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Unedited Rush Transcript Event The Shift and the Shocks: What We've Learned--and Have Still to Learn--from the Financial Crisis Martin Wolf, Financial Times Athanasios Orphanides, MIT Sloan School of Management Kevin Warsh, Hoover Institution, Stanford University Peterson Institute for International Economics, Washington, DC October 9, 2014 Adam Posen: Great man comes and that’s not me. Welcome everyone back to the

Peterson Institute for International Economics. It’s a very pleasant evening. We’ve got some people here who are rarely here. We’ve got some people here who’ve been living here all week so it’s a good blend. We have one of the more festive occasions on our pre-meetings calendar, a good friend and a role model of communication Martin Wolf has agreed to premiere his Washington book and premiere his book, excuse me, do the Washington premiere for his book. It’s been a long week, I’m sorry. Do the Washington premiere for his book here at the Peterson Institute and we’re delighted to have him back on our stage.

We had a great discussion with him about the Euro area with Jacob

Kirkegaard and others a few months ago and tonight, we’re blessed to have two terrific policymakers who will now be able to discuss some of the implications of Martin’s book.

But of course the main purpose of all this being economists is to sell. This

is the book. The Shifts and the Shocks by Martin Wolf. This book is for sale outside. This book is not coming money to us; it’s money to Martin. We like Martin. Go buy the book. Special added bonus, if you buy the book tonight right here, Martin will sign it for you. I have now publicly shamed him into doing that. Buy The Shifts and the Shocks. Okay, enough of that.

So all of you are aware of the central role Martin Wolf plays in the public

and the highest level of discussions of economic policy in the world. He is the chief economics commentator at the Financial Times. He was made CBE commander of the British Empire in the 2000 honors list for services to financial journalism. He’s an honorary fellow of Nuffield College, Oxford, an honorary fellow of Corpus Christi College, Oxford, an

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honorary fellow of the Oxford Institute for Economic Policy and just to show his diversity, an honorary professor at the University of Nottingham.

He is of course ubiquitous at the World Economic Forum at Davos. He’s

is ubiquitous at events around the world. I used to, when I was living in London, have some notion of his travel schedule. It frightened me terribly. But most of all, he is a serious committed independent commentator on the world we see and he cares about trying to get it right and that’s why his columns have these horrible little data charts on them every week in the financial times because he’s actually trying to figure out reality. And interestingly even when I subbed for him, they won’t let me have charts either so Martin is very special.

The subtitle of his book which is the real talk he’s going to give us today

is what we’ve learned and have still to learn from the financial crisis and I will introduce our distinguished discussants afterwards but now if Martin is ready, turn it over to him. Thank you, Martin.

Martin Wolf: Thank you very much, Adam, for that very kind introduction and for some

reason that I don’t really understand because I’m usually quite efficient about this, I had six as the time this was going to start and now I was told it was actually 5:30. So I apologize to all of those of you who have had to wait. I should just correct one point because of the extraordinary and indeed almost disgusting activities of my agent, I will get no money from any of the copies that you buy because he managed to persuade the poor hapless publisher to make an advance that they will certainly never recoup and certainly, you will not make the difference I assure. So I’ve been doing this just for penguin. From now on, I’m trying to reduce their losses perhaps in the hope that they will publish me once again.

This is an incredibly ambitious book in the sense that I’ve tried to put

together my thoughts about what’s been going on in the global economic system and in the financial system and how they interacted before and since the crisis, I tried to integrate the global aspects of the crisis including the emerging world with the specific issues raised by the Eurozone so about a quarter of the book is about the Eurozone and like nearly all the books written about this crisis, it does recognize that there were other countries involved than the United States.

The overwhelming dominant literature on the crisis is of course from the

US and most of it with some very distinguished, but rare exceptions, really seems to think there was only a crisis in the US, nothing else really happened. And so it is very ambitious in scale and scope and in some places very radical and provocative and that was intentional. I wanted to shake people’s confidence that we ever knew what we’re doing and that we know what we’re doing now. So if I offend you, well, tough.

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What I’m going to do is divide my discussion of my book into two parts.

The first part really covers the first two sections of the book which I call the shocks and the shifts and the second part is about my ideas about solutions and responses. I should stress and it is inevitable, in the course of writing the book and in the course of events, my ideas changed to a certain degree--that’s good. So there’s always these imperfections but I decided that I had to stop at a certain point and I’m absolutely sure if I started the whole book now, it would probably be quite different, but that’s just how things are if you’re writing about an analytical book on current events which of course these are. I’m a little better off in this regard than the people who wrote books about the crisis a year or two after because so much happened after that.

So let’s start off then with what happened, my view of happened. The first

point is a very big point and it’s probably key to me in starting this. This was a gross failure. This was a colossal failure of policymaking and I think the people in charge and by the way, it’s also a colossal failure of commentary including mine that I didn’t understand how severe the dangers were though I was aware of some of them and indeed I wrote about some aspects of the problems and risks in my book for Johns Hopkins which followed the lectures I gave in 2006 in size which did bear on some of these issues and I understood some of them, but I certainly didn’t understand the potential disaster.

And I think it’s important that we start off with what we have to learn that

what we used to think which really should shake our confidence, when I say we, I mean respectable people running respectable institutions like treasuries and central banks and respectable people writing columns in respectable papers like the Financial Times, what we used to think was utterly wrong. And what we used to think more or less was that if we had an inflation targeting central bank which did a good job of inflation targeting, we had a relatively competitive deregulated financial system which was subject to what we in Britain used to call light touch regulation. In the US, you might call it Greenspan regulation that everything basically will be fine.

And if anything went wrong it would be pretty easy to clean up the

problem afterwards. I’m not going to name names. This was pretty universally believed. I should say that I was never of the, and indeed, I wrote already in the early 2000s, never in the camp of thinking that it was easier to clean. But I thought leaning was very difficult.

And as a result of this I regard what has happened as a shock not just to

the world economy which it clearly is, that’s obvious, we’ll come to that in a moment but it has to be a shock to economics, to macroeconomics and

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the macroeconomic conventional wisdom. And in fact, it’s one of the two huge transforming shocks since the Second World War, the first of course being the great inflation of the ‘70s which led to radical rethinking of economic policy and macroeconomic policy.

And I think one of the real issues here is no comparable rethinking seems

to me to be going on in response to this shock. Economists seem to think that somehow it didn’t happen or if it did happen, it wasn’t very important. And so, I think, the economists have not responded adequately so this is my manifesto as it were. People should be thinking about this disaster seriously.

My argument is in essence that the reason the crisis was so enormous is

that it came out of the interaction between some really extraordinary and some of those I was aware, developments in the global macroeconomic system. I think and I quote here in my book, Larry has caught this best with using Alvin Hansen’s famous phrase secular stagnation, but that sort of brings together this theme. Bernanke not thinking it in the same way, but bringing some of those ideas out came up with the saving glut idea which I think is a very similar idea if you look at it as I do of course as a [inaudible 00:10:17].

I argue that there were some very profound macroeconomic forces which

generated a very steep fall in real interest rates in the late ‘90s and early 2000s and it also generated or it was associated with some huge emergences of global imbalances in capital flows, capital flowing uphill, something I’ve written about a lot. And these were managed by central banks not deliberately but simply because of their objectives. These were large disinflationary forces working in the world economy.

They were managed essentially via the mechanism of bubble creation, not because they said to us, that’s what we’ve got to do, but because if you wanted to keep inflation up in this context of essentially very powerful disinflationary forces--some of which I can’t really discuss--you had to pursue an extremely aggressive monetary policy. And basically all the central banks did that and in the process they exploded balance sheets; much of this in relationship to housing sector bubbles because that’s far and away the easiest way to blow up how balance sheets. Most of our financial sector in all our countries is really linked to property finance to an extraordinary degree.

And the credit creation process generated enormous endogenous fragility

in the context of this sort of monetary environment, incredible confidence. And in this regard, I’ve sort of taken on board fully--and I haven’t done that before--Minsky’s great idea. Minsky, obviously had a great problem that he couldn’t turn his immense insight into the way economy works into

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a proper macroeconomic model so he was merely right instead of being rigorous. And that of course destroyed him professionally. But his great insight is that stability prolonged destabilizes and that seems to me absolutely clearly the case. I’ve subsequently read all his work and I find it in this sense purely persuasive.

And my argument at the Eurozone, the pre-crisis Eurozone, the Eurozone

has essentially the same characteristics as I’ve described with the central bank facing more or less the same dilemma. I see Jean Claude is here so he knows the dilemma that his monetary policy effectively worked via some really crazy things going on in a number of countries most significantly Spain.

So let me just take you through quickly this analysis. First real interest

rates and housing bubbles, I’ve got many different charts of what has happened to the global real interest rate on safe assets. I have done something perhaps a little naughty but I’m British so I’m going to use British data. I’m taking the view that index-linked bonds from tripe A rated governments should roughly track one another. The UK has been running index-linked gilt since the mid ‘80s so it’s a very long term data set. The US doesn’t really have data before the early 2000s. Fortunately, I don’t show this here. US tips and UK index-linked gilts crack each other almost perfectly so they seem to be as you’d hope very highly correlated.

And the interesting thing about this chart, I don’t go further back is that

real interest rates on UK, index-linked gilts were over 4% up to the Asian financial crisis. During the course of the Asian financial crisis they halved to 2%. They’ve never went up above that again and as you can see if you look at the real house price series which are the UK at the top then Spain and then the US, you can see it seems to be not particularly surprising as a point made by Mervyn King and many others.

