NICOLAS VAN DE WALLE: OK, welcome to the second annual Lund Critical Debate. My name is Nick van de Walle. I'm a professor in the government department and the current chair of the Einaudi Center for International Studies Foreign Policy Initiative. The Foreign Policy Initiative is now in its fourth year, and it aims to promote the discussion of foreign policy issues on campus. Let me thank, at the Einaudi Center, Heike Michelsen, the director of programs at the Center for her great work on doing really most of the work for this session today.
The Foreign Policy Initiative has promoted a number of faculty and student research activities on campus and fosters a series of debates, of talks and bringing various people to campus. The Lund Critical Debate Series, which is today's event, is a key component of the Foreign Policy Initiative. It tries to bring a diversity of views on issues of critical importance in foreign policy and international affairs more broadly defined. Let me thank, on behalf of the Einaudi Center, Judy Lund Biggs, class of 1957, for her very, very generous support that makes this series possible.
Today, we have our second debate on the great financial crisis. My role is really purely to welcome you, so I'm about to leave the stage. And the moderator, who I'm about to present, will do really all of the officiating today. That moderator is Jonathan Kirshner, who is my colleague in the government department.
Jonathan is a professor in the government department, and he's currently the director of the Peace Studies Program here on campus. He's the author of a number of books, including Currency and Coercion-- The Political Economy of International Monetary Power and Appeasing Bankers-- Financial Caution on the Road to War, which won the 2009 Best Book Award by the International Studies Security Studies section of the International Studies Association.
He's also edited a number of volumes, and he's in charge with Eric Helleiner of a multidisciplinary book series at Cornell University Press. He's the recipient at Cornell of the Provost Award for distinguished scholarship and the Stephen and Margery Russell Distinguished Teaching Award. I will now turn the floor over to Professor Kirshner.
JONATHAN KIRSHNER: Thanks, Nick. It is both an honor and a pleasure to introduce today's speakers and to moderate this debate. It was suggested from our luncheon conversation that our debaters may agree on much, so hopefully, we will be able to draw out some areas of constructive disagreement amongst them.
And they are, in alphabetical order, Barry Eichengreen, the George C. Pardee and Helen N. Pardee Professor of Economics and Political Science at the University of California Berkeley. He is a research associate of the National Bureau of Economic Research and research fellow at the Center for Economic Policy Research.
In 1997-'98, he was senior policy advisor at the International Monetary Fund. He has held Guggenheim and Fulbright Fellowships and been a fellow at the Center for Advanced Study in the Behavioral Sciences and the Institute for Advanced Study. The author of numerous books-- I will take pleasure in calling your attention to a truly outstanding study of his from some years ago called Golden Fetters-- The Gold Standard and the Great Depression, one of my personal favorites.
Robert Kuttner is co-founder and co-editor of The American Prospect magazine, as well as a distinguished senior fellow at the New York think tank Demos. He was a longtime columnist for Businessweek, a syndicated columnist and national staff writer on The Washington Post, chief investigator of the US Senate Banking Committee, and economics editor of The New Republic. He continues to write columns in The Boston Globe. Kuttner is also the author of many books, and once again, instead of listing them all, I'll single out a personal favorite, The End of Laissez-Faire.
Eswar Prasad is our favorite son, the Tolani Senior Professor of Trade Policy here at Cornell University. He is also a senior fellow at the Brookings Institute, where he holds the New Century Chair in International Economics, and he is also a research associate at the National Bureau of Economic Research.
He was previously chief of the Financial Studies Division in the International Monetary fund's research department, co-editor of the journal IMF Staff Papers, and was the founding co-editor of the IMF Research Bulletin. His writings also appear with regularity in the Financial Times and a number of other media outlets.
It's a great pleasure to have such a distinguished panel of speakers here today to talk to us about the financial crisis. Each of our speakers in the order that I have introduced them will talk for about 12 minutes on the general topic of the crisis, what caused it, what next. I've then been instructed by Nick to start out with a short round of questions, hopefully once again highlighting more of the differences than the similarities between the presentations. And after our panel has had a chance to consider those questions and to the statements of each other, we'll open the floor for questions from the audience. And with that, it's my pleasure to turn it over to Barry.
BARRY EICHENGREEN: So thank you to Jonathan, and thank you to everyone at Cornell. It's a pleasure to be here in Ithaca for the very first time. I'm gratified, in a way, to see such a large audience. I'm also a little bit alarmed. This is a signal, I think, that from many people's point of view, the financial crisis is not over.
In Berkeley, in October, right after Lehman Brothers, we had a thousand people turn out to listen to four rather dry presentations by economists in a town where chefs and artists are the real celebrities. So for me, that was a sign that we were going through a financial crisis that is truly a once-in-a-lifetime event, or at least, we hope so.
It is the case, whatever the future brings, that nothing like this has been seen in 80 years. For me, at least, that fact creates a presumption that a unique combination of factors, a perfect storm, has, in some sense, come together to create this truly extraordinary, catastrophic event.
My contribution in my remaining few minutes will be to argue that we have to understand that combination of factors and how they came together from a historical point of view. Only history explains how and why they combined as they did to produce such a disastrous outcome.
My take on the causes of the financial crisis focuses on three factors, and perhaps if there is disagreement among the panelists, some of it will have to do with the relative importance of those factors. First on my list would be deregulation and the intensification of competition in the financial services industry in the United States and globally.
That deregulation is something that can only be understood historically. So the US financial system was very tightly regulated as a result of the financial catastrophe that was the Great Depression. Gradually over time, those memories faded, and strict regulation of our financial system was relaxed.
So we saw, first in the 1970s, the elimination of fixed commissions on stock trading. So broker-dealers like Bear Stearns-- you will have heard that name-- who could make a comfortable living earning fixed commissions to trade stocks had to move into new lines of business, which might be riskier and which they didn't always understand. The elimination of Regulation Q ceilings on the interest that banks could pay depositors made them have to compete for deposits and pay more to attract them and to go into riskier activities in order to pay the freight.
The elimination of Glass-Steagall restrictions on the extent to which commercial banks and investment banks and insurance companies like AIG could compete with one another similarly led to a narrowing of margins and an intensification of competition and caused institutions to lever up their bets, to use more borrowed money, among other things, in the desperate effort to survive. So I think to understand how it was that we deregulated our financial system and that contributed to the disaster that resulted, we have to look at that process as it unfolded over a long period of time.
The second contributing factor in my view was-- and in reality, I'm listing them and what I regard as descending order of importance, although they're all important-- was lax US monetary policy. I think very loose US monetary policy most recently after 9/11 and stretching into the middle of this decade provided the liquidity and encouraged the stretching for yield that fueled the financial bubble. And that approach to monetary policy reflected, if you will, the hegemony of inflation, targeting the idea that central banks should target a low and stable rate of inflation to the exclusion of most other considerations, such as financial stability and prospective risks thereto.
Where did this inflation targeting framework come from? Well, it came heavily from academia, but it reflected historical considerations, the fact that the battle against inflation was the principal war that central bankers were waging with good reason in the 1970s and 1980s.
And third-- what Chairman Bernanke called a few years ago the global savings glut, the fact that there was a large pool of savings out there in the world economy, a considerable fraction of which flowed toward the United States in the last 10 years. That, in turn, reflected deep-rooted historical factors, the emergence of emerging markets with their high savings rates, the globalization of financial markets, which enabled those funds to flow toward the United States.
I think you can really only understand the crisis as the interaction of those three sets of factors-- financial deregulation run wild in the United States, which occurred for, if you will, good historical reasons; a monetary policy that focused on low and stable inflation to the exclusion of all else, which we pursued for good historical reasons; and a global savings glut, whose effects we felt quite powerfully, again, for good historical reasons.
Where are we going now? I guess that was the other question I was supposed to address. My answer would be nowhere fast at two levels. Number one, I think we are not going to recover and grow our way out of this morass quickly.
