An Overview of the Global Debt Crisis

SEBASTIAN MALLABY: We can get started. I'm Sebastian Mallaby. I work here at the Council on Foreign Relations. Welcome to the third annual Stephen C. Freidheim Symposium on International Economics. And we're very happy to have Steve here in the front row.

I've got two housekeeping notes. First of all, this is on the record. Secondly, please turn off those cellphones and BlackBerrys and things that go "beep."

And thirdly, Alan Greenspan needs no introduction, but I'll introduce him a bit anyway. If he's not bored of hearing it, he was a private-sector consultant and forecaster from 1948 most of the time until 1987, with a brief exception of where he chose for (about ?) almost the only time in his life to work for somebody else, to have a boss. The boss was the U.S. president. This was the Ford administration. But aside from that, he ran his own shop. And then, of course, he was chairman of the Federal Reserve from 1987 to 2006.

This is a symposium about the debt crisis in the mature world. We knew when we planned the date that, of course, the November 23rd supercommittee deadline would be coming up, so on the second session, we'll be focused on that issue. We knew that something would be going on in Europe. We didn't quite know that Italian spreads would have broken through 7 percent, but that will be the focus of the third session.

In this first session, we're going to draw out Alan Greenspan a bit on those issues. But I'm going to start with a sort of big- picture framing question, which is, you know, why is it -- you know, debt levels, debt ratios have been rising for a long time in advanced economies. Why is it that it all came to a head in the last four or five years? What's changed?

ALAN GREENSPAN: Sebastian, I think the turning point was what I've called a huge rise in contingent liabilities. Prior to, I guess, the Bear Stearns bailout, the general presumption in the marketplace was that governments would not bail out a large institution. And indeed, there had been great debates previously when a few of them did get bailed out. But the conventional wisdom was it wasn't in the culture, and therefore there was a limit to the amount of federal debt that would be involved.

I think that what has happened, especially in recent years, and probably starting with the Bear Stearns central bailout and then, obviously, accelerating with Lehman and the like, what we began to see is that the whole financial sector was being guaranteed by the U.S. government. And it is remarkable as well that we began to even have an incursion into the nonfinancial area with the auto companies.

And so we're at a point now where the difference between the aggregate debt, public and private, in the United States and that which is strictly federal is now very blurred. And if you -- no matter how you take an analysis of the contingent liabilities -- and there are all sorts of technical ways, but it varies, incidentally, what the discount rates are; it changes all the time -- but the point that I'm saying here is that the markets at this particular stage, when they're looking at the size of the federal debt, don't ask, essentially, what is it, because we have a very specific measure, but what, under stress, will it become?

And that's the figure that is relevant, because the markets are responding basically to this type of issue, and I think that there is no way to retrace that. It is -- what you'd have to do at this stage to regain the position of the inviolateness of the system, you'd actually have to throw some three or four big institutions into bankruptcy, and somebody will get shaken and say: Well, maybe they mean it this time.

Promises don't work. We have all been up against that final hour of what do you do when your question is, do you bail out X or do you take the uncertain consequences of not bailing it out?

MALLABY: You've argued for a long time the benefits of a commodity money standard. And I want to see whether you think, in some sense, this crisis, this point that we've reached, reflects the fact that we don't have a gold standard, something like that. To the extent that under a fiat money system, the government can create the money to liquefy the financial sector through crisis after crisis, whether it's Penn Central in 1970; whether it's the rescue, in a way, of the futures --

GREENSPAN: Continental Illinois?

MALLABY: -- Continental Illinois, but the futures brokers in 1987 -- and you can go down the list of moments when liquidity was provided to the private sector. In some sense, wasn't there a creeping creation of this --

GREENSPAN: There was. You know, I agree. There was a creeping creation, and there was a big dispute about that. But it never got to the point where it was a conventional procedure, where it was perceived that when push came to shove, there will be a cave. And we didn't demonstrate that, really, until Bear Stearns. The implementation of the Federal Reserve's Amendment 13-3, which essentially enables the Federal Reserve to lend to virtually anybody with no restrictions -- it was the technical restrictions in the law, but you know, it's the -- you need collateral acceptable, basically, to the lender, and if the lender wants to make the loan, effectively it's an open-ended type of a vehicle. I think that was a very major turning point.

I was very distressed myself when we didn't attack the "too big to fail" issue, because I think that the "too big to fail" issue is the base of the question of the credibility of a financial system.

The issue and a certain -- (the initiative ?), say, of the gold standard -- we can't have a gold standard today because a gold standard essentially is a type of monetary system that does not go with the welfare state. It goes back to the so-called rugged individualism of the pre-1930s and the issue where you would have a situation where taking charity was considered to be a sin of some form or another, and there were no entitlements, and essentially the political philosophy as such was that entitlements are wrong. The only entitlements that existed are freedom of speech, freedom of the press and those enunciated in the Constitution.

Now when you get a culture like that, you can make the gold standard work, and it worked from 1870 to 1914. It didn't work thereafter because they misaligned the exchange rates after World War II -- after World War I, and it never worked thereafter.

But in a crazy way, we're on a quasi-gold standard now.

I mean, people say, you know, is -- why is it that the euro and the dollar are both trading in a relatively narrow range when all this chaos is going on? Well, in a sense, there's a third currency out there which you can measure it against, and it is gold. And it's -- you're seeing what's been happening recently. And I don't think you can address this issue in an economic sense. It is fundamentally a cultural and political issue.

MALLABY: So gold may not be an official currency, but it's a privately held currency.

GREENSPAN: Well, when central banks started buying gold at over a thousand dollars an ounce, you know that something's going on.

MALLABY: (Laughs.)

So on "too big to fail," we now have a country that could be regarded as "too big to fail," namely Italy. And there's a central bank, the European Central Bank, that faces, in a way, the mother of all decisions, where does it print money to prevent this absolutely catastrophic potential failure, or does it say to itself, you know, that would be preserving a system that is fundamentally untenable and it's better for the euro to break up? Which side of that debate do you think you lean toward?

GREENSPAN: Well, we -- the debate originated in the United States. I knew exactly where it was coming out, and it did. It's different -- it's different in Italy and it's different in Europe for one very interesting reason, that the central bank, which is the sole mechanism for essentially bailing out these institutions because the SFS (ph) -- the EFS (ph) --

MALLABY: The European bailout fund.

GREENSPAN: -- (chuckles) -- the bailout fund, that's really an intermediary mechanism. There's only one institution that can create currency, and indeed, the ECB can, but the statute says it can't.

Now, the problem with that is the statute also said, when it was originated, the Stability and Growth Pact, that you couldn't do a number of things they did really -- it broke down. I mean, it was France and Germany which violated the 30 and 60 percent prohibitions -- 30 percent of the deficit as a percentage of GDP, and 60 percent as a percent -- debt as a percent of GDP. When that was breached, the penalties which were in the law were not enacted. They were just sort of quietly put away. I got sort of nervous about what the state of the euro system was going to be -- and deservedly so. I mean, we've seen what's been going on basically since then.

MALLABY: You know, you talk about the legal environment around the central bank, and some of that is driven by what the Germans decide they're going to tolerate. I mean, if they decided that their definition of legality was different to what it was last month, I think that would have a material effect.

And watching Germany in this crisis, I'm sometimes reminded of the United States in 1998, when after the Russia collapse, you had a kind of global liquidity need, and the U.S. did respond with monetary easing, which I think was aimed as much at the global situation as with the domestic one. Do you think Germany, faced with this chaos outside its own borders, is possibly making the wrong choice? It should have a bigger view of monetary policy?

GREENSPAN: Well, there's a very odd dilemma which I think Germany has got. It -- just looking at the data as it exists as of today, it's very obvious that if you construct exchange rates for the old legacy currencies, you'll find that the Deutschemark is -- was moved up against the euro very significantly -- and that's true of all the northern European countries. And they're exactly offset by "Club Med" as I like to call it, which I only do that when I'm not in a position where somebody can hit me on the head.

MALLABY: (Laughs.)

GREENSPAN: But the difficulty here is that you've got a situation where the system as it stands now does not work. And it can't work largely because if you ask yourself what is wrong with the euro system as it stands now -- and what is clearly wrong is the fact that if you take a look at today's or yesterday's or the day before, our 10-year sovereign notes or bonds, of all the various members, as a ratio or as a spread against the German bund, and you array them against the unit cost increases in euros going back to January 1999, there's a very high correlation.

In other words, the markets are basically saying that a number of these countries are competitively out of sync, they cannot meet the competition. And so they are pricing them accordingly.

And if you go back and look, it is fascinating. What you see is the more culturally Germanic type of countries -- which of course are Germany and The Netherlands and so forth -- that those particular countries have got very high savings rates, relatively speaking, low inflation -- remember, the fact or the existence of the euro doesn't say anything about price levels -- have low inflation. And the southern part of the euro system essentially is dealing with very low savings rates. In fact, Portugal and Greece have been running dissavings, negative savings, since 2003.