The point at which the real interest rate collapsed coincided with the point

at which the real housing bubble started and then we were off to the Minsky races with a staggering increase in leverage associated with this rising asset prices. Every one of these countries had different specific characteristics and the same is true of Ireland which I could have also put in but these were the interest elastic countries. These were the countries where the credit systems were designed in some way or even pushed by governments to support housing borrowing. Other countries suppressed this, Germany most notably, and the result was extraordinary credit booms, extraordinary expansions in the balance sheets of financial institutions but each of course had different characteristics I discussed out of my book, but I don’t have enough time to do this.

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Now one of the elements in this story which is why I think the savings glut hypothesis looks pretty plausible, it’s not just about shifting preference for triple A rated assets is that there was a huge increase and this is the standard IMF from the previous, the last IMF outlook, world economic outlook, the most recent one. There was a huge expansion associated with this in global imbalances as the emerging world predominantly Asia, Asian emerging countries predominantly China and then oil exporters along with a few very big developed countries particularly Germany became massive exporters of capital, giant exporters of capital and these huge exports of capital were imported by just two groups of countries.

One group which imported 70% of these surpluses was the US and the

remainder which imported net, the remaining 30% of this surplus capital was peripheral Europe, West Europe, South Europe and Central Eastern Europe and what these countries have in common is they all went into implosive crisis, this ended up in tears. This is simply a statement of fact so this seems to me to support my view of what went along.

An important element in this story which I can see Fred Bergsten here,

Fred probably finds sympathetic to his view is of course these huge capital outflows and the associated accumulation of claims from the emerging world on the developed world didn’t just happen because the private sectors decided to do these. There were very clear government policies and the best indicator of the very clear government policies is what happened to global foreign currency reserves. I think there were all sorts of reasons why they did this. A very important one was insurance against the financial crisis, the Asian financial crisis having been such a disaster. They reached the conclusion they would never get vulnerable like that so they wanted to strengthen their current accounts massively and accumulate massive reserves.

But the figures here are truly staggering. Back in the late ‘90s, global

foreign currency were about a trillion dollars. Today, they’re about 12 trillion dollars. They’ve been continuing to rise since the crisis. You can see the little dip in the crisis and of course a third of them are held, roughly a third of them are held by China alone, but it’s not the only participant I want to stress in this. It’s the most important one by far. So it’s a massive government-determined capital out flow plays a very large part in this story.

I regard the Asian financial crisis as a key pivotal event in this because I

think it changed people’s views in the emerging world. It also changed investment behavior. I think I talk about as an investment [inaudible 00:18:09] as much as a savings glut, but I think it was decisive in shifting the balance. And I think it’s important at this stage to understand how strange this was. This is a point I made many, many times.

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If you think and I made this many times, if you go back to the late 19th,

early 20th century globalization, the great globalization period before the First World War, there was a huge capital outflow I mean roughly comparable in scale relative to economies from the richest countries in the world principally the UK, but also France to emerging countries and the US was the biggest borrower. So the US or the biggest recipient in absolute terms, not proportionately, it went to Canada, Argentina, all these countries and that was the flow you would expect then Britain accumulated huge net claims on the rest of the world which of course got demolished completely in the two World Wars.

This time, we had an inverse performance. Namely we had massive capital

exports from the countries with the best investment opportunities in the world truly massive and they were being absorbed by countries which it turned out demonstrably didn’t have any good investment opportunities because they waste them pretty comprehensively. That’s the story. They were put into housing stock and housing bubbles into financing consumer spending. I have a long discussion what was happening in the corporate sector, but I’ll just cut short. Basically these flows ended up net in the household sectors and this was crazy and also turned out to be completely unsustainable.

And associated with it, ,I’ve just done this for the US since I’m in the US.

This is what happened to the debt stock relative to GDP in the US up to the crisis and you can see a nice kink as the growth started to accelerate in the second half of the ‘90s, but it is important to stress and I remind you that this massive leveraging occurred throughout the last 30 years before the crisis and then of course got reversed.

And basically the leveraging occurred in two sectors, the financial sector whose balance sheet increased six times relative to GDP over those decades and the household sector. The corporate sector did not. I think that’s a very, very important fact that we are in a world in which there are lots of willing savers and lenders and the corporate sector doesn’t inaugurate the nonfinancial corporate sector in the western world does not need these funds. It’s a very important fact.

When the crisis hit, the bubble solution to our deficient demand problem

of course failed. You know this, the official interest rates of the major central banks collapsed. The ECB tried very hard to keep its rates up even moving them up as you can see in 2011, but ultimately it’s been driven down to the floor and we now have a situation essentially for the last five years since 2009, beginning of 2009 so it’s much more the five, nearly six years. Intervention rates by the major central banks have been pretty close to zero. We’re zero bound and if you want to be really cheered up, I put in

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Japan here going back to ‘95. That’s been the Japanese situation for 20 years.

And I suppose if you told anyone before 1990 that it was possible for the

four major economies of the western world, US, the Eurozone, Japan and the UK to offer free money from their central bank and their major problem is deflation, you would have been told that you were seriously demented. I don’t think anyone—I cannot imagine, maybe I’m wrong, maybe there was some genius in 1989 or 1988 thought this could happen but it’s where we’ve been.

And of course it wasn’t enough in addition to this as we know very well;

there have been explosive increases in the assets at the central banks. This is true for all of them. The Eurozone has recently had a decline. Mario Draghi is clearly desperately trying to reverse the decline. The US and UK by the way with their QEs have ended up expanding their balance sheets exactly the same amount relative to the economy and Japan after 20 years of zero rates has finally decided to have a serious monetary policy and it’s the blue line going explosively up to the top.

So this is a really extraordinary picture. So we have this collapse after this

very strange pre-crisis period that central banks were desperately hard to get our economies moving again and they have been essentially remarkably unsuccessful. This is the Larry Summers view.

What I’ve done here is just to, I mean, there are many ways to do this and

this is very naïve, but I’m a generalist. I don’t have to be sophisticated and I probably couldn’t be anyway. So what I’ve done here is to show what’s happened to the US in a very long term context. Actually in the book, I have US per capita GDP going back to 1870 thanks to Angus Maddison, one of my favorite charts.

But this shows US real GDP in aggregate. It’s not per head from 1950 to

today. That’s the red line. The blue line is the fitted curve, a very simple exponential fitted trend from 1950 to 2007 just continued on and the green line which you have to read on the right hand side is the deviations from that trend. And the US today as you see the red line since the crisis is a completely different trend from the previous one, it continues to be a completely different trend and today the US economy is 18% smaller than that trend would have suggested. So that is a pretty dramatic short fall.

Now, I’m going to turn to the Eurozone story which in a way is

remarkably similar to the world’s. The red line here shows the overall current account balance for the Eurozone, pretty close to balance until the crisis hit. But it was very, very small imbalances at the beginning then Germany did what Germany did. We know what it did. It cut its unit labor

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costs. It restored its competitiveness. It moved from balance to a massive current account surplus. The other big current account surplus country, it was the Netherlands and this was mainly absorbed by Spain in absolute terms which was running a current account deficit of 10% of GDP but a number of countries in Europe ran current account deficits, that big Greece, Portugal and also the Baltics but they’re so small. I’m not going to stress them.

The really important point is when the crisis hit them. The Eurozone

solved this in a very interesting macroeconomic way which is essentially the current account deficits were eliminated everywhere. They’re in the process of being eliminated. All the countries that are in balance or in surplus in the Eurozone has moved into surplus and the swing is large. The swing is about 3% of GPD roughly so 3.5% of GDP. So it’s a very, very large swing and it looks very much like that global picture.

This was associated with a sudden stop in capital flows in the Eurozone

very similar to what happened in US and UK but in the US and UK, the central bank basically became the lender of last resort and the government debt problem never became significant. But in the Eurozone, the government debt problem did become significant. Spreads which was zero before the crisis exploded and I’ve shown you these explosive spreads and I’ve also put in the various programs that deal with it, the LTRO, the OMT. I couldn’t put all of them and the OMT which if you look at the lines at the bottom, Italy and Spain, this role of the central bank has dealt with the panic stages.

So the panic in the US and UK diminished. We know that. I don’t go

through all the story. The panic in the Eurozone took longer to deal with because of the institutional defects but is ultimately diminished and today, the panic signs, we would go later into whether that’s durable have basically disappeared. So we are back to just miserable performance.

Now a particular problem in the Eurozone, Mario Draghi was talking

about it looking at where we are is this inflation period. So what I’ve put in here is the inflation rates of a number of countries in the Eurozone since 2007. They are a very closely bunched, but the essential point is Germany, the benchmark is at 1%. Italy is close to Germany at 1%. There are countries like Greece and Ireland that have had massive deflation, Greece is in deflation now, Spain and Portugal are close to deflation and essentially the only way they can restore competitiveness is having falling prices and that is having a pretty devastating effect on their debt dynamics which I talked about in my column this week.

And this is the Eurozone GDP growth since the crisis. Eurozone GDP is

not easily available for fairly obvious reasons before the middle of the

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‘90s so I start with the published figures. I haven’t put them together and the Eurozone aggregate growth was slower than the US is mainly for demographic reasons but the basic story is the same with exception that since the crisis hit, essentially Eurozone GDP has been pretty well flat. They had a big decline, a very small recovery and then it’s been completely flat. This goes up I think to the second quarter of this year and the loss there is, I think, 14% below trend which wasn’t a very dynamic trend.

