Martin Wolf on Radical Reform for the Global Financial System

Martin Wolf on Radical Reform for the Global Financial System

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from C. Peter McColough Series on International Economics

Martin Wolf, chief economics commentator of the Financial Times, joins Columbia University's Glenn Hubbard to discuss the state of the world economy following the financial crisis. Wolf comments on the causes of the global financial crisis, radical solutions for reform, and the still-unstable financial system. 

The C. Peter McColough Series on International Economics is presented by the Corporate Program and the Maurice R. Greenberg Center for Geoeconomic Studies.

HUBBARD: Good morning, everyone. Welcome to this C. Peter McColough lecture series discussion with Martin Wolf of the Financial Times.

I'll do the short Oprah Winfrey moment here at the beginning and hold up a copy of Martin's new book, The Shifts and the Shocks: What We've Learned—and Have Still to Learn—from the Financial Crisis.

It is an absolutely terrific read, as anybody familiar with Martin's work could guess.

Just a short introduction, though he really doesn't need one. Martin is a recovering World Banker. He is a CBE in 2000 for his financial journalism contributions, an honorary fellow of Nuffield College at Oxford and a World Economic Forum stalwart.

He is, of course, to all of us in this room, a regular and featured Financial Times columnist, whose pieces are must-reads. Ican say that from positions in academia and business and in government, always having enjoyed talking with Martin and working with him.

His writing is always extremely economics-oriented, which to an economist is a good thing, but also very cogent and well-written, which very few economists manage to pull off.

And "The Shifts and the Shocks" is no—is no exception. It's not really a review of what precipitated the crisis as much as it is a discussion of shifts that are needed in thinking and policymaking.

So Martin, to get started, whenever I think about the financial crisis, I often start at a place you do in the book, which is actually the Queen of England's question at the London School Economics.

The Queen of England actually asked one of the most cogent questions in the financial crisis, and the question was this: "Why did nobody notice it"?

The issue then in our profession that often gets discussed is that it was a forecasting error. We simply blew it. We estimated one thing, and it was something else.

But the issue that you talk about in the book is—is actually much deeper than that, and you hearken back to the idea that's—that's more terrible, that is, that we didn't even entertain the notion of a financial crisis. And we all know that that kind of complacency would've amused Hy Minsky, who famously wrote about financial crises.

How should we rethink our role or our conception of a crisis and the role of finance in the economy?

WOLF: Wonderful question.

First of all, it's a great pleasure to be back here. I've always enjoyed my association with the Council, and it's a great opportunity to discuss the book here, so I'm very pleased to be here.

My starting point obviously is exactly with—indeed, it was—it is the starting point of the book, because I start with—I think it's in the preface—with Hy Minsky's remark that economics—any macroeconomic theory, as it were—macroeconomic view has to include the possibility of great depressions. It's one of the possible states of the world.

And I suppose it is true that for most economists, increasingly, as the Great Depression faded into the past and economic theory evolved in the post-war period, as we knew it did—though we could discuss this further—this possibility really disappeared from the—the—the way we thought.

Now, of course, people were very, very well aware that there'd been lots of financial crises in emerging countries. There'd been a big crisis in Asian emerging countries, for example, Latin America's (inaudible) Tequila crisis, the Latin American debt crisis.

Not that people aren't aware that crises have occurred, and they'd also, of course, occurred in some developed countries.

But these were usually explained away by special features—crony capitalism, something like this—some way in which these countries didn't really understand capitalism the way Americans and British people understood capitalism, so they—they—it was quite understandable they made such a mess of it.

But of course, we really did. We were—as I pointed out in the book, this was seen, rightly, I think, as the—London and New York were seen as the centers of world capitalism, financial capitalism and the most sophisticated institutions and theoretically, the most sophisticated central banks.

So it was sort of thought, I think, by most economists, that this just couldn't happen.

Well, once we—one realized—and I have to say that I didn't think that it couldn't happen in—that there couldn't be a financial crisis, but I certainly didn't think, until it happened, that we could the financial crisis on the scale we did have in 2008.

That obviously raises profound questions. And in part of the book, one of the chapters in the book is about the perspectives of different economic schools going back to the late 19th century. I start with Wicksell--on the question of what makes financial fragility, how the financial sector interacts with the real economy, why one can't really have any serious of macroeconomics which doesn't treat credit and money and the—the role of the private sector in creating both a central—that—that's a central part of my book. All seems pretty obvious now, but it wasn't very obvious before.

I don't want to make this invidious, but probably the most influential living macroeconomist, Robert Lucas, has this famous remark, which, of course, I couldn't get away from, in his presidential address, I think '94—I can't remember the exact date—in which he says, "Well, of course, the problem of depressions has been resolved, to intents and purposes, for all time."

So we have to, I think—one of the lessons of the—of the experience and one of the things I grapple with in the book is what it means for economics.

HUBBARD: And of course, Lucas subsequently is awarded the Nobel Prize in Economics...

WOLF: Indeed.

HUBBARD: ... on top of that, and draws on a rich tradition, because Arthur Burns, in his presidential address, said that the business cycle was dead. So economists have a long history of this sort of forecasting.

WOLF: We do suffer from hubris rather badly, don't we?

HUBBARD: Yeah, I'm afraid that's true.

Well, your—your book does talk a great deal about policy action, and there's a lot there, but I want to focus with you on one particular area.

