Global Financial Crisis

Global Financial Crisis – Causes and Solutions

by Patricia Edema

The global financial crisis, that began to manifest itself in July of 2007, emerged as a liquidity crisis, which in turn can be traced back to the U.S. subprime housing market. When interest rates for loans rose between 2004 and 2006 and the prices of houses began to decline in 2007, failures in the repayment of subprime mortgage loans as well as failures in the repayment of subprime mortgage-backed debts and other securities heavily increased. Major financial institutions, that had borrowed or invested in mortgage-backed securities of non-depository finance companies, were forced to declare bankruptcy or were taken over by other banks. The emergence of the global financial crisis was also the result of the doubtful use of high-risk off-balance sheet instruments with zero liquidity and uncertain value on the side of non-depository financial institutions. Mortgage-backed securities and collateralized debt obligations (CDO), which commercial banks traded to investors to distribute credit risk, but which turned out to be illiquid for most of the part, heavily accelerated in the year before the financial crisis surfaced. By contagion, the housing market downturn and subsequent financial market crisis have also affected the broader U.S. real economy. Due to the growing integration of financial markets and industries during the past 20 years, the crisis spread to Europe with dramatic slowdowns occurring across Europe and with the recession widening into a global problem. Some of the factors that led to the financial crisis in the U.S. – high-risk, non-banking mortgage loans, low interest rates, aggressive (subprime) credit expansion, ignoring of the credit risks of borrowers – created similar problems in Europe. The reasons causing the economic crisis within the Eurozone vary from country to country, though. While some European countries got into debt without any connection to the financial system, others tried to rescue their highly indebted banking system: Greek fiscal crisis refers to huge budget deficits due to excessive government over-spending, whereas Ireland’s and Spain’s economic crises go back to residential real estate bubbles, based on massive over-production of dwellings. In the case of Ireland, six main domestic financial institutions financed a property bubble that lead to the subsequent collapse of the domestic economy. Ireland was the first country to secure an International Monetary Fund-EU bailout package through the European Financial Stability Fund (EFSF), the European Financial Stability Mechanism (ESM) and the International Monetary Fund (IMF). The purpose of the IMF-EU bailout package was to spur the Irish economy and to restore a properly functioning Irish banking system.

In the new, globalized world of closely interdependent economies, the U.S. crisis affected almost every part of the world – in fact, the global financial crisis highlighted the complex international linkages between financial markets and between the U.S. and European economies. Professor Martin Hellwig, who opened the panel discussion “From Financial Crisis to Debt Crisis– Financial Markets, Monetary Policy and Public Debt” of the 2011 Lindau meeting on Economic Sciences, stressed the fatal global interdependencies of banks and governments as a key problem when analyzing and validating the global financial crisis. It is the worldwide entanglement – U.S., Irish or Spanish banks having funded a bubble with German or French banks having funded U.S., Irish or Spanish banks or sovereign debtors – which makes it difficult to thoroughly grasp the crisis.

Panel Discussion (2011) - Panel 'From Financial Crisis to Debt Crisis - Financial Markets, Monetary Policy and Public Debt': Robert A. Mundell, Roger B. Myerson, Myron S. Scholes, William F. Sharpe, William R. White (Chair: Martin Hellwig)

