15 May 2009
In Their Own Words: Economists Mackintosh and Meltzer
Speakers answer questions from China, Australia, New Zealand in webcast
The speakers are moderator Tanya Brothen; economists Stuart P.M. Mackintosh, executive director of the Group of Thirty, and Allan H. Meltzer, a professor of political economy at Carnegie Mellon University and a visiting scholar at the American Enterprise Institute; and audience members.
(begin transcript)
TANYA BROTHEN: In Focus is coming to you from the Washington headquarters of the Bureau of International Information Programs of the U.S. Department of State. Thank you for joining us. I’m Tanya Brothen. The focus of today's program is the global financial system. We’ve invited two guests to our studios today in the hopes of creating a friendly debate of sorts.
First we have Dr. Allan H. Meltzer. Dr. Meltzer is a professor of political economy and public policy at Carnegie Mellon University in Pittsburgh, Pennsylvania. He is also a visiting scholar at the American Enterprise Institute in Washington, D.C. Dr. Meltzer is the author of the recently published History of the Federal Reserve Volume 1, which covers the years 1913 to 1951. And volume 2 is in the works?
ALLAN H. MELTZER: It is.
BROTHEN: Ok. Next we have Stuart Mackintosh. He is the executive director of the Group of Thirty, which is a private nonprofit international body that aims, among other things, to deepen understanding of international economic and financial issues. Mr. Mackintosh also sits on the board of the National Association of Business Economics and, according to the biography that he sent me, he's also an avid cyclist and mountain biker. Is that true?
STUART P.M. MACKINTOSH: That is true.
BROTHEN: Okay. Also joining us remotely is the U.S. Embassy in Beijing, where assistant spokesman Nicholas Snyder has organized a group of local citizens who are interested in this topic. We also have other U.S. embassies joining us from the East Asia/Pacific region of the world, including Guangzhou, Hong Kong, Shanghai, Sydney and Wellington, so welcome to you all. We'll spend the next hour discussing the global financial system. First we'll have an interview with our two guests, and then we’ll have a Q and A session with our audience in Beijing. There will also be a few minutes for questions from each of the five additional participating embassies. So thank you so much both for being here. Let's get started, shall we?
So, we’ve been hearing a lot of economists try to explain in layman's terms exactly what happened to the global economy to get us into this situation. I'd like to ask each of you to describe in your own words what you think is the cause of the current crisis. I know, Mr. Mackintosh, you've used the analogy of a suburban neighborhood in chaos. I was hoping you that could explain that analogy to our audience.
MACKINTOSH: Certainly. I think that one way of imagining that is, as you say, we live in a global neighborhood. We — let's say we live in a street, and it’s called Global Lane, and the largest house on that street is a McMansion, and it’s owned by an American couple who are mostly concerned with foreign affairs, and so they take a laissez-faire attitude to supervising their many, many children. They also allow those children to handle their own allowances. Soon enough, the older children start becoming tearaways — Citi, Lehman, Bear, AIG. They gamble up a storm, they max out their credit cards and invite all the other children in the street around to party.
And meanwhile, little Hedge Fund and his pals Madoff and Sanford are running around the street ripping off the rest of the children in the street.
If we think about looking down the street a little bit further, next door we have a British couple who take a principal's approach to supervising their children. They are also pretty wealthy, but their children are as thick as thieves with the American kids. So soon, Northern Rock, HBOS and RBS are learning all the wrong lessons from their American friends.
If we look a little bit further afield, we can see a different approach from, let's say Hong Kong, where the parents there take a much more structured approach to the supervision of their children's upbringing, and they have a lot of timeouts and they also require the children to keep their allowances —you never know when you might need them.
Finally we have some Australians who are living in the street and they take a Twin Peaks approach to the supervising of their children. Again, they are a bit more conservative, but they too are influenced by what's happening in the McMansion up the street.
Finally, Barack is brought on board to, in essence, re-establish some rules — some parental supervision rules for the street, for the whole neighborhood — and indeed he then turns to his grandfather figure, Paul Volcker, to step in and actually establish some new rules for the entire global neighborhood. And that's how I think of it. I think of the drive to re-establish a form of stricter parental supervision, as it were, financial supervision for the global neighborhood.
BROTHEN: Great. Dr. Meltzer, what's your analysis of the cause? Do you have a different take on this?
MELTZER: Yes. I’ve written an epilogue to my book that describes what I think of as the seven principle causes. I’m going to talk about two of them, which are the most important.
The first was that Congress and the administration, several administrations, can't do enough for housing. So after starting with — in the 1930s, with Fannie Mae and later Freddie Mac, they allowed them to expand in terrible ways. I mean, they allowed non — they allowed — they had the FHA, the Federal Housing Administration, allow no-down-payment loans. And then they allowed no-credit-scoring loans. And so they built up an enormous amount of risk.
And because of the second big problem, which is that for 30 years we've had “too big to fail” in the American banking system. And if a bank is too big to fail, in my opinion, it's too big. It's too big because the benefits that we get from economies of scale and economies of scope don't nearly compensate for the losses that we take now.
So those two things together brought us the bulk of this crisis. Banks didn't believe they were going to be allowed to fail, and after Bear Stearns, one of the big financial houses, failed, and was bailed out, they — many of the bankers wrote and talked about how the worst was over, because the Federal Reserve and the Treasury had bailed out the losers.