You have a quite—at least in my view, quite radical proposal to shift to narrow banking a la what you rightly refer back to in the book as the old Chicago plan from the 20th century.

Do we really need to do this, and is it not possible that an alternative of more contingent capital and a credible end to "too big to fail" would do the trick?

And isn't the issue really more one of leverage and not this bank leverage? So is this solution really right?

Tell us about the narrow...

WOLF: Well, I think there's—there're a whole set of very interesting issues about alternative proposals.

So I put forward—discuss a number of possible ways forward to—to deleverage the system and to make the financial system less fragile.

And in fact, most of my focus is on raising capital. That's the—the longest discussion in the section on financial sector reform. There isn't one chapter on financial sector reform, and since so many hundreds of thousands of millions of words have been written on—obviously can't cover everything.

So it does seem to me that given where we are now, the natural way to go is in the direction of raising capital requirements in banks towards levels which would've been regarded as perfectly reasonable a century ago.

And of course, that would have implications for neobanks, for entities that—that essentially pursue bank-like strategies, which are not called banks. These would emerge, so there're always going to be some difficulties about that.

And I also talk about resolution regimes, which are related really to your contingent capital or debt. If we pursue that, that will certainly be—certainly be a big improvement, and it might be sufficient to—to help—to help a great deal.

Now, my interest in the—the Chicago plan actually has two aspects to it, one probably much more controversial than the other.

The more obvious one is—is simply the idea that if you have a system who—which creates most of our money, all (ph) our money, as a byproduct of its lending activities, the—I describe this as essentially a public-private partnership in the creation of money, with the central bank backing these entities.

Then the—it's very, very likely—and this is clearly what the Chicago plan people concluded—that at some point, this will run away with itself. There will be a point at which it will run away with itself.

When it does run away with itself, the elasticity of the system is—I mean Wicksell's great insight is that there is no stopping point before credit collapse, you know, before mass bankruptcy. It must (ph) continue.

You have this insight—let's think about it as if there's one bank. It's lending, creates money, and as long as people are prepared to—to hold it and go on without limit—doesn't need capital until suddenly, people are worried about the soundness of the loans, and that takes a long time.

But if you move to 100 percent reserve banking or even very high reserve banking, you will curtail this elasticity very, very significantly, and you can give central banks much more direct control than—than interest rate policy has given them in the past over what they do.

And these banks would then be sound. There would no—be no reason to run on them. Of course, it is absolutely true that you would then have the question of what happens outside this core system. And one—and we—I discuss this to some extent. There are obviously a number of possibilities.

One, you would in—in—there will be—you would not allow any other institutions to become very much like banks. And as soon as they did, they would have come under the same perspective, the same constraints.

I won't go into all the details of this, but the—my—my proposal here is these, I think, very, very interesting ideas, and I would like somebody to try experiment with it. So I'm trying to get the Icelanders to do this at the moment...


... and—and see what would happen. I think Iceland is perfectly suited. Now, there is another aspect to what I think, which is much more radical than that. And it's not something I put forward very strongly, but I have become—and I—I genuinely think this is, to me, a puzzle, a real puzzle. But we seem to find it very, very difficult to create reasonably balanced and stable demand growth in our economies at the moment without credit bubbles. It seems to become a pandemic phenomenon.

Now, I have some views of why this has happened. And maybe people in the audience have better views than I do. But it does seem to me a feature. Well, if that's the case, then I suppose I'm increasingly tempted by the idea that the solution to that problem—if that's the problem-- is Milton Friedman's helicopter money.

And that—and that means government-created money is the simplest way of financing expansions in demand if the only alternative is crazy credit booms. And, of course, if you go that way, since you want to contain the consequences, you want to manage that, well, then, you—you end up with, inevitably, as we can see already with Dewey, huge reserves in the—in the banking sector.

You can see the reserves, and I think we are going to end up in all arctic countries with much higher reserve requirements in order to manage those. I think that's how that will probably end up. Because I don't think these balance sheets will be reversed. I may be wrong on that.

And I think it's possible that we will be forced to do more of that in the future. I stress possible. I don't say certain. But it is one of the puzzles about where we are that we have become so credit-bubble dependent.

HUBBARD: I want to come back to the credit bubble and the radical Martin in a moment, but I want to keep on this issue of neobanking for a moment. So if one had neobanking, so no more fractional reserve banking, 100 percent reserves, which is the old Chicago plan...

WOLF: Yeah.

HUBBARD: ... what would you do about your banks? How would the Federal Reserve or any other regulatory entity assure itself that leverage doesn't just simply move from commercial banks to somewhere else?

WOLF: Well, the Chicago plan, as I understand it, had two versions of this. The most important proponent of the Chicago plan was, of course, Irving Fisher, who was not at Chicago, I think.

HUBBARD: He was not.

WOLF: So it's not really a Chicago plan. Anyway, Irving Fisher was...

HUBBARD: (inaudible)

WOLF: Yeah. Yeah, yes. Irving Fisher was the—greatest American economist. I think he was. And so...

HUBBARD: Although he, too, said stocks were the...

WOLF: Yeah, yeah...


WOLF: He got bankrupted by—the failure to foresee stock prices is—has devastated many individuals, and I don't there's anyone who suggested that economists are necessarily particularly good at that.

HUBBARD: That's correct.

WOLF: So...

HUBBARD: My wife would confirm that.


Well, they had essentially two ideas. One idea, which is the most radical, is essentially Kotlikoff's. I mean, Kotlikoff has resurrected this.

