How the Global Financial System has Failed

Wednesday, September 27, 2006

ANDREW CROCKETT: Good morning ladies and gentlemen, and welcome to this session. My name is Andrew Crockett and it’s my pleasure to moderate the discussion with Martin Wolf.

Before we get started, there’s just a few of the announcements that many of you will be familiar with. To say that this meeting is sponsored by the Council’s Corporate Program and the Hank Greenberg Center for Geoeconomic Studies. It’s part of the Peter McColough series on International Economics. And to remind you that the next meeting in the series is on October 25 th with Jerry Muller, professor at the Catholic University of America, who will discuss “Where is Globalization Headed?”

Maybe you’d like to come back, Martin!

MARTIN WOLF: I know the answer to that question. (Laughter.)

CROCKETT: And I should remind you that the discussion is on the record. And last and most important, please everybody check once more that your cell phones are turned off.

It’s a great pleasure for me to introduce Martin, who’s a good friend. I’m not going to go through the customary list of his achievements. I always think that on a Wednesday morning, gatherings like this are divided into two groups: those who have already read Martin Wolf’s Wednesday column and those who are about to read it. But for those of you in the second category, we have him here and you can learn, I’m sure, in the course of this discussion quite a lot. I’ll ask Martin some questions for the first part of the discussion, and then look around to have audience participation.

The subject Martin has chosen is, “How the Global Financial System Has Failed.” And the first question I’d like to put, Martin, is, we’ve had now four years of more or less record global growth, inflation is relatively low, trade is at record levels, capital flows are higher than they have ever been. In what sense has the system failed?

WOLF: I’ll deal with the question second.

First let me say that this is perhaps the greatest honor I’ve ever received, having so many people turn out at this insane hour to hear me. I’m wondering whether you’re all at the right place, but I presume—(laughter)—you’re all smart enough to get to the right address, even at this time in the morning. So thank you very much for coming.

It is terrifying because of course normally when I do things like this it’s all beautifully scripted, at least for the first 10 minutes, so I know what I’m going to say. And I find it even more terrifying to be clearly at the wrong end of an interview. It’s not my role to be interviewed by Andrew, it is my role to interview Andrew. So it’s a very strange and terrifying experience.

Now let me deal with the question, which is, I suppose, my fundamental thesis. I talked about the global financial system; I don’t mean that the global economy has failed, and I think it’s important to distinguish these things. Important though the financial system is, as I will argue, there are obviously other things going on in the world, and as I’ve argued many times and I don’t think we need to repeat that, there are some profound, real forces working in the world economy which we often put under the heading of globalization which are driving economic growth.

These consist essentially of a mixture of technological changes, very profound technological changes in one specific area above all, in communications technology, with radical consequences for our ability to organize the world economy in a truly transforming way; the liberalization revolution in general, the opening of economies, particularly on the real side, to trade and fixed investment; and, of course, it goes without saying, the entry of China and the other Asian powers into the world economy, which is a huge real, positive real shock, with immense long-term consequences for the world.

I sometimes say that the first globalization was essentially a land shock. It brought the Americas above all into the world economy, and had among other things the effect of creating the forerunners of the common agricultural policy you’re still trying to get rid of today 130 years later. And now we’re in the middle of a colossal labor shock.

So these are really powerful forces driving the world economy. What I am saying about the financial system is something more specific. I think we have discovered—and I’m happy to elucidate it, elaborate further, and I imagine that I will be asked to—as a result of 25 years of incredibly painful experience with the consequences of financial opening in the current context—we’ll come to further—we have, as it were, tripped on a solution to the fundamental unworkability of a system which is predicated, I think—what one would normally assume predicated—on once one opens a global financial system to the proposition that capital should flow from relatively rich countries to relatively poor countries in relatively smooth ways building up the capital stocks of the latter—which is, of course, exactly what happened in the first globalization at the end of which, as you probably know, the United Kingdom had net assets equal to three times its GDP, which, of course, it proceeded to lose in the two wars. But that was, as it were, what you would expect a great globalization period on the financial side to do.

We have completely failed to make that work every time. There are—and I’ll discuss this at more length if you want—every time we’ve had any sustained period of large net transfers of resources from developed countries to developing countries, we’ve ended up with shattering economic crises. This has been shattering financial crises and of course economic crises associated with this. The countries at the recipient end who can have basically decided to cease to be net recipients of funds. They’re doing this by recycling both the current accounts they’re generating and all the capital inflows back into foreign currency reserves. And the entire net flow of funds across the world, and it is gigantic, or 80 percent of it, is going towards the U.S.

So we have achieved, and this is in some sense a great success. The world works like this as long as the U.S. is deemed to be infinitely creditworthy. How long that will be, I don’t know. It’s a big subject for discussion. But as long as the U.S. is able to receive funds on this scale—at what remain, in my view, ludicrously low long-term interest rates given the risks—then we have a stable macroeconomic system related to the malfunctioning of the financial system, this recycling process that I have described very often.