And then look at the combination of all what I call the metrics of culture, which is essentially: Are you a saving society; meaning do you have a focus over the longer term and you invest? Is your time preference such that you have a disproportionately large amount of long-term investment relative to other countries? And what you're basically seeing in the savings data is a notion that in the north they are far more prudent and longer-term focused than in the south.

So that the interesting question here is that when you get into this sort of situation, what do the -- what happens? In other words, prior to January 1999, all of the southern countries periodically devalued. That's the way they remained competitive. And when the change occurs in January 1999, that obviously stops. But what happens instead is that rather than, as was contemplated that with the onset of the euro that Italy would behave like Germans, or Italians would behave like Germans, that the Greeks would behave like Germans -- that was the -- that was the general consensus at the time, and they didn't. And they never did. In other words, it wasn't a question that they deteriorated. From January 2nd, 1999, forward, they didn't change their behavior at all.

MALLABY: So in other words, if you look at the data, what you see is a bunch of thrifty northerners and a bunch of party-going southerners, and putting them together in a --

GREENSPAN: (Inaudible) -- live with.

MALLABY: Yeah, it is the kind of -- is the sort of party ratio theory of currency unions that you're positing there. (Laughter.)

So building on what you say, it may have been a mistake to try to push the party types together with the thrifty types. But now that we're there, right, there's a question as to whether Greece managed the crisis better by throwing out of the window its unit of account. I mean, doesn't that just add further panic? You know, I think, the incoming Greek leader. I mean, how do you think he's going to handle it? How should he handle it?

GREENSPAN: I don't think he's going to have much chance, because the problem is that we are funding Greece -- or I should say the northern part of the eurozone is funding Greece, Portugal and Spain, et cetera. They are funding these people, and the question is where does it show? Well, it shows in the current account, intra- Europe -- intra-eurozone accounts.

And what you see, starting in January 1999: a very big buildup in surpluses in the north and negatives in the south, with France being the one odd question here. France has got different characteristics. They behave, in many respects, like the south. Well, the question is, as this buildup occurs, you begin to get increasing political domestic pressure in the north, is what we're seeing.

And what -- to answer, go back to answer your earlier question -- the issue with Angela Merkel at this particular stage could be doing is to essentially argue that these are not real lateral transfers, permanent. What they are essentially is the cost of goods sold of maintaining a low currency, which helps exports. So that the Germans have an export boom. Why? Basically because the euro is selling at a significant discount to where it ordinarily would be as measured by the Deutsche Mark, the shadow Deutsche Mark.

And so what Merkel could argue is that these are not gifts; this is the cost of our maintaining our export capabilities, the viability of the economy and our employment rate. Now, she's not doing that -- I'm pretty sure she understand the issue, but it strikes me that there are lots of very odd things going on in here. And I would say, if I were a German, I would be -- I would not to be thinking in terms of the fact that what I am doing is shoveling money out to some -- to various people who shouldn't be getting money.

MALLABY: A hard argument, maybe, for a political leader to make, to say what looks like payments to Club Med is really a devious plot by us to subsidize our exports.

GREENSPAN: (Chuckles.)

MALLABY: I want to ask you a question about the U.S. -- the U.S. outlook there. I'm hoping -- you know, given how you've laid out the problems facing Europe, I'm hoping you feel a tiny bit more optimistic about the problems facing the United States, although we have our own debt battles here.

GREENSPAN: The major problem the United States has got, aside from a long-term political issue and a lot of other things, is basically Europe. I get up in the morning and --

MALLABY: Is Europe.

GREENSPAN: -- I look -- and I just look at the European stock prices, and I can forecast with a hundred percent correlation what's going to happen in New York when it opens. That wasn't always the case. We have a global -- we have a global marketplace. And as far as I can see, what's basically driving the U.S. economy are some of our fundamentals, but with that caveat.

The fundamentals are really actually not bad. And the way I would put it is that if you think of the United States economy as segmented into two basic types of economic activity, one is long-lived activity -- let us say asset purchases of 20 years and over -- in other words, in a sense, strip down the GDP and make it a cohort of how long the particular asset that you're producing is going to last. What we find is that for the first time in the post-World War II period, the longest-lived assets, which are obviously structures, private structures, in every recovery would grow disproportionately more than GDP and really, therefore, contribute to the recovery -- every single recovery until now. And now it's sort of -- it's flattened out.

I've gone through various simulations in which I take into consideration that the ratio of structures to GDP has been going in a somewhat downward trend as the population is slowing and the growth is slowing. And I just flip that curve, which is a relatively stable curve, and then read the difference under that curve as to what actually is going on. And you're cutting about a percentage point of growth a year for, I think it was -- would be 2008, 2009, and continuing to 2011. If you convert that shortfall into employment, we have lost about three percentage points in the unemployment rate. We would be under 6 percent in my simulated model, which is another way of saying --

MALLABY: Under 6 percent unemployment.

GREENSPAN: Unemployment, yeah -- which my model is essentially saying that the activities that are going on, for example, in the capital investment area, in shorter-lived assets, cost-saving equipment, so a lot of the equipment data, is doing not great but is doing reasonably --

MALLABY: Information technology investment is good.

GREENSPAN: Yeah.

MALLABY: Building a factory is terrible.

GREENSPAN: Exactly.

MALLABY: (That's it ?).

GREENSPAN: It's precisely that that's happening. And the issue here is, well, why is it happening? And I've got a means by which I sort of replicate, which I remember I was involved in in a lot of corporations in devising how do you go about the issue of estimating capital or what the -- what the company should or should not do.

And there were two things which the -- no matter who the company was, they would do. They would take a look at the equipment of what was being proposed largely by the (products ?) managers or somebody else. They'd get the average expected rate of return, you know, properly discount it and take a look at it relative to the cost capital to the corporation as a whole.

If it passed muster, then they'd go on to the more interesting part, which is what is the variance of that expectation. And the variance -- I mean, it's pretty obvious that if you have a cost-saving project, the variance is rather narrow. If you have a market- expanding investment, the expected rate of return has got to be 25 percent, or you won't do it. But the range is minus 10 to plus 60. That project will be turned down.

And so what I'm getting at here is that the cause of the uncertainty that we are looking at is basically this process of the variance. And I measure it in statistical terms by taking the proportion of nonfinancial corporate cash flow that is -- that the corporation chooses to invest in longer-term illiquid assets as a measure of how confident they are about the future. And that statistic now is at the lowest level since 1940. And indeed, if you look at the issue of comparable numbers like equity premiums in the market, we're getting very much the same results.

MALLABY: So it's, in some sense -- I mean, the U.S., in productivity growth terms and corporate profits, is doing well.

GREENSPAN: Well, it's the productivity which is driving -- remember, the productivity is coming from the short-term investments, which in turn is driving productivity, which in turn is opening up profit margins and profitability. But it's confronting a very high equity premium. But that's good, not bad, because it's very difficult to (measure ?) it getting very much higher. Therefore, any increase in expected earnings per share flows directly into the stock price.

And if it weren't for Europe, I think the markets would be quite a good deal higher than it is, which is very important because I also think that we underestimate the wealth effect, in the broadest sense, on economic activity. I think it's -- you know, you could have seen -- you know, during the crash we lost -- I think it was global listed -- global listed stocks went down $35 trillion. It was a 50 percent decline, in effect, a doubling in leverage. And that -- and in fact, that stock price decline -- I mean, actually, the gutted value of collateral meant that the system was really under some huge stress, wholly financial.

MALLABY: So if people's feel of the future is such that they are -- that stock prices are, in some sense, attractively valued, it's poised to recover if the European situation clears up a bit and maybe if some domestic political concerns can be cleared up. And once that wealth recovery comes in the stock market, you foresee a bounceback in the economy. Is that --

GREENSPAN: Provided that the administration continues to do what it's doing now, which is nothing. (Laughter.)

MALLABY: Do nothing?

GREENSPAN: No, what this -- a thing which fascinates me is whenever there's a problem, the issue is, well, what is the government going to do about it. But they always leave off the list what is a very important potential choice, and it's called do nothing, because that allows the system to heal.

And if anything, it induces the risk premiums that is that variance that the corporate sector is looking at to shrink. That will do more to GDP than any stimulus program anybody's invented.

MALLABY: Well, thanks to the fantastic quality of the council's research team, I know that you wrote a piece in the 1970s in The New York Times which was entitled the "Do Nothing Prescription". So you've been consistent over some period on that. (Soft laughter.)

I think it's time --

GREENSPAN: Only 40 years.

MALLABY: (Laughs.) I think it's -- I'd love to have asked you about China. I think we should go to the members out here, and see if anyone wants to join the conversation. Please put your hand up, state your name and affiliation if you do have a question. And if you don't, I will continue to grab the chance.

