusion of control over credit and liquidity risk in the banking system. As market participants uncovered the truth, as they always eventually do, however late, confidence quickly gave way to fear and doubt; with uncertainty in full fever, cash was hoarded, counterparties viewed each other with suspicion, no business appeared worthy of financing. A full-blown seizure, a heart attack, occurred and the economy starved of lifeblood ground to a halt.

By now I suspect many share my conviction regarding the need for improved financial regulation. We are even hearing a different tune from those who, only a few years ago, proclaimed the transcendent efficiency of financial markets, what I refer to as the elaborate conceit of the Fisher Market Theory, where today's prices are always right, markets are self-correcting and regulation is kept to a bare minimum.

In theory, the Fed's monetary policy and regulatory functions are separate. In practice, they are anything but. In fact, they have a symbiotic relationship.

The past two years have highlighted the interconnections of monetary and regulatory policy. Monetary policy depends on regulation that ensures the soundness of financial institutions. Changes in the Fed Funds' rate and other methods employed to implement monetary policy get transmitted to the economy through the arteries of the financial sector, affecting the rate at which businesses produce and grow employment and the exchange rate of the dollar and, by extension, international trade and capital flows.

The process works most efficiently when those arteries are open and healthy and strong. Sclerotic banks cannot lend. They cannot act as intermediaries. When they cannot lend or otherwise are hampered, monetary policy actions lose their capacity to influence the economy with accustomed efficiency.

So here's the message for those who would peel away regulatory policy from the Fed. We depend on our regulatory arm to provide in-depth, hands-on assessments to guide us as we perform our duty as the lender of last resort. We can't properly operate a discount window or perform the functions of a lender of last resort if we don't have first-hand knowledge of our borrowers' financial health.

We cannot implement monetary policy effectively without staying abreast of developments in the banking and financial system through the eyes and ears and constant contact of the 12 banks in our system, who observe up close and personal the activities of the banks of all sizes, the roughly $1.7 trillion in assets we observe and the 843 state member banks that we regulate, to the roughly $17 trillion in assets and the 5,002, as of this morning, bank holding companies, including, but not exclusively, the large financial institutions, the LFIs, whom we regulate.

During a crisis, we need the ability to make proper decisions quickly. It's simply impossible to properly evaluate the health of a potentially troubled borrower with information that is generated by another agency. This is one of the very harsh lessons we learned from examining the entrails of Lehman and of AIG, over whom we had no regulatory oversight at the time they went into cardiac arrest.

In my view, proposals being discussed in the Congress to shrink the Fed's regulatory and supervisory responsibilities by placing, for example, all state charter banks under, say, the FDIC, or all nationally chartered banks under -- and their holding companies under -- some new regulatory agency, leaving the Fed with either with no regulatory oversight or solely with the regulatory oversight of the LFIs, are seriously misguided.

To keep our -- with my cardiovascular theme, I would argue that removing the Fed from supervision and regulation of banks of all sizes and complexities, from community banks to the most complex LFIs would be the equivalent of ripping out the patient's heart. Now that would surely prevent another heart attack, but it would likely lead to serious consequences for the patient. So going forward, our job is to keep the patient healthy, to prevent another attack, and the best way to do that is to keep the Federal Reserve in the business of supervision.

Now I mentioned LFIs, large financial institutions. A truly effective restructuring of our regulatory regime will have to neutralize what I consider to be the greatest threat to our financial system's stability, the so-called too big to fail banks.

In the past two decades, the biggest banks have grown significantly bigger. In 1990, the ten largest US banks had 25 percent of the industry's assets. These -- this share grew to 44 percent in 2000 and now 60 percent, roughly, at the end of 2009, even larger than before we went into the crisis.

The existing rules and oversight are not up to the acute regulatory challenge imposed by these large institutions. First, they are sprawling and complex, so vast that their own management teams may not fully understand their own risk exposures. If that is so, it would be futile to expect that their regulators and their creditors could untangle all the threads, especially under rapidly changing market conditions.

Second, the big banks may believe that they can act recklessly without fear of paying the ultimate penalty. They have made their creditors assume the Fed and other government agencies will push them to fall and assume the damages, even if their troubles stem from negligence or trickery. They have only to look at recent experience, by the way, to confirm that suspicion.

Some would argue that bigness is not bad per se. I can accept that argument. Many ask how the US can keep its competitive edge on the global stage if we cede large financial territory to other nations -- an argument, by the way, I consider quite hollow, given the experience of the Japanese and others who came to regret seeking the distinction of having the world's largest financial institutions.

I know this much: Big banks interact with the economy and financial market in a multitude of ways, creating connections that transmit the limits of industry and of geography. Because of their deep and wide connections to other banks, and financial institutions, a few really big banks can send tidal waves of troubles through the financial system if they falter, leading a downward spiral of bad loans and contracting credit that destroys many jobs and many businesses worldwide.