MARTIN HELLWIG. Welcome to this panel, “From financial crisis to debt crisis, financial stability, monetary policy and public debt”. Let me first present the participants of this panel. My name is Martin Hellwig I'm at the Max Planck Institute for Research on Collective Goods in Bonn. If you ask me what are collective goods, we are still doing research on that. But we have decided that financial stability is a collective good. In the initial announcement of this panel, Robert Mundell was also supposed to be a participant, unfortunately he had to leave early, this is especially unfortunate since the issue of optimal currency areas would be one issue that might be discussed in this context. We actually have here Roger Myerson who received the prize in 2007 for his work on incentives, Myron Scholes who received the prize in 1997 for his work on option pricing, Bill Sharpe who received it in 1990 for his work on capital market equilibrium, and then, last but not least, Bill White, currently at the OECD, who used to direct the economics department, economics and research of the Bank for International Settlements in Basel and has thus been a very close observer of events as they unfolded. I'm planning to give a short introduction myself, then to have ten minute statements from each of the participants and afterwards to have a discussion, first among the participants themselves and then with the audience. Before we start I would like to say, given that there are journalists here, everything that is being said is to be attributed to the persons saying this, without any relation to the institutions that might be behind us. This concerns in particular Bill White and myself. You will notice that the title of the panel has also been changed, the reference to the European Monetary Union has been dropped, the reason for that is, among other things, that the problem of public debt is a problem not only in Europe, but we’ve just had the instance of the downgrading of the United States’ federal government by Standard and Poors. A few days ago, in a discussion Ned Phelps was saying that, well, one of the monkeys on the back of the United States is debt explicit and implicit, entitlements and explicit debt, which is somewhere between seventy and eighty trillion dollars. A response to that from Peter Diamond was that, well, if you cut entitlements a bit and you raise taxes a bit, the problem is going to disappear, or the problem is much less serious than it would seem if you just take the bare number of seventy to eighty trillion. Of course there is this issue of what political will is there to actually do this. I suspect that some observers of developments over the past few months have been concerned in particular about that. On Wednesday, at the initial panel, one of the young participants of this conference said Greece has done all it could and now it could not do anymore. I looked at the actual numbers and found that Greece is running a primary deficit, which means that before paying any interest on debt, the Greek government doesn’t make ends meet. Tax revenues are less than public spending, which to me raises the question, which is the same as the one I just raised about the US: Why can’t Greek society agree on what government should do and how to pay for it? Since I'm German I think it’s appropriate in this place to say that this also was the problem of the Weimar republic. As school children we learnt that the Weimarer republic was burdened by reparations. But for every single year in the 1920s, capital imports, borrowing in particular from the US exceeded reparations. And the Weimar republic had exactly the same problem of not being able to agree on how to make ends meet. In discussions of the crisis one sometimes hears a story about sequence. First there was overindebtedness of households, private households borrowing too much against their incomes. Then there was overindebtedness of banks having too much leverage. And now we have overindebtedness of sovereign debtors. And in between sovereigns tried to rescue banks and that got them into trouble. I submit that this sequencing is misleading, because if you look at the sovereign debtors there are two types: There are some countries that simply ran deficits without any connection to the financial system, Greece and Portugal would be examples. And there are some countries that got into trouble because they tried to save their financial systems, Ireland would be the prime example and Spain we also have this kind of problem. And then there are countries where the difficulties have to do with banks lending to banks, German banks providing funds for American banks to provide funds to American households. I'm shortening the chain but that’s roughly the story. Or German banks providing funds to Irish banks providing funds to Irish builders. And at the back then you have the German government trying to provide funds to these German banks. The so called euro-crisis that we have been worried about over the past fifteen months of course, is not the currency crisis in the strict sense of the word, but it’s a combination of a crisis of sovereign debtors. An Irish style banking crisis, banks have a funded bubble and the problems of German or French banks having funded the Irish banks or having funded the sovereign debtors on their own. And it’s the entanglement of these crisis, which makes it so hard to even think about. So I think we should talk about how did we get into this mess and how might we get out of it. It is part a question of economics and part a question of politics. I will briefly report on some of the things that have been said about these matters by non-participants of this panel during the last few days. We first had president Wulff criticising rescue operations in the eurozone. Criticising the bailing out of countries, installation of the EFSF and the ESM, the role of the European Central Bank in buying up government debt with the statement – Should the ECB or should the EFSF or rather the other governments have let things go or was there more damage to be field? Then we had Bob Mundell suggesting that the crisis, in particular from the US point of view, was not really so much a financial problem but had a lot to do with exchange rate governance, like the revaluation of the dollar relative to the euro in 2008, causing problems for the US ameliorated by the devaluation in 2009 and resurrected by a revaluation again in 2010, and he was suggesting that coming to some agreement to fix exchange rates would greatly stabilise the system. I was surprised to hear this from the proponent of the theory of optimal currency areas, given that much of the discussion about the eurozone has been to the effect that the euro zone is too large and too heterogeneous to be an optimal currency area. But that’s what we were told. Then we had Edmund Phelps talking about the need to have more finance for innovation, in particular innovation at small firms. Peter Diamond talked about problems of small banks, which were crucial for financing small and medium enterprises because they are in bad shape, that’s part of the problem in the US. Which brings me to a question that I would like to raise for Myron Scholes, in your presentation you talked about financial intermediaries as institutions that in a sense smooth risks from market imperfections trying to market system work better and take away risk from anybody else. The notion of information production by an intermediary was downplayed in this account and it was crucial in Peter Diamond’s presentation. By the way, we had a panel on the crisis, this is at odds with something that was said yesterday, we had a panel on the crisis three years ago and in that crisis Muhammad Yunus was saying – well, in terms of credit worthiness, the people that his micro-finance institution is giving money to, are much worse than any subprime borrower and they have rather fewer lawyers involved, but they make sure that incentives to repay work and that they look at the individual contracts in great detail, which of course is another way of saying information production at the very retail level plays a big role. Then we had Joe Stiglitz talking about securitisation and fertility, securitisation reducing incentives to look into what the clients actually are worth, this links up with what I just said before. And then interconnectedness, globalisation, spreading of risks across the world being a source of contagion mechanisms. Joe Stiglitz also raised the possibility that the crisis had more to do with structural change, a shift away from manufacturing to services, but parallel the shift away from agriculture to manufacturing in the great depression. The notion that we should be focusing much more on the real sign, the production sector was also central to Prescott’s presentation, who emphasised the role of productivity development relative to finance. Now, Joe in his presentation also asked ‘why did standard macro not foresee the crisis? And here I'm getting directly to Bill White, the BIS report of 2007 mentions subprime, mentions the possibility that subprime might have consequences for the rest of the world, but without any great sense of urgency. And as I’ve read this report, it’s one amongst several items that are a cause for worry. Speaking from personal experience - I participated in a conference of the Bank for International Settlements in late June 2007 – I don’t think I’ve heard the word ‘subprime’ once during that conference, nor the word ‘shadow banking system’ or ‘conduit’ or ‘SIV’, ‘structured investment vehicle’. The one word that I very much heard was the word ‘hedge fund’. But this is where I want to turn over to Bill, I should say, before I do so, that he has for quite a number of years prior to the outbreak of the crisis asked the question ‘Is price stability enough?’ And answered it in the negative saying ‘Central banks should not just be worried about price stability’, but you didn’t provide a recipe for what else they should be worried about. WILLIAM R. WHITE. Let me start off by saying thank you for having being invited to even attend. It’s an even greater honour to be asked to participate with such a distinguished group of people, so, first point, thank you very much. Second point, if it’s not clear already, I spent my entire adult career as a policy maker, or around policy makers, rather than as an academic. And I think in the current crisis, at least my presentation about this crisis will indicate, I think the policy makers have a lot to answer for. Policy-making is very hard, it’s very hard to avoid errors and the problem is that there’s a lot of different kinds of errors to avoid. Now, some of you may remember Donald Rumsfeld, a while back, and Donald Rumsfeld said And people initially said, boy that’s really stupid, and then after a while they said, well, no, actually that's really pretty smart. Mark Twain said something about error about a hundred years earlier, which I think is very relevant to frameworks and theory and stuff. Mark Twain said – ‘it ain’t the things that you don’t know what get you. It’s the things what you know for sure but ain’t so’. I want to talk about two things here in the ten minutes or so I’ve got, that I think are relevant to this questions of error and where did they come from. First thing I want to talk about is the surprising end of the great moderation. Go back to some of the things Martin said, it was surprising. Why was it surprising, what are the consequences of being surprising? Then the second thing I want to talk about is the underlying roots of this crisis. I’ll say nothing about policy in this early part of the presentation because I guess my firm conviction is that, unless we can get some agreement on what the problem is, we are not going to get any agreement on what the solution is. And this actually is a problem that faces the G20 and the whole political context. Well, let me say a few words then about the great moderation and the surprising end of the great moderation. The great moderation, Bob Mundell mentioned this yesterday, remember, he talked about the three booms, but he put all the three booms together and what comes out of it is the great moderation. That basically from 1980 onwards at least in the advanced market economies. GNP grew rapidly, volatility was very, very low, and you could say the same thing with inflation, and it was deemed that the great moderation. I think the general sense was that it was going to continue, I mean at various conferences that I attended in Jackson Hole and elsewhere, you know, these were the good times and the good times would roll. And when the end of it came in this highly, highly non-linear disruptive fashion, it was enormously surprising to everybody. And what came out of that surprise in a sense was denial. You may remember that Ben Bernanke, when this thing started, he said its 50 billion dollars and it’s going to be in the subprime area and it’s contained to the subprime area. Then, when it spread up to the inter-bank area, he said it is a broader financial problem, but it’s a liquidity problem. And then, a few months later, with AIG and the rest, it became clear that it wasn’t a liquidity problem, it was a Minsky moment that looked like a liquidity problem, it was a solvency problem. And the reaction, again denial, was to say, well, that’s on the financial side, we can sort that out. And it took another three quarters, I think, before real side tanked. And then everybody said oh my god we’ve got a problem on the real side. Still it is denial, surprising. We’ve got a problem on the real side. And going back to something that Joe Stiglitz said yesterday, they thought about it then in demand side terms, and of course they responded in demand side terms. And what they didn’t realise was that underneath the deficiency of demand was that we had a long period of misallocation of resources, so that huge numbers of industries, and I'm thinking banking, retail, cars, construction, all got too big and they still got to get a lot smaller and we’ve got all of east Asia geared up to produce stuff that people in the western countries can no longer afford to buy. So there’s a supply side component, all of this stuff was surprising. And the vast majority of people they didn’t see it coming. Now, the next question is: Why not? Why didn’t people see this coming? The people in the private sector, I don’t know if you have comments to make on this, but they were making huge sums of money. And they believed they were making huge sums of money because they were smart. They didn’t want to talk about the fact that maybe they were making huge sums of money because they were taking on extra risks. They didn’t want to talk about that. The treasuries didn’t want to talk about it because there were huge sums of money flowing into the treasury during the boom years, and, never look a gift horse in the mouth. They took the money and ran, spent it mostly. And the central bankers, of course, they were so focused on price stability, and they had price stability largely because of the structural changes Joe was talking about, China, Slovakia, all these countries coming into the world order, they had price stability, there was nothing to worry about, everything was fine. That’s why it was surprising. But I think, above all, and I say this to a group of academics, above all it was surprising because it was an analytical failure. It was an analytical failure. You think about the kind of models that are increasingly used in the academic world, the macros, the dynamics, whatever. These models, and you know this far better than I, they have no room for crisis of this sort. And the models that they use in the central banks, and I'm familiar with them for thirty years, and at the IMF and at the OECD, and don’t tell the OECD I said this, those models are fundamentally deficient, they have no financial sector, they are highly linear, there’s no room for bankruptcies, they also assume that if things go wrong, interest rates or whatever can move and fix it. And I fundamentally believe this is not true. So we have an analytical failure here that we’ve got to come back and think about. Now, the fact that it was surprising, had a lot of undesirable implications, and I say this because these issues have not yet been resolved. Because the thing was surprising, because it couldn't happen, nobody tried to prevent the crisis from happening. When the crisis happened, as I say, everybody went into denial. Prior to the crisis happening, nobody made preparations for a crisis. Think about the United Kingdom for example, was there adequate deposit insurance? Were there adequate memoranda of understanding between the agencies, were there adequate bank insolvency laws? Where there international debt burden sharing arrangements? None of those things were there, because this crisis couldn't happen. So at the analytical level, a kind of framework that doesn’t allow you to plan for bad things happening is an analytical framework that needs to be rethought. What I sense yesterday and the previous two days is that that’s happening and that’s a very good thing. Let me move onto the underlying causes of the crisis, I’ll say nothing about policy. I think there’s two schools of thought, I characterised these earlier on as ‘the school of what is different’ and But more formally it comes down to ‘does this thing have its roots in the financial sector or does this thing have its roots in the monetary and exchange rate framework’. Both of the above are true. I think both of them have played a role here, but I think the second one is more important and I’ll tell you why. This ‘school of what is different’, that it’s got its roots in the financial sector, the ‘school of what is different’ is always in the ascendancy right after a crisis. John Kenneth Galbraith has a wonderful quote, he said: ‘once a bubble bursts, attention shifts to the way the bubble manifested itself, new instruments, linkages and the like, while the key factor, speculation, is ignored’. And this time around we saw exactly the same thing. At the beginning, what was the problem? The problem was off-balance sheets, subprimes, SIVs, conduits, CDOs, CDO-squareds, it was all the new stuff. And it’s very comforting to talk about the new stuff, because in everybody, the regulators, the central bankers, the lot of them. They can all say this stuff was brand new, you couldn't have expected me to see the full implications of everything that happened. And to the extent that there is blame to be attributed, if it’s in the financial sectors, blame the hedge funds, blame the banks, blame the greedy, it’s all very comforting particularly for the central bankers. Second school of thought, which I think it's more important, is what I call the ‘school of what is the same’. That school starts off by noting the fact that, I hope people here have read this book by Carmen Reinhart and Ken Rogoff, 800 Years of Financial Folly. Just in recent times we’ve had huge crisis in 1874 and another one in 1907 and 1929. Japan, Southeast Asia, we had all of these crisis, they’ve gone on for time immemorial, and what's more, they all look the same. They start off with some good news, the good news enhances profit opportunities, the banks lend more money, the money gets spent, the economy booms, the value of collateral goes up, the value of collateral can be used to get still more money, and so the boom continues until it finishes, okay. The boom and the bust. And we’ve seen it over and over again. What in a sense is so discomfort for all of the people on the governance side, both inside the banks and regulators and central banks, is that it was the same thing as we’ve had so many times before, and they just missed it. They just missed it, they thought it was a new era, as Martin Wolf has put it the four most dangerous words in the English language: “This time it’s different”. And they should have seen it because just prior, and I welcome comments from the panellists on this, just prior to the crisis, all of the imbalances that sort of traditionally filled up were there, and people should have seen them. What I mean by that is that credit spreads got down to very, very low levels for sovereigns, for peripherals in Europe, for emerging market countries, for high risk, credit growth was very, very rapid. Interest rates were very, very low. Household savings rates fell to zero in the United States, in China capital investment went up to 50% of GDP. Volatility went down to nothing, the lowest ever recorded. These should have been seen as contrary indicators. These are not signs of ‘all is well’. These are signs of ‘risks are building up and we have a serious problem’. And everybody missed it. And one of the difficulties, as we go back to the underlying, who caused all of this? I personally believe that’s why - the OECD doesn’t believe this, but I believe this - monetary policy has a lot to answer for here. That monetary policy was run very, very easily. You remember, in 2003 interest rates in Japan were at 0, interest rates in the States were 1, interest rates in Europe were 2 percent. And all you need to do is just eyeball a chart, and what you can see from 2003 on is a clear inflection point in every asset class you want to talk about. This may just be coincidence, but I think it had a lot to do with monetary policy. Again I would welcome the panel’s comments on this, Raghuram Rajan says that those low-interest rates and the search for yield were also the reason why so many of these new instruments came into being. That they were consciously designed to push all the tails out into the risks, all the risks out into the tail, where disaster, myopia sort of reigns and where effectively they just disappeared. So you had Tasmanian pension funds buying CDOs and structured products for four basis points, you know. There was something seriously, seriously wrong there. I would note two last things that, and I guess I better finish up here, but this easy monetary policy in response to the crisis at the end of the last decade, this wasn’t the first time. Remember the Greenspan put in 1987, the Greenspan in 1987, when the interest rates went way down and the answer in 2001, when they had another problem, was again the interest rates went way down, and the answer in 1997 and 1998 and 2001 to 2003 – it’s been the same response every time, which is easy monetary and easy fiscal policy. And at the end you wind up where we currently are, in that the interest rates are at 0. I don’t want to let the emerging markets off the hook here. I think one of the, in addition to the financial problems or the problems roots in the financial centre, the roots were in monetary policy in the advance market economies but also in the emerging market economies. Because over the course of the years, as we in the advanced countries kept monetary policy pretty tight, what should have happened, was our exchange rates ought to have gone down, which means the exchange rates of the emerging markets, particularly China, should have gone up. But for various reasons they decided that that was not what they were going to do. The reaction was, if you guys in the west can print the money to get your currencies down, we can print the money to keep our currencies from going up, and that’s precisely what they did. And so the whole thing emerged in a kind of global problem of excess liquidity. Now, if we had an international monetary system with some degree of control, this would not have been able to happen. But we didn’t. I think it’s very, very important that we start thinking seriously about the frameworks. I will say very little about Europe here, but in a sense the European problem arises in exactly the same way that through the fixed exchange rates peripheral countries got a monetary policy that was absolutely not right for them. They took the money and they ran. And then you had all this overextension in the private sector in so many countries. So that’s my story, my story is that the roots of the crisis are in the financial system but still more in the monetary and exchange rate system. That of course raises a paradox, I’ll finish with this now, the paradox is how did this turn into a sovereign debt crisis? If I think the fundamental roots are financial, monetary and exchange rate related, how did this turn into a sovereign debt crisis? I think there’s three reasons which have accumulated one upon the other. One of them is secular. For decades virtually all of the western countries have been running asymmetric fiscal policy, just like monetary policy, you know, they didn’t lean very much on the upside but they lent a lot on the downside. It was asymmetric. Fiscal policy was much the same, so in the bad times they would spend the money to cushion the economy, but in the good times the countries never accumulated as much money as they should have done to ensure that their debt profile was not constantly trending upwards. So this is a problem of very long standing. Secondly, in the boom, the last boom, so many, and I see this as chairman of the EDRC at the OECD, so many countries benefited from the boom, the treasuries benefited from the boom, the money just kept flooding in and they interpreted it because they didn’t really understand it, they interpreted it as being secular not cyclical. They interpreted it as being a permanent inflow, a new era, times have changed. And they spent the money in very large parts, so that was the second mistake. The third mistake was, well, this wasn’t a mistake, then the boom came to an end and of course all the cyclical revenues disappeared, in addition the economy tanked, the automatic stabilisers kicked in, particularly in Europe where they are very, very powerful. And the upshot was that the debt exploded. Now, Reinhart and Rogoff in their various publications say that this is what almost always happens after a big crisis, where there is involvement in the financial sector, the fiscal side explodes, this is very, very common. But having said that it’s not very comforting. I say that because you just look at the newspapers in the last few days, the global economy is faltering. Secondly, all of the imbalances that were there in 2007 are still there. Some of them are even worse, the imbalances that were there are still there. And thirdly, I think we’ve virtually exhausted all our room for manoeuvre on the fiscal side and the monetary side as a result of all of this asymmetric behaviour going back decades. So I will finish with the joke about the Irishmen, someone is lost in Ireland in a small lane, some of you know them, the small lanes of Ireland. And he meets a man, an old man in a ditch doing some digging and he says: “How do I get to Dublin from here?”. And the old man replies: “Sir, if I wanted to go to Dublin, I wouldn't start from here”. ROGER B. MYERSON. I’ll follow your impressive standing here, try to give the maximal energy that this deserves, it’s a privilege to be here as guests of Lindau and St. Gallen to talk about these major issues. As a theorist, my job can only be to try to use what I understand as the most fundamental economic theory to try to sort out what is at the basis of the dichotomy that William outlined, that between those who blame the banks and those who look to fundamentals of asset prices, bubbles coming from speculation, I think my theoretical prejudice was leading me towards the blame the banks guy. I think the importance of financial intermediation has been for decades under-appreciated in macroeconomic analysis, for the simple reason that the theory of banking is ultimately a theory about banks and financial intermediaries exist, because they have better information about where are the good investments in our economy than the great mass of people, who’s savings are going to fund those investments, and so it’s an informational question. I am one of many in this room and in the rest of the world with the privilege of being a Nobel laureate, as a part of the great advances over several decades in information economics and the study of transactions between people and different information. And one of the important consequences of information economics was, since the 1980s the great development of analytical theory of banking and now in this financial crisis the analytical theory of banking, I think, is being introduced more into the fundamentals of macroeconomic theory to guide policy-making than before. But to me, and I read Reinhart and Rogoff’s This Time it’s Different, yes, the fundamental drivers and excessive confidence, you could both blame the banks and blame the irrational exuberance. There can be an asset bubble in the sense of ‘I think prices are going to continue to go up, I think land in Japan is going to continue to be an escalating, the price is going to continue to escalate so I want to buy it now and some greater fool will buy it from me later’. But the investment, the bubbles that Kindleberger talks about in this survey of booms and crashes that Reinhart and Rogoff talk about are typically national bubbles where global funds come in and they are coming in through financial intermediaries, a structured investment vehicle that’s off-balance sheet is enabling creditors, enabling a bank to become excessively leveraged. But the leverage is there to protect the creditors, so what's the point? The point is that the creditors believed these banks were more credit worthy than the regulators say, because they seem so profitable, why would they want to put their profits at risk by misleading me and my investment. But ultimately, if the banks exist to verify - a fundamental purpose of the banks is, for small and medium sized businesses, that are so important in our economies, to have their credit verified to the investing public. The banks and other financial intermediaries exist to verify the credit worthiness of businesses that drive our economy. Well, who verifies the credit worthiness of the verifiers of credit worthiness? This is the fundamental problem that makes it political, that brings in bank regulation, and so our political leadership and our system are central banks, and our system of bank regulation seems fundamental to me to prevent the excessive exuberance that of course ultimately we blame, This Time it’s Different, investment for the bubble, but a stable system requires regulation at the top. And that’s ultimately a political and public question. I come from the prejudice that we need to think about why the financial system matters from an informational perspective. In the little time I have, I think I'd like to mention at least one classical finance that I think has more insights for macroeconomic policy-making than has been appreciated. This is a classic paper by Myers and Majluf, which itself was really in translation into corporate finance of an earlier paper by George Akerlof on The Market for Lemons. And what Myers and Majluf argued using George Akerlof’s kind of model was that when corporations are deciding whether to finance, when corporations see investment opportunities, if they need funds from the broader public, if they see investment opportunities that are larger than they have the cash to handle, then they could offer debt. They get funds from the general public by promising to pay back specific monetary amounts or they get funds from the general public by offering a share in the profits, selling equity. But the decision to sell debt or equity is either one can serve the basic financial function of bringing general savings in to meet the special opportunities that some people know about and the rest of us don’t. However, what Myers and Majluf observed is that if the managers know the best about the current profit, the potential profitability of even the current operations of the firm, they know about investment opportunity but they also know about how profitable their current business is, and if the managers are acting on behalf of the current owners of the firm, then for any given price at which the market will allow them to sell new shares, they’ll tend to decide to sell new shares if in fact that price is higher than the real value of the firm. That is to say the new shareholders will pay more than it’s worth and thereby giving a nice transfer to the old shareholders and to the managers as old shareholders, but they’ll tend to issue debt if that price is lower than what the managers think the firm is really worth, based on their inside information. Outside investors understanding that the debt, the new equity tends to be issued by the managers more than the managers have bad news that they haven’t told, that the public doesn’t know, that means that equity tends to be underpriced. All of our accounting for capital, why banks argue that they need to be more leveraged, is based on statistics that take into account this winners curse effect, and which by the way would be mitigated if capital regulatory requirements forced them to sell capital more aggressively, then there would be less of the winners curse effect and they would be able to sell capital at a higher price than the statistical analysis of the past would suggest. But what Myers and Majluf have taught us is that we should expect that those who have the best information in our corporations and in our financial industries that are trying to raise funds for profitable investments they see because of informational asymmetries and because of this winners curse effect problem, they are more likely to issue debt than to issue equity in most cases. Of course there are situations where equity is also issued, but there is a biased towards issuing debt that’s built into the fact that the managers of the corporation or the bank have better information about the situation, the profitability, the future profitability of their enterprise than the rest of the investing public. So to me, I begin to look, this panel has ‘debt’ in the title, and ‘debt’ sounds like irresponsible behaviour, but from the Myers and Majluf perspective we begin to realise there’s a fundamental reason why those who have the best information about where the best investments are - and I'm talking both about senior management of large corporations and senior executives in great financial intermediaries - that they will find it for fundamental reasons more profitable, more efficient to raise the funds that they need by debt and by equity and by issuing shares, and so they become indebted. There’s household debt, now I don’t know anything but when I borrowed to buy a house, I had no private information, but corporate debt is about the productivity. Irving Fisher, I should mention, when we talk about financial crisis we should mention that Irving Fisher’s debt-deflation theory was published a few years before John Mainard Keynes’ general theory, and is still one of the important fundamental ideas. Irving Fisher observed that trying to understand the great depression and its onset is that, my theory is that the great depressions are caused by a deflation when there is also too much indebtedness. Who was indebted, was it mentioned, just aggregate debt and that’s a hard theory to understand in some sense, because when you look at the economy as a theorist everybody’s debt is somebody else’s asset. My debt is an IOU that you have in your pocket, that’s an asset on your balance sheet. But I think somebody was excessively indebted, and of course financial intermediaries and corporations that have good productive opportunities, they are by the Myers and Majluf theory going to be the ones who are systematically indebted. Other people are indebted, too, but it’s the financial intermediary theory. The debt-deflation theory suddenly makes a lot more sense when we realise that those who have the best information about where investments are to be made in our economy are systematically indebted. And if they are excessively indebted, then when the price level is lower than expected, then the burden of their debts, their monetary debts from the past is greater than expected relative to the assets, the real assets that they control, and new investment opportunities that they may discover, they will now not be in a position to take advantage of, and as we look at the unemployment data, there’s a sudden decline in new hires was exactly what happened after the financial crisis in 2008 in the United States. Let me draw one example of macro policy from that perspective. Once we understand that a price level that’s lower than predicted, deflation or even firms who are expecting inflation and there hasn’t been as much as expected, means, among other things, that those who have the best information about where our potential investment opportunities are, those people are now, in aggregate on average, in a worse situation. Their balance sheets are more disadvantageous, the burden of their debt is greater than expected and they are in aggregate more likely to be statistically in financial trouble. That makes it very easy to understand why a nation can be in recession or depression in such a situation. But that suggests, everybody agrees that monetary policy, the central banks that have the licence to print money any time they want, should be subject to rule to which the banks can be held accountable. But the goal of avoiding a price level that’s often unpredicted is not exactly the same as the goal of keeping the inflation rate at a predicted level. Because if you have, as we have today, several years of insufficient inflation, of less inflation than expected, then we should recognise that that situation is problematic for balance sheets of the people of the best information. Perhaps from the Myers and Majluf’s informational perspective, the better goal would be to specify that the central banks should try to have a price trajectory, not a regressive but long term, basically say three percent exponential price path for some broad index of consumer and other asset prices. And when the index is below that level, the bank should be aiming at a higher inflation rate. When the index goes above the level, they should be aiming at lower inflation rate. Not to get, to comfort us that in any one quarter that the value of money is right, but to guarantee that those who take, who incur debts in order to make productive investments - and they incur debt because the public wants something about which they have no asymmetric information to deal what's promised - those individuals, they have to worry about the price of whatever it is they are selling, but they should not have to worry about aggregate price level risks in the future in where their investments are. MARTIN HELLWIG. The next speaker will be Myron Scholes. I understand from Bill White’s presentation that risk is greatest when assessments of volatility and credit spreads are lowest. That was the signal that something really bad was going to happen, so I’m wondering whether an expert in finance, in capital markets, would agree with that assessment. MYRON S. SCHOLES. Thank you. It’s good to be here. Actually listening to Bill and to Roger I got to thinking about structuring, and this idea of ‘this time it’s different’ or ‘this time it’s the same’, you know, it’s interesting that when I look at the water from afar, everything looks the same. And when you look at the water very up close everything looks very turbulent and different. So I think both are very important because you learn a lot from this crisis, from the crisis that happened, and if you had an absurd excess volatility for a long period of time, then lots of things build up, that when a shock occurs, actually you can learn a tremendous amount. So I think it’s a disservice to just say we look at 800 years of history and basically that things are the same. The interesting part about volatility being low, and you notice that when volatility is low, that that’s a time, which is the case that you should be most worried, it may be so or may be not. Maybe it’s the case that there is that we have figured out exactly that things, we’ve learnt so much that actually risks have been reduced, and the actions that had been taken are commensurate and compensating with the risks that we have. So the interesting issue in that could be wrong, in other words, if the case evolved that volatility has been low and the effects and shocks had been muted over the last number of years from the 1980s to the 2008 period, that led to greater risk taking by all of us, it lead to greater risk taking by financial entities and institutions, and that led to greater risk taking by individuals, it led to greater risk taking by governments, in the sense that assumptions were made about future growth, volatility will be very low, that economies would continue to grow, that individuals and entities could be taking risks with regard to their operations, allowing them to concentrate on various activities, without having to diversify or to have reserves against contingencies in addition to the amount of leverage that was taken in the system and the new instruments that were born that allowed for more risk taking in the system. So the question of whether we look at a system and whether it’s really an unstable system or a chaotic system where we have the sandcastle effect, as you watch your children in the playground where they are taking sand and putting it on a sand castle, the various shovels of sand cause the sand castle not to collapse. But there’s one shovel of sand that causes the castle to collapse and then, after the fact you can say that the castle would have collapsed and therefore you should have known everything about it along the way. So there’s really an issue if the world was less volatile than being less conservative in both operations and less conservative in risk taking might have been allright, because basically there’s the envelop theorem in economics that basically, when you learn something and know it, then you want to be more experimental. So there’s a real problem with ramification. If central governments themselves actually continue to encourage the amount of risk taking in the sense that, as we said, Mr. Greenspan in the US would say, the fundamentals of the economy are good and the government has always said “don’t worry, there’s not a recession, the economy is going to grow”. If there’s really an indication that providing false signals about the level of volatility, maybe the government officials should say nothing about what the economy was going to do, because we don’t know the correct level of volatility, and the economy doesn’t have enough fear or uncertainty, such that we don’t cut back on our operational flexibility, we don’t cut back or increase the amount of risk taking that we take. So if we try to dampen the economy through fiscal and monetary actions to make the volatility appear low, the consequence might be the dampening works for a while, but when it explodes, it explodes in such an effect that the consequences of the explosion have far greater than allowing natural amounts of volatility to occur in the economy. So keeping the economy stable is not necessarily the best policy. So the question then becomes, if we look at why this is different this time, that we know that financial entities, when the volatility became lower increases leveraged dramatically, they tried to target returns and equity. We teach in finance targeting returns and equity is not something to do, but yet financial entities tended to do that over this period of time. What we learnt, as well as that the accounting system is opaque, and it’s still opaque, it’s completely opaque, and that, if you look at the balance sheet today of any bank in Europe or the United States, that it’s large, it’s impossible to know exactly what the risks are of that bank, exactly to know what the value of acquisitions of that bank. And we talk about transparency, but in the derivative positions, for example, you don’t know whether that bank is long, short or completely hedged in its positions. And you have no idea as to how to market the assets that the bank holds. So I think, one of the great lessons that we learnt from this is that to have discipline of the markets and to have discipline of bond holders, to have discipline of equity holders and not rely on a bailout of governments, banks have to be transparent. They have to have balance sheets and income statements that allow us to know from an accounting perspective what the value of assets are. And additionally to let people understand and to report to regulators and to other of their bond holders and equity holders, what the risk positions are of that entity. Having a snapshot at a moment in time is not valuable from the point of view of investors as to monitoring and disciplining bank activities. So the accounting system has to be completely changed and thought about. And additionally the regulatory system, in my view, as we learnt this time and what's different is that the number of regulations and regulators has increased dramatically, that the question is that we have learnt that there is very little accountability in the system and there is very little knowledge within the regulatory bodies. Those who are in regulatory bodies are very dedicated persons, but the problem is to rely on just that giving to the state as a way of attracting the best. If we are going to have a complicated financial system, then it’s the case that we should have a regulatory system that can monitor those entities that they are regulating and be held accountable. And have pay, that allows these persons to attract good persons and to think of it as a career in their own activities. So I think that if we look at what we learnt this time, in addition was that we developed a whole new housing industry, a whole new way of financing housing, which completely failed. We had crazy loans to homeowners who can not afford them in the United States, no down payment, so we gave them a free option. They could buy on their application with no verification, we had teaser rates. No one was forced to make these loans and even financial economists would think that was a terrific deal to be able to get a loan where you could lie, and get it and not afford it and didn’t have to pay high rates. We have in the United States built organisations in a quiet period of time since the ‘80s called Fanny and Freddie, the GSEs, Government Supported Entities, and we allowed them to go public. And they then went into uncontrollable growth with leverage, political error and huge appetite for risk, which cost taxpayers amazing losses. And no one in the government or no one in the financial system for that matter, financial people who funded these agencies didn’t control them. A view which is completely unfounded that real estate prices would never fall, which led to leverage and led to this growth, was something that obviously relying on rating agencies was a bad mistake. In addition, as far as the financial functions were concerned, proprietary trading at banks increased, this is a completely new innovation from the ‘80s on. It’s completely different from previous times, where banks became gigantic hedge funds. They had different margin rules, different capital rules, no limits. The leverage of banks became excessive through the use of proprietary trading at these entities. And they became highly levelled, they took high-level liquid real estate positions that were mis-rated by the rating agencies whose models were completely wrong. We learn ‘this time it’s different’ in the sense that rating agencies rated things that used insufficient data, had bad models of rating, had insufficient data to rate them, believed incorrectly that home owners would default idiosyncratically as opposed to home owners defaulting together. And additionally believed that people in the system would not reverse engineer what they are doing and downgrade the quality of the assets on paper in the system. Another major problem that we learn from this crisis, and very different, is that senior management of the financial institutions, though being well paid and garnering additional pay, did not really understand how to manage the proprietary trading activities of banks. And the risks that were being taken, the risk management function was not integrated into the operation of the entity, so my view of risk management is that it’s an optimisation technology, it’s taking both returns and risk into account simultaneously, that was not done at the banks. Basically the senior management have relegated the risk management people to the back office, or more like policemen or providing regulatory reports to the BIS, not being an integral part to advise the Board. And so the risk management, learning how to think about changing the miss-management, how to manage risk, is something that is far different that we have to learn how to change to make the system work. In a lot of ways it seems as though the senior management of the banks tended to lose their minds, in the sense that the amount of risk taking, the amount of leverage that was taking the banks, the tremendous belief in the efficacy of rating agencies to rate CBOs and other structures, they were not forced to believe that real estate crisis was always going to go up. And not forced the relegate the risk management group to the back room. I think that we learnt as well from the crisis that derivatives and other over-the-counter contracts, when a bank becomes insolvent, under the Lehman experiment, which was very costly, we learnt a tremendous amount from the Lehman bankruptcy, but that was not put into place and we should have learnt a tremendous amount more from the Lehman bankruptcy. That learning was not put into place in the new rules. We had a bankruptcy system and a market system for derivatives that was based by the insiders and their belief under the ISDA and the International Settlement Agreements. And those mechanisms put into place actually were not sufficient to handle the bankruptcy, to allow two and a half million contracts that have collateral posted against them to be settled over a weekend is virtually impossible in any system. The lack of information is just gigantic. So we didn’t learn, we need new infrastructure, we have to learn at a time of shock, when the system breaks, when intermediaries can’t intermediate again, we need to have a regulatory system that allows for the system to get unseized, if you want to think of it that way, and create a way that we have mechanisms to allow for time, to allow markets to again start to function, and that has not been addressed at all. If there’s going to be another crisis some time down the road, which probably there will, and again that in mind because we never know when the crisis is going to occur. Then we need to think about how to change the bankruptcy rules, to make them more effective. The way it currently works in the United States, it’s a black hole, because the FDIC is supposed to take over systemically firms that are systemic and cause difficulties, but unfortunately they have no skills, no apparatus, no ability to do it, and if you are required under the rules to fire all the people that are involved, then they’ll know nothing. You can’t run an organisation without knowing where the toilet paper is or any other parts of the organisation so it’s not going to work. As soon as it looks like the FDIC is going to take over one particular entity and dissolve it, every other entity is going to run for the exits and basically it’s going to be a black hole. So I think that we could have learnt a lot more from bankruptcy rules, so that we can make them better, so the effects of crisis could be actually muted. So I think that, as I said, the amount of debt and management of risk, which is part and parcel of the problems, or make sure you have operating flexibility, but the key thing is really to think where the responsibility should be and, within the financial organisations, as well as reasonable limits within the amount of risk taking and the amount of activities that can be handled in financial entities. MARTIN HELLWIG. Our last speaker will be Bill Sharpe. WILLIAM F. SHARPE. When you are the last speaker on a panel, one of two things happens: The first is that what you should say becomes crystal clear, the other is that it becomes totally opaque, and I find myself in the second category. So let me ramble a little, and I’ve asked the chair to please yell if I go over ten minutes, so you are protected at least on one side. Let me start with whom to blame. I'm very happy to blame the banks. I'm very happy to blame the governments. I'm delighted to blame the monetary authorities. But let me try a couple of perhaps more fundamental issues. I want to blame bad incentives almost everywhere you look. And you’ve heard a lot of that from my colleagues. I want to blame the accountants for what is sometimes called phoney accounting although I sometimes think that’s a redundant expression. And then let me be a bit more specific and many of these points have been made. Clearly we know - Bob Merton, Myron Scholes, Fischer Black taught us – that you have a particular kind of options where you get the upside if things go well, and it’s not that bad on the downside if things go badly. Bankers since time immemorial, if they have debt, and they always have of some sort of another, have been in that position. We know that the value of that option can be increased by increasing the variance of the underlying business or asset on which that option is written. Now, how then have we built a structure over the centuries in which businesses and financial institutions were financed both by debt and equity? Well, the presumption was that people who issued the debt, who loaned the money, know about those potentially perverse incentives and they built in provisions in the arrangement for the debt and, as you know, there’s many, many ways this can be done. And so if you have an intelligent informed, I think Myron’s description of the heads of the banks I thought, summarised it for myself, they are stupid and they are dormant. And I'm not willing to quarrel with that, at least in some instances. But at least the competitive model, the free enterprise story, to which many in this room but certainly not all subscribe, is that somehow or other in that competitive environment and those issues will be taken into account via contracting and debt equity ratios etc. For various reasons that didn’t happen in many cases, especially when you had the Freddies, the Fannies, the government entities where the incentives were radically different, where you had the implicit and in some cases explicit understanding that there would be a bail out if things got too bad. And that exacerbates the whole optionality problem, if I run a bank, and I know, if I take a lot of risk, I can be far richer than anyone in this room or all of us in this room. But if things go badly, the government will bail out the bank, I may have to look for another job, I may have to settle for a hundred million dollar settlement, as some of the heads of the banks, like Lehman brothers was mentioned. Well, that’s perverse, you are going to get terrible results. I want to blame something else, I'd like to blame point estimates. What could I mean by that? I'd like to blame people who say we need to predict X, and the idea is that you predict one number and those of us in financial economics have all of our careers been dealing with probabilities, you don’t predict this will happen, you predict a range of things that could happen, and what the likelihoods are. Now, I don’t mean to let anybody off the hook, there should at least be in the range of things you think might happen a financial crisis. We can quarrel as to what probability you might have assigned, and I think many of the points that were made I would just reframe a little, people, regulators, monetary authorities, regulators, etc perhaps did not assign a high enough probability, but I would be very unhappy if they assigned a probability of zero. And with the point estimate you kind of stuck with that, so I think this mentality we have to predict what the GDP growth will be next year as a number, I think it's helpful if we get away from that. Nobody has really said anything about how to fix anything, so let me just, since I know nothing about the banking sector but nonetheless have signed a document or two which Martin Hellwig had a role in framing along with some of my colleagues at Stanford, let me just tell you how I think about possible ways of addressing some of the issues Myron in particular mentioned. One would be better accounting, obviously, maybe I’ll say a little bit more about that. Governments, I think, do that possibly worse than anyone. But the three things that people talk about are more regulation - I would just point out I know some of those people, those PhDs, MIT in physics, on Wall Street and even some MBAs from places like Stanford, folks, in Byron I’ll take exception, they are a lot smarter, they get paid a lot more, they are a lot quicker, a lot less constrained, and they can think up the most amazing ways of conforming to a regulation in principle but not in substance. So I think that will however smart and dedicated, and they are dedicated, the regulators may be, that is an unfair battle. That’s a problem. But more regulation, better regulation certainly can help. Another is to basically bust them up, if it’s too big to fail it's too big to exist. A point that has been advocated by a number of people and with which I'm sometimes quite sympathetic. The third is to say, well, banks just have to have a lot more equity capital. Just a lot more than they would otherwise. And it’s that point that Martin and my colleagues have been stressing, we can talk about what that percentage is. I had no notion but I'm convinced that it’s a lot larger than even the high numbers that are being talked about here, and a lot even more larger than the much lower numbers that we hear and see in the United States. What else to say? Let me say a couple of things about phoney government accounting and give you two examples. A few years ago, US Congress passed and the President signed a little change in the medical health care system called Part D, which Dan talked about briefly. At that point, sixteen trillion dollars of unfunded liabilities were added into the total debt, you heard the number sixty seven trillion the other day, the entitlement programs had those huge present values. Well, we are economists, we know about present values, wouldn't it be nice if you could see somebody put a present value down somewhere on a government report? Wouldn't it be nice to at least have a number of that sort in mind? I'm getting those numbers, by the way, from the government documents. I'm not making them up. Another case in point for years and years, decades perhaps, States and local governments in the United States have been giving very generous pension promises and health care promises to their employees, not putting the health care liabilities, which are huge, on any statement or report in most cases, and, are you ready for this, discounting the future projected payments for the pensions at the expected return on the assets. The excepted return on the assets. Yet these are promises that must be paid with certainty, guaranteed by a sovereign government of at least the State or a local government. Now, we would all say, use the treasury rates or something comparable. They don’t, and the numbers they then put out are low by a factor of at least, well, the true number is at least 50% higher, and the numbers are staggering large. So the debt situation of governments in the United States is significantly worse than the governments accounting would lead you to believe and I think it's time for us to acknowledge that, States are beginning to realise what a problem they have. Thank you, my time is up. MARTIN HELLWIG. Let me briefly summarise and draw relations. Bill White stresses the role of denial of risk and the role of imbalances, misallocation of resources, and worries because these imbalances are still there. Roger Myers focuses on the role of debt, debt as being natural because of information problems. Myron Scholes and Bill Sharpe both point to issues of moral hazard. To some extent I would expect that both of you see leverage as a result of moral hazard, which to me raises, I mean Bill himself focused in particular on the need to regulate the leverage, which to me raises a question to Roger. If debt is so natural, do you see a need to regulate it, would you agree with them? Or do you see that this is something where we should just accept that indebtedness of banks is a fact of life? On the role of monetary policy, I heard Bill White saying, we shouldn't go into the game of having too much ease again, and I heard Roger Myerson say, well, the central bank should be targeting the price level, and if the price level is too low and we get a debt deflation, maybe they should do something to get it up again. Which to my mind links up with the question of what are we to think about the monetisation of debt that we’ve seen both in the US and in the eurozone, including of course the purchase of sovereign debt by the European Central Bank. I see a certain conflict there between the prescriptions, implicit in what Bill White said and what Roger Myerson said. So that’s linked to the question of how do we get out of the mess, after all we are still in the crisis in that respect. On the issue of prescriptions, a new bankruptcy law or new regulation, wonderful, but why haven’t we had any of this? Why is there no international negotiation about bankruptcy rules? For instance, the rules to be implied, close out clauses, change of control clauses and derivative contracts which create a mess for proceedings, or the rules that provide for a separation of bankruptcy proceedings for different subsidiaries, according to the country of the subsidiary, which in the case of Lehman brothers led to complete chaos in relations between the UK and the US. Why is regulation and in particular capital regulation so meek? Even after the crisis. Perhaps Bill might want to answer to that. I also heard a slight descent between Bill Sharpe and Myron Scholes. Myron focused much more on market discipline and on internal discipline, organisation of risk management inside the bank, the need for transparency as a way to get debt holders to impose discipline, whereas Bill called for capital regulation. Am I exaggerating the conflict or is it there? So maybe, Bill White, you can say briefly something on why you think monetary policy shouldn’t continue what it did before? WILLIAM R. WHITE. Well, what is clear is that the central banks virtually everywhere are providing us with more of the same. In fact I think one of the principle reasons is, because it seems to be the only game in town, we are in trouble, people recognise that the fiscal things got to the end of the line, and monetary policy is the only game in town. So what have they done? Well, we are all familiar with the fact that the interest rates have gone down to zero. We’ve had in the United States now QE1, QE2, the recent announcements that are going to keep interest rates down until 2013, we’ve seen the ECB having to get into the bond market purchasing bonds, Italy and Spain. Describing it as trying to smooth out the transmission mechanism which is perfectly legitimate. The bank of Japan is now lending money to small and medium sized enterprises, so everybody is getting into it. Now question one, will it work? I think the answer is probably not, we certainly have not seen as a result of all of these policies a resumption of the strong balanced and sustainable growth the G20 keeps talking about, so I don’t think it’s going to work. Are there downsides to this? I think there are some serious downsides to it, there’s all the misallocation of capital that we talked about, the generation of bubbles. I think this recent set of stuff is in part responsible for the bubble we are seeing in the emerging markets now, where inflation is really taking off, property prices all this sort of stuff. The zombie companies, zombie banks, from all this perspective this is a very bad thing to do. Now having said that, I go back and I agree with Myron in particular, the fundamental problem we have here, and it’s been around for decades and decades, is moral hazards. And whether it’s on the regulatory side or the bailout side or the Greenspan side, what has happened here is that the downside of everything has been basically, how do you say, put a peak on the downside. How do you express it. But the difficulty is that this thing started so long ago that every time you do it people get induced, not just the lenders to behave badly, but the borrowers to behave baldy. Every time you do it, the underlying fundamentals get scarier and scarier. So at each moment when you look at it and say ‘we are in a bad path, we’ve to get off this path’, the price of doing so, which is not just a little recession but maybe a great big one, because you haven’t had anything serious on the downside for decades, it just looks so scary that the only answer for both the central bankers, I think, and surely the politicians, is more of the same, and bad things happen, put it off until it’s on somebody else’s watch. That’s the fundamental problem we are dealing with. And it’s of long standing. Roger Myerson I agreed entirely with what Myron said about financial bankruptcy reform. As I'm thinking about it, I realise that I have more than the time allows us to say, so I simply want to say: I don’t know whether there have been major conferences on the question of ideas for financial bankruptcy reform, but what to do for reforming the legal framework and legal administrative framework for dealing with banks that have become illiquid and insolvent in order to keep the institutional framework of our banking system. I think there’s much that can be done and I wish there were more discussion on that, I think that’s a huge issue. What I can address more easily within the few seconds I should take now, is the capital, the basic capitalisation requirements for banks, they are needed. I can see that a radical proposal for very much larger capital requirements could encourage a shadow banking system and part of what we want from bank capital is that its owners should actually be participating in monitoring the bank, which is true of some fraction of bank ownership, but some is going to be held by the broader public, but certainly higher capital requirements within the range we have seen are very good, you argue in publications and to question, the basic idea of having different capital charges for different kinds of assets. And if I could say something very important, from my perspective, which is from an American and from a fundamental economic theorist. As people look at the current eurozone problem of sovereign debt, I'd like to toss out the hypothesis that at the root of all of it, the reason that it’s a problem for future tax payers in some excessively indebted country, is because of many things that might be discussed, the temptation, the short-term temptation of politicians, but the reason it’s a problem for Europeans, even in countries that are not excessively indebted, is because the banking system excessively bought this debt, and that begins fundamentally what it suggests, more than anything else, from the fact that the regulatory rules have been written to put the minimal capital charge on assets that are sovereign national debt. We need a banking system in the economy to provide financing for small and medium sized enterprises. Why is the capital charge for sovereign national debt so much lower than the capital charge for loans to the economically essential function of banks, all the rest of us can buy the sovereign debt bonds directly. Can this be discussed? WILLIAM R. WHITE. I would like to make a point, clearly, this example, and this is an extreme one, there are similar examples, the rating agencies in the US were basically empowered and anointed by the government, so if you want to sell your bond to a particular class of financial institution, it has to be rated a certain level by the rating agency that was specified. Who pays them, the issuer of the bond, I mean all these terrible incentive systems. The idea of raising capital on banks assumes that you have got an insurer, the government, a contingent claims offer, a lender waiting in the wings who is not acting in the best interest, presumably of the taxpayers, but certainly all these confused incentives. I think we need to look more at the incentives and as we as economists think about regulatory structures, capital requirements etc, we are going to have to get a little bit closer to the political science and build in something about the incentives of the government mechanisms which are big players. That’s all, unless you say too big to fail, too big to exist, we are not going to bail anybody out, good luck to you. Then perhaps, after a terrible retching period of possibly decades, we might get back to the simple models that we often have in our text books. MYRON SCHOLES. One thing in terms of the currency base on the macro side, whether it’s, in macro policy, whether you should have rules versus discretion, the idea that the central bank shouldn't try to manage the economy in a way that tries to intuitively respond to the economic circumstances. As I said, when I introduced my talk, is that one of the unintended consequences of discretion, which causes the volatility of the economy to dampen, that leads entities and individuals to, because of either incompletion or possibility of trying to understand exactly in a complex environment what all the data are, the consequence is that they take more risk and basically, if things are less volatile, we all take more risk. As a result of that we have to really think what the amount of risk or volatility is in the economy, so that people are generally just more cautious. So if you dampen the risk intentionally, then it has consequences, if the individuals believe or come to believe that that’s the natural evolution and we are in a lower risk posture. And in terms of why we haven’t gotten to bankruptcy rules and accounting rules, we’ve ignored completely accounting. I rely, or try to rely on the market, as Bill said, when I said, there’s an alternative, or in addition to that we have regulatory bodies that were accountable, and also had more sophisticated people, or people that were more than well paid, so that they can counter these forces. I was trying to rely on market forces and regulatory forces in combination and not just saying market force, but I do want to have market discipline. So if we want to get around the moral hazard problem, we have to think the debt holders can suffer losses and therefore they can suffer losses, there is going to be discipline in the market place which will prevent the firms from having leverage or the price of them raising money is going to go up dramatically. And so that means that the information system has to be changed in such a way that outsiders can have a chance to do it. And whether if we have an opaque accounting system, then you have to rely on the government to bail out the banking system, if you can’t understand what the banking system is doing, and/or shadow banking system. So basically we have to figure out how to wean ourselves off this. The other point in terms of the bankruptcy rules, either because there was a rush to have a Dodd-Frank bill passed because of anger at the financial system or a need for retribution - we produce a 2,300 page bill without any regulations - and as a result of that it’s virtually impossible for anyone in the financial system to know what the evolution of rules are going to be. And that causes in a lot of ways a lot more disruption in the economy. But in terms of bankruptcy or thinking about what the sensible things to do, there wasn’t a demand for sensibility at that time, you had to get something out as opposed to thinking about studying something, it takes time to learn something from the data. To learn from a Lehman or learn from the consequences of AIG as opposed to just reading things in the paper and then going from that. MARTIN HELLWIG. Okay, thank you very much, I'm afraid there won’t be time for a general discussion, because we have to close. On this bankruptcy issue two comments, we had our institute together with the Austrian National Bank, a conference on this a year ago and problems were easily recognised and easily described. But the problem of international coordination is a political problem and nobody is willing to touch it. And the problem has been recognised at the time of the LTCM collapse in 1998, at that time nobody wanted to do experimental research on a bankruptcy proceeding, not even so very large, but very internationally connected institution. The following ten years were wasted without any work on the problem, and we are embarking on another waste of time without substantial work on this problem. On that pessimistic remark I wish to close this panel, thank you audience, thank the participants and hand over for the next part of this exercise.