Now, I regard this as problematic in two ways. This is why I describe it as a failure. First, I remain of the view that it’s profoundly perverse. When I would have been asked in the early ‘80s what is the purpose of opening up the global financial system and encouraging countries to integrate into the financial system, I would not have answered in order that there should be a flow of $800 billion dollars a year from the rest of the world into the United States. That was not what I would have thought is the prime aim of this sort of thing from a development economics point of view.

And the second point I make, which I discuss at some length in the column, is that it creates, it seems to me, further fragilities. I don’t know how significant they are, but I think they’re potentially quite significant in the financial system and therefore in the global macro system; my fundamental point being, of course, that the financial system is so central a part of the world economy, or any economy, that it always has profound macro-effects when things go wrong.

Well, the problem is that we are deeply reliant for stability in the world economy as a whole on the willingness and ability of United States to accumulate net liabilities at current and quite possibly growing rates in years to come. My view is that this creates two fairly serious problems for the world and for the U.S.

The first, which is what I discussed this morning, is somehow or other the external imbalance must be matched in the U.S. by internal financial imbalances. It has to be; otherwise, you have a deep recession. And the way you solve the problem in the last five, six years is by running an absolutely staggering household financial deficit, staggering in the sense that it’s much bigger than anything I’ve ever seen in any other major developed country, and much bigger than in your past.

So that’s the internal problem the U.S. faces. And the external problem, of course, it seems to me, is that at some point people are going to say, well the long-term spread we’re getting just isn’t matching the risks we’re having as we’re accumulating an ever-larger share of our portfolios in U.S. liabilities. We’re going to want a risk premium on these things, and the market adjustment could then, if it does happen, be quite painful, and the engine which the U.S. has been will be cut off.

So it’s in that sense that I would argue the financial system has failed. We’ve got around the problem, actually I have to admit, incredibly much better than I would have ever guessed four or five years ago, but it remains the case this is how we’ve solved the problem.

Now, let me just make a final comment on why this has been the solution. My view is—and this is something I’ve talked about quite a lot—is there is one fundamental difference between the first globalization and the second, the era I talked about, the British era, and this, one absolutely fundamental difference, and it’s the core aspect of this story, I think, and that is that ultimately it was a single-currency world, it was a gold standard world. And the gold standard was credible, and therefore countries were all actually effectively, mostly anyway, operating the same currency.

We now live in a multi-currency world, in a radically multi-currency world, but we have a very small number of vehicle currencies in which most people are prepared to transact, and far-and-away the most important is the U.S. dollar. And if you look at the problem created by currency mismatches in the financial system, it follows pretty naturally in this sort of world that the only country that can readily and easily accumulate very large net liabilities is one that can denominate the whole lot in the currency which is the primary vehicle currency of the world. So this, in my view, is the single biggest reason why the U.S. has ended up as the borrower of last resort for the entire system in this very fascinating way.

Final comment. If that were to stop—let me put it this way. Look, I don’t think one can underestimate the significance for macro-equilibrium in the world economy as a whole of the ability, the willingness of the U.S. to run these very, very large bond requirements. It has played a very crucial role in macroeconomic equilibrium for the last few years, and it’s a very central feature of our world economy. It’s an astonishing feature, in my view, rather a worrying one.

CROCKETT: Thank you Martin. I detect in what you say two concerns that I will try and separate and probe you a little bit on separately.

One is the anomaly of the capital flowing, so to speak, uphill from poor countries to rich countries, and second is the fragility of the system with the currency imbalances, particularly in the United States.

Now, taking the first one, you could look at it from another point of view and say that when we have a market-oriented system, flexible exchange rates and so on, saving is determined by the preferences of countries and individuals, and investment is determined by investment opportunities. Is it not the case that participants in this system—take China as an example. It has a very high savings rate, has investment opportunities that are perhaps not as high as its savings rate; it’s not unnatural for it to expend the surplus of saving over investment abroad. And by the way, that’s a net figure. China imports a tremendous amount of capital in foreign direct investment, and benefits quite a lot from the openness of the system. What’s your answer to that?

WOLF: Well, my answer is that I don’t regard the savings rates of these countries as exogenous and, as it were, as just out there and unaffected by the macro policies they’re pursuing. Let me just elucidate what I think is going on in the principal capital flow recyclers.

Obviously, the oil-exporting countries, which have become a very big part of the story in recent years, are a separate case, and because of the oil surpluses, which are about half of the surpluses out there at the moment, one would expect large borrowing by others anyway, and it’s one reason, I think, why the equilibrium deficits for major industrial countries has gone up. So, that’s a separate thing. But look at the recyclers.

The way I think about what they’re doing goes something like this. They have decided—there are many ways you can respond, and I think the pivotal event in the perception of the East Asians, and they’re generating in aggregate about half the world’s surplus—the pivotal event in the psychology of the East Asians was, of course, the ‘97/’98 financial crisis. I think many people outside the region, including here, probably underestimate the psychological and social and political trauma associated with that crisis and its enduring nature, and the profound feeling of humiliation and also desolation, sense of being abandoned, that was associated with that crisis.

We—that is to say, respectable economic opinion in the West—concluded from this crisis that the big mistake had been to have pegged exchange rates, and the right thing was to have freely floating exchange rates and that would eliminate all the problems. And that’s, of course, a view I tend to hold, at least to some degree. This is not the conclusion, in my view, they reached. The conclusion they reached was that it’s perfectly all right to have a heavy currency intervention, or even a peg, as long as what you end up with is an undervalued exchange rate.

