C. Peter McColough Series on International Economics: The Global Financial Crisis - Causes and Consequences

MODERATOR: This meeting is part of a Peter McCullough series on international economics. The next meeting will be on November 4th, in which Richard Posner will be the speaker.

I guess one of the oldest cliches in American life is for the moderator to introduce a speaker and announce that he doesn't need an introduction, and then proceed to give him a long introduction. Well, this speaker doesn't need an introduction, and I'm not going to give him one. (Laughter.) So I introduce to you Mr. Alan Greenspan. (Applause.)

ALAN GREENSPAN: (Off mike.) (Laughter.)

(Audience remarks and laughter off-mike.)

GREENSPAN: Sing a song.

MODERATOR: You know, since -- since the chairman and I are of the almost identical age, I feel free to say this. Everybody wants to have a course on anger management. I've been proposing a course on aging management. And I think it's far more imposing a requirement.

He'll be here in just a moment. (Pause.)

GREENSPAN: There's a first for everything. Usually when Pete introduces me, and as he's done that for generations, I think, there's always a zinger at the end. I didn't catch one, and it threw me off, and I don't know what to do about it. I guess you're trying to be increasingly kindly to me as we both go on in years.

MODERATOR: It was neutral, I thought.

GREENSPAN: Oh. Okay. (Laughter.) The small -- little, small morsels I accept.

Let me start off with a general view of what's been going on over the past year and what it implies about the future, to the extent that we can infer it.

The Lehman default was one of the most extraordinary economic events in global financial history. It's remarkable in so many different characteristics that I don't think that until we look back upon it, over the years, we will recognize this as truly a once in either a century or a once in 80 year event.

The critical characteristic of this particular period is perhaps shown by the extent to which short-term credits, which are the strongest part of any financial intermediary system, collapsed.

Under all circumstances that you can think of, in modestly severe financial crises, long-term debt collapses. You cannot sell anything over five years or three years or two years. Or as New York City recognized, when it was heading towards bankruptcy, the maturity kept shrinking and shrinking and shrinking.

But we almost never find a situation in which short-term debt disappears. It did in 1907, when the coal money rate literally had no offerings for 24 hours. And it did in part in the '30s on occasion.

But none were as severe as the one we are going through, because when the Lehman crisis hit, within days, you began to see the whole collapsing of the system and especially for trade credit.

Trade credit is something we rarely think about, and one of the reasons it's one of the really bread-and-butter pieces of transactions and product that the banking system offers. It virtually disappeared or in certain cases, the price went to 600 basis points over LIBOR, effectively shutting down the market.

The result was a collapse in export trade of unprecedented proportions around the world. You could look country by country, and every single one of them had a flat export pattern for a very long period of time, and then they all went off the cliff, and essentially simultaneously.

The other aspect of this was in the other parts of the short end of the money market, which got also very sharply constricted. And here it's a mixed problem, because one of the consequences of the extraordinary fall in exports was a dramatic backing up of inventories in transit. I mean, we don't think very much about how long it takes to go from the Port of Los Angeles to Shanghai, but just think in terms of what happens if you slam the door on the import capability of a number of countries and you have all of this inventory in place. It backs all the way up.

And then, of course, we have the extent to which this and the backup of inventories in the sort of -- what I would call the regular economies; the effect was to create a huge buildup overall, worldwide, in days' supply of inventory, which collapsed industrial production. And industrial production went straight down virtually everywhere.

And if there ever was any doubt that we got ourselves into a truly global economic environment in the last decade or so, those doubts were put to rest with -- on September the 15th and immediately thereafter of 2008.

On top of this, we had a $17-trillion decline in the market value of listed stocks around the world. This happened in six weeks, and it disabled the financial intermediary system. Because remember what that system is all about. We have got, in corporations -- and, in fact, in any borrowing institution -- a capital buffer which exists that supports the debt. Debt ratings of any company or any institution are a function of how much capital buffer there exists at market values.

And when you bring down that buffer significantly, you erode the credit rating, all of the debt. Debt prices fall dramatically. And so the combination of the market collapse on equities plus the decline in the market value of all forms of debt removed a very large chunk of the collateral from the intermediary system, and it essentially immobilized it. And the effect was worldwide and unremitting.

In the United States, we saw very much all of those patterns and a very dramatic rise in the unemployment rate. Now, it's interesting in the fact that our unemployment rate has gone up far faster than most anybody else's. And the reason, essentially, is American business very evidently assumed that the crisis which was emerging after Lehman was going to be far more severe than it actually turned out to be.

And you can tell that by the fact that the total number of hours worked during this period went down more than did the GDP -- which, of course, the GDP fell quite significantly. And the result of that was that we had sort of a meaningless increase in output per hour. I mean, it didn't reflect efficiency; it merely reflected the fact that the business community squeezed the labor force by reducing average weekly hours and very substantial layoffs to a point where we are now at a level where the processes by which employment can start to pick up again are emerging, because we are really -- we don't have enough people to staff the level of economic activity we have, and essentially, where, I think, we are basically going.

The -- needless to say, the profits fell very sharply during the immediate aftermath of Lehman. But because of the major cost reductions that were going on, they overdid it. But the consequences, obviously, were that profit margin opened up, and profits are moving reasonably significantly.

The question is -- this particular period is very important, because how one evaluates it matters a great deal to what we do with respect to financial reform. If it's a once-in-a-century event, that is essentially what you would expect to happen -- mainly, this particular crisis -- once in a century.

And the reason is very interesting. Central bankers have always been aware of the fact that because risk-based management systems of necessity place enough capital to meet virtually every contingency to which they can think -- but I say virtually all, because were they to try to cover the so-called negative-risk tail, that would require capital being in place all the time, or being useful and productive only extremely rarely.

Now, financial intermediaries -- without getting into the nature of what causes all of this -- cannot function unless they have extraordinary leverage. And a problem that you have here is that when you get into this type of situation, you would expect that that once in a century, or once in 80 years, will happen. And when it happens, it's by definition incapable of being handled by the private sector alone.

And that -- I remember a seminar I was involved in 10 years ago in which we were discussing this hypothetical, and it sure looked hypothetical from any context. But what we recognized is that when that happens, the central banks have to step in and substitute sovereign credit for the private credit, which is precisely what has happened. And it may have stumbled around a bit with TARP and a variety of other means, but the TARP was very important and -- that is the Troubled Asset Relief Program, where the Treasury put capital into the banks. That helped very significantly to stabilize the system.