The final point I would make on what happened is that there has been a

very significant and important divergence between the US and the Eurozone and what this shows the capacity to respond. The US is growing very weak by its standards. It’s an incredibly weak recovery, but the economy has been growing about 2% a year and demand and GDP, real demand and real GDP have been growing roughly in line over that period, after initial period when the external balance improved greatly because GDP did better than real domestic demand.

In the Eurozone, the red line is real domestic demand which is now 5%

below the pre-crisis peak which is after all nearly seven years ago; so it’s still 5% below the pre-crisis peak. Real GDP has done a bit better though it’s also flat and that’s the other side of the real improvement in the external balance. But the Eurozone at the moment is really bumping along the bottom. If it recovers, it will take many years to get back to the starting point.

So that’s my story in brief about what’s happened. So what are the

solutions? Well, my first point, the first point I want to make is that I think we should question what I call the new orthodoxy. In response to this crisis, policymakers have of course rethought very radically, rethought what policy should be, but I argue that on the macro policy level in terms of what macroeconomics should do, we have been actually extraordinarily conservative in the following sense:

We have made no change in inflation targeting or even targets though a

number of very distinguished economics, Olivier Blanchard and [inaudible 00:29:54] have argued that one of the big lessons of this crisis is we allowed inflation to be too low and that created this huge risk of going to the zero bound. Second as I said it’s the same [inaudible 00:30:05] we have been very, very cautious on large scale debt restructuring. It’s been politically very difficult. We knew that and so that the debt overhangs around particularly in the Eurozone. There’s been more debt restructuring in the US in its relatively ruthless way than in Europe.

And there’s been a tremendous unwillingness to rethink the basic view

that fiscal policy should be in balance in almost all circumstances not to

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use fiscal policy even in this zero lower bound instead use unconventional monetary policies. And I think it’s really remarkable how little this macro wisdom changed.

And furthermore, we really haven’t changed our views in any profound

way I would argue of the financial system. There’s massively tighter regulation. I’m going to come to that in [inaudible 00:30:56] in a way. There is hope that we will be able to resolve major global international institutions in cases of difficulty but so far I think it’s still just a hope. The regulation is incredibly complex and torturous. There is more concentration at least in the banking industry than there was before because so many competitors have disappeared. That’s dramatic in the UK for example but also here. The banks are less highly leveraged than they were but these are still incredibly highly leveraged entities in which normal leverage is in the 25 to 1 range which was certainly not what banks were like a century ago.

We still rely on risk weighting of assets. I’m going to come to that in a

moment. I think it’s a completely fraudulent activity and of course the financial institutions remain essentially global and that makes them incredibly difficult to regulate because nobody really understands what’s going on in these complicated systems.

So essentially, I would argue in the new orthodox, we have much the same

financial system, but there has been a profound breakdown in trust between the public and the regulators in the one hand and the banks on the other. So I think we almost have the worst of both worlds. We have essentially the same financial system as I’ve said, but this time we really don’t trust them so we would like to regulate everything as it goes along. This is just not the way it seems to me to run a private sector economy.

I thought I’d throw this in because it’s one of my really fun charts. It’s just

to clarify why I think risk weighting is fraudulent. This is from UK so it’s nothing about the US. The red line shows the risk weighting on assets prior to the crisis. So it starts in about 2000 I think, but just look at what happened between 2004 and 2008. The years as we know before the greatest disaster in the post-war period what the British banks and I would remind British banks were enormous. Their aggregate balance sheets were almost as big as the US banks because they were global.

What they were reporting is that every year, their assets got safer. Every

single year, their assets got safer and why did they do that? Because they look back on the data for the last previous year, they got an additional year in which nothing had gone wrong so it was getting safer all the time and of course because it was getting safer and safer that actual leverage exploded from 25 to 1 to 50 to 1. That’s the [inaudible 0:33:25] curve. So the actual

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banking system was getting more and more dangerous as it was telling everybody how wonderfully capitalized it was and how safe it was and I think there is a lesson to be learned there.

So I just thought I’d put up this quote on this wonderful regulatory system

we are constructing on the US. This is a quote from Andy Haldane, investor [inaudible 00:33:49]. It’s a paper that was of course published and produced in Jackson Hole and I have this quote at length and I discussed its implications. So as of July this year, I think this was 2012, yes. So it’s gotten worse probably.

Two years after the enactment of Dodd-Frank, a third of the required rules

had been finalized. These completed have added a further 800,843 pages to the rule book. At this rate once completed, Dodd-Frank could comprise 30,000 pages of rule making. That is roughly a thousand times larger than its closest legislative cousin Glass-Steagall. Dodd-Frank makes Glass-Steagall look like throat clearing and it’s for this sort of reason that I’m so keen on structural solutions for banking.

By the way, not to make you think that you’re out on your own, their

estimate is that the European rule book which these regulators and bankers are supposed to follow will end up at 60,000 pages and I can’t be the only person. I’m not a banker, I know, and I’m not bright enough to manage these institutions and wouldn’t dream of it nor would they dream of employing me, but I really cannot believe that anybody can manage an institution sensibly in those circumstances.

Now, the key to making this work apart from this regulatory structure is

expected to be macro prudential policy. We’re placing an extraordinary weight on avoiding these disasters. This is the one big genuine innovation, I think, not completely new but new in the scale and it’s designed to be a way of protecting the financial sector from the cycle and the cycle from the financial sector. But I think it’s going to raise very big challenges. It’s going to be very difficult to make these interventions. They’re going to be highly discretionary, very discretionary. They will be politically very unpopular. That’s obvious because you will be specifically targeting just the things that people want to borrow when they want to borrow it and I think I wouldn’t have the may.

I think it will conflict with monetary policy and this could have very

serious unintended consequences. I discussed these at length. I’ve actually just come from a conversation with Larry Summers in discussing this very issue. The problem is just think what would have happened if in the early 2000s when the US Fed was really worried about what was going to happen to deflation. If you have really serious macro prudential policy which had succeeded in stopping the housing boom in its tracks, what

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would the Fed have had to do because it was concerned about deflation? It would obviously have had to cut interest rates further.

Now, that would either have then reignited the housing boom or it would

have worked somewhere else to do something crazy but it had to work somewhere and I think that we don’t understand fully the implications of having a regulatory regime that will be fighting the main vehicle through which monetary policy works which is credit and property at the same time and I’m deeply skeptical that this in fact will work when we really need it. By the way, the one country in Europe that really tried to use this was Spain and we know what happened there.

Now, that’s the financial regulation side. Let me finish this, I apologize. I

have gone a bit—there’s also a very long discussion of course and everybody knows my views on this I suppose about the demand side. As I’ve noticed, we have not had an adequate recovery. I think it’s very difficult for me to accept that we needed to lose so much output in the bubble, so much potential output every year. We are adjusting our potential output measures down to actual output and I think it’s perfectly realistic because if you have stagnation for years, that affects investment, it affects human capital. It really does affect potential output. Short-term losses become permanent if they are allowed to last long enough and the losses in economic welfare have been enormous.

One of the points I make in this that in the US and UK and I looked very

carefully at what happened to the economies during the bubble after the Second World War. If we continue the current trends, the cumulative losses associated with this crisis will be much bigger than a world war in economic terms alone. This is really an enormous event and the losses appear permanent. And why are the losses so large? Well, to some extent, the pre-crisis trends were unsustainable because they depended on this massive leveraging cycle. There was the impact of the crisis itself, on confidence on the financial sector, on the ability to recover. It was done more quickly here than in Europe but that was the impact of the crisis. There’s a huge post-crisis debt overhang. That’s Ken Rogoff’s point and I think there have been some very mistaken post-crisis policies especially in the Eurozone largely about fiscal policy.

So what are the solutions in the medium run which is the sort of run over

which the secular stagnation story might hold? I have no idea how long it will hold. Nobody does but it seems to me it’s where we are now with a real interest rate. On so many safe securities, it’s zero. That seems to be obviously the case. We need stronger demand so I echo the calls for higher public investment, possibly tax cuts as well if they’re pro-growth, pro-efficiency and I think that’s the best response ,and I think monetary policy should actively support such a public investment program in a low

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inflation world. And I’ve of course famously or notoriously or eagerly suggested that we should think of Milton Friedman’s helicopter money as the direct solution to that so that’s a permanent monetization of the deficit. It doesn’t worry me. I have a discussion of why it shouldn’t worry you but I won’t probably sell you on that.

There’s a really big problem in the Eurozone and I’m going to be blunt

about this and this is not about the integration. Last time I was here, I focused a lot on institutional reform, banking union and so forth. They’re doing a lot of quite good institutional reform. But there’s a fundamental macroeconomic issue in the Eurozone which is not about the institutions at least these institutions which is that the essential strategy being followed in my view at a macroeconomic level is to convert the economy of the Eurozone as a whole into what I call a greater Germany.

The greater Germany strategy is essentially what I think of as the normal

post-war strategy of Germany except during the post-unification period which is you rely on the external sector as the balancer of demand. You balance the fiscal system as far as you can, as close to deficit to balance as you possibly could be or possibly in surplus. And if a private sector has large savings and the private sectors have large savings and pretty well every European country now, then you go for a huge current account surplus. So the Eurozone becomes a huge current account surplus region.