What do I mean by an undervalued exchange rate, and why do I think this savings surplus is generated as a result? Because of course there’s an intimate relationship in basic theory between the real exchange rate and the, as it were, the aggregate savings rate, which is going to give you internal balance in the economy at home in terms of full employment, which basically means that the demand and supply of non-tradables are in equilibrium and so you don’t have either inflation or deflationary pressures there. And you have a given outcome for the trade surplus given the real exchange rate.

I think essentially what China—take China as the simplest example—is doing is targeting the real exchange rate. That’s the prime vehicle. I mean, it’s targeting the real exchange rate, clearly, because it has essentially an inflation target, it doesn’t want any, and it’s got a fixed exchange rate. So it’s targeting the real exchange rate. And that real exchange rate—China is generating, as we know, a very large surplus of exports over imports. So in order to balance its economy, it has to ensure that this doesn’t spill over into a huge excess demand for non-tradables; in other words explosive inflation. It has to control the inflationary consequences of this huge surplus, which is, of course, they’ve got this additional inflationary pressure, as you’ve pointed out, from the capital inflow, and they are intervening in the markets to generate reserves at the rate of $200 to $250 billion a year. As you know it’s now gone up to a trillion.

So the Chinese, as it were, have to follow policies and they have to follow a whole range of policies which will ensure the excess of savings over investment at home, which will match the current account surplus which is being generated by the real exchange rate, which they have decided is their policy target de facto. So they must generate savings and investment surpluses.

Now, if you start looking at the Chinese situation, it simply isn’t true this is the result of some household saving, high because households are such high savers. About a third of the gross savings in China are household savings; the household savings rate is about 16 percent of GDP, which is clearly high, a hell of a sight higher than here or in the U.K., but it doesn’t explain it. Two-thirds of the savings in the Chinese system are government savings. In fact about 20 percent of GDP are the profits of enterprises predominantly owned by the Chinese state, and the rest is government—is straightforward government savings. The government takes no dividends from the state enterprises, this has been much discussed, which of course keeps the savings very high, and it has chosen not to spend more of its revenue to reduce its savings.

Now, government savings—which as I said, are about 32 percent of GDP roughly in China—are a policy variable. It’s something they can decide to put pretty well at any level they want. They control the investment rates by the government sector, and they control effectively the investment rate by the SOE sector.

So it’s wrong, I think, definitively—I mean you can go (to) the other countries, the NIEs are not so different from this—it is completely wrong to think of this as caused, in my view, by exogenous savings which generates this huge surplus over investment.

A much better way of thinking about what’s going on is you’ve got a real exchange rate target generating a huge current account surplus, in addition with a capital inflow going into reserves, and effectively a sterilization operation, which occurs in many different ways, requires that the government generates the savings sufficient to—given the investment—to be the counterpart of the desired—or not the desired, the current account surplus that results.

So that, I think, is the mechanism. The saving rates and indeed the investment rates, because they’re trying to control investment too, both of them are within the power of these governments. The target, effectively, is the external relative price. At that (set of ?) relative prices—an exact inverse applies to the U.S, by the way. I don’t think it’s a point I’ve made very often. There is an idea here that the U.S. controls its monetary policy. It seems to me completely wrong. Given the real exchange rate for the dollar, an exact inverse applies in terms of what happens to the current account here at full employment. And internal balance in the U.S., as I’ve already argued, requires huge financial deficits internally to match the external deficit at something close to full employment. And if you don’t have the financial imbalances here, the excessive spending over income internally, you have a whopping great recession.

So I think the most important single variable driving the system now, leaving aside the oil fight, is real exchange-rate policies in other countries, of which Japan, effectively China, the newly industrializing economies, but not only them, also lots of other countries that are trying to get their exchange rates down in the Western Hemisphere, also apply.

You have to think of savings and investment. I mean, I’m not trying to say that it’s mono-causal. Obviously, there are relationships and in the end you could say this will blow up. But I think it is much better in the present situation to think we live in a world of real exchange-rate targeting outside the U.S. than to think that we’re living in a world in which savings and investment at the national level just happen to be what they are and have nothing to do with government policy. That’s just completely wrong.

CROCKETT: A lot of provocative observations in there, which I’m sure people will likely come back to. But let me just, before I finish my part of the morning, go to the second question that you raise, which is obviously tied up with this, which is the vulnerability and fragility of the system in the face of these imbalances.

It seems to me in some way you’ve described a situation in which there is, at least for the time being, an equilibrium. The rest of the world wants to have these surpluses. The U.S. consumer is comfortable with low savings rates, in part because wealth has been rising in the form of housing. Why should this system be vulnerable, and why should it not eventually—everybody agrees it’s unsustainable—why should it not unwind in roughly the same way that it’s wound up in the first place?