And then, what occurred was a remarkable phenomenon, which probably is the consequence of the fact that stock prices are never viewed as something which governments control. So we had this huge selling climax, basically in March of this year, and it reflected the extremes to which you could carry the notion of fear. In other words, human beings accept increasing fear only up to a point, history shows. And when you get to this level, at the level we reached in March, it starts to resist. And the markets began to stabilize. And going from an extreme negative to zero change was an -- actually a significant plus. And indeed, we have since recovered very significantly.

And the total amount of equity recovery since March is $15 (trillion), $17 trillion globally, and it's almost 5 trillion (dollars), incidentally, in the United States.

I've always argued -- and I think the evidence is increasingly the case -- that stock prices, to be sure, as everyone agrees, is a leading indicator of economic activity, but I think it is demonstrable that it also is a cause of economic activity, and replenishing the market value of capital reversed -- very significant part of the process of the disabling of the financial intermediary system. And the result of that, as we are acutely aware, has been economies going up in not only in the United States but worldwide.

And I think that if we could forecast the market continuing to rise -- and it's been fighting everybody's negative forecasts; I don't think it means anything, but the Dow went to 10,000 yesterday, because that just means that either Dow or Jones got up on the wrong side of the bed in the early stages and fixed the level of the index -- but it is relevant, only, if nothing more, is to put it on the front pages, as it did this morning, of the newspapers.

The argument is going to arise as to whether or not it's the stimulus or the capital gains which have repopulated the financial system and causing a remarkable collapse in risk spreads -- whether that's been the -- (inaudible) -- pushing or, I should say, the motivating factor of the nature of the recovery we're going through.

There's an awful lot to say on these issues, and I think they will probably be arising in the question period, and I think I better stop there, because the clock says I'm already over time. (Applause.)

MODERATOR: Mr. Chairman, some of us are having a little trouble adjusting to all the implications of the unprecedented numbers that we're hearing on the fiscal deficit side.

We casually talk about a trillion-and-a-half-dollar deficit, several times what it's been before. We casually talk about nearly another $10 trillion over the next 10 years, which would double the public debt. Some of us are concerned about the outlook for foreign debt as our current accounts remain high, though they are falling. This implies a huge amount of Treasury financings, it seems to me.

And I wonder whether we're being a little too easy and glib in assuming the market can absorb that level of financing at reasonable rates. And to what extent do you -- are you concerned about the implications of this huge increase in public and perhaps foreign debt?

GREENSPAN: Well, I think, Pete (sp), it's the most worrisome aspect of the economic agenda in the United States. It's not true throughout the rest of the world. And you've taught me over the years, having spent more time on this issue than anybody I know, very productively, it's something you just cannot push under the covers somewhere.

I frankly think that one of the most unfortunate events that occurred in the United States was the emergence of budget surpluses -- because, remember, it was the dot-com boom and the huge revenue surge that occurred as a consequence of that that basically eliminated all of the notions of fiscal restraint that had emerged during the early 1990s.

And, indeed, there was very significant movement -- the wonderful issue of trying to get a vote in the House and -- basically in the House in restraining the budget deficit back then. And we did build in a PAYGO system. We built in a lot of restraints that I think, had we been required to adhere to them subsequent to the surplus disappearance, we'd be in far better shape.

And what strikes me here as very unfortunate is the fact that people say, look, in the 1990s we were crying wolf on the deficit and all the dangers. Then it disappeared. Now, how do I know this one won't disappear? And the answer is, you don't, but you should very well presume that it won't.

And indeed if anything, the numbers that you're citing and the numbers we're looking at out there are probably underestimates of what the actual true most accurate estimate, of the long-term prospects, are.

You've been in government. I've been in government. And you know what happens in those various calculations. You always assume, when confronted with uncertainties about whether A will happen or B will happen, you always choose the most favorable one.

And reality doesn't like that, and it seems to cause problems. So I think this is a far more severe problem, mainly because of the issue of the markets essentially crying wolf once before.

MODERATOR: How do you see it manifesting itself in the marketplace, this?

GREENSPAN: Well, it's very interesting because we have just done -- confronted with this extraordinary set of circumstances, essentially in the money market, we've put together sets of equations which try to capture how one evaluates, what are the implications of, for example, the Federal Reserve doubling its balance sheet?

And the issue there is that you get some remarkable correlations on the rate of inflation with two factors. One factor is one every forecaster uses, which is the degree of slack in the system. And indeed there is no question that that has a very major economic impact.

And those who are arguing that inflation is dead, for an indefinitely long period of time, are arguing, we're not going to close that gap very quickly. But there is another.

There is another variable in that equation, which is what I call unit money supply, which is the dollar value of the money supply divided by the capacity of nonforeign business sector. And that has an even higher correlation but with a three-year lag.

And so you have a sort of slack effect variable with a three- quarter lag and another one with a three-year lag, so that if it's just looking at the economy as it worked historically, without any anticipatory elements in this equation, you don't get inflation emerging, because of all of the actions that have been occurring in both fiscal and monetary policy, for several years, but then it takes over.

And all history tells you -- as indeed so does this econometric equation -- that in the simplest terms, if the claims, aggregate claims, on the amount of goods rises relative to the physical amount of goods, inflation rises.

And it's got to. We define price as the value of the currency relative to the value of the good. So forgetting all of the econometrics every -- when you pump out huge amounts of debt issuance, which ultimately puts pressure on the central bank to essentially accommodate it in one form or the other, inflation takes hold. And what concerns me is, because it is unlikely to be a near-term phenomenon -- indeed, our forecast is that the rate of inflation is going to fall into next year, into the early first and second quarter of next year -- but then after, it begins to stabilize, and gradually rises.

The missing issue is, I do not have in that equation any what economists call anticipatory variables, because people begin to anticipate what's going on out there, and that will begin to affect the yield on long-term interest rates because a 30-year has a very substantial part of its value in, you know, five to 20 -- five to 30 years out.

So you begin to see it in areas of rising long-term interest rates and declining exchange rates. Now, I'm not overly concerned about the most recent decline in the dollar, for example, because remember, the dollar surged when the crisis began, as we still are conceived of as a safe haven. And we're now back to the levels of just prior to the crisis.

So it's not as though we've, you know, come all the way down, but it's very difficult not to look out over the future and make the case for a strong dollar with the size of fiscal problems which remain to this day unattended to.