The dangers posed by too big to fail banks are, in my view, too great. To be sure, having a clearly articulated resolution regime, as is being debated now, would represent a step forward, although I fear that it might provide false comfort and that a special resolution treatment for large firms might be viewed favorably by creditors, continuing the government-sponsored advantage that has been bestowed upon them.

Given the danger these institutions pose to spreading debilitating viruses throughout the financial world, my preference is for a more prophylactic approach, an international accord to break up these institutions into ones of more manageable size, more manageable for both the executives of these institutions and the regulatory authorities.

So I align myself closer to Paul Volcker in this argument and I would say that if we have to do this unilaterally, we should. I know that will hardly endear me to an audience in New York City, but that's how I see it.

Winston Churchill, by the way, said that, and this is a great quote, "In finance, everything that is agreeable is unsound and everything that is sound is disagreeable." So I think the disagreeable, but sound thing to do regarding institutions that are too big to fail is to dismantle them. Dismantle them over time into institutions that can be prudently managed and regulated across borders. This should be done before the next financial crisis, because what we have learned is that it surely cannot be done in the middle of a crisis.

Now, while my views on too big to fail may be slightly radical, my perspective on the importance of central bank independence, I believe, is mainstream. central banks must take a long-term view of the economy and craft appropriate policy responses. We must have the leeway to raise interest rates when others want cheap credit and to rein in risky financial practices when others want easy profits.

A Fed committed to wringing out the economy's excesses and keeping banks on the straight and narrow is never going to win a popularity contest. Some of those displeased by Fed decisions will seek to satisfy their desires by resorting to political pressure.

Now, independence does not mean unaccountable. We have always been subject to oversight, but since Ben Bernanke took the chair we have ramped up our efforts to be as transparent as is prudent in the conduct of monetary policy. For example, the Fed is the only business in America that I know of that publishes a public accounting of its balance sheet every week; it's what's called the H.4.1 release. You can get it on the Net.

We now release more fulsome economic projections and minutes of our meetings. Of course, at twice-yearly reporting intervals, we have the Humphrey Hawkins testimony, where the chairman responds directly and audibly and distinctly to questions from members of key oversight committees, which is a shift from the way that business was conducted previously.

We have responded to suggestions we feel further our mission. For example, in the recent Humphrey Hawkins session, the chair made clear that we are willing to go the extra mile of letting the GAO peek behind the curtains of the special credit and liquidity facilities that we have created, even unto identifying the names of the firms that participated in them, after an appropriate delay, so that they can allow themselves to conform to their own reporting obligations.

So I believe we have significantly improved transparency. I also believe there are limits. Some advocate making the monetary policy deliberations held by my colleagues and me at the FOMC subject to GAO audits. For example, were this to come to pass, I believe it would lead to the politicization of the Federal Reserve process of the FOMC monetary policy setting process. Injecting Congress at whim into monetary policy and, if so, eventually putting us on the on-ramp to a road that would lead the United States directly to the fate suffered by once-great economies like pre-Weimar Germany and Argentina, and others that allowed monetary policy to become the handmaiden of fiscal policy.

Here's the point: a politicized central bank is a crippled central bank. Only a Fed insulated from the short-term, political impulses can focus on crafting the right mix of policies for an economy in the long run. We need enough space to make the tough calls, most notably, when interest rates have to be pushed upward to slow the economy in flush times. Fed independence does not just matter for monetary policy and that's the point I want to make this morning.

A central bank insulated from politics and the accompanying lobbying can also be a tougher regulator, insisting on strict adherence to capital and leverage requirements, as well as prudent management and lending practices.

By the way, I think you mentioned Claude Trichet is going to be here. It's -- I'm a Lilliputian by comparison, standing on this stage, but I would say that we see in the current Greek debacle, a significant example of one of the great virtues of an independent central bank.

Historically, profligate fiscal authorities in that country have turned to the monetary authority to print their way out of the corner that they painted themselves into, debasing their debts through inflation and currency depreciation. This is no longer possible in Europe; the burden of correcting for fiscal malfeasance now rests squarely on the shoulders of those authorities who are responsible for it. Imagine that. That is the way it should be, be those authorities Greek or Irish or American.

I started out by noting that booms propelled by greed and busts born of fear are as old as time itself. This quirk of human nature will always ignite the euphoria that fuels the ups and exacerbates the downs. Nonetheless, we need a monetary policy that leans against that propensity.

We need regulatory and supervisory powers that lead to policy that ensures a sound financial system, capable of most efficiently channeling monetary policy actions into the real economy. We need to keep monetary and regulatory authority united, so we can work together in the interest of the entire financial system, not just the interests of the largest institutions and those considered too big to fail. And we need to ensure that this authority is free from short-term political pressures.

So Joan, that's my sermon for today. I've raced through it. During the Q&A I'd be happy to harangue you further on supervision and regulation, or we can talk the economy as seen from the Elysian Fields of Texas. Or we can talk about the impact of globalization or whatever suits your fancy.

