International Implications of the Financial Crisis

Thursday, October 16, 2008

ROGER ALTMAN: Good morning, ladies and gentlemen. Good morning and welcome to the Council. I'm Roger Altman and this morning we're going to discuss the international implications of this financial crisis, which we're all more familiar with than we'd like to be. I'm joined by Simon Johnson on my right and Tim Adams on Simon's right.

Simon is a senior fellow at the Peterson Institute for International economics and a co-founder of, which is a website on the financial crisis. He was previously the International Monetary Fund's economic counselor and director of the research department, and at the IMF, Simon led the Global Economic Outlook Team. He's also the Kurtz Professor of Entrepreneurship at MIT's Sloan School.

And Tim is a managing director of the Lindsey Group. Previously Tim served as undersecretary of the Treasury for International Affairs and was responsible for all of the wide range of matters that that position always carries with it, including exchange rate issues, G7 issues, and the IMF and World Bank issues. And prior to assuming that post as undersecretary, Tim was chief of staff, both to Treasury Secretary Paul O'Neill and to his successor John Snow.

I will remind everybody that the normal rules of the council on non-attribution apply, and our format is going to be a discussion between the three of us for about 25 minutes, and then we will open this up to questions from all of you for the remainder of our hour. Needless to say, I think we are having this discussion at about as propitious a moment as one could have. If anyone in the audience knows exactly where this is going from here, please stand up and tell us right now -- (laughter) -- and I assure you that Tim and Simon and I will dutifully take notes. In fact, you can take the podium if you'd like.

But we all know we're witnessing the most severe financial crisis since the '30s and that it has gone further and gone deeper and shaken more of the foundation than anyone that I know foresaw, certainly including me, and exactly what happens now, whether we've seen the bottom -- and as we're going to discuss this morning -- what the international and geopolitical implications of this is subject for great debate.

So I'm going to start, if I may, by asking a very basic question, which is -- and I'll start by asking this of you, Tim, and then I'll ask Simon to answer it too -- how do you think that this crisis alters the geopolitical balance of power, at least over the medium term, or does it?

TIMOTHY ADAMS: Well, that is a basic and key question, without a doubt, Roger. I think it certainly accelerates the trends that this council and other forum have made note of, of a diminution of power away from the U.S. and Europe to other nodes -- political and economic nodes around the world, whether it's China or Russia or the Middle East, and I think this certainly situates that.

I note a headline out of the Sydney paper that said, quote, "End of U.S. Era, Now China Calls the Tune." I note yesterday or the day before that the Pakistan delegation goes to China to raise funds for its government; Iceland getting a bailout from the Russians. And what we're seeing are countries -- and I think probably more over the coming weeks and months as this crisis convulses to the emerging markets. I know Simon has some thoughts about that, but that's the next shoe to drop: the number of countries that will seek refuge in the safe harbor of countries where cash is king and they have a lot of it or they're very resource-rich, or in fact those countries -- Russia, for example -- seeking to regain some of its prominence by reaching out to its former client states in a way that reasserts its authority, maybe in Central Asia. There was a discussion yesterday about the elections in Azerbaijan.

So I think it accelerates that process. I don't want to count the U.S. out. I think as we move from a unipolar world to a multipolar world -- a multipolar world without multilateralism likely -- that the U.S. is still the dominant power -- the dominant economic power, the dominant military power -- and will remain so, I think for our lifetime, but the world is going to look very different, and I think this speeds or accelerates that process.

ALTMAN: Just before you answer, Simon, I made the first of what I'm sure will be several mistakes today as my day unfolds, because that's been my usual style, and that is I'm so used to saying that the usual council rules on non-attribution apply that in fact that's not right for this morning. The meeting is on the record and is being teleconferenced regionally, so let me just correct myself so everyone knows that the ground rules actually really are. Simon.

SIMON JOHNSON: Thank you, Roger. Well, I think I'd like to disagree a little bit with Tim on at least some parts of the broad picture. I would completely emphasize and agree with what Roger said a moment ago, which is this is the worst, most severe financial crisis since the 1930s. I think it's also, almost without a doubt, going to be the most severe recession -- global recession that we've seen at least since the 1930s, and that's my baseline view. I think it could be worse.

Now, why is that good for the United States? My view is that, you know -- well, everybody is going to go down. This is a global synchronized downturn. The U.S. -- and the U.S. is going to be at the center -- is at the center of it, so the U.S. is going to have a very -- series of very big problems. It's actually going to, I think, be less affected and bounce back quicker than other parts of the world. And we can go through this in detail, but let me just quickly run through the reasoning here.

I think the Eurozone is in very bad trouble. I was, as Roger said, chief economist at the IMF through the end of August, so I'm not going to tell you how I know this -- (chuckles) -- but I can tell you that my very strong feeling is they still don't get it. They still don't understand the mess they're in. And in fact, we're in this mess in part because they were so slow to react in the middle of September. I think they will be obsessed with keeping inflation down. I think that will prove to be exactly the wrong policy. Charles Goodhart, a former senior Bank of England official said the other week that he thought that Eurozone would break apart. That's a remarkable statement from the former central banker governor. We can talk about that.

I think the Gordon Brown just bought the -- just acquired basically half the British banking system. Good luck to him with that. It's going to be very -- I don't think that makes his life any easier. I think that their position will become more difficult. And I think all of these problems -- and, as Tim said, it's happening right now -- feed directly into commodity prices. I think the price of oil is already high. If you look at the implied price of oil that's in the stock price of major oil companies around the world, it's much lower. I wouldn't be surprised if oil prices go down to something in the region of $20 to $30 a barrel. I'm not saying it's definitely going to happen. Obviously people in the market don't feel that way right now, but it's certainly possible. And I know a number of prominent emerging markets that have built their economies around this assumption of oil at somewhere in the $50 to $60 range, which seemed pretty conservative six months ago or three months ago. Now it actually seems like they're not ready for this. So it was economies based on commodity exports, including Russia, though not exclusively Russia; including Brazil, who's going to have trouble.

And then this is a question where I think Roger and I may differ on this a little bit and we can discuss it, is what happens to the big manufacturing export powerhouses, particularly China. How much does $2 trillion of reserves more or less buy you in this world when financial systems are disintegrating, when currencies are coming under enormous pressure, and when nobody really wants to buy your exports? To what extent can China switch into domestic demand? To what extent can they diversify their markets? I'm happy to discuss that further. My view is their prospects are also rather limited. So the whole world goes down; the U.S. goes down with it. Well, then the U.S. bounces back, but for reasons we can talk about.