MODERATOR: Now, some things seem to have happened in the last few years that at least I've never seen before, and what does that say to you? Does it suggest that maybe our models of more financial markets have got some flaws in them? What do you take out of these series of unprecedented events that have taken place?

GREENSPAN: Yeah. Pete, I think that's why it is critical to make the judgment as to whether this is truly a once-in-a-century event which is encompassed in the whole structure of risk management that has developed over the last 50 years, which has spawned innumerable Nobel prizes, has been embraced by the academic community, and explains a goodly part of what goes on in the world.

If this is truly, as I suspect it is, a once-in-a-century event, then we're essentially saying, yes, this is part of what we expect to happen, we expect it to happen extremely rarely; but events that happen extremely rarely do happen. And when you're living through them, it doesn't feel as though it's a one-in-a-hundred shot; it feels like it's one out of one.

And this means that a goodly part of our supervisory regulatory debate is not quite focused -- and truly it's very difficult to focus -- on whether this is a major breakdown in the financial system. Well, first of all let me say it is a breakdown. The question is that conventional historic theory always expects that there will be periodic breakdowns because no risk-management model covers all conceivable possibilities of capital.

But you can use that as a -- it's the standard lingo that everyone would use all the time, but it means something. And you've got to make -- before you decide to -- before you decide to make major changes in the system, you've got to answer the question, is this something which is rare but not out of the concept of conventional wisdom, so to speak?

Or are we actually looking at a change in the way the system fundamentally functions?

MODERATOR: Well, let me be sure I understand. What's your conclusion on that question?

GREENSPAN: Well, my conclusion basically is, I think it's not an aberration. It is an extremely rare event. But economics is an imprecise science, and we often look back on events which made no sense at the time and recognize that there were seminal changes which altered our way of thinking. I don't think that is true, but I can't rule out the possibility, knowing that all economics -- indeed, all of the social sciences, to a large extent -- basically are probabilistic and not as exact as we would like them.

MODERATOR: All right. Let me -- my final question relates to health care, health-care costs. We speak with great pride that we're going to have some new benefits that are deficit-neutral. And you have some of us who've been railing about the long-term problems, about which this does nothing. For example, as you know, Alan, Medicare's unfunded liabilities and promises are about $38 trillion. It strikes me that the specter of this long-term problem on health care is not being addressed. So how do you assess what's going on on health care?

GREENSPAN: Well, I've said publicly that I think that the criterion for the reform bill should not be revenue-neutral, but to recognize that before we started all of these discussions and negotiations, that by what I would consider somewhat optimistic assumptions, that Medicare was only half funded for, say, the year 2030. And in this particular reform bill, a lot of the offsets which create it being revenue-neutral are the types of easy cuts in the overall unified budget which one could look to to sort of resolve the broader issue that you're raising.

So the notion here that we are doing enough on the cost-side strikes me as not quite right. We have to do far more in recognizing that our major fiscal problem is not the stimulus; it's not even all the monies we've spent in TARP and elsewhere. It's basically a much bigger issue, which is, you know, the $38 trillion unfunded liability.

I find when you use that number, people just get numb. I mean, it doesn't tell them anything. But it is real; and it says that we either have to increase revenues or decrease spending by enough to take away that whole issue. It's very evident that if you try to do all of it on the tax-side, it would probably squeeze the economy to the point that the actual size of the tax base would decline, and you would -- probably would only get part of the revenues you thought, so that you can't get around the issue that part of the solution arithmetically is that some benefits have to be cut.

And it strikes me that what we're looking at is what every other country looks at: that if you have open-ended subsidized third-party pay-for-fee systems as the way we have, you've got to find some way to ration it. You cannot just allow it to keep going. If you -- if it weren't subsidized, then market forces would ration it.

Look, medical care used to be fully rationed by market forces. We just don't like to use the word today, but that's what we are confronted with. The aggregate amount of demand for medical services over the years -- and if you just even think what could happen.

Well, I mean, we're only in the early stages of transplant medicine, which are extremely expensive operations.

I mean, you could begin to see an extraordinary technological change, where I wouldn't say "Six Million Dollar Man" is about produced here, but medical technology's doing extraordinary wonders.

And as you've pointed out, we spend far more, many multiples more, on high-tech medicine using all forms of equipment, in which the evidence of improved life expectancy or low morbidity is not there, so that the system is broken. And I'm not certain that we've really confronted the fundamental issues that we're going to have to confront to bring our medical system in line with what we ultimately must have, which is a sound non-inflationary fiscal system that -- out, you know, 10, 20 years.

MODERATOR: I take it that you dared to mention the word "rationing" -- that you're not anticipating public office in any way. (Laughter, groans.)

GREENSPAN: Well, I was, and I was trying to head it off. (Laughter.)

MODERATOR: Yeah, I see. (Chuckles.)

Okay. This meeting, incidentally, is on the record. We'll turn to you now for questions. I think that's what the schedule allows. Yes, sir.

QUESTIONER: (Off mike) -- very much. Marshall Sonenshine, Sonenshine Partners. Mr. Greenspan, you've argued, I think persuasively, here and elsewhere of the rarity of the financial crisis and the fact that its solution would not efficiently be found in the hoarding of excess reserves over long periods of time in the private markets.

But a question about financial regulatory reform still would seem apt for the circumstances, and that of course was a subject that was well in hand and developed under the prior administration, well before the financial crisis, going back to the blueprint by the Treasury Department under Secretary Paulson.

Are there some fixes -- and accepting we may be due for some level of -- some form of financial regulatory reform anyway. We have a patchwork of -- as we know, a patchwork of regulatory structures that are understandable historically but may not be optimal. Are there some elements of regulatory reform which might efficiently help mitigate even the rare crises that you say might be one in 80 years or a hundred years, they -- we humans crave mitigation of risk when the consequences are dire.

And we are pretty good at finding ways to do that.

Are there some elements, at least with hindsight, as we look back through the prism of the crisis, some elements of financial regulatory reform which might be efficient ways to steer the economy and the financial system clear of these types of grave dangers?

GREENSPAN: Most certainly.

Remember that when you're dealing with a market-based system, you have innovations occurring all the time. And not all innovations work. Indeed, you know, few people realize that Edison probably had more failures than successes.

And the issue of our system, which is essentially a creative destruction system, has many failures. And one of the purposes of a market system is to clean them out.