We dug ourselves a deep hole, regrettably, in the course of this financial crisis, and now it will take a while to climb back out of it. The banks will not be lending. We will have an overhang of debt, a combination of loose fiscal and tight monetary policies that will not be investment friendly, so I'm not optimistic that we can do what the Swedes and the Finns did after their banking and financial crises in the early 1990s and rapidly grow our way out of this problem.
And I also think we will not be heading quickly down the road of meaningful financial reform. So some financial reform there will be, to be sure, but I worry that the critical window of opportunity is now closing, that the sense of urgency is gone, and that there is powerful pushback, as you would expect, from entrenched interests, from the financial services sector, first and foremost, that will prevent us from doing the kind of radical surgery on the regulatory framework and on the financial system itself that some of us, in our dreams, would like to see. Thank you.
JONATHAN KIRSHNER: Thank you.
ROBERT KUTTNER: First of all, I am delighted to be here at Cornell. All of my career, I have learned a lot from what I would call the Cornell school of political economy, which I would take to be historical, institutional, yet also rigorous and respectful of the value of a managed form of capitalism rather than an ultra laissez-faire form of capitalism. You were promised a debate, and while I agree with almost everything Professor Eichengreen said, let me do my best to make it a little bit edgier and focus a little bit more on the politics.
During the past 30 years, the purely financial part of the economy was allowed to become increasingly speculative, loosed from its regulatory moorings and from the needs of the real economy. It became a playground unto itself.
Financial engineers were able to use staggeringly high degrees of leverage. The different parts of the financial economy became interconnected and opaque, not just too big to fail but too complex to understand and too politically powerful to constrain, and this was true both domestically and globally. As Simon Johnson, the former chief economist of the IMF, recently pointed out, at the peak of the bubble, the share of profits of purely financial firms in the S&P 500 was about 40%, slightly higher, of all the profits compared to maybe 10 or a little bit more during the period when the financial sector was usefully harnessed to serve the rest of the economy.
All of this set up the economy for a crash comparable to 1929 and, in some ways, more serious because the leverage ratios were higher. They were typically 30 to 1, in the hedge fund private equity derivative world, sometimes even higher. In the case of AIG, the ratios of borrowing were infinity because AIG and its cohorts had managed to get the law changed in 2000 so that credit default swaps were not allowed to be regulated either as insurance or as securities-- and this is my favorite part-- or as gambling, which, in fact, when you have no reserves against the risk of loss, you are simply gambling.
Also, the global dimension was bigger and more ominous because in 1929, the United States was the world's biggest creditor nation. Today, we are the world's biggest debtor nation, and we have this folie a deux with the Chinese, which, in theory, can go on forever, except it can. And international borrowing has disguised the vulnerability of the US economy. So that's the snapshot of what happened.
I want to also address why it happened. First, there was a regulatory default, and I think the regulatory default was one part ideology, one part corruption, and one part politics, a power shift. And let me take those in turn.
The economics profession, I think, is part of the ideological shift. As Paul Krugman asked in a New York Times Sunday piece a couple of weeks ago, how did so many economists get it so wrong? And I think the answer is that after the memory of the Great Depression faded into the mists and after liberals and Keynesians were held responsible for the stagflation of the 1970s, market fundamentalism came roaring back not just in public policy but in the economy, in the economics profession.
And free-market economics-- despite the Great Depression, despite the Keynesian interlude, free-market economics remains the purest version of economics, just as a fundamentalist religion is the purest version of religion. And when you complicate the equations with rather messy institutional history and market imperfections, you are at risk of sounding like a sociologist or a political scientist or a historian. And financial economics is the purest part of free-market economics.
So you have the efficient-market hypothesis and all of the other doctrines that went from being fringe doctrines to being hegemonic doctrines in the profession in the '70s and '80s. And economists who questioned whether financial markets really priced assets and risk accurately were few in number, and they were scorned. And they were taking career risks.
Also, this message that financial deregulation and innovation are, by definition, virtuous-- this was music to the ears of Wall Street and to the Greenspan Fed, to the conservative foundations who were investing in the academy. Now, there were certainly heterodox economists and economic historians, such as Professor Eichengreen, but they did not dominate. And the academy in particular, the economics profession, the mainstream economics profession, contributed this to this.
So you have ideology. You have the academic version of ideology, and then you have politics. The 1970s was a period when the countervailing institutions that Professor Galbraith wrote about became much weaker.
There was this anomalous period between the '30s and the '70s in the United States in which activated citizens and the labor movement and interventionist governments pretty much fought the power of concentrated wealth to a draw. And then after the '70s, that power balance began tipping, and the natural political power that flows to big money reverted to its normal status.
And all you have to do is look at the interconnections between Goldman Sachs and the US Treasury under both Republican and Democratic administrations, and it looks like something that a Marxist might have made up after several drinks. The influence of Bob Rubin and his proteges on the Democratic Party for 25 years-- shepherding deregulation through Congress, isolating truth tellers like Brooksley Born-- was very much the counterpart of Republicans like Alan Greenspan and Phil Gramm so that deregulation became the ideology and the policy of both parties.
And tragically, this has continued to a degree into the Obama era, which really should have been a Roosevelt moment. For as radical a break with the old order both in policy and in politics and in rhetoric as Roosevelt brought us in 1933, it has not yet been that.
Also, I think some of this was old-fashioned corruption both in the way industry operated and in the way politics operated. You only have to look at the whole subprime scandal and the failure of regulators to use the powers that they had of which there were several. There were people on the Board of Governors of the Federal Reserve warning that this would end in tears.
There was unused power under the 1994 Home Ownership Equity Protection Act, which directed the Federal Reserve to require that even institutions that were not otherwise federally regulated use sound underwriting standards in their provision of mortgage credit. And the fact that an entire business model was based on what in the industry was known as liar loans suggests to you that this is not just a regulatory default, but this is systemic fraud. So that's the domestic part of the story.
I want to take just a couple of minutes to talk about the international part of the story. Globalization under laissez-faire auspices became the handmaiden of deregulation. In the '40s, you had a very different kind of social compact both domestically and globally. The original Bretton Woods system was intended to make possible a managed form of capitalism domestically. By the '70s, the Bretton Woods institutions had become their opposite, and the IMF and the World Bank had become instruments for ultra liberalization.
The deregulation of financial markets globally were not part of the trade agenda until the Uruguay Round, and you have people like Professor Jagdish Bhagwati, who are devout free traders, who are very offended and affronted by the fact that the instruments of the trading regime have been used as battering rams to deregulate financial markets. Trade and finance are not the same thing, but they have been treated by the GATT and then the WTO and by the sponsors of these two regimes as if they were one and the same so that the nation state, which is the only possible locus of regulation of finance, has been weakened by globalization.
This is surprisingly true in Europe, where the EU was going to be the center of a countermodel of managed capitalism, an alternative to the Anglo-Saxon model of laissez-faire capitalism. But in the past decade, the Europeans have been drinking the same Kool-Aid that we've been drinking, compounded by the fact that the EU and the Commission of the EU institutionally suffer from some of the same deficiencies of our own Articles of Confederation. Once upon a time, nation states in Europe were strong enough to regulate markets. The EU is too weak to regulate markets, and the Constitution of the EU privileges free commerce over social counterweights.
So to conclude, all of this is rooted in politics in the same way that the golden age of managed capitalism was rooted in politics, and if we are ever going to get that back, we need a political more than a technical or policy wonk counterrevolution. Thank you.
ESWAR PRASAD: We are all here because the financial crisis has touched us all in some way or the other, big or small. My personal academic story about the financial crisis is that last fall, my friends in the astronomy department invited me to come and talk to them at their relativity lunch about why on Earth their 401(k)s are falling down from the stratosphere to the ground. They haven't invited me yet this fall. I'm not sure what exactly this augurs.
Let me talk about three things, one, what got us here, which Barry and Robert have already touched upon to some extent; where we are today; and what the future looks like. On the first count in terms of why we are here, you've heard about a long list of villains, and I think they are all very complicit in this.