So my overall message for everyone based in the U.S. and thinking forward about the U.S. is reassuring. The rest of the world, not so much. (Laughter.)

ALTMAN: Let's see, everybody's a loser and that's reassuring. Okay. I'm going to follow up one thing that you just said and ask Tim if he agrees or not agrees, which is that the Eurozone will be damaged more than the U.S. will be damaged. Can you agree with that?

ADAMS: Yes, relative to the U.S., simply for all the reasons that we have discussed: the structural rigidities in Europe, the lack of a labor mobility and product mobility, the absence of innovation, inability to have a unified fiscal response -- there's no central fiscal authority -- a central bank that has a single mandate that up until a few weeks ago seemed to take that mandate with a great amount of zeal in almost this zealous approach to inflation, which I thought was overdone at the time.

So I think, as I said before, never count the U.S. out. We have so many important attributes of innovation and -- I refer to it as the double I's. It's innovation and it's the intangibles. It's a great university system. It's the ability to innovate. We're going to wash our system; we're going to flush it. We're not going to be like Japan. We're not going to have zombie corporations. We're going to price these assets to their appropriate value, whatever that is, and we're going to wash them out of the system, and 36 months from now we're going to be back on our feet stronger than ever.

But I agree with Simon that this is a coordinated or a unified global slowdown. The idea of decoupling has now been completely dismissed. You know, in the election of 1992 Ross Perot talked about the great sucking sound of NAFTA. There's a great sucking sound going on now. It's called capital coming out of the emerging markets. And that is going to have a profound effect, as Simon has noted, across the board. Some countries, I think like China, will probably do better than others, but there are a whole host of markets out there that 24 months ago were the darlings of global portfolio managers and are now on the brink of disaster.

But, yes, Roger, I think the U.S. comes out of this better than Europe, for a whole host of issues dealing with structural rigidities and our ability to respond.

JOHNSON: I would just add to that list -- all of which I would agree with -- I would add two things and one piece of evidence. I think the balance sheet of the U.S. is much stronger going into this than the Europeans, so obviously the federal government -- (inaudible) -- put on the table or acquired at least a contingent responsibility for about 70 percent of GDP over the past two weeks. If you add up all the bits and pieces, you know, it's real money. But we go into it with, you know, private sector holdings of government debt below 50 percent. We can afford this, we can afford more, and we will grow our way out, for the reasons that Tim said.

Not to pick on anyone in particular, but look at the U.K. where you have bank liabilities -- assets and liabilities six times GDP, right? The -- (inaudible) -- banks are different, basically. And, you know, Gordon Brown just acquired the Royal Bank of Scotland. It's now under his control and he's already saying what the lending policy will be. That bank has a balance sheet equal to the GDP of the U.K. So how they manage that, how they manage that through the recession and how they manage, you know, government-controlled lending without getting themselves into even more trouble is a very interesting question. The U.S. is not going to go there.

And the other thing I would emphasize is the flexibility of U.S. policymakers. And I think you have to have sort of been through a lot of things with them, closely watching them and talking to them, to see that they're very -- and I know they've had a little bit of a bad press recently, and obviously mistakes have been made. I'm not a second guesser. I have never claimed that I would have done anything different from what they did. I'm in the business of trying to come up with creative ideas moving forward, not recriminations.

The U.S. policymakers have consistently tried to really come up with smart, innovative ideas, particularly of late, and they deserve a lot of credit, okay? It's not enough --

ADAMS: I agree with that.

JOHNSON: -- we are going to go into a recession. The Europeans have not. The Europeans have basically gone from denial to complete disarray to being somewhat disorganized. And finally on Sunday, I think under a fair amount of pressure and with a reasonable amount of luck actually -- that that was when the G7 meeting was, that weekend -- that they actually managed to pull something out that I thought Monday was reasonable. Wednesday it doesn't look so good, right, because the markets went down and overnight doesn't look so -- so we'll see what comes out of that.

But Eurozone policymakers in particular, at the national level and at the Eurozone level, are not flexible. They have an inflation mantra. They are perfectly positioned to handle the 1970s. This is not the 1970s; this is something very different, and the U.S. knows this. The guys at the top of the U.S. know this now, all right? Maybe they should have woken up a week earlier, but they've woken up. The Europeans, not really. And the piece of evidence I just threw out there is what of course is happening to long-term interest rates in the United States. Despite all the disruption, despite all the problems seen around the world, these rates are low, they've stayed low, and in fact in some of the most stressed moments over the past few weeks the dollar has actually strengthened, particularly relative to the euro.

So the U.S. is a safe haven. People believe in the U.S. balance sheet and they believe in the ability of the U.S. to bounce back, and they're right, and that's how the U.S. will come through.

And I didn't mean to be flip, and I'm sorry if I at all injected a humorous note. My wife gives me a very hard time for this. She says, you shouldn't smile and laugh when you're on television, but, you know -- (chuckles) -- if you don't try and make it a little --

(Cross talk.)

ALTMAN: -- making a career out of it. (Laughter.)

JOHNSON: If you don't try and see the positive side here, Roger, a lot of people are going to be a lot more depressed.

ALTMAN: I agree with that. Well, we're going to have a very hard time fitting into allotted time this morning all the questions, but let me turn to this one. You're both reflecting quite a bit of optimism about the snap-back, at least here in the U.S. Let me strike a querulous note on that by asking this: How damaged is the system of what I'll call Western finance? I happen to think it's quite damaged. And why do you think it's going to be such a short time for it to recover to what we'll call normal, healthy functioning in terms, say, of credit flows?

ADAMS: Well, I think if you're using the last seven years as your baseline, we won't snap back to that, for a variety of reasons. One is I don't think banks are going to get back in the lending business. We can force them as much -- Hank can call them up and urge them to lend, and the chances are Brown will call them up in the U.K., but I don't think it's going to happen. I think we're going to see a replay of what we saw in the early '90s where you simply used your deposits and go out the longer the yield curve and try to use the spread to rebuild your balance sheet. That's a long, tough process, and I think the animal spirit of the lending community is gone for a considerable period of time. In fact, we've just taken out a whole piece of our infrastructure, and that is the mortgage piece of it.