WOLF: Well, I think that’s a really interesting question. It’s obviously the point of which I’ve been—Andrew and I were talking about the embarrassment—I have the great virtue over all of you that I don’t have to bet my money, which I don’t have, on the propositions that I make. (Laughter.) I merely get embarrassed by being reminded, not infrequently, by my good friends of the many mistakes I’ve made, so I’m happy to admit them. And I am surprised by the extent to which this has gone on. And I suspect most economists—not all, there are wiser people than us—in 2000 I thought the correction would start, and it seemed logical because the time at which the readjustment would occur would be after the stock markets started to collapse and that people would then say, well we’ve over-weighted the U.S. assets.

And actually, on the private sector side that’s actually what did happen for about three or four years. Somewhere between a third and 40 percent of the net finance of the U.S. current account deficit, according to U.S. balance of payment statistics—and there’s much controversy about interpreting them—was actually from foreign governments. So I think the adjustment would have occurred if the governments hadn’t intervened in the scale they did. The dollar would have fallen more, the adjustment would have started, and that’s what I think should have happened. And it would have been very good for these countries if they hadn’t pursued these policies, but they didn’t because they didn’t want to go back into crisis territory, which is where we start.

Now, I think the thing I have misunderstood, to be perfectly honest, if I had been asked—and I followed China modestly closely for the last 15 years—if I had been asked in 2000, when, I think if I remember correctly, China’s foreign currency reserves we’re about $240 billion—somebody can correct me if that’s wrong, but it’s something in that neighborhood—that the Chinese will be quite happy to hold a trillion dollars worth of reserves and rising at the rate of something like a quarter of a trillion dollars a year, possibly exploding upwards—I would have said that doesn’t strike me as very plausible, because really the Chinese are imaginative enough to find a use for all this money. I was obviously wrong; they weren’t imaginative enough to find another use for all this money. So, in other words, the line of credit for the U.S., broadly speaking, has been—and oil surpluses (allowed this ?)—has been much, much bigger than I imagined, and it can therefore go on for much longer than I imagined.

What worries me is, and this may be a profound error, but what does worry me is that properly measured—and there is an excellent paper by Daniel Gross, which I recommend, looking at what’s the real peculiarities of the U.S.—investment figures where the European FDI seems to just disappear, it’s gone, so I think that it’s almost certainly the net liability position is much worse than the official statistics show. But what worries me is that at some point, as you say, people will say it is enough, it is enough. The Chinese will hold $5 trillion or $6 trillion of U.S. liability and—“Well, that is enough, thank you very much”—and the adjustment will start at a point at which, under it seems to me very plausible assumptions, the net liability position of the U.S. might be equal to GDP or not much smaller. There will be a very large negative net income figure. The U.S. is a great hedge fund, but I can’t believe the hedge fund will manage to get ever larger returns—net spreads between the cost of funds and its returns in that situation.

And the result, it seems to me, could be rather a brutal and wrenching adjustment for the U.S. economy of the kind that I tried to sketch out a bit today. Higher long-term interest rates in the U.S., quite significantly higher long-term interest rates in the U.S. in this situation, and households which have borrowed very, very heavily beginning to find themselves in very substantial difficulty and moving back nearly to normal patterns in terms of their spending relationship to their income, which, by the way would mean that they cut their spending by about 7 or 8 percent of GDP. That’s what it would mean to go back to normal; we’re not talking about small deviations.

And that would clearly generate a large recession in the U.S., not a depression, and I think the Americans would, as I argue today, quite naturally say, “Well, if we’re going to have a large recession, thank you very much, we would like this to go abroad. And we’ve had enough of this exchange rate nonsense, you’re just going to have to accept that the dollar’s going to go down.” And this would be a rerun, in much more painful circumstances in a relationship particularly with China, which is much more geopolitically fragile than the ones with the Europeans and Japan in ‘71, but it will be a rerun of ‘71. And I think trade policy could go completely to hell in this situation.

So while I agree with you it’s perfectly possible and I can easily describe nice, smooth scenarios of adjustment over the next 20, 25 years in which nobody really minds very much and manage very well, I can also imagine adjustments which are very threatening for both global macro-stability in the world trading system and trade policy in the U.S. Just think about what would happen in the run-up to a presidential campaign if there were to be such a sharp slowdown in the household sector and it basically generated a recession and hardly shifted the current account deficit.

So I think it is complacent. Now, I have been accused of being alarmist on this. With my name, perhaps that’s appropriate. (Laughter.) The job, anyway, of pundits is to play the role of Cassandra, and the fate of Cassandra was to be ignored and proved right always. (Laughter.)

CROCKETT: One last question, Martin, before we open the floor, and if you could answer briefly to allow time for others to ask. We’ve got this far and nobody’s used, you haven’t used, the term “IMF.” What about the architecture of the system? There’s been a lot of talk—we just had the IMF meetings—about how it could play a role, particularly in the imbalances, in making the system work better. Is that key to solving the weaknesses in the system that you see?

WOLF: Well, I think there are two—I’ve been trying to write about this. I’m finding it very difficult to get hold of this issue. But there are two completely different ways of thinking about this issue. The first way is simply the role of the Fund as a coordinator, an adviser to governments, elucidating the implications of current trends, elucidating the possible effects if things go wrong, and in getting governments to think about the very obvious fact that exchange rate policies don’t affect them alone; this is a global thing.