It is very evident to me for example that the amount of capital that the financial intermediaries were required to hold, in a regulatory sense, was much too low despite the fact that there's a very famous sentence or two, in a Spring 2006 Federal Deposit Insurance Corporation document, which said more than 99 percent of insured institutions met or exceeded the highest regulatory standards of the regulatory agencies.

One year later, that was trashed completely. So the question is, did we have too low capital? The answer is unquestionably yes. A great deal of the problems that can -- that are there and which are broken and have to be fixed. In other words, I'm arguing that we have to repair the system.

It is broken, but that doesn't mean we replace it. And that means significantly higher capital. It means that we do numbers of things, like for example trying to get an increasing proportion of derivatives standardized and put on centrally clearing systems or on exchanges.

The critical problem that we have, which we've got to resolve, is the too-big-to-fail issue. That is to me the major issue which is, if we do not confront it, we are going to be in terrible shape. Because remember, the purpose of a financial system is to take the scarce savings of a society, plus what it may -- the savings it may borrow from abroad, like our current account deficit, and invest them in a manner in which physical assets are produced that create the highest rate of growth and output per hour.

To the extent that you use those savings to prop up obsolescent companies or obsolescent industries or those which are too big to fail, which almost by definition are obsolescent, that savings is not also available for cutting-edge technologies which create the advances in productivity and, therefore -- (word inaudible) -- standards of living.

Now, there are innumerable other adjustments which will be made, should be made, and that's what the debate is going to be all about.

MODERATOR: On this side, back there, please.

QUESTIONER: Ben Upham (sp), Clarin (sp) Capital. It's often said that you're either learning or making money in the markets. And so we've learned a lot in the last year and a half. My question would be, what long-term structural changes do you think should be and will be learned from this crisis for the U.S. consumer? Savings is sort of the one that everyone goes to, but I would hope there'd be more lessons than just that.

GREENSPAN: Well, are you asking basically about the notion about a consumer -- consolidating all consumer financial affairs in one agency? I'm not quite sure what the nature of the question is.

QUESTIONER: So rather than from a government perspective, what ought the U.S. consumers sort of as a group, in aggregate, change the way they interact? For example, current account deficit would be one. Saving, investment --

GREENSPAN: You're talking about the --

QUESTIONER: (Off mike.)

GREENSPAN: I see. You're talking -- okay. Yeah.

Well, I think this is what markets are supposed to do. In other words, the fundamental purpose of markets is to infer the value preferences of the society as it's manifested in prices, and essentially invest or save. And this is one of the reasons why the financial system is a critical player.

There's a general belief that finance is just a casino in which people make money, lose money, do lots of things, but make no major contribution to our society. Financial intermediation -- and which really comes out of -- the old goldsmiths started fractional banking -- has turned out to be a remarkable human invention which has enhanced the standards of living of hundreds of millions of people over time.

And I think that we have to recognize that that system does work, but there are cases when it runs off the track. And one of the reasons it runs off the track is not essentially because the system itself is bad. It reflects what it wants to reflect, the -- what is out there to be reflected.

But there is an extraordinary cycle in human nature which goes from euphoria to fear in a remarkably consistent manner over the generations. The only way that that is going to change is if human nature changes, and there's no evidence that that's the case. So what we have to do is adjust to the fact that we will periodically be confronted with big euphorias and big bubbles.

Because, remember, a necessary and probably a sufficient condition for a bubble is a protracted period of prosperity, low inflation, and usually low long-term interest rates. When that happens, you begin to get major aberrations in the economy, and then eventually it burns itself out or something else happens, and you get the reverse, as we observed in the most extraordinary circumstances in the last several years.

So aside from the basic market forces, I don't think we've got a great deal of protection against ourselves, if I may put it that way.

MODERATOR: All right. On the side, in the back, please. Right here. (Pause.) I was pointing to the woman right here.

QUESTIONER: Julia Coronado with BNP Paribas. Mr. Chairman, I know you're a big fan of the Federal Reserve's flow of funds accounts, and I'm wondering, how do you interpret the unprecedented and savage contraction in private credit creation that is still ongoing? Despite the fact that the stock markets improved and credit spreads have come in, private credit is still being destroyed at a -- to me, at an alarming pace. And how does that inform your view of both economic activity and inflation?

GREENSPAN: Yeah, well, first, remember, where part of it is coming from is the dramatic decline in inventories.

In other words, the rate of inventory liquidation is utterly unprecedented. Since a significant proportion of those inventories come -- are financed by commercial and industrial loans, as well as consumer loans and other things, you would expect an extraordinary contraction in credit as the credit-financed part of the economy comes down as sharply as it would. But over and above that, we've had an extraordinary number of layers of financial intermediation, one on top of the other, where you go from mortgages, to mortgage-backed securities, to collateralized debt obligations, to collateralized debt obligations squared. And the system of mathematicians who've been employed by Wall Street have invented every crazy way in which you could pyramid on the system.

A goodly part of that pyramid has come down, and it has eliminated a lot of the multiple-layered types of things -- some of which, frankly, I think are good, and they will come back; others of which are of a type of failed innovation, and they won't come back, and shouldn't.

QUESTIONER: And how does that -- (audio break) -- does this process -- (audio break)?

GREENSPAN: Yeah, it -- it's not influencing economic activity, for one important reason; that the sharp increase in the market value of equity worldwide has enabled credit spreads to come down very dramatically. And it's not the outstanding credit, or even the credit availability per see, the abstract, that finances economic activity. It's interest rates.

And if you get, for example, CCC corporate junk bonds -- about as bad as they get and still be capable of being sold -- those have been one of the most dramatic capital gains in recent months, as the spreads have all come down. So that in the sense that the financing system is gradually returning to normal, it's not quite there because, for example, banks are still going to experience losses -- or I'll put it the other way around. They've experienced losses, but they haven't acknowledged them yet.

And they're still there and they're still creating a problem.

And even though the OIS-LIBOR spread is back to normal, we are still looking at fears, on the part of loan officers, that they don't have enough capital to trust lending out to other people, for fear it won't come back. But that's gradually dissipating. And I'm not sure that's the problem that really confronts us.

MODERATOR: Right here in the fourth row.

Thank you.

QUESTIONER: Thank you. (Inaudible.)

Mr. Chairman, how specifically should we address the issue of "too big to fail"?

GREENSPAN: What? I'm sorry.