So when we do have an up-cycle in housing -- some day it will come -- you know, I'm concerned that there is the absence of the infrastructure to take advantage of that upside. I think we're in for a long, tough period if it's relative to the period that just ended, and that is because household balance sheets, especially for the lower 50 percent, the bottom 60 million households in this country, are probably under water and getting worse. They have very little liquidity. They live paycheck to paycheck. And over the past two years they've spent $400 billion more than they've earned. And how did they do that? They did it with cheap and abundant credit that's no longer there.

And so I think -- in some ways I think that Senator Edwards was right; there are two Americas. There are multiple Americas, but there are certainly two Americas, and those at the bottom half are going to struggle through this period, not for two years, not for three years, but maybe for a decade. But I do think that banks are going to be hoarding cash, protecting capital, and trying to protect their balance sheet for a long period of time, and this period that we've been in where we've seen this -- (inaudible) -- around the big high-cost banks through the securitization process has now ended. I don't know what replaces it, but for the meantime we're back to the big, high-cost institutions that we were told 24 months ago couldn't be managed, and there was a question about whether they could actually manage the risk, but that's not a centerpiece of our financial system.

Whether it's that way five years from now I don't know, but it is not going to be a recipe for swift response with respect to getting credit flows, which is why I think you'll see the federal government more involved in directing credit, whether it's student loans, whether it's mortgages, whether it's supporting state and local governments. I think what you'll see is, out of Washington, a more activist government with respect to where capital flows are going.

ALTMAN: Let me ask you to answer that question, Simon, but let me punch it up a bit. Martin Wolf was here at the council yesterday morning and he spoke his usually -- usually a very trenchant way, but one of the points he made was the following, that we've seen 50 years of finance evolution in three months and now, he argued, what you have here in the United States is the emergence of a European-style banking oligopoly, which he said is cozy but not conducive to entrepreneurship and growth. And that's another way of asking the same question: How damaged and changed is the system of Western finance, and what does that imply for recovery?

JOHNSON: Well, I think it's a system of global finance, Roger, because everyone who is doing any kind of modern industrial production or service operation is using the same sort of financial system and these financial systems got highly leveraged, and I think it's the degree to which you can sustain high degrees of leverage and large bank balances relative to the size of national economies. That's really an important question everywhere and -- you know, I won't name particular countries but I'd say broadly across emerging markets that's absolutely true. I think obviously what's happening in Russia, which is very much in the public arena so I can discuss it, is just the canary in the coal mine in this regard. So the entire system, the way in which we structure and involve financial credit in production is going to be rethought, and it's damaged everywhere.

Now, in that context I think what Martin is saying and what you're saying is very important because the issue is going to be to what extent can a country find innovative ways around these bottlenecks in the existing system, new ways to come up with forms of credit, new kinds of lending instruments that do not create system risk? And the issue for the U.S. I think is exactly going to be when we consolidate regulation -- because it's going to be consolidated; you can't play nine big guys against 54, 55 regulars anymore. Yes, you're going to have one or two big consolidated regulators quite quickly would be my prediction, all right, and they'll integrate securities regulation and banking regulation I think much more than in the past because it doesn't make any sense to keep themselves separate anymore.

But the question is, when you do that, do you do it in a way that encourages this entrepreneurship? Remember, I am a professor of entrepreneurship. In addition to doing very macro things I work on very micro things. And so, you know, if you take the ideas and the innovation comes out American universities, we're very good at finding productive ways to put them -- ways to put them to work in new start ups and new ideas in the U.S., and that's actually one of our big advantages. Can we make that happen in the financial sector or do we put such a -- do we get so scared by what happened that we say, no, all we do is just pure, plain vanilla stuff? And then I think it's harder to recover.

But, as I said, I believe in the flexibility of U.S. policy and I believe the Congress will come up with some sensible legislation, and that will allow innovation within a system that will be much more severely constricted than in the past, for sure. Other countries will struggle with the same problem and they will not find such good solutions.

ALTMAN: Let me just interject one of my own comments. I think what you might be missing is the following: Markets overshoot -- markets chronically overshoot, and when they do so in an extreme fashion we see bubbles, and bubbles, for better or worse, actually occur with considerable regularity, this being one of the worst, but we've had lots of them. And then when they overshoot on the downside, which is what we're seeing now, of course the psychology overshoots too. And in this particular case what I mean is we're entering into a period where the psychology of lenders and the psychology of all sources of finance is going to overshoot, to a great degree, to the conservative side, and it's going to take quite some time -- it always does, longer than rationality would suggest -- for the psychology to return to normal.

So if you think of the psychology of risk management systems, of credit standards, of all lending criteria, just to name three, we're going to go into a period where it's going to take -- it's going to be extremely conservative -- in effect the once burned twice shy mentality -- and in my experience over almost 40 years in finance, it's going to take longer than the equations and the analysis would suggest for that extreme conservative psychology to come back towards the center. And that's a reason why, in my view, the amount of time it will take to return to what one might call normal, healthy credit flows is going to be longer rather than shorter.

ADAMS: And we may make it worse in Washington. If we have a Congress that rushes in -- and I believe Simon is right; I believe there is going to be a rush to rewrite the regulations and rewrite the institutional framework. If we end up with a financial version of Sarbanes-Oxley on steroids, we're going to have real problems. And it's going to be in law for the next 50 years. Think how long it took us to undo -- (inaudible) -- and you might argue whether that was smart or not, but once this new regulatory regime is put in place it will be with us for our lifetime, and my fear is that there are enormous unintended consequences coming from that, but there will be such a political response, just as you noted in markets and psychology, that Washington overreacts, that it will only exacerbate the very problem that you just laid out.

JOHNSON: Okay, well, I have two responses to what you're saying. First of all, I think it's actually going to be a lot worse wherever possible, but in addition to your psychological point, which is very important, you're going to see defaults, you're going to see people rewriting contracts, you're going to see the kind of behavior we've seen in a relatively isolated form in emerging markets over the past 20, 30 years when they've run into financial problems, but you'll see it in a much more synchronized way across lots of countries, including countries that you'll be amazed when it happens there, right, because you thought it was sort of not an emerging market.

So they will have the psychology problem and the rewriting of contracts, the breakdown of relations with creditors, and then it's a terribly long workout process. I don't think the U.S. is going to have that. I think the U.S. will actually have more inflation or be comfortable with more inflation than some other places, and that will help a little bit smooth this out.

