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Appeared in: Volume 4, Number 3
Published on: January 1, 2009
"The Worst Possible World"

Francis Fukuyama talks with Martin Wolf, the Financial Times’ chief economics commentator about structural fixes for a post-meltdown world.

AI: I presume you heard Alan Greenspan’s testimony before Congress this past October, in which he admitted that he had been wrong in a number of policy decisions he made as Chairman of the Federal Reserve. You have exonerated Greenspan from the criticism that he should have pricked the housing asset bubble years ago using interest rates to do so, but surely there was a lot that he as Fed Chairman could have done to prevent the current debacle.

Martin Wolf: Yes, the question of the role of the Federal Reserve in the leadup to the crisis is quite fascinating. As a general rule, you cannot attribute all asset bubbles to Fed policy, but rather to global macroeconomic conditions, some of which the Fed bears no responsibility for—particularly the level of long-term interest rates, which monetary policy does not determine. But it’s possible to argue that Greenspan should have directed a somewhat tighter monetary policy in those years in which the Fed was worried about deflation, which at that stage turned out to be not worth worrying about.

The point is that monetary policy would have to have been very much tighter to prevent the asset price bubble. We’re not talking about a percentage point or two. We’re talking about five or six. That would have meant really no recovery and, after the stock market bubble, a long period of stagnation in the U.S. economy, at best. I simply don’t see how the Fed Chairman could have done that and expected to survive.

AI: Could they have done more on the regulatory side?

Martin Wolf: It’s clear that the regulatory decisions of the Fed were peculiar. They were of the temper of the time, when the general view was that markets should be allowed to do their thing because they were self-regulating. But the Fed took it to extreme degrees, discouraging the idea of regulating the banking system or regulating mortgage origination. On the contrary, there was very powerful encouragement, not just from the Fed but also from Congress, obviously, for the extension of home ownership to people with marginal income for this purpose.

If the U.S. government, at Greenspan’s urgings, had made a much more determined regulatory effort to look at who was getting the loans and the conditions at which the loans were being made (in terms of loan-to-value ratios, in terms of the rating agencies, in terms of the securitization process, in terms of the off-balance sheet activities of banks and the capitalization of banks)—if they had taken all these things together and tightened up substantially, it would undoubtedly have made a difference in eliminating some of the worst lending practices. But since the underlying objective was to get the economy going, the result might have been even looser monetary policy and bad lending somewhere else.

So one mustn’t exaggerate the role that regulation might have played. Greenspan now obviously accepts, as I do, of course, that a different sort of regulation would have helped in eliminating the worst sorts of lending and banking practices. We would have gotten more transparency, and presumably loans would have gone more to people who could actually afford them.

AI: There’s a political consensus now that we need more regulation of the financial sector once we’re past the current crisis. You’ve had an interesting dialogue with your Financial Times colleague John Kay, who has suggested that it’s really not possible to do that. The regulatory lag will never be fully closed because the financial sector has better people, moves faster and is less bureaucratic than the government. How do we design a system nimble enough to keep up with regulatory arbitrage and the things the financial institutions may do in the future?

Martin Wolf: First of all, I’m hoping that there is a future for some sort of market capitalism. It’s very early to think about the regulatory system after this crisis because we’re so obviously not even through the beginning of it. There is so much still to happen that will undoubtedly shape not just the regulatory climate but also what sort of financial system survives at the end.

In the first few months of this year, as it happened (when I thought we’d see a pretty serious financial event, but one that could be managed less painfully then turned out to be the case), I did make some suggestions on regulation. I looked very carefully at the suggestions that came out of the Financial Stability Forum and the Institute for International Finance representing the banks. That is all completely irrelevant now. It is clear that the crisis is of such scale and severity—the most complete breakdown in the financial system, I think, that has ever occurred—that we’re really going to have to go back to scratch. We need to think from first principles about what sort of financial system we want and what sort of regulation there should be.