Then the government did something that it had not done to any degree for 30 years. It allowed — without any warning, it allowed Lehman Brothers to fail. That was a shock to the market, and as I tell my students, if I had been running a big portfolio, I would have run for cash too. Because you didn't know what they were going to do next. They had changed all the rules.
Now, I don't like those rules. I think we have to get rid of “too big to fail.” But the way to do it is not suddenly to spring it on people in the midst of a downturn. And that created chaos. We're just beginning to come out of that chaos now. And in reforming the banking system, we have to get rid of “too big to fail.” If we don't get rid of “too big to fail,” then we'll sooner or later have another crisis just as bad as this because “too big to fail” encourages banks to believe that they make the profits and the taxpayers take the losses, and that's not a system that's viable or one that we should have.
The other thing that we need to do is get rid of Fannie Mae and Freddie Mac. What they do is subsidize home mortgages. And it's a principle of democratic government that those subsidies should be on the budget, not something hidden away in financial institutions that people don't understand. And that encourages corruption, as it did; it encourages favoritism, giving special mortgages to people; it encourages lots of lending that shouldn't have been done, and those things, especially, created — were the bulk of the reasons why we have this crisis.
And other people all over the world including, of course, in China, bought Fannie Mae bonds, and that meant that the government had to, in the end, guarantee it. That's going be the largest loss ever visited on the American taxpayers.
BROTHEN: Thank you both. So now we have our base established here, we can get deeper into the issue. One of the things that I wanted to ask you, Mr. Mackintosh, was if you believe that faith in the self-regulating nature of markets has been misplaced. Of course, this was used as a rationale for deregulation, and I'm wondering if you think the foundation of our economic system needs to be relaid.
MACKINTOSH: I wouldn't go so far as to say that the foundation of our economic system is drawn into question, but I do think you can say it is a crisis of the system, not in the system. And I think we have seen this notion that self-regulation is the appropriate way to manage the risks taken by very large complex financial institutions come up short in a huge way.
I think self-regulation is an oxymoron. I don't think we can rely on that. I think we have to recognize and I believe that this is one of the sort of tenets of the last few years was that we ought to use self-regulation and that's broken; we know that that doesn't work. Therefore, the debate is, the extent to which you reregulate, how you regulate, what activities you regulate, which markets you oversee and so on.
So we are swinging away from that. I don't think we're going to see self-regulation again used in the same way that we have seen it in the run-up to this especially severe crisis. It simply didn't work. These banks, as Professor Meltzer said, took extremely large risks, put the entire financial system – and indeed the real economy — at risk. And we can't allow that to happen again.
BROTHEN: So going back to you, Dr. Meltzer, you said the system of what the United States has, what you call democratic capitalism, that you believe it is sufficiently flexible to make the needed adjustments to economic policy, and I wanted to know if you see anything in kind of the recommendations that are out there right now that goes beyond the limits of democratic capitalism or that pushes the boundaries of it?
MELTZER: First, I would like to say that the banking system is a heavily regulated system, and it always will be a heavily regulated system, because we and everyone else, either de facto or by law, have deposit insurance. If you have deposit insurance, you’ve taken a lot of the risk away from the depositors, but you can't allow them to adjust the banks, to adjust the asset side of their balance sheet.
We didn't deregulate the banking system. We changed a few laws, but most of them didn't have much effect anymore because the bankers had learned to circumvent them.
The first law of regulation, as far as I'm concerned is, that bureaucrats and lawyers make regulations, but bankers and markets learn how to circumvent them. And they circumvent them all the time. They circumvented Glass-Steagall. They didn’t remove very many regulations, and the banking system is not self-regulated. It is examined over and over again by all sorts of agencies of the government, of the states. It just isn't true that they are deregulated.
What we do have is a government policy which is heading in the wrong direction. It is going — what they want to do or what they say they want to do, is they want to find a super-regulator. There are two reasons why I think the super-regulator is a bad idea.
First because I don't think they can do it. The record of the Federal Reserve is, it never was ahead of a crisis. The SEC — this is the age of Madoff. The SEC was given pages, 20 or more pages, explaining what Madoff was doing. Couldn't possibly be being what he actually was doing. They couldn't figure it out. They didn't regulate him. And we had the biggest fraud we’ve ever had in the financial market. To give them more power to regulate is a non-starter. It won't work. It will fall on people who will do it — my friends at the Federal Reserve, I tell them, you know, you're making a big mistake if you take this on because you can't do it. You haven't any record in which you do it.
They weren't there for the savings and loan crisis. They weren't there for the Latin American debt crisis. They didn't see or do anything about the dot-com crisis they didn’t do anything about the credit market crisis. So, why give them more power?
Second, I think that it is a mistake to give them that power. What you want to do is increase the responsibility of the bankers. And the way to do that is not to move the responsibility to some Washington office; move it back to the bankers. Tell them, look, we do not allow “too big to fail.” If you take risks that cause you to fail, you fail. And then they become much more prudent.
All right. Now, our Chinese friends should understand very well that if you allow bankers or encourage bankers to take risky securities, you have big losses. And the government, the Chinese government bails out those losses. That's not a very good system, and we certainly don't want to move further in that direction.
BROTHEN: I saw kind of a puzzled or quizzical look on your face, Mr. Mackintosh, during the strong statements. Would you agree with him?