Thank you very much.

SPERO: No. That was great.

FISHER: Thank you.

SPERO: Thanks.

Could I pick up on your Greek theme? I'm going to ask a few questions and then I know the audience has a lot, so we'll turn it over to them.

What lessons have we learned from -- or are we in the process of learning for the current crisis in the euro zone?

Well, again, I think Mr. Trichet will be better at explaining that, but I do think there's a positive lesson, which is the virtue of an independent central bank, as I mentioned earlier.

Secondly, there is a limit to how far you can push the need for fiscal responsibility. We're confronting that limit now. You see that. Either in what's happening in the political grassroots or the reality of the kind of debates that take place in the senate.

Let me add, at the Dallas Fed, at least, and we feel that P. Peterson's (sp) numbers are way too mellow, in terms of the depth of the obligations that are unfunded. We place, at the Dallas Fed, because we use an infinite time horizon, we are central bankers, he only goes out to 75 years; we like to think long term.

But just Medicare alone has an unfunded liability of commitments already made to the American people of over $90 trillion. These are promises already made that our children and grandchildren will be expecting that cannot be funded.

I watched this one particular senator make a rather stern statement on the floor, a former baseball pitcher whose name I will not mention, but he has an interesting point; how do you pay for this stuff?

The worst thing that can happen -- and the nice lesson from Greece is what people have done historically, whether it's ancient Rome, even though they didn't have a central bank like we do, to, as I mentioned, the Weimar Republic to Nationalist China, you can walk through the list -- you turn to the monetary authority to print your way out of it.

This cannot happen in Europe. We cannot let it happen in the United States. It's a very easy thing to do and you can't make the harsh decisions on tax and spending, reining it in, to say, okay, central bank, print our way out of it.

We won't do it. So now we have to face the music, that's the harsh lesson that's been learned.

SPERO: If we -- if the central bank can't allow it to be done, how does it get as far as it did in the United States?

FISHER: These are the people that voted those people into office. Look at yourself in the mirror.

I know it's a harsh lesson, but that's the way it works. Whether it's me or you or you, Joannie, we keep shoving the ultimate obligation of squaring our fiscal corners down the path and all of us are responsible.

So I like to tell people, if you're mad, look at yourself in the morning when you shave, you're the person that did this.

Have a nice day. (Laughter.)

SPERO: I'm going to keep you outside the U.S. for a minute. I told Richard, when I saw him beforehand that I was going to ask him about China and he reminded me, he didn't remind me, he told me something I had not known; that he was on the first visit with Deng Xiaoping back in 19...

FISHER: '79.

SPERO: I'll let him tell you about that, but my question -- a lot has happened to China since 1979.

FISHER: That's an understatement.

SPERO: Can you talk a little bit from your perspective about what's going to happen with the international monetary system, the role that the Chinese might play? How that affects us? They're hostage to us, but we're hostage to them. Could you talk about that a bit?

FISHER: Well, first, historical reference, if you look at the People's Daily on March 3rd of 1979, you'll see me on the cover in the background with Michael Blumenthal, then Secretary of the Treasury, Tony Solomon and myself, walking forward with Chairman Hua -- of course, he was more of a figurehead for our meetings with Deng Xiaoping.

Of interest in those days, they, and many of you know Tony Solomon, they changed the shape of our eyes on the front of the paper, so we had more Oriental eyes. It was a very interesting thing; on the front of the People's Daily.

Those were the discussions where Deng Xiaoping started to lay out what he wanted to accomplish. It has been truly one of the great historical transformations of any great societies.

I'd like to remind people that we won, meaning we won the Cold War. This is good news. There is no more Soviet Union. There is no Maoist China. The Indians are trying to do whatever they can to become a successful society. Our former enemy, when you and I were in college, were sending people to kill the Vietnamese; we now trade with the Vietnamese, we now issue their paper, we buy their paper and vice versa.

So here's the point. This is good news. "These are competitors and they are co-operators", as Milton Friedman used to say.

I'm delighted that the Chinese are invested in our markets. I wish we had domestic savings that were sufficient to do that. We don't. I'd rather have them in bed with us, I was going to use LBJ's skunk in the tent, but that's not -- that's a little bit crude and maybe saying in bed with us is a little bit crude as well. But I'd rather have them invested with us than warring against us.

So it is a miraculous development. These are determined people, I respect them enormously. I've been to China over 50 times and to watch that transformation is truly magnificent.

But, Joan, as to changing the monetary system, I do not see in the immediate foreseeable future the dollar being replaced in its role as a reserve currency, if that's your question. I know that there have been proposals made for SDRs.

This goes back to when I was an undergraduate and studying under Marty Feldstein and others. To me, that's the Esperanto approach, I doubt it's practicable. We have to live up to our obligations and I think the fact that we have global investors of size, Japanese, Chinese and others, that they're invested in treasury markets, forces discipline upon us.