QUESTIONER: How specifically should we address the issue of financial institutions that are too big to fail?

GREENSPAN: If they're too big to fail, they're too big. (Laughter.)

I -- this one has got me. And the reason it's got me is that we no longer have the capability of having credible government response which says, henceforth no institution will be supported because it is too big to fail.

In other words, we could believe that. And I used to go up and testify, up until Fannie and Freddie essentially went into conservatorship, that the law said that full faith in credit does not -- is not backing Fannie and Freddie. And I could say with a straight face, with my fingers crossed, that that's what the law says. I presume the law will be enforced.

The Wall Street practitioners didn't believe it. And they gave essentially a 20-basis-points subsidy, to Fannie and Freddie, because they believed that it was not risky debt. They turned out to be right, and the government turned out to be wrong. It's going to be very difficult to reproduce the credibility again. Because when push came to shove, they didn't stand up to the pledge.

I think -- I mean, I hate to think of just arbitrarily breaking down organizations into various different sizes. At a minimum, you've got to take care of the competitive advantage they have, because of the implicit subsidy, which makes them competitively capable of beating out their smaller competitors, who don't get the subsidy.

And if you don't neutralize that, you're going to get a moribund group of obsolescent institutions, which will be a big drain on the savings of this society.

So I don't have a simple solution, but that something has to be done. There is no doubt in my mind -- and I don't think merely raising the fees or capital on large institutions or taxing them is enough. I think that'll -- they'll absorb that; they'll work with it; and they will still be inefficient; and they'll still be using the savings.

So I mean, radical things, as you -- you know, break them up, you know. In 1911, we broke up Standard Oil. So what happened? The individual parts became more valuable than the whole. Maybe that's what we need.

MODERATOR: Right here in the third -- fourth row.

QUESTIONER: Good morning. Brian O'Neill. Mr. Chairman, I'd like to build on the question earlier on regulatory framework, as well as on this "too big to fail" question. If 8,000 or so commercial banks in the United States at -- I guess, at most, they'd claim maybe 25 percent of credit intermediation -- a lot of the credit intermediation is done away from the regulated commercial bank system. And look at the concerns now about commercial real estate finance and the shutdown of the securitization markets related to that sector. What does "too big to fail" mean when nonbank credit markets are (3-X ?) the regulated system?

GREENSPAN: Well, I think "too big to fail" is a bad policy anywhere, because it is wholly contrary to the very structure of what make markets work. If you want to have a different type of system, you can go to a basically central planning type of system -- which it doesn't have "too big to fail." Everything is just controlled by government and nothing fails, which is one of the problems.

Failure is an integral part, a necessary part of a market system. When you talk about creative destruction, remember, what you're talking about is that you use the depreciation reserves or depreciation charges, plus of obsolescent declining facilities, plus the new savings of society, to invest in the cutting-edge technologies whose output per hour is higher than the average.

And so that if you knock out a low company or reduce its size and raise the other, the average goes up.

If you start focusing on those who should be shrinking, it undermines growing standards of living and could even turn them down.

So if you want the benefits of a market economy -- and they are huge, even granted they periodically go into the types of problems we see -- you've got to allow failure to occur. Unless you do that, the system will not work, and people who talk about, you know, open markets and everything else like that, that's meaningless if there's not failure in the system.

MODERATOR: Okay. Way back on the lefthand side, please. Yes. Yes.

QUESTIONER: Thank you. Nina Rosenwald, American Securities. A few days ago in The Wall Street Journal, there's an article by Lawrence Kadish predicting that if we don't -- if we're not more careful about the service on the debt that's growing, the national deficit, we could possibly destroy the economy. Do you have any thoughts on that?

GREENSPAN: Well, I think that's an arithmetical question. It's very obvious that the amount of debt service -- or, more specifically, let's just talk in terms of interest, as the aggregate size of the outstanding debt times the average interest on the debt. And clearly, as the debt increases in size -- doubles, triples -- interest payments go up proportionately. And you will soon find that, under the type of forecast we're making, they become the very largest part of outlays.

And there are simple mathematical calculations which can demonstrate to you that there are occasions in which certain relationships become progressively explosive. In other words, the large increase in interest payments increases the deficit and increases the debt, which in turn increases the interest payments, which increases the deficit and the debt, and that does not converge.

And I don't say we're there at this particular stage, but we're approaching it. And I must say that throughout my lifetime, I've always been aware of the fact that we never allowed federal debt in this country, going all the way back to Alexander Hamilton, to come anywhere close to our capacity to fund it. And that cushion that we always kept out there was one of the reasons why the dollar was such an important currency in the world and why we eventually became -- we displaced sterling in the latter part of the 19th century and have held to that position every since.

We're getting to the point where we're getting ever closer to where the capacity to fund that debt is. I don't know where that level is. Nobody knows. But there is no question that the cushion is going down. And we will learn very quickly when we're getting close, which is when long-term rates begin to move, inflationary pressures begin to build, and that's very late in the game to turn it around.

MODERATOR: All right, right up here, please.

QUESTIONER: Luck Komisar. I'm a journalist. What would you do about credit default swaps? Do you think that they should be permitted only by parties that have skin in the game? And should we ban them being used as casino chips by third and fourth and tenth parties?

GREENSPAN: Well, let me just say that credit default swaps as a concept is a very valuable addition to a financial system, because what it does is -- at least what it was supposed to do was largely move the credit risk from those who initiated it, which were institutions which were highly leveraged, to those who had much greater capacity to absorb losses.

And indeed, in the very early years, the credit default swaps were a very valuable instrument. Because we went through the telecom catastrophe, when too many telecom operators were doing something which only one of them could do as a natural monopoly, and there were a huge number of defaults. And not a single financial institution ran into any problem, and largely because of credit default swaps.

Now, I suspect that it was that success which ultimately ballooned the whole system into a point where, in 2005, the New York Federal Reserve, as Bill would know very well, began to operate -- that's Bill McDonough, former president, the Federal Reserve Bank of New York, who is a great colleague and a wonderful guy to deal with. In any event, in 2005, they began to have very serious questions about how the -- the plumbing was working.

I used to argue that we had this 21st-century product in which the back-office operations were done with 19th-century technology -- the telephone, the pencil and the pad -- and it just was scary, because nobody knew what they had agreed to.