Martin Hellwig on the Interdepen- dencies of International Ecomomies
(00:06:17 - 00:08:56)

Leading economists, analyzing the causes of the global debt crisis, refer to the financial industry as a key factor liable for fundamentally endangering the monetary union. Real estate bubbles such as the ones in the U.S., Spain or Ireland could not have formed without the mismanagement of local banks. In his panel statement at the 2011 Lindau meeting on Economic Sciences, financial economist and recipient of the Sveriges Riksbank Prize, Myron S. Scholes, focuses on the banking sector as he advocates more market discipline and bank transparency to prevent excessive exuberance. Financial institutions, as Scholes argues, should provide trustworthy balance sheets and income statements that inform investors and regulators about the value of their assets and risk positions. In fact, the global financial crisis might as well be conceived as a securitization crisis. Investment banks and hedge funds, that were able to obscure their leverage levels from bond holders and regulators through the use of complex, off-balance sheet securitizations, played a crucial role in the formation of the housing bubbles. Provided with credible estimates of the value of a financial institution’s assets, investors would be able to make better capital allocation decisions that in turn would lead to improved macroeconomic outcomes over the long-run.

Panel Discussion (2011) - Panel 'From Financial Crisis to Debt Crisis - Financial Markets, Monetary Policy and Public Debt': Robert A. Mundell, Roger B. Myerson, Myron S. Scholes, William F. Sharpe, William R. White (Chair: Martin Hellwig)