Because the first sign that things are out of control is rates will back up, regardless of monetary policy. To put that fiscal policy back into equilibrium will require action, particularly at the treasury market acts, in a responsible way. So I don't lose sleep over worrying about what the Chinese are going to be doing. I hope they're successful economically.

I will give you one point, I doubt any of you are aware of it, the largest exporting state is Texas. We overtook California about seven years ago. Our largest, fastest growing market, not our largest market, but our fastest growing market is China.

This is what, comparative advantage and open trading is all about. So I think it's a good thing, not a bad thing. Despite the differences of our government style and all the drawbacks, with regard to freedom and other things in China, I want them in the system and I worked very hard with Charlene Barshefsky and Mike Blumenthal, going way, way back, to get them into the system. I'm glad they're there.

SPERO: Well, I'm not allowed to ask you any more questions.

FISHER: Those were great questions.

SPERO: This is time to turn it over to the audience. So I'm going to ask that you raise your hand. Someone will bring you a mic. Speak succinctly and put a question mark at the end.

Okay.

QUESTIONER: : I'm Dick McCormack from Bank of America. Last summer, our friend, Mr. Trichet, made a very interesting speech at the Jackson Hole Conference, where he denounced the Greenspan view that you could not anticipate asset bubbles and that one should deal with them retrospectively rather than pre-emptively. How did you feel about his analysis?

FISHER: It's something that we should strive to, it's often difficult to implement.

Paul Volcker has a wonderful little quip, which is if he knew that if a bank was getting too large, when the chairman of the bank became the chairman of the art committee, when they brought in McKenzie (sp) as a consultant for compensation purposes and you could tell by then that they were losing control. There are always signs that things are getting out of control.

I think it's the duty of regulators as well as monetary authorities to lean against those wins. It's often extremely difficult.

I don't think it took a genius to see that we were having a housing bubble. We -- it spread home ownership, the American dream, as broadly as possible for our society. The beauty of it was we had minorities that were participating in the American dream to an extent we had never seen before. The methods that were used are questionable as to how we made that possible. There may have been better methods, but clearly people were borrowing against an illiquid stock for liquidity purposes. I believe that was identifiable and could have been dealt with through regulation, if not through the very blunt tool of monetary policy.

Those two tools need to be used interactively, but I personally believe that you can anticipate and you should lean against however political difficult it must be, which is why you have to have as much independence as you can as a monetary authority and as a regulator.

Now, I ran a hedge fund for 11 years and our rule was that if you saw any CEO of any company we owned long on the cover of any major magazine, we shifted to a short position. They weren't. So there are little ways to identify these things.

To do it systemically and to do it through analysis and then to be able to deal with the inevitable political pressure, when things are going well, no one wants to throw sand into the gears. But remember William McChesney Martin, about the job of the central bank, take the punch bowl away just as the party gets going. I do differ with the chairman on that, I believe rates were held too low for too long and I also believe that we did not do our job from a supervisory standpoint.

We have since changed our regulatory structure in terms of the management of it, the dynamic of it internally and we have to remember not to repeat the mistakes we did in the past.

SPERO: Yes, in the aisle, here, on the left?

QUESTIONER: Hi. Sy Jacobs, JAM Partners

You said earlier that the -- very sternly, the Federal Reserve won't --

SPERO: Could you stand up? I think it's a little bit --

QUESTIONER: Yes. You said earlier that the Federal Reserve --

FISHER: Whoa. Sit down. You're too tall. (Laughter.)

QUESTIONER: Won't print money to get the economy out of trouble, risking inflation. But isn't buying $1.25 trillion of MBS and treasuries, which is debt of the government, running deficits, printing money to get the government out of trouble?

FISHER: Yes. Let me say --

SPERO: How do we get out of that? When do we get out of that?

FISHER: Let me say two things.

First, I want to come to your point, but let me first remind you, we created an enormous amount of liquidity facilities to bring the markets back for commercial paper, for asset-backed securities, to make sure no one, again, broke the buck in terms of money market mutual funds.

We levered up our balance sheet significantly there, almost $1 trillion worth. We've now reduced those to zero.

Point number one, we said what we were going to do, we did it and we stopped. Now we have longer-term assets on our balance sheet. We have $1 trillion 250 billion, we're about to complete that exercise of mortgage-backed securities you pointed out. We have an additional $300 billion in treasuries above and beyond the normal needs of what's known as the system open market account, the SOMA account.

The purpose of those two exercises -- for the record, I was against the first because I felt it would indicate to the markets we were monetizing deficits, we stopped that program at $300 billion. The other is a much larger part of the balance sheet, obviously $1 trillion 250 billion and that we should not be in the business in normal times of interfering in the mortgage markets. We did it to restore health to the longer-term credit markets. The result has been to suppress those yields that exist in mortgages, and the interesting effect is that actually as we have announced that we're going to discontinue that program that we expect it to end, the spreads have actually narrowed with treasuries. In fact, mortgage-backeds declined by 14 basis points last week. That may seem like a little, but it's interesting that this is happening as we've announced that we're in the program.