Broadly speaking, there are two choices and one big issue. One choice is to go back to the Glass-Steagall world. In that world you have banks that are essentially utilities, because you’d never allow much of the banking system to disappear (at least the big banks are too big to fail). They would have what amounts to a very lucrative franchise from the government—namely, to create money. Many people have never thought about it, but in fact most of the money created in our societies is created by banks, and the government stands behind that money in various ways and also, of course, literally prints it. Then banks use the money to run the payment system and to lend money to a vast range of small businesses and households. They’re really better at doing this than anyone else, because they have contacts with these people.

These banks would be run, as I say, as utilities. You would regulate them very tightly in terms of the kinds of assets they could hold, and they would essentially be lending institutions for the sorts of activities I have described. They would not be engaged in derivatives activities. They would not be engaged in any of the casino-like betting activities, proprietary trading or the rest of what much of Wall Street has engaged in.

That would be the regulated core. For the rest—investment banks, mutual funds and so forth—there would be loose regulation, similar to what we have in the Securities and Exchange Commission but probably tightened a bit. The basic point to make would be that engaging with these institutions is dangerous. Much of what they tell you is a lie, because it’s based on privileged information they have and you don’t. It’s a bit of a casino. When they tell you that you’re always going to do well buying stocks in the long run…well, it depends on what “long” means.

So the rest of the financial system would be recognized for the very risky place it inherently is, and the public would be made very well aware of that. This world would be back to Glass-Steagall in spades.

AI: And the second option?

Martin Wolf: The second possibility is to say that going back to Glass-Steagall is impossible. We can’t separate institutions out in this way, and in any case, we now have these gigantic banking-cum-investment banking firms, which have been merged, and it would be very difficult to disassemble them. We then have to conceive of a regulatory net for the whole system. That would probably mean very seriously curtailing its activities: eliminating most if not all of the over-the-counter derivatives markets and putting everything onto exchanges. One might well have a clearing process, a kind of testing process, for all new derivatives products. After all, we test all new drugs. As we’ve seen, these derivatives products can in their own way be just as dangerous. We would also police the capital ratios of all significant financial firms, whatever they happen to be called. Once their assets got beyond a certain size, they would all have required capital ratios. Thus we would have a uniform regulatory system for the whole financial system, and a much tighter one than anything we’ve yet seen.

AI: What about the international dimension?

Martin Wolf: Of course, anything we do will have to be done globally (unless we now see the disintegration of the whole international financial system within nations, which is possible). One of the things we’ve learned is that it’s incredibly easy to create huge problems because institutions operate across borders. Which country is responsible for the liabilities of which institutions, and where? Is the government of Iceland responsible for the deposits taken by Icelandic institutions in Britain? That’s one of the issues we’re now discussing.

Similarly, bankruptcy procedures are problematic. I’m no expert on this, but very big difficulties arose because of the way Lehman Brothers went bankrupt and the way that’s being handled in the United States, even though much of its activities are carried out in London and elsewhere.

There are gigantic issues about making it global, but I would go back to the conceptual issue. Either we have utilities on the one hand plus a casino on the other, and they’re kept separate, or we do the whole thing together, in which case we would end up policing it much more tightly than before. The possibility of going, as some in America are now recommending, to the absolute, total, free market in which banks and financial institutions do whatever they like and are simply allowed to fail is just one of those fantasies that the American libertarian Right indulges in from time to time. It should be ignored.

AI: It seems to me that the first option you’ve outlined poses many dangers. Even if you go back to the Glass-Steagall world, the casino part can still run out of control and impose a lot of costs on everyone else.

Martin Wolf: Absolutely. What I’ve described is John Kay’s position, and my argument against John is the one you’ve just raised. I’ve actually had this argument with very senior central bankers, and their view is that, yes, John’s view is very attractive, but in the end governments cannot ignore what the casino does, because even if you tell people that they shouldn’t be dealing with it, nonetheless it can become very powerful. People will put money into it because it offers such big rewards, and when it implodes, governments can’t just stand by.