HUBBARD: This is Larry Kotlikoff who is...


WOLF: ... has produced a book, which is really—I think he refers to the Chicago plan, but as far as I can see, it's identical. I mean, essentially, his idea was all other financial institutions will be mutual funds or investment—investment trust. That is to say everything else—there's a logic here, which is very brutal, that essentially says intermediation is dangerous if it—if you take risks on balance sheets, which are, in fact, not capable of taking those risks. (inaudible) Ultimately, all equity is owned by household, by definition, everything.


WOLF: So one instance (ph) of financial sector is so fragile if it has intermediation within it on the basis of very limited equity in the system, and there's all these contagion of facts. So the simple answer to that is everything is mark-to-market on the asset side, and on the liability side, it's far through to the—to the investor.

So you get away from this pretense—and it is a pretense in some deep and obvious way—that you can have a whole slew of very risky, uncertain price-varying assets on one side, and make guaranteed promises in the other that you will meet your obligations at par instantaneously.

And you could say, and I would say, that's essentially a fraudulent promise. That is to say there are many states of the world, not difficult to imagine, in which that promise cannot be met. And this is Larry's basic point. And if you build your financial sector on—on a system in which many states of the world, the fundamental promise of the system—that is to say you can meet your liabilities at par perfectly liquidly instantaneously while you have all this other stuff on the other side, you're asking for trouble.

So the answer Larry puts forward, and that goes back I think to Irving Fisher, is you just say you can't make those promises. They're illegal. By the way, interestingly, this is the position taken by the most interesting contemporary Misesian, a—or at least I found, a Spanish economist called, I think Jesús Huerta de Soto or something like that. Anyway, he's written a huge book on money and credit in which he say—basically says the whole of Anglo-Saxon finance is a fraud.

And the—goes back—and he goes back into the history of how we got away with creating these entities, which may—actually, I think it was invented by the Italians. But I won't go into the—the origins of the banking idea.

So one radical idea is essentially you make—you make institutions that make those promises illegal. And everything else is passed through to the investor. And every day, your market moves up and down, and your...and if you want money, then you have to be backed by money.

The less radical alternative—I really like that—so if I were—that's what I want Iceland to do and see what happens...


And I know I'm not going to persuade it to happen in the U.S., but it's logical. It is logical. It is important to understand that if the main characteristic of your financial system is enormous balance sheets in the intermediation sector—I'm sure this is many people here—that make these promises, you're going to have trouble from time to time from panics.

Inevitable you're going to have panics. They're built into the system, and the only entity that can back you against the panic is a government entity, a central bank. So it's not really a private sector. That's really important. It's not really a private sector at all. It's a solely public sector. This is why I make this crack in my book—I think that you really should regard bankers as very, very highly paid civil servants.


Because they are ultimately dependent on the public sector's balance sheet. That's why the Fed was created.

So the other alternative is, indeed, to say you can go and do these things. But the regulators will go look at you, and whenever you start making promises that look bank-like, they will force you back into banks. And if you're not making promises that are bank-like, they will insist on high capital requirements and all the rest of it.

So—and the regulators then will have to be very active in pursuing that. But the—as I point out in my book, and that's one of the central parts of the book, the regulators are being—even without doing that, the regulators are being insanely (audio gap) active.

One of the most important things in my book, I think, is to try and spell out the nature of the regulatory response to the crisis. And the—the fascinating thing, and this is derived from the work of Andy Haldane, in particular, at the Bank of England, the paper he presented at Jackson Hole in 2012, in which he points out that in our response to the crisis, we have created, without any doubt, the most complicated, incomprehensible, convoluted regulatory structures imaginable, which nobody—he doesn't understand. He's the regulator. He doesn't understand, and he's the cleverest regulator I know. Then it seems to me that it's not a very good system. That's not a very good way to run things.

So I think the more radical ideas I put forward are not at all ridiculous. They're just radical. And they're radical, became radical, because where we've ended up now is that we have these huge and highly (inaudible) financial sector, absolutely colossal, which makes promises that in states of the world it cannot keep.

We've lost confidence in it, a regulatory system, political system has lost confidence in it. And the way it expresses that loss of confidence—just open the paper every day—is evermore intrusive rules on everything: what you pay people; how you pay people; what risks you can take; what—how much capital you need against this risk; and how much capital you need against that risk. I mean, it's micromanagement of the most insane kind.

I don't think anybody left, right, center can think this is very sensible place to be. It's unworkable. So that's a part, a radical part of my book. So I think we should be thinking about much more radical alternatives.

This is one alternative, as I've said, these types (ph), is really to go (inaudible) with—with leverage reduced in all systemic institutions, and then you go around and decide what they are from thirty to one to somewhere between three and four to one, to, at the most, ten to one. That's the other way to go. I think they're the only rational ways to go if we don't want this, to my mind, insane micromanagement, which can't...

HUBBARD: Yeah...

WOLF: Nobody can believe will really work.


WOLF: Sorry. It's a long answer.

HUBBARD: Yeah, yeah, I—no...

WOLF: But it's a very good question.

HUBBARD: ... and I agree with you that there's no way that regulation is going to keep up with this. And the history of financial regulation is (inaudible) it never—it never does.

The world you described of higher capital does hearken back to the 19th century when there were double-name commercial paper...

WOLF: Yes, yep.

HUBBARD: ... bank shareholders were individually liable again...