And there are two problems with this. One, the world can’t cope with it.

And two, the Eurozone being almost as big as the US simply cannot get the sort of growth it needs that Germany more or less got out of that strategy particularly in a floating rate world where it doesn’t control the exchange rate. So the adjustment has to be to a significant extent internally. By that, I mean, there must be really rapid demand growth in Germany and in the core countries. And as I make it really provocative, I will regard the Eurozone macro policy successful when inflation in Germany is 4%. That seems to be the criterion because then inflation can be 2% and the others can have zero and it will all adjust nicely.

There also, I think, needs a case for faster debt structuring especially in the

Eurozone and possibly much better cooperation between monetary and fiscal policy and I’ve already discussed that. And in the long run, finally, let me just conclude. I’m really close to the end. I apologize if I’ve gone on too long, I think one of the really big questions which is core to this is can we really run a globalized world economy successfully if emerging and developing countries are as terrified of deficits as they are now?

It seems to me it doesn’t make sense to have a globalized economic

system in which countries with aging populations don’t at least export some capital at the emerging world, not to the US. US is not the right

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destination. The US itself should be doing this and I argue at length that that means changes in institutions which in fact are the sort of changes which were thought about when the Bretton Woods Conference occurred 70 years ago. I’m sure that Keynes would be arguing that his original proposal, bancor, was the right one.

Maybe we should look at some other monetary arrangements. I talk about

that in the book and finally domestically well, we have this macro problem that I’ve talked about. I think we have to be prepared to use monetary and fiscal policy together but beyond that, I’m really very concerned about the sort of financial system we’re creating, this massively over regulated concentrated sort of industry, less a problem here but very big problem in Europe. I think there needs to be much more capital in backs so we can be more relaxed about the way they perform, focus on capital regulation [inaudible 00:43:02] have argued, we need to think seriously about the amount of leverage we generate in our economies and how much we subsidize leverage in our economies. It’s long-term thinking.

As [inaudible 00:43:16] have argued, I think we should be and Bob

[inaudible 00:43:17] has been arguing for years, we need to be much more imaginative about the sorts of contracts, financial contracts we’re creating. We should be able to do much more risk sharing, equity sharing contracts in our financial system which will reduce dramatically the fragility we’d have and I even throw in for fun and I’m not going to go into that, the 100% reserve banking thing. I don’t have time to go into that.

So my conclusion of the book is first and foremost, the most important,

this is a massive disaster by any standards from which you really have to learn as economists and policymakers and we’re pretty well comprehensively implicated so very few of us cannot feel we’re in the same boat in this case. It was my view by the interaction between very powerful macroeconomic forces, some of which I’ve talked about, inequality is in my book. I haven’t the time to talk about it. I think it’s also important. The behavior of the corporate sector, non-financial corporate sector in the western world is a central issue.

The new orthodoxy is certainly an improvement, but I think it is far too

conservative in central elements which I’ve tried to describe and I think that is likely to mean that when we want another boom, we’re going to have another bubble and it will create us problems. We need to make the global macroeconomy much better balanced with capital moving in the right direction to people who really might be able to use it instead of people who’ve demonstrated their inability to do so and we need to make finance much less fragile and above all, we need to be much less complacent about where we are.

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Thank you for listening. Adam Posen: I know after Martin’s talk and PowerPoint, you all feel you have already

read the book, but nonetheless for sale in the lobby, The Shifts and the Shocks. I promise that’s the last time. I pulled in some favors which wasn’t very hard because of Martin—the esteem Martin is held in and got two ideal discussants for this book and for this presentation. So I’d first like to turn to my old friend, Athanasios Orphanides who is currently professor of practice of global economics and management at MIT. He of course served as governor of the Central Bank of Cyprus in May 2007 to May 2012 where he was in charge of monetary policy, voted on the governing council of the ECB, was in charge of bank supervision and saw as best he could Cyprus through the crisis.

Prior to that, he had a long and distinguished career at the Federal Reserve

Board starting out there in 1990 and then ending up as a senior adviser to the board. Athanasios, I hope you will talk both about the Euro area piece and the monetary piece since you’re obviously qualified for both.

Athanasios Orphanides: Thanks, Adam. It’s a pleasure to be here. I appreciate the invitation

and the opportunity to discuss Martin’s book. Now, I’m going to call this a great book and this is because I do not have a proper English accent. If I had, I would have said brilliant, but you know really it sounds terrible when I say that.

Martin Wolf: I suppose you can say it in America. You can’t say it in Britain. Athanasios Orphanides: I see this as classic Martin being a reader of Martin’s columns. He

suggests that his presentation of the book is deliberately provocative, not for classic Martin. No, it’s not. Not relative to the columns I’m used to at least. He talks about the global financial crisis, the Euro area, causes, lessons, solutions. I will not elaborate on all of that stuff in great detail because Adam actually subdivided the task. So I will focus on the Euro area. I’ll only touch on some of the other issues.

On the financial crisis overall, you’ve seen through the presentation,

Martin emphasizes the imbalances in the balance of payments. He actually ends up emphasizing that inside the Euro area as well. He talks a lot about the flaw of the regulatory framework. I agree with the flaws he identifies. I will not go into the details on that except to say that really capital, we allowed the system to have insufficient capital at the end of the day. You correctly go into great discussion on this.

Now, I’m an economist so I need to at least spend a couple of sentences on

the failure of mainstream economics and the last bullet I have there, I fully agree with him on the importance of the insights that Minsky had in his

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writings. I agree that it was tragic for the profession that we didn’t have the so-called proper models that meant that the profession of economics couldn’t really offer as much to policy as it could.

So I have a quote from the book on this issue. And I have to say that as an

economist, I agree with this critique. I agree fully with this critique of the dominant neoclassical economics model that we are taught in schools that we’re supposed to be publishing in journals later on. So many of the things that are crucial in practice are just ruled out by assumption so you do not have hope and fear in human behavior in the models we’re supposed to be writing down. You do not have the optimism and pessimism waves that we see in March. All of these behavioral aspects associated with decision making that are simply not reflected in the neoclassical model. But I’m going to say that this is a known major problem in the profession. It’s been known that our I would say fringes in the profession that try to deal with it but not enough and I fully agree that we need much more of that.

I’m going to move to the Euro area where again, I could have spent ten

minutes defending the Fed. I’m not going to do this because we have the separation here. Exactly, yeah. So I’m going to talk a little bit about the Euro area. Really, I’m going to focus the rest of my time on the Euro area. A quote from the book, the Euro has been in disaster. No other word will do. I would say I sort of agree with this. I could think of other words that are not so kind to the experience than the word disaster to describe the Euro.

Again, on things that Martin emphasizes with which I have some

questions I have to say is the balance of payments in balances. So he says in the book that in a monetary union like the Euro area, the balance of payments becomes even more important than it would be otherwise. I have to say I do not necessarily agree with this. It really depends on how policy decisions are taken and I’m going to come to some of the reasons for my disagreement with this. But he talks about the flawed construction of the Euro that we’ve known, the mismanagement and again, you’re going to excuse my non-English pronunciation [inaudible 00:51:18].

So a failure of mainstream economics in the Euro area, with this I would

take some difference because my recollection is that sober economists who are not based in Europe had a consensus before the creation of the Euro pointing out most of the problems that could show up. Some of the problems were missed, I have to say, but really the fact that the Euro was not a good idea as was constructed was the consensus view of even European economists who had a safe distance and clearer perspective, than those who are in Europe.

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So in that sense, I’m not sure that the Euro area component of the crisis really reflects so much a failure of mainstream economics. Still it’s useful to get a sense of what this is all about. This has been an immensely costly crisis. The IMF published its latest WEO a couple of days ago. I took the data from it to just create this chart on per capita real GDP where I compared the US, that’s the data there and then I have a constructed Euro area 12 measure. I just took the first 12 members of the Euro area joined well before the crisis and did a weighted average, this is the approximation.

You can see the difference there. You can see the global financial crisis,

they really have a difference in terms of per person GDP between the US and the Euro area. It’s when the crisis got converted into specifically a European crisis that then divergence started showing up. To get a sense of just how bad this is, it’s useful to do a lost decade comparison and we have of course Japanese experts in the room, Japanese economy experts.

So the lost decade in Japan by comparison, it wasn’t that lost. So

according to the IMF WEO numbers, there was growth in real per capita GDP of about three quarters of a percent per year. So what I did is I put that in the black straight line in there just to compare what the performance of the US, Euro area and Japanese economies have been for this decade. It’s almost ten years. If you put the projection that the IMF has published, we have more than a decade already.

What you can see is that the US and Japan in this crisis are doing better

than the lost Japanese decade, but the Euro area isn’t. The Euro area is actually quite far away in the ten years since the beginning of the crisis from what would be the lost decade in Japan. So it’s quite bad. But I have to say that I have some differences in emphasis more than disagreements. I do have some disagreements, but more differences in emphasis about the analysis in the book.

I’m going to pose this in terms of questions. Was the Euro area crisis

unavoidable? My reading of the book, the weight comes out with all of the emphasis on the current account imbalances. It looks as if it was unavoidable. I have questions about that. I agree on the crisis management issue but I have questions about whether it was unavoidable or not. I don’t mean the global financial crisis. We’ve had that. I mean about the Euro area component that started really in 2010 on.