OK, I see -- I see one here.

QUESTIONER: I'd like to ask a question about inflation.

MALLABY: Could you identify yourself, sir?

QUESTIONER: Yes, Richard Weinert, Concert Artists Guild. I'd like to ask a question about inflation. Do you think it's -- high inflation rates are likely in the future, and do you think they would be healthy for recovery?

GREENSPAN: It's going to depend how this issue -- these very large excess reserves in the commercial banking system play out. At the moment we have, as you know, because of the huge increase in purchases of assets by the Federal Reserve, we've built up a very large -- (free/three ?) reserves, if you want to put it that way -- in the commercial banking system. And they're holding those reserves at 25 basis points at the 12 Federal Reserve banks, but they are not lending it.

And they are not lending it, as you can see, because we can actually -- the Federal Reserve's got data which I find very useful, which is an evaluation of the amount of C&I loans are that are made periodically and under what -- various conditions. It's very obvious, looking at those data, that a commercial bank can relend these reserves that they're holding of the so-called deposits at the Federal Reserve at very significant advantage. I mean, it's over a hundred basis points to take the deposit and relend it. They are not doing it, and the reason they argue they're not doing it is basically that they are uncertain about their capital requirements in the future, and they are struggling to get to the point where they're willing to lend, but they haven't reached that point yet.

And if they don't reach that point, it is perfectly credible to me that at the some point the Federal Reserve is going to start to want to pull its excesses. And if there has not at that point been any significant increase in the money multiplier, as we say, meaning the movement of those reserves into active lending and active economic activity -- if it hasn't happened at that point, then you could pull all excess liquidity in, and you won't get inflation.

If, however, the money multiplier begins to move, then all of the statistics I look at suggest that there are very strong expectations of a major move on the upside. I've tried to model that, and I've got a very interesting equation, which I don't believe, but the ones I don't believe usually are the ones that work.

MALLABY: (Chuckles.)

GREENSPAN: What I did is, I said take the core (PCU ?) -- that's the consumer's price index in a more elaborate form -- and make it as a function of the operating rate of the nonfinancial economy and also -- and I might add that that is a very significant variable to explain it, and that's what most people use. It's the slack variable which, going back to John Maynard Keynes, is the reason why inflation held down.

But I have another variable in there, and that is what I call unit money supply, which is M2 divided by the capacity of the economy. And that has got an even higher correlation, but with a very long lead time, like 13 quarters or even more than that, on occasion, and so that even though we have had an upturn in the money supply -- it's still positive -- it's technical; it's got to do with demand deposits, which you can hold at the -- no cost, really, anymore -- but in any event, what the equation says is that we are beginning to see, after the -- calculated value following the actual deflation, by itself, beginning now to turn up.

One of the two things are going to happen. Either the price levels are going to grow in a manner in which I am going to forget I ever wrote the equation --

MALLABY: (Chuckles.)

GREENSPAN: -- or it's going to capture something which is very important, and it will basically tell us to what extent is the expansion in the central bank balance sheet ultimately impacting.

There are no examples of which I am aware -- and maybe Marty Feldstein can tell me I'm wrong on this -- where we have -- where anybody has created this much liquidity in the system, never sopped it up and didn't -- wasn't visited by inflation. In fact, it's almost built in to the definition of inflation. Price is the number of units of your currency -- transaction currency to the quantity of a physical good. And so money is part of the definition, and it's just not credible that you can create a huge amount of excess without inflation.

Now, the second part of your question was -- I assume this is the issue -- would our trying to create inflation be helpful now? The problem, unfortunately, is it sounds very nice, and if you actually could do it, I would say probably, but you can't. Because what happens under those conditions is that -- the markets are very complex. You will try to get a modest amount of inflation, and what you will end up with is it will take off. You cannot control it. And it is a very risky monetary-policy maneuver because -- it works in a macro-econometric model. You know, you just stick in the variables, and lo and behold it just very gradually adjusts because it's built into the mathematics of the way you constructed the models.

The problem is, I hope we all ran into a roadblock on the question of how we use models by the fact that nobody's very sophisticated macro-model predicted September the 15th, 2008.

The Fed's model certainly didn't, and the Fed's model is really terrific if you're an academic and you love the mathematics of how those things are put together. It's a very elegant model.

The IMF was actually arguing in the spring of 2007 that the risks in the world were falling, not rising. And J.P. Morgan, which has got to be presumably the best we've got in this sort of financial modeling area, had, at that point in early 2008, the GDP accelerating in the United States through the next year. Everybody got it wrong.

Now, why we would tend to use those models to simulate what we think a particular economic policy is going to do is beyond me. When people simulate a model -- simulate a result and get -- and say this is going to create 1.25 million jobs, I say that's terrific; that's what the arithmetic shows, but it also shows that there wasn't supposed to be a crisis in September the 15th, 2008. (Laughter.)

So what do you do? I mean, the question here is -- there is a very high risk in (taking ?) activities, and I hope people don't get becalmed by the fact that the models say it's this, that or the other thing. I've been playing with these models for I cannot tell you how many -- it seems like centuries, but it's a long time.

MALLABY: (Chuckles.) That is, but only 40 years.

And let's go to a question here.

QUESTIONER: I'm Padma Desai. I'm the Harriman professor of economics at Columbia University.

On assuming charge of the European Central Bank, Dr. Mario Draghi, the new president, lowered the interest rate by a quarter percent. This is a total turnabout from the policies of the previous president, Mr. Trichet, who had been raising interest rates. Would you like to comment on the monetary policy contrast of the two central bankers -- (inaudible)?

GREENSPAN: No. (Laughter.) You've raised the question in a way that was going to get that answer.

QUESTIONER: (Inaudible.) (Laughter.)

MALLABY: (Right ?) for the occasion or (right ?) for debate? That's it. OK. (Laughter.)

Over there.

QUESTIONER: My name is Halad Azim (ph). Sir, would you mind commenting on your views about Basel III, about the proposed regulatory reform, particularly about the new capital and liquidity requirements for banks?

GREENSPAN: Yeah, I think the first thing we ought to recognize is that there is only one reform that I think comes out of this current crisis, and that is inadequate capital in the financial intermediaries. And I say one reform, and I say you do -- you get the capital levels correct and you can stop there. The reason I say this is that what we mean by adequate capital is that capital in which the probabilities of a financial intermediary default are negligible.

If you don't get a default, you don't get any contagion, you don't get any problems. And had we adequate capital in 2008, the falling home prices would have fallen -- been significant. I suspect the stock market would have been a significant decline. But the capital position of the banking system would not have been impaired. And if you don't impair the capital of the banking system, you don't create the secondary -- you don't create the breach that induces the system to come apart.

I find it useful to think in terms of -- financial crises in terms of snow avalanches. They start very small, and then they begin to break out, and then all of a sudden it collapses. If you never get to the point where the -- even though the capital obviously is going to decline in a crisis like 2008, that's not the issue. Does it get impaired where you -- where the institution's solvency is at stake? If that does not happen, then you do not get any secondary effects, and as the economy stabilizes because the financial system didn't break down, you begin to get -- the retained earnings in the -- in the system build up, and you restore what has been a reduction in capital, but not a breach.

So as far as I'm concerned, having sat in on many Basel meetings -- I went to as many as Bill McDonough has, but he survived. So I guess they can't be all that bad.

MR. : (Off mic.) (Chuckles.)

GREENSPAN: Yeah. You -- I mean, I remember we barely got through Basel II. It was within seconds when it became obsolete.

And that tells you how frail this conceptual operation is.

The FDIC, as recently as 2006, was arguing that -- essentially that the American banking system of thrift institutions and commercial banks were overcapitalized. Now you cannot politically get through the type of thing which is now in Basel III in the context of 2006, 2007, because when the senior agency in charge of making that judgment -- this is the institution which ensures the banking system and its protection is the amount of capital in the banking system, and it is basically saying you've got more than will be necessary -- this is two years before the crisis.

Now I purposely went to look at their quarterly reports after 2006 to see how it, you know, sort of would deteriorate. They first -- the things that got -- in 2006 (their view's that ?) 99 percent of banks were overcapitalized --

MALLABY: This is the FDIC report?

GREENSPAN: Yeah. And as it -- go quarter to quarter, you can see that thing gradually disappear. But it didn't fully disappear at the time of the crisis. And I don't see how -- that unless you put in place capital which, by definition, will not be used for protracted period of time, it's buffer -- buffer capital, remember, is the savings of a society which cannot, if used for bank capital, also be used to build a building or to fund any of a number of other operations.

Savings must equal investment, and that balancing mechanism requires that -- if you use the nation's savings for one thing, it's not available for something else. And what we've got to recognize is that if we are going to continue the type of financial system in general that we have had, it's going to require more capital, with the recognition that for a vast period of time, it's not going to be used.