It was not just financial regulatory failures in the US compounded by the lack of regulation on some fronts but the fact that you did have a fair amount of easy money flowing in from the rest of the world, China in particular but many emerging markets and also the oil-producing countries that were running fairly large surpluses. And they were all fairly happy to fork over their cash to the United States and fuel a consumption binge here both by the government and by individuals, and of course, this prevented the normal sort of equilibrating mechanisms from coming into play.
Normally, if you have a large amount of borrowing within an economy, interest rates begin to rise, and the party has to end. But what prevented this from being a small bubble that popped and instead turned into an inferno, if you'll pardon the mixed metaphor, is essentially this loose money coming in from the rest of the world. But that's not to say it was all their fault. In fact, this is one of the easiest storylines here, that it was all their fault, either the Chinese or the unscrupulous people in the financial system or the politicians.
But we have to recognize when we talk about things like liar loans, there were liars who were taking those loans, and essentially, we were all, to a very large extent, happy about the increase in financial wealth that we were experiencing. We had allowed our savings rates to drop to essentially zero-- and by we, of course, I mean the average American household-- because our financial wealth was rising. And of course, this would all have gone on very happily if we'd had an increase in home prices at about 2% to 3% a year. It didn't take very much.
And it was all predicated on this collective delusion. So I think to argue that it was just a set of villains and that we had no role to play in this is, I think, taking the story a bit too far. But there have to be systems in place that prevent this from getting out of hand, and this is where the issue of regulation, of course, comes in. Even if people want to do crazy things, there has to be something in the system that prevents it from becoming a systemic event that hurts even the innocents, and clearly, a lot of innocents have gotten hurt in this bloodbath.
So the question is whether we can get out of this mess in a sensible way. Now, the encouraging thing, relative to past crises, is that the policy response was very, very aggressive both in the US and in other countries. Now, one can question whether this was sensible aggression. Expanding the fiscal deficit to the levels that it has risen to today is a questionable issue, but there was a limit to how much one could think about the government doing.
And one must also reflect on the fact that today we are in a very different place from where we were just a few months ago. When we were having these kinds of discussions at the end of 2008 or early 2009, it looked like there was no hope. The US had hit a wall. The major emerging-market economies, including China and India, had hit a wall. It looked like the financial system was at the verge of collapse, so things have certainly improved a great deal since then.
Now, in terms of the macro economy, there are still a lot of headwinds. The economy has begun to level off in the US, but there are lots of headwinds especially because the financial system is still just slowly coming back to its feet, and no matter what one might say about the problems of the financial system, it still remains the lifeblood of the economy both for consumers, investors, and the overall economy. So having a decently functioning financial system is essential even for corporations.
In addition, we have the problem that state and local governments are still hurting. This means that even though there is a lot of fiscal stimulus that the government has put into the pipeline, a lot of it cannot be easily absorbed by the system. Now, there are many positives as well. Consumer and business confidence are beginning to rise. In addition, inventory levels are at relatively low levels, so just rebuilding of inventories could actually improve things.
Although we've heard about the $800 billion stimulus package, it turns out that only about $300 billion has been spent so far, so there is still a lot of stimulus in the system. The big problem, though, of course, is that the unemployment rate is going to continue to rise this year, which could be a real drag on the recovery and makes things very fragile.
As one steps back and look at the rest of the world, things are actually beginning to look a little better. Some of the other economies, Japan and Germany, look like they have started growing. China and India have started growing at very rapid rates again.
But there is a problem, and the problem comes back to one of the roots of the crisis, which is, again, related to this issue of global macroeconomic imbalances. If you think about China, it's very likely that this year they will actually register about an 8% growth rate, which is stunning when you think about the economy basically having hit a wall at the end of last year. How are they doing it? In China, luckily, they own the bank, so they can tell the banks to go out and lend. And the banks have been lending a tremendous amount, nearly $1 trillion, in fact, a little more than $1 trillion worth of bank lending in just the first six months of 2009.
Plus, there has been a very large stimulus package. All of this is adding to investment, some of which is very good. It's infrastructure investment, but in addition, they're also building up a lot of excess capacity in industries where there was already excess capacity to begin with. In addition, they need the exports because that's where they get most of their employment growth from.
So now you have this potential scenario where GDP growth looks very good, but household income growth and employment growth are not going to keep up. So what does China do? It has to look for export markets, and it's not just China. It turns out that even some of the other major advanced economies like Japan and Germany still rely on exports to a very great deal in order to maintain their recoveries. And so you look around about who could take these exports, and there isn't much of a choice but the US.
So in fact, the rest of the world is still looking to ride the coattails of the US to a recovery. Can the US take on this burden? Now, in the US, in fact, some adjustment has, in fact, been taking place. The personal saving rate has gone from basically 0% of disposable income to about 7% of disposable income.
This is good. Households are beginning to rebuild their balance sheets, which were devastated by the financial crisis. This is not so good in terms of the domestic consumption powering the economy, and the domestic consumption in the US has powered not just the US economy but a significant chunk of the global economy so far.
In the short run in this year, perhaps for the medium term, the US government is filling in the breach. The US government cannot fill in the breach forever because this drives up the amount of borrowing that the government is doing. In fact, the Congressional Budget Office and the White House say that the budget deficit over the next decade in the best-case scenario is going to be about $1.6 trillion this year and about $9 trillion over the next decade, and this is a reasonable scenario.
If things don't turn out quite as planned, then we face trouble. So we are facing this difficult situation where, in fact, the issue that Barry spoke about, global imbalances, could come back to haunt us. Now, there is another aspect of global imbalances.
It was not just the desire for export-led growth but also the desire among many emerging-market economies to protect themselves from precisely this sort of crisis. If you build up a lot of foreign exchange reserves, if you have a large holding of US dollars or euros, if your currency comes under pressure, which has happened to many emerging markets in the past, driving them to crisis, it's good to have a lot of dollars. The problem is the way you build up these foreign exchange reserves is by running trade surpluses.
So now we face a situation where emerging markets have, if anything, an even stronger set of incentives to build up reserves because they've seen how virulent this crisis has been. They've seen that what used to be thought of as very large stocks of reserves don't seem that big anymore. Russia and India, for instance, lost about 20% of their very large stocks of reserves in less than half a year during this crisis, and India wasn't a terribly hard hit economy, even. So now economies begin to wonder whether they should hold even more reserves.
There is the IMF that could backstop these crises. The problem there, again, is going to the IMF with a begging bowl in hand still carries a tremendous amount of stigma, so countries are not willing to go to the IMF unless they absolutely have to. So now all the incentives are, again, towards leading to a rise in global imbalances.
Now, it was a combination of global imbalances and regulatory failures that led us where we are, so how are we doing on the regulatory front? So let me cheer you up a little more. If you think about the financial system intrinsically, it is fraught with problems. Intrinsically, the financial system in any economy tends to be very fragile, and this is why we have institutions like the Federal Reserve Board as a lender of last resort. This is why we have the Federal Deposit Insurance Corporation, which insured all our deposits up to $100,000 before the crisis, so that we don't have panics that lead to people showing up at the door of the banks and demanding their money back all at once.
Unfortunately, here, the political will, as Dr. Kuttner mentioned, to make serious reforms does seem to be passing. In addition, there is a problem that the very act of getting us out of this crisis let the government to do certain things-- bail out the very large firms-- that has created even greater problems in the system, what we economists call moral hazard, in the sense that now the larger institutions at some level are protected by the government.
And not only do the institutions know that. We all know that. The markets know that, that something like Lehman will not be allowed to happen again.
So the question is whether we can, in fact, extricate this moral hazard out of the system. There are ways to do it, and in fact, the government, to its credit, is trying to do some of these things-- by tightening the regulation of certain products, by bringing more derivatives onto exchanges so they can be traded out in the open, by increasing requirements on banks to hold more capital in order to protect themselves from these issues.