Was the severity of the crisis due to economic mismanagement? So there

is a lot of analysis on the economics of managing a crisis and what can go wrong if you misunderstand the economics and the models in the book. Was that the major issue? Well, I have some questions about that because I have questions about what Martin’s real views are on the role of politics

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in managing the crisis underneath. Then there are questions about what the role of the ECB has been where, I think, we have the real expert in the room so perhaps we can have a couple of minutes of those views.

But I’m going to show you some questions that will need to have answers

on this later on. I’m going to end with a question that Martin didn’t talk explicitly about in his presentation but he’s quite explicit in the book about whether we are out of the woods yet in the Euro area. So I’m going to start with the first one.

In my mind, the one difference I would have the analysis is the relative

emphasis between economic and political factors in the crisis. I would side more with Helmut Schmidt’s analysis, this is from the speech he gave October 19, 2011 at the [inaudible 0:56:33] opera house honoring Jean-Claude Trichet that day where he stressed that this was a political crisis and we needed to handle this in a political manner and we needed to find a solution that would be a positive acceptable solution on the political front not so much in economics.

And actually I agree with this interpretation and would not emphasize the

economics so much. Now, I have to say that of course Martin does get into politics from time to time, but I would say in a rather charitable way. There is this paragraph I quote from the book. In a financial crisis creditor’s rule and in this way he explains what the role of German politics has been in shaping the dynamics of Europe and he mentioned that this is one of the unfortunate things we see that could be interpreted as he mentioned in the presentation as an effort to turn the Euro area into a greater Germany which is not going to work if this is the only plan we have.

But I consider this to be a charitable interpretation of the politics because

there are less charitable interpretations that could actually have the national politics dominate over really all of the economic thinking that we could put down. And the way I think about this is by starting from the observation that every crisis generates losses. And then when you are talking about crisis management, the whole game is about managing those losses, how they’re going to be realized over time, what the incidents of those losses are going to be and how you manage this in an efficient manner so that you minimize the economic cost.

And my observation of the crisis in the Euro area is that instead of having

the economics drive the management of the crisis, we had member state politics drive the dynamics of the crisis management. And they get into these questions. What happens if you are in a non-cooperative game where member state governments are trying to shift losses to each other? Well, that’s going to generate some pretty nasty dynamics, a considerably higher

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total cost for Europe as a whole and massive destruction in some member states which is pretty much what we’ve seen.

So my less charitable interpretation would focus on the politics and not the

economics. I would agree on one element that there is a fundamental failure of mainstream economics but my fundamental failure with mainstream economics especially for the case of examining the Euro area crisis is the failure to properly address the role of political motives in the policy decisions that drive economic outcomes.

If you look at it like that, then you ask the question, who had done it and

we have answers. You can do analysis episode by episode analysis. You can do very detailed case studies and see what has gone wrong. This was one of the [inaudible 00:59:57] was the most catastrophic instance in the crisis, not the only one. We have a number of blunders. I don’t have time to go through them and the point of those blunders is that they’ve increased the overall cost of the crisis and they created this distribution that generated winners and losers and Martin talked about the winners and losers. Here’s one way of looking at them.

I think the Euro area right now is really two economies—Germany and the

rest and you can look according to IMF data per capita real GDP has been for the other 11 economies. This is the 11 of the original 12 here. You can do this country by country. Germany, France, the yellow is Spain and blue is Italy. This is not one economy anymore. This is not a crisis that was managed for the Euro area as a whole anymore.

They have the nightmare on the ECB. I’ll only spend 30 seconds on this

again. Jean-Claude can fill in the details on this. The ECB has saved the Euro in a sense with SMP and the OMT but doing whatever it takes whenever tensions are high creates this difficulty in that it fends off immediate collapse at one point but it doesn’t solve the problem. So this is a question on whether the ECB has helped or not and are we out of the woods yet or not, I will just let you read the slide. This is classic Martin so I thought I would get a quote from one of the columns he wrote ten years ago that reflects both the concerns about the political dynamics in Europe and still the hope that is also reflected in the book. Thanks.

Adam Posen: Thank you very much, Athanasios. It’s good to have someone a little more

provocative than Martin occasionally. Martin Wolf: Someone who’s made me a defender of the European institution and the

European progress. Adam Posen: I’m now going to turn to Kevin Warsh, distinguished visiting fellow at

Stanford’s Hoover Institution who was of course a member of the board of

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governors of the Federal Reserve from February 2006 to March 2011 after serving in some key White House roles. This of course massively understates Kevin’s influence and importance during the crisis and we hope his future destiny as Treasury Secretary. But for the moment, up to you.

Kevin Warsh: Thank you very much except for that last bit. So I’ve been out of

government for about three and a half years. I’m not sure if that’s been sufficient to give me a perspective on the events of the financial crisis. Let me first tell you about Martin, things that you already know. First, Martin and I came to know each other during the crisis as he was investigating different things, but we became particularly well acquainted because Warsh and Wolf got placed next to each other at a series of periodic conferences that we attend.

So we’ve been sitting next to each other for quite a few years and I should

have known about a hint as to the book because during these conferences, he’s doing three things simultaneously. He is weighing into the discussion, lobbing barbs at the other speakers calling them foolish and the like as you get a sense. He’s writing his column on his laptop and then he’s going back to his book all sort of fully engaged in these whereas I am paying some passing attention to the speaker, looking at my BlackBerry wondering what time the next break is.

And so I was not surprised by the comprehensive nature of the discussion

of the book. He takes up ideas in the book and uses words to describe them. Some things are vital and important and essential. Other things are stupid, nonsensical and colossal failures. You’ll notice a bit of difference in language between former Federal Reserve officials and Financial Times columnists so the way that was just set, I’m not going to fight with Martin, but I will show some areas of some modest discrepancy or change in emphasis I think is the word that was described. I still have great affection for Martin matched only by my disagreements on many of the things that he’s described.

Although I should tell you I agree with much of what he said on the

regulatory front. I am rather full-throated in my support for his idea that we have gone down a very dangerous track in the US and I fear it’s contagious. We have turned our banking system into a set of quasi-public utilities. If the measure of reform was we wouldn’t receive these fateful calls on Friday afternoon which I received a plenty during the crisis, the tune from a CEO that says we will not be able to open up for business on Monday and I asked myself what would happen to that Friday call today. Our response I’m afraid to admit would be almost the same.

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There are some restrictions on the Federal Reserve as to what we would do but I have a feeling that that weekend would be as dark and dire four years later as it was in the depths of the crisis and if anything that should tell us that this path that we are on is both harmful from a financial stability perspective and I should add to Martin’s comments quite unhealthy for the economy where we have decided to aggregate assets at a few institutions that remind me now more of Fannie and Freddie in the darkest days leading up to the crisis than they do of a vibrant competitive banking system.

The second piece on Martin which I would say I find fascinating and

useful as I think about my former colleagues in and around the official sector at treasuries and central banks and I think some of them have great impacts but I think many of them don’t seem to be driving policy or pushing it in their direction. Well, Martin Wolf is having a huge impact on public policy. We don’t even say his name anymore inside the hallways of the central banks. We just say did you see what Martin wrote today even when we’re not familiar with him as much as I’ve come to so he is in the arena. He is driving a world of ideas and is having great influence.

I would say that many of the ideas in the book that he referenced are

provocative. Many of them are radical and I think what Martin might perceive as the greatest slight, some of them strike me as all too conventional, all too common and almost all subject to a new group think as to how we get out of this mess. Martin in the book describes the economic profession as having essentially failed us and I don’t disagree with much of that. But I worry that the post crisis looks like we are with very little data going to a set of new themes that are somehow going to solve these problems and instead as I think about them, it looks to me as though in many of these areas, we are now back in the business of overpromising and under delivering.

Now for a central bank like the Federal Reserve, it’s pretty risky business.

When Ben Bernanke and I showed up in 2006 having worked together previously, why did Ben Bernanke and his new group of governors have any credibility at all? Well, it’s because of the imprimatur on the top of the letterhead. It was because it was the Federal Reserve, not quite yet the Bernanke fed. And so we inherited an incredible amount of credibility. And I worry given the extraordinary things that this central bank and many around the world have done that we are signing up for more than we are capable of doing.

And unless we are a little bit more clear about what we can accomplish and how important that is, but what is outside of our agreement, outside of our capabilities and the things that we have failed at repeatedly over the last generation that many of our central banks including this one are

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putting themselves at grave, grave risk because if the next crisis comes as it inevitably will. And the Federal Reserve and these other central banks have not re-established what they can do and what they can’t, the next blow could be fatal not just for the economy, but for the credibility of these central banks to have all the power and authority that they’ve had.

So I thought I’d take up maybe six themes that Martin raised in the context

of the book that are going to be quite common to all of you make a brief comment on each of them. So first Martin rightly in the book describes the global nature of the financial crisis and at the beginning, I heard him say you know those Americans think that or thought that this was just an American crisis. I think that is a proper diagnosis and a grievous error that we maintained throughout 2007 and ‘08 and ‘09 and 2010.

We described this in the US as the subprime mortgage crisis. And so the

rest of the world given our narrative was very late to realize that this crisis was finding its way in their way, to their own shores and to their own banks. Our misdiagnosis of events was in some sense the necessary prerequisite for the world to misdiagnose it.