WOLF: Yeah.

HUBBARD: ... for the amount of capital in the bank. Yet, there were financial panics repeatedly in the 19th century. So it doesn't...

WOLF: But you didn't have a...


WOLF: I agree. No, I—only going to 100 percent reserve banking you eliminate the panic. But the—the—and you didn't—but you didn't have a central bank.


WOLF: I've seen that the argument I've made, which I think follows Mervyn King, which whom you probably have here because I know he's been involved, is—let me go back in slightly different ways and good story. It's a—it's a British story.

One of the good things—one of the things about my book, which I think is quite good, is that it does treat it as a global crisis, not just as a U.S. crisis. So we have Northern Rock. Northern Rock was the first bank run that the British had had for more than a century—public bank run. So it was a big deal for us. We've had fewer crises because we have a—by the way, I should mention this.

WOLF: There is another way of running your banking sector. I think of it as the Canadian way. You get...

HUBBARD: Oligopoly.

WOLF: You have a nice tight, boring oligopoly, with most of the risk borne by the government. Nearly all banks now do mortgage lending, and more outside the U.S. than here, than the U.S., but you have government entities to do this because you have a completely (inaudible) housing market, but the other countries—in other countries there is a sort of quasi-private sector, but it's guaranteed.

That's another way of doing it. I think that's really the worst of all possible worlds. I wouldn't want to go into that boring oligopoly route. So that's not the way we go.

So where was I before I interrupted, just myself? What was the question you just asked?


HUBBARD: You were—you were...

WOLF: Northern Rock, Northern Rock, good little story.

HUBBARD: And, by the way, we only socialized the housing losses here, not gains, yet.


WOLF: That's the best sort of socialism, isn't it?

So, Northern Rock run, the Northern Rock run. Northern Rock couldn't fund itself, once the crisis happened in 2007 because the wholesale markets froze. And, but Northern Rock had a lot of assets that it needed to fund, and also money was being withdrawn.

So the Bank of England was called upon to act as a lender of last resort. And the Bank of England obviously wanted to pursue, to impose haircuts on these assets, to devalue these housing mortgages in the U.K., whose values were highly uncertain.

And Northern Rock had next to no equity.

So the Bank of England's problem was really very simple. It worked out that, as things were, as lender of last resort, it would end up funding at least a third of the balance sheet within a few months. And if it applied a normal discount on the value—this is very important, why capital is so important for liquidity operations, for a central bank—then Northern Rock would be insolvent.

That is to say, it will be funding an entity the value of whose assets was below the level of its liabilities, including the liabilities to the Bank of England.

And the Bank of England's view was, our job is not to take on the credit risk of this kind, therefore, we couldn't do it. And, in the end, that forced the government to nationalize the firm.

But, Mervyn's point is that if Northern Rock had had a, you know, capitalization of, let's suppose, even 10 percent of the balance sheet, let naught 2 percent of the balance sheet, then the solvency of the Northern Rock would have been much more unlikely.

It could have lent on the penalty rate on a much large scale, while being completely or at least much more comfortable about the credit risk, and, therefore, operating as a genuine lender of last resort, which as (inaudible) had always explained, was not about taking serious credit risk. It's—it's—that's why he wanted, among the reasons he wanted people to lend at a penalty rate, is immensely much easier if banks are properly capitalized.

And if banks aren't properly capitalized, acting as a lender of last resort involves taking huge credit risk and, in fact, of course, we know very well, though it worked out perfectly well in the end, that the Fed took a lot of credit risk in the 2008-09 crisis.

But in the more—or that ultimately amounts to a pretty open subsidy, not just on liquidity, but on capital values. And the—I don't want central banks to go there, so it's a—it seems to me quite an important reason, if you don't go the really, really radical route, which we discussed, to have enough capital in the banks to get around it.

There is another way of doing this, which is the classic way, which is that the banks pledge assets whose value, market value, is easy to determine. There is a—and you can impose a penalty simply on the assets, and so you don't need to worry about the balance sheet of the institutions.

But, given the sort of balance sheets that banking institutions have nowadays, they don't have a lot of this—they have much less of this very transparent, tradeable paper that used to be the case in banks back in the 1960s, particularly British banks, so that doesn't seem a very realistic way to go.


WOLF: I mean, what haircut would you need to have imposed on so- called toxic assets to decide a value? I mean, central bank couldn't decide that in a sensible way.


WOLF: So, that's my answer.

HUBBARD: Let me go back to Helicopter Martin for a moment.

WOLF: Helicopter Martin.

HUBBARD: So, is it your position that major industrial economies are in what Alvin Hansen would have called secular stagnation, and that the solution to that, because Hansen's original argument was on the demand side, the solution to that is this permanent money financing of higher government spending? Is that a good way of characterizing your position?

WOLF: My position is that this possibility seems more plausible to me now than it has seemed in my professional lifetime. I have become increasingly concerned that—and this is part of my analysis before the crisis, with the point that Larry his since sort of crystallized in his way, brutal way...

HUBBARD: This is Larry Summers, building on the Hansen argument.

WOLF: Yeah, that—and I think a number of other economists have made the same observation, that periods of what appears to be rapid—reasonably rapid and balanced growth in our economies have coincided with—not coincided with—have been driven by what looked, certainly ex post, and looked, to some of us, ex ante, at the time, to be obviously unsustainable credit booms.