MALLABY: You know, there's one addendum maybe we could bring in. Rick Souderman (ph) has said to me sometimes that in addition to this extra capital, a partnership structure in more financial intermediaries would improve incentives to manage risk. Do you agree that's an additional shift worth considering to reduce the risk in the system?

GREENSPAN: I'm sorry --

MALLABY: A partnership structure for financial intermediaries increases the risk control because the partners have their own money on the line.

GREENSPAN: My chagrin in retrospect -- and I can't say -- I don't remember how I felt about it. In 1970, the New York Stock Exchange up to that time required that all broker-dealers be partnerships. I remember Goldman Sachs wouldn't lend you a nickel overnight, and when they finally started to get to bridge loans, saying, what are they doing? I mean, this is, you know -- you're putting partners funds at risk for three days? No.

And what happened as they went to -- became incorporated, the whole ethos changed. In fact -- I don't recall whether or not there was chagrin, but the pressures that were coming from a lot of the (brokerages ?) were beginning to expand and they wanted external capital -- forced that on the New York Stock Exchange.

But I think the consequences are very obvious, unambiguous. And if we basically went back to all broker dealers have to be partnerships that would not, in my mind, be bad.

MALLABY: So more capital and more partnerships.

Another question. I can see one right there.

QUESTIONER: Thank you. More time to get the mic than to pose the question. Thank you. I was curious about my -- Paula DiPerna, the NTR Foundation. Could you comment on the implications, say, of municipal bankruptcies, like Jefferson County, and the prognosis in Harrisburg? What do you think they mean, if anything, for the macro situation?

GREENSPAN: Well, I think it's sort of self-evident you'd expect that if you're getting significant strains on the capital adequacy in the financial system and nonfinancial system and all aspects of the private system, since it is essentially they that fund, in one form or another, directly or indirectly, governmental structures, especially in the municipal area, that one of the signs that the system's under strain is that some municipalities will go down. And indeed, I think we're probably going to see more of that.

MALLABY: Another question. There, right in the front here.

QUESTIONER: Frank Brosens, Taconic Capital. You commented about the capital adequacy in banks. One of the other issues obviously in '08 was the quality of the assets and the misperception of the quality of the assets in banks. Basel III gives very strong preferential treatment to sovereign credits.

What are the implications of that?

GREENSPAN: Well, I haven't seen the latest version, but in Basel II, there was a big argument about whether all sovereign credit was homogeneous, meaning that they were all riskless, so that there are -- the long-term obligations of Greece had exactly the same standing, so far as Basel II was concerned, as the United States, and that, essentially, you would have a situation where if anybody said, but wait a second, this doesn't make any sense -- not that anybody expected at the time that there'd be defaults -- but that you couldn't argue that the credit -- the credit status of the United States was equal to that of, say, Greece or Portugal or anybody else, but the political pressures inside the mechanism of the Basel discussions was such as it would be an affront to the Greek people if their sovereign was considered not to be equal to the United States, for example, because that's the very concept of sovereignty. You are independent, and you have a certain relationship to the world.

Now, I don't know what they're doing now. Have they finally gotten to the point where they're willing to put haircuts or just -- not take -- in Basel II, the capital requirement was zero for all sovereigns. Is that the case now for -- does anybody who's up on Basel III know what that is? I don't.

MALLABY: I'm sure Frank knows the answer.

QUESTIONER: The capital requirements are small, but they're better than zero.

GREENSPAN: They've moved them?

QUESTIONER: They've moved them from zero, but they give preferential treatment for equivalent rated sovereigns over corporate rating.

MALLABY: It's the U.N. General Assembly model of finance, right? One country, one vote; they're all equal; and what we need is to shift to the Security Council. (Laughter.) It is a foreign policy organization.

GREENSPAN: Right -- I find that one of the things that has happened since I've left office is I'm remarkably uninformed about things which I no longer care about. (Laughter.)

MALLABY: (Laughs.) I can see a question back there.

QUESTIONER: Steve Hellman, Eos Energy Storage. Mr. Greenspan, can you comment on -- I'm trying to phrase this question so you don't answer no. (Laughter.) Can you please speak about the moral hazard issue? You talked a little bit about banking capitalization and so forth, but have we even attempted -- or has the partial addressing of the issue of moral hazard problem in financial institutions created a better environment going forward than we had in the past?

GREENSPAN: Oh, I think the moral issues have risen -- in fact, my opening remarks basically are really essentially -- is directed in part on this issue. The moral hazard issue is essentially a function of the expectation of when government will intervene in the market process to divert the consequences which are perceived to be politically unacceptable. I would say it's a much higher level now than I would guess it's been in very many years. I mean, obviously, it was more so. The National Recovery Act in the 1930s was -- I mean, moral hazard in the extreme.

But I think it's come up a great deal in recent years, and I think for very much the reasons I stated at the -- in my opening remarks, really. I'm very much concerned about that. And I think that one of the things that's come out of this crisis is the notion of "too big to fail," which I think is a very dangerous notion if finance is to do basically what it always has been supposed to do -- namely, to marshal the scarce savings of a society and to direct it to the most productive, cutting-edge technologies available -- in a sense, that what a financial system should be doing is taking the depreciation reserves of obsolescent industries and, coupled with the new savings of the society, direct them to the highest cutting-edge technologies, which essentially is how productivity rises year on year.

Once you have "too big to fail," meaning that you immobilize certain parts of the savings in the system, that's not available for financing cutting-edge technologies.

MALLABY: Another question. Right over here.

QUESTIONER: Scott Helfstein (ph), United States Military Academy. Dr. Greenspan, thank you for your remarks.

A little earlier you discussed the constraint to bank lending and the fact that they weren't willing to make loans. Given the debt overhang that we face, do you think that in a lot of ways that reflects prudence? And should we see a significant increase of lending or are we worried about adding further -- further debt to a system with quite a bit of liability already facing it?

GREENSPAN: Yeah, I've -- it's hard to answer that question, but it raises another question which I've been struggling with for quite a while. I've asked a number of people whom I thought would know a good deal more about this issue than I, and I've gotten no real answer. And here's what the facts are. And it's not -- it's only indirectly related to your question.

Since 1947 in this country, the share of domestic -- gross domestic income going to finance and insurance has risen from 2.3 percent up to close to 10 percent today. It essentially went into the crisis, stuttered a little bit and then started back up again. This raises a very interesting question which, if it were only for the United States, could be unique, but it isn't. There are a number -- not all countries in the world have that same pattern, but it is pretty diversified.

And even one of the most obvious ones, which strikes me as sort of telling you there's something important going on here -- China. China's share of finance and insurance has been going out -- I'm sorry, China's finance and insurance's share of gross domestic income has been rising steadily as well. Now, that raises an interesting issue, is the ever-increasing division of labor in our global economy -- (is it ?) requiring, in order to make the system function, an ever- increasing proportion of finance?

Now, the purpose of a good deal of Dodd-Frank is to go exactly in the opposite direction, and I'm not sure whether or not we're running into the implications of Dodd-Frank -- because remember, Dodd-Frank is not going to be implemented for a very long period of time. Theoretically, it was all supposed to be done fairly quickly, but -- you know -- and Bill, I don't know what you remember, but I remember, you know, at the Fed if we had -- at the board we had 10 rulings a year, that was -- we were overloaded. But when you have to do 180 in a short period of time, it's just inconceivable.

So I don't see how all of that is going to be done in an effective manner. But whatever is happening there, I'm concerned that it is restricting the expansion of the financial system when in fact it is needed.

There is no question that there's an awful lot of very dubious issues going on in financial markets which we learned about later than we should have, but the point that I'm concerned about is that there undoubtedly was a lot of wasted financial activity leading up to the crisis. And I therefore expected that when we got into the crisis and that share actually temporarily turned down, that that was an indication of how much of our original finance and insurance income was really misused. But it's come all the way back. And that leads me to conclude that there's something here going on which I don't fully understand.

But it does raise the question that -- if we can't explain why China's share is going up, ours is going up, Australia, a whole list of others. The only qualification here I have on this whole thesis is it's not apparent in the pre-world War II data system and it is not evident in every country.

MALLABY: We're left with a verdict which I think provides a terrific segue into the next two sessions of the symposium, because the verdict appears to be that in a globally sophisticated and -- an economy with a division of labor that requires the allocation of capital amongst increasingly specialized functions, you may need a financial sector that is growing, and yet the same financial sector, because of its leverage, prevents these "too big to fail" problems, this moral hazard which Alan Greenspan has been describing as a bunch of contingent liabilities on the governments of the mature world.

So the system is both necessary, and at the same time, scary. The next two sessions will grapple with this with respect to both the United States and then with Europe.

So thank you for being here, and thank you to Dr. Greenspan. (Applause.)