MARTIN HELLWIG. Welcome to this panel, “From financial crisis to debt crisis, financial stability, monetary policy and public debt”. Let me first present the participants of this panel. My name is Martin Hellwig I'm at the Max Planck Institute for Research on Collective Goods in Bonn. If you ask me what are collective goods, we are still doing research on that. But we have decided that financial stability is a collective good. In the initial announcement of this panel, Robert Mundell was also supposed to be a participant, unfortunately he had to leave early, this is especially unfortunate since the issue of optimal currency areas would be one issue that might be discussed in this context. We actually have here Roger Myerson who received the prize in 2007 for his work on incentives, Myron Scholes who received the prize in 1997 for his work on option pricing, Bill Sharpe who received it in 1990 for his work on capital market equilibrium, and then, last but not least, Bill White, currently at the OECD, who used to direct the economics department, economics and research of the Bank for International Settlements in Basel and has thus been a very close observer of events as they unfolded. I'm planning to give a short introduction myself, then to have ten minute statements from each of the participants and afterwards to have a discussion, first among the participants themselves and then with the audience. Before we start I would like to say, given that there are journalists here, everything that is being said is to be attributed to the persons saying this, without any relation to the institutions that might be behind us. This concerns in particular Bill White and myself. You will notice that the title of the panel has also been changed, the reference to the European Monetary Union has been dropped, the reason for that is, among other things, that the problem of public debt is a problem not only in Europe, but we’ve just had the instance of the downgrading of the United States’ federal government by Standard and Poors. A few days ago, in a discussion Ned Phelps was saying that, well, one of the monkeys on the back of the United States is debt explicit and implicit, entitlements and explicit debt, which is somewhere between seventy and eighty trillion dollars. A response to that from Peter Diamond was that, well, if you cut entitlements a bit and you raise taxes a bit, the problem is going to disappear, or the problem is much less serious than it would seem if you just take the bare number of seventy to eighty trillion. Of course there is this issue of what political will is there to actually do this. I suspect that some observers of developments over the past few months have been concerned in particular about that. On Wednesday, at the initial panel, one of the young participants of this conference said Greece has done all it could and now it could not do anymore. I looked at the actual numbers and found that Greece is running a primary deficit, which means that before paying any interest on debt, the Greek government doesn’t make ends meet. Tax revenues are less than public spending, which to me raises the question, which is the same as the one I just raised about the US: Why can’t Greek society agree on what government should do and how to pay for it? Since I'm German I think it’s appropriate in this place to say that this also was the problem of the Weimar republic. As school children we learnt that the Weimarer republic was burdened by reparations. But for every single year in the 1920s, capital imports, borrowing in particular from the US exceeded reparations. And the Weimar republic had exactly the same problem of not being able to agree on how to make ends meet. In discussions of the crisis one sometimes hears a story about sequence. First there was overindebtedness of households, private households borrowing too much against their incomes. Then there was overindebtedness of banks having too much leverage. And now we have overindebtedness of sovereign debtors. And in between sovereigns tried to rescue banks and that got them into trouble. I submit that this sequencing is misleading, because if you look at the sovereign debtors there are two types: There are some countries that simply ran deficits without any connection to the financial system, Greece and Portugal would be examples. And there are some countries that got into trouble because they tried to save their financial systems, Ireland would be the prime example and Spain we also have this kind of problem. And then there are countries where the difficulties have to do with banks lending to banks, German banks providing funds for American banks to provide funds to American households. I'm shortening the chain but that’s roughly the story. Or German banks providing funds to Irish banks providing funds to Irish builders. And at the back then you have the German government trying to provide funds to these German banks. The so called euro-crisis that we have been worried about over the past fifteen months of course, is not the currency crisis in the strict sense of the word, but it’s a combination of a crisis of sovereign debtors. An Irish style banking crisis, banks have a funded bubble and the problems of German or French banks having funded the Irish banks or having funded the sovereign debtors on their own. And it’s the entanglement of these crisis, which makes it so hard to even think about. So I think we should talk about how did we get into this mess and how might we get out of it. It is part a question of economics and part a question of politics. I will briefly report on some of the things that have been said about these matters by non-participants of this panel during the last few days. We first had president Wulff criticising rescue operations in the eurozone. Criticising the bailing out of countries, installation of the EFSF and the ESM, the role of the European Central Bank in buying up government debt with the statement – Should the ECB or should the EFSF or rather the other governments have let things go or was there more damage to be field? Then we had Bob Mundell suggesting that the crisis, in particular from the US point of view, was not really so much a financial problem but had a lot to do with exchange rate governance, like the revaluation of the dollar relative to the euro in 2008, causing problems for the US ameliorated by the devaluation in 2009 and resurrected by a revaluation again in 2010, and he was suggesting that coming to some agreement to fix exchange rates would greatly stabilise the system. I was surprised to hear this from the proponent of the theory of optimal currency areas, given that much of the discussion about the eurozone has been to the effect that the euro zone is too large and too heterogeneous to be an optimal currency area. But that’s what we were told. Then we had Edmund Phelps talking about the need to have more finance for innovation, in particular innovation at small firms. Peter Diamond talked about problems of small banks, which were crucial for financing small and medium enterprises because they are in bad shape, that’s part of the problem in the US. Which brings me to a question that I would like to raise for Myron Scholes, in your presentation you talked about financial intermediaries as institutions that in a sense smooth risks from market imperfections trying to market system work better and take away risk from anybody else. The notion of information production by an intermediary was downplayed in this account and it was crucial in Peter Diamond’s presentation. By the way, we had a panel on the crisis, this is at odds with something that was said yesterday, we had a panel on the crisis three years ago and in that crisis Muhammad Yunus was saying – well, in terms of credit worthiness, the people that his micro-finance institution is giving money to, are much worse than any subprime borrower and they have rather fewer lawyers involved, but they make sure that incentives to repay work and that they look at the individual contracts in great detail, which of course is another way of saying information production at the very retail level plays a big role. Then we had Joe Stiglitz talking about securitisation and fertility, securitisation reducing incentives to look into what the clients actually are worth, this links up with what I just said before. And then interconnectedness, globalisation, spreading of risks across the world being a source of contagion mechanisms. Joe Stiglitz also raised the possibility that the crisis had more to do with structural change, a shift away from manufacturing to services, but parallel the shift away from agriculture to manufacturing in the great depression. The notion that we should be focusing much more on the real sign, the production sector was also central to Prescott’s presentation, who emphasised the role of productivity development relative to finance. Now, Joe in his presentation also asked ‘why did standard macro not foresee the crisis? And here I'm getting directly to Bill White, the BIS report of 2007 mentions subprime, mentions the possibility that subprime might have consequences for the rest of the world, but without any great sense of urgency. And as I’ve read this report, it’s one amongst several items that are a cause for worry. Speaking from personal experience - I participated in a conference of the Bank for International Settlements in late June 2007 – I don’t think I’ve heard the word ‘subprime’ once during that conference, nor the word ‘shadow banking system’ or ‘conduit’ or ‘SIV’, ‘structured investment vehicle’. The one word that I very much heard was the word ‘hedge fund’. But this is where I want to turn over to Bill, I should say, before I do so, that he has for quite a number of years prior to the outbreak of the crisis asked the question ‘Is price stability enough?’ And answered it in the negative saying ‘Central banks should not just be worried about price stability’, but you didn’t provide a recipe for what else they should be worried about. WILLIAM R. WHITE. Let me start off by saying thank you for having being invited to even attend. It’s an even greater honour to be asked to participate with such a distinguished group of people, so, first point, thank you very much. Second point, if it’s not clear already, I spent my entire adult career as a policy maker, or around policy makers, rather than as an academic. And I think in the current crisis, at least my presentation about this crisis will indicate, I think the policy makers have a lot to answer for. Policy-making is very hard, it’s very hard to avoid errors and the problem is that there’s a lot of different kinds of errors to avoid. Now, some of you may remember Donald Rumsfeld, a while back, and Donald Rumsfeld said And people initially said, boy that’s really stupid, and then after a while they said, well, no, actually that's really pretty smart. Mark Twain said something about error about a hundred years earlier, which I think is very relevant to frameworks and theory and stuff. Mark Twain said – ‘it ain’t the things that you don’t know what get you. It’s the things what you know for sure but ain’t so’. I want to talk about two things here in the ten minutes or so I’ve got, that I think are relevant to this questions of error and where did they come from. First thing I want to talk about is the surprising end of the great moderation. Go back to some of the things Martin said, it was surprising. Why was it surprising, what are the consequences of being surprising? Then the second thing I want to talk about is the underlying roots of this crisis. I’ll say nothing about policy in this early part of the presentation because I guess my firm conviction is that, unless we can get some agreement on what the problem is, we are not going to get any agreement on what the solution is. And this actually is a problem that faces the G20 and the whole political context. Well, let me say a few words then about the great moderation and the surprising end of the great moderation. The great moderation, Bob Mundell mentioned this yesterday, remember, he talked about the three booms, but he put all the three booms together and what comes out of it is the great moderation. That basically from 1980 onwards at least in the advanced market economies. GNP grew rapidly, volatility was very, very low, and you could say the same thing with inflation, and it was deemed that the great moderation. I think the general sense was that it was going to continue, I mean at various conferences that I attended in Jackson Hole and elsewhere, you know, these were the good times and the good times would roll. And when the end of it came in this highly, highly non-linear disruptive fashion, it was enormously surprising to everybody. And what came out of that surprise in a sense was denial. You may remember that Ben Bernanke, when this thing started, he said its 50 billion dollars and it’s going to be in the subprime area and it’s contained to the subprime area. Then, when it spread up to the inter-bank area, he said it is a broader financial problem, but it’s a liquidity problem. And then, a few months later, with AIG and the rest, it became clear that it wasn’t a liquidity problem, it was a Minsky moment that looked like a liquidity problem, it was a solvency problem. And the reaction, again denial, was to say, well, that’s on the financial side, we can sort that out. And it took another three quarters, I think, before real side tanked. And then everybody said oh my god we’ve got a problem on the real side. Still it is denial, surprising. We’ve got a problem on the real side. And going back to something that Joe Stiglitz said yesterday, they thought about it then in demand side terms, and of course they responded in demand side terms. And what they didn’t realise was that underneath the deficiency of demand was that we had a long period of misallocation of resources, so that huge numbers of industries, and I'm thinking banking, retail, cars, construction, all got too big and they still got to get a lot smaller and we’ve got all of east Asia geared up to produce stuff that people in the western countries can no longer afford to buy. So there’s a supply side component, all of this stuff was surprising. And the vast majority of people they didn’t see it coming. Now, the next question is: Why not? Why didn’t people see this coming? The people in the private sector, I don’t know if you have comments to make on this, but they were making huge sums of money. And they believed they were making huge sums of money because they were smart. They didn’t want to talk about the fact that maybe they were making huge sums of money because they were taking on extra risks. They didn’t want to talk about that. The treasuries didn’t want to talk about it because there were huge sums of money flowing into the treasury during the boom years, and, never look a gift horse in the mouth. They took the money and ran, spent it mostly. And the central bankers, of course, they were so focused on price stability, and they had price stability largely because of the structural changes Joe was talking about, China, Slovakia, all these countries coming into the world order, they had price stability, there was nothing to worry about, everything was fine. That’s why it was surprising. But I think, above all, and I say this to a group of academics, above all it was surprising because it was an analytical failure. It was an analytical failure. You think about the kind of models that are increasingly used in the academic world, the macros, the dynamics, whatever. These models, and you know this far better than I, they have no room for crisis of this sort. And the models that they use in the central banks, and I'm familiar with them for thirty years, and at the IMF and at the OECD, and don’t tell the OECD I said this, those models are fundamentally deficient, they have no financial sector, they are highly linear, there’s no room for bankruptcies, they also assume that if things go wrong, interest rates or whatever can move and fix it. And I fundamentally believe this is not true. So we have an analytical failure here that we’ve got to come back and think about. Now, the fact that it was surprising, had a lot of undesirable implications, and I say this because these issues have not yet been resolved. Because the thing was surprising, because it couldn't happen, nobody tried to prevent the crisis from happening. When the crisis happened, as I say, everybody went into denial. Prior to the crisis happening, nobody made preparations for a crisis. Think about the United Kingdom for example, was there adequate deposit insurance? Were there adequate memoranda of understanding between the agencies, were there adequate bank insolvency laws? Where there international debt burden sharing arrangements? None of those things were there, because this crisis couldn't happen. So at the analytical level, a kind of framework that doesn’t allow you to plan for bad things happening is an analytical framework that needs to be rethought. What I sense yesterday and the previous two days is that that’s happening and that’s a very good thing. Let me move onto the underlying causes of the crisis, I’ll say nothing about policy. I think there’s two schools of thought, I characterised these earlier on as ‘the school of what is different’ and But more formally it comes down to ‘does this thing have its roots in the financial sector or does this thing have its roots in the monetary and exchange rate framework’. Both of the above are true. I think both of them have played a role here, but I think the second one is more important and I’ll tell you why. This ‘school of what is different’, that it’s got its roots in the financial sector, the ‘school of what is different’ is always in the ascendancy right after a crisis. John Kenneth Galbraith has a wonderful quote, he said: ‘once a bubble bursts, attention shifts to the way the bubble manifested itself, new instruments, linkages and the like, while the key factor, speculation, is ignored’. And this time around we saw exactly the same thing. At the beginning, what was the problem? The problem was off-balance sheets, subprimes, SIVs, conduits, CDOs, CDO-squareds, it was all the new stuff. And it’s very comforting to talk about the new stuff, because in everybody, the regulators, the central bankers, the lot of them. They can all say this stuff was brand new, you couldn't have expected me to see the full implications of everything that happened. And to the extent that there is blame to be attributed, if it’s in the financial sectors, blame the hedge funds, blame the banks, blame the greedy, it’s all very comforting particularly for the central bankers. Second school of thought, which I think it's more important, is what I call the ‘school of what is the same’. That school starts off by noting the fact that, I hope people here have read this book by Carmen Reinhart and Ken Rogoff, 800 Years of Financial Folly. Just in recent times we’ve had huge crisis in 1874 and another one in 1907 and 1929. Japan, Southeast Asia, we had all of these crisis, they’ve gone on for time immemorial, and what's more, they all look the same. They start off with some good news, the good news enhances profit opportunities, the banks lend more money, the money gets spent, the economy booms, the value of collateral goes up, the value of collateral can be used to get still more money, and so the boom continues until it finishes, okay. The boom and the bust. And we’ve seen it over and over again. What in a sense is so discomfort for all of the people on the governance side, both inside the banks and regulators and central banks, is that it was the same thing as we’ve had so many times before, and they just missed it. They just missed it, they thought it was a new era, as Martin Wolf has put it the four most dangerous words in the English language: “This time it’s different”. And they should have seen it because just prior, and I welcome comments from the panellists on this, just prior to the crisis, all of the imbalances that sort of traditionally filled up were there, and people should have seen them. What I mean by that is that credit spreads got down to very, very low levels for sovereigns, for peripherals in Europe, for emerging market countries, for high risk, credit growth was very, very rapid. Interest rates were very, very low. Household savings rates fell to zero in the United States, in China capital investment went up to 50% of GDP. Volatility went down to nothing, the lowest ever recorded. These should have been seen as contrary indicators. These are not signs of ‘all is well’. These are signs of ‘risks are building up and we have a serious problem’. And everybody missed it. And one of the difficulties, as we go back to the underlying, who caused all of this? I personally believe that’s why - the OECD doesn’t believe this, but I believe this - monetary policy has a lot to answer for here. That monetary policy was run very, very easily. You remember, in 2003 interest rates in Japan were at 0, interest rates in the States were 1, interest rates in Europe were 2 percent. And all you need to do is just eyeball a chart, and what you can see from 2003 on is a clear inflection point in every asset class you want to talk about. This may just be coincidence, but I think it had a lot to do with monetary policy. Again I would welcome the panel’s comments on this, Raghuram Rajan says that those low-interest rates and the search for yield were also the reason why so many of these new instruments came into being. That they were consciously designed to push all the tails out into the risks, all the risks out into the tail, where disaster, myopia sort of reigns and where effectively they just disappeared. So you had Tasmanian pension funds buying CDOs and structured products for four basis points, you know. There was something seriously, seriously wrong there. I would note two last things that, and I guess I better finish up here, but this easy monetary policy in response to the crisis at the end of the last decade, this wasn’t the first time. Remember the Greenspan put in 1987, the Greenspan in 1987, when the interest rates went way down and the answer in 2001, when they had another problem, was again the interest rates went way down, and the answer in 1997 and 1998 and 2001 to 2003 – it’s been the same response every time, which is easy monetary and easy fiscal policy. And at the end you wind up where we currently are, in that the interest rates are at 0. I don’t want to let the emerging markets off the hook here. I think one of the, in addition to the financial problems or the problems roots in the financial centre, the roots were in monetary policy in the advance market economies but also in the emerging market economies. Because over the course of the years, as we in the advanced countries kept monetary policy pretty tight, what should have happened, was our exchange rates ought to have gone down, which means the exchange rates of the emerging markets, particularly China, should have gone up. But for various reasons they decided that that was not what they were going to do. The reaction was, if you guys in the west can print the money to get your currencies down, we can print the money to keep our currencies from going up, and that’s precisely what they did. And so the whole thing emerged in a kind of global problem of excess liquidity. Now, if we had an international monetary system with some degree of control, this would not have been able to happen. But we didn’t. I think it’s very, very important that we start thinking seriously about the frameworks. I will say very little about Europe here, but in a sense the European problem arises in exactly the same way that through the fixed exchange rates peripheral countries got a monetary policy that was absolutely not right for them. They took the money and they ran. And then you had all this overextension in the private sector in so many countries. So that’s my story, my story is that the roots of the crisis are in the financial system but still more in the monetary and exchange rate system. That of course raises a paradox, I’ll finish with this now, the paradox is how did this turn into a sovereign debt crisis? If I think the fundamental roots are financial, monetary and exchange rate related, how did this turn into a sovereign debt crisis? I think there’s three reasons which have accumulated one upon the other. One of them is secular. For decades virtually all of the western countries have been running asymmetric fiscal policy, just like monetary policy, you know, they didn’t lean very much on the upside but they lent a lot on the downside. It was asymmetric. Fiscal policy was much the same, so in the bad times they would spend the money to cushion the economy, but in the good times the countries never accumulated as much money as they should have done to ensure that their debt profile was not constantly trending upwards. So this is a problem of very long standing. Secondly, in the boom, the last boom, so many, and I see this as chairman of the EDRC at the OECD, so many countries benefited from the boom, the treasuries benefited from the boom, the money just kept flooding in and they interpreted it because they didn’t really understand it, they interpreted it as being secular not cyclical. They interpreted it as being a permanent inflow, a new era, times have changed. And they spent the money in very large parts, so that was the second mistake. The third mistake was, well, this wasn’t a mistake, then the boom came to an end and of course all the cyclical revenues disappeared, in addition the economy tanked, the automatic stabilisers kicked in, particularly in Europe where they are very, very powerful. And the upshot was that the debt exploded. Now, Reinhart and Rogoff in their various publications say that this is what almost always happens after a big crisis, where there is involvement in the financial sector, the fiscal side explodes, this is very, very common. But having said that it’s not very comforting. I say that because you just look at the newspapers in the last few days, the global economy is faltering. Secondly, all of the imbalances that were there in 2007 are still there. Some of them are even worse, the imbalances that were there are still there. And thirdly, I think we’ve virtually exhausted all our room for manoeuvre on the fiscal side and the monetary side as a result of all of this asymmetric behaviour going back decades. So I will finish with the joke about the Irishmen, someone is lost in Ireland in a small lane, some of you know them, the small lanes of Ireland. And he meets a man, an old man in a ditch doing some digging and he says: “How do I get to Dublin from here?”. And the old man replies: “Sir, if I wanted to go to Dublin, I wouldn't start from here”. ROGER B. MYERSON. I’ll follow your impressive standing here, try to give the maximal energy that this deserves, it’s a privilege to be here as guests of Lindau and St. Gallen to talk about these major issues. As a theorist, my job can only be to try to use what I understand as the most fundamental economic theory to try to sort out what is at the basis of the dichotomy that William outlined, that between those who blame the banks and those who look to fundamentals of asset prices, bubbles coming from speculation, I think my theoretical prejudice was leading me towards the blame the banks guy. I think the importance of financial intermediation has been for decades under-appreciated in macroeconomic analysis, for the simple reason that the theory of banking is ultimately a theory about banks and financial intermediaries exist, because they have better information about where are the good investments in our economy than the great mass of people, who’s savings are going to fund those investments, and so it’s an informational question. I am one of many in this room and in the rest of the world with the privilege of being a Nobel laureate, as a part of the great advances over several decades in information economics and the study of transactions between people and different information. And one of the important consequences of information economics was, since the 1980s the great development of analytical theory of banking and now in this financial crisis the analytical theory of banking, I think, is being introduced more into the fundamentals of macroeconomic theory to guide policy-making than before. But to me, and I read Reinhart and Rogoff’s This Time it’s Different, yes, the fundamental drivers and excessive confidence, you could both blame the banks and blame the irrational exuberance. There can be an asset bubble in the sense of ‘I think prices are going to continue to go up, I think land in Japan is going to continue to be an escalating, the price is going to continue to escalate so I want to buy it now and some greater fool will buy it from me later’. But the investment, the bubbles that Kindleberger talks about in this survey of booms and crashes that Reinhart and Rogoff talk about are typically national bubbles where global funds come in and they are coming in through financial intermediaries, a structured investment vehicle that’s off-balance sheet is enabling creditors, enabling a bank to become excessively leveraged. But the leverage is there to protect the creditors, so what's the point? The point is that the creditors believed these banks were more credit worthy than the regulators say, because they seem so profitable, why would they want to put their profits at risk by misleading me and my investment. But ultimately, if the banks exist to verify - a fundamental purpose of the banks is, for small and medium sized businesses, that are so important in our economies, to have their credit verified to the investing public. The banks and other financial intermediaries exist to verify the credit worthiness of businesses that drive our economy. Well, who verifies the credit worthiness of the verifiers of credit worthiness? This is the fundamental problem that makes it political, that brings in bank regulation, and so our political leadership and our system are central banks, and our system of bank regulation seems fundamental to me to prevent the excessive exuberance that of course ultimately we blame, This Time it’s Different, investment for the bubble, but a stable system requires regulation at the top. And that’s ultimately a political and public question. I come from the prejudice that we need to think about why the financial system matters from an informational perspective. In the little time I have, I think I'd like to mention at least one classical finance that I think has more insights for macroeconomic policy-making than has been appreciated. This is a classic paper by Myers and Majluf, which itself was really in translation into corporate finance of an earlier paper by George Akerlof on The Market for Lemons. And what Myers and Majluf argued using George Akerlof’s kind of model was that when corporations are deciding whether to finance, when corporations see investment opportunities, if they need funds from the broader public, if they see investment opportunities that are larger than they have the cash to handle, then they could offer debt. They get funds from the general public by promising to pay back specific monetary amounts or they get funds from the general public by offering a share in the profits, selling equity. But the decision to sell debt or equity is either one can serve the basic financial function of bringing general savings in to meet the special opportunities that some people know about and the rest of us don’t. However, what Myers and Majluf observed is that if the managers know the best about the current profit, the potential profitability of even the current operations of the firm, they know about investment opportunity but they also know about how profitable their current business is, and if the managers are acting on behalf of the current owners of the firm, then for any given price at which the market will allow them to sell new shares, they’ll tend to decide to sell new shares if in fact that price is higher than the real value of the firm. That is to say the new shareholders will pay more than it’s worth and thereby giving a nice transfer to the old shareholders and to the managers as old shareholders, but they’ll tend to issue debt if that price is lower than what the managers think the firm is really worth, based on their inside information. Outside investors understanding that the debt, the new equity tends to be issued by the managers more than the managers have bad news that they haven’t told, that the public doesn’t know, that means that equity tends to be underpriced. All of our accounting for capital, why banks argue that they need to be more leveraged, is based on statistics that take into account this winners curse effect, and which by the way would be mitigated if capital regulatory requirements forced them to sell capital more aggressively, then there would be less of the winners curse effect and they would be able to sell capital at a higher price than the statistical analysis of the past would suggest. But what Myers and Majluf have taught us is that we should expect that those who have the best information in our corporations and in our financial industries that are trying to raise funds for profitable investments they see because of informational asymmetries and because of this winners curse effect problem, they are more likely to issue debt than to issue equity in most cases. Of course there are situations where equity is also issued, but there is a biased towards issuing debt that’s built into the fact that the managers of the corporation or the bank have better information about the situation, the profitability, the future profitability of their enterprise than the rest of the investing public. So to me, I begin to look, this panel has ‘debt’ in the title, and ‘debt’ sounds like irresponsible behaviour, but from the Myers and Majluf perspective we begin to realise there’s a fundamental reason why those who have the best information about where the best investments are - and I'm talking both about senior management of large corporations and senior executives in great financial intermediaries - that they will find it for fundamental reasons more profitable, more efficient to raise the funds that they need by debt and by equity and by issuing shares, and so they become indebted. There’s household debt, now I don’t know anything but when I borrowed to buy a house, I had no private information, but corporate debt is about the productivity. Irving Fisher, I should mention, when we talk about financial crisis we should mention that Irving Fisher’s debt-deflation theory was published a few years before John Mainard Keynes’ general theory, and is still one of the important fundamental ideas. Irving Fisher observed that trying to understand the great depression and its onset is that, my theory is that the great depressions are caused by a deflation when there is also too much indebtedness. Who was indebted, was it mentioned, just aggregate debt and that’s a hard theory to understand in some sense, because when you look at the economy as a theorist everybody’s debt is somebody else’s asset. My debt is an IOU that you have in your pocket, that’s an asset on your balance sheet. But I think somebody was excessively indebted, and of course financial intermediaries and corporations that have good productive opportunities, they are by the Myers and Majluf theory going to be the ones who are systematically indebted. Other people are indebted, too, but it’s the financial intermediary theory. The debt-deflation theory suddenly makes a lot more sense when we realise that those who have the best information about where investments are to be made in our economy are systematically indebted. And if they are excessively indebted, then when the price level is lower than expected, then the burden of their debts, their monetary debts from the past is greater than expected relative to the assets, the real assets that they control, and new investment opportunities that they may discover, they will now not be in a position to take advantage of, and as we look at the unemployment data, there’s a sudden decline in new hires was exactly what happened after the financial crisis in 2008 in the United States. Let me draw one example of macro policy from that perspective. Once we understand that a price level that’s lower than predicted, deflation or even firms who are expecting inflation and there hasn’t been as much as expected, means, among other things, that those who have