We will have to get those off our balance sheets. Our long-term objective is to go back to just having treasuries. But it was an interim step taken to restore health in the longer-term end of the yield curve. We felt we did a good job on the liquidity side and we have unwound those programs.

But therein lies the debate of what our exit strategy is. The offset to that on the balance sheet is banks have $1 trillion in excess reserves on -- in the 12 Federal Reserve banks. How do we unwind that, so that we don't have inflationary pressures, as that money courses back into the system?

You know that the monetary basis has been going like this, but the velocity has been going like this. There's no activity in the economy. It's lifting slightly, but not by much.

The trick is as we come back, and grow, and as velocity and money moves through the system, we're going to have to make sure that that combination of base, $1 trillion in excess reserves and velocity doesn't lead to price pressures and the standard inflationary fuel. That is the reason we spent so much time now debating what our alternative strategies are. Pay interest on reserves? Create time deposits to keep that money out of the marketplace? Engage, and we've been testing our repo capacity. Or just sell those mortgage-backed securities outright? We're debating it. Which is to happen when or ultimately to raise the Fed Funds rate.

So we have a tool kit. We're ready. The question is when do we deploy it and the answer that question is a function of what the circumstances are at the time.

I hope I answered your question.

SPERO: In the front. Sergio?

QUESTIONER: Thank you. Sergio Galvis. I listened to your comments on large financial institutions. I asked myself this question, the question I want to ask you. Freddie Mac, Fannie Mae, AIG, non-regulated entities from your perspective, put those aside. Lehman Brothers might have been bought by a large financial institution, but for some accidents of history, if you will. But JP Morgan buying Bear Stearns, WaMu; Bank of America buying Merrill Lynch; Wells Fargo buying Wachovia; large financial institutions keeping the body alive, what would have happened if those institutions weren't around with the capacity to make those acquisitions and absorb those costs?

FISHER: Well, this is the point I made. You can't treat these issues -- we had the crisis, the crisis had to be dealt with. You can't deal with the issue of institutions too big to fail during a crisis. You have to deal with that issue while things are healthy.

My point is, don't -- if a bank is too big to fail or an institution is too big to fail, it's too big period.

The best time to treat that condition is when you're under healthier circumstances. In the midst of a crisis, you cannot do that.

So I guess the simple answer is, these institutions wouldn't have been allowed, under proper regulatory regimes, and the most vexing is the insurance, by the way, you mentioned AIG. Who's responsible where, given the authority of regulation under the state system that insurance companies have, but to work and labor, to make sure that these institutions don't get such a size that if they fail, they present a risk to the entire system.

But I want to remind you, those decisions, and we're going to have armchair quarterbacks double guessing, triple guessing, reguessing whether we were right or wrong, condemning us or praising us as we go through time, were taken under duress.

My point is, I don't want to be put in that position ever again.

SPERO: But, Sergio, is your question also what if they hadn't been able to do that?

QUESTIONER: That actually is my question.

SPERO: If what -- I mean, would we really be in another AIG situation?

FISHER: If we had -- if we hadn't allowed them to get to that size, we wouldn't have had that need for an even larger institution to absorb them. That's my point. So this is the typology.

SPERO: Okay. We'll come back to that.

FISHER: Okay.

SPERO: Yes.

QUESTIONER: Marc Levinson, I'm a fellow here at the Council.

Regarding too big to fail, I wanted to ask whether you think that the Fed has an adequate supervisory handle on the operations of foreign banks in the United States at this point? Conversely, whether you have any feel for whether foreign supervisors have an adequate handle on the activities of US banks and their interests?

FISHER: Yes, they're very different. I do believe we are increasing our ability to gain insight in those institutions. We do lend to the discount window and through the special facilities that we've created.

So the truthful answer is there's always need for improvement. We're improving our capacity in that front.

As to whether or not our foreign counterparts have the reciprocal ability, you'd have to ask Mr. Trichet and others who come to speak. But I believe we've got a better handle than we did before. Not that we didn't have a good handle, but there is need for improvement and we are improving upon it.

SPERO: Could I follow that? I'm taking liberties with the chair today. Could I follow --?

FISHER: (Off mike.)

SPERO: Could I follow on that and ask how you think international cooperation is working in the crisis? What about Basel I, II, III?

FISHER: I think Basel I, II and III were not successful.

SPERO: Yes.

FISHER: It's pretty clear. However, there -- the central bank governors do communicate rather fully.

You may remember, there was a point where we actually did a coordinated rate cut and I remember the discussions that Ben, Chairman Bernanke, had with Trichet and with Mervyn King and so on. This hadn't been really done for some time.