On the how far it takes to come back -- you obviously know much more about finance than I do, but I do know a little bit about technology because I work at MIT and I work a lot with technology entrepreneurs, and the psychological facts of the Internet's run up and then the bust were quite profound. You know, nobody wanted to touch anything to do with new technology for at least three or four days. (Laughter.) And then they start thinking about new -- honestly, these guys are crazy. I don't so this. I'm a professor. I'm a very -- I should say I'm a very positive, optimistic person. I was not bearish about the global economy, not that bearish until the Lehman, AIG sequence of events, okay? I moved my view. I'm very proud of that. That's the point of the website; I communicate -- I'm trying to communicate what my view is and why it has moved and what continues to move it, and how you can turn things around.

So I do, it's true, have a positive, somewhat optimistic bent, which you may be resisting, but at the same time I've seen it -- I mean, I've seen it with the MIT students, I've seen it with the people around MIT, and I've seen other countries come to MIT and try to learn from us: How do we get this kind of dynamic optimism in an entrepreneurial sense? And, you know, we try and help them but it's basically an impossible task, right? Now, you may be right that finance is different. It could be that finance is different and the same sort of enthusiasm won't spill over, but then I think the entrepreneurs will figure out how to grow companies without any external finance. Don't ask me how they'll do it, but these guys are pretty good.

ALTMAN: Two quick responses. First of all, the events of the last year have instructed me that I actually know nothing about finance -- (laughter) -- but secondly, I have a rather different memory of the fallout from the dotcom bubble than you do. But in any event, I want to rattle off about three quick questions before we have to turn to the audience.

First, let's get a little deeper into the implications of this for the LDCs, or the emerging countries. There's a lot of talk that those emerging countries that run current account deficits are going to go back to some version of the 1997, 1998 crisis. What's your view on that? And I'll start with Tim.

ADAMS: Well, I think it's going to look different in that it's less the sovereign problem now and more the corporate problem. We've had about $800 billion flow into emerging markets just last year. That will probably be, in 2009, a number about half that. It's principally going into the corporate sector, but there is foreign direct investment taking advantage of the natural resource sectors in many of these countries, but there's a tremendous amount of corporate borrowing -- not equity but debt -- and a lot of that debt is going to have to be rolled over in the next 90 days and the next four quarters.

So I think what you're going to see is enormous stress in the corporate sector of many of these emerging markets, and therefore you could see nationalizations and public support for the principal corporates in many of these countries, which is just going to add to their own balance sheet problems. But those countries which have been running a large current account deficit and have been dependent on foreign capital or imported capital -- and I remind myself that we import $2 billion every single day to run our economy -- I think it will be tougher for them to import capital and I think they're going to pay more for it.

So I agree. As I said, it's a great sucking sound of capital coming out of the emerging markets and that's going to have a profound impact, especially for those who have been living on the edge anyway, the outliers, but I think it flows into even the countries, as I noted earlier, that were the darlings of the market just 24 months ago.

ALTMAN: Simon?

JOHNSON: Absolutely we're in a period of very rapid -- not total but very rapid outflows of capital from most emerging markets, and of course I think the hedge funds have pretty much left. Now it's domestic investors who are really trying to crowd out the exits. I would divide the countries into three categories. The first is the obvious ones that have large credit account deficits, and for the reasons Tim mentioned it's very hard for them to finance that. You know who they are; they're mostly in Eastern and Central Europe, but there's some others scattered around the world.

In addition -- and that's been a fairly obvious vulnerability in the world for some time, but in addition, what we're seeing now is cracks -- very important big cracks in countries where the government holds lots of reserves and had actually been very conservative, but the private sector has acquired lots of debt, so Russia will be an interesting example. The numbers in my Washington Post article on Sunday, roughly speaking, gross liabilities are about equal to -- of the private sector -- are about equal to the reserves of the central bank, right? And the central bank -- you know, we can discuss strategy for or against doing this, but so far they seem to have committed about $200 billion to basically replace the buyout of those positions and shore up their banks as a result because the banks would obviously have a problem if they can't rollover their debt.

Now, so you immediately sort of change the basis of calculation. It's not the solvency of the Russian government sector -- official sector anymore; it's what's the balance sheet of Russia? What's the rollover risk? How long are capital markets going to be closed? How much capital is going to leave? When should they -- when will they want to spend their reserves? And of course the IMF is -- also in the newspapers -- is considering or is about to make a bunch of loans to emerging markets, and this is going to be a key -- this is a key strategic question: To what extent do you allow the oligarchs to get out of their positions basically, right? So I think there's a big, big problem there for them, and that's a large set of countries.

The third set of countries that we see are those for whom exports at the margin are an important part of the economy, either because its commodities -- and this is a lot of countries -- so 80 or 90 countries in the world will be hit very hard by what I expect to happen to commodity prices. I don't know how you word that; it's not a matter of reserves. It's not a reserve issue but a cash flow issue.

And then of course there's manufacturing exporters -- and this is where I hope you'll come back here a little bit on China, Roger, because I know you have views on this subject. You know, I would like to believe that $2 trillion is a lot of money. I used to think it was a lot of money. It sounded like a lot of money, you know, two months ago or three months ago, but given the nature of the problem we're facing, given the destruction of finance, and given the fact that China isn't particularly responsible for any of this -- well, we can argue about the capital flows piece, but their markets I think are just drying up, and their ability to switch into domestic consumption -- and this is obviously not typical of China, but in general, just like other emerging markets, government consumption is a small part of GDP, less than 20 percent. Infrastructure is pretty much bottlenecked; it's hard to get more money through there. You can say they could spend a lot of money building a social safety net and pension system -- I'm in favor of that -- but that's a five- to 10-year project. That's not going to get them through the short term.

So I think -- I mean, I would like to be convinced, or I would like you to convince me otherwise, but I feel pretty negative about them. And my three categories basically exhaust all the emerging markets in developing countries out there.

ALTMAN: All right, let me follow that up, although I want to also get to the dollar, and one or two other issues before we open this up.

How negative effect will this have on China?

JOHNSON: I thought you were going to tell me.

ALTMAN: No, I'm going to ask you. (Laughter.)

JOHNSON: (Laughs.) To me, that's implausible. I think we can see pretty much, you know, how a lot of this plays out, including in some rather unpleasant ways in the Eurozone, because we know a lot about the policymakers and how they respond. We know a lot about those economies.