The latest World Economic Outlook, which I have just read and written a little bit about, is an excellent example of what have generally been, I think, very good reports in an analytical way. These will presumably be used as the basis of this envisaged five- party discussion which I think is occurring between the U.S., Japan, the Euro-zone, China and Saudi Arabia. I believe that is the group of countries. Britain, in typical way, is very miffed not to have been invited. I don’t give a damn. As our governor of the Bank of England said, happy is the country that is not part of a global problem. (Laughter.) We should have taken the role of being free riders much more seriously than we have in recent years. (Laughter.) So that’s one side of it, the Fund as coordinator and so forth. Another and much deeper question is whether we can resuscitate the Fund’s role as a lender of last resort. The reasons why you might say that would be desirable is that we now know—it’s not a hypothesis—that in a world in which countries that think they might get into crisis, which are essentially countries which don’t have the sorts of currencies that people are prepared to hold in almost limitless quantities outside of their borders, which is many of the countries of the world, have decided—it’s evident they have decided that they can’t rely on external assistance to get them through what they regard, rightly or wrongly, as unreasonable behavior by capital markets which generate unreasonable and irrational crises. That’s what they think has happened to them. Right? And so what they have decided—and this is particularly true of the Asians, but I think it’s happened to a considerable extent elsewhere. It’s quite interesting at the moment, there is only one region of the emerging world which has a really significant deficit, and that’s Central and Eastern Europe, including Turkey. There’s no other. So what they’ve essentially decided is to self-insure. And the exchange-rate policies cum reserve policies I’ve described is an enormous exercise in self-insurance.

The scale is quite staggering. As I like to point out, approximately two-thirds of all the foreign currency reserves accumulated by all the countries of the world since time began have actually been accumulated in the last five years. It’s about $2.8 trillion now of additional investment. And most of it is going to U.S. liability, so it has been a great deal for the U.S., there’s no doubt about that.

Now you could argue self-insurance on this scale is really irrational. The logic of the Fund at the very beginning was that it was a revolving fund under the assumption that any country might get into difficulty at some time, things happen, and there would be an ability to draw on this to deal with temporary disequilibria, which would then be adjusted, money would go back afterwards. The fact that they have done this shows that they have no trust in the Fund to play that role. And one pretty obvious reason why they should have no trust in the Fund’s playing that role is that the Fund’s resources are about $300 billion, which doesn’t get you very far against $2.7 trillion.

And the other reason is the people who are likely to borrow from this institution. It’s no longer a revolving fund. There is one set which are clearly the potential borrowers, and the other guys who control it. And they don’t want to be under the control of the people who control it. I think you can say, as safely as you can say anything on God’s earth, that the chances the Chinese will get themselves into a situation in which the U.S. Treasury can do to them what they did to South Korea in ‘97 is zero. So the result is, the Fund’s role as a revolving fund to deal with this has disappeared.

I actually think—I’m in the minority among economists—I think this is a pity. I actually think the revolving fund, liquidity-providing role is perfectly reasonable. I think the moral hazard arguments against it are hugely exaggerated. I don’t think they are zero, but I think they’re hugely exaggerated. I think it is possible to deal with it. But actually, whether I like it or not, it’s gone and it’s not going to come back.

If it comes back, as I argue in my column last week, it will come back through arrangements among emerging market countries, like the Chiang Mai Initiative in East Asia, which is essentially an agreement to borrow among East Asian countries, to use their reserves to deal with a crisis in that region.

So I actually think the Fund is collapsed back into the former role, the coordination role, the liquidity-providing role, which is very much what Keynes had in mind in the beginning, is no longer deemed relevant. And I can think of perfectly good arguments—you know, have a sort of (floating rate ?) system, why we wouldn’t want that. So I think we have to say that in the core function of the Fund as it was originally envisaged, as a revolving fund to help countries deal with liquidity crises generated by panics in markets—whether you agree with any of that description, I do, but others don’t—that role of the Fund is really just dead.

Just a final comment, which is central to the reform agenda at the moment. Obviously, even as a coordinator, as a broker of views among governments, the Fund has to be legitimate and credible to all parties. And one of the reasons why the reweighting of the votes in the Fund is so important and the European dominance of the ND position has to be changed is that countries like China and India are rising powers and are simply not going to consider this a legitimate institution if, for example, India’s vote continues to be smaller than Belgium’s.

Some people think that’s an anomaly; and about 1.1 billion of them live in India—(laughter)—and 1.3 billion of them live in China, and we’ll have to change the institution for that reason alone. Otherwise, it just becomes a European and American club with nobody to talk to except some poor, hapless African countries we can continue to bully indefinitely.

CROCKETT: Thank you very much, Martin.

Let’s open the floor to discussion. Please wait for the microphone to be brought to you, speak directly into it, and try to make your questions brief so that we can have as many as possible.

The first table here. And would you identify yourself at the beginning.

QUESTIONER: My name is Lucy Komisar. I’m a journalist and I’m also with Tax Justice Network. To follow up, you mentioned Africa. When you talk about the statistics of money moving out of the rest of the world, including the developing world, here, it seems a little bit bloodless. But then when you look at the realities of the devastation in Africa; the fact that in Latin America the reason for the election of half a dozen progressive governments had to do with a combination of odious debt, where the money went in and went right out through the international banks into the stock markets; you talk about the corruption of money that was stolen by multinationals through evasion of taxes through transfer pricing, and then there’s always a little bit of payoff that went into the offshore banks.