MACKINTOSH: If I can just come back on a couple of points. I agree with the professor that the banking sector was regulated and that there were failings by the supervisors, not least the Fed, and others. However, part of the transmission mechanism that created this sort of burst from being a small sub-prime crisis that people thought was worth at most a few hundred billion dollars of defaults, into a global crisis of colossal magnitude was the transmission mechanism of these risks through complex securities in markets which were largely unregulated or lightly regulated, so I'm talking about the credit default swaps, I’m talking about the CDOs, the CDOs squared, and so on. Those markets were not regulated.
And furthermore, a lot of the companies that were very active in these places, in these spaces were not regulated. AIG, big failing of the U.S. system, was not properly regulated. So I agree that the commercial banking system was already regulated. But I think part of the story around the crisis in America has to do with the unregulated side of the industry. And that is why the response of the Obama administration and indeed others around the world is to say, okay, henceforth, what they call the “shadow banking industry” will be under some form of modest regulation and if institutions become too big to manage or too big and systemically important, we will take actions to mitigate those risks and try and cut down on the ris- taking by those institutions.
MELTZER: It doesn't work. I mean, simply the history is it doesn't work. I mean, the SEC is supposed to regulate the financial markets. What do they do? They told the financial — the investment banks they could increase their leverage from 11 to 33 times. That's terrible. And that creates big losses.
What you want to do is you want to put the burden of managing the losses on the people who make the decisions. And then they will be more prudent.
My judgment is that the regulation we need now is to say, if you're too big to fail, you're too big. And so, as your size increases, you have to hold more
reserves. The reason you have to hold more reserves is because you have to protect the public.
Now, what does the history of regulation show to me? It shows that the regulators protect the banks. They don't protect the public. What are they doing? They are bailing out bank after bank. They bailed out AIG; they should have let AIG fail. AIG would have been better off if it had failed; we would be better off if it had failed. They would have paid their losses, and that would be that. Now, here we are, $180 billion into bailing out AIG, with more to come. Fannie Mae and Freddie Mac. They’re coming for more money. The government has guaranteed huge losses. That just tells you, regulation does not work. People circumvent it, they get around it, they don't do it. And they — and the regulators mostly help their clients, not the public. Regulation does not work to serve the public. It has not worked to serve the public, and it will not work to serve the public. The way we get it to work to serve the public, is to make the people who make the mistakes pay the cost.
BROTHEN: Okay, so we definitely have a real clear understanding of where both of you stand on this issue. But one last quick question that I would like to ask before we go to the Q and A is, I would like to get each of you to tell us what you think the key reform is that is needed to prevent this crisis from happening again. Is there one thing that you think could be changed to make things better in the future? We'll start with you, Mr. Mackintosh.
MACKINTOSH: Maybe I can cheat a little and split it into two pieces.
BROTHEN: Go right ahead.
MACKINTOSH: First of all I would say that we absolutely must have a system that deals with the institutions at the core of our financial structures. Those banks, and some nonbanks, that are so large that they pose systemic risk. And I agree with professor Meltzer that in some cases if they are so big and complex and difficult to manage, as was the case in AIG, that perhaps they ought not to be in that structure anymore. Perhaps they ought to be smaller.
But I think one of the fundamental, central things we must do is apply stricter standards if institutions get that big and our political leadership decides they cannot actually break up these institutions in such a way that they cannot engage or it becomes extremely expensive to engage in extreme risk-taking behavior involving high levels of leverage and so on and so forth. So that's the central plank. We must address the very risky activities of the largest institutions at the center of our financial system.
And, secondly — and this I think is supplemental and also coincides with what the professor was saying earlier — we do need a system that allows these banks and nonbanks to fail. We must send a signal that you don't get a guarantee with no strings attached. Far from it. Shareholders must pay the price if their management takes excessive risk, and causes the firms to come close to collapse. We must be able to manage that collapse.
But we must limit the public exposure. That is clear.
BROTHEN: Dr. Meltzer.
MELTZER: We agree on that last point. Very strongly. I mean, the only thing I would add to what Mr. Mackintosh just said is, we want not only the stockholders to take the loss, we want the management to lose its jobs. We want to reorganize. We want people to understand that they’re taking risks. They are taking the risks, not us. We don't understand enough about what goes on inside large corporations to be able to manage them better than the people who are there. So we have to give them incentives — the word is not regulation, it is incentives –we want to give them the incentives to do the right thing. That's the job of regulation. It is to give people incentive to do the right thing.
So what would I do? I have a list of seven things, and I'll spare you all the details. [ Laughter ] Just say, the two things that I think are most important, we want to take Fannie Mae and Freddie Mac away and put it on the budget. We want to help for good social reasons. We want to help people to own houses, but we want to do it in the right way, which is put it on the budget, where everybody has -- Congress has to vote, instead of just doing it through back door where nobody quite knows what’s going on except a few committee chairmen.
So that's the first reform and the second one is the one we agree on; we have to get rid of “too big to fail.”
BROTHEN: And if people want to hear the other five, they can buy your next book? Is that true?
MELTZER: Right. [ Laughter] And I hope they will.
BROTHEN: Yes. All right, well, why don't we go to the Q and A session now. If — Nicholas Snyder, if you are there in Beijing, would you mind letting us know a little bit about the group that you’ve organized there and go on your first question.
NICHOLAS SNYDER: Thank you, Tanya. Thank you, Dr. Meltzer and Mr. Mackintosh. I'm Nick Snyder, assistant spokesman at the U.S. Embassy in Beijing. We know it’s late in D.C., so we thank you for making the time to share your insights with us and debate these pressing economic questions of our day and the future of our global financial system. You’ve already given us some great food for thought and your strong positions on regulation. Now it is time for our Beijing audience to ask a few questions.