But, you know, the Chinese economy has many black boxes inside other black boxes, and the question is how many flexibility does it have? Can they switch -- could they switch to being a more domestically driven economy? Theoretically, absolutely -- and a good idea. And would be (laughs) kind of -- (inaudible) -- to do it.

But, it's hard to know. And it's -- (inaudible) -- even after talking to lots of the policymakers, it's hard to know, do they get it? Do they want to do it? Can they do it? Can the do it quickly? I'm not sure.

The $2 trillion buys them time, no question about it. They're not in the same category as Russia, as far as we know. I'm pretty confident about that. So, the immediate pressure is not there.

But, if you think that we're in this big, fairly rapid global slowdown over the next six to nine months -- and that affects, you know, all the markets where they (place their ?) exports, and you think that those exports would be adversely hit -- which is, would be my expectation, then, I'm not sure.

I think it's -- there's a big slowdown. And, you know, their economy's obviously got a productive dynamic -- (inaudible) -- tended to be more tied to exports. Then they have a less productive, more stake-driven part, right, where the bad loans have traditionally accumulated, and that's essentially more domestically oriented.

So, particularly, can these productive export -- (inaudible) -- towards the domestic market and make money doing so?

ALTMAN: Let's turn -- let's turn then to a big imponderable, which is the implications of all this for exchange rates. And I think there are as many views on this question out there as there are people who are interested in expressing them.

But, Tim, what's your point of view, starting with the dollar?

ADAMS: I think the dollar is something of a safehaven, in the short-term, as this crisis convulses through the emerging markets. And capital is a coward, it goes where it's treated well. We treat it well in the United States, and so I think it comes here.

Longer term, though, I worry about a world awash with dollars in treasuries. We're going to -- we're going to issue lots of debt over the next year. And I suspect we're going to re-inflate our way out of it.

You can't tell that now because we're in a deflationary period, but I think the magnitude of the policy response -- with more to come on the fiscal side, and maybe even more to come on the monetary side -- is that I think we're sowing the seeds for another inflationary period, the next double. It may be three or five years down the road.

But, I think that's how we ultimately get out of this is, is we're going to re-inflate asset prices, and we're going to do it aggressively. That --ultimately, that is less attractive for the dollar.

But, I think, in the short-term, it is attractive -- the capital flow here, because it's a race to the bottom. We've led this cycle, and the emerging markets and the Europeans are going to be cutting rates behind us. And just on a sheer interest rate differential, I think the dollar benefits.

ALTMAN: Simon?

JOHNSON: Yeah, I think I broadly would agree with that. I think the dollar clearly has been a safehaven over the past few weeks, and those were -- (laughs) -- pretty upsetting week. Right now the European balance sheets don't -- balance sheets are in play, and the European balance sheet doesn't look as good, and the Eurozone obviously has issues going forward.

So, I think that this all -- and, as you know, I guess, the implied inflation in the -- if you look at the U.S. index bonds, they're at 1 percent -- 1 percent a year -- (inaudible) -- over the next 10 years.

I would agree with -- tend to agree with Tim that that's a little optimistic, that what you'll tend to get is -- (inaudible) -- inflation of asset prices, as opposed to, sort of, more general wage-price inflation, asset prices stay where they are, and the real burden of debt goes down. I think some degree of that, at the margin, would actually be helpful, including to the poor people, who Tim stressed -- rightly, how vulnerable they are in the U.S.

Of course, if inflation gets out of control, then everybody's got a big problem, including, and particularly, the vulnerable people. (Inaudible) -- I'm not suggesting it's a panacea, nor is it my recommendation at this point, but I do think it seems likely to be in the cards.

I find it very hard to believe the Germans would ever want to go -- move toward and kind of inflation. Even 2 percent -- (laughs) -- makes them uncomfortable. I think the French will stay in very close to the Germans.

I think other European countries will increasingly wonder if they really should go through such difficult times in order that Germany can keep inflation down at 2 percent. I think they'll see other countries around them, including the U.K., who will tend to inflate their way out of this, and that will have repercussions.

So, inflation -- (inaudible) -- strong short-term inflation in the U.S., longer term, how that plays out -- (inaudible) -- how the other big currency -- (inaudible) -- are doing politically.

ALTMAN: All right, let's open this up and take questions from all of you. The floor is open.


QUESTION: Yes, I'd like to spend a little more time on China. -- (inaudible) --

ALTMAN: Hold on a sec, Joe -- to mike.

QUESTION: I'd like to spend a little bit more time on China because they're kind of the big unknown here. And that is, do you believe that they're going to go through a recession -- the way the global recession is that you're talking about? If they are, how are they going to use their reserves right now?

And what's that going to do towards their continued move from socialism to capitalism? In other words, internal unrest?

JOHNSON: Well, -- can I, can I start with that one?

ALTMAN: Sure, please do.

JOHNSON: Well, the joke in the U.K., of course, is that, you know, if you remember the 1983 British Labour Party manifesto called for the nationalization of banks. So, Gordon Brown's actually achieved that this week. (Laughter.) So, I'm not sure anybody's on the move -- anybody's moving from Western socialism to capitalism. That's a global remark.

On China, I mean, it's a big unknown. It's not that big, remember, I mean, they've -- in talking in global terms, they're about 10 percent of GDP, if you use the -- the weight in the purchasing power parity weights, which tends to play their role up -- expand their role.

So, I think what happens with China is important for China. I don't think it saves the world economy. The idea that China can, sort of, pull the rest of us out of that strikes me as being somewhat implausible.

How they're going to use their war chest is a great question, and maybe Roger can speak to that. You can think of some very interesting, strategic things they could do to support other countries, particularly relatively small countries that will -- you know, perhaps, don't want to go to the IMF, for whatever reason; perhaps don't want to approach their, sort of, usual sources. And, of course, the U.S. Treasury may have less ready cash than in some previous crises.

And will China step in and make strategic investments there and help out people? That I don't know. I mean, that -- you could see them -- that obviously plays, or goes into the geopolitical issue, coming out of this.

Maybe you come out of this with the U.S. and China as two bigger -- relatively bigger players into world. compared to everybody else. I'm not sure.

I mean, the Chinese economy strikes me as being not sufficiently flexible. There's a lot of rigidity in any middle-income country. It's very hard for them -- it's very hard for them to handle it. But, they have handled some pretty big bumps in the road before, so we'll see.