So how do you deal with the fact that your numbers are not just something to put on a chart, but really represents and it’s almost a proof of the fact that we are not helping the developing world, we are sucking the money out of the developing world? What do your numbers tell you that needs to be done in terms of policy?

CROCKETT: I think it was more or less your thesis, wasn’t it? (Laughter.)

WOLF: Well, it’s a related, but slightly—this is actually the thesis I advanced, or part of the thesis I advanced, an aspect of the thesis I advanced in my St. Paul lecture. But you’re raising issues that go clearly well beyond the financial system, financial crisis per se.

Let me just make—because we could end up in a discussion of this subject which would go on for hours on end. In terms of the global macroeconomic story and its relationship to the history of financial crises and what has happened with large net lending, the countries you refer to are actually quite a small part, in fact a very small part of the story. And the reason is that with very few exceptions—and they’re all Latin American, and the one or two large ones, Mexico, Argentina, Brazil being the important ones—these just very, very small players in the world economy, world economic system.

So in terms of the global picture it’s—and I agree with you. The word “bloodless” is actually great. It doesn’t matter. That doesn’t mean it doesn’t matter; it just means in terms of the global macroeconomic picture, it’s not central.

The second point to make is that most of the African countries, sub-Saharan African countries, with a few exceptions, were not the recipients and have never been the recipients of large-scale private capital inflow. They have, as you say, been the recipients of large-scale investment in minerals. And I think it is completely fair—and this will be the last point—to argue that in those cases there are many examples of money which has been generated by royalties out of natural resource rents which have been recycled—how does one put it—by the leaders of these countries out into the pockets of some of the institutions almost certainly represented in this room.

And I think, and this is the big point I would make, I don’t—and I suspect there are lots of points that you and I may disagree, but let me make quite clear, if you start looking very seriously and carefully at the development problems of some of the smallest and weakest economies in the world, and the roles of war, civil war and, as I said, offshore corruption and the recycling of royalties, rents out of these countries and so forth, it’s not difficult to feel that implicitly and sometimes quite explicitly, institutions in the outside world are culpable. And I mean private capital institutions are culpable.

And I have come to the view, therefore, something I have written in several pieces, that we do have to think very, very seriously about the impact of what we do on very fragile societies with very defective political systems, a very high level of corruption and all the rest of it because, as I put it in various contexts, it amounts to debauching minors. And this is, I’m sure, language which is very different from the way you would put it, but I do think that our involvement in the fragile states of the world, and particularly where it tends to be involvement around resource riches and the use thereof, it raises a lot of questions for the way we ought to be behaving if development is to proceed. But I think it’s a separate issue from the big global financial story, but it is incredibly important, unbelievably important if one takes development seriously as a challenge, as I do.

CROCKETT: Third table from the back, there.

QUESTIONER: John Mbiti from UBS. You mentioned in your speech that one of the problems with the current financial system is the fact that the U.S. dollar is the de facto reserve currency. I wonder, in terms of considering solutions to the issue, whether in lieu of policy considerations we should actually consider the market solution.

And by that I mean take, for example the, euro. If you looked prior to the introduction of the euro in ‘99, most of international debt capital markets were denominated in U.S. dollars. There has now been a shift towards denominating—or issuing debt in euros and dollars, so that I think if I’m not mistaken, it’s about 40 percent of the debt issued is now in euros, 40 percent is in dollars.

Now, going forward, as the euro becomes more of a reserve currency is it possible that a lot more countries will start shifting their assets away from the U.S. dollar into the euro, and then we’ll have this realignment?

WOLF: It’s certainly possible. I mean, it’s a very intriguing fact, to me, anyway, that—I mean, it tells you a lot about what is going on in the world—and it’s quite fascinating that the euro-dollar rate has moved as little as it has despite a long-term interest rate differential, which is only about a little over a percentage point, and despite the extraordinarily different net-liability positions, when in fact most of the net flows into the U.S. seem to be in bonds, they’re not in equity anymore. So it’s not that people are going for high real returns. So, I think people have underpriced the euro. And it can’t be just explained by slow growth in Europe, because if you want to buy bonds, slow growth in Europe is a damn good thing; you want it.

So there’s a sort of puzzle in my mind. It may be that people continue to have a question of whether the euro is actually going to survive, if this is a viable currency. It’s an extraordinary invention. I always believed it was possible to create it; I’m reasonably sure it will survive. Whether it will survive with all its current members is another interesting question, but that’s separate. But the big point I wanted to make is simply that it’s not the answer.