I'm with about 20 journalists from the leading national economic and municipal newspapers and magazines. We’ve been following the debate with great interest. We'll soon, after the next 15 minutes or so, turn over to the other posts watching around Asia — Sydney, Shanghai, Hong Kong, Guangzhou and Wellington — and we'll move in a fast-paced and coordinated format. But, right now without further ado, [inaudible] Wu from Caijing magazine is going to ask the first question.
AUDIENCE MEMBER IN BEIJING: Good morning. Well, rather, good evening.
I have a — thanks for the discussion on the regulation part. I guess I have a question about government direct intervention. Throughout the crisis, we see the U.S. government intervene in the markets, on perhaps unprecedented level we have never seen. But, the latest example being the upcoming restriction on short selling they are talking about. So, and also there are criticism from the markets saying the whole stress test by the government is a way to “manipulate the market” by being too optimistic or whatever.
So, I'm just wondering, from China's perspective, because China’s pushing ahead so hard on opening the market and further deregulate the service sector, and that largely involves less intervention from the government, so where is the line between? How do we understand the whole thing and where is the line between good and bad government intervention? Thanks.
MELTZER: Do you want me to answer that? That's a line that I would draw very sharply. What the government can do and should do is regulate things where there is a divergence between private and social cost; the government — to eliminate what economists call externalities, differences between private and social costs. An example is we insure in every country, one way or another, we insure the deposits in the banking system. That means that we take away the risk to the customers and to the banks that the deposits — that there will be a run on the deposits.
We can't allow them then just to invest willy-nilly if they are about to do that, as some might, so we have to regulate what they can do. And that's an example of bringing the private costs — the social costs down to the private costs.
And other regulation gets circumvented. For example, in the most recent crisis, the Basil agreement said, look, to a bank, if you take on risky assets, you have to hold more capital. What do the bankers do? They didn't hold the risky assets. They put them in separate entities off the balance sheet and didn't hold the additional capital. Now, it turned out that neither the regulation nor the circumvention worked in that case. But it tells us that regulations get circumvented. And that's true not only in finance, it’s true everywhere else.
So there are only three things that you can to do. You can try to regulate and get circumvention. You can try to eliminate the difference between private and social costs, or you can have draconian regulation where the regulation either creates a monopoly that someone wants to hold, or you regulate by really using extreme measures to enforce the regulation. That's not a very good idea. In fact it’s a very bad idea. The only good regulation, as far as I'm concerned, equates private and social costs.
BROTHEN: Do you have something to add?
MACKINTOSH: Yes, I would say obviously people are concerned here as well about the extent to which the Treasury and also the Federal Reserve intervened in an exceptional manner during the crisis in October and September of last year, and since then. We know that the Federal Reserve has spent two trillion dollars — or even more than that, on these exceptional measures to enhance liquidity, to keep the markets fluid and basically to restart the credit markets. So I think they were following a policy which was essentially ad hoc reactive to the crisis; they were literally reacting to things as they occurred upon a day-by-day basis.
Was there a pure ideological nature to what they were doing? Not at all. They were in fact being reactive and in some sense, policymakers here I think felt that was necessary, that you had to take actions on a case-by-case basis, because the crisis was so severe. However once the crisis is over the implied question from the questioner is, “Well, how much is too much?” Well, we need to now figure out what the exit strategies are, how the government can step back from this extensive involvement in the private sector, underpinning the private sector the way we have been doing so up until now.
I would just say, by way of addition, professor Meltzer keeps coming back to the “Regulate or not?” question. I think that you could think of it as a car. If a car breaks down and because there is a fundamental failure in one of its mechanisms, you don't throw up your hands and say, oh, well, it is in the nature of cars to break down. What you do is you take it to your mechanic, in this case your supervisors and political leadership, and you say, “What is fundamentally wrong? Let's change it.”
Now, making adjustments to the regulations doesn't guarantee that you will always deal with the future crises. But you still ought to address those failings that you see. Otherwise, you're simply left throwing up your hands and saying, “Well, there’s nothing we can do here,” and I don't think that's an acceptable response, and I don't think that the public or the politicians would accept that from the Federal Reserve and the Treasury at this point.
MELTZER: May I just add that — yes, of course if you have a crisis, then you want to deal with it, but you also want to think about more than what’s going to happen in the next three weeks or three months. You want to think about what’s the long-term consequence of what you're doing. Federal Reserve isn't good at doing that. It never has been good at doing that, and it isn't very good at doing that now.
As our Chinese friends warned us several times, they think that we're going to have a big inflation. So do I. I’ve never seen a country which had huge deficits, fast money growth and the expected decline in its exchange rate that didn't have to worry about inflation. So I think we have to worry about inflation, and I think that's going to be the problem. I don't believe that they should do nothing, but I do believe that they should be concerned about both today and tomorrow.
BROTHEN: Beijing, do we have another question?
SNYDER: Yes, thank you. We have Gwen Chen from the Global Times newspaper.
AUDIENCE MEMBER IN BEIJING: Good evening, I have a question for Mr. Meltzer. So, I read an article written by you about inflation on New York Times. You said that big, heavily subsidized programs are rarely good for productivity. So, in your opinion, so what can U.S. government do to enhance productivity, hence boost economic rates, and also avoid inflation? Thanks.