So, that's what happened in the early 2000s here. It's what happened in Spain, which I argue had a lot to do with what happened in—which helped Germany. The—it also, interestingly, is what—it's what happened in Japan in the late '80s, it's what happened in China after—interestingly, after your credit boom blew up—or the Western credit boom blew up.

Now there's an interesting question of why that is the case. And I discuss in the book a number of possible hypotheses. The things that I focus on here are changes in global imbalances, which I think is very important, mainly the perverse, but I think comprehensible situation, in which you're measuring economies that have become huge net exporters of capital to the developed world, which we find very difficult to use, changes in the behavior of the nonfinancial corporate sector, both on the investment side and the profit side, shifts to profits, which are not matched in any way by increasing investments, very important macro economic phenomena, changes in income distribution.

So in the Western world, not only have we become dependent on credit booms, we've become dependent on very specific private sector credit booms, that is household-led borrowing.

It's quite interesting, because it seems quite new. When I reread Minsky, his concerns were all about corporate sector leverage, not household leverage. That's a new invention. And it turned out to be particularly destructive.

So I think the possibility that that's where we are is not to be ignored.

It's—now, there are a number of possible ways, one thinks—one response might be, well, that's it. So that means that growth is just going to be slower. End of story. Just live with it.

Lots of friends of mine think you forget about it.

Another possibility is just to think about policies that affect investment, corporate savings, retained earnings, how they're used, distribution of income.

Of course, people on the left would start talking—like Joe Stiglitz would talk about redistribution of income as a core part of the solution to this strategy. That takes you all the way back, by the way, to Marx's theory of the credit cycle. That's was what he believed was at the roots of this.

I don't actually have Marx in my book. No way. There we are.

But if we can't think—and I'm agnostic about this at the moment, in the sense that I'm not saying that as a permanent structural policy this is what we should do. But my friend, Adair Turner, Lord Turner, who was chairman of the FSA, he's put forward this idea, and I think that we may be driven to this possibility.

It'll be very interesting to see how this upswing, which is a very feeble upswing, exceptionally feeble by U.S. standards, and nonexistent in Europe, will proceed. And I sort of hope that it will end up with balanced growth in the financial—in the private sector without another credit boom, but I'm increasingly concerned that in the U.S. and U.K., the way we are, the way the banks, central banks, are operating, the way we are trying to drive ourselves out of this is to create another credit boom, and from the—from the top—from the position in which that we deleverage a little.

Take the U.S. simply. The U.S. has deleveraged. The financial sector's deleveraged. The household sector's deleveraged. But it's only back to 2002-2003 levels roughly, which is just four years before it blew up, so you've got four years of fun, and then it blows up again.

If that happens, and I think it's quite plausible that it will happen that way, that's what we're going to end up with, if it works at all, then we're—then after the next crisis, we're going to have to think of something new. And this is one possible thing we'll have to think about.

And, as I said, it has very respectable Chicago School antecedents.

But we are in a very strange place, in which I think the economy's had—you know, we—it doesn't look as though we get an equilibrium in our economies, growth, demand and supply matching in a—what without ending up with zero rates, insane Q.E., and all the rest of it, all this huge Q.E. phenomenon, without having potentially unsustainable asset price buckle and credit going with it.

And that's a pretty worrying situation.

HUBBARD: Before we open it up to the audience, I want to take you globally a bit, to talk about austerity, build on your comments.

It's clear, I think, to many of us, that there was too much near- term austerity in the United States and in Europe, but arguably there's still a need for—well, not arguably, I would say factually, a need for a great deal of long-term austerity.

How do we do this, given the discussion that you just had? How do we get long-term government budgets back in balance, or, since you borrowed from another radical in your book, Lenin, what is to be done?

WOLF: What is to be done?

Well, my first best proposal, which I regard as a medium- to long-run proposal, is, well, it would go like this: Let's go back to the late 19th and early 20th century's globalization, which had a much more natural structure of savings and capital flows.

So, which—in other words, at that stage, you know, the richest old countries were Britain and France, to some degree. Britain was an enormous capital exporter. Actually, it exported abroad about half its savings. That money was invested in the most dynamic emerging economies of the time, of which, of course, the U.S. was the most important, so the U.S. accumulated very large—U.K. accumulated very large claims on these countries like the U.S., obviously the dominions, Canada, Australia, New Zealand, South Africa, Argentina.

And, actually, the U.K. went into the First World War with assets roughly three times GDP, which had contributed very greatly to the developments of these various countries.

WOLF: That would seem to be the natural process. Obviously, unfortunately, this wonderful treasure trove of wealth was completely and utterly consumed in two world wars, but that's just one of those things that happens in life.

And the—and our then subsequent principal predator of the U.S. as Benn has described so well in his recent book, drove some pretty hard bargains in the process. Now that's not important. So it seems to me if we are where we are, the aging economies, aging rich economies, which seem to have in the private sector ex ante excess savings. One of the symptoms of that is our interest rates today, should be exporting capital, not importing it. So Germany is, in fact, the future.

But Germany, for all of us, but that only works if the rest of the world is happy about importing capital. And you would think, if you look around the world, and most of the world is emerging economies, they have tremendous investment opportunities, why should they save even more than they invest?

I mean, it's sort of really ridiculous because they're foregoing consumption of opportunities now, in order to support their investment. It would make much more sense if we invested in them. So I do discuss both the rationale for this and the international institutions that might possibly support that then it will happen.

