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.

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)

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)

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