the best information about where our potential investment opportunities are, those people are now, in aggregate on average, in a worse situation. Their balance sheets are more disadvantageous, the burden of their debt is greater than expected and they are in aggregate more likely to be statistically in financial trouble. That makes it very easy to understand why a nation can be in recession or depression in such a situation. But that suggests, everybody agrees that monetary policy, the central banks that have the licence to print money any time they want, should be subject to rule to which the banks can be held accountable. But the goal of avoiding a price level that’s often unpredicted is not exactly the same as the goal of keeping the inflation rate at a predicted level. Because if you have, as we have today, several years of insufficient inflation, of less inflation than expected, then we should recognise that that situation is problematic for balance sheets of the people of the best information. Perhaps from the Myers and Majluf’s informational perspective, the better goal would be to specify that the central banks should try to have a price trajectory, not a regressive but long term, basically say three percent exponential price path for some broad index of consumer and other asset prices. And when the index is below that level, the bank should be aiming at a higher inflation rate. When the index goes above the level, they should be aiming at lower inflation rate. Not to get, to comfort us that in any one quarter that the value of money is right, but to guarantee that those who take, who incur debts in order to make productive investments - and they incur debt because the public wants something about which they have no asymmetric information to deal what's promised - those individuals, they have to worry about the price of whatever it is they are selling, but they should not have to worry about aggregate price level risks in the future in where their investments are. MARTIN HELLWIG. The next speaker will be Myron Scholes. I understand from Bill White’s presentation that risk is greatest when assessments of volatility and credit spreads are lowest. That was the signal that something really bad was going to happen, so I’m wondering whether an expert in finance, in capital markets, would agree with that assessment. MYRON S. SCHOLES. Thank you. It’s good to be here. Actually listening to Bill and to Roger I got to thinking about structuring, and this idea of ‘this time it’s different’ or ‘this time it’s the same’, you know, it’s interesting that when I look at the water from afar, everything looks the same. And when you look at the water very up close everything looks very turbulent and different. So I think both are very important because you learn a lot from this crisis, from the crisis that happened, and if you had an absurd excess volatility for a long period of time, then lots of things build up, that when a shock occurs, actually you can learn a tremendous amount. So I think it’s a disservice to just say we look at 800 years of history and basically that things are the same. The interesting part about volatility being low, and you notice that when volatility is low, that that’s a time, which is the case that you should be most worried, it may be so or may be not. Maybe it’s the case that there is that we have figured out exactly that things, we’ve learnt so much that actually risks have been reduced, and the actions that had been taken are commensurate and compensating with the risks that we have. So the interesting issue in that could be wrong, in other words, if the case evolved that volatility has been low and the effects and shocks had been muted over the last number of years from the 1980s to the 2008 period, that led to greater risk taking by all of us, it lead to greater risk taking by financial entities and institutions, and that led to greater risk taking by individuals, it led to greater risk taking by governments, in the sense that assumptions were made about future growth, volatility will be very low, that economies would continue to grow, that individuals and entities could be taking risks with regard to their operations, allowing them to concentrate on various activities, without having to diversify or to have reserves against contingencies in addition to the amount of leverage that was taken in the system and the new instruments that were born that allowed for more risk taking in the system. So the question of whether we look at a system and whether it’s really an unstable system or a chaotic system where we have the sandcastle effect, as you watch your children in the playground where they are taking sand and putting it on a sand castle, the various shovels of sand cause the sand castle not to collapse. But there’s one shovel of sand that causes the castle to collapse and then, after the fact you can say that the castle would have collapsed and therefore you should have known everything about it along the way. So there’s really an issue if the world was less volatile than being less conservative in both operations and less conservative in risk taking might have been allright, because basically there’s the envelop theorem in economics that basically, when you learn something and know it, then you want to be more experimental. So there’s a real problem with ramification. If central governments themselves actually continue to encourage the amount of risk taking in the sense that, as we said, Mr. Greenspan in the US would say, the fundamentals of the economy are good and the government has always said “don’t worry, there’s not a recession, the economy is going to grow”. If there’s really an indication that providing false signals about the level of volatility, maybe the government officials should say nothing about what the economy was going to do, because we don’t know the correct level of volatility, and the economy doesn’t have enough fear or uncertainty, such that we don’t cut back on our operational flexibility, we don’t cut back or increase the amount of risk taking that we take. So if we try to dampen the economy through fiscal and monetary actions to make the volatility appear low, the consequence might be the dampening works for a while, but when it explodes, it explodes in such an effect that the consequences of the explosion have far greater than allowing natural amounts of volatility to occur in the economy. So keeping the economy stable is not necessarily the best policy. So the question then becomes, if we look at why this is different this time, that we know that financial entities, when the volatility became lower increases leveraged dramatically, they tried to target returns and equity. We teach in finance targeting returns and equity is not something to do, but yet financial entities tended to do that over this period of time. What we learnt, as well as that the accounting system is opaque, and it’s still opaque, it’s completely opaque, and that, if you look at the balance sheet today of any bank in Europe or the United States, that it’s large, it’s impossible to know exactly what the risks are of that bank, exactly to know what the value of acquisitions of that bank. And we talk about transparency, but in the derivative positions, for example, you don’t know whether that bank is long, short or completely hedged in its positions. And you have no idea as to how to market the assets that the bank holds. So I think, one of the great lessons that we learnt from this is that to have discipline of the markets and to have discipline of bond holders, to have discipline of equity holders and not rely on a bailout of governments, banks have to be transparent. They have to have balance sheets and income statements that allow us to know from an accounting perspective what the value of assets are. And additionally to let people understand and to report to regulators and to other of their bond holders and equity holders, what the risk positions are of that entity. Having a snapshot at a moment in time is not valuable from the point of view of investors as to monitoring and disciplining bank activities. So the accounting system has to be completely changed and thought about. And additionally the regulatory system, in my view, as we learnt this time and what's different is that the number of regulations and regulators has increased dramatically, that the question is that we have learnt that there is very little accountability in the system and there is very little knowledge within the regulatory bodies. Those who are in regulatory bodies are very dedicated persons, but the problem is to rely on just that giving to the state as a way of attracting the best. If we are going to have a complicated financial system, then it’s the case that we should have a regulatory system that can monitor those entities that they are regulating and be held accountable. And have pay, that allows these persons to attract good persons and to think of it as a career in their own activities. So I think that if we look at what we learnt this time, in addition was that we developed a whole new housing industry, a whole new way of financing housing, which completely failed. We had crazy loans to homeowners who can not afford them in the United States, no down payment, so we gave them a free option. They could buy on their application with no verification, we had teaser rates. No one was forced to make these loans and even financial economists would think that was a terrific deal to be able to get a loan where you could lie, and get it and not afford it and didn’t have to pay high rates. We have in the United States built organisations in a quiet period of time since the ‘80s called Fanny and Freddie, the GSEs, Government Supported Entities, and we allowed them to go public. And they then went into uncontrollable growth with leverage, political error and huge appetite for risk, which cost taxpayers amazing losses. And no one in the government or no one in the financial system for that matter, financial people who funded these agencies didn’t control them. A view which is completely unfounded that real estate prices would never fall, which led to leverage and led to this growth, was something that obviously relying on rating agencies was a bad mistake. In addition, as far as the financial functions were concerned, proprietary trading at banks increased, this is a completely new innovation from the ‘80s on. It’s completely different from previous times, where banks became gigantic hedge funds. They had different margin rules, different capital rules, no limits. The leverage of banks became excessive through the use of proprietary trading at these entities. And they became highly levelled, they took high-level liquid real estate positions that were mis-rated by the rating agencies whose models were completely wrong. We learn ‘this time it’s different’ in the sense that rating agencies rated things that used insufficient data, had bad models of rating, had insufficient data to rate them, believed incorrectly that home owners would default idiosyncratically as opposed to home owners defaulting together. And additionally believed that people in the system would not reverse engineer what they are doing and downgrade the quality of the assets on paper in the system. Another major problem that we learn from this crisis, and very different, is that senior management of the financial institutions, though being well paid and garnering additional pay, did not really understand how to manage the proprietary trading activities of banks. And the risks that were being taken, the risk management function was not integrated into the operation of the entity, so my view of risk management is that it’s an optimisation technology, it’s taking both returns and risk into account simultaneously, that was not done at the banks. Basically the senior management have relegated the risk management people to the back office, or more like policemen or providing regulatory reports to the BIS, not being an integral part to advise the Board. And so the risk management, learning how to think about changing the miss-management, how to manage risk, is something that is far different that we have to learn how to change to make the system work. In a lot of ways it seems as though the senior management of the banks tended to lose their minds, in the sense that the amount of risk taking, the amount of leverage that was taking the banks, the tremendous belief in the efficacy of rating agencies to rate CBOs and other structures, they were not forced to believe that real estate crisis was always going to go up. And not forced the relegate the risk management group to the back room. I think that we learnt as well from the crisis that derivatives and other over-the-counter contracts, when a bank becomes insolvent, under the Lehman experiment, which was very costly, we learnt a tremendous amount from the Lehman bankruptcy, but that was not put into place and we should have learnt a tremendous amount more from the Lehman bankruptcy. That learning was not put into place in the new rules. We had a bankruptcy system and a market system for derivatives that was based by the insiders and their belief under the ISDA and the International Settlement Agreements. And those mechanisms put into place actually were not sufficient to handle the bankruptcy, to allow two and a half million contracts that have collateral posted against them to be settled over a weekend is virtually impossible in any system. The lack of information is just gigantic. So we didn’t learn, we need new infrastructure, we have to learn at a time of shock, when the system breaks, when intermediaries can’t intermediate again, we need to have a regulatory system that allows for the system to get unseized, if you want to think of it that way, and create a way that we have mechanisms to allow for time, to allow markets to again start to function, and that has not been addressed at all. If there’s going to be another crisis some time down the road, which probably there will, and again that in mind because we never know when the crisis is going to occur. Then we need to think about how to change the bankruptcy rules, to make them more effective. The way it currently works in the United States, it’s a black hole, because the FDIC is supposed to take over systemically firms that are systemic and cause difficulties, but unfortunately they have no skills, no apparatus, no ability to do it, and if you are required under the rules to fire all the people that are involved, then they’ll know nothing. You can’t run an organisation without knowing where the toilet paper is or any other parts of the organisation so it’s not going to work. As soon as it looks like the FDIC is going to take over one particular entity and dissolve it, every other entity is going to run for the exits and basically it’s going to be a black hole. So I think that we could have learnt a lot more from bankruptcy rules, so that we can make them better, so the effects of crisis could be actually muted. So I think that, as I said, the amount of debt and management of risk, which is part and parcel of the problems, or make sure you have operating flexibility, but the key thing is really to think where the responsibility should be and, within the financial organisations, as well as reasonable limits within the amount of risk taking and the amount of activities that can be handled in financial entities. MARTIN HELLWIG. Our last speaker will be Bill Sharpe. WILLIAM F. SHARPE. When you are the last speaker on a panel, one of two things happens: The first is that what you should say becomes crystal clear, the other is that it becomes totally opaque, and I find myself in the second category. So let me ramble a little, and I’ve asked the chair to please yell if I go over ten minutes, so you are protected at least on one side. Let me start with whom to blame. I'm very happy to blame the banks. I'm very happy to blame the governments. I'm delighted to blame the monetary authorities. But let me try a couple of perhaps more fundamental issues. I want to blame bad incentives almost everywhere you look. And you’ve heard a lot of that from my colleagues. I want to blame the accountants for what is sometimes called phoney accounting although I sometimes think that’s a redundant expression. And then let me be a bit more specific and many of these points have been made. Clearly we know - Bob Merton, Myron Scholes, Fischer Black taught us – that you have a particular kind of options where you get the upside if things go well, and it’s not that bad on the downside if things go badly. Bankers since time immemorial, if they have debt, and they always have of some sort of another, have been in that position. We know that the value of that option can be increased by increasing the variance of the underlying business or asset on which that option is written. Now, how then have we built a structure over the centuries in which businesses and financial institutions were financed both by debt and equity? Well, the presumption was that people who issued the debt, who loaned the money, know about those potentially perverse incentives and they built in provisions in the arrangement for the debt and, as you know, there’s many, many ways this can be done. And so if you have an intelligent informed, I think Myron’s description of the heads of the banks I thought, summarised it for myself, they are stupid and they are dormant. And I'm not willing to quarrel with that, at least in some instances. But at least the competitive model, the free enterprise story, to which many in this room but certainly not all subscribe, is that somehow or other in that competitive environment and those issues will be taken into account via contracting and debt equity ratios etc. For various reasons that didn’t happen in many cases, especially when you had the Freddies, the Fannies, the government entities where the incentives were radically different, where you had the implicit and in some cases explicit understanding that there would be a bail out if things got too bad. And that exacerbates the whole optionality problem, if I run a bank, and I know, if I take a lot of risk, I can be far richer than anyone in this room or all of us in this room. But if things go badly, the government will bail out the bank, I may have to look for another job, I may have to settle for a hundred million dollar settlement, as some of the heads of the banks, like Lehman brothers was mentioned. Well, that’s perverse, you are going to get terrible results. I want to blame something else, I'd like to blame point estimates. What could I mean by that? I'd like to blame people who say we need to predict X, and the idea is that you predict one number and those of us in financial economics have all of our careers been dealing with probabilities, you don’t predict this will happen, you predict a range of things that could happen, and what the likelihoods are. Now, I don’t mean to let anybody off the hook, there should at least be in the range of things you think might happen a financial crisis. We can quarrel as to what probability you might have assigned, and I think many of the points that were made I would just reframe a little, people, regulators, monetary authorities, regulators, etc perhaps did not assign a high enough probability, but I would be very unhappy if they assigned a probability of zero. And with the point estimate you kind of stuck with that, so I think this mentality we have to predict what the GDP growth will be next year as a number, I think it's helpful if we get away from that. Nobody has really said anything about how to fix anything, so let me just, since I know nothing about the banking sector but nonetheless have signed a document or two which Martin Hellwig had a role in framing along with some of my colleagues at Stanford, let me just tell you how I think about possible ways of addressing some of the issues Myron in particular mentioned. One would be better accounting, obviously, maybe I’ll say a little bit more about that. Governments, I think, do that possibly worse than anyone. But the three things that people talk about are more regulation - I would just point out I know some of those people, those PhDs, MIT in physics, on Wall Street and even some MBAs from places like Stanford, folks, in Byron I’ll take exception, they are a lot smarter, they get paid a lot more, they are a lot quicker, a lot less constrained, and they can think up the most amazing ways of conforming to a regulation in principle but not in substance. So I think that will however smart and dedicated, and they are dedicated, the regulators may be, that is an unfair battle. That’s a problem. But more regulation, better regulation certainly can help. Another is to basically bust them up, if it’s too big to fail it's too big to exist. A point that has been advocated by a number of people and with which I'm sometimes quite sympathetic. The third is to say, well, banks just have to have a lot more equity capital. Just a lot more than they would otherwise. And it’s that point that Martin and my colleagues have been stressing, we can talk about what that percentage is. I had no notion but I'm convinced that it’s a lot larger than even the high numbers that are being talked about here, and a lot even more larger than the much lower numbers that we hear and see in the United States. What else to say? Let me say a couple of things about phoney government accounting and give you two examples. A few years ago, US Congress passed and the President signed a little change in the medical health care system called Part D, which Dan talked about briefly. At that point, sixteen trillion dollars of unfunded liabilities were added into the total debt, you heard the number sixty seven trillion the other day, the entitlement programs had those huge present values. Well, we are economists, we know about present values, wouldn't it be nice if you could see somebody put a present value down somewhere on a government report? Wouldn't it be nice to at least have a number of that sort in mind? I'm getting those numbers, by the way, from the government documents. I'm not making them up. Another case in point for years and years, decades perhaps, States and local governments in the United States have been giving very generous pension promises and health care promises to their employees, not putting the health care liabilities, which are huge, on any statement or report in most cases, and, are you ready for this, discounting the future projected payments for the pensions at the expected return on the assets. The excepted return on the assets. Yet these are promises that must be paid with certainty, guaranteed by a sovereign government of at least the State or a local government. Now, we would all say, use the treasury rates or something comparable. They don’t, and the numbers they then put out are low by a factor of at least, well, the true number is at least 50% higher, and the numbers are staggering large. So the debt situation of governments in the United States is significantly worse than the governments accounting would lead you to believe and I think it's time for us to acknowledge that, States are beginning to realise what a problem they have. Thank you, my time is up. MARTIN HELLWIG. Let me briefly summarise and draw relations. Bill White stresses the role of denial of risk and the role of imbalances, misallocation of resources, and worries because these imbalances are still there. Roger Myers focuses on the role of debt, debt as being natural because of information problems. Myron Scholes and Bill Sharpe both point to issues of moral hazard. To some extent I would expect that both of you see leverage as a result of moral hazard, which to me raises, I mean Bill himself focused in particular on the need to regulate the leverage, which to me raises a question to Roger. If debt is so natural, do you see a need to regulate it, would you agree with them? Or do you see that this is something where we should just accept that indebtedness of banks is a fact of life? On the role of monetary policy, I heard Bill White saying, we shouldn't go into the game of having too much ease again, and I heard Roger Myerson say, well, the central bank should be targeting the price level, and if the price level is too low and we get a debt deflation, maybe they should do something to get it up again. Which to my mind links up with the question of what are we to think about the monetisation of debt that we’ve seen both in the US and in the eurozone, including of course the purchase of sovereign debt by the European Central Bank. I see a certain conflict there between the prescriptions, implicit in what Bill White said and what Roger Myerson said. So that’s linked to the question of how do we get out of the mess, after all we are still in the crisis in that respect. On the issue of prescriptions, a new bankruptcy law or new regulation, wonderful, but why haven’t we had any of this? Why is there no international negotiation about bankruptcy rules? For instance, the rules to be implied, close out clauses, change of control clauses and derivative contracts which create a mess for proceedings, or the rules that provide for a separation of bankruptcy proceedings for different subsidiaries, according to the country of the subsidiary, which in the case of Lehman brothers led to complete chaos in relations between the UK and the US. Why is regulation and in particular capital regulation so meek? Even after the crisis. Perhaps Bill might want to answer to that. I also heard a slight descent between Bill Sharpe and Myron Scholes. Myron focused much more on market discipline and on internal discipline, organisation of risk management inside the bank, the need for transparency as a way to get debt holders to impose discipline, whereas Bill called for capital regulation. Am I exaggerating the conflict or is it there? So maybe, Bill White, you can say briefly something on why you think monetary policy shouldn’t continue what it did before? WILLIAM R. WHITE. Well, what is clear is that the central banks virtually everywhere are providing us with more of the same. In fact I think one of the principle reasons is, because it seems to be the only game in town, we are in trouble, people recognise that the fiscal things got to the end of the line, and monetary policy is the only game in town. So what have they done? Well, we are all familiar with the fact that the interest rates have gone down to zero. We’ve had in the United States now QE1, QE2, the recent announcements that are going to keep interest rates down until 2013, we’ve seen the ECB having to get into the bond market purchasing bonds, Italy and Spain. Describing it as trying to smooth out the transmission mechanism which is perfectly legitimate. The bank of Japan is now lending money to small and medium sized enterprises, so everybody is getting into it. Now question one, will it work? I think the answer is probably not, we certainly have not seen as a result of all of these policies a resumption of the strong balanced and sustainable growth the G20 keeps talking about, so I don’t think it’s going to work. Are there downsides to this? I think there are some serious downsides to it, there’s all the misallocation of capital that we talked about, the generation of bubbles. I think this recent set of stuff is in part responsible for the bubble we are seeing in the emerging markets now, where inflation is really taking off, property prices all this sort of stuff. The zombie companies, zombie banks, from all this perspective this is a very bad thing to do. Now having said that, I go back and I agree with Myron in particular, the fundamental problem we have here, and it’s been around for decades and decades, is moral hazards. And whether it’s on the regulatory side or the bailout side or the Greenspan side, what has happened here is that the downside of everything has been basically, how do you say, put a peak on the downside. How do you express it. But the difficulty is that this thing started so long ago that every time you do it people get induced, not just the lenders to behave badly, but the borrowers to behave baldy. Every time you do it, the underlying fundamentals get scarier and scarier. So at each moment when you look at it and say ‘we are in a bad path, we’ve to get off this path’, the price of doing so, which is not just a little recession but maybe a great big one, because you haven’t had anything serious on the downside for decades, it just looks so scary that the only answer for both the central bankers, I think, and surely the politicians, is more of the same, and bad things happen, put it off until it’s on somebody else’s watch. That’s the fundamental problem we are dealing with. And it’s of long standing. Roger Myerson I agreed entirely with what Myron said about financial bankruptcy reform. As I'm thinking about it, I realise that I have more than the time allows us to say, so I simply want to say: I don’t know whether there have been major conferences on the question of ideas for financial bankruptcy reform, but what to do for reforming the legal framework and legal administrative framework for dealing with banks that have become illiquid and insolvent in order to keep the institutional framework of our banking system. I think there’s much that can be done and I wish there were more discussion on that, I think that’s a huge issue. What I can address more easily within the few seconds I should take now, is the capital, the basic capitalisation requirements for banks, they are needed. I can see that a radical proposal for very much larger capital requirements could encourage a shadow banking system and part of what we want from bank capital is that its owners should actually be participating in monitoring the bank, which is true of some fraction of bank ownership, but some is going to be held by the broader public, but certainly higher capital requirements within the range we have seen are very good, you argue in publications and to question, the basic idea of having different capital charges for different kinds of assets. And if I could say something very important, from my perspective, which is from an American and from a fundamental economic theorist. As people look at the current eurozone problem of sovereign debt, I'd like to toss out the hypothesis that at the root of all of it, the reason that it’s a problem for future tax payers in some excessively indebted country, is because of many things that might be discussed, the temptation, the short-term temptation of politicians, but the reason it’s a problem for Europeans, even in countries that are not excessively indebted, is because the banking system excessively bought this debt, and that begins fundamentally what it suggests, more than anything else, from the fact that the regulatory rules have been written to put the minimal capital charge on assets that are sovereign national debt. We need a banking system in the economy to provide financing for small and medium sized enterprises. Why is the capital charge for sovereign national debt so much lower than the capital charge for loans to the economically essential function of banks, all the rest of us can buy the sovereign debt bonds directly. Can this be discussed? WILLIAM R. WHITE. I would like to make a point, clearly, this example, and this is an extreme one, there are similar examples, the rating agencies in the US were basically empowered and anointed by the government, so if you want to sell your bond to a particular class of financial institution, it has to be rated a certain level by the rating agency that was specified. Who pays them, the issuer of the bond, I mean all these terrible incentive systems. The idea of raising capital on banks assumes that you have got an insurer, the government, a contingent claims offer, a lender waiting in the wings who is not acting in the best interest, presumably of the taxpayers, but certainly all these confused incentives. I think we need to look more at the incentives and as we as economists think about regulatory structures, capital requirements etc, we are going to have to get a little bit closer to the political science and build in something about the incentives of the government mechanisms which are big players. That’s all, unless you say too big to fail, too big to exist, we are not going to bail anybody out, good luck to you. Then perhaps, after a terrible retching period of possibly decades, we might get back to the simple models that we often have in our text books. MYRON SCHOLES. One thing in terms of the currency base on the macro side, whether it’s, in macro policy, whether you should have rules versus discretion, the idea that the central bank shouldn't try to manage the economy in a way that tries to intuitively respond to the economic circumstances. As I said, when I introduced my talk, is that one of the unintended consequences of discretion, which causes the volatility of the economy to dampen, that leads entities and individuals to, because of either incompletion or possibility of trying to understand exactly in a complex environment what all the data are, the consequence is that they take more risk and basically, if things are less volatile, we all take more risk. As a result of that we have to really think what the amount of risk or volatility is in the economy, so that people are generally just more cautious. So if you dampen the risk intentionally, then it has consequences, if the individuals believe or come to believe that that’s the natural evolution and we are in a lower risk posture. And in terms of why we haven’t gotten to bankruptcy rules and accounting rules, we’ve ignored completely accounting. I rely, or try to rely on the market, as Bill said, when I said, there’s an alternative, or in addition to that we have regulatory bodies that were accountable, and also had more sophisticated people, or people that were more than well paid, so that they can counter these forces. I was trying to rely on market forces and regulatory forces in combination and not just saying market force, but I do want to have market discipline. So if we want to get around the moral hazard problem, we have to think the debt holders can suffer losses and therefore they can suffer losses, there is going to be discipline in the market place which will prevent the firms from having leverage or the price of them raising money is going to go up dramatically. And so that means that the information system has to be changed in such a way that outsiders can have a chance to do it. And whether if we have an opaque accounting system, then you have to rely on the government to bail out the banking system, if you can’t understand what the banking system is doing, and/or shadow banking system. So basically we have to figure out how to wean ourselves off this. The other point in terms of the bankruptcy rules, either because there was a rush to have a Dodd-Frank bill passed because of anger at the financial system or a need for retribution - we produce a 2,300 page bill without any regulations - and as a result of that it’s virtually impossible for anyone in the financial system to know what the evolution of rules are going to be. And that causes in a lot of ways a lot more disruption in the economy. But in terms of bankruptcy or thinking about what the sensible things to do, there wasn’t a demand for sensibility at that time, you had to get something out as opposed to thinking about studying something, it takes time to learn something from the data. To learn from a Lehman or learn from the consequences of AIG as opposed to just reading things in the paper and then going from that. MARTIN HELLWIG. Okay, thank you very much, I'm afraid there won’t be time for a general discussion, because we have to close. On this bankruptcy issue two comments, we had our institute together with the Austrian National Bank, a conference on this a year ago and problems were easily recognised and easily described. But the problem of international coordination is a political problem and nobody is willing to touch it. And the problem has been recognised at the time of the LTCM collapse in 1998, at that time nobody wanted to do experimental research on a bankruptcy proceeding, not even so very large, but very internationally connected institution. The following ten years were wasted without any work on the problem, and we are embarking on another waste of time without substantial work on this problem. On that pessimistic remark I wish to close this panel, thank you audience, thank the participants and hand over for the next part of this exercise.