So the -- we do have meetings in Switzerland and Bill Dudley from New York and, of course, the chairman and the -- Don Kohn in his capacity as vice chairman have spent a great deal of effort in terms of communication.

But we need to do more and from a regulatory standpoint, I think that's going to be the difficult patch.

SPERO: Yes. Yes.

FISHER: But in defense of Tim Geithner, which I don't think I have to defend him in this room, but he was always a critic of Basel I and Basel II. It just didn't -- wasn't successful.

So we have to do something better.

SPERO: It wasn't far enough? It wasn't targeted correctly or...

FISHER: Well, it just didn't seem to capture the risk, obviously, that was implicit in the system.

SPERO: Risk. Yes. Yes.

FISHER: So much that was trying to quantify or categorize certain types of risks, but risks that were not foreseen.

SPERO: Yes.

FISHER: The interlinkages of those -- a sensitivity that they were there, but not quite capturing it in the right way. So we have to do better.

SPERO: Yes, in the front.

QUESTIONER: (Off mike.)

SPERO: The mic is coming.

QUESTIONER: Thank you. Have you addressed the derivatives and how do we bring transparency to the markets with these new trading methods?

FISHER: The question is derivatives and how to bring transparency. I can give you -- and by the way, everything I say is my personal view. I don't speak for anybody else at the Federal Reserve.

Every time I think of an insurance contract, I think of that great quote from Charles Dickens in a book called Little Dorrit. "Insurance is when one party who cannot pay gets another person who cannot pay to say that they can pay."

So it's clear to me, at least in terms of credit default instruments, I personally would like to make sure that those that write those contracts have the capacity to perform. It would be nice, and I think we should be driving towards and we are, to have as much transparency in that market as possible. To me, that means some kind of clearinghouse, where at least we know what's being traded.

To me, and this is my personal view, I believe that the market should be regulated to an extent that at least we are assured that people writing contracts can perform, as I said earlier.

I don't want to contain a financial innovation. I do believe in the power of insurance. I think it's important to be able to offset the risks that people take. That's what makes it -- capitalism so vital. So I would like to see at least a clearinghouse and a minimal regulatory regime that identifies the capacity to perform.

SPERO: In the back? Sort of in the middle? There? Yes. You.

QUESTIONER: Thank you. Arthur Rubin, Atlas One.

Certainly we're going through a period of self-examination with respect to regulatory environment. But certainly there's also a view that the excess liquidity in the global system is a result of the systemic balances we've seen over the last decade, it was a necessary condition for the asset bubbles we saw. So the question is, however much regulatory reform we make, until those imbalances are corrected, aren't the preconditions for future bubbles still there?

FISHER: They're always there, if you've read history. We've seen panics, bubbles, new bubbles, new panics. That's one of the points I was trying to make. This is human nature and I don't think we'll ever be able to contain it.

So it's always there. There is an enormous amount of liquidity.

I mentioned the liquidity in terms of excess reserves that are -- by the way, that wasn't a mannerism that was a mosquito or something. Corporations -- right now, the S&P 500 companies have over $1 trillion in liquidity, they're waiting to put that stuff to work.

We're seeing a pick-up in acquisitions and mergers. I would like to see a pick-up in activity in terms of hiring and putting those assets to work, that liquidity to work, in terms of the conduct of business.

So there is a lot of liquidity sloshing through the system. I suppose it really depends on the productive use of that liquidity, how much confidence people have in the economic future.

Right now there is a reticence to commit to capital -- to CapEx. There's a reticence to commit to expanding payrolls and expanding businesses. I think that will gradually resolve itself over time. It'll have to take some time because we've just been through a real shock, a traumatic shock.

But the answer to your question, again, if you read the history books, whether it's the South Sea bubble or whether it's the coffee panic in the 1600s or 1719 or 1825 or 1873, we've seen this repeatedly throughout time. So the risk is always there.

Our job is to make sure that the -- in our business, conducting the book of business we conduct, that the excess reserves that are built up on our balance sheets is deployed, eventually, in a way that doesn't create price instability. Hopefully, through a regulatory regime that is practicable and rational, is to the best extent possible distributed or the invisible hand can use it most properly.

Go ahead, follow-up?

QUESTIONER: Yes, just to follow-up. Specifically the massive illiquidity in China and also in Asia, as a result of trade imbalances, it needs a place to go. So, point taken about what's happening in the United States but could you address the imbalances, with respect to foreign reserves?

FISHER: They're either building up because there's not adequate potential domestically or the capacity to use them domestically. The standard hackneyed argument is China needs to consume more, we need to consume less. I believe that's occurring, I believe the successor generation in the United States will not be as selfish as my generation, robbing our children and grandchildren just for their selfish needs. They'll consume less, save more. That means it takes more time for us to grow because the consumption function is so critical in our society.

I think it'll take time for China to abandon what is a cultural proclivity plus this long march. They've come out of the bad side of China into being a productive member of the global economic society and these things will take time to equilibrate.