The answer to my problem—it’s not the answer, but an answer or a big part of an answer to my problem—I think is to take the logic of a multi-currency world seriously, which is in essence—and this is incredibly simplistic and reductive—but in essence, it seems to me fairly persuasive that the most important reason why “normal,” quote-unquote, foreign currency crises turn into systemic financial crises in net borrowers, large net borrowers, is that if you are a large net borrower and most of your borrowings are denominated in somebody else’s currency and there is a big fall in your real exchange rate because you’ve got a large current account deficit and people think you have to adjust to a real exchange rate depreciation, which is normal, you will then end up—you have very large currency mismatches by definition in your private sector, either in the financial system or the non-financial system, and it actually doesn’t really matter which, because the banking system will go under, if all of its corporate borrowers go under, just as well. So if you end up with very large-scale net foreign currency liabilities in your economy as a result of this process—it can happen, of course, if you’re in balance, too, but it’s less likely then that people expect a large currency depreciation. If you end up with this situation, a big currency adjustment is a recipe for mass bankruptcy of the entire private sector. And that’s essentially what happened in one financial crisis after another in Argentina, it happened—almost happened in Brazil, and of course it happened in East Asia.

So there is only one solution to this problem. One, have absolutely fixed exchange rates, which brings us back to the gold standard; or two, borrow in your own currency.

Every time I go to Australia, the former and wonderful central bank governor said, when I talked about it—he said when I talked about it—he said, “You shouldn’t worry about the U.S., because the U.S. is just like Australia. It’s a little bigger but it’s just like Australia, and we’ve been doing this forever. And the reason we can do this forever is that we issue a sound currency and everybody—we do most of our borrowing in our own currency. And yes, of course we’re a dinky little country, but still people are prepared to lend in Australian dollars.”

And that, by the way, is the answer as far as lending is concerned. The other answer, of course, is to do it through equity flows. And it’s not, in my view, in any way an accident that the only large, sustained, consistent net flow of resources into developing countries in the last 15 years has been foreign direct investment. It’s not an accident because the risk allocation between creditors and debtors is so much more attractive in this situation.

So I think the solution as far as lending is concerned—and there’s been a big increase in this—is foreign currency—is domestic currency lending. And you guys will get more and more used to holding portfolios stuffed with currencies most of you—no, actually not of you, you have euros—but most people in the world have never heard of.

And the way I put this when I put it most brutally—and I understand fully the logic on the other side—if you can’t lend safely to a country in its own currency, you can’t lend safely to a country in any other currency, either.

CROCKETT: The center table, Dick Gardner.

QUESTIONER: Richard Gardner, Columbia University. Stieglitz, Soros, other critics of the IMF, many NGOs, have said the IMF has been pursuing bad policies, forcing on developing countries market fundamentalism, pushing what they call the Washington consensus. How do you evaluate the IMF’s role in advising and laying down conditions on borrowers in the developing world?

WOLF: I’ve been told to be brief, so the brief answer will be, I think the IMF policies during the crises and afterwards, with some fairly significant wrinkles which depend on each case, have mostly been right. My judgment in my own book is that the failure of the IMF, and it’s very evident, also of the U.S. Treasury, our Treasury and OECD, was to fail to appreciate and to explain the nature of the risks associated with elimination of exchange controls and increased borrowing by developing countries running rotten financial systems; so that the mistake was before the crises, not during and afterwards.

CROCKETT: Peter, table here.

QUESTIONER: Yes, Peter Garber, Deutsche Bank. Your views are really the conventional views of the academic macro-economists. And as you say, since early 2000 they have been calling for a readjustment and an end to these imbalances, and that’s almost seven years now. Last time that leading macro-economists of the day got it so wrong for so long was in the early 1930s, and as a result, they were discredited and their careers went into eclipse. But today, each year that this goes on there’s a call for even more rapid adjustment because the crisis is going to be even greater, and the rationale for maintaining their views is that the markets are proliferating bubbles everywhere.

You have a milder explanation that the markets have just failed, but admitting that economics is somewhat of an empirical science and therefore its theories might adjust to empirical outcomes, is it not reasonable to start embracing the idea that perhaps capital may flow uphill in a world where there’s profound labor market disequilibrium?

WOLF: Right. Well, thanks for the question. I suppose the difference between—I mean, it seems to me economists are always wrong about everything, but maybe the difference—there is a sort of moderately important difference between saying in the ‘30s that a Great Depression can’t happen—I presume that you’re referring to it—and if it’s happening, there’s nothing we can do about it, while 30 percent of the world is unemployed, or 30 percent unemployment—from saying that a process that is continuing, doesn’t look very sustainable in the long run and looks rather perverted, seems to me a different order of mistake, morally, at least.

Now on the question of why it’s mistaken, it seems to me actually—and I may be misunderstanding you—the only real difference between your position and mine is what is motivating a set of governments to pursue the policies they’re pursuing. Now it seems to me that economists are economists, not political scientists, so the failure to predict government policies correctly is a failure, clearly, but it’s, to my mind, anyway, (morally/moderately ?) understandable failure.

The really interesting difference between us is what is motivating these government policies. And your view, if I understand it correctly, and I don’t think this is irrelevant, is this is an indirect form of—I’m putting it rather crudely—but an indirect form of labor subsidy. That the best way they can possibly find to generate additional employment is through a very large subsidy which takes the form of giving away, effectively, a large part of their exports to the United States.