Myron Scholes on the Absence of Transparency in the Banking Sector
(00:55:47 - 00:57:18)

Aside from claiming more discipline in the private and banking sector, German Federal President Christian Wulff in his opening address at the 2011 Lindau meeting on Economic Sciences underscores the fiscal self-discipline of sovereign governments. With respect to Europe, Wulff points to the problem of EU member states violating massively the stability criteria established in the Maastricht Treaty. The stipulated ceiling of 60% for public debt was transgressed in 2010 by more than half of all EU member states, including Germany. The stipulations formulated in the Stability and Growth Pact (SGP) should be strictly enforced and practiced by the Eurozone governments and not be just mere formula.

Christian Wulff on Governmental Violations of the Maastricht Stability Criteria
(00:33:12 - 00:34:55)

In methodological terms, economist Joseph Stiglitz, at the 2011 Lindau meeting on Economic Sciences, holds standard macroeconomic models liable for the creation of economic bubbles. Stiglitz, who received the Sveriges Riksbank Prize in 2001, questions the efficiency of standard macroeconomic models that failed to foresee the global financial crisis – in fact the financial crisis itself, as he notes, is a good illustration of the Standard Models’ inefficiency. In his 2011 lecture “Imagining an Economics that Works: Crisis, Contagion and the Need for a New Paradigm”, Stiglitz states that monetary authorities allowed housing bubbles to grow, partly because the Standard Models said that there could be no bubbles affecting markets on large-scale levels. Calculations based on the Standard Models, including risk diversification, foresaw that the breaking of a bubble in the U.S. subprime mortgage market would be a too small perturbation to have any global macroeconomic effects.

Joseph Stiglitz (2011) - Imagining an Economics that Works: Crisis, Contagion and the Need for a New Paradigm