And I think what we have run into is a critical problem here in which the contracts read that those who essentially give out the protection have the right to get back the actual asset which is being protected when it defaults. And when you've got 10 times the number of credit default swaps per unit that we're working with, it cannot work. Right at the moment, it works in part largely because everyone is willing to voluntarily take cash, but that's not what the contract says.

And there's something structural which we have to work at. There are a lot of little issues about having skin in the game or -- there was an interesting, I thought a very interesting Financial Times editorial the other day, in which they talked about the question of merely being a hedger, official hedger, should allow you to play in the game, so to speak.

It's an issue which I think has got to be resolved. I hope that we don't forget that this is actually a potentially very useful instrument in the financial intermediary system, but it surely requires some really major restructuring.

MODERATOR: Mr. Chairman, I trust your ego has withstood the assault of a lack of a fulsome introduction by myself. (Soft laughter.) You seem to be able to function without it.

GREENSPAN: Do you want to remedy that, or -- (Laughter.)

MODERATOR: That would change our whole relationship. (Laughter.)

Okay. Thank you all very much. (Applause.)

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THIS IS A RUSH TRANSCRIPT.

MODERATOR: This meeting is part of a Peter McCullough series on international economics. The next meeting will be on November 4th, in which Richard Posner will be the speaker.

I guess one of the oldest cliches in American life is for the moderator to introduce a speaker and announce that he doesn't need an introduction, and then proceed to give him a long introduction. Well, this speaker doesn't need an introduction, and I'm not going to give him one. (Laughter.) So I introduce to you Mr. Alan Greenspan. (Applause.)

ALAN GREENSPAN: (Off mike.) (Laughter.)

(Audience remarks and laughter off-mike.)

GREENSPAN: Sing a song.

MODERATOR: You know, since -- since the chairman and I are of the almost identical age, I feel free to say this. Everybody wants to have a course on anger management. I've been proposing a course on aging management. And I think it's far more imposing a requirement.

He'll be here in just a moment. (Pause.)

GREENSPAN: There's a first for everything. Usually when Pete introduces me, and as he's done that for generations, I think, there's always a zinger at the end. I didn't catch one, and it threw me off, and I don't know what to do about it. I guess you're trying to be increasingly kindly to me as we both go on in years.

MODERATOR: It was neutral, I thought.

GREENSPAN: Oh. Okay. (Laughter.) The small -- little, small morsels I accept.

Let me start off with a general view of what's been going on over the past year and what it implies about the future, to the extent that we can infer it.

The Lehman default was one of the most extraordinary economic events in global financial history. It's remarkable in so many different characteristics that I don't think that until we look back upon it, over the years, we will recognize this as truly a once in either a century or a once in 80 year event.

The critical characteristic of this particular period is perhaps shown by the extent to which short-term credits, which are the strongest part of any financial intermediary system, collapsed.

Under all circumstances that you can think of, in modestly severe financial crises, long-term debt collapses. You cannot sell anything over five years or three years or two years. Or as New York City recognized, when it was heading towards bankruptcy, the maturity kept shrinking and shrinking and shrinking.

But we almost never find a situation in which short-term debt disappears. It did in 1907, when the coal money rate literally had no offerings for 24 hours. And it did in part in the '30s on occasion.

But none were as severe as the one we are going through, because when the Lehman crisis hit, within days, you began to see the whole collapsing of the system and especially for trade credit.

Trade credit is something we rarely think about, and one of the reasons it's one of the really bread-and-butter pieces of transactions and product that the banking system offers. It virtually disappeared or in certain cases, the price went to 600 basis points over LIBOR, effectively shutting down the market.

The result was a collapse in export trade of unprecedented proportions around the world. You could look country by country, and every single one of them had a flat export pattern for a very long period of time, and then they all went off the cliff, and essentially simultaneously.

The other aspect of this was in the other parts of the short end of the money market, which got also very sharply constricted. And here it's a mixed problem, because one of the consequences of the extraordinary fall in exports was a dramatic backing up of inventories in transit. I mean, we don't think very much about how long it takes to go from the Port of Los Angeles to Shanghai, but just think in terms of what happens if you slam the door on the import capability of a number of countries and you have all of this inventory in place. It backs all the way up.

And then, of course, we have the extent to which this and the backup of inventories in the sort of -- what I would call the regular economies; the effect was to create a huge buildup overall, worldwide, in days' supply of inventory, which collapsed industrial production. And industrial production went straight down virtually everywhere.

And if there ever was any doubt that we got ourselves into a truly global economic environment in the last decade or so, those doubts were put to rest with -- on September the 15th and immediately thereafter of 2008.

On top of this, we had a $17-trillion decline in the market value of listed stocks around the world. This happened in six weeks, and it disabled the financial intermediary system. Because remember what that system is all about. We have got, in corporations -- and, in fact, in any borrowing institution -- a capital buffer which exists that supports the debt. Debt ratings of any company or any institution are a function of how much capital buffer there exists at market values.

And when you bring down that buffer significantly, you erode the credit rating, all of the debt. Debt prices fall dramatically. And so the combination of the market collapse on equities plus the decline in the market value of all forms of debt removed a very large chunk of the collateral from the intermediary system, and it essentially immobilized it. And the effect was worldwide and unremitting.

In the United States, we saw very much all of those patterns and a very dramatic rise in the unemployment rate. Now, it's interesting in the fact that our unemployment rate has gone up far faster than most anybody else's. And the reason, essentially, is American business very evidently assumed that the crisis which was emerging after Lehman was going to be far more severe than it actually turned out to be.

And you can tell that by the fact that the total number of hours worked during this period went down more than did the GDP -- which, of course, the GDP fell quite significantly. And the result of that was that we had sort of a meaningless increase in output per hour. I mean, it didn't reflect efficiency; it merely reflected the fact that the business community squeezed the labor force by reducing average weekly hours and very substantial layoffs to a point where we are now at a level where the processes by which employment can start to pick up again are emerging, because we are really -- we don't have enough people to staff the level of economic activity we have, and essentially, where, I think, we are basically going.

The -- needless to say, the profits fell very sharply during the immediate aftermath of Lehman. But because of the major cost reductions that were going on, they overdid it. But the consequences, obviously, were that profit margin opened up, and profits are moving reasonably significantly.

The question is -- this particular period is very important, because how one evaluates it matters a great deal to what we do with respect to financial reform. If it's a once-in-a-century event, that is essentially what you would expect to happen -- mainly, this particular crisis -- once in a century.