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THIS IS A RUSH TRANSCRIPT.

SEBASTIAN MALLABY: We can get started. I'm Sebastian Mallaby. I work here at the Council on Foreign Relations. Welcome to the third annual Stephen C. Freidheim Symposium on International Economics. And we're very happy to have Steve here in the front row.

I've got two housekeeping notes. First of all, this is on the record. Secondly, please turn off those cellphones and BlackBerrys and things that go "beep."

And thirdly, Alan Greenspan needs no introduction, but I'll introduce him a bit anyway. If he's not bored of hearing it, he was a private-sector consultant and forecaster from 1948 most of the time until 1987, with a brief exception of where he chose for (about ?) almost the only time in his life to work for somebody else, to have a boss. The boss was the U.S. president. This was the Ford administration. But aside from that, he ran his own shop. And then, of course, he was chairman of the Federal Reserve from 1987 to 2006.

This is a symposium about the debt crisis in the mature world. We knew when we planned the date that, of course, the November 23rd supercommittee deadline would be coming up, so on the second session, we'll be focused on that issue. We knew that something would be going on in Europe. We didn't quite know that Italian spreads would have broken through 7 percent, but that will be the focus of the third session.

In this first session, we're going to draw out Alan Greenspan a bit on those issues. But I'm going to start with a sort of big- picture framing question, which is, you know, why is it -- you know, debt levels, debt ratios have been rising for a long time in advanced economies. Why is it that it all came to a head in the last four or five years? What's changed?

ALAN GREENSPAN: Sebastian, I think the turning point was what I've called a huge rise in contingent liabilities. Prior to, I guess, the Bear Stearns bailout, the general presumption in the marketplace was that governments would not bail out a large institution. And indeed, there had been great debates previously when a few of them did get bailed out. But the conventional wisdom was it wasn't in the culture, and therefore there was a limit to the amount of federal debt that would be involved.

I think that what has happened, especially in recent years, and probably starting with the Bear Stearns central bailout and then, obviously, accelerating with Lehman and the like, what we began to see is that the whole financial sector was being guaranteed by the U.S. government. And it is remarkable as well that we began to even have an incursion into the nonfinancial area with the auto companies.

And so we're at a point now where the difference between the aggregate debt, public and private, in the United States and that which is strictly federal is now very blurred. And if you -- no matter how you take an analysis of the contingent liabilities -- and there are all sorts of technical ways, but it varies, incidentally, what the discount rates are; it changes all the time -- but the point that I'm saying here is that the markets at this particular stage, when they're looking at the size of the federal debt, don't ask, essentially, what is it, because we have a very specific measure, but what, under stress, will it become?

And that's the figure that is relevant, because the markets are responding basically to this type of issue, and I think that there is no way to retrace that. It is -- what you'd have to do at this stage to regain the position of the inviolateness of the system, you'd actually have to throw some three or four big institutions into bankruptcy, and somebody will get shaken and say: Well, maybe they mean it this time.

Promises don't work. We have all been up against that final hour of what do you do when your question is, do you bail out X or do you take the uncertain consequences of not bailing it out?

MALLABY: You've argued for a long time the benefits of a commodity money standard. And I want to see whether you think, in some sense, this crisis, this point that we've reached, reflects the fact that we don't have a gold standard, something like that. To the extent that under a fiat money system, the government can create the money to liquefy the financial sector through crisis after crisis, whether it's Penn Central in 1970; whether it's the rescue, in a way, of the futures --

GREENSPAN: Continental Illinois?

MALLABY: -- Continental Illinois, but the futures brokers in 1987 -- and you can go down the list of moments when liquidity was provided to the private sector. In some sense, wasn't there a creeping creation of this --

GREENSPAN: There was. You know, I agree. There was a creeping creation, and there was a big dispute about that. But it never got to the point where it was a conventional procedure, where it was perceived that when push came to shove, there will be a cave. And we didn't demonstrate that, really, until Bear Stearns. The implementation of the Federal Reserve's Amendment 13-3, which essentially enables the Federal Reserve to lend to virtually anybody with no restrictions -- it was the technical restrictions in the law, but you know, it's the -- you need collateral acceptable, basically, to the lender, and if the lender wants to make the loan, effectively it's an open-ended type of a vehicle. I think that was a very major turning point.

I was very distressed myself when we didn't attack the "too big to fail" issue, because I think that the "too big to fail" issue is the base of the question of the credibility of a financial system.

The issue and a certain -- (the initiative ?), say, of the gold standard -- we can't have a gold standard today because a gold standard essentially is a type of monetary system that does not go with the welfare state. It goes back to the so-called rugged individualism of the pre-1930s and the issue where you would have a situation where taking charity was considered to be a sin of some form or another, and there were no entitlements, and essentially the political philosophy as such was that entitlements are wrong. The only entitlements that existed are freedom of speech, freedom of the press and those enunciated in the Constitution.

Now when you get a culture like that, you can make the gold standard work, and it worked from 1870 to 1914. It didn't work thereafter because they misaligned the exchange rates after World War II -- after World War I, and it never worked thereafter.

But in a crazy way, we're on a quasi-gold standard now.

I mean, people say, you know, is -- why is it that the euro and the dollar are both trading in a relatively narrow range when all this chaos is going on? Well, in a sense, there's a third currency out there which you can measure it against, and it is gold. And it's -- you're seeing what's been happening recently. And I don't think you can address this issue in an economic sense. It is fundamentally a cultural and political issue.

MALLABY: So gold may not be an official currency, but it's a privately held currency.

GREENSPAN: Well, when central banks started buying gold at over a thousand dollars an ounce, you know that something's going on.

MALLABY: (Laughs.)

So on "too big to fail," we now have a country that could be regarded as "too big to fail," namely Italy. And there's a central bank, the European Central Bank, that faces, in a way, the mother of all decisions, where does it print money to prevent this absolutely catastrophic potential failure, or does it say to itself, you know, that would be preserving a system that is fundamentally untenable and it's better for the euro to break up? Which side of that debate do you think you lean toward?

GREENSPAN: Well, we -- the debate originated in the United States. I knew exactly where it was coming out, and it did. It's different -- it's different in Italy and it's different in Europe for one very interesting reason, that the central bank, which is the sole mechanism for essentially bailing out these institutions because the SFS (ph) -- the EFS (ph) --

MALLABY: The European bailout fund.

GREENSPAN: -- (chuckles) -- the bailout fund, that's really an intermediary mechanism. There's only one institution that can create currency, and indeed, the ECB can, but the statute says it can't.

Now, the problem with that is the statute also said, when it was originated, the Stability and Growth Pact, that you couldn't do a number of things they did really -- it broke down. I mean, it was France and Germany which violated the 30 and 60 percent prohibitions -- 30 percent of the deficit as a percentage of GDP, and 60 percent as a percent -- debt as a percent of GDP. When that was breached, the penalties which were in the law were not enacted. They were just sort of quietly put away. I got sort of nervous about what the state of the euro system was going to be -- and deservedly so. I mean, we've seen what's been going on basically since then.

MALLABY: You know, you talk about the legal environment around the central bank, and some of that is driven by what the Germans decide they're going to tolerate. I mean, if they decided that their definition of legality was different to what it was last month, I think that would have a material effect.

And watching Germany in this crisis, I'm sometimes reminded of the United States in 1998, when after the Russia collapse, you had a kind of global liquidity need, and the U.S. did respond with monetary easing, which I think was aimed as much at the global situation as with the domestic one. Do you think Germany, faced with this chaos outside its own borders, is possibly making the wrong choice? It should have a bigger view of monetary policy?

GREENSPAN: Well, there's a very odd dilemma which I think Germany has got. It -- just looking at the data as it exists as of today, it's very obvious that if you construct exchange rates for the old legacy currencies, you'll find that the Deutschemark is -- was moved up against the euro very significantly -- and that's true of all the northern European countries. And they're exactly offset by "Club Med" as I like to call it, which I only do that when I'm not in a position where somebody can hit me on the head.

MALLABY: (Laughs.)

GREENSPAN: But the difficulty here is that you've got a situation where the system as it stands now does not work. And it can't work largely because if you ask yourself what is wrong with the euro system as it stands now -- and what is clearly wrong is the fact that if you take a look at today's or yesterday's or the day before, our 10-year sovereign notes or bonds, of all the various members, as a ratio or as a spread against the German bund, and you array them against the unit cost increases in euros going back to January 1999, there's a very high correlation.

In other words, the markets are basically saying that a number of these countries are competitively out of sync, they cannot meet the competition. And so they are pricing them accordingly.

And if you go back and look, it is fascinating. What you see is the more culturally Germanic type of countries -- which of course are Germany and The Netherlands and so forth -- that those particular countries have got very high savings rates, relatively speaking, low inflation -- remember, the fact or the existence of the euro doesn't say anything about price levels -- have low inflation. And the southern part of the euro system essentially is dealing with very low savings rates. In fact, Portugal and Greece have been running dissavings, negative savings, since 2003.