Well, thank you Martin and let me thank Lindau and its sponsors for bringing us all together. What I'm going to do today is to focus on some aspects of modern macro economics. As it should be clear, a little bit in contrast to some others that may have spoken, I don't think this has been exactly a golden moment for macro economics. In fact as I mentioned 2 days ago modern macro, the standard models that are used by Central Banks and by most economists didn't predict the crisis. In fact it is remarkable, the last meeting of Lindau was in 2008, in August of 2008, I don't know if you remember, you probably were too young to remember what happened in September of 2008. It was the beginning of the global economic crisis. And yet it was remarkable at that meeting 3 years ago, there was almost no discussion of the impending crisis. It was as if you had this, the most important event in economics in the last 75 years and an assembly of economists that was supposed to be thinking about what are the major problems facing our societies, missed this critical event. The test of any science is prediction. And if you can't predict something as important as a global financial crisis of the magnitude of the one that we're going through, obviously something is wrong with your models. In fact as I mentioned in some quarters there's a complacency that macro economics is in its golden age. As I say I think if it is in its gold age it's a very tarnished gold. The standard models, not only didn't predict the crisis, in some ways it was worse than that, they said bubbles couldn't happen, they asserted that the shocks that an economy experiences are exogenous, not endogenous. And these shocks were endogenous. The kinds of research that Roger Myerson talked about, trying to construct a model where the shocks were endogenous, exactly the kind of direction in which we aught to be working. In fact the policy frameworks adopted by Central Banks and many of you are from Central Banks, suggested that keeping inflation low and stable was necessary and almost sufficient for stability and growth. The governments didn't have the instruments to prevent bubbles and it was cheaper to clean up the mess after the bubble broke than to interfere with the wonders of the market. Each of these properties is not true in general. In a sense the models that most economists used focused on dead weight losses associated with the distortions in allocations associated with inflation. We're focusing on second, I would say even third order effects and ignoring the first order effects of the losses associated with financial fragility and the breakdown of the financial system. The losses that have occurred as a result of this crisis in terms of the gap between potential and actual GDP in the order of trillions of dollars. The gaps of the dead weight losses that were associated with the Harberger triangles were much, much smaller than that. One of the things that many of the presentations at this conference have pointed out is that all models are simplifications, all models represent assumptions that simplify the real world. The criticism of the DSGE models and the other standard macro economic models is not that they're a simplification. The criticism is that they're the wrong simplification. They included things that were second order and didn't include things that were first order. And I'll come to some of that a little bit later. It's not only that they didn't predict the crisis, it's not only as you said sources of the crisis could not be a source of crisis but even after the bubble which they said could not occur had broken in 2007, economics like Bernanke claimed the effects were contained. The models, the theories on which they were basing their policies and on which their analysis were based said that that was the case. They talked about, in those models there's risk diversification. They did a calculation, a reasonable calculation, based on those models. And if you take even the sub-prime mortgage market, you diversify it in the global economy, it was a small fraction of global wealth. And therefore the breaking of a bubble in the sub-prime mortgage was so small that it would not have any global macro economic effect. They were wrong. And we have to understand why the models which continue to be used were so wrong. Not surprisingly such models have not only failed to predict the crisis and to give us insights into the causes of the crisis, not surprisingly the advice they gave to governments on how to respond to the crisis was also inadequate. The nature of this inadequacy is at least hinted by the fact that now it's been almost 4 years since the beginning of the recession, recession began in December of 2007, we're not in 2011, unemployment levels remain very high and the likelihood is, at least a very significant likelihood that we'll be going into double dip. Even if we don't go into double dip almost surely growth in the United States and in Europe will be too slow to create enough jobs for the new entrants in the labour force so the jobs deficit will be increasing. Let me just give you a couple of examples of the kinds of things that were not included in the macro models that should have been included. Last night I was sitting with somebody from one of the Central Banks and I somewhat jokingly asked him in the model that they use, a DSGE model, did they have a banking sector. And of course I knew the answer, the answer was "no". Now to me it's amazing that a Central Bank has a model of the financial economy, the economy in which there are no banks. Why do we have central banks, it has something to do with the banking sector and yet the standard models leave out credit. And this is clearly a credit cycle, this is clearly a problem with credit. And if you don't have credit model, well inside the model, how are you going to give advice about how to restore the credit flow. Let me give you another example, securitization, a central part of what has happened to the financial system in recent years. Most of the models, almost all the models simply assume that securitization works, it helps diversify risk. But there are in fact inherent problems with securitization that have been pointed out in the economics of information 20 years ago. It's not just an accident the problems with rating agencies. They are inherent problems. So it's not a surprise that the attempts of the Fed to restore securitization have totally failed. Because they haven't understood what is required to make securitization work. Well, I could go on and I should just mention one thing to tease the Central Bankers, you may remember that after the crisis Greenspan was called to testify to congress and he said, he had discovered a flaw in his reasoning. The flaw in his reasoning was that he expected banks to be able, to have an incentive to manage their risk better. But I was surprised at Greenspan's surprise. Because the one thing that economists agree on is that incentives matter. And you look at these incentives that the bankers had and they had incentives for excessive risk taking and short sighted behaviour. If the bankers had not behaved in the bad way that they did, we would have had to rewrite micro economics. Fortunately we don't have to rewrite our text books. Unfortunately for the economy they behaved in a way that we predicted. But the regulators didn't understand. Moreover if I make a mistake, if I gamble excessively it doesn't have any consequence except for me and my family. But if the banks, a large bank engages in excessive risk taking and fails, it has societal systemic consequences. That's why we have externalities. And yet we have regulators that didn't understand the reason that we have regulation. And if you don't have regulators who understand regulation it's not surprising that things didn't work well. Well, in a way not only is there a crisis in our economy, there ought to be a crisis in economics. Because many of the propositions that we have held very strongly have been shown not to be true when they come under challenge. To give you one other example, much of the macro economics have said that the underlying problem are wage rigidities. And yet strikingly among the countries that performed most poorly in terms of persistence of unemployment is the United States which has very, allegedly very flexible labour markets. And countries like Germany that have more intervention have actually performed much better. There actually is some econometric work that I did with Bill Easterly and Roumeen Islam a number of years ago that show that this is actually a pattern. That the source of much of the instability is not wage and price rigidity but financial instability, financial problems of which this crisis is the most recent example. But most of the macro economics ignored these lessons. Another quandary, puzzle is there were large losses associated with the misallocation of capital before the bubble broke, in fact no government has ever misallocated capital, wasted resources on the scale of American financial system. And it's not only the hundreds of billions of dollars that were misallocated before the crisis but as I mentioned before there are trillions of dollars of gap between potential and actual output in the subsequent years. Now of course it's easy to construct models of bubbles but most of the losses occur after the bubble breaks. In this persistent gap between actual and potential output. Standard theory predicts a relatively quick recovery as the economy adjusts to the new reality. But sometimes recovery is very slow and most of our models do not explain this kind of persistence. Well, it should be clear I think that there is a need for new economic thinking especially in macro economics. And I think it's fortunate that there have been a number of foundations and individuals that come together to help support the creation of some new ideas, the institute for new economic thinking in New York is particular supportive of young economists, you should look at their website. It does provide grants for economists looking for support for more innovative directions. Trying to create a network of economists that are focused on understanding some of the deficiencies with existing doctrines. This morning in the limited time I have available I want to talk about 2 aspects of, And much of my research in the last few years has been focused on this and I only have time to talk about 2 issues. The first is that there had been large and often adverse changes in economy's risk properties. In spite of supposed improvements in markets. An example I already hinted at was the moving from banks to markets predictably lead to deterioration in the quality of information. But another one that I'm going to be talking about is that the increased interdependence among financial institutions has led to more financial fragility, that's one of the issues I'm going to talk about. The second is that the global economy is undergoing a major structural transformation. Structural transformations are associated with extended periods of under-utilisation of resources that are associated with deep market failures. And it's important, there's an important role of government to facilitate this transformation because of these market failures. There's an analogy here to the great depression. The great depression was a period of structural transformation. In the 19th century most individuals made their living by working in agriculture. And then success in agriculture led to enormous increase in productivity in agriculture. But that meant relatively few people were necessary to grow the food that people wanted. Today about 3% of the population is engaged in employment in agriculture in the advanced industrial countries and they produce more food than even on obese society can consume. Today the analogous issue is manufacturing. There's been enormous increase in manufacturing productivity, 6, 7% or more. But that means that the ability to absorb employment in manufacturing, even if we consume more cars than a planet can survive, more flat panel TV's, means that people will have to move out of manufacturing. Both exacerbated by globalisation which means the locus of this activity will be also changing. This is a structural transformation that is going on today. The important lesson of this is fixing the financial system is necessary but it's not sufficient to address our problems. And so it's important that we go ahead and do the work of fixing, which we have not done but we should not be surprised that when we fix the financial system the economies will not be returning immediately to robust growth. So let me talk very quickly about each of the 2 ideas that I want to focus on. The first is does increased interconnectivity lead to more or less systemic stability. The standard answer is that spreading a risk with concavity leads to better outcomes. But economic systems are rife with non-convexities illustrated for instance by bankruptcy. And the result of this is that interlinked systems are actually more prone to system wide failures with huge cost. And the underlying concept here is that privately profitable transactions may not be systemically desirable, socially desirable. The basic idea here, in a way is a theorem that tried to explain why the fundamental welfare theorems o f Adam Smith and Arrow-Debreu were wrong. The idea, one of the most fundamental ideas in economics is that the pursuit of self-interest lead as if by an invisible hand to the well-being of society. But what we've learned is that when information is imperfect, risk markets are incomplete which is always, the reason that the invisible hand often seems invisible is that it's not there. That economies in general constrain Pareto inefficient. And a particular aspect of this that we're concerned with is that the privately profitable contracts can lead to large elements of systemic risk in the absence of regulation. And this crisis is a good illustration. In a way the standard frameworks illustrate the incoherence in modern macro economics because international institutions, I won't name any of them but you know who I'm talking about, argue for the benefits of diversification, integration, before a crisis hits. But after the crisis, what do they talk about, the word that they use is contagion. What do we normally do when somebody has a contagious disease or what we used to do, we quarantine them. So we say we don't want integration, we want to isolate. Well, if you had a coherent model you would recognise that yes there are some benefits to integration but yes there are also some costs. And we have to integrate the benefits ex ante and the cost ex post. If we could eliminate crisis then we could say we can just focus on the benefits but in fact the crisis are inherent, inevitable. And therefore we have to balance out the optimal system design, balance out the benefits and the cost. There's an analogous problem that may give some intuition into what we're talking about. With an integrated electric grid, the excess capacity required to prevent a black out can be reduced but the consequence and we've done some experiments on this, when we have a more integrated electric grid, a failure in one part of the system can bring down, can lead to a system wide failure and we've had some experience in the United States, we had a more integrated system and then we had a little problem in Ohio that led to a black-out along the whole east coast. And that's what we see in this crisis. A malfunction in one economy in the United States brought down the global economy. Well, in electricity and the design of electrical networks, well-designed networks have circuit breakers to prevent contagion in the failure of one part of the system to others. But economists have missed this fundamental insight. Now one of the aspects of modern economics is that there are rational expectations and I've been a very strong critic of rational expectation, I'm going to give you one example of irrational expectation. I always expect that I can talk faster than I can and so I thought I was going to have time to present a model and then go drive some results and I'm not going to be able to do that. So here it is, if you have quick eyesight you can read it. Here I'll go even faster, ok now we have it, the basic insight is that even with mean preserving reductions in risk associated with risk pooling, the probability of any particular country falling below the bankruptcy threshold or the crisis threshold may increase with economic integration. And there's some further results that are quite general, one of them is that full integration never pays if there are enough countries. There are some degrees of integration are desirable but the optimum involves less than full integration. And that there ought to be restrictions on capital flows. In other words the capital flow restriction can be viewed as analogous to circuit breakers. And some of the theoretical research I've been involved in, there are 2 further directions and modelling mentioned very briefly, one of them is the concept called trend reinforcement. When you have a negative shock, it increases the probability of the stochastic process moving down further. For instance the result of equity depletion, interest rates that a firm will have to pay increases. And we model systems by using coupled stochastic differential equation, this is some work with Stefano Battiston in Zurich and some Italian economist. And what we've shown is that again with this kind of trend reinforcement there's an optimal degree of diversification. Another set of ideas has been explored in some work that I've done with Bruce Greenwald and some work that a former student of mine, Franklin Allen has done with his colleague Gale and that's a concept called bankruptcy cascade. Where the bankruptcy of one firm affects the likelihood of the bankruptcy of those to whom it owes money. And other people in the credit network. The important point is that the architecture of the credit system can affect the risk that one bankruptcy leads to another. In other words we can affect by analysing the architecture of the credit system, we can affect the likelihood of these kinds of bankruptcy cascades. There is a broad agenda here that I call the architecture of economic systems. Where we focus on the optimal architecture with respect to risk sharing. And one of the points that is very natural when you're looking at these models with non-convexities is that the solutions that appear are not in general going to be symmetric. One of the things that also comes put is that different architectures may lead to a greater ability to absorb small shocks but less resilience to large shocks. And that's been a characteristic of many of the so-called improvements in the financial markets in recent years. One of the corollaries of the Greenwald-Stiglitz theorem that I mentioned before is that reducing the set of admissible relationships and behaviours can have benefits. A more general observation is enlarged non-linear systems with complex interactions, even small perturbations can have large consequences. So there's a broad agenda I had in the design of optimum networks including the optimum degree and form of financial integration, the design of circuit breakers and so forth. Well, as I say there is a large literature that I've referred to here that's beginning in this area. The second topic that I want to talk about very briefly are the issue of structural transformation. The suggestion that we are, the current crisis is partly a structural transformation. And as I mentioned the great depression was a structural transformation from agriculture to manufacturing, this is a structural transformation from manufacturing to services. The fact is that productivity growth is now well in excess of the growth in demand and implying a decrease in demand from labour in manufacturing and the problem both then and now is that if labour gets trapped, and I'll explain in a second what I mean by trapped, in a declining sector, then income will decline. In a sense while productivity growth in perfect markets is welfare enhancing, when we have market imperfections it may not be. The reason is that techno change always can induce large distributive consequences. One of the important implications is that representative agent models that don't take account of this recent changes are never going to have insights into what is going on in a macro economy. With perfect markets the implication of course is that winners could compensate losers but they seldom do. But with imperfect markets the decrease of welfare of those in the trapped sector has spillover effects on others. And especially so with the efficiency wage effects, there can be adverse macro economic consequences. And again I won't have time to give, go through the model but it's very easy to construct a model, say in agriculture and industry, have a productivity increase in agriculture and the results can be summarised really simply. The basic result is under certain conditions the steady state is stable and so forth, then an increase in agriculture productivity unambiguously yields a reduction in the relative price of agricultural goods. And reduces employment in manufacturing. The result is that a mobility constraint, agricultural sector productivity growth can lead to an extended economy wide slump. The second theorem is that under the stability condition an increase in government expenditure, particularly if it's directed at facilitating that mobility can increase urban employment and raise agricultural prices and incomes. And again a third condition is that a decrease in urban real product wages can increase urban unemployment and lower agricultural prices and income. Let me just comment very quickly on the role of modelling. As I said before it's very important in models to focus on the right, make the right assumptions. Since structural transformations occur very seldom, rational expectations models are not likely to be of much help. Since the central issue is structural aggregate models with the single sector are not likely to be of much help. Thirdly since among the major effects are those arising from redistribution a representative agent model is not going to be of much help. Fourthly since the central issue entails frictions and mobility, assuming perfect markets, is not of much help. And finally the problems are exacerbated by information problems, those can give rise to efficiency wage effects assuming perfect information is not going to be a good way to begin. The policy implications for this current crisis are very clear, there's to be structural policies to facilitate the movement of labour that is trapped in a dying sector. Even though structural policies are part of the solution, traditional Keynesian polices, especially if they have a structural component, play a role. This is in marked contrast to those who are now beginning to claim that most of the remaining unemployment is structural. But I have to commend Peter Diamond's remarks 2 days ago where he pointed out that this excessive focus on structural is misguided. The real worry is that this is being used by those who want to argue that there's a new normal to which we must now accommodate ourselves and therefore policies designed to stimulate the economy may now not only be useless, they may be counter productive. In some of our work what we've suggested is that these kinds of Keynesian structural policies were at the centre of the recovery from the great depression. Let me conclude, since my time is almost up with some very general remarks. I think this is an extraordinary exciting time to be a young economist. We know that the models of the past are inadequate to the task before us. On the other hand I think we have developed many of the tools, we have good models for instance of credit, of banking, at the micro economic. We haven't integrated them into macro economics but we developed a lot of the micro economic foundations, models of agencies, of understandings of externalities. We understand the problems of corporate governance much better than we did 50 or 100 years ago. The real problem is, particular in macro is that these insights of modern micro economics have not been incorporated into macro economics. There's another problem I think though that with much of economics today. We've not always asked or focused on the right questions. One of the key problems today in our society, in our economy is growing inequality. In the United States for instance today 1% of the population is earning about 25% of all the income and has control of over 40% of the wealth. I was head of an internal commission put in by in the UN to look at the causes of this crisis and one of our conclusions that underlined the crisis was in fact growing inequality. Growing inequality diminished aggregate demand and was covered up, the diminishing aggregate demand was covered up by the Central Bankers as they engineered a bubble and as they had lax regulation. Interestingly the IMF last spring also emphasised the importance of inequality and has moved inequality into their agenda because they have said that their responsibility is stability and inequality leads to instability. And so inequality really ought to be at the centre of their agenda. But the standard theory in economics to explain inequality is margin and productivity theory. We know that margin and productivity theory cannot explain the level of inequality in our society or the changes in equality that have occurred in recent years, something else is going on. But I don't know about you but most of us in our graduate courses do not spend much time talking about inequality. And when we do it's focusing typically on things like margin productivity theory. So this is an example of an area where we haven't been asking the right question and the models that we typically use have been the wrong models. Let me give you a third example, we know that GDP is a bad measure of economic performance. And it's even a worse measure of well-being. I chaired an international commission on the measurement of economic performance and social progress and there was unanimity that it was a bad measure. And why is that important. Well, many of you are running regressions between economic policies on the one hand and economic performance. But what do you put on the left hand side of your regression, GDP, GDP per capita. But if you're using a bad measure of performance the inferences you make from those regressions are wrong, they're not going to get better societal performance, they're not going to lead to increased well-being of citizens. So another important agenda is to try to think how do we get a better measure of well-being, one that reflects the well-being of citizens and that will take into account sustainability. You know before the crisis many people in Europe looked at America and said we ought to imitate the United States because it was growing more rapidly, growing on the basis of per capita income. You don't hear that so much anymore. But the most important point is to realise that medium income today in the United States is lower than it was in 1997. All of the growth has gone to the upper part of the population, most American's incomes have been going down or stagnating year after year, that is not a good economy. An economy that compromises the environment for the whole world, an economy that leaves most people stagnating, a lot of people in poverty is not a good economy. So it's important to get better measures of performance and try to understand what are the policies that lead to better measures. I don't know how many of you noticed as you walked in to the hall that there's some posters on the wall outside. And one of those posters says, a lot of those posters are very critical of the economics profession. And I think with some justification. One of those signs say that an alternative world is possible. I thought economic science could help provide foundations of this other world. I saw around me as I grew up a world marked by economic instability, episodic recessions, unemployment, inequality, discrimination, poverty. In a country with a great deal of riches. And it seemed to me at that time that another world was possible. I saw a rich country in a world in which most countries were in poverty and that also seemed wrong in a fundamental sense. And so if we're going to create that I think we have to have an understanding of economic science in the broader social sciences. I still believe that alternative world is possible. A couple of weeks ago I was in Spain and some of you may know that there has been a big civil protest movement going on in Spain, people had come from all over Spain, a group of people that call themselves the Indignados, the indignants and most of them were young people. I think they were right to be indignant, the unemployment rate among the youth in Spain is over 40%. These are young people who worked hard to get an education, to get the skills and yet the economy, society is not providing them any opportunity. There's been a failure of our economy and of our society and they are right to be angry and to be working for an alternative world. So I hope some of you will devote yourself to an economic science, not only to making bankers wealthier, not only to making financial systems work better, but also to help create this alternative world. A world in which there is greater social justice. A world in which we do a better job at protecting our environment. And which the focus is on the enhancement and the well-being of all the citizens of our societies. Thank you.

Joseph Stiglitz on the Inefficacy of Standard Macroeconomic Models
(00:02:07 - 00:05:13)

Capital market imperfections, leading up to the economic crisis, were falsely assumed as exogenous shocks, not as endogenously generated. In fact, markets are massively inefficient on microeconomic levels, as Stiglitz also states in his 2008 lecture “The Global Financial Crisis: Lessons for Policy and Implications for Economic Theory”, so the crisis should be analyzed as a microeconomic failure that in turn is leading to a macroeconomic failure. Furthermore, Stiglitz emphasizes the importance of growing inequality as a major of cause of the global financial crisis. Growing inequality diminished aggregate demand that in turn was covered up by the Central Bankers as they created housing bubbles.

Time for a World Currency?
In order to avoid great systemic crisis in a global context, 1999 Economics Laureate Robert Mundell in his lecture “The Case for a World Currency” at the 2004 Lindau meeting on Economic Sciences, argues for an international monetary system anchored to a stable global currency unit. Mundell considers constant revaluations of major currencies like the U.S. dollar and the euro as having destabilizing effects on the economic and financial stability worldwide. He calls for a multiple-currency monetary union with the U. S. dollar, the euro, and the yen areas (DEY) as the anchor unit for a global currency (World Currency Unit). DEY should have a fixed exchange rate to which all other participating currencies could be fixed. Mundell reaffirms his theory of implementing a system with fixed exchange rates in his 2011 lecture “Currency Wars, Euro-Mania and the Price of Gold”. He refers to the Bretton-Woods-System – an international monetary management system with fixed exchange rates that established the U.S. dollar as common denominator to which each participating country fixed its currency. The U.S. dollar in turn was tied to gold at a fixed rate and was the only currency that would be freely convertible into gold.