ALTMAN: I'd add one comment. I believe that the Chinese authorities are interested in playing the role that Simon just alluded to -- in other words, making a series of what you might call strategic investments which, among many other things, would help accelerate the development of a more modern infrastructure within China.

That infrastructure might pertain to financial services, or it might pertain to other industrial sectors, but, I believe they have that as a goal. Now, whether they actually pull the trigger and begin to implement it or not, I don't know. But, I think that's one of the things that's very much on their minds, based on information that I've seen.

ADAMS: They do have enormous fiscal capacity to build lots of railroads, lots of highways, lots of bridges. And, like other places, they won't be bridges to nowhere -- schools, public buildings. So they can turn on the fiscal spigot, and they can do it fairly quickly, and they can do it in a very massive fashion. The problem is that there's a lag effect from the time it's turned on until it actually makes a difference.

I think (we ?) probably have a soft landing -- exports were growing close to 26 percent last year; 40 percent of their exports go to the U.S. and Europe. That obviously is going to decline, but still an investment-led economy.

Some of that investment is a function of exports, but it's still investment led and I think if they take pretty aggressive action they can probably get by with a soft landing, but a soft landing of 8 percent, which may, for some, feel like a recession if you're used to 12, or 13 or 14 percent growth. We really don't know what their growth rate. We know what the numbers say, but it could be more.

QUESTION: But, they'll still be growing?

ADAMS: They'll still be growing, absolutely.

JOHNSON: Well, I'm not so sure about that. (Laughs.) I mean, I think one thing that's very important in these situations is not to suffer a failure of imagination. I mean, I think we've had a number of really big disruptive events in the past few days. Basically, an emerging market crisis broke out at the core of the world economic and financial systems. We've never seen anything like that, to my knowledge, ever, okay.

So, I would not necessarily want to assume that China continues to grow. I mean, the numbers will probably show growth -- (laughs) -- as Jim said. I'm not -- I would not want to assume they necessarily continue to grow. I think it depends on these -- (inaudible) --

Of course, I could throw one other geopolitical -- (inaudible) -- into the balance. You know, if the Chinese were really able to get strategic on -- they could do the following, they could actually set up a Asian monetary fund, which has been very much discussed. They have these currency swaps, which have been built out of the -- (inaudible) -- Chiang Mai Initiative. And there's been a lot of interest in Asia in doing something like this for a day like this.

Now, they haven't done it. It's not in place. It's very hard to put in place any kind of institutional arrangement of that nature actually in a crisis. And China's relationship with the rest of Asia is obviously not uncomplicated.

But, they have a lot -- they have a big war chest. Other countries definitely would like to be able to participate in the cover provided by that war chest. So, that would be a very big strategic shift which, if it happens, would really change a big part of the world.

ALTMAN: Okay, let's take some other questions.

Yes, ma'am?

QUESTION: Barbara Samuels.

I wanted to push on both sides of the equation, in terms of more on the financial architecture. You have Gordon Brown suggesting we have a Bretton Woods II. We have, at the U.N., the Financing for Development powwow with heads of state, ministers of finance, and the like, at the end of November.

And at question really are the roles -- we already see the deteriorating role of the IMF, the World Bank and others, and the rating agencies are on play here, what are the kind of big ideas?

Political leaders are under pressure to really say, 'how can we be more successful?' How can -- instead of having Chavez, China and others go into developing countries and fill the hole that was big before but even bigger now, what can we do there?

The other side of the spectrum, of course, is risk management. We have failures. We're being criticized there. There's a real opportunity here to really look at the ways that we do credit analysis, securitization, derivatives and the like. So, on both fronts, what are the big ideas that we need to push for the third way? Thank you.

ADAMS: First of all, I support the idea of returning to Bretton Woods, or some similar location -- Bretton Woods is nice this time of year. And if we did nothing other than reaffirm our post-war principles and values, and our belief in trade flows, and capital flows, and that these institutions matter.

There have times where I've been very tough on the Fund. It was tough love, because I think it matters. It's imperfect, but it's the best we have. And if we start trying to reinvent or invent new institutions, it takes some time. We should embrace the Fund and try to make it a useful instrument for our collective objectives.

I think one of the big ideas is to look at why so many emerging markets exported capital to the developed world. Because our models and theory always told us that capital should stay in those places because of the abundance of labor. Why do they export capital -- as Martin Wolf said, to the U.S., which was like "one big hedge fund" that just intermediated its capital and then sent it back out.

The reason is there's no financial infrastructure in many of these countries, and they lack the institutional framework. They don't have rule of law; they don't have a judiciary system; (they don't have ?) enforceable contracts.

If we can find ways through a development agenda that creates the institutional framework that savings can stay in these countries and be intermediated there -- it doesn't need a round trip through New York, it's hard for those here who do that -- then it's a way for those countries to become stronger in terms of, more resilient in terms of global shocks, but they can put their own capital to work, and take a development approach that's more bottoms up than pouring capital in from the top.

JOHNSON: So, let me reply in three pieces. First of all, the IMF does have a role today, and it's a good thing you have the IMF. The IMF has that $200 billion in ready cash. I would guess they could lay their hands on another $100 billion pretty easily. That can actually help a lot of emerging markets countries.

Now, we can discuss the strategy. I'm not sure the strategy they will be recommending is what I would be recommending, but that's a -- that's a different issue. At least there's a -- there's a firewall there. If it's used well, I think it could actually be very helpful.

But the IMF's role, obviously -- the traditional role, and the role they seem likely to play this time around, is as firefighter and a helper for emerging markets that are vulnerable to large capital flows, which is just about everyone right now.

I think Gordon Brown is putting on the table a very interesting question, which is, where do we go from here; what's the bigger architecture? And I don't think anybody has any particularly good ideas there, except to say it's probably not the existing traditional Bretton Woods institutions. Those who've got a certain amount of baggage, have a certain amount of history, they can continue to play a role. But, I think he's looking for something bigger, broader, and something that involves spa treatments and hotels, which is probably not a good -- obviously, not a good idea to do that now.

I think we have to get through -- I don't think you'll see anything until we get through the worst of this global recession. I think people are not ready to do it. If you know anyone who is ready to put $2 trillion on the table -- oh, I guess we do know one country -- (laughter) -- China, then, you know, maybe you can have a conversation about that, but I really don't think that's, that's a realistic possibility. It could be a little bit of a distraction, if anything.