But the problem here, again, is that in terms of systemic risk, I don't think we have done as much as we might have done. So the difficult reality we face right now is that we have a situation where global imbalances could begin to resurge, and if they don't, we have two potential scenarios. One is something that we macroeconomists, in fact, thought would lead to a crisis that with the excessive borrowing in the US, excessive debt buildups by the US in terms of its borrowing from the rest of the world, eventually, the dollar would start declining. And this would cause a problem if the dollar declined very sharply.
Right now, in fact, it looks like the best-case scenario for getting us out of this is to return to global imbalances where the US consumer, you and me, go back to our old ways and consume a lot, and then we deal with the problems in the future. The big risk, of course, is that we are setting ourselves up for an even bigger fall, and this is a real concern.
Of course, if the dollar were to plunge today, it would add to even more turmoil in currency markets and could make a bad situation worse. But interestingly, it would also inflict a great deal more adjustment pain on other countries where they would have to rely much less on exports to the US or the rest of the world and, in fact, start trying to stoke their domestic demand, which is what China has been doing. So a lot more could be done in this economy.
So I think what we need to think about right now is whether, in fact, we have strengthened our financial system to prevent this from happening again. There, my answer is mixed, whether we have prevented the situation that could lead to a resurgence of global macroeconomic imbalances. There, I am somewhat more pessimistic and whether we can prevent both of these from resulting in the sort of pickle we are in right now. Policymakers have shown their wisdom, their alacrity, but I think a lot more needs to respond in the system before we can get to a situation where we are comfortable and can sleep well at night. Thank you.
JONATHAN KIRSHNER: Thank you. Thank you. Yes, OK. Thank you, gentlemen.
So we're going to proceed from here. I'm going to ask a series of hopefully provocative questions, a couple of general questions, and then a few directed at each of our panelists. And then I think in the same order they spoke, they'll have a chance to respond to my questions and also, I hope, respond to points of disagreement with each other. And after that round, we'll open it up to questions from the floor.
So three general questions followed by a couple of pointed questions for you individually-- the general questions are, each of you, I believe correctly, emphasized the role of financial deregulation particularly in the United States as a contributing factor to what led to the crisis. At the time, in particular, of the repeal of the Glass-Steagall Act, many of us and many of you who opposed that repeal, I think, were told that the technology was leaping ahead of the ability to regulate finance, and I was wondering if each of you would be interested in speaking to the practical ways in which finance could be recaptured by some prudential regulations.
The second general question-- each of you is pessimistic about the prospects for major financial reforms both in the United States and-- it almost went unspoken-- reform of the International Monetary system, even though at least two of you have written books about that in the past. And I was curious if, in some sense, the saving of the financial system, just the steps the government took to stop it from totally cratering, actually is, somewhat on the financial side of things, a victim of its own success, that the crisis was just bad enough not to allow for truly fundamental reforms that we might have seen.
And I would be curious to hear each of you speak to-- obviously, you'll pick and choose amongst these-- the sustainability of the US-China relationship both on the trade side on the financial side. And each of you alluded to this partially in your discussions of the role of the international macroeconomic imbalances that may or may not have contributed to the overall context of the financial crisis.
And finally, to be a little more pointed in provocative and questions for each of you, to Barry, I'm curious, are we really going to let the phrase "global savings glut" be used? Given our falling savings rate over the decades, is this not heroin addicts complaining about the global poppy seed glut as being the cause of the addiction?
To Robert, you point out the role of the failure of politics to reform the financial system, and I would ask you, sir, if, just as we get the presidents we deserve, are we perhaps getting the financial regulation that we deserve?
And to Eswar, in talking about the importance of the financial sector to the economy, I was wondering, however, about what your sense of the proper size of the financial sector was in a healthy advanced economy because it can be suggested that the expansion of the financial sector reflected an underlying dysfunction in the economy as a whole.
And then I would invite-- and I mean this sincerely-- Eswar and Robert to establish the criteria by which they would affix blame to lenders versus creditors as the sources of troubles and irresponsible lending and borrowing. And with that, I will turn it over in alphabetical order, again, to the panel and give you a few minutes each to take on what you wish of that and each other's comments and then to the floor.
BARRY EICHENGREEN: So that's a full plate. On the global savings glut, I don't feel like I have to defend myself. I, I think, along with Eswar, pointed to large capital inflows into the United States as a factor contributing to the buildup of financial problems and vulnerabilities. But I asked myself, if we had properly regulated our own domestic financial system, would the high savings rate in China and in the oil-exporting countries have led to the greatest financial crisis in 80 years? And my conjecture would be no.
So what's the most important, and what is a contributing factor? Jonathan referred to the bloodhounds and the greyhounds problem, that the bloodhounds are the regulators, and the greyhounds are the financial engineers. And they run very fast, and this inevitably leads to a problem that the regulators lag behind. But the bloodhounds have certain simple rules of thumb that they use. They keep their noses on the trail.
I think even in this financially sophisticated world, we can use some simple rules of thumb like leverage ratios-- you can't use more than the following amount of borrowed money relative to your own money-- and capital requirements where you have to have enough skin in the game so that you are encouraged to be prudent. That gets you some of the way toward dealing with high-tech financial markets.
The China-US relationship is, of course, very much in the news this week. For a long time, the conventional wisdom has been kind of mutually assured deterrence, that we both have such ability to damage one another's economies that we have no choice but to work harmoniously together, and there's a lot of truth to that statement.
But the danger here is that on both sides, policymakers are tempted to play to their domestic audience in ways that antagonize their foreign counterparts. So can you say tire tariffs? The Chinese similarly know that their domestic audience is not happy about the losses that they've taken on Fannie Mae and Freddie Mac securities and the like. So there is an issue there.
Finally, I guess, I feel compelled to respond a little bit to what Robert said about academic economists and their contribution to the problem, not entirely to disagree with him, however. So because I had an early entry into this question of why didn't we see this train wreck coming, I lost sleep in the winter and the spring wondering why I, as a student of the Great Depression, hadn't seen it all before it happened.
So my entry appeared in the national interest. My title for it, which I really liked, was "Intellectual Value at Risk," but they thought that was to obscure a title. So if you look for the piece, it's called "The Last Temptation of Risk," and I have no idea what they meant by that title.
My point was that, in fact, we academic economists had, in our intellectual portfolio, right in the mainstream of what we do, all the tools needed to understand and anticipate this crisis. So asymmetric information is a central concept in every first-year microeconomics course. Agency theory, where the agent, the portfolio manager, and the principal, the person whose money he or she is managing, don't have well aligned interests is central to every first-year graduate program.
Behavioral economics and behavioral finance, where we study why people run with the herd and how it's difficult to process information and optimize and how people use rules of thumb, are very much the rage in academia. The question is why those strands were not more influential while the boom was at its height.
And I do think there my point is pretty much, I think, the same as Robert's, that we need to reflect more on the sociology of academia, of which the economics profession may be an extreme case, where we, too, acted as behavioral economists would have predicted and ran with the herd. And when the consulting gigs were there, too many of us accepted them and looked the other way. I think it's worth, for those of us in the field, at least reflecting on that.
ROBERT KUTTNER: Well, let me take the easiest question first. Is it possible to put the genie back in the bottle? Of course, it is. I mean, we had the genie out of the bottle in the 1920s, and the whole regulatory regime that was created under the New Deal did a terrific job of putting financial markets back under regulatory constraints.
It's fashionable to say that, well, but today, you can execute trades at the speed of light. Well, you could execute trades at the speed of light in 1890 with telegraph wires. As Keynes pointed out, the question was whether the politics was there to use prudential regulation to keep the financial part of the economy from going haywire.
Was the rescue a victim of its own success? Let me answer that in a very particular way. I think the rescue was, for the most part, bad policy because instead of reforming the system in a fundamental way at a moment when the system was in a rare state of political vulnerability, the reform, so-called, propped up the system.