Robert Mundell (2011) - Currency Wars, Euro-Mania and the Price of Gold

Thank you very much, it’s very nice to be here, I have to say I don’t think there’ll be too much overlap between Bob Aumann’s talk and mine. We have slightly different subjects. Currency wars, Euro mania and the price of gold, well we’re going to look at, start off with a little bit of the history of the international monetary system. And see what comes of that. We have all these different systems and historically we try to make sense of why one moves into the other. From buying metals and the international gold standard, the dollar gold standard, the 1915 to 1924 most people don’t think of that, that was very much like the Bretton Woods system although there was no kind of codification of the rules. Because the European countries had gone off gold, most of the world had gone off gold, the US was on gold and in the 1920s the dollar was already being used as the anchor currency. Until the European countries went back to the gold standard and that only lasted a short period of time. Britain went off in 1931 and the United States in 1933 and then except for France, until 1938 all the world was off the gold standard except for the United States. even though the Bretton Woods act didn’t take place, the conference didn’t take place until 1944. But effectively what the Bretton Woods agreement did was to codify the system that had already come into place. Which was essentially where the US fixed the price of gold and the other countries fixed their currencies to the US dollar. Well that broke down in 1971 when the US took the dollar off gold. because there’s a billion ounces more or less in the system. But by 1971 they had sold 400 million ounces mainly to Europe and at that point President Nixon took the dollar off gold and Bretton Woods, other countries took their currencies off the dollar and that broke up the system. So from 1934, 1971 to ’73 they went back temporarily to a pure dollar standard but a disagreement between the United States and Europe led that to break up and move to flexible exchange rates, in June of 1973. the minister for finance in Germany and Giscard d’Estaing the minister for finance in France. Of course those 2 other guys got to be presidents a little later. But that broke up the system and while there was an attempt to restore it, nobody wanted flexible exchange rates, they couldn’t agree on it because they couldn’t find a symmetrical system. Throughout there was this problem of the, what to do, how to do something with the dollar, the dollar had become more important than the other currencies and you couldn’t find a way of writing a treaty for the system that would put the dollar on the same level as the other countries. So they by default went to flexible exchange rates. I think then the system changed again a little bit with 1999, the creation of the Euro, that changed the system, now I’m going to talk about that in some minutes after, this is just another look at the same kind of graph but with reserve assets and the different countries that were the principle leaders in the system. Currency areas, these are zones of fixed exchange rates or single currencies. Monetary power, defined by transaction zone, we’ll see a graph in a minute about this. There are monetary powers more or less proportionate to GDP and currency areas we can depict these on a global map. The global map evolves over time with the international monetary system and the growth of big countries, you can look back on the history of the world if you like, write a history of the world in terms of these globes circling around and the sizes of them as they become, as one great power gives way to another power. You look at this around today, these as I say these circles, areas are proportionate to GDP. The US is a little less than $15 trillion, the Euro area on the right is $13 trillion. The RMB area is, at current exchange rates, nominal exchange rates, $6 trillion and Japan is $4½ to 5 trillion. So Japan is number 4 in the currency picture. And then Britain is quite a bit down, about $2½ trillion. And then the other countries aren’t big players in the global system. You see looking at that the 2 big players by far in the system, actually the RMB area is a little bit exaggerated here because if we put it at purchasing power parity exchange rates the RMB would be more or less the way it is here but it’s actually at nominal rates, would be a little less than that. But the 2 big giants in the picture are the dollar/Euro area and that dominates the arrangements and that’s what has to affect it. Now what my basic thesis is that in this system that it’s a pity in a way that the system broke up into fluctuating exchange rates. Because what happened is that under the fixed exchange rate system which was designed at Bretton Woods to codify the system that had naturally come into existence. There was a set of rules. But once the system broke up there’s no set of rules. And that’s why we have big imbalances that countries want and the IMF doesn’t have enough power to do anything about them and there’s no agreed system. So I made the argument we should go back to a system of fixed exchange rates, but it’s not easy to do that. Just for the same reasons that we talked about before. You have to find a way to make that compatible. But I want to show the harm that comes from fluctuating, huge fluctuations in exchange rates and make this comment that before 1914 under the gold standard, you never had great systemic crisis, of course you had great wars which created problems but not great crisis of the system. You didn’t have that under the Bretton Woods period but you have had a series of great crisis that are almost systemic crisis since the 1970’s. And you had first the 2 great oil crisis of the early ‘70’s and the late ‘70’s. Then you had the international debt problem, a crisis of 1982 when Mexico went into default and that cut off supplies of capital to developing countries for a decade. Then you had the Savings and Loan Association over here in 1982 and ’84. In the 1990’s you had the Asian crisis. And then you have the great crisis that we’ve been through, the great panic. Now my thesis is not very popular in some circles who love flexible exchange rates. But my thesis is that underneath every one of these crisis are big swings in the major exchange rates. Just before I go on, let me say in the 1979/1980, the US had 13% inflation. In 1980 there was 3 back to back years of inflation and the dollar went down, it fell in half against the Deutsche Mark, then the second number 2 currency in the world. Then in the first half of the ‘80’s the dollar soared, it doubled against the Deutsche Mark. And what happened over that period, well the developing countries were all borrowing money, Euro/dollar banks were pushing money at them, they all borrowed huge amounts and governments can't resist loans that seem to be free, low interest rates. And then suddenly with the whiplash of the dollar going back up again, they had to pay almost double and that’s what broke the bank, what broke the developing countries problems. When you read the history of that you’ll say oh it’s a problem of what, Chile did the wrong thing or Argentina did the wrong thing of Brazil did the wrong thing and of course every country is always partly to blame for their own crisis. But in fact the big swings of the exchange rate in terms of trade which meant they had to pay double the amount in their own currency, was the major problem. And in the 1990’s the Asian crisis, which is commonly said, wasn’t predicted by anyone in the IMF and later the IMF and other people said oh it was caused by crony capitalism, they were looking at Indonesia and it wasn’t the case at all, it was again big swings in the exchange rate. Because in 1994 China devalued its currency, the price of the dollar, the dollar was 5.5, after the devaluation it was 8.7, then later came down to 8.28 by 1997. So the Chinese currency suddenly had a big competitive edge over other countries. And then Japan in 1995, April, just after the Mexican crisis, in the wake of the Mexican crisis, the dollar went down and the yen went way up, the dollar went down to 78 yen, from April 1995 until the present time, the last month, only the last month did that exchange rate get reached again when the yen rose down below 78. But what happened after that, from April 1995 to June 1998, the dollar went from 78 yen up to 148 yen and that’s what knocked all those currencies off, the dollar was so strong against that period, this was in the great period of the US expansion, the IT revolution, tremendous boom going and a strong dollar over that period, that knocked all those currencies off the crisis. But it was the depreciation of the yen and the RMB that made all those currencies, exchange rates were fixed to the dollar, uncompetitive. Well, I want to talk, use this as an example and go into some depth, not those past historical episodes but the most recent one and the most interesting one and in a way the most important one. But the context of it is that there were 3 great booms, you had the great Regan supply side boom after the tax cuts made the US a more efficient economy, supply side economics came into force. And you had a tremendous expansion from an initial recession due to the tight money to stop the inflation, the 13% inflation, that got down to 4% in 1984 but you had a strong economy with strong tax cuts going ahead under the Regan administration Then you had a 9 month recession, the economy soared then and this moved up to the longest expansion in American history, from 1991 to 2001. And then the third great boom started, the Bush expansion of 2002 and 2008. Now I haven’t talked about when the next one is, we hope, are we in a recovery now, well the last few months or so people say the recovery is shaky. And European growth was much below what people had expected, not much more than 1%. And so this is bad news, if there’s a pause in the recovery. But we have to now get back to what I want to talk about which is the cause of this great crash. Now does anyone know what caused the great crash of 2008. Well, there were reports of, in congress, several reports offered an analysis and they list 10 causes, if you have 10 causes they don’t know what the cause is because, obviously. But there’s one principle cause that was the most important thing of all that was missed and not included. The crisis has 4 acts, like a 4 act play or maybe a Wagner opera. There’s the sub-prime mortgage crisis which crystallised on August 9th and 10th, those 2 days when the central banks pushed out $300 billion in money. The European Central Bank in one day issued €95 billion of new credit, amazing expansion because that had been due to all these terrible toxic assets that had got into the system and securitised. And then the credit ratings agencies just didn’t, were way behind the mark on this and the people who were ahead of it were people like John Paulson who of course dug up and made $5 billion by selling the housing market short buying insurance and these things. The second crisis which people run them together with the sub-prime mortgage crisis was completely different, it was 13 months later. Throughout that period you had weaknesses going on, you had the couple of institutions who were weak and so on but the big bankruptcy of Lehman Brothers which crystallised that. It was in the 3rd quarter of 2008 that the big panic created, caused the aftermath that was so devastating. Then the third part, the economic contraction that I date from 2008, third quarter, going on for a full year, to be ending to the expansion started in 2009. That’s sometimes dated by the national bureau, dated in December 2007 but the second quarter of 2008 came out with 2.8% growth and it was revised downward but it wasn’t, 2 quarters of negative growth is the usual conventional definition of recession. So I date it from the third quarter of 2008 in this. And then the forth part is the European debt deficit fall out of this but it maybe really started with the peak of the Euro in June of 2008. So why the Lehman Crisis of 2008, well the sub-prime mortgage crisis had been managed as I said with that big bailout, what detonated then the Lehman Crisis crash more than a year later. Well, the answer is the Federal Reserve Board let the dollar soar by 30% after 2008. Now let me say at the moment I’m not particularly blaming the Federal Reserve Board for this. The Federal Reserve Board first of all in charge of international monetary policy is not the Federal Reserve at all but the secretary of the treasury, it’s the authority on the exchange rate. But under flexible rates it’s a muddied issue and the fact is that this was one of the problems that created, it wasn’t only that, that showed that the Fed was culpable in this. Because there are 4 symptoms of monetary tightness, remember a lot of people in June 2008 were screaming about the inflation danger. Because the income velocity of money had fallen in half, that’s the ratio of GDP to the money supply. And that had fallen in half, GDP had gone down and the money supply had soared. And certainly especially with high powered, a good part of it was high powered money supply. So monetary tightness, well the interest rates weren’t changing but you got tightness through the soaring dollar, plummeting gold prices, plummeting commodity prices, plummeting inflation rate from, to deflation, and we’ll come to the details in a moment. The price of gold went down from $980 to $720 in October. Oil prices went from, spectacularly from $148 to $33 in 3 months, 2 months, incredible collapse of oil prices. And then monthly inflation rate which was 5 ½ % and one reason why the Fed was tightening in June ’08 to negative in early 2009. Those are the numbers that back this up and so on. And this is what is happening, the red line is the Euro/dollar exchange rates, the dollars per Euro in the rising part and the falling part is the gold price going down. And this is what was happening to the CPI. It was just in March, in this negative part over there, where it goes below the line here in March of ’09 that Bernanke started his QE1 program. Why QE1. The most important thing for the Fed is each month, each year to expand the money supply and expand it evenly over a period, at least under flexible exchange rates. But they need to cover up this mistake, the mistake from the tight money and the deflation. In 2000, in March when he announced QE1 they suddenly announced that the CPI was negative, they announced it was below what it should be and that’s why they put in, that was the motivation for putting in QE1. There’s a book on this that looks at the Fed and what the Fed does, it’s a lot about Bernanke and it lists things on Bernanke’s dashboard, things like the oil price is there and GDP growth and things like that but there’s no CPI index there, there’s no gold price in there, so he needs to put more things on his, what they call his dashboard. The list of 5 or 6 elements that he did look at So a suitor for Lehman, the Korean development backed away because with the soaring dollar it was all much more expensive than any deal made before. And Paulson and Bernanke decided not to save Lehman which was a colossal mistake. Dollar appreciation dealt the final blow. The recession continued with deflation setting in at the end of 2008 and running through the first half of 2009. Then QE1 was announced, mentioned again, then the recovery began around June 2009. But in the fall of 2009, in the spring of 2010 the dollar began to soar against the Euro again. In June 2009 the Euro fell to an even lower point than before at $1.18. The Euro fell to $1.18. So this very strong dollar again choked off the recovery. And then a few months later, this is the long run push of these dollars movement, the cycle, it shows, you can see big upward movements in the dollar and this is a big point of what I’m saying about the problem. G20 meetings in Korea, they considered quantitative limits on imbalances. France assumed the chairmanship of the G20 and President Sarkozy raised the question of international monetary reform, criticising these things along the lines I’ve been criticising also, so I agree really completely with these criticisms. Sarkozy argued that reform of the system is needed to address 3 major issues. Instability of exchange rates, instability of raw material prices, need for improved governance of the system. That really means from a French standpoint less control of it by the US or better control of it by the US. So what kind of systems do you have, international monetary reform, well you had metal-based systems until 1971, dollar was the dominant currency since 1915, the second year of World War 1 and then Bretton Woods revised gold standard was, that was, the articles of agreement accommodated dollar hegemony and they did that by fixing, requiring every country to fix exchange rates. But if one country admitted or represented that it was buying and selling gold freely then it was deemed to be fulfilling that perfectly. So the US has never intervened in the foreign exchange market much at this point. So what they did was, the US fixed the price of, was fixing the price of gold and so the other countries then fixed the dollar which was then the only convertible currency. Another bylaw of the IMF said if you’re fixing a convertible currency you’re deemed to be fulfilling all the requirements of fixing all the other exchange rates of your other members in the system. Well, question, what kind of reform could you have, could Bretton Woods be re-established with a new gold price. Well the price of gold as I said in October 2008 was as low as $720 but it’s about $1,900 today, it’s almost 2½ times. If you restored the dollar to, let’s say you went to the Bretton Woods system the US fixed the price of gold, first of all it would have to be a price that would be at least $2,000 an ounce, maybe $2,500 an ounce number 1. Second the US now holds only a quarter of the world’s monetary gold stock. Europe, the European countries, the European Union countries and Switzerland hold 2/3 of it. So the only group that could fix it would be the European Union and the European Central Bank. But it’s not clear that they would do it and it’s not clear that it would. And then the big problem is with the huge debts that all these countries have, Europe and the United States both have, they’ve all got debt GDP ratios. They’re getting close to 90% or 100%. To make these and these debts convertible into gold seems like a losing proposition, it doesn’t seem to be plausible to do it. If you capitalise the value, someone once made this comment, if you capitalise the value of all future payments of the United States for social welfare payments, they’d run up to $50 or more trillion. Which makes even the US GDP of $15 trillion pale by light. So gold is not in anyone’s ballpark right now, even though the private market thinks that the upshot of all this debt is going to be more inflation and so it quite rightly thinks that there’s a chance of inflation and that’s why the price of gold has gone up to that rate, although I don’t myself believe that inflation is coming up to this. But what I believe needs to be done is to have the dollar/Euro exchange rate, has to be the pillar by which you fix the thing, fix the dollar/Euro exchange rate and then add China to it and have the IMF create, ask the 3 big countries, the Euro, US and China to fix, to be the anchor for a global currency which I would call the INTOR and then go on with it. So before the Euro, here’s the point of why the Euro is, fixing the Euro is the place to start, because you’ve got the dollar and the Euro areas. Before the Euro came in you can see that the dollar is number 1 dominating currency, but after the creation of the Euro then this created a rival to the dollar. The Europe area became a rival to the dollar, very close to it and it’s got 14 African countries tied to it and expanding countries, maybe ultimately 25 or 26 countries in the Euro zone will be in the Euro and this will be comparable to the dollar. But what it means is that the dollar used to be the anchor for most currencies, if any country fixed their currency to the dollar they could be deemed to be satisfying more or less a fixed exchange rate system. But now with the big swings in the dollar/Euro exchange rate you don’t have that any longer and a big problem for countries like Hong Kong and even China that fix their currencies more or less to the dollar. But that doesn’t give them fixed exchange rates, they have huge problems when there are big swings between the dollar/Euro rate and that is something that needs to be corrected. So the creation of the Euro severed the role of the US as the mainstream of the world economy and now it makes the dollar less universal as the unit of account. The continued role of the dollar for oil prices is not assured. It’s still there with the alliance between the US and Saudi Arabia but it’s not a done deal and there’s opposition to it. The dollar is less useful as an anchor because of third country effects. Now countries, we need to have a world currency, the proposals that Bretton Woods called for a world currency, the Keynes proposal, called it bancor. The White proposal of the US treasury called it unitas. But world currency didn’t get accepted I think because 1944 was a presidential election year. And it wasn’t good politics in the United States. Then the world currency was objected but then they agreed to the SDR’s, the Special Drawing Rights which was supposed to be the embryo of a world currency. And that recognised the need for a world currency, although the SDR was never allowed to take off. So you can’t have an international monetary system with these big swings in the dollar/Euro exchange rate, so the case for fixing it is definitely there. Paul Volcker the former chairman of the Fed and advisor to Obama, says a global economy needs a global currency. If you have fixed the dollar/Euro rate suddenly and you stabilise that and you coordinate monetary policy and you jointly fix the exchange rate, each supporting the other currency at the bottom, then you have now a new dominance of the mainstream of the world economy. And other countries could then fix that on and then if you, this is the way you would go about doing it, if you add China to it and in the process you have to coordinate monetary policy so you have to make an agreement to China to give up sterilising its balance of payments surpluses so there’ll be an adjustment to it. And you get to an equilibrium system because China now has enough reserves, then you would have 50% of the world economy covered by this, in this central core with just 3 decision makers in it and coordinated by the IMF. This would be a great deal for all the other countries, a wonderful deal for Russia which has terrible problems whenever the dollar/ Euro rate changes. And a big problem for, as I say for Hong Kong and for Latin America and for Africa when the dollar/Euro rates change. So the INTOR would be the basic pivot based on the Euro/dollar and China is the anchor. And countries would have power in the system in proportion to their quotas in the IMF as they’re being adjusted. Thank you.

Robert Mundell on the Need for a World Currency
(00:26:36 - 00:27:10)

Mundell holds huge swings of the U.S. dollar-euro exchange rate liable for financial problems of every country in the world as almost all countries relate their currencies to the U.S. dollar zone and Eurozone, respectively. Both zones represent 40 percent of the world economy. Mundell therefore envisions a stable U.S. dollar-euro rate as anchor with China as third largest currency area joining the U.S. dollar-Eurozone.

Crisis as Chance? – The 2012 Nobel Peace Prize and Its Global Effects
Aside from economic reasoning, public actions of high symbolic relevance foster international solidarity and coherence. In 2012, the Nobel Peace Prize was awarded to the European Union – exactly at a time when the global financial crisis still had a firm hold on national economies: With a still high U.S. jobless rate of over 8 percent, with dramatic high youth unemployment rates of over 50 percent in southern European states such as Greece and Spain, with social unrest and the threat of disintegration, with talks of Greece’s expulsion from the Eurozone, the Nobel Peace Prize poses an unambiguous symbol of affirmation and encouragement to keep up fostering integration, solidarity and peace. Accordingly, the timing of the award doesn’t seem to be a coincidence. In its statement, the Nobel Peace Prize Committee emphasized the EU’s historical role in promoting peace and spreading democracy during the last decades:

“[F]or over six decades [the EU has] contributed to the advancement of peace and reconciliation, democracy and human rights in Europe”. [1]

In his opening speech at the 2011 Lindau meeting on Economic Sciences, Federal President Christian Wulff underscores the meaning of transatlantic relations between Europe and the U.S. Both countries share the same foundational values of peace, social justice and democracy as well as the fundamental objective of combining economic and social progress. Within the framework of a common value system, Wulff envisions a “global domestic policy” aiming to acknowledge mutual interdependencies and enforcing commonly defined goals. Since the European and U.S. financial and economic crises have dramatic effects on national economies especially in emergent and developing countries, Wulff refers to America’s and Europe’s exemplary role and calls on them to act responsibly by fostering long-term sustainable economic growth within the international context.

Christian Wulff on Europe's and America's Exemplary Role
(00:17:13 - 00:17:52)

So far, both the U.S. and the European Union could prevent government shutdowns and live up to their principal cause of securing peace and unity within their borders. Coordinated fiscal support, coupled with EU-IMF-mandated austerity measures and severe federal budget cuts, is by far not sufficient to restore national economies, but pose a first initial step to make weakened economies able to act again. Will the U.S. and the European Union as key players of the world economy be able to set up a regulatory framework to enforce more responsible market behavior, thereby promoting sustainable growth of the real economy (Wulff)? Will the Eurozone’s wealthiest members be able to call on weaker states to embrace strict governmental measures, without risking popular unrest, conflict and national governments to fall apart? Will monetary authorities learn from their mistakes of the past by providing more transparency (Scholes) and by basing their calculations on more efficient analyzing tools – on a new paradigm, as Joseph Stiglitz calls for? And finally, will the U.S., Europe and China enter a global currency coalition by implementing a joint world currency unit (Mundell) to foster economic and financial stability? The future will show whether financial and governmental agents can take on new responsibilities to address effectively the major future challenges of economic and financial globalization.

Patricia Edema

[1] http://www.nobelprize.org/nobel_prizes/peace/laureates/2012/press.html

Additional Lectures by the Nobel Laureates Associated with the Global Financial Crisis:
Robert Mundell 2004: The Case for a World Currency.
Joseph Stiglitz 2008: The Global Financial Crisis: Lessons for Policy and Implications for Economic Theory.
Myron Scholes 2008: The Role of Liquidity and Risk Transfer Services in the Economy.
Edmund Phelps 2008: The Good Life Needs an Economy of Dynamism - Originality, Novelty, and Challenge - and these depend on Attitudes as much as Institutions.
Roger B. Myerson 2011: Roger B. A Model of Moral-Hazard Credit Cycles.
Sir James Mirrlees 2011: Poverty, Inequality, and Food.
Christopher Pissarides 2011: The Future of Work in Europe.
Myron Scholes 2011: Quantitative Finance and the Intermediation Process.


Cite


Specify width: px

Share

Cite


Specify width: px

Share