And the reason is very interesting. Central bankers have always been aware of the fact that because risk-based management systems of necessity place enough capital to meet virtually every contingency to which they can think -- but I say virtually all, because were they to try to cover the so-called negative-risk tail, that would require capital being in place all the time, or being useful and productive only extremely rarely.

Now, financial intermediaries -- without getting into the nature of what causes all of this -- cannot function unless they have extraordinary leverage. And a problem that you have here is that when you get into this type of situation, you would expect that that once in a century, or once in 80 years, will happen. And when it happens, it's by definition incapable of being handled by the private sector alone.

And that -- I remember a seminar I was involved in 10 years ago in which we were discussing this hypothetical, and it sure looked hypothetical from any context. But what we recognized is that when that happens, the central banks have to step in and substitute sovereign credit for the private credit, which is precisely what has happened. And it may have stumbled around a bit with TARP and a variety of other means, but the TARP was very important and -- that is the Troubled Asset Relief Program, where the Treasury put capital into the banks. That helped very significantly to stabilize the system.

And then, what occurred was a remarkable phenomenon, which probably is the consequence of the fact that stock prices are never viewed as something which governments control. So we had this huge selling climax, basically in March of this year, and it reflected the extremes to which you could carry the notion of fear. In other words, human beings accept increasing fear only up to a point, history shows. And when you get to this level, at the level we reached in March, it starts to resist. And the markets began to stabilize. And going from an extreme negative to zero change was an -- actually a significant plus. And indeed, we have since recovered very significantly.

And the total amount of equity recovery since March is $15 (trillion), $17 trillion globally, and it's almost 5 trillion (dollars), incidentally, in the United States.

I've always argued -- and I think the evidence is increasingly the case -- that stock prices, to be sure, as everyone agrees, is a leading indicator of economic activity, but I think it is demonstrable that it also is a cause of economic activity, and replenishing the market value of capital reversed -- very significant part of the process of the disabling of the financial intermediary system. And the result of that, as we are acutely aware, has been economies going up in not only in the United States but worldwide.

And I think that if we could forecast the market continuing to rise -- and it's been fighting everybody's negative forecasts; I don't think it means anything, but the Dow went to 10,000 yesterday, because that just means that either Dow or Jones got up on the wrong side of the bed in the early stages and fixed the level of the index -- but it is relevant, only, if nothing more, is to put it on the front pages, as it did this morning, of the newspapers.

The argument is going to arise as to whether or not it's the stimulus or the capital gains which have repopulated the financial system and causing a remarkable collapse in risk spreads -- whether that's been the -- (inaudible) -- pushing or, I should say, the motivating factor of the nature of the recovery we're going through.

There's an awful lot to say on these issues, and I think they will probably be arising in the question period, and I think I better stop there, because the clock says I'm already over time. (Applause.)

MODERATOR: Mr. Chairman, some of us are having a little trouble adjusting to all the implications of the unprecedented numbers that we're hearing on the fiscal deficit side.

We casually talk about a trillion-and-a-half-dollar deficit, several times what it's been before. We casually talk about nearly another $10 trillion over the next 10 years, which would double the public debt. Some of us are concerned about the outlook for foreign debt as our current accounts remain high, though they are falling. This implies a huge amount of Treasury financings, it seems to me.

And I wonder whether we're being a little too easy and glib in assuming the market can absorb that level of financing at reasonable rates. And to what extent do you -- are you concerned about the implications of this huge increase in public and perhaps foreign debt?

GREENSPAN: Well, I think, Pete (sp), it's the most worrisome aspect of the economic agenda in the United States. It's not true throughout the rest of the world. And you've taught me over the years, having spent more time on this issue than anybody I know, very productively, it's something you just cannot push under the covers somewhere.

I frankly think that one of the most unfortunate events that occurred in the United States was the emergence of budget surpluses -- because, remember, it was the dot-com boom and the huge revenue surge that occurred as a consequence of that that basically eliminated all of the notions of fiscal restraint that had emerged during the early 1990s.

And, indeed, there was very significant movement -- the wonderful issue of trying to get a vote in the House and -- basically in the House in restraining the budget deficit back then. And we did build in a PAYGO system. We built in a lot of restraints that I think, had we been required to adhere to them subsequent to the surplus disappearance, we'd be in far better shape.

And what strikes me here as very unfortunate is the fact that people say, look, in the 1990s we were crying wolf on the deficit and all the dangers. Then it disappeared. Now, how do I know this one won't disappear? And the answer is, you don't, but you should very well presume that it won't.

And indeed if anything, the numbers that you're citing and the numbers we're looking at out there are probably underestimates of what the actual true most accurate estimate, of the long-term prospects, are.

You've been in government. I've been in government. And you know what happens in those various calculations. You always assume, when confronted with uncertainties about whether A will happen or B will happen, you always choose the most favorable one.

And reality doesn't like that, and it seems to cause problems. So I think this is a far more severe problem, mainly because of the issue of the markets essentially crying wolf once before.

MODERATOR: How do you see it manifesting itself in the marketplace, this?

GREENSPAN: Well, it's very interesting because we have just done -- confronted with this extraordinary set of circumstances, essentially in the money market, we've put together sets of equations which try to capture how one evaluates, what are the implications of, for example, the Federal Reserve doubling its balance sheet?

And the issue there is that you get some remarkable correlations on the rate of inflation with two factors. One factor is one every forecaster uses, which is the degree of slack in the system. And indeed there is no question that that has a very major economic impact.

And those who are arguing that inflation is dead, for an indefinitely long period of time, are arguing, we're not going to close that gap very quickly. But there is another.

There is another variable in that equation, which is what I call unit money supply, which is the dollar value of the money supply divided by the capacity of nonforeign business sector. And that has an even higher correlation but with a three-year lag.

And so you have a sort of slack effect variable with a three- quarter lag and another one with a three-year lag, so that if it's just looking at the economy as it worked historically, without any anticipatory elements in this equation, you don't get inflation emerging, because of all of the actions that have been occurring in both fiscal and monetary policy, for several years, but then it takes over.

And all history tells you -- as indeed so does this econometric equation -- that in the simplest terms, if the claims, aggregate claims, on the amount of goods rises relative to the physical amount of goods, inflation rises.