I remember joining Jean-Claude at a G20 meeting in 2009. Ben stayed

back behind as we were in the middle of another tortured weekend and I remember describing to a small group at a dinner before the main event the global financial crisis and one prominent person who’s a friend of both Jean-Claude’s and mine came up to me in the break and said, "You keep describing this global financial crisis. This is an American crisis and we’re not going to let you export your cancer on to our shores." That fundamental misdiagnosis of the nature of the crisis as a subprime mortgage crisis that led one CEO of a major European bank I know to say nothing to worry about here because we don’t own any of these subprime mortgages.

Well it turns out, I think without a lot of deep analysis that what happened

in the lead up to the crisis was the mispricing of virtually every asset everywhere around the world and what we find ourselves in even six years later is a re-pricing of those assets, some far afield from subprime mortgages in the US. So I think Martin is right to focus on the global nature of the crisis and right in some sense to criticize both the US and the rest of the world for missing the essential story.

Most books that have been written about this subject are breathless

accounts including many that I enjoyed including by an author here of certain proper nouns and what happened on every weekend and those books have an important role in history, but I dare say if you take out any of those proper nouns even Lehman Brothers and I’ll be the first to admit errors were made on all sides of this. In many of these fights I won, some I

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lost, sometimes I was right, sometimes I was wrong. But I think these proper nouns of particular banks and insurance companies, though very interesting, are not in essence what the story is about and we have a tendency to go back to certain weekends and say, "Well, if only the official sector did X."

My own judgment is once we got past spring of 2008 through a proper

noun you rarely hear about anymore, Bear Stearns and you find yourself with other large institutions like Fannie and Freddie that become insolvent. This situation had become so dire that if Lehman Brothers and others did not exist, the broad magnitude of this crisis that affected the US and the world was already entrained. And I think Martin’s big contribution of the book in my judgment is to take that lens back deeper. It doesn’t mean that we shouldn’t be criticized for different actions we did. I’m not asking for absolution, but the lens is a broader lens and I think he brings really that to the case.

Early in the book he says too much moral hazard happened at the

beginning. That’s not exactly my judgment. Too much of a misdiagnosis happened at the beginning. Too convenient of set of excuses happened at the beginning and when I look around at my colleagues many of whom are preoccupied with all sorts of things these days, I don’t see a ton of moral hazard that was driving their thinking throughout the period. They can be accused of many things, but somehow being august moral hazard believers was not the gang that I spent so much time with.

So a second theme which I thought I’d make reference to is globalization.

Martin, of course, has written definitively on this subject for a very long time and I thought what he was going to get to in the section of the book, he catches a bit, but I would catch a bit more. So most of the people that are grown up in the US and the global economy over the last two generations feel as though globalization is in some sense a birthright. This is inevitable and we’ve been seeing it.

Well, if you look at the global economy over the last five or six years, you

are seeing dangerous strains of de-globalization. You are seeing a re-regionalization of the economy. Look to the banking sector. In spite of, or because of a set of regulatory reforms coming from most of the major financial capitals in the world, what I see are banks racing home to their own domicile. What I see is a pull back from the global bank. What I see are banks that are trying to serve interests of their fiscal authorities and political leaders rather than pushing into new territories.

This may or may not be a good thing for the banking sector, but I would

say that the banking sector is indicative of what we’re seeing in credit and what we’re seeing in trade flows. Since I was a kid, I’ve always been

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interested in planes and trains and if you watch the trading routes of ships and planes that are delivering goods to all of us, those maps look so much more different than the globalization wave we had seen for 40 years. You’re seeing a new amount of traffic inside of Asia. You’re seeing an incredible amount of traffic relative to GDP even intra-Europe and you’re seeing trade that we would have only imagined in the post-NAFTA era that is between Canada, the US, and Mexico.

So as I look at trade flows, capital flows, credit flows and the incentives

for banks, I see five or six years where this is a step back from the globalization phenomenon. This could be a short term phenomenon, but as Martin referenced with respect to short falls in aggregate demand, the longer this stays on, the more we could be giving up in some sense. Some benefits of globalization benefits to the economy et cetera and I don’t think we’ve had enough time and attention to focus on it.

The third theme, it is natural when folks like the three of us talk about

public policy that we talk about the conduct of macroeconomics. This is what we do for a living but I think the piece that has been missing from this discussion for too long are the micro foundations of macro. We used to talk and write and read and I remember being taught by some of my Stanford professors about the micro foundations and it’s almost been lost in this discussion.

The decisions, millions of decisions every day of households and

businesses small and large, of banks small and large that are being impacted by shortfalls in global demand that are being impacted by a brand new orthodoxy in Martin’s words. We might have different judgments about whether this new practice of macroeconomic policy is good or bad, but I can tell you it’s different. And part of the reason, I will maintain why the forecasts from the IMF and the Federal Reserve and the OMD are chronically disappointing five and six years after the crisis.

This is now predominantly in my view because of a mistake in a set of

multipliers or a set of unforeseen headwinds coming from Europe. It’s that we have not taken to account that we have fundamentally changed the incentives and the decisions of millions of people who we do not know. The most important businesses, I don’t know the name of and that is true of the most important credit providers and I would say the micro foundations of macro have been lost in this discussion.

It does not mean that QE is a good thing or a bad thing. It does not mean

that new regulatory environment is good or bad what it means is, I think, we’re missing the story. And as others talk about secular stagnation and the rest, I have a different judgment as to what’s causing this phenomenon and it might not be secular stagnation. It could be policy stagnation. And it

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could be that we have not addressed the right policies or at least taken account of how individual incentives are changed by virtue of a new orthodoxy and I think it’s having very real implications.

Inequality. Martin made reference to it and there’s good sections in the

book on this subject. Again, I am not here to describe and say that central bank aggressiveness is driving a new amount of inequality but again if we look at in the US, those that own stocks and own their homes and ask ourselves whether they have been disproportionate beneficiaries of policy at the zero lower bound, I think the unequivocal answer is yes.

If you look at half the country that do not find themselves with a balance

sheet, they have similarly not found themselves with a balance sheet recovery and there has been no income statement recovery. This is again not to pre-judge the wisdom of what central bankers are doing and Martin is discussing, but our fear in talking about the distributional consequences of aggressive central bank policy strikes me as really quite deficient.

When there is a proposal for new fiscal policy, new stimulus, new tax

policy, we are all running distribution tables and we’re asking about who are the winners and losers, yet somehow it makes us uncomfortable to do the same in monetary policy. I think we should not be uncomfortable. Again, that doesn’t pre-judge what we should do, but inequality discussion and the role of central banks strike me as in some sense a discussion that has to be joined.

Fifth, I made reference to the secular stagnation story and the more time I

spend in Washington which is really quite limited, the more I find that this is becoming infectious. We all think that somehow we have decided that the long-term potential is really not nearly as good as we could have imagined. And I understand why we’ve come to that conclusion. Our model-based regressions that look at the US economy based on a model that was born in 1946 that we’ve been making improvements ever since say the economy would have been much stronger.

So one way to explain or should I say rationalize the poor impact of these

policies relative to the projections that the authors of these policies gave us was to say well the policies worked, but it turns out that we’re just not capable of that kind of growth rate. That is an ex post facto rationalization and it could turn out to be true. But my own judgment is potential output both in the medium-term and long-term are a function of policies and it is not to criticize many of the things that we’ve done, but suggest that if policies change, my own judgment is potential output can change and we ought not resign ourselves to this idea that a theory that had been much discussed in the academy that has now been popularized in places like Washington is the new normal. I don’t think that it has to be. I think it’s

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still in malaise and I think we should fight with this idea instead of all embracing it in what I described as a bit of a new group think.

Many of the ideas that Martin describes in terms of improvements to

aggregate demand are ideas that are not only talked about, but that we’ve actually practiced. President Bush had a stimulus plan in ‘08. President Obama had a stimulus plan in ‘09 and the idea that there could be more projects on infrastructure strike me as absolutely true. And if we design them right, they’ll actually have a positive return on invested capital. So I wouldn’t call them stimulus, I’d call them prudent investment for a country that needs them.

But those that are advocating more of these investments have to recognize

the political economy. And you have to recognize that these multipliers that we have decided in the academy are right. Once it gets through the political process might be that the worst of the projects, not the best of the projects are founded. So for all the discussion of aggregate demand that we’ve heard for a very long time, in some sense, the secular stagnation theory suggests that maybe the supply side of the economy has something to say about it. We ought not to re-litigate supply and demand fights of years gone by but supply and demand cross. And the good provision of economic policy should recognize both of them early and often. It strikes me instead of overweighing one at the expense of the other.

Finally, macro prudential policy. So I agree with the noble ambitions of

macro prudential policy, but I think Martin says two things in the book that strike me as important and in conflict. One is it’s vital and two is we have no idea how to do it. This is a another huge challenge so instead of admitting that in the public square that macro prudential policy understanding the broad consequences of what these decisions mean is only lacking a few things. One is we don’t know the instruments. We don’t know their efficacy. We don’t know what our objective function is and it’s not obvious to us that have been tasked with these jobs or to the political authorities what the trade off is with the rest of policy.

So I worry that macro prudential policy if you say it fast enough sounds

like we have the antidote. But if you look back to the research before the financial crisis and you want to see the literature on macro prudential policy by whatever its name, you will find yourself with a Google search that yields nothing. There is very little to it. That means that macro prudential policy is important but for those of us that are advocating that as a new doctrine for central bankers to undertake, new squads of people and budgets that need to be gotten, it strikes me we need to wrestle with the hard questions and yet again be honest about what we can deliver upon.