And my view is—that may be part of it, but I think it is not consistent with the evidence on how we got here. My view is that a more important part of the reason for this is their profound—I find that so irrational as to find it really difficult to believe that they can be so foolish. That’s obviously the difference between you and me. I think a much larger part of the reason that they’re doing this is that they have decided to follow a set of policies which absolutely reduces the risks of financial crisis to the absolute bare-bone minimum. So there’s an interesting empirical difference between us of why this has happened.

Now the second difference, I think, is over whether this is a process then that will wind, unwind, in a benign way or not. And the honest answer to that, at least as far as I’m concerned now, and I’ve said this many times, is I don’t know. It could be either.

May I make one final comment? Obviously, from time to time processes occur in economics which strike me as slightly unreasonable and likely to reverse. One example is what happened to the stock market in the last two or three years before 2000. Obviously, lots of people could have at least reasonably said to me, “Well, you’re completely wrong, because look what’s happening.” But it did happen in the end.

So I think as an economist one has to continue to apply the analysis as best one can. But, it seems to me the fundamental difference between us is, why are they doing this, how long will it last, and what will be the nature of the adjustment? And I think to my mind all those questions remain open.

CROCKETT: We will finish promptly at 9:00, which means we have time for one question or two if the questions and answers are brief.

You’ve been waiting patiently.

QUESTIONER: Thank you. I’m Padma Desai of Columbia University. Regarding the prospects of adjustment from the U.S. side itself, I mean it’s true that U.S. households and the federal government have benefited from the saving glut outside the U.S., but the short-term interest rate, which was about 1 percent in 2004, has risen to 5.25 percent now, raising the cost of borrowing by U.S. borrowers. So will that not set the adjustment in motion from this side?

WOLF: One of the most interesting questions is the nature of the domestic offset. And here Peter and I truly agree these are policies being determined outside the U.S. to which the U.S. has to adjust. The U.S. adjusts by spending roughly 7 percent more than GDP. It has to. And it has to do this either through the public or the private sectors. The public sector has made a contribution. The much-derided U.S. fiscal deficit, in my view, has been rather useful, but there’s a big controversy about that.

The corporate sector has behaved in a very fascinating way in the last six years. It’s been a supplier of funds to the market rather than a user of funds, and though there’s been a very small adjustment in that, it’s really modest, it’s very difficult to see. And if you imagine an enormous investment boom, or a collapse in profits, I don’t imagine you want to think about the latter, and the former seems—doesn’t seem very likely, and the former seems—a huge explosion of the investment seems unlikely, if we haven’t had it so far, though there’s some improvement.

So that basically means if you’ve got a current account deficit of 7 percent of GDP, you need the households to run a financial deficit of 7 percent of GDP at full employment, and otherwise it doesn’t work. So one way or another, the Fed has to find a monetary policy which does that. And if it can’t be done at 5.25 percent, the interest rate will go down.

CROCKETT: Thank you.

WOLF: Possibly to zero; who knows. We’ve been there before.

CROCKETT: Here, front table.

QUESTIONER: Thank you. Richard Thoman, Corporate Perspectives, and Columbia University also.

When economists talk about performance in their domestic economies, they talk a lot about productivity. Greenspan talks a lot about the technology miracle and productivity. We’ve seen a period in the United States where technology investment declined dramatically from 2000, went down, has come back, but it really hasn’t reached its 2000 level till 2005. So the engine of our productivity, growth in the late ‘90s and early part of this decade hasn’t been fueled for the last little while.

Would you talk a little bit about a world in which U.S. productivity grows at three and three and a half, as opposed to one, and what that means for your hypothesis about adjustment? Is productivity completely irrelevant in your hypothesis?

CROCKETT: Two minutes, Martin.

WOLF: Two minutes. (Laughs.) (Laughter.)

U.S. productivity growth has been a very important part of the overall world economic growth story, that’s clear, even though it hasn’t spread outside. It’s been something of a miracle if you look at standard explanations, I mean in the sense that it obviously falls into the black box called “total factor productivity,” not investment, and that’s always fascinating because by definition we don’t know what that is. So will it go on? Yes, quite possibly, or not.

It’s interesting, probably true by definition, that you can’t attribute, I think, the extraordinary profitability of companies to any significant degree, because the extraordinary profitability of countries, companies, is a universal phenomenon of the world, and the productivity explosion is here. And I think a much more plausible reason for that is the labor supply shock I talked about before. We’ve got a world-wide shift from labor income to capital income. The new Economist’s survey of the emerging markets, I think, discusses that very well.

And, finally, I think it was very plausible that in the late ‘90s the productivity story was a large part of the sell for people buying U.S. shares, directly and also for FDI, but from my reading of the capital inflows of recent years, it’s no longer a huge part of the story since they seem to be predominantly going to—in forms which will not respond to productivity—where the returns won’t respond to productivity. But obviously—finally—the faster that you really cause any growth in the U.S., of course, the more sustainable any given external deficit is. If the real economy grew at 8 percent a year, it would look completely different, with a current account deficit of 8 (percent), from a real economy growing at 2 percent. So fast U.S. growth is clearly part of the sustainability story.

CROCKETT: With apologies to those who didn’t get to put their questions, please join me in thanking Martin for a very entertaining and provocative morning. (Applause.)

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