It's clearly a perverse situation that we have now. Why should China be a huge exporter of capital, when it's already got this—it's much lesser now, but still the emerging world continue to be a substantial exporter of capital. A lot of that has to do with of course the failures of policymaking, emerging developing countries, failures of institutions, legal institutions and all the rest of it.

But that's the natural solution. And I give some arithmetic and some ideas in which we would solve our problem quite easily, if we became net exporters of capital. So the U.S. wouldn't be running a current account deficit anymore, it would be running a surplus of, say, three, four percent of GDP. This is not an unreasonable view of the world.

Unfortunately, it doesn't seem to be available. We seem to be driven and it's a central part of my argument how that happened. We seem to have been driven to a situation in which we are forced, I think, by choices elsewhere, in large measure, particularly in emerging country choices and particularly East Asian choices to actually run our economies in a way that our total expenditure exceeds our output.

And in the—in that run-up to the crisis, that excess was enormous. And that creates tremendous problems for policymakers, because if you don't want the government—coming back to your point—to run the fiscal deficits, that means that the private sector must run large financial deficits and for the private sector to run financial deficits, as far as we can see, that—particularly when the corporate sector is so cautious, that means that we end up with this household problem.

In that context, doing the things you want on fiscal policy is very difficult. If we want to—and I discussed that actually in my column today about the UK, if we want a balanced budget and to drive down our debt over time, so—in our case, it would probably take twenty years—twenty-five years of normal growth to get our public net-debt ratio back to 30 percent of GDP, which is where we started. Now it's 80 percent. So we have to run a balanced budget.

For that to happen, given that we seem to have, again, a large structural current account deficit, which doesn't change very quickly or easily, but I assume that's the case, then we have to have a huge financial deficit in the private sector. And I think that's going to be impossible to do without destabilizing the economy again.

So what we would want to do is to move into surplus on the external account—re: not have these excesses. But that means the rest of the world has to adapt. It's a huge global adjustment problem. And if the whole developed world does this, not just Germany, it's a very big—to my mind—a very big global macro adjustment problem.

So getting your fiscal position where you want it to be, when you're talking about the West as a whole—so not just individual countries—really does mean thinking about how the rest of the world economy will adjust to that situation.

And I think the only way the rest of the world economy adjusts to that situation, plausibly, given where we are, is if the developed world becomes really large net capital exporter. And that's a complete transformation of a situation we've been in for the last twenty years. And it's not a situation, I think, that will emerge naturally, because I think most emerging economies just don't want to be there.

HUBBARD: Great. So we've gone from Simons and Friedman to Lenin all in one morning. But now the floor is yours for any questions. Yes. Please wait for the microphone and identify yourself.

QUESTION: I'm Sam (inaudible). Good morning. Actually before my very brief question, the notion of our bankers becoming public servants, does that also imply they be paid as public servants?

WOLF: Well...

QUESTION: I know you don't have to answer the question.

WOLF: ... the implication is that they should be, but I don't expect them to be.

QUESTION: No. But my question, is if we had some major terrorist event in one of our major Western countries, here, Western Europe, how would that affect the extraordinary thoughts given to us this morning about how we fix our problem?

WOLF: I suppose, it must depend, in part, on what you mean by a major terrorist event. The—so let me give you my idea of what a major ...

(UNKNOWN): (Inaudible).

WOLF: Well, yeah—what I think of as a major terrorist event, as opposed to a minor one, would consist of two things—one or both of two things. And somebody here may have more imagination than I have. One, somebody lets off a nuclear device in a downtown of a major city, like New York or London. And a device sufficient to kill hundreds of thousands of people and destroy a substantial part—this is a Graham Allison's nightmare, right. And you've all followed, I am sure, what Graham Allison's work in this area. So that's one major event.

And the second major event that people talk about is the ability to infiltrate very porous cyber-security systems on vital utility grids, most obviously, the electricity system, and closes it down. Well, I can't just the plausibility of the latter. I just can't. I'm told it's possible. I don't know for how long this is going to go on.

Well, either of those events would be—how does one puts it, in the most delicate way, game-changers. And we would—if they—I have no sense of a plausibility in such scenarios. But if either of those events, and particular the former were to work out, well, first of all, far from the immediate impacts of a devastating nuclear explosion in the town, in the center of New York or London, apart from those—the simply immediate effects, it would change everything about our world. Globalization, it seems to me, will be over. The movement of people would become controlled beyond belief. There would almost certainly be massive military consequences of, I think, an imperial kind. This is—how did the Roman Empire expand. The Roman Empire expanded every time you bounded across the border. But there were some uncontrolled place with some nuisance trying to attack them. So expanded.

So in this world, I wrote this in—twelve years ago --at the time immediately after 9/11, one of the things we learned at 9/11 is that our borders in the modern world are with everybody. So the only solution in this world is control everybody. This is a really scary possibility. The—or to close up completely. That becomes one of the two possibilities. So my assumption is if we're talking about an event of that type, that's what you mean by a major terrorism event, we are in a different world.

So let's not hope—let's hope it doesn't happen.

QUESTION: OK, so we're choosing between Caesar and Hadrian's Wall, but yes.

WOLF: Yes, exactly.


WOLF: Perfectly defined. Caesar—neither strategy worked in the long run, by the way, but that's normal in life.

QUESTION: Mr. Wolf, there's an interesting trial going on in New York, as I'm sure you know.

WOLF: I am aware of it.