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So with those sort of six themes many of which surely overlap with Martin’s own comments, I’m going to take my seat and we’re happy to take your questions. Thank you.

Adam Posen: Thank you, Kevin. I actually meant no insult by proposing you for

government service. In Washington, that’s a compliment. I realize in Stanford that’s an insult so I apologize. I would open it right up to questions, but Martin in email, perhaps intending to flatter his host suggested that I should make a couple comments as well. So let me just very quickly make three comments and then we’ll open it up to some of the esteemed authorities and participants in the room.

First is I want to echo Kevin’s take on Martin’s book and not being an

official, I’ll be a little less polite. I think Martin you concatenate too many causes. You don’t need them all and I think you’re being too conventional by giving equal weight to so many and I think in the end, there are arguments to be made as Janet Yellen did in her first Camdessus lecture at the IMF a couple months ago that the regulatory mistakes that were made, the deregulation, the excessive liberalization, the—what I’ve called—high church Anglo-American turbo financial capitalism really take precedence over other things and we can talk about other things. We can talk about global savings glut and we can talk about mistakes of inflation targeting, but I think it is fair and right to try to prioritize and I would put the priority there. You can disagree, others can disagree, but I think you are in a sense dropping the ball by having too many description.

In terms of Athanasios, I really want to praise him not for what he did

while in office, sorry, but for being very clear since leaving office that we did not have to have the Euro crisis we did and I think that is an important point that has to be echoed. And this actually is a contradiction I think of one of or maybe two of Kevin’s six points.

To my mind when you look at that chart of the GDP per capita that

Athanasios put up and you see the US and the UK and Euro area moving in tandem until 2010 and then you see the divergence that is proof both the mishandling of a crisis makes it worse and that if you go against the basic policy tools that do work, you make things worse.

The entire gap there, we would like to tell it as a tale of American nobility

and greater creative destruction and so on but that’s not true. And as Martin has rightly pointed out, we have not credibly reformed our banking system that much differently than Europe as Kevin has credibly pointed out. We’ve created quasi utilities of the too big to fail. To me again, I may be wrong, but to me, the screaming answer is that the US undertook the mainstream policies and that made the difference.

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So finally, before turning it over to this distinguished audience, I would say something about the economics profession. We’ve had all three of our distinguished speakers tonight talk about the failures of the economics profession. I would echo them. Athanasios and I were together I think on a panel at the European Business Cycle Network I think in 2009, early days of the crisis and we had one distinguished academic and one distinguished official from the ECB on the panel with us who were still selling real business cycle models and without financial institutions in them, with endogenous shocks. And it is an extraordinary challenge to our profession that we’ve done so little to change that and I just echo very strongly the members of this committee.

You might then say, well, what are we at the Peterson Institute doing?

And I’m not going to advertise all the brilliant work of my brilliant colleagues. What I am going to say is the following: Rather than going to try to create new theoretical basis and new micro foundations, we’re doing bottom up empirical work. And maybe that’s not going to get all of us tenure at Harvard, but I do hope it will be a useful contribution and if we think about the development of physics, you have to have Kepler and Copernicus and Tycho Brahe establishing the empirical patterns before Newton and Leibniz and others could establish the theory. And so for me and I think for my colleagues, that’s where we’re going to try to make the contribution. So thank you for that.

I know Martin would love to respond to everything, but since we have

such a great audience, let me just ask if whether it’s Jean-Claude or anyone else or José, we have a traveling mic up front and we have a standing mic at back. Jessica, could you give the microphone to José?

José de Gregorio: Okay, I’m José de Gregorio from [inaudible 01:27:36] Peterson and I was

governor of the central bank during the crisis. So I hope that some of the discussants would take on the issue that inflation targets failed miserably. And I fully agree with all the points that Martin Wolf made about financial system and I think that if basically why in emerging markets we didn’t have the global crisis was because we had already financial crisis so we know that financial deregulation and unfit financial markets are quite dangerous and that’s why they are very, very regulated and that’s a risk now.

So I fully endorse—I discuss [inaudible 01:28:17] papers in Jackson Hole

and I like the idea of simple strong rules. [Inaudible 01:28:25] high capital. I have no problem. But if I look at inflation target, it’s very difficult to say of course I understand that in the UK, there was such a disaster, the crisis that you could blame inflation targets. That was not inflation target because otherwise we would have the problem in Norway,

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in New Zealand, in many, many emerging markets and I think that has been quite successful to have an ability to run monetary policy.

So I think that this is not just what happened in many countries and I agree

also with the Minsky stability destabilizers, but the solution is not to destabilize to have stability. It’s to have rules and to have very strong regulation. Finally, the only thing that I hear from this fail inflation target is to go to 4%. Going from 2% to 4% won’t make a difference with the huge financial crisis that we had. We’ll give you a scope for 2% more before getting to the zero lower bound but that’s a retail compared to the cost of being 50 years with 4% inflation because we hope that his happens every 50 years. Thanks.

Adam Posen: Thank you. Jean-Claude please. Jean-Claude: Thank you very much. First of all, it is fascinating to hear Martin and I am

one of his fans even if I disagree quite often but it’s always stimulating and Athanasios and Kevin extremely stimulating too. Let me only say that for me one question which would be [inaudible 01:30:03] to the analysis of Martin for Europe would be how the hell is it possible that in the worst crisis ever since World War II which in my own analysis could have been the worst crisis ever since World War I had we not reacted extremely swiftly and boldly, how the hell is it that the Euro as a currency has remained during all the crisis. A little bit too credible to be clear and frank with the exchange rate level which was higher than the entry level vis-à-vis the US dollar. It’s a paradox.

I could read in some slides the crisis of the Euro so I understand it’s not

the crisis of the Euro because there was no crisis of the Euro as a currency paradoxically and it demands response, what exactly is behind. Then it is the crisis of the Euro area as a concept. It was a failed concept from the very beginning, very poorly managed. I agree with that. Extraordinarily bizarre as it regards the interaction with the political element. Athanasios gave the dramatic example of the Dublin agreement which was totally crazy and totally contradictory with what we were doing ourselves and it drives us together to stop the SMP because the SMP was totally contradicted by this political move.

But still despite all that, we have against the concept practically

everything. The Euro area did not explode in the worst crisis ever since World War II. Greece didn’t leave if it had many occasion of deciding to leave. Germany and the others didn’t say it’s a good occasion to get rid of the [inaudible 01:31:59] Greeks and so forth and three new countries entered in plus a fourth country which will enter next January. So we were 15 at the moment of the Lehman Brothers collapse. We are 18 today, 19 tomorrow if I may.

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So how the hell is it possible? What’s behind in a purely pragmatic Anglo-

Saxon vision. It seems to me that the most interesting book should be written on what’s behind and what I understand is that of course it is not only an economic monetary concept. It’s a history column, very profound which has very, very deep roots historical phenomenon and we don’t understand anything if we don’t have that including all the mistakes, all the bizarre [inaudible 01:32:54] of what has been done and also of course from a very, very profound, I would say, level at the ground. And also the reason why the political element when the crisis is there finally decides positively and not negatively. Now, I don’t want to elaborate more on that but these are two questions I would like very much to have the response to these questions.

Let me make only one remark because of course the success of the Euro

area will be judged in the long run, in the middle and long run on growth and job creation. That’s absolutely certain, but I’m not sure that if we compare the trend before the crisis of the UK, US and Europe and we don’t take into account the fact that to my knowledge, neither the UK nor the US, they had a financial crisis. They didn’t have a signature crisis. The rest of the world didn’t say well we have no confidence in the UK, no confidence in the US. We stop the financing.

It is what we have experienced, 40% of the Euro area had no financing at a

certain moment. And that moment Athanasios and I have some memory of that because it was the moment where we decided ourselves to purchase treasuries of Spain and treasury of Italy after having sent letters to the two prime ministers that Friday. We purchased the next Monday.

So I mean, we were in a totally dramatic situation and it looks much more

like the addition of the US problem and I fully agree with Kevin, it was its global crisis of course and with you Martin. And on top of that, we had an Asian crisis localized in Europe or Latin America crisis localized in Europe. And it is the accumulation of the two touching 40% of the GDP of the Euro area which explains--and I think the chart of Martin was very convincing because we could see clearly that the Euro area was extraordinarily different between the 40% in question and the 60% because again it’s not only Germany. It’s a mistake.

Only six countries and I count Cyprus at the very beginning of the

sovereign risk crisis were heavily touched with this credit disappearing, evaporating and the others were not. I mean, of course they were indirectly touched but it was a minority of the Euro area which was so dramatically touched. So again, on the conclusion, it would be very, very close to all what you have said.

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Let me only add one element because I cannot let this idea that all solutions are activating domestic demand. I looked again at the current account deficit of a number of countries and you heard that already. US minus 2.5, minus 2.6 in ‘14 and ‘15 according to the IMF. Canada, minus 2.7, minus 2.5. Australia, minus 3.7, minus 3.8. New Zealand, minus 4, minus 6. UK, minus 4, minus 4.