MELTZER: We're moving into a world which is going to be very different for Asia and very different for the United States. The United States, as everyone knows, has been consuming more than it produces. It now has run up a big debt, certainly, among others, to the Chinese central bank. It’s going to have to service that debt, and the debt is going to get larger because the current budget of — the budget of the current government is very, very much in deficit. So what can the United States do under those circumstances?
It has to export. It has to export in order to earn the money to pay the interest on its debt. That means it has to reduce the growth of consumption. We’re going to have to make that adjustment. Future generations, for a while, are going to see less consumption growth. That's going to have an influence on China and on every other part of the world that has depended upon exports to America. So that’s going to be a change. If we don't make it now, we're going have to make it later. But sooner or later we have to service that debt.
So what should we be doing? To increase -- to answer your question, what should we be doing to increase productivity? We should be instead of encouraging consumption, which is what the administration is doing, we should be encouraging investment.
We don't get any productivity growth out of the energy program. If anything, it will hurt our productivity. We don't get very much productivity growth out of the health care program. It may be a good thing, the public may want it, but it isn't going to lead us where we have to be. We have to be in a place where we can be a big exporter so we can pay the interest on our debts — not retire them, just pay the interest. And that's going to be a big challenge for the future. And the way to do that during this period of transition is to prepare for it, and prepare for it by encouraging investment in productivity growth.
BROTHEN: Next question, Beijing.
SCHNEIDER: Yep, our next question is coming from Eric Won at the 21st Century Business Herald.
AUDIENCE MEMBER IN BEIJING: Hello, Mr. Meltzer. This is a reporter from 21st Century Business Herald. I decide that bankers are too big to fail. So I just want to know why we can’t make it happen. If they failed, what should we do?
MELTZER: We should tell them that, “You are no longer too big to fail. If you take too many risks, you fail.” Now, that isn’t the only thing we should do, but let me just say, that that's not a new idea. The United Kingdom, Britain, had a policy all through the 19th century. Very successful. They had bank failures, but they didn't have financial crises. Why? Because they said, “If you have a problem, if you have good collateral, we lend to you. If you don't have good collateral, you fail.” So banks had the incentive to hold good collateral. And that's what they did. And that's what we need to do.
We also need to say, “Look, if you get to be of large size, you have to hold more reserves. The larger you are, the more reserves you have to hold.” That will take away some of the profits from being of large size and will do what I think needs to be done; it will bring the private costs and the social costs together. We, the taxpayers, the citizens, are paying an enormous cost in this recession in the debt we're accumulating, in the bailouts that we're paying for. And the bankers are walking away after having made big profits. That's not the way the system is supposed to work. That's not a viable system. And, in my opinion, sooner or later some smart politician is going to recognize that we can’t have a system in which the bankers make the profits
and the public takes the losses. So that’s why we have to move — adjust to the system like the one the British had in the 19th century. We'll lend to people who have good collateral. And we'll lend as much as we need to prevent the crisis from spreading. But we won't bail out the failures.
BROTHEN: Would you have anything to add to that?
MACKINTOSH: I would add a couple of things to that. One is, I think — I agree, I think we ought to have higher capital requirements for the larger institutions particularly related to the risky activities that they undertake. One of the things we had proposed in the Group of Thirty is they should be prohibited from engaging in excessive proprietary trading. Now, that hasn't become official policy, but I would note that in America there are a number of major banks that have started to sell off their trading activities precisely — we feel — in a recognition that this type of activity will not be permitted or will be highly charged for in the future. And so I think there are steps that you can take, as Allan says, to make it more expensive, perhaps prohibitively expensive, for these large institutions. They then may decide to get somewhat smaller.
I would also say, though, it’s of course not — as evidenced from having so many of you from all over the world here, listening to us today — it's not a national problem, so part of the crux of the issue is it can not only be solved by America alone or by the U.K. alone, dealing with national banking failures. So, it's not quite as simple as to say that we should just let them fail. Well, if — the British government obviously stepped in to seize the Icelandic banks that were operating in Britain to protect its depositors. Well, the Icelandic banks that owned those branches then said, well, you created the collapse in Iceland by doing so. So, the burden-sharing issue, the fundamental question of how you deal with potential collapse of internationally active and systemically important financial institutions has not been solved. We don't know what the answer is yet. And that's something that everybody is grappling with, in addition to this notion that we should have some sense of allowing these institutions to fail. We still need to manage those failures, all those crises, better internationally.
BROTHEN: Great. Beijing, next question.
SNYDER: Well, thank you, gentlemen. I think that's all the time we have for from Beijing, and it’s time to turn it over to Casey in Sydney for his five minutes of fame. [ Laughter.] Sydney, over to you.
SYDNEY MODERATOR: Thank you. I'll turn it over to Paul Brunker from J.P. Morgan to ask a question.
SYDNEY AUDIENCE MEMBER: Good evening. Look, if I can just be cheeky and just ask two quick questions. One, on the “too big to fail” question, is it enough that stockholders feel there is genuine failure risk in a bank and arguably the stockholders have been pretty much wiped out in many of the big U.S. banks and entirely wiped out, for example, in Northern Rock. Is it also necessary that creditors be wiped out to a degree? So what would your comment be on the protection of everyone from depositors through to pref shareholders and in between in the capital structure. Secondly, could you also give a quick comment on the idea that monetary policy should try and lean into the wind in asset bubbles, perhaps, in other words, cutting off the demand at the source rather than regulating the supply of excess credit to the economy, that monetary policy shoud either through interest rates or reserve requirements actually try and act against asset bubbles even if conventional inflation is quite low.