We had a problem of banks that were too big to fail. We now have banks that are even bigger because the solution was to merge banks with other banks, and Goldman and Morgan Stanley are the two survivors. In investment banking, Citi and JPMorgan Chase and Bank of America are bigger than they ever were. And the administration's proposal for systemic risk regulation doesn't get at this problem.
I think if you go through the administration's white paper on principles for financial reform, in virtually every respect, it doesn't go far enough. Derivatives, just to take one example-- they're saying that standardized derivatives have to be traded on exchanges, but they're still allowing customized derivatives to not be regulated, to not be traded on exchanges.
Well, guess what. Guess where the smart money's going to go. It's going to go to the products that get the least regulation.
And if you read the fine print of the white paper, there are lots of other inadequacies, giving the Fed, which completely missed this crisis, which responded to it by propping up existing institutions and denying the degree of insolvency-- the remedy is to give the Fed even more power. And we could spend the rest of the afternoon talking about where it doesn't go far enough.
The other point is that by failing to do what the FDIC does in the case of a medium-sized bank failure-- throwing out management, letting the stockholders take a loss, and doing a resolution. By failing to do that, as has been the case with Citibank and Bank of America, you fail to acknowledge the real depth of the problem.
The Congressional oversight panel has been trying to get the Treasury to put some kind of a number on what the extent of underwater securities, toxic assets, adds up to. They won't do it. I'm not sure if they won't do it because they can't do it or because they don't want to do it, but there has been a willful refusal to recognize just how serious the problem is and an effort to restore confidence prematurely before we've cleaned the thing out.
And the consequence of that is that the weakness of the financial economy continues to undermine the weakness of the real economy, and then the two things feed on each other. So even though the Fed has put rates down to 0, credit is hard to come by in many sectors because banks are looking for borrowers who were almost risk free, and the two sides of the equation feed on themselves.
Eswar said a very interesting thing. In China, they own the banks, and so they can direct the banks to extend credit. Well, guess what. Our government owns the banks, but for ideological reasons, there's a willful failure to act like owners because that would be more intervention than the people in power want. So we are a little bit pregnant without acknowledging that we're a lot pregnant and using that condition to our advantage.
US-China-- is it sustainable? It's fundamentally unsustainable. How could it possibly be sustainable for the United States, already in hock to the tune of $2 trillion, to borrow more and more money every year because we don't make the products that we consume and China to just keep lending us more and more money?
Sooner or later, the skirmish over tires versus chickens is going to turn nasty, and in theory, this co-dependency can go on indefinitely because the Chinese need us to buy their products. We need them to supply us the capital, but according to that theory, World War I didn't happen. Diplomacy is full of examples of catastrophic miscalculations, and the US-China relationship is just an accident waiting to happen.
How do you unwind that? Well, it seems to me three things. China needs to raise the living standards of its own people, absorb its growing productivity domestically so that whether it's social consumption in the form of infrastructure or social insurance or whether it's household consumption, the rising living standards that the Chinese people have earned by their increasing productivity should go to benefit their living standards.
Secondly, we need a level playing field when it comes to trade rules. The United States, for a variety of reasons, some of them geopolitical, some ideological, has turned a blind eye to Chinese mercantilism. I mean, China is the classic developmental state. It does what Japan and Korea did. Only, it does it better.
And if this keeps going the way it's going, we won't be able to right this imbalance because even if we change the way we do trade, we don't make enough things anymore, and the whole strategy of outsourcing anything that can be outsourced has compounded the imbalance. So we need a level playing field when it comes to trade. We need China to absorb more of its own production.
And third, we need to finance more of our own debt. I mean, in World War II, we had war bonds, and we may need recovery bonds that are purchased by Americans so that we can afford larger short-run deficits to invest in the infrastructure that we need and use public outlay to power a recovery. I don't know where else recovery is going to come from at this point.
The last question about the failure of politics-- are we getting the financial regulation that we deserve? Well, I was thinking the other day that in 1940, most Americans did not graduate high school, and now we have a society where one in two young people go to college. And yet our politics is much more impoverished, and our civic life is much more impoverished than it was then when we were a less well-educated nation.
So in that sense, we get the politics we deserve, but I do want to take exception to one thing that Eswar said. There is a kind of a mantra that says, well, we all did it. There were some financial scoundrels, and there were some regulatory scoundrels. But Americans, ordinary people, took out those liar loans.
I really think that's misleading. I don't have the same amount of power that the president of Goldman Sachs or the head of the Federal Reserve has, and I think if you look at the liar loans, a lot of them were marketed to vulnerable people who really didn't understand what they were buying who simply wanted a piece of the American dream.
The other problem is that although American productivity has doubled in 30 years per capita, the standard of living of the bottom 2/3 of the income distribution has been stagnant. The historic relationship of rising productivity to rising wages began diverging in the 1970s, and so debt for a lot of working Americans became a substitute for income, the plastic safety net, as my colleague Tamara Draut calls it.
And this was exactly the period when you had what Jacob Hacker called the great risk shift. Risks that had been borne by large institutions, the government, or corporations were shifted to individuals-- the risk of losing your job, the risk of losing your health insurance, the risk of not having a real pension.
And so I don't think we ought to blame average citizens for that. I do think there's a lot of blame for the impoverished nature of our politics, and until we take our politics back, we are going to get the regulation that we deserve.
ESWAR PRASAD: I think Robert is right that the politics are very important here, and I didn't mean to directly suggest that we're all complicit in this. There were different levels of complicity, but it is partly the political system. The notion, for instance, that homeownership is a dream that the government should facilitate has, I think, led us into a lot of dark corners that we are dealing with right now.
There were many benefits that came out of this, and it does seem like a reasonable ideal. But having public policy oriented towards favoring one particular asset, I think, does create some problems, and of course, it is a very appealing line that I think all of us found resonating. So in terms of the politics, I think there are broader issues that we do need to come to terms with.
Let me try to answer Jonathan's question about the appropriate size of the financial system with a parable about emerging markets, actually, because it turns out that emerging markets are doing some things that, by most standards, will seem much more mature than the industrial economies. During the financial crisis, in fact, in the midst of the financial crisis, some of the key policymakers in countries like China and India did not say, let us block financial reforms, did not say, let us make sure all the banks are our own, and did not say, let's stop creating new markets.
In fact, what they said was, this crisis suggests even more why it is that we need stronger financial systems, but they meant it in a very specific way. It was going back to the basics in terms of strengthening banking systems but also building up certain derivatives markets. Now, derivatives and securities have taken on these very negative connotations, but parts of the financial system do provide a very legitimate and useful service.
So in China and India, for instance, even during this crisis, currency derivatives markets have not only been set up but have prospered because importers and exporters do need them in order to hedge foreign exchange risk. So there is this concern that we may be tarring the financial system with this very broad brush.
But having said that, I think the medium lies somewhere between where the emerging markets are today, and they had thought that the endpoint was going to be something like a US system which was thought of as being much more resilient. And the US system clearly had certain problems in terms of allowing this pooling of risk.
Many people, including some of us economists, had grown attached to this notion that the best way to deal with risk-- and risk is always there. The best way to deal with risk is to diversify it, to spread the risk. What we had not recognized clearly was that risk did end up pooling in certain places because the incentives were set up for people to take on very large amount of risks, the leverage that Dr. Kuttner was referring to, and this created a problem not just for those institutions themselves but systemically.
And I think that's the key issue we need to deal with. How can we think about a system where there are still incentives and rewards for taking risk but where the process of taking on risk doesn't end up infecting the entire financial system?
Now, one would like to start from scratch in terms of designing an effective regulation system. We are very far from where we need to be, and perhaps in the process of coming out of this crisis, we may not be getting where we really need to be. But again, I think that some useful things are being done.
Institutionally, it's very difficult to get away from the setup we have right now. We already have a large number of regulatory agencies. The alternative might be thought of as having one regulatory agency which could do it all. It sounded very appealing. The UK had one regulatory authority, the Financial Services Authority, which was supposed to do it all, but there again, they regulated with a light touch.