And then look at the combination of all what I call the metrics of culture, which is essentially: Are you a saving society; meaning do you have a focus over the longer term and you invest? Is your time preference such that you have a disproportionately large amount of long-term investment relative to other countries? And what you're basically seeing in the savings data is a notion that in the north they are far more prudent and longer-term focused than in the south.

So that the interesting question here is that when you get into this sort of situation, what do the -- what happens? In other words, prior to January 1999, all of the southern countries periodically devalued. That's the way they remained competitive. And when the change occurs in January 1999, that obviously stops. But what happens instead is that rather than, as was contemplated that with the onset of the euro that Italy would behave like Germans, or Italians would behave like Germans, that the Greeks would behave like Germans -- that was the -- that was the general consensus at the time, and they didn't. And they never did. In other words, it wasn't a question that they deteriorated. From January 2nd, 1999, forward, they didn't change their behavior at all.

MALLABY: So in other words, if you look at the data, what you see is a bunch of thrifty northerners and a bunch of party-going southerners, and putting them together in a --

GREENSPAN: (Inaudible) -- live with.

MALLABY: Yeah, it is the kind of -- is the sort of party ratio theory of currency unions that you're positing there. (Laughter.)

So building on what you say, it may have been a mistake to try to push the party types together with the thrifty types. But now that we're there, right, there's a question as to whether Greece managed the crisis better by throwing out of the window its unit of account. I mean, doesn't that just add further panic? You know, I think, the incoming Greek leader. I mean, how do you think he's going to handle it? How should he handle it?

GREENSPAN: I don't think he's going to have much chance, because the problem is that we are funding Greece -- or I should say the northern part of the eurozone is funding Greece, Portugal and Spain, et cetera. They are funding these people, and the question is where does it show? Well, it shows in the current account, intra- Europe -- intra-eurozone accounts.

And what you see, starting in January 1999: a very big buildup in surpluses in the north and negatives in the south, with France being the one odd question here. France has got different characteristics. They behave, in many respects, like the south. Well, the question is, as this buildup occurs, you begin to get increasing political domestic pressure in the north, is what we're seeing.

And what -- to answer, go back to answer your earlier question -- the issue with Angela Merkel at this particular stage could be doing is to essentially argue that these are not real lateral transfers, permanent. What they are essentially is the cost of goods sold of maintaining a low currency, which helps exports. So that the Germans have an export boom. Why? Basically because the euro is selling at a significant discount to where it ordinarily would be as measured by the Deutsche Mark, the shadow Deutsche Mark.

And so what Merkel could argue is that these are not gifts; this is the cost of our maintaining our export capabilities, the viability of the economy and our employment rate. Now, she's not doing that -- I'm pretty sure she understand the issue, but it strikes me that there are lots of very odd things going on in here. And I would say, if I were a German, I would be -- I would not to be thinking in terms of the fact that what I am doing is shoveling money out to some -- to various people who shouldn't be getting money.

MALLABY: A hard argument, maybe, for a political leader to make, to say what looks like payments to Club Med is really a devious plot by us to subsidize our exports.

GREENSPAN: (Chuckles.)

MALLABY: I want to ask you a question about the U.S. -- the U.S. outlook there. I'm hoping -- you know, given how you've laid out the problems facing Europe, I'm hoping you feel a tiny bit more optimistic about the problems facing the United States, although we have our own debt battles here.

GREENSPAN: The major problem the United States has got, aside from a long-term political issue and a lot of other things, is basically Europe. I get up in the morning and --

MALLABY: Is Europe.

GREENSPAN: -- I look -- and I just look at the European stock prices, and I can forecast with a hundred percent correlation what's going to happen in New York when it opens. That wasn't always the case. We have a global -- we have a global marketplace. And as far as I can see, what's basically driving the U.S. economy are some of our fundamentals, but with that caveat.

The fundamentals are really actually not bad. And the way I would put it is that if you think of the United States economy as segmented into two basic types of economic activity, one is long-lived activity -- let us say asset purchases of 20 years and over -- in other words, in a sense, strip down the GDP and make it a cohort of how long the particular asset that you're producing is going to last. What we find is that for the first time in the post-World War II period, the longest-lived assets, which are obviously structures, private structures, in every recovery would grow disproportionately more than GDP and really, therefore, contribute to the recovery -- every single recovery until now. And now it's sort of -- it's flattened out.

I've gone through various simulations in which I take into consideration that the ratio of structures to GDP has been going in a somewhat downward trend as the population is slowing and the growth is slowing. And I just flip that curve, which is a relatively stable curve, and then read the difference under that curve as to what actually is going on. And you're cutting about a percentage point of growth a year for, I think it was -- would be 2008, 2009, and continuing to 2011. If you convert that shortfall into employment, we have lost about three percentage points in the unemployment rate. We would be under 6 percent in my simulated model, which is another way of saying --

MALLABY: Under 6 percent unemployment.

GREENSPAN: Unemployment, yeah -- which my model is essentially saying that the activities that are going on, for example, in the capital investment area, in shorter-lived assets, cost-saving equipment, so a lot of the equipment data, is doing not great but is doing reasonably --

MALLABY: Information technology investment is good.

GREENSPAN: Yeah.

MALLABY: Building a factory is terrible.

GREENSPAN: Exactly.

MALLABY: (That's it ?).

GREENSPAN: It's precisely that that's happening. And the issue here is, well, why is it happening? And I've got a means by which I sort of replicate, which I remember I was involved in in a lot of corporations in devising how do you go about the issue of estimating capital or what the -- what the company should or should not do.

And there were two things which the -- no matter who the company was, they would do. They would take a look at the equipment of what was being proposed largely by the (products ?) managers or somebody else. They'd get the average expected rate of return, you know, properly discount it and take a look at it relative to the cost capital to the corporation as a whole.

If it passed muster, then they'd go on to the more interesting part, which is what is the variance of that expectation. And the variance -- I mean, it's pretty obvious that if you have a cost-saving project, the variance is rather narrow. If you have a market- expanding investment, the expected rate of return has got to be 25 percent, or you won't do it. But the range is minus 10 to plus 60. That project will be turned down.

And so what I'm getting at here is that the cause of the uncertainty that we are looking at is basically this process of the variance. And I measure it in statistical terms by taking the proportion of nonfinancial corporate cash flow that is -- that the corporation chooses to invest in longer-term illiquid assets as a measure of how confident they are about the future. And that statistic now is at the lowest level since 1940. And indeed, if you look at the issue of comparable numbers like equity premiums in the market, we're getting very much the same results.

MALLABY: So it's, in some sense -- I mean, the U.S., in productivity growth terms and corporate profits, is doing well.

GREENSPAN: Well, it's the productivity which is driving -- remember, the productivity is coming from the short-term investments, which in turn is driving productivity, which in turn is opening up profit margins and profitability. But it's confronting a very high equity premium. But that's good, not bad, because it's very difficult to (measure ?) it getting very much higher. Therefore, any increase in expected earnings per share flows directly into the stock price.

And if it weren't for Europe, I think the markets would be quite a good deal higher than it is, which is very important because I also think that we underestimate the wealth effect, in the broadest sense, on economic activity. I think it's -- you know, you could have seen -- you know, during the crash we lost -- I think it was global listed -- global listed stocks went down $35 trillion. It was a 50 percent decline, in effect, a doubling in leverage. And that -- and in fact, that stock price decline -- I mean, actually, the gutted value of collateral meant that the system was really under some huge stress, wholly financial.

MALLABY: So if people's feel of the future is such that they are -- that stock prices are, in some sense, attractively valued, it's poised to recover if the European situation clears up a bit and maybe if some domestic political concerns can be cleared up. And once that wealth recovery comes in the stock market, you foresee a bounceback in the economy. Is that --

GREENSPAN: Provided that the administration continues to do what it's doing now, which is nothing. (Laughter.)

MALLABY: Do nothing?

GREENSPAN: No, what this -- a thing which fascinates me is whenever there's a problem, the issue is, well, what is the government going to do about it. But they always leave off the list what is a very important potential choice, and it's called do nothing, because that allows the system to heal.

And if anything, it induces the risk premiums that is that variance that the corporate sector is looking at to shrink. That will do more to GDP than any stimulus program anybody's invented.

MALLABY: Well, thanks to the fantastic quality of the council's research team, I know that you wrote a piece in the 1970s in The New York Times which was entitled the "Do Nothing Prescription". So you've been consistent over some period on that. (Soft laughter.)

I think it's time --

GREENSPAN: Only 40 years.

MALLABY: (Laughs.) I think it's -- I'd love to have asked you about China. I think we should go to the members out here, and see if anyone wants to join the conversation. Please put your hand up, state your name and affiliation if you do have a question. And if you don't, I will continue to grab the chance.