QUESTION: Yes, I bet.

WOLF: You know much about it, I'm sure, than I do.

QUESTION: Oh, yes, I used to work for AIG, so I have a self- interest.


QUESTION: And Greenberg is suing, on behalf of Starr, for $25 billion. And any shareholder who wanted to participate can, and I did. What have I got to lose? I think he'll lose, but that's beside the point. It could go all the way to the Supreme Court. As a little clause there that that nobody knows about that he made, or that AIG made with the Fed, that if he were to win that it's AIG's problem. So that means, of course, AIG would go out of business. Having said all that, you criticized our regulatory mechanisms. How do you think the regulators back in 2008 handled it?

WOLF: By the way, when you said—I—I must be precise. I didn't criticize specifically your regulatory procedures. I criticized our regulatory procedures, so that includes everybody else. I'm not, in any way, trying to suggest that there's anything special about U.S. regulatory procedures. The rule book we're creating in Europe is even worse that yours. So (inaudible) very aware of that.

So on the AIG case, I find it very, very difficult and I've read a lot of literature, but I wasn't there. I wasn't a participant To second- guess the decisions taken by the authorities in the autumn-fall of 2008 and early 2009, as it were, in real time, it's very, very easy. I think you call it Monday night quarterbacking here?

QUESTION: Monday morning.

WOLF: Monday morning, I apologize. Yes, we've got—so Sunday.

QUESTION: You've got...

WOLF: Monday—whatever, whatever. It's very easy after the event to argue that they made a great many mistakes in the way they handled specific cases. And there's still an ongoing debate about Lehman, about whether they were right to let it fail or let it fail in that way and whatever. AIG is obviously a very big case—about the deal, how they fully paid off all the AIG obligations.

So there are lots and lots of—there's lots and lots of second-guessing here. And the—but it seems to me that if you're in the middle of a world-class panic, which we were, with the economy declining very, very rapidly and no real idea of how—when this would stop, they had to go in with overwhelming force.

That is something I agree with Tim Geithner on completely. You have to stop this. And you—AIG had been a surprise for them. They didn't understand before it happened how central AIG's activities, London activities had been in providing what I'd call a pseudo-credit—or pseudo-capital, sorry, as that's capital to the system, because, essentially, everybody was riding on AIG's AAA, which couldn't be actually used for this purpose by—the regulators wouldn't allow it to be used for this purpose—in order to allow all the other institutions not to have as much capital as they really needed, and, because they could get credit default swaps from AIG.

So, this was a really, to put it mildly, dubious activity that AIG had been involved in.

So I have to say, I find the case complete chutzpah. I mean, I think it's sort of amazing that this case could be even brought, given the activities of AIG that played such an extraordinary role in devastating—a devastating role.

But I think the authorities didn't understand how important it had been. They were surprised by how devastating it might be. They were concerned what would happen if all AIG's credit default swaps weren't met in full. They thought that—even though it's very controversial, a lot of the benefits, of course, went to European banks. We all know that.

But I sort of feel, well, maybe there was some better path, but since I wasn't there, I wasn't exhausted, I wasn't having to make this decision over weekends in extreme pace, and they had to prevent the credit—the panic from spreading.

I find it very difficult, and certainly didn't try in my book, to argue, well, if only they'd done this or that or whatever else, and then it would all have been much better.

I think the big—to me, the bigger question was the Lehman failure. Though I still feel, tend to feel, that if they hadn't let that happen, if some such event hadn't happened, they would never have come to grips with the crisis at all.

But, so I would take the view—the British view would certainly be, if this was a British case, you know, there are extreme situations in which the sovereign has to act—has to make discretionary decisions to save a country from a severe threat of panic. That's what we have sovereigns for, that's what governments are for in extremis. They're insurance agencies, as far as I'm concerned, at the core.

And in extreme crisis, the sovereign has to have discretion. And it's not for the judicial authorities later on to go along and say, well, actually, they should have exercised this discretion in some ways.

There's absolutely no way this case will get within anywhere in the U.K., anywhere, it would be just inconceivable.

But the U.S. legal system is a wonder of—all of its own.


WOLF: And I may—and I want to say, (inaudible), but I think in the end I'm not going to second-guess these people. They dealt with the panic in a messy way, but it was a very messy panic.

HUBBARD: You've channeled Abraham Lincoln very well.

WOLF: Oh, yes. He would have taken that view, wouldn't he?

HUBBARD: Exactly.

QUESTION: Maurice Templesman. May I shift from policy desirability to policy achievability, and that leads us to the intersection between economics and politics. In a system such as we have it, unfortunately, where it's government by consent and persuasion, how do you create political will among politicians? How do they get re-elected while proposing remedies which in effect negatively affect their constituency in order to be preventive, really, than actually reactive, to the motivation that the crisis provides?

WOLF: Well, I think the short answer is in your question, you don't. And that's why we are where we are.

The—in my book, I describe what we've done in this essence, is we've re-created, resurrected, that's not the right word, but, mainly the old system. You know, we haven't had the strength to be very radical about the financial system or economic policy-making.

But we've done—we've combined that. So, that's the conservative side, because there are very, very powerful forces preventing any profound changes, and that's what happened even in the '30s, though it's more radical, because it's a bigger change.

So, we've done that. So that's one side of the political outcome, the conservative one. Essentially, it's the same system as before, more concentrated than before, obviously.