So the reality is that we don't have these principles well worked out yet, but there are some principles that are becoming more important, that we need to make sure that financial institutions are protected not just against solvency risk but also against liquidity risk, in other words, when markets begin to freeze up.
Many financial institutions have to dispose of their financial assets into fairly illiquid markets, and that sets off this entire spiral where asset values fall. We see all our stock prices falling. Markets start freezing up, so to prevent that sort of event from happening is, I think, a critical issue. Now, the too big to fail problem is something we will have to live with for a while.
And this morning, I was at a speech by Chairman Bernanke where he was talking about this being a major problem. What the Federal Reserve Board and the Treasury are trying to do is think about a resolution mechanism where, in fact, you don't have institutions that fail spectacularly, bringing down the rest of the system with them, but are moved into some sort of orderly receivership where, in fact, they can go through a bankruptcy procedure where people who have taken the risks through those firms do take a haircut, but it doesn't affect the whole system. But this is an extraordinarily challenge, and I don't think we have quite met up with it and partly because of the very Anglo-Saxon approach we have towards free markets that I think we may have to get a little beyond or at least think about more firm regulatory structures to get beyond this.
Now, in terms of the China-US relationship, I've characterized it, in fact, as a sort of death embrace. Even if you love your spouse a lot, if you're stuck with that spouse hour after hour for months on end, it's likely to grate on both of you, and it will lead to certain sparks like what we saw this weekend. But the reality is that in the short term, these two economies are very closely bound together. China needs the export markets of the West, in particular the US.
Now, the Chinese financing of the US deficit has become less of an issue. Last year, China accumulated about $420 billion worth of foreign exchange reserves. They put probably $300 to $325 billion of it in the US. This year, they may accumulate another $350 to $400 billion of reserves, maybe put $250 to $300 billion here.
Relative to an overall financing deficit in the US of $1.6 trillion, it doesn't seem like an overwhelming amount, but the problem is with these exploding deficits and debt levels. And the prospect that the only way to get out of this mess may be to essentially inflate, that is, print more money to pay off that debt, which essentially would be a tax on all of us, including the Chinese-- that is making them very nervous.
And the problem is that, as Dr. Kuttner pointed out, there could be precipitous actions taken by the Chinese, which in and of themselves may not be a problem but could basically crystallize this very fragile sentiment that there is in currency and bond markets. So the real risk that we face right now is that given the very fragile environment we still are in, although it's a lot better than where we were a few months ago, things could very quickly go wrong still.
Now, the one good thing from the point of view of the international community is that it's become clear, especially in the process of the G20, is that many of these problems have an international dimension, but the solutions also have an international dimension. And thank god we are beginning to get some degree of leadership from this White House in terms of trying to deal with this on a multilateral level, and there, there is some hope.
But again, the reality is that as the crisis recedes-- and it's receding into memory far quicker than one might have imagined, at least in terms of policymakers being willing to do the things they need to do. The problem here is that this could lead to a real problem in terms of trying to generate the sort of consensus we need in the international community to do what is right. Thanks.
JONATHAN KIRSHNER: Thank you all. I think there's a system in place for getting microphones to questioners in the audience. Is that true?
SPEAKER 1: Yeah, there's a microphone right here, so I can take that from both sides. We'll have one on this side and one on the other side. Yes?
SPEAKER 2: All right, good. Let's go to work.
SPEAKER 1: Jonathan, you have to--
SPEAKER 2: Gentleman over there.
AUDIENCE: My question is that Professor Prasad should really answer his colleague when he said that about the average citizen not to be blamed, but my question to the three speakers is the following, why you were not able personally-- I mean, I would like to reflect personally-- unable to predict accurately this crisis and considering your knowledge and what's happening there. And please be frank and please give a grade to yourself at the end.
SPEAKER 1: Anybody want to grab a hold of that?
ESWAR PRASAD: Is it too late to drop this class?
ROBERT KUTTNER: Well, I actually predicted it. I mean, I wrote a book that went to press in the spring of 2007 called The Squandering of America, which warned that we were headed for a crisis as severe as the Great Depression.
I think there were people-- I mean, you can go back. There are people who cemented their reputations on having predicted the crisis-- Nouriel Roubini, Paul Krugman to some extent, Joe Stiglitz. But I think the belief in the equilibrating tendency of markets, particularly financial markets, and the gospel that these exotic instruments actually spread risk in the sense of diversifying it, not spreading risk the way an epidemic spreads cholera, that was just pervasive.
And I'm not a licensed economist. I'm an economics journalist, so it's a little easier sociologically for me to hold somewhat heretical views. And I think for people inside the profession, like Professor Eichengreen, who dissented to some extent, that's real heroism, but most people went with the herd.
And I would also say that when the stock market is booming and everybody is making money-- I forget who said it. I think Charles Prince, the former head of Citigroup, said, when the music is playing, you've got to dance, and it really was a case of herd instincts.
BARRY EICHENGREEN: So I'd like to ask whether that was a fair question or not. In other words, there is the view-- I'm not necessarily subscribing to it, but I'm airing it-- that this is a "once in every 80 years" event, something that none of us had seen in our lifetimes, that reflected the interaction of multiple factors in a contingent manner. Is this the kind of event that one can plausibly expect economic scientists to predict?
My former student Nouriel Roubini predicted a crisis, but not this one. Bob Shiller detected a housing bubble but not the greatest financial crisis in 80 years. So I think we understood different ones amongst us. We were like the blind men with the elephant. We understood different parts of the animal, but no one, I would submit, was able to put the pieces together.
And that raises the question of whether that's something as social scientists-- do we have the-- are our tools sufficiently powerful as predictive instruments to anticipate those kind of once-in-a-lifetime events? It's the question.
ESWAR PRASAD: Professor Barazangi, in fact, predicts earthquakes, so I guess he was hoping that we could predict this one. But let me turn to this issue of complicity. Again, the reason I made that comment which may have seemed provocative is essentially to put the burden on us to actually carry forward one of Dr. Kuttner's points that we need to push harder through the political system to effect the change we need.
And we are all too easily sucked in by these very smooth-sounding messages about, say, home ownership or when the goings are good to allow things to keep going. In fact, the Federal Reserve Board is consistently under pressure when the going is good not to take the punch bowl away from the party. So we have designed the system where essentially, when the times are good, it's very difficult to put in place reforms, but the tragedy at one level is the fact that we're not using this crisis effectively to push forward the reforms we need to move forward.
Now, the president, I think, is showing very good leadership. The system is difficult to shake, and it's easy to think about starting from scratch. But that's not an easy thing to do, so I think within the constraints of the system, actually, he's doing a decent job. But it's up to all of us, essentially, to keep the pressure on him and our elected representatives to make sure that this thing goes the right way.
In terms of predictive capability, again, our models had many shortcomings, and many of us economists, us academic economists, at least, don't have any pretense about being good at forecasting. Our models are good at giving us some insights but not predictive ability. But having said that, I think Barry was right that our models may not have been adequate, and our world view may not have been adequate enough to encompass the possibility of the financial system in an economy like the US coming apart the way it did.
JONATHAN KIRSHNER: When in doubt, speak up. Yes.
AUDIENCE: Sorry. This mic's off. So my question is I think you all slightly touched upon the concept of the idea of partially blame and partially political responsibility and push by, basically, the masses, basically the entirety of the country, and that pushing the political views of the country.
And I hear a lot of opinions from the three of you about regulation. As a matter of fact, from most economists, there's a lot of viewpoint that more regulation was necessary, but there's a large inertia within not just the United States but throughout the Western countries against more regulation.
In the past, this was the opposite. Back in the '60s, the '70s, there was a lot of push towards regulation, and economists such as Hayek and Friedman really pushed the masses and the politicians towards accepting more deregulation. So my question is to the three of you, being academics and, inevitably through that, educators. What do you see your role in educating and pushing for these changes that you have academically reached?