OK, I see -- I see one here.

QUESTIONER: I'd like to ask a question about inflation.

MALLABY: Could you identify yourself, sir?

QUESTIONER: Yes, Richard Weinert, Concert Artists Guild. I'd like to ask a question about inflation. Do you think it's -- high inflation rates are likely in the future, and do you think they would be healthy for recovery?

GREENSPAN: It's going to depend how this issue -- these very large excess reserves in the commercial banking system play out. At the moment we have, as you know, because of the huge increase in purchases of assets by the Federal Reserve, we've built up a very large -- (free/three ?) reserves, if you want to put it that way -- in the commercial banking system. And they're holding those reserves at 25 basis points at the 12 Federal Reserve banks, but they are not lending it.

And they are not lending it, as you can see, because we can actually -- the Federal Reserve's got data which I find very useful, which is an evaluation of the amount of C&I loans are that are made periodically and under what -- various conditions. It's very obvious, looking at those data, that a commercial bank can relend these reserves that they're holding of the so-called deposits at the Federal Reserve at very significant advantage. I mean, it's over a hundred basis points to take the deposit and relend it. They are not doing it, and the reason they argue they're not doing it is basically that they are uncertain about their capital requirements in the future, and they are struggling to get to the point where they're willing to lend, but they haven't reached that point yet.

And if they don't reach that point, it is perfectly credible to me that at the some point the Federal Reserve is going to start to want to pull its excesses. And if there has not at that point been any significant increase in the money multiplier, as we say, meaning the movement of those reserves into active lending and active economic activity -- if it hasn't happened at that point, then you could pull all excess liquidity in, and you won't get inflation.

If, however, the money multiplier begins to move, then all of the statistics I look at suggest that there are very strong expectations of a major move on the upside. I've tried to model that, and I've got a very interesting equation, which I don't believe, but the ones I don't believe usually are the ones that work.

MALLABY: (Chuckles.)

GREENSPAN: What I did is, I said take the core (PCU ?) -- that's the consumer's price index in a more elaborate form -- and make it as a function of the operating rate of the nonfinancial economy and also -- and I might add that that is a very significant variable to explain it, and that's what most people use. It's the slack variable which, going back to John Maynard Keynes, is the reason why inflation held down.

But I have another variable in there, and that is what I call unit money supply, which is M2 divided by the capacity of the economy. And that has got an even higher correlation, but with a very long lead time, like 13 quarters or even more than that, on occasion, and so that even though we have had an upturn in the money supply -- it's still positive -- it's technical; it's got to do with demand deposits, which you can hold at the -- no cost, really, anymore -- but in any event, what the equation says is that we are beginning to see, after the -- calculated value following the actual deflation, by itself, beginning now to turn up.

One of the two things are going to happen. Either the price levels are going to grow in a manner in which I am going to forget I ever wrote the equation --

MALLABY: (Chuckles.)

GREENSPAN: -- or it's going to capture something which is very important, and it will basically tell us to what extent is the expansion in the central bank balance sheet ultimately impacting.

There are no examples of which I am aware -- and maybe Marty Feldstein can tell me I'm wrong on this -- where we have -- where anybody has created this much liquidity in the system, never sopped it up and didn't -- wasn't visited by inflation. In fact, it's almost built in to the definition of inflation. Price is the number of units of your currency -- transaction currency to the quantity of a physical good. And so money is part of the definition, and it's just not credible that you can create a huge amount of excess without inflation.

Now, the second part of your question was -- I assume this is the issue -- would our trying to create inflation be helpful now? The problem, unfortunately, is it sounds very nice, and if you actually could do it, I would say probably, but you can't. Because what happens under those conditions is that -- the markets are very complex. You will try to get a modest amount of inflation, and what you will end up with is it will take off. You cannot control it. And it is a very risky monetary-policy maneuver because -- it works in a macro-econometric model. You know, you just stick in the variables, and lo and behold it just very gradually adjusts because it's built into the mathematics of the way you constructed the models.

The problem is, I hope we all ran into a roadblock on the question of how we use models by the fact that nobody's very sophisticated macro-model predicted September the 15th, 2008.

The Fed's model certainly didn't, and the Fed's model is really terrific if you're an academic and you love the mathematics of how those things are put together. It's a very elegant model.

The IMF was actually arguing in the spring of 2007 that the risks in the world were falling, not rising. And J.P. Morgan, which has got to be presumably the best we've got in this sort of financial modeling area, had, at that point in early 2008, the GDP accelerating in the United States through the next year. Everybody got it wrong.

Now, why we would tend to use those models to simulate what we think a particular economic policy is going to do is beyond me. When people simulate a model -- simulate a result and get -- and say this is going to create 1.25 million jobs, I say that's terrific; that's what the arithmetic shows, but it also shows that there wasn't supposed to be a crisis in September the 15th, 2008. (Laughter.)

So what do you do? I mean, the question here is -- there is a very high risk in (taking ?) activities, and I hope people don't get becalmed by the fact that the models say it's this, that or the other thing. I've been playing with these models for I cannot tell you how many -- it seems like centuries, but it's a long time.

MALLABY: (Chuckles.) That is, but only 40 years.

And let's go to a question here.

QUESTIONER: I'm Padma Desai. I'm the Harriman professor of economics at Columbia University.

On assuming charge of the European Central Bank, Dr. Mario Draghi, the new president, lowered the interest rate by a quarter percent. This is a total turnabout from the policies of the previous president, Mr. Trichet, who had been raising interest rates. Would you like to comment on the monetary policy contrast of the two central bankers -- (inaudible)?

GREENSPAN: No. (Laughter.) You've raised the question in a way that was going to get that answer.

QUESTIONER: (Inaudible.) (Laughter.)

MALLABY: (Right ?) for the occasion or (right ?) for debate? That's it. OK. (Laughter.)

Over there.

QUESTIONER: My name is Halad Azim (ph). Sir, would you mind commenting on your views about Basel III, about the proposed regulatory reform, particularly about the new capital and liquidity requirements for banks?

GREENSPAN: Yeah, I think the first thing we ought to recognize is that there is only one reform that I think comes out of this current crisis, and that is inadequate capital in the financial intermediaries. And I say one reform, and I say you do -- you get the capital levels correct and you can stop there. The reason I say this is that what we mean by adequate capital is that capital in which the probabilities of a financial intermediary default are negligible.

If you don't get a default, you don't get any contagion, you don't get any problems. And had we adequate capital in 2008, the falling home prices would have fallen -- been significant. I suspect the stock market would have been a significant decline. But the capital position of the banking system would not have been impaired. And if you don't impair the capital of the banking system, you don't create the secondary -- you don't create the breach that induces the system to come apart.

I find it useful to think in terms of -- financial crises in terms of snow avalanches. They start very small, and then they begin to break out, and then all of a sudden it collapses. If you never get to the point where the -- even though the capital obviously is going to decline in a crisis like 2008, that's not the issue. Does it get impaired where you -- where the institution's solvency is at stake? If that does not happen, then you do not get any secondary effects, and as the economy stabilizes because the financial system didn't break down, you begin to get -- the retained earnings in the -- in the system build up, and you restore what has been a reduction in capital, but not a breach.

So as far as I'm concerned, having sat in on many Basel meetings -- I went to as many as Bill McDonough has, but he survived. So I guess they can't be all that bad.

MR. : (Off mic.) (Chuckles.)

GREENSPAN: Yeah. You -- I mean, I remember we barely got through Basel II. It was within seconds when it became obsolete.

And that tells you how frail this conceptual operation is.

The FDIC, as recently as 2006, was arguing that -- essentially that the American banking system of thrift institutions and commercial banks were overcapitalized. Now you cannot politically get through the type of thing which is now in Basel III in the context of 2006, 2007, because when the senior agency in charge of making that judgment -- this is the institution which ensures the banking system and its protection is the amount of capital in the banking system, and it is basically saying you've got more than will be necessary -- this is two years before the crisis.

Now I purposely went to look at their quarterly reports after 2006 to see how it, you know, sort of would deteriorate. They first -- the things that got -- in 2006 (their view's that ?) 99 percent of banks were overcapitalized --

MALLABY: This is the FDIC report?

GREENSPAN: Yeah. And as it -- go quarter to quarter, you can see that thing gradually disappear. But it didn't fully disappear at the time of the crisis. And I don't see how -- that unless you put in place capital which, by definition, will not be used for protracted period of time, it's buffer -- buffer capital, remember, is the savings of a society which cannot, if used for bank capital, also be used to build a building or to fund any of a number of other operations.

Savings must equal investment, and that balancing mechanism requires that -- if you use the nation's savings for one thing, it's not available for something else. And what we've got to recognize is that if we are going to continue the type of financial system in general that we have had, it's going to require more capital, with the recognition that for a vast period of time, it's not going to be used.