MELTZER: The monetary authority is not a very good judge of future risk. There are going to be judgmental questions. The bankers are going to say it’s perfectly safe. The regulator is going to say it isn’t safe. They’re going to argue about that. They’re not going to do very much and they haven't done very much.
We have a law on the books here, called FDICIA. FDICIA is the Federal Deposit Insurance Corporation Improvement Act. It was passed by Congress in 1991. The idea was to have something called structured early intervention. Close the bank, before all the capital was gone.
Why did they pass that law? Because the Federal Reserve kept banks, kept lending to banks, long after it made good sense. The losses would then accumulate and then they would let the bank fail when they couldn't lend or decided not lend it anymore, and they were depleting the deposit insurance fund.
So Congress wanted to protect the deposit insurance fund, so it passed FDICIA and it said if the bank has depleted its capital, but still has some, we're going to close it down, we're going take away the losses and send them to stockholders, we’re going to remove the management, and sell the remaining part of the bank, so the bank will continue to function, it will just have new management and new stockholders.
Where have we seen that used? Not at all. That was supposed to prevent the spread of failures. It failed. Because the regulators didn't do it.
Now, they have all kinds of reasons why they didn't do it. But the simple fact is, they didn't do it. They didn't use the bankruptcy laws, they didn't use FDICIA. You can't really trust them to do that. Regulation is not the solution. Incentives are the solution. You have to put the incentives on the people who are making the judgments to get them to make judgments that will be seen to them to be in their interest.
MACKINTOSH: If I can come in on that. The question you raised as to sort of leaning into the wind. I think up until this most recent severe crisis, the general feeling at least amongst the central bankers that I speak to, was that you couldn't do that, what you should do is pick up the pieces after the crisis, that you shouldn't try and deflate or somehow limit the size of bubbles as they grew. It wasn't worth attempting to do that as a central bank.
I think that position is fundamentally changed in many cases. I think the debate is now clearly on the side of actually trying to identify these red flags as we see developing new asset bubbles, and central banks and regulations ought to try and lean into the wind.
Now, will they be successful all the time? No. They won't. But, the scale and the severity of the fallout on the real economy in the multiple tens of trillions of dollars is so massive, that it is not sufficient anymore to say that this is just the nature of capitalism, and that we’ve just got to buckle under and hope that management does their best job. Because the trouble is that managers’ rational decisions, for them individually, may as a collective mass create a dynamic which is damaging to the economy as a whole, and it ought to be the supervisor's role to see that coming.
I'm not saying that you can gauge when the tipping point is. But I do think we will see central bank governors in the financial stability board, and through the BIS and other institutions, trying to lean into the wind. It isn't easy. They may fail. But I think it is worth trying given the scale of the crisis we’ve seen.
BROTHEN: Beijing, can you let us know where in the world next we're going?
SNYDER: There’s a lot to follow up there but I think we better move on to Shanghai for the moment.
BROTHEN: Okay.
SHANGHAI AUDIENCE MEMBER: Many people know that America’s wrong fiscal policies and monetary policies are important causes to this crisis. My question is that why the federal government of USA made these wrong policies. I would too focus (inaudible) why is broken government. They are written by American scholars. Do you think there is a fiscal constitution failure and monetary constitution failure in USA. Thank you.
MELTZER: Absolutely. I mean, we have a history, let's look at the history. We have 150 years of low deficits, surpluses, low money growth. Why did we do that? We had two rules that people believed in. One was balanced budgets, the other was the gold standard. Now I'm not an advocate of either of those rules. But those rules worked prevent us from doing the foolish things that we've been doing recently. We have to replace them with rules that are better, that work better, than what we have, which is a free flowing system in which the Congress and the administration can vote enormous budget deficits.
We have a president who says, well, in my administration, we're going to cut the budget deficit by half in the first four years. He doesn't say that when it’s cut in half, it’s still going be a trillion dollars a year, about 6 percent of the U.S. GDP at that time. That's an enormous deficit. And it’s going to be disruptive for us and for the rest of the world.
MACKINTOSH: I think I would agree obviously we need to see a change in attitude by some of the policymakers and also by, let's face it, the individual Americans whose profligate ways and excessive consumption has to stop. And, as the professor said earlier, that does mean if the consumers actually pull back from this excessive consumption and start saving, which we all want them to do, that the recovery will be slower and the growth rate overall will be lower, but I think that's a reasonable price to pay.
But it does have significant implications for our trading partners around the world.
On to — briefly on the deficit point, I agree that generally speaking, you can't sustain the deficit over 5 or 6 percent in the long term. It doesn't work or at least the evidence shows that you will have a crisis. I think in the short term, much of that deficit is caused by a collapse in revenues during the recession, which has been shown by Carmen Reinhart and Ken Rogoff in a very good paper recently. Some of the run-up in deficit that we're seeing right now is indicative of the financial crisis, it’s not long term. In other words, we will grow our way out of it. Will we get all the way out of it without sensible, more prudent budgetary policies and also spending policies? Perhaps not. But, I still remain hopeful.
BROTHEN: Great. Nick in Beijing, next, please.
SNYDER: All of us in the U.S. will become savers like the Chinese here on the mainland. [ Laughter ]
MELTZER: Let's hope that’s true.
SNYDER: We'll jump over to Hong Kong a little bit offshore, and Martha, your question, please.
HONG KONG MODERATOR: I have Annie Chang with Asia Week with a question.