In the meantime, I'm very pleased that they want to invest those surpluses in my country, in my currency, in the United States, in the United States treasuries. I'm also not displeased that like with any investor, it creates incentives for our fiscal and our monetary authorities to conduct themselves appropriately.

So, yes, these imbalances exist. We all know that. It'll all -- it'll take time to work them off. In the meantime, we provide an investment vehicle. We have to earn the confidence of those that invest in us and I think it's good discipline that is being exerted upon us. I don't -- again, I don't lose sleep over these imbalances.

In the beginning of this whole exercise, we were funded significantly by what we refer to as emerging economies. That helped keep interest rates low, it may have fed speculative excess and, again, I think the regulators have a significant duty there to make sure that they can take the edge off that speculative excess to the greatest degree possible, given political reality. It's not a perfect world.

SPERO: Here in the front?

QUESTIONER: Bill Drozdiak, the American Council on Germany.

Richard, I would like to take you back to the euro crisis. I think the real problem is not so much Greece, but really the larger countries, Spain, Italy, the threat that they won't be able to manage their debts.

Since you talked a lot about political responsibility, would you share Marty Feldstein's view that's an inherent contradiction that the governments are not willing to face up to these things, that the euro could implode? Do you think that's a real risk if these debts and the austerity measures called for are not taken?

FISHER: Well, I'm always hesitant to ever differ from Marty. So --

SPERO: He left.

FISHER: I know. So I will differ from Marty.

So, he's much more thoughtful and knowledgeable than I am.

This is a test. The Europeans went through great effort to create a monetary union, an economic community, a central bank. The central bank is independent and, by the way, run by one of the best central bankers I've ever met. You're lucky to get him to come here.

Of course, he's a Frenchman that runs on a German model. A great formula for success.

SPERO: A great compromise.

FISHER: A great compromise.

But this is a test and you know, because you know Germany better than I, the anguish. Angela Merkel's going meet with Papandreou this weekend. That's a tough one when you have a society that retires at the age of 67 and being asked to subsidize Greeks who retire at the age of 57.

So you can see the tensions going on in Europe. It's a test for Europe. I don't think it will undo the European central bank.

I disagree with Professor Feldstein and his recent proposal that you ought to let the Greeks opt out of the euro, bring back the drachma, devalue it and have the things that they typically do.

First of all, it's not legal. It's a highly academic proposition. I admire that. But it's just not practicable. It would set a terrible example for what others do.

Let me give you a contrasting behavioral pattern. Look at what Ireland has done. At great pain, they buckled down, they're cleaning themselves up. Unfortunately, I don't think Greece has an option. That's the response that will have to be taken under the regime that's currently in Europe. It'll permit -- create tremendous political fissures.

I found it quite interesting, Joan, that in the midst of a fiscal crisis, who is the first to go on strike in Greece? The tax directors. It's a very interesting society.

SPERO: It sounds like a Woody Allen movie.

FISHER: Yes, right out of a Woody Allen movie. But, no, this is a serious matter for Greece. It's a serious matter for Europe. I don't want to denigrate it, but it's also a test. Again, I think it is a great test as to the value of having a central bank that is independent of the fiscal authorities and therefore I'm rooting for them to stick to their knitting, which I believe that they will.

SPERO: There was a question in the back. Yes.

FISHER: This lady has a question too.

QUESTIONER: Hi. Amity Place (sp), how are you?

FISHER: Hi.

I haven't seen you in a long time.

QUESTIONER: I liked the cardio metaphor very much and it's probably the best metaphor to explain central banking, but I do have a question. You have a patient there and his heart is going and important leaders or surgeons are surrounding him and he might die. But what if his problem is endocrine?

FISHER: You'll have to walk us through what you think the endocrine problem is.

QUESTIONER: Well, you could be in a coma if you have an endocrine crisis too.

FISHER: Right.

QUESTIONER: So the point being, one of the questions being asked, not always directly, is are we taking the -- are we making monetary too important in the current crisis and liquidity, blood, too important?

Now I'll drop the metaphor. Specifically, on the issue of too big to fail, I think everyone in this room agrees that if a bank is too big, is too big to fail, it's too big. But the question is, there is no mechanism in what you laid out for the bank to fail by itself.

FISHER: Yes.

QUESTIONER: And don't big banks also need, eventually, to fail by themselves in order that banks after them know it's wrong to grow or too risky to grow too big? Where is that in the International Court for a scenario, for example?

Thank you.

FISHER: You're right. In an ideal world, it would be nice, those that fall out of place should be allowed to fail.

But when you have interconnections that can create enormous damage, then I think you have a duty to prevent that from occurring in the first place. To me, the best way to prevent it from occurring is to not let people get to that stature.