The one, big lesson of history—at least over the past century or so—is that governments just cannot stand by when the financial system implodes. This is why I believe that the second option is the one we’re going to be driven towards. But I would like to stress that there is that other option, and it has some real attractions, if you think the government can somehow manage to live with the casino. There would be standard conduct of business rules, fraud and all these things still subject to the law. But basically government could just stand by and watch them all collapse. Whether it can really do that is a very big question.

AI: I think it’s interesting that Europe has organized itself behind Gordon Brown, while the United States has been largely absent in terms of international leadership in responding to the crisis. Is this just a result of the American interregnum because of our election, or does it suggest a future for European leadership as we move forward? The other interesting part of this is that it has really been governments and not multilateral institutions that have been doing the important responding and negotiating. Does this tell you anything about how the world is going to respond to a crisis like this in the future?

Martin Wolf: I don’t suppose it’s any great secret that I lack any admiration for the present U.S. Administration. Its performance has generally been very poor. Though I think the Fed has actually handled the crisis rather well, the Treasury has created some real problems and made some real mistakes. And of course, at the head of the Administration there’s no moral authority within the United States, let alone outside the United States. I hope desperately that will not be the case from January 20 on, because we can’t fix any of these problems without U.S. involvement.

First of all, the United States must fix itself, because we’ve now had an absolutely clear demonstration of the fact that for the foreseeable future the United States will remain the world’s superpower, in both directions: It retains a unique capacity to do good as well as a unique capacity to do harm when things go wrong. So we’ll need American leadership and active engagement in constructing the new world.

But I do hope the Europeans will add a useful voice to this. Some of them have done not too badly in this crisis. It came rather late in the day, but Gordon Brown and the Bank of England provided crucial conceptual leadership in dealing with the crisis, which has been followed by the Europeans and now by the Americans, as well. In a vacuum, someone has to take a leadership role, and I’m pleased somebody did. God knows where we’d be otherwise. But the United States remains indispensable. Of course, I also hope the discussion will include other important powers, most notably China and Japan.

In this area as well as many others, perhaps I hope too much for the new Obama Administration. One of my concerns is that we do not have the sort of dreadfully prolonged transition, which has been the case in previous changes of administration, particularly in changes of party. The world just doesn’t have the ten months it seems to take to put in place a new Administration. I hope Mr. Obama understands that. He seems like an organized man. I hope that he’s already worked out whom he’s going to put forward and that, with a Democratic Congress, they will be confirmed very quickly.

AI: And what about the role of international organizations?

Martin Wolf: I’m not really surprised that in a crisis of this magnitude there is little that international organizations can do—with one important qualification. In the end, dealing with a crisis like this, at its core, comes down to money. The only institutions with lots of money are governments. And the only institutions with unchallengeable money, as it were, are the solvent governments of G-7 nations and, above all, the United States. So it is inevitable that governments and the central banks that are their creatures have to take the leading role when a financial crisis reaches this sort of scale.

In the case of the coordination among governments of expenditures of money in the trillions, no international organization can possibly have the legitimacy to intervene, as it were, to impose itself between governments talking to one another. The IMF, however, can play an important role in this regard in its surveillance function, in putting forward ideas, in acting as a secretariat in certain respects—this is the qualification I mentioned just a moment ago. The IMF has played a useful role in its reports, particularly the Global Financial Stability Report, in setting out the risks and perhaps shaping a common understanding of the problem. The IMF can also play a very useful role on behalf of poorer countries whose access to credit has been severely limited, and whose governments are unable to borrow in their own currencies. The IMF by itself may not be big enough for this purpose, but it nonetheless has an important role to play. The Bank of International Settlements has played a role in the past. But once a crisis hits, it is inevitably inter-governmental, even in Europe, because that’s ultimately where the power to tax resides.

Of course, we do need international agreement and conversations about the regulatory regimes we’re after. Presuming we still have a global financial system—and that’s a big “if”—I hope we’ll try to set up a body of financial regulators with shared rules and principles, everybody trying to do more or less the same thing. I hope that body will look at all the problems and agree on how they’re to be handled: the structure of the financial system, the capital requirements of the financial system, the counter-cyclicality of those requirements, liquidity, the management of derivatives, the management of bankruptcies and bailouts. There’s a long list of things for which we really are going to have to agree on a set of rules of the type we have in the trade arena.