HONG KONG AUDIENCE MEMBER: Hello, I have two questions if time permits. One is, as one of the major international financial centers in the world, I wonder, what lessons can Hong Kong learn from this crisis, you two think, and the second one is, do you think we are at the beginning of the end of this crisis, or just vice versa at the end of the beginning? Thank you.
MELTZER: Yes. What Hong Kong should do is what Hong Kong has done. It’s pursued very prudent policies. It doesn't run big budget deficits and it doesn’t run — it has a fixed exchange rate, and it manages to keep its economy growing rather well over time, and it engages in prudent policies so it should continue to do what it’s been doing, and not what we do.
As to whether the recession is ending. People are making a lot out of the fact that we haven't seen the bottom of the recession. All we’ve seen is a slowing of the decline.
Now I know enough about students and journalists to know that they have difficulty understanding difference between first and second derivatives. The first derivative is the growth rate. The second derivative is how fast the growth rate is rising or falling.
Well, the growth rate is falling. It’s just not falling as fast. We have a lot of problems facing us, commercial real estate problems, credit card problems. We haven't solved the problems of the banking system and we haven't solved the problems of the housing system. We have a huge — still a huge stock of unsold houses and we still have declining house prices.
So, while the government has done a tremendous amount of spending, it hasn't done what I think it needs to do. It needs to encourage people to buy the existing stock of unsold housing and I have been saying that, I got congressman to introduce that bill, and include it in the president's stimulus program. At the end, because the Democratic Congress is so much more concerned about distribution than it is about growth, they eliminated a big part of the stimulus to buy houses. What they did was, they limited it to people who are making their first purchases. I don't want to limit it to first purchases. I want to clean up the stock of unsold housing because that's a major step toward improving the banking system and preventing additional failures, preventing additional mortgage defaults and getting the economy to recover.
MACKINTOSH: If I may come in and take the two questions backwards and follow up from where the professor came off. I think he's right. There are significant problems ahead in all the areas he talks, about at least potentially.
Certainly commercial real estate, certainly credit cards, deliverables, and then, then we are not out of the housing slump as yet. And we should also rememberthat on average, banking crises from peak to trough take at least six years, and if we accept that this started in 2006, that means that the U.S. banking crisis won't be over until well towards the end of 2011.
And so I'm very sorry to depress you all, but I think we need to be realistic, so I would agree, we are not at the bottom yet, there is a calm. I’ll also note there was a period of calm in the Great Depression, after the initial collapse. And indeed a slight rally in the stock market after which it collapsed again. So, let's hold on to our seats. We don’t know that we're out of the woods, we’re out of the danger yet.
As to what should Hong Kong do, I would definitely agree with the professor as well. I think the supervisory attitude and the structure in Hong Kong has stood you well. The banking system is well capitalized. I don't see any evidence of problems there and I think you should indeed keep doing what you're doing. You’ve been an example of a small effective country, or not country but part of China that has done extremely well because of the type of actions you’e taken to mitigate and protect yourself against the severity of the crisis.
BROTHEN: Nick, on to the next question, please.
SNYDER: We'll move quickly away from any political statements, Mr. Mackintosh, to one of the hardest hit parts of mainland China, Guangzhou. Go ahead and let your question rip. Thanks.
MODERATOR IN GUANGZHOU, CHINA: Good morning, gentlemen. Thank you for talking with us this morning. Mr. Ronald Lee of daiyo.com is going to be posing a question, and it’s one of the major English web portals here in Guangzhou.
AUDIENCE MEMBER IN GUANGZHOU, CHINA: Good evening. And I have a question. In the coming months, how should the international communities cooperate on global economy. And could you comment a little bit on China's efforts to help with the global finance? Thank you.
MELTZER: I’ve been answering them all first. Why don't you start?
MACKINTOSH: I think they started well at the G20 summit on April the second. I think you have a whole series of deliverables that the people are working on. It covers everything from standards of supervision, to future coordination, and, of course, these efforts at stimulating the national and global economies together. I don't think that it’s going be easy. I think these long-term structural solutions, attempts to solve the problems that we‘ve been facing, will take many years. So, I don't think those will bear fruit immediately.
But, I do think that we are seeing an unprecedented degree of international coordination at this time, something that people I think in the past wouldn't have expected. The old G7, then G8, was often derided for not having any teeth and for not being able to come up with communiques that actually held any meat inside them. This time we actually saw a difference. So I'm hopeful that we can see that sort of spirit of international coordination, and collaboration, continue in the months ahead. But, we have to keep pushing our governments to collaborate appropriately.
MELTZER: I'm happy to talk. I remember very well my first visit my first visit to Guangzhou so I'm happy to talk to you.
I think that the Chinese government has some work to do. It needs to do more to spur domestic consumption, because if I'm right about where the United States is going, China has to make a move in the same direction, that is, it has to depend less on exports to us, and more on domestic growth and consumption. There is a big population that can absorb a lot more consumption. So I think that's something that China has to do. Second, it is to again straighten out its banking system and prepare its currency to become a market-adjusted currency. And, that I think is an important long-term program. It’s not something that's going to happen overnight. But it’s something that the Chinese government has to prepare to do, as it becomes a stronger amd more vital part of the Asian and world economy.
BROTHEN: Okay, Nick, how about the last question there.
SNYDER: I think it’s time now to bounce back over the ocean to Wellington. Wellington, you're up.