On mismanagement, I would say the following: I've, among other things, you know, done some work on mathematical models. Some of my very best friends are quantitative finance people. I've even published in quantitative finance journals. I knew we were in trouble last August when I --

ALTMAN: They must have a lot more time to talk to you now.

JOHNSON: (Laughs.) You know, they're a little -- a little down, some of them. But, I -- (inaudible) -- in trouble last August when -- (inaudible) -- quoted in the newspapers as saying that his models, or the models they were working with, were -- at his shop, were good, except for events that occur once every 10,000 years. And he said we've had three of those this week. (Laughter.)

So, I think that -- I think that quantitative finance is going to end up being constrained to a rather small part of the economy. There will be limits set on it relative to the size of GDP. And no one is going to be so very confident in mathematics, and the management of risk, through anything that can't be understood in plain language when you tell it to the C.E.O. I don't think we're going to go back to make that -- we'll make that very same mistake again. We'll make different big ones.

ALTMAN: Yes, sir?

QUESTION: John Beatty (sp) from UBS.

You seem to be relatively sanguine about the prospects of the U.S. economy, however you haven't really discussed the increasing size of the U.S. current account deficit. Given the dearth of U.S. domestic savings, there's an increasing need to rely on foreign direct investments to finance these deficits.

As time goes by, do you really think that the rest of the world will be willing to continue to finance the U.S. current account deficit when sovereign wealth funds, in particular, are increasingly looking to diversify their investments into other areas?

ALTMAN: -- (inaudible) --

ADAMS: Well, as I noted earlier, we import $2 billion every day to run our economy. We spend too much; we save too little. And I suspect those trends are going to change. And I'm actually hoping for a change in values in this country, in the sense that we begin to live within our means and we decide that we don't need to fill our house -- houses full of stuff that we buy from other places.

And so if we can see a rise in household savings -- which have been dropping for 30 years, we didn't get here two years ago, or five years ago, this has been three decades in the making -- if we can see that transition to higher household savings, and living within our means, I think that's a positive long-term trend. Getting from here to there can be quite painful.

Running a current account deficit, or a capital account surplus isn't necessarily a bad thing if those -- if those investments are used for productive enterprises which create a cash flow that pays for itself. Unfortunately, a lot of what we borrowed went into building housing stock that, as a percentage of GDP, became the highest since the 1950s. And what we found was that we've got excess housing stock and that housing stock isn't worth what we thought it was two years ago.

So, it wasn't into productive enterprises; it wasn't into something that created a cash flow so it could pay for itself. It went into an asset which is now dropping in value. So, the theory is not a bad thing, but I think for us we need some substantial changes in the way in which we run fiscal policy, and the way in which we approach household savings and the way in which we spend -- both at the federal level, but also at the household level.

ALTMAN: Let's get a few more questions in.

Yes, ma'am -- in the back?

QUESTION: Hi, Cathy Taylor (sp), Dutch's (sp) friend. Thanks very much for your comments.

It may be a small issue, given the magnitude of what we're dealing with and the largesse of most of the companies involved, but it concerns me that I've heard virtually nothing from the government, or really anyone else -- the Press, about small business. And small business has historically been the real engine of growth and job creation in our country, and even more importantly in emerging markets.

So, without access to the very open Fed window that the larger companies have, what do you see as some of the prescriptions for small businesses that are not going to see the (raft ?) that they expected, but might be able to help fill in that 8, 10 percent forecast of unemployment?

ALTMAN: Simon, do you want to --

JOHNSON: Well, that's -- that's an absolutely essential issue in this economy and others. The small businesses are going to get very much squeezed. And this is where, you know, you have to decide who -- government has to decide to what extent they want to get involved in lending.

Gordon Brown has said, one of the things the Royal Bank of Scotland will do is lend to small businesses. So, you might feel good about that. On the other hand, this is politically directed lending. It always goes wrong everywhere where it happens, right.

A little bit, though, could help. And so I think some temporary measures to try and smooth out that part of the credit hit for small businesses -- for example, in the U.S., would be worth thinking about. But, it's very hard to design a way to do that that doesn't start to become a monster, a political monster that then creates lots of other problems.

So, I think that sector is really going to be damaged. Bigger businesses, as you say, will probably come through this relatively well, because, you know, Mr. Paulson has created what I'm calling an ark. It's a very nice ark, and it's got some nice chairs on it, and -- (inaudible) -- got seats on the ark. But not everybody got seats on the ark. (Those, as you know, hunt the unicorn, ?) is now a little bit of an issue in this economy, and more globally, right.

There's a lot of people who are vulnerable. And a lot of people are going to be hurt by this, and the small business sector is definitely going to get damaged.

ALTMAN: I'm afraid I agree with that.

Yes, sir?

QUESTION: Peter Schlesinger (sp).

It seems that the subprime was sort of the catalyst and the instigator of some of this downfall; and also the derivatives that very few of the investors were able to understand, particularly foreign investors. Do you think that there has been enough emphasis given by the institutions to help in that area? And how much more danger is there out there? And are we still going to receive more surprises, do you feel, in the magnitude of the subprime loans?

ALTMAN: Tim, do you want to take that?

JOHNSON: Yeah, well, could I -- could I start with that one?

I think this is really very important and we don't lose sight of this, because there is still an underlying housing problem in the United States. And while many sensible policy proposals have been put on the table and then quickly adopted in the U.S. over the past few weeks, I don't think we've really got to grips with, or come up with ideas for how you break this debt spiral in falling house prices, foreclosures, forced sales, further falling house price.

In many communities in the U.S. it's absolutely devastating. You have to find a way to get in there earlier, and find ways to keep people in their homes, and find ways to restructure their mortgages. And none of this is stuff we're very comfortable with in the United States, okay.

There are people with Fannie Mae and Freddie Mac -- who, by the way, now work for the government, who actually quite good at taking over foreclosed properties and finding ways to limit the losses of that foreclosure. You need to find a way to scale it up and get them earlier involved, so that when mortgages already go delinquent they're involved in restructuring and keeping people in their home. Some sort of rent-to-own program would be one good idea.

Option ARMs are a train heading straight for it. Anyone who thinks that most option ARMs are not going to go delinquent, we can talk afterwards. You just have to get ahead -- we have to, I'm afraid, put some ideological and other preconceptions to one side and get serious about the housing problem.