MALLABY: You know, there's one addendum maybe we could bring in. Rick Souderman (ph) has said to me sometimes that in addition to this extra capital, a partnership structure in more financial intermediaries would improve incentives to manage risk. Do you agree that's an additional shift worth considering to reduce the risk in the system?

GREENSPAN: I'm sorry --

MALLABY: A partnership structure for financial intermediaries increases the risk control because the partners have their own money on the line.

GREENSPAN: My chagrin in retrospect -- and I can't say -- I don't remember how I felt about it. In 1970, the New York Stock Exchange up to that time required that all broker-dealers be partnerships. I remember Goldman Sachs wouldn't lend you a nickel overnight, and when they finally started to get to bridge loans, saying, what are they doing? I mean, this is, you know -- you're putting partners funds at risk for three days? No.

And what happened as they went to -- became incorporated, the whole ethos changed. In fact -- I don't recall whether or not there was chagrin, but the pressures that were coming from a lot of the (brokerages ?) were beginning to expand and they wanted external capital -- forced that on the New York Stock Exchange.

But I think the consequences are very obvious, unambiguous. And if we basically went back to all broker dealers have to be partnerships that would not, in my mind, be bad.

MALLABY: So more capital and more partnerships.

Another question. I can see one right there.

QUESTIONER: Thank you. More time to get the mic than to pose the question. Thank you. I was curious about my -- Paula DiPerna, the NTR Foundation. Could you comment on the implications, say, of municipal bankruptcies, like Jefferson County, and the prognosis in Harrisburg? What do you think they mean, if anything, for the macro situation?

GREENSPAN: Well, I think it's sort of self-evident you'd expect that if you're getting significant strains on the capital adequacy in the financial system and nonfinancial system and all aspects of the private system, since it is essentially they that fund, in one form or another, directly or indirectly, governmental structures, especially in the municipal area, that one of the signs that the system's under strain is that some municipalities will go down. And indeed, I think we're probably going to see more of that.

MALLABY: Another question. There, right in the front here.

QUESTIONER: Frank Brosens, Taconic Capital. You commented about the capital adequacy in banks. One of the other issues obviously in '08 was the quality of the assets and the misperception of the quality of the assets in banks. Basel III gives very strong preferential treatment to sovereign credits.

What are the implications of that?

GREENSPAN: Well, I haven't seen the latest version, but in Basel II, there was a big argument about whether all sovereign credit was homogeneous, meaning that they were all riskless, so that there are -- the long-term obligations of Greece had exactly the same standing, so far as Basel II was concerned, as the United States, and that, essentially, you would have a situation where if anybody said, but wait a second, this doesn't make any sense -- not that anybody expected at the time that there'd be defaults -- but that you couldn't argue that the credit -- the credit status of the United States was equal to that of, say, Greece or Portugal or anybody else, but the political pressures inside the mechanism of the Basel discussions was such as it would be an affront to the Greek people if their sovereign was considered not to be equal to the United States, for example, because that's the very concept of sovereignty. You are independent, and you have a certain relationship to the world.

Now, I don't know what they're doing now. Have they finally gotten to the point where they're willing to put haircuts or just -- not take -- in Basel II, the capital requirement was zero for all sovereigns. Is that the case now for -- does anybody who's up on Basel III know what that is? I don't.

MALLABY: I'm sure Frank knows the answer.

QUESTIONER: The capital requirements are small, but they're better than zero.

GREENSPAN: They've moved them?

QUESTIONER: They've moved them from zero, but they give preferential treatment for equivalent rated sovereigns over corporate rating.

MALLABY: It's the U.N. General Assembly model of finance, right? One country, one vote; they're all equal; and what we need is to shift to the Security Council. (Laughter.) It is a foreign policy organization.

GREENSPAN: Right -- I find that one of the things that has happened since I've left office is I'm remarkably uninformed about things which I no longer care about. (Laughter.)

MALLABY: (Laughs.) I can see a question back there.

QUESTIONER: Steve Hellman, Eos Energy Storage. Mr. Greenspan, can you comment on -- I'm trying to phrase this question so you don't answer no. (Laughter.) Can you please speak about the moral hazard issue? You talked a little bit about banking capitalization and so forth, but have we even attempted -- or has the partial addressing of the issue of moral hazard problem in financial institutions created a better environment going forward than we had in the past?

GREENSPAN: Oh, I think the moral issues have risen -- in fact, my opening remarks basically are really essentially -- is directed in part on this issue. The moral hazard issue is essentially a function of the expectation of when government will intervene in the market process to divert the consequences which are perceived to be politically unacceptable. I would say it's a much higher level now than I would guess it's been in very many years. I mean, obviously, it was more so. The National Recovery Act in the 1930s was -- I mean, moral hazard in the extreme.

But I think it's come up a great deal in recent years, and I think for very much the reasons I stated at the -- in my opening remarks, really. I'm very much concerned about that. And I think that one of the things that's come out of this crisis is the notion of "too big to fail," which I think is a very dangerous notion if finance is to do basically what it always has been supposed to do -- namely, to marshal the scarce savings of a society and to direct it to the most productive, cutting-edge technologies available -- in a sense, that what a financial system should be doing is taking the depreciation reserves of obsolescent industries and, coupled with the new savings of the society, direct them to the highest cutting-edge technologies, which essentially is how productivity rises year on year.

Once you have "too big to fail," meaning that you immobilize certain parts of the savings in the system, that's not available for financing cutting-edge technologies.

MALLABY: Another question. Right over here.

QUESTIONER: Scott Helfstein (ph), United States Military Academy. Dr. Greenspan, thank you for your remarks.

A little earlier you discussed the constraint to bank lending and the fact that they weren't willing to make loans. Given the debt overhang that we face, do you think that in a lot of ways that reflects prudence? And should we see a significant increase of lending or are we worried about adding further -- further debt to a system with quite a bit of liability already facing it?

GREENSPAN: Yeah, I've -- it's hard to answer that question, but it raises another question which I've been struggling with for quite a while. I've asked a number of people whom I thought would know a good deal more about this issue than I, and I've gotten no real answer. And here's what the facts are. And it's not -- it's only indirectly related to your question.

Since 1947 in this country, the share of domestic -- gross domestic income going to finance and insurance has risen from 2.3 percent up to close to 10 percent today. It essentially went into the crisis, stuttered a little bit and then started back up again. This raises a very interesting question which, if it were only for the United States, could be unique, but it isn't. There are a number -- not all countries in the world have that same pattern, but it is pretty diversified.

And even one of the most obvious ones, which strikes me as sort of telling you there's something important going on here -- China. China's share of finance and insurance has been going out -- I'm sorry, China's finance and insurance's share of gross domestic income has been rising steadily as well. Now, that raises an interesting issue, is the ever-increasing division of labor in our global economy -- (is it ?) requiring, in order to make the system function, an ever- increasing proportion of finance?

Now, the purpose of a good deal of Dodd-Frank is to go exactly in the opposite direction, and I'm not sure whether or not we're running into the implications of Dodd-Frank -- because remember, Dodd-Frank is not going to be implemented for a very long period of time. Theoretically, it was all supposed to be done fairly quickly, but -- you know -- and Bill, I don't know what you remember, but I remember, you know, at the Fed if we had -- at the board we had 10 rulings a year, that was -- we were overloaded. But when you have to do 180 in a short period of time, it's just inconceivable.

So I don't see how all of that is going to be done in an effective manner. But whatever is happening there, I'm concerned that it is restricting the expansion of the financial system when in fact it is needed.

There is no question that there's an awful lot of very dubious issues going on in financial markets which we learned about later than we should have, but the point that I'm concerned about is that there undoubtedly was a lot of wasted financial activity leading up to the crisis. And I therefore expected that when we got into the crisis and that share actually temporarily turned down, that that was an indication of how much of our original finance and insurance income was really misused. But it's come all the way back. And that leads me to conclude that there's something here going on which I don't fully understand.

But it does raise the question that -- if we can't explain why China's share is going up, ours is going up, Australia, a whole list of others. The only qualification here I have on this whole thesis is it's not apparent in the pre-world War II data system and it is not evident in every country.

MALLABY: We're left with a verdict which I think provides a terrific segue into the next two sessions of the symposium, because the verdict appears to be that in a globally sophisticated and -- an economy with a division of labor that requires the allocation of capital amongst increasingly specialized functions, you may need a financial sector that is growing, and yet the same financial sector, because of its leverage, prevents these "too big to fail" problems, this moral hazard which Alan Greenspan has been describing as a bunch of contingent liabilities on the governments of the mature world.

So the system is both necessary, and at the same time, scary. The next two sessions will grapple with this with respect to both the United States and then with Europe.

So thank you for being here, and thank you to Dr. Greenspan. (Applause.)

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