WELLINGTON MODERATOR: Thank you. Let's go right to the question, not waste any time here.
WELLINGTON AUDIENCE MEMBER: Good afternoon, everyone. I'm Jeff Golts from Wellington, and we have a question, I guess, in relation to probably about the implications of the things that you’ve been talking about. New Zealand is obviously affected like everyone globally is by what happened in the U.S. Professor Meltzer makes a compelling case for less regulation, and this has not traditionally been the U.S. response to financial crises in the past. Sarbanes-Oxley is probably a reasonable example of that, and certainly we had implications for that in our banking sector as well as Australia, et cetera.
In your view, will the U.S. actually act differently this time, and what are the kinds of things that you would put in place in the way of incentives I think professor Meltzer refers to, in relation to that, and how would you — do you think the transition could be managed from the regulatory environment that currently exists to something else? That’s kind of a practical question, I suppose.
MELTZER: Well, let's start with that. Not easily. Not easily. But that’s something that we just have to do. And we have to train the bankers to take the risks and bear the costs. And you in New Zealand, I again remember very fondly my visit to New Zealand, and my friend Don Brash who was then governor of the central bank, and so you in New Zealand certainly understand the advantages of a deregulated economy. Because you went through a major change in that direction with long-term benefits to New Zealanders, so we have to do that as well. And it will not be easy.
And you're right. We get bad legislation like Sarbanes-Oxley, which once it’s on the books, it’s very hard to get rid of. It takes years and maybe decades. But it’s bad legislation. If we continue to move along those lines that people are talking about, more regulation, what we'll see is a major industry in the United States, the financial industry, will move elsewhere.
What we're having now is regulations that hamper the American-owned banks, and so a lot of the most experienced successful bankers are moving to work for the American branches of Deutsche bank or UBS, a Swiss bank, and other banks. That's not something that we need to either encourage or want to achieve. And regulation is doing many of the wrong things. And we will have those costs to bear if we continue down that line.
MACKINTOSH: I think part of the difficulty will be transitioning into a more rational system of regulation. Because remember that reforming the U.S. system doesn't necessarily mean more regulation. The U.S. system is very duplicative, it also has large numbers of gaps, competitive arbitrage, forum shopping, and all of these types of activities that were actually problematic and not supporting of the financial sector. And so I think if we had a more more rational structure not unlike the structure, for instance, used in Australia, which is the type of structure that's been proposed by the Paulson report of a couple of years ago, and is similar to the type of suggestions being made by Tim Geithner at the U.S. Treasury now.
I think you would actually see a lot of the financial players pleased to be regulated more rationally, more clearly and transparently by fewer regulators, not more.
So I think that we do need to bear in mind that a proper restructuring of the U.S. system might actually result and indeed should result in less regulation, not more regulation. That doesn't mean to say it isn't difficult. The congressional system we have here mitigates against rational consideration of issues, because you have clashes between chairmen, you have multiple bills coming out and so on and so forth.
But thus far they’ve held off from doing that. We're waiting to see what Tim Geithner’s proposal will be. He said he will provide a holistic proposal that will look at the system as a whole, not in pieces, which is what is what Paul Volcker urged him to do, so I'm hopeful that we can actually come out of this with a more rational structure that is actually easier to understand and less onerous.
And I think the history of banking crises, not just in America but all over the world, shows that post crisis, you often get bursts of reform, that often times result in a more rational structure. Not always a more onerous one.
BROTHEN: Great. And I know we're at the top of hour but I just wanted to give both of you gentlemen a chance, if there was something that you wanted to say that you didn’t get out during this discussion, closing remark for our audience. Go ahead.
MELTZER: I haven't hesitated. So I thank the people all over Asia, and Australia, and New Zealand, for their comments and questions.
MACKINTOSH: Yes, thank you very much. It’s been a pleasure. Thank you.
BROTHEN: Great. Well, thank you to both of you.
SNYDER: Can I ask --
BROTHEN: Yes, Beijing?
SNYDER: Can I ask one question more from Beijing ,if you don't mind, to put things in context for our Chinese audience? Can you characterize how mainstream your views are? To my mind they are quite mainstream and you just represent two sides of the current debate. Mr. Meltzer on the more gloomy, and Mr. Mackintosh perhaps on the more optimistic. But if you could maybe take just a quick second or two to put it into the overall context of the debate that’s going on in the U.S., we’d greatly appreciate it over here.
And thank you again for your time.
MELTZER: I would say I'm in a distinct but growing minority.
MACKINTOSH: Yes, I think that the policymakers on this side who see failures in the regulatory structure, see failures in supervision and so on, and feel the need to address them through political legislative means and regulatory means, clearly are in majority at the moment, and so we are seeing the pendulum swing back from a period of relatively light regulation but also a tendency not to regulate inefficiently, and I think we're going in the other way and it ought not to be necessarily a bad thing.
MELTZER: I might add, I'm used to being in a minority, but sometimes, we win. [Laughter ]
BROTHEN: Great. I hope that answers that final question, Beijing. Thank you so much.
SNYDER: Absolutely does.
BROTHEN: Great. Thank you so much to our guests, first of all for being here, late at night in Washington. We really appreciate you taking the time. It’s been a good discussion. Thank you so much to all of our audiences around the world. A special thanks to Embassy Beijing for serving as a coordinator in that regional with us. We really appreciate it. And if anybody wants more information regarding today's topic, they can go to our Web site, America.gov, and there's plenty of information about this. Thank you so much.
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