AI: Last question: We’ve seen the fall of the dollar, which seemed to signal the unwinding of the structural imbalances you have written about with such insight. But, particularly since the September and October turmoil, the dollar has climbed again. It seems that, for all the problems in the American economy, people still think of the United States as the only safe haven for their money. Does this mean that we’re still far from unwinding the world’s structural deficits? Can the United States continue to rely more or less indefinitely on this flow of liquidity or capital into the country?

Martin Wolf: I have no idea how long this period of panic-stricken reflow will go on. I suspect that a lot of it has to do with the implosion of hedge funds. They have to dump assets in order to pay back dollar-based investors, who are particularly prone to taking risks. This is why stocks are falling all around the world. So it may turn out to be temporary.

It’s clear, though, as you suggest, that this whole story leaves us with a terrible dilemma in terms of the overall global pattern of demand and spending. The desirable way to get out of this crisis is for those parts of the world not as affected by the bubbles to expand demand, to reduce their surpluses or to go into deficits, allowing countries like the United States, the United Kingdom and Spain to essentially export their way out of this, getting toward more balanced economies and smaller deficits. That’s the ideal thing.

As a matter of fact, however, what is happening is that the weakening of demand is becoming global. Far from offsetting the weakness of demand, particularly in the United States, the actions of surplus-holding countries are probably going to multiply it. That means that the more the United States succeeds in adjusting, the greater the slowdown in the rest of the world, and the more of a global recession we get. So we’re caught in a rather horrible dilemma.

What is now happening will simplify the problem somewhat for the rest of the world. They will continue to run surpluses. But they will be doing so by what is essentially a “beggar-your-neighbor” process or a “bail out the United States” process. If the United States over the next two years loses its export growth—and it’s very plausible that it will, given the slowdown in the rest of the world and the movement of the dollar—then the recession in the United States will be even deeper, precisely because the rest of the world is not adjusting to this in the way I would like to see it. One of the real nightmares of the next two or three years is that everything will be pushed back into the United States.

Now, the problem the United States has is that in the next two or three years, the only way it can sustain global demand in the context of a rising dollar and weak demand in the rest of the world is by massively increasing the U.S. Federal deficit. Going for an enormous fiscal boost is basically the right policy, but it will create problems in the longer term, in terms of the debt the United States will accumulate, the ultimate costs of servicing it and even, in the longer run, the credibility of the dollar. So I think the United States has gotten itself into a very big problem in this most recent aspect of the crisis. For the rest of the world, a policy of U.S. fiscal stimulus makes life a bit easier, but it can only be a temporary solution.

What I’ve been saying for years now is that this is not a stable or desirable way of sustaining demand in the world. I don’t see how you can get the U.S. private sector to spend again that way, even if you drove interest rates down to zero, which we might well be seeing quite soon. But at the limit, I suppose you should go back and look at Ben Bernanke’s stuff on helicopter money. If there’s no alternative, that’s what we’ll see: The United States will continue to print money and distribute it around the population. It’s the least bad outcome, but it’s a palliative that doesn’t solve the larger problem and may make it worse.

Again, this comes down to huge failures in international economic diplomacy and huge failures in managing the global system, which will be exacerbated rather than solved in the wake of this crisis.

AI: That’s a cheery note to end on…

Martin Wolf: It’s very difficult to be cheery at the moment, I must say. Thinking back on everything I’ve written about this, I believe we are in the worst possible world now. Not quite, perhaps. We do still have a banking system. But of the alternative outcomes which one could have imagined a year or so ago, we are certainly in the extremely bad end. So it’s really quite difficult to be cheerful, unfortunately. I wish I could be.

Francis Fukuyama talks with Martin Wolf, the Financial Times’ chief economics commentator about structural fixes for a post-meltdown world.
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