BARRY EICHENGREEN: Well, speaking to fora like this one, when I think about trying to convince people that we need smart regulation and, in a number of cases, more regulation, I think it's useful to go back to first principles and remind ourselves why we think markets need to be regulated sometimes.
The three reasons-- one is consumer protection. We regulate pharmaceuticals and food products on consumer protection grounds. I frankly fail to understand why there is effective opposition to creating a financial consumer product safety commission, but there is.
Number two, market integrity-- we don't want big agents in markets to be able to manipulate them to their advantage, and we do have a problem there. The big banks dominate financial services, and they've grown bigger.
And number three, systemic stability-- enough said. We've had a demonstration recently of how important that is. So I think if you bear in mind why the circumstances under which regulation is needed, the path forward becomes a little more clear.
ROBERT KUTTNER: Well, I want to go back to politics. I mean, I'm not an academic. I have done stints as a visiting professor at various places, but I'm mainly an economic journalist with a viewpoint. I'm a passionate defender and advocate of a managed form of capitalism because I think a mixed economy is both more efficient and fairer than a laissez-faire economy, and I think history demonstrates that over and over and over again.
But if you wonder why these views are not taken more seriously, even after the practical disgrace of the free-market ideology, the answer is power. Wall Street still has an unimaginable amount of political power so that, for example, you have a guy like Chuck Schumer, the senior senator from New York, who is a liberal in every other respect except when it comes to regulation of Wall Street, and on those issues, he is the agent of Wall Street.
And you don't have to be paranoid or Marxian. You simply have to be a competent journalist to watch how pressure is applied. You have a rather gentle proposal for a financial consumer protection agency that would only deal with the retail part, not the wholesale part that really caused the crisis. And this is just being fiercely opposed, as is the effort to require derivatives to be traded on exchanges.
So the reason is that some of the wealthiest and most powerful people in the country wouldn't have quite the same ability to make quite as much money as they make. It's pretty basic, so they fiercely resist this. And it's very hard for dissenting voices to be heard, and as a consequence, we are at risk of getting reforms that are palliative, that don't really get at the heart of the problem.
ESWAR PRASAD: As an educator, what I try to do is not give my students answers but give them frameworks to think about problems and perhaps come up with answers themselves. That's my way of apologizing for saying I don't really know the answer to your question. And the question is an important one, and I would frame it the following way.
The financial system does serve a useful purpose. Financial innovation [INAUDIBLE] maybe right now does serve a useful purpose, but we need a balance between financial innovation and regulation. A lot of innovations have taken place in the financial system that have made all of us better off. These innovations in the US went a little too far.
And in addition to the fact that we didn't have regulations to begin with, these regulations that did exist on the books were not applied evenly, and there was a blind eye, as was mentioned earlier, turned to certain very obvious regulatory failures. So at a minimum, we could try to set up a system whereby the existing regulations are more effectively applied.
So thinking about it as more regulation may allow us to sleep better at night, but it really shouldn't because the incentives to get around the system are so powerful that essentially once you set up a regulation, the whole industry comes into place to try to get around it. Again, what we need to do is think about, as Barry nicely put it, smart regulation that responds to this fact that there are social actors out there who, once you have regulation, are going to try to find their way around it and make sure that that stays within a relatively closeted part of the economy.
It's not easy. I don't think there are any clear answers out there. Clearly, what we had was not good enough, but I don't think we have a clear and precise answer about exactly what the ideal system should look like. We are still groping. At least, I am.
AUDIENCE: Thank you.
AUDIENCE: After the Great Depression, the Keynesian stimulus of Roosevelt's administration and the Second World War led to America's recovery, but important factors there were the fact that the Second World War had given the US a massive competitive advantage because most other countries had been wiped out and that the US was a creditor nation, as you said, and exported a lot. How are these Keynesian stimuluses that are being enacted now supposed to help when none of those assistive factors exist for America today?
BARRY EICHENGREEN: I would certainly agree with the subtext of your question that there are a variety of reasons why fiscal stimulus under present circumstances might not work as powerfully as it has in other times and places, but I wouldn't agree with the point that it's ineffectual. I think in a circumstance where we've vaporized $3 trillion of private demand, it's time for the public sector to step up with a bit of public demand and create a demand for goods and services through state and local governments, the point made before, and infrastructure spending and otherwise to begin to put people back to work and get the economy rolling again.
We were in a situation where the problems in the financial sector-- problems on Wall Street were creating problems on Main Street that were feeding back to problems on Wall Street, and I think you have to address each side of that problem in order to stabilize and begin to heal the economy. So we need to address the problems in the financial sector, but if we don't address the fact that people are out of work and that home mortgages are being defaulted on and homes are being foreclosed on and commercial property is going to hell and all that, that feeds back on the financial sector again, and we don't get out of this mess.
So I do believe that the administration has taken the right approach by, at the same time, trying to, number one, recapitalize the banks and get securities markets going again; number two, doing some fiscal stimulus; and number three, addressing the housing problems. I don't believe they have done enough to my taste on any of those three fronts, but I think it would have been a mistake to address one or two of them without attempting to address the third.
ROBERT KUTTNER: I think the analogy of the '30s and '40s really fits in a couple of different ways. In the late '30s, after six years of the New Deal, the United States economy was growing again, but it was stuck at an equilibrium of very high unemployment.
And unemployment before the war was about 15% if you didn't count people who were working in public works projects for the government. It was about 10% if you counted people who were working for the WPA or the PWA or what have you. So the New Deal got us half way out of the Depression.
The war was the biggest Keynesian program of all time. I mean, the deficit this year is going to be 10% or 11% of GDP. In 1942, '43, '44, it was about 29% of GDP, and that got us out of the depression big time. The unemployment rate dropped to 2%. The economy in real terms increased by almost 40% during the war.
So the problem is that a deficit of 10% or 11% is a big deficit, but most of that is not caused by stimulus spending. Stimulus spending is only about 2% of GDP per year. Most of that deficit is caused by a fall-off in tax revenues, which is what happens when you have this kind of an economic collapse.
I think the challenge, as I said before, is ultimately we can't rely on foreigners and on foreign borrowing to finance all of this debt. We're going to have to start financing it ourselves, and I completely agree with Barry that the stimulus needs to be bigger.
I think the simplest thing you could do is write 50 checks so that state and local governments are not laying off people, suspending projects, and raising taxes in the middle of a recession. The stimulus covers about 40% of the state and local government shortfall. It should cover close to 100%.
I think the housing rescue-- houses are still being foreclosed upon at a much faster rate than refinancings, and the press is reporting that something like 30% or 40% of the people who were getting these loan modifications are actually ending up spending more money, not less money. And I also think that financial reregulation and resolution of failing financial institutions needs to be much more aggressive. So I think the real risk here is that we have headed off a Great Depression only to miss the political moment for more fundamental reform, and we may be in for a great stagnation.
JONATHAN KIRSHNER: Let's take one more question. You caught my eye several times, so you can ask the final question. And then I will invite each of our panelists to have any closing comments they wish to make. And so you'll ask your question. I think we'll go in reverse order of our tradition, start with Eswar, and then come back down this way.
AUDIENCE: Thanks a lot. My question is going to be for Professor Eswar. You talk a little bit about the developing economies and their skepticism in the International Monetary Fund. I can attribute a skepticism to the fact that most of the developing economies that have agreed to the economic policies of the Washington Consensus have had suffer of deep crisis and currency devaluation.
And my question is going to be concerning the economy of two different developing economies. One is the Mexican economy. The Mexican economy, in the last 25 years, has proven to be a market from the last fundamentalist economy that tries to keep a hold of their macroeconomic and implemented almost all the policies from the Washington Consensus. They borrowed from the IMF and so on.
And their way to get out of this crisis has been increased revenue by taxing consumption up to 17%. They're concerned that their deficit is going to be 0.5% of their GDP when it's a real minimum. They have increased-- they have proposed all these free-market economies policies. So are you suggesting that the Mexican economy, who's struggling and-- sorry about that. [INAUDIBLE] that the Mexican economy, who's going with all these policies, is going to perform better than maybe another developing economy like the Brazilian economy that is not going towards the policies of the IMF and the World Bank. That's my question.