And, but, the other side, as I've said is we've also a whole other slew of political pressures say we've lost confidence in the financial sector. And so, channeling that side of the public's attitude, we get all the regulatory stuff.

So the political equilibrium, which is not surprising, is, on the one hand, the system is strong enough to survive as it was, and to prevent any profound change in the way the system worked. And on the other side, we are incredibly angry and we're not going to allow the system to get away with anything.

And so, that's the equilibrium, political equilibrium I think we've reached, which is fantastically over-regulated, but still hypertrophied and essentially still highly leveraged and unstable financial system. This is a very undesirable place in my view to have ended up.

But, as you imply in your question, it's exactly what you would predict from a political point of view. I can't do much about that, except describe it.

QUESTION: Benn Steil, Council on Foreign Relations.

Martin, one of the consequences of the crisis for our profession is that the various schools of macro thought have been to a test in a way they hadn't been previously.

Broadly, to caricature—somewhat, at least. The Austrian liquidation school, looks very very weak. The Keynesian, it's all fiscal school, looked extremely strong, I would argue until 2013, when they were saying that the fiscal multiplier in the United States was a very high number, at least 1.5, probably over 2, yet we had a large fiscal crunch and no recession.

That led to a victory lap being taken by the third school, which is really sort of a post-crisis phenomenon, the market monetarist school, that argues essentially that fiscal policy is just socialism. It's the job of the central bank to stabilize the economy by stabilizing nominal GDP, and then it—that, in fact, the central bank has all the tools to do this.

Where do you come down on this?

WOLF: I think that's really very interesting. The—OK—the—I divide economics, perhaps a bit like you. There are two big schools and then there's sub schools. The two big schools are, one, to be very, very (inaudible), supply creates its own demand, forget about demand. Just doesn't matter. And there's the sort of rational expectations version of that and the Austrians are sometimes there.

Austrian macro I've always found very difficult to get my mind around, and I've tried quite hard. I mean, I do understand what Hayek is trying to say, I just don't think—see how it all fits together.

I think when von Mises is really interesting to me, he's just like Minsky, so—on his view on credit and money.

So there's the supply creates its own demand school. And then there's the demand matters state.

And I think the supply creates its own demand theory gets pretty well destroyed in crises. So put that to one side.

So then you've got the demand side. Now, in the—one might describe is as the Hicksian synthesis—of course, he was the great synthesizer—the conclusion was reached that monetary policy, and I think it's been the dominant subsequent view, that monetary—though it's changed from time—that monetary policy is, in normal times, the best way of manipulating demand, adjusting demand, so it's market monetarism.

But in severe crises, when you get to the zero bound, monetary policy becomes less effective, and therefore, you have to use fiscal policy.

And the—and I feel at the moment, in response to what you say, that what has happened so far gives enough support to both sides. That is to say, we haven't had a knockout conclusion between the two.

In a severe panic such as 2008, '9, I think—I really do think the evidence suggests that relying purely on monetary policy is pushing-on-the-strings type of stuff, the famous Keynesian idea, you needed direct demand and the decision effectively to allow governments to go massively into deficit and even have a modest stimulus but above all to go massively into deficit in 2009, '8, '9, which they all did as revenues collapsed and—and public programs, welfare programs increased spending it was just automatic, was incredibly important, and that had been part of Minsky's view.

Now, in the subsequent developments, my view is slightly different from Benn's, but I don't disagree with this.

The—the evidence, to my mind, looking at what has happened in the way monetary policy's interacted with fiscal policy, is that fiscal tightening, which has been substantial everywhere, has curtailed demand growth. It has had negative effects. It's one of the reasons demand growth has been so modest.

But monetary policy has turned out to be more effective at the zero bound than many Keynesians thought. And—and the—so in that sense, the—the market monetary school's (inaudible) and so forth have some support.

And that was very much Friedman's view, though I'm not persuaded the right way of thinking about that is in strict quantity terms. I mean, that's not—not that helpful.

The—the - the question then arises—and this is where I get my usual sort of in-the-middle sort of way—is what is the most effective way of using monetary policy when you've got a situation of chronically deficient demand, because of deleveraging and all the rest of it? What is the best way to use it?

And it seems to me that what we've actually done after the worst of the crisis was over—so forget that crucial period when everything was working together and I think quite effectively—we basically used—beyond having very low interest rates, we basically relied on Q.E. as a mechanism for purchasing predominantly government bonds.

And I don't think that has been a very effective policy instrument. It hasn't been hopeless, but I don't think it's been a very effective policy instrument.

What would've been the most effective policy instrument? Well, we come back to helicopter money, the use of money to finance fiscal deficits, larger ones, if necessary.

So I tend to see the zero bound, in this situation, that it's the combination of the two instruments that is probably the most effective.

But since nobody really tried that ruthlessly—nobody tried that ruthlessly—and nobody really managed a reasonable recovery, I think it's fair to say that the test hasn't been—yet been made. The full test has not yet been made.

But so—but my basic conclusion in this is that you use what you have, which is both of these things, which is effectively what we've done. But I do agree with Benn that after the panic stage, monetary policy turned out to be more effective than I thought it would be.

By the way, I do expect that the next time around—and there will be a next time—the liquidationists are going to have their go, and then we will see what that does to us.

HUBBARD: Well, I'm going to have to come down on the side of monetary policy and take the punch bowl away while the party is still going, because we need to wrap up.

But please join me in thanking Martin Wolf.



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