I think we have to take into account human nature here. The reason I open my book is because I wrote down a wonderful -- I don't know if you read the obit that was written about Irving Crystal, but here's what David Brooks said, in a little article, he said, "Three cheers to Irving." This is in the New York Times, September 22nd. He said that growing up in a working class Jewish neighborhood in Brooklyn, what Irving Crystal concluded was, "Don't be a schmuck. Don't fall for fantastical notions that have nothing to do with the way people really are."

Now regulators have to make sure they can deal with the way people really are. It's in our nature to want to become as big and successful as we possibly can be. These people are not bad people that build these large institutions, I'm not implying that whatsoever. They are doing what we are driven to do biologically and psychologically to become as successful and as promising as we possibly can be.

If in doing so, and figuring out a way to, for example, take advantage of government guaranteed deposits, to ramp up your other activity that puts the system in danger, it's not that they're not being good citizens and not great Americans, that they're not "doing God's work."

SPERO: That's a little --.

FISHER: But I believe that's where regulation has it's -- a place to play and preventing it from happening in the first place, because human nature is just being channeled.

So it's not cardiovascular, it's not endocrine, it's really just letting human nature run its course.

Question, and I know your conservative and thoughtful philosophy, how do you contain what is the downside to that behavior? That's really what the issue is all about.

QUESTIONER: (Off mike.)

FISHER: But remember, you're supposed to ask questions.

QUESTIONER: Right, well. The question back is what are the structures that would make the big bank, next time, feel that the economy of scale of becoming bigger is more than offset by the risks of becoming bigger?

FISHER: Yes, I think you just have to impose that upon them. You have to have a regulatory framework that doesn't allow it to happen in the first place.

SPERO: So an antitrust kind of a --

FISHER: I don't know what the exact -- that's up to our legislators, but I'd try to -- now there may be some interim measures and there's been plenty of proposals, whether it be special bankruptcy procedures, a resolution regime, CoCo bonds, maybe some formulation of that.

I worry, and I'm just speaking as an individual here, I worry out loud, that there may be false comfort, as I said on my text, that you may indeed still be underwriting moral hazard, perhaps to a lesser degree, but it's still there. I do believe the preferred option is not to let it happen in the first place. So...

SPERO: Okay. Question here, in the third row.

QUESTIONER: I think if there's a -- sorry, Henny Sender from the Financial Times. When I talk to regulators abroad, the thing that really concerns them about the way that we've handled things over the last two years is the inconsistency.

FISHER: Yes.

QUESTIONER: At some points, like with WaMu, we wipe out the debt and the equity. In other places, we save everyone. That inconsistency is very troubling to regulators abroad. I wondered if you might talk a bit about the resolution authority, how vital is it to have haircuts to creditors and how do you establish your regime without letting people feel that you are encroaching on their property rights and the moral bankruptcy process? Thank you.

FISHER: Good question.

Henny, that's a very good question. This is what's being debated right now in the Senate Banking Committee. I want to be careful not to get in the middle of that debate.

It's pretty clear to me, again speaking only as an individual, from my perch at the Dallas Fed, that for example, the unsecured creditors need to pay a price. Well, that didn't happen. In not every case were the shareholders wiped out. They took that risk, that's a mature risk you take, going back to Muriel Feinberg's (sp) question, there are ways to offset some of those risks using different financial instruments. Instruments, which by the way, are as old as time, going back to the Dutch in the 17th century.

We tend to forget that. Nothing is really new under the sun, they're just mathematically and computer, better driven. But I think you're right, which is why you have to have a resolution regime that has standards that eliminates the confusion you spoke of.

My ideal outcome of not allowing institutions to become too big to fail in the first place, I realize, is, as I mentioned, somewhat radical. So you're more likely to come up with something in between. A resolution regime that lays out, in resolving the dismantling of an institution that errs with some greater precision, that's the purpose of the exercise.

So the criticism, I can understand. We have to address the criticism in the remedy. The remedy's being put together by the people that make the laws and regulations in the United States, which are not me or my colleagues at the Fed. It's the people that you elect to Congress. Not you, but everybody else.

SPERO: Well, I think we've reached the witching hour.

FISHER: Can I say one thing real quick?

SPERO: Please.

FISHER: This is -- you know my wife, Nancy.

I became a member here on June 4th of 1976 and I still have in my home a letter from David Rockefeller and it says, "The Admissions Committee has just voted to accept you as a member of the Council on Foreign Relations." I had this vision of David Rockefeller rushing out of that meeting just coming, we just accepted little Richard Fisher before the word gets on the street.

It has been a pleasure and an honor to be a member of this organization all those years. So when I was leaving, my wife was flying to L.A., I was coming out of here, and I said, "Can you imagine, I'm going to be speaking at the meeting? And in your wildest dreams, sweetheart, could you ever imagine that I would be, instead of in the audience, on the stage?"

Do you know what her response was? "Richard, we've been married 37 years. You do not appear in my wildest dreams." (Laughter.)

FISHER: Thank you.

SPERO: Thank you. Thank you, Richard. (Applause.)

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