Do you really trust that what we need in the advanced economy of that

type is additional spending, additional investment, whatever? The rest of the world is called to finance that. Are we paving the way for the best of the world possible if the West and the major industrialized economy think that it is an additional financing coming from outside that they will find their own success in the long term? I doubt that. And it seems to me that the fact that there is practically no disagreement now. It’s the motto in Washington. Like Kevin, I’m a little bit uneased with that.

Adam Posen: I will resist the urge to respond [inaudible 01:37:12]. Martin, do you dare

respond to Jean-Claude? Martin Wolf: Should I respond perhaps very briefly to a few other points. Adam Posen: Sure, that would be great. Martin Wolf: First of all, I immensely appreciate this discussion which was kinder than I

expected. So I very much appreciate it. I’m going to come to Jean-Claude together with Athanasios’ comments because they go together.

I find actually to my surprise that and perhaps I didn’t understand him.

Kevin is often very subtle and oblique that he indicated to me that I was too conventional. I understand what he meant by that and that’s probably true though I think in some respects, I go beyond the conventional. I haven’t talked about my views about the nature of monetary and fiscal coordination at the zero bound. But it seems to me that I agree with everything Kevin said that it’s a global nature of the crisis. There is de-globalization of finance. There’s absolutely no doubt about it. I regard it as inevitable. I explained why.

But I think the paradox has been that and I argue this, it’s very important

that once states ended up whether we like it or not as guaranteeing their financial systems, it was inevitable that the governments are regulators who represent those states as active agents would ask themselves “well how far do we want to take that guarantee? If it’s a market sector, yes, it can be global but if it’s one we are propping up, well not really.”

I was trying to balance—I was involved, it’s a very important point, in our

independent commission on banking and we tried to solve this paradox in

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the UK where we have an enormous global financial system which our banks of sort of about 60% of their assets are abroad by creating the ring fencing of the domestic retail bank focusing the support from the government on that. And so they’re trying to pretend or hopefully not just pretending that the rest would be global and would live and die by the market.

So trying to preserve a global financial sector base in the UK along with a

domestic ring fence one as a compromise. And I think this is a very big issue. But I’ve actually come to the view that if we are backing these institutions with government finance, the only country at the moment, maybe China will be one in the future that can really back global financial institutions in large number is the US.

Third, Kevin is raising a very fundamental issue which is how far are the

policies we’ve adopted since the crisis undermined people’s confidence and therefore affected the micro. And I think this is a very important issue but I would make it broader and it’s not something I discussed and I regret this now, but it seems to me a giant crisis like this has devastating effects on confidence. It’s one of the costs and it affects the way companies will manage themselves in term of their liquidity and cash management, their willingness to take the risk of investment. They become very cautious for a very long time because partly it was simply so surprising. And it may be made worse by the overreactions of regulators and the instability of policy that follows the constant interference every time you have a new policy on bank pay and all the rest of it.

But I think the fundamental issue is—one of the reasons crises are so

damaging is they devastate confidence so much. I have nothing more to say about inequality, secular stagnation. I don’t think actually our disagreement so much except that you stressed the political economy of policy. I certainly would not disagree that you might have a good theory and you have sensible ideas about policy, but if they can’t be implemented, that’s not going to be help at all. And it seems to me that on macro prudential policy your position and mine is the same that there’s much too much confidence in the ability to operate as I see this very, very much in my own country.

Then we get to the Eurozone, sorry, I mean, I’m sorry, Adam. I just

disagree with you. I’m not the only person who disagrees with you. Adam Posen: I understand that. Martin Wolf: It seems to me that explaining what happened purely as a result of

regulatory mistakes is global crisis doesn’t really work. I don’t deny at all

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there were huge regulatory mistakes, but I try to discuss the tensions between regulation and the macroeconomic situation. And why some sort of financial instability was a very likely outcome of this peculiar structure of the world economy. It should be remembered that lots of other people have a similar view. [Inaudible 01:42:26] …

Adam Posen: Martin, don’t run to other people’s support. Stick with your arguments. Martin Wolf: No, just basically the point being that there were macro reasons for

pursuing these policies. One of them I discussed at length was the rising inequality.

Now finally, let me turn to this very deep set of questions about the Euro. I

think I’m sort of in between Athanasios and Jean-Claude in some respects, but in others it’s different. Let’s first of all separate out Jean-Claude’s question at the very end. Was the crisis inevitable? Given what happened in the first ten years, the massive divergences and competitiveness and the huge current account imbalances that emerged in a period when risk spreads was zero and in a time of a global credit boom, then I think some sort of crisis was inevitable.

So the fact that the Eurozone would get caught up in this in a fairly serious

way and indeed that there will be sudden stops as they were and much discussed in the financing of a number of countries seems to me to be inevitable. Then however, could it have been handled different to reduce the extent of the disaster? Yes, I think there’s no doubt it could have been handled differently. And I think that it’s clearly in theory even given the weakness of the institutions which were inevitable because it was an incomplete monetary union everybody knows, it could have been handled in a more cooperative and forthcoming way if the attitude of the policymakers to helping countries in difficulty--and I mean here the fiscal policymakers, the governments had been different from what it was.

But I don’t think there’s anything surprising about the attitudes adopted. I

analyzed the politics of the countries concerned, particularly Germany and it seems to me pretty well inevitable given the nature of the promises that had been made to the German people about how this would work that the difficulties that did emerge in funding the adjustment process. And in making the macroeconomic adjustments that I think are necessary would have emerged. I don’t think you need a particularly—personally, you have to think that people are particularly malevolent to produce this outcome.

The simple fact was that the Eurozone was constructed on the assumption

that funding would be national that countries would be responsible for themselves. There will be no "bailouts" and therefore once countries got into a situation which for whatever reason they couldn’t fund themselves,

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there was bound to be a colossal mess. How big the mess would be could have been affected somewhat, but I tend to think that that very serious crisis which was going to reform the Eurozone and it has reformed it a great deal would arise.

I still think that the macro policy inconsistencies within the Eurozone are

very serious. Now finally, on Jean-Claude’s point, I think he’s raised a very fundamental issue which is why did people go on buying the Euro when lots of people, financial people were speculating constantly on its breakup.

Now my own view by the way pretty consistently and I wrote this through

the crisis and I’ve written this here. There were many reasons to expect it not to break up and one of them which I do discuss at some length by the way is the political commitment. And indeed I’ve written columns from time-to-time in which I pointed out that the American view, widely held American view that it was bound to break up was wrong because the political commitments here were so profound. To which I added a very important point that the cost of break up will be so enormous anyway even if you won’t concern the political cost, the break up for anybody.

The only country that seem to me to have a reasonably low cost exit

possibility from an economic point of view in the short run is Germany. And for pretty political and economic reasons. It wasn’t going to take it. So I think people thought it was likely to break up far too easily and far more likely is what I’ve called in my book and subsequently is the disappointing marriage. Now and I think the commitment is very profound.

My explanation of why the Euro continued to survive is I think and was

traded was well is that even if you were relatively skeptical about the future of the Euro, and lots of people clearly were, you can see that in the market, I think they assumed well if the worse comes to the worst, a few not particularly important countries will leave. The core countries remain incredibly competitive above all Germany and we basically got an option on whatever the breakout currencies will be and if a bit of what we get is the D-mark, we’re going to do very well. Is this right? I have no idea. I think there’s a problem and the other explanation given the other pricing in the market.

Finally, I am fascinated and I think it is very important that a number of

countries, small countries have continued to join and maybe bigger ones will too and I think that does show and perhaps more than we "Anglo-Saxons" tend to believe that the political commitment to this project in Europe remains overwhelming. I just wish it worked better because a bad marriage is a very risky place to be because there’s a lot of bad politics

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that could result and the politics aren’t over. I think I must stress that, the politics aren’t over.

There are lots of countries, some very important countries with an

immense amount of political stress. So I think one could say that even if it will survive, if it doesn’t work better, there is a big problem. Finally, I think I’ve failed to be clear about my position on one very important point which was detailed on inflation targeting. I described or what I meant to describe is a belief that the combination of inflation targeting with a deregulated financial system would generate stability on its own.

You know and I know that there is a very big debate which I discussed

only relatively briefly in the monetary policy community of which the BIS was and still is, was before the crisis, the most obvious proponent that it would have been sensible for monetary policy to take account of what was happening to asset markets and lean against it. Thus reducing the need to clean up after the crisis. That would have meant accepting a somewhat lower inflation rate and not having a completely pure inflation targeting.

My own view on this point is agnostic. I think there’s a case there. We

don’t know what the counter [inaudible 01:49:46] will be, but I’m perfectly prepared to accept that this somewhat wider band on inflation targeting than we actually followed might not have been enough to prevent the worst of what happened. And therefore we end up relying on regulation and that brings me back to where Adam was. I remain unconvinced that the regulatory arrangements we’ve constructed after this crisis will be sufficient to give us a good financial system and a stable one. But on that, only time as they say will tell. Thank you.

Adam Posen: Well, I appreciate that Martin, at least because your last two sentences are

a place I can fundamentally agree with you. But most of all, we’re very grateful to everyone who came and who enjoyed this discussion. There are obviously some very senior and important people in the room. We’re not going to have time to allow to speak at the moment. We’re going to have to close the formal discussion, but I will say two things. Thank you, Martin.

First, there is still time to purchase your copy out in front and Martin will

sign it. Second, thank you to Kevin Warsh, thank you to Athanasios Orphanides and thank you especially to Martin Wolf who was gracious enough to let us be the Washington premiere of this book. Thank you very much.