That will -- you don't -- you can't turn it around -- it's a two, to four or five year problem there, you can't turn it around completely. But, if you could show that the house prices are going to stop falling, and that there's sort of a deceleration of the fall, at least, that would help a lot, I think, turn around other parts of the economy, including the real economy.

ALTMAN: Other questions?

I'm going to pose one myself, then.

Fiscal deficits. It's likely to emerge that the U.S. faces not only the largest nominal deficit in its history, but --

(Audio recording cuts off here for approximately 40 seconds.)

JOHNSON: (In progress) -- direction, because they feel themselves to be more fiscally constrained. They're worried about their balance sheets. And I think they're -- they're probably making a mistake, under the circumstances, but that's, that's where they're coming from.

They would like to claim they have stronger automatic stabilizers -- and that means we don't have to use as much discretionary fiscal policy, but I think that's a, that's a "business as usual" thinking that's going, that's going to really constrain what they do.

You know, obviously, what matters, geopolitically, is what you buy with your money. And so what's happening to commodity prices? What's happening -- you know, how much fuel do you need for your aircraft carriers? Can you, can you go out and build -- do you put some of the money into military spending, or into keeping the, you know, U.S. hard and soft power strong? I think those are pretty good value propositions, actually, in this environment.

Europeans will most certainly cut back. They will use much -- something much closer to the fiscal austerity that has got people into trouble in previous severe episodes.

So, again, I think this shifts the relative balance towards the U.S. Although, I'm not sanguine about it, and don't say I'm sanguine -- I'm relatively sanguine, yes, but everybody goes down, it's a disaster, right? And the question is now managing disaster; coming out of it; and making sure we do have a snap-back.

The snap-back is not guaranteed in the United States. That depends on good policy. I'm putting my faith in good policy, good politics in the U.S., which I think will come through. But, that's not all a done deal.

ALTMAN: Where I disagree with Simon is in the use of the word "snap." (Laughter.) Tim, do you want to comment?

ADAMS: Enormously constraining, especially with our ability to project ourselves globally, and at a time when we probably need to provide more bilateral assistance. In other places around the world we're simply not going to be able to do it, and we'll be constrained on a whole host other fronts.

It couldn't have happened at a worse time, as we think about the retiring Baby-Boomers; Social Security goes cash-negative, 2017; asset-negative, 2041. And that's, that's a tenth of the problem that we have with Medicare and Medicaid. We have enormous long-term, medium-term and short-term fiscal challenges in this country. And I hope -- I hope whoever the next president is can address them.

We've seen in Sweden, in Canada and other countries throughout history -- recent history, use financial (crises ?) to get their fiscal house in order. This is a wake-up call for this country, and we should seize it.

ALTMAN: One more host prerogative: I want to ask someone in the audience what they think of the emergence of these unprecedented deficits.

Rick, what do you think the impact of these will be on financial markets, and the recovery -- financial recovery pattern as people wake up and realize how big the deficit's going to be?

QUESTION: I think it's going to be a very significant reaction. But, Roger, let me, let me take advantage of having this mike to make one comment and ask one question.

Your comments about the psychological response to stress of this sort on the part of managements of companies reminds me of a conversation I had with a newly elected C.E.O. of the Chase Manhattan Bank in the early '80s, when the Latin American debt crisis was really hitting its zenith and Chase and other banks were being criticized for their international activities.

So, I said to this guy, so what's the response of the Chase Manhattan Bank to this situation? Do you pull in your horns? Do you curtail your international activity? And he said emphatically, "Not on my watch. That is not going to happen." And yet, for the next two years all you read about was Chase Bank closing branches in Latin America and other parts of the world.

It's simply human nature to become more conservative after a shock of that order of magnitude. This is much worse. So, my feeling is you're going to have a pulling in of the horns on the parts of these companies, which will be exacerbated by a greater degree of regulation. So, I think we haven't really taken into account that human-nature, conservative response to this kind of extreme stress.

Let me ask you a question, Tim, and I was interested in your comments about sort of a "chapter one" being deflation; "chapter two" being inflation. I'm more worried about chapter one than chapter two, because I think the policy response to a highly -- potentially inflationary environment, I think, is one we understand and how we can deal with it.

I'm much more concerned about the deflationary prospects. And we have much more deleveraging to come -- we have declining house prices, we're going to have more regulation. It seems to me we are really sowing the seeds of a deflation, which is going to be hard to control and hard to reverse.

So, my question is, what are the -- (inaudible) -- (responses ?) available to people here, in light of these very elevated fiscal deficits -- here, and in other parts of the world, to try and counteract that deflation?

ADAMS: Well, the Fed has already doubled the size of the balance sheet, and they'll maybe triple it, or increase it four-fold. We'll do what countries have done throughout history, we'll monetize the problem and we'll print money. And we'll inflate our way out of it.

At the top of our discussion I noted that the bottom 50 percent of households in this country -- 60 million households are probably, technically, bankrupt -- that they owe more on the assets, including their home, and their trucks, and their cars, than the value of those. They have no cash flow and they've been living on credit. The average American has over 10 credit cards.

The only way you're going to fix that is to inflate our way out of it. And I think that's -- that's where we are five or six years from now, but in the meantime it is going to be continued deleveraging and continued deflation. But, I think officials turn to the traditional methods that officials have been using for a long time and will simply print money.

ALTMAN: Do you agree?

QUESTION: I don't know what the alternative is. I think -- (inaudible) -- we have more than doubled the -- (inaudible) --. But, I think that's right, I think all we can do. But, I think it's very worrisome.

I think also deflation is a lot harder to -- we had very little experience in dealing with it, and less experience in dealing with it successfully. So, I think deflation is hard to turn around, and I think that's what we're in for.

ADAMS: And I also agree with Simon. I think we have to address housing -- housing prices individually. We've been pouring money in from the very top. I think we've got to have a bottoms-up approach, and I think there's actually a political consensus developing in Washington to do that. It will be expensive; it'll be timely; it would be difficult to manage from a bureaucratic standpoint, but I think we have to have a bottoms-up approach.

ALTMAN: My job to be sure we end on time. So, we've reached that point. So, I'll just close with a rhetorical question, which is: Apropos of this last discussion, it's interesting to say -- and very provocative to say that the Fed may expand its balance sheet, ultimately, three times or four times. But, the question is whether there is a line which might be crossed, where such expansion would undermine confidence rather than promote confidence.

On that note, thanks everybody for being here. (Laughter, applause.)









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