ESWAR PRASAD: I'll follow that into my concluding comments.
JONATHAN KIRSHNER: Sure, yes, that's great.
ESWAR PRASAD: I think the key issue here is to think about what are the right policies for different set of countries given what we economists call the initial conditions, given the level of financial development, given the level of institutional development, and so on. And it is a humbling time at one level for economists. I think we should and are going back to the books ourselves to try to understand where it is that our models may have been deficient or defective in terms thinking through these issues.
We haven't yet thrown out the old playbook yet because there are many insights that, I think, are relevant, but there are many issues that we didn't deal with adequately in the context of our theoretical and empirical models, trying to understand, for instance, the relationship between the financial system and the macro economy. Clearly, there is an interesting and important relationship as this crisis has shown, but these are sort of complicated enough to study in their own boxes. And we hadn't quite put them together. That's something we'll have to think hard about doing.
And then the issue of what sort of policies we should be recommending to emerging-market economies is, again, a very open question right now. On many issues, such as whether economies should open up their capital accounts, in fact, our thinking has evolved over time. Initially, the notion that is identified with the Washington Consensus, although it was not clear there ever was a clear consensus on all elements of what is called the Washington Consensus-- one notion was that those emerging-market economies should open up the capital accounts fully so that they can get the benefits of foreign capital and grow faster, and this would make everybody better off.
The crisis of the '80s and '90s already suggested this might not be the case, and yet despite all the risks, we see emerging markets continue to open their capital accounts, albeit somewhat slower than the conventional models might suggest or recommend. So clearly, there seems to be some wisdom in policymakers about when they should liberalize financial markets, about when they should open up their capital accounts.
Ultimately, I think most economies, including economies like China, do seem to view more market-oriented economies and more open economies, economies that are open to both trade and financial flows, as desirable, but I think this crisis is teaching us that if we don't have sufficient precautions in place, that sort of openness, that sort of liberalization can come back to bite us.
So my sense, which may differ from some of those of the other panelists-- and perhaps you hope it does-- is that ultimately these forces towards a more market-oriented economy are embedded in even the very command-driven economies as of now. But the question is, even in the very market-oriented economies like the US, how do we bring this process under control to make sure that we don't once again face the cataclysm that we have now faced? Thank you.
JONATHAN KIRSHNER: Robert.
ROBERT KUTTNER: Well, I think the financial imbalance between the United States and China is one problem that is almost entirely separate and separable from the more basic problem, which is the excessive swing to market fundamentalism over the past 30 years that manifests itself not just in the free rein given to finance but in the whole litany of policies of privatization and deregulation and particularly deregulation of labor markets, all of which served to upset the apple cart of a system that, after the war, had been a better blend of dynamism and efficiency on the one hand and shared prosperity on the other hand.
And that system that thrived for almost three decades after World War II was, in some respects, a historic anomaly. It took the Depression and the success of the United States in World War II and the creation of the Bretton Woods institutions and the reconstruction of Western Europe to create a kind of a template, which Americans would call progressive and Europeans would call social democratic or social market.
And when that began succumbing to the normal political influence of finance and wealth, the argument was that this would produce greater dynamism, greater growth. It produced no greater growth. It produced more instability, and it produced, of course, a widening of inequality and insecurity. And I think it was a false gospel.
And my fear is that this crisis is being wasted because we're not getting the kind of fundamental reform that this crisis deserves and requires. And interestingly, the most successful developing countries were the countries that were most successful at fending off these views. Joseph Stiglitz tells the story of trying to get the World Bank to commission a report on Japan and on the success of Japan as the country that defied every element of the model, and they kept fending him off. He finally got it done because he got the Japanese to pay for it.
And there's a set of blinders even in the face of evidence to the contrary that really is going to require a counterrevolution. The institutions that you do have, such as the Basel Committee, are that much more undemocratic. They're not accountable directly to citizens.
They're much more vulnerable to capture by interested parties so that we have a tremendous challenge ahead of us, comparable to the challenge of rebuilding a mixed economy in the Great Depression. And it occurs at a global level where you don't have the civic and political institutions to function as democratic counterweights. So this is a moment where we could rebuild, or it's a moment where we could sink deeper into crisis.
BARRY EICHENGREEN: I hear a lot in what Robert has to say about the third quarter of the 20th century in particular that I recognize and that I agree with. I think it was an extraordinarily successful period for certain parts of the world, not including China, India, and not including, in other words, a majority of the world's population, but for a lot of us in the now high-income countries.
But I think the question is whether we can recreate that kind of mixed economy, that kind of embedded liberalism, that kind of cooperative, neocorporatist capitalism or whatever you want to call it. Eswar was probably-- I interpret him as saying that we can't go back there, and I recognize that view as well, that the world is a much more globalized place economically.
Transportation costs have come down in ways that were unrecognizable to many of us in our childhoods. So when I spent my junior year abroad, I could call my parents back in the US once a semester because of the high cost of telephone calls. The world has changed. I don't think we can go back there. We have to think about a different model. I'm not denying the desirability of thinking hard about it, but I am questioning kind of the tendency one sometime hears to rarefy that period and suggest that we can recreate it.
Let me conclude with what I think are some concrete challenges for the United States, and I think the three important ones to work our way out of this mess and avoid recreating it are housing policy, fiscal policy, and financial regulatory policy. On housing, number one, there is a question of how to get rid of the current problem, and I think we really need to give bankruptcy judges the ability to cram down mortgage restructurings in the way that they can cram down settlements on credit card companies.
And there, too, there are good political reasons why so far that hasn't been possible. Barney Frank says he wants to revisit the idea. I hope he does, but going forward, we really have to think about whether we should put such an emphasis on being a nation of homeowners.
Why did they not have in Canada, which I am told is only a two-hour drive north of here-- why did they not have a subprime crisis like we did? Because they require 30% down payments. Would there be political support in the United States for a simple fix to housing problems of that sort?
On fiscal policy, there's been some discussion about whether a second stimulus would be desirable or called for. All I would add to that is the assertion, the forecast, since someone wanted a forecast, that it's not going to happen, that there is no political appetite either among the public or the Congress for a second stimulus. So we're going to have to hope that we're lucky enough to continue recovering without one.
And on financial regulation, I have a list of five things that, I think, ought to be the priorities, most of which have been mentioned, but at least one, interestingly, hasn't-- higher capital requirements for banks, resolution mechanism for intervening and seizing and restructuring large financial conglomerates. So the FDIC can do that for banks. It could have done it for the old Citibank but not for the new Citigroup, which is a much more complicated animal.
Number three-- forcing more derivatives onto organized exchanges and clamping down on that parallel market. Number four-- a single systemic risk regulator, although I would give the Fed that responsibility as the least of the available evils. Giving that responsibility to an independent entity like they did in the UK-- that didn't turn out so well, either.
And finally, the fifth, which ought to be mentioned and have its own symposium in the future, is the rating agencies, their compensation models, and their conflicts of interest. Until we really address that, we're not going to address the weaknesses in our financial system.
JONATHAN KIRSHNER: Thank you all very much.
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There is no single villain in the story of the recent global financial crisis, and no quick or easy path to recovery.
Panelists Barry Eichengreen, economist and political scientist at the University of California-Berkeley, journalist and author Robert Kuttner, and Eswar Prasad, Cornell's Tolani Senior Professor of Trade Policy, spoke on the causes and possible outcomes of the financial crisis in the annual Lund Critical Debate at Kennedy Hall's Call Auditorium on Sept. 15, 2009.
The event, moderated by Jonathan Kirshner, professor of government and director of the Peace Studies Program, is part of the Foreign Policy Initiative organized by the Mario Einaudi Center for International Studies with the support of Judith Lund Biggs '57.