And it's got to. We define price as the value of the currency relative to the value of the good. So forgetting all of the econometrics every -- when you pump out huge amounts of debt issuance, which ultimately puts pressure on the central bank to essentially accommodate it in one form or the other, inflation takes hold. And what concerns me is, because it is unlikely to be a near-term phenomenon -- indeed, our forecast is that the rate of inflation is going to fall into next year, into the early first and second quarter of next year -- but then after, it begins to stabilize, and gradually rises.

The missing issue is, I do not have in that equation any what economists call anticipatory variables, because people begin to anticipate what's going on out there, and that will begin to affect the yield on long-term interest rates because a 30-year has a very substantial part of its value in, you know, five to 20 -- five to 30 years out.

So you begin to see it in areas of rising long-term interest rates and declining exchange rates. Now, I'm not overly concerned about the most recent decline in the dollar, for example, because remember, the dollar surged when the crisis began, as we still are conceived of as a safe haven. And we're now back to the levels of just prior to the crisis.

So it's not as though we've, you know, come all the way down, but it's very difficult not to look out over the future and make the case for a strong dollar with the size of fiscal problems which remain to this day unattended to.

MODERATOR: Now, some things seem to have happened in the last few years that at least I've never seen before, and what does that say to you? Does it suggest that maybe our models of more financial markets have got some flaws in them? What do you take out of these series of unprecedented events that have taken place?

GREENSPAN: Yeah. Pete, I think that's why it is critical to make the judgment as to whether this is truly a once-in-a-century event which is encompassed in the whole structure of risk management that has developed over the last 50 years, which has spawned innumerable Nobel prizes, has been embraced by the academic community, and explains a goodly part of what goes on in the world.

If this is truly, as I suspect it is, a once-in-a-century event, then we're essentially saying, yes, this is part of what we expect to happen, we expect it to happen extremely rarely; but events that happen extremely rarely do happen. And when you're living through them, it doesn't feel as though it's a one-in-a-hundred shot; it feels like it's one out of one.

And this means that a goodly part of our supervisory regulatory debate is not quite focused -- and truly it's very difficult to focus -- on whether this is a major breakdown in the financial system. Well, first of all let me say it is a breakdown. The question is that conventional historic theory always expects that there will be periodic breakdowns because no risk-management model covers all conceivable possibilities of capital.

But you can use that as a -- it's the standard lingo that everyone would use all the time, but it means something. And you've got to make -- before you decide to -- before you decide to make major changes in the system, you've got to answer the question, is this something which is rare but not out of the concept of conventional wisdom, so to speak?

Or are we actually looking at a change in the way the system fundamentally functions?

MODERATOR: Well, let me be sure I understand. What's your conclusion on that question?

GREENSPAN: Well, my conclusion basically is, I think it's not an aberration. It is an extremely rare event. But economics is an imprecise science, and we often look back on events which made no sense at the time and recognize that there were seminal changes which altered our way of thinking. I don't think that is true, but I can't rule out the possibility, knowing that all economics -- indeed, all of the social sciences, to a large extent -- basically are probabilistic and not as exact as we would like them.

MODERATOR: All right. Let me -- my final question relates to health care, health-care costs. We speak with great pride that we're going to have some new benefits that are deficit-neutral. And you have some of us who've been railing about the long-term problems, about which this does nothing. For example, as you know, Alan, Medicare's unfunded liabilities and promises are about $38 trillion. It strikes me that the specter of this long-term problem on health care is not being addressed. So how do you assess what's going on on health care?

GREENSPAN: Well, I've said publicly that I think that the criterion for the reform bill should not be revenue-neutral, but to recognize that before we started all of these discussions and negotiations, that by what I would consider somewhat optimistic assumptions, that Medicare was only half funded for, say, the year 2030. And in this particular reform bill, a lot of the offsets which create it being revenue-neutral are the types of easy cuts in the overall unified budget which one could look to to sort of resolve the broader issue that you're raising.

So the notion here that we are doing enough on the cost-side strikes me as not quite right. We have to do far more in recognizing that our major fiscal problem is not the stimulus; it's not even all the monies we've spent in TARP and elsewhere. It's basically a much bigger issue, which is, you know, the $38 trillion unfunded liability.

I find when you use that number, people just get numb. I mean, it doesn't tell them anything. But it is real; and it says that we either have to increase revenues or decrease spending by enough to take away that whole issue. It's very evident that if you try to do all of it on the tax-side, it would probably squeeze the economy to the point that the actual size of the tax base would decline, and you would -- probably would only get part of the revenues you thought, so that you can't get around the issue that part of the solution arithmetically is that some benefits have to be cut.

And it strikes me that what we're looking at is what every other country looks at: that if you have open-ended subsidized third-party pay-for-fee systems as the way we have, you've got to find some way to ration it. You cannot just allow it to keep going. If you -- if it weren't subsidized, then market forces would ration it.

Look, medical care used to be fully rationed by market forces. We just don't like to use the word today, but that's what we are confronted with. The aggregate amount of demand for medical services over the years -- and if you just even think what could happen.

Well, I mean, we're only in the early stages of transplant medicine, which are extremely expensive operations.

I mean, you could begin to see an extraordinary technological change, where I wouldn't say "Six Million Dollar Man" is about produced here, but medical technology's doing extraordinary wonders.

And as you've pointed out, we spend far more, many multiples more, on high-tech medicine using all forms of equipment, in which the evidence of improved life expectancy or low morbidity is not there, so that the system is broken. And I'm not certain that we've really confronted the fundamental issues that we're going to have to confront to bring our medical system in line with what we ultimately must have, which is a sound non-inflationary fiscal system that -- out, you know, 10, 20 years.

MODERATOR: I take it that you dared to mention the word "rationing" -- that you're not anticipating public office in any way. (Laughter, groans.)

GREENSPAN: Well, I was, and I was trying to head it off. (Laughter.)

MODERATOR: Yeah, I see. (Chuckles.)

Okay. This meeting, incidentally, is on the record. We'll turn to you now for questions. I think that's what the schedule allows. Yes, sir.

QUESTIONER: (Off mike) -- very much. Marshall Sonenshine, Sonenshine Partners. Mr. Greenspan, you've argued, I think persuasively, here and elsewhere of the rarity of the financial crisis and the fact that its solution would not efficiently be found in the hoarding of excess reserves over long periods of time in the private markets.

But a question about financial regulatory reform still would seem apt for the circumstances, and that of course was a subject that was well in hand and developed under the prior administration, well before the financial crisis, going back to the blueprint by the Treasury Department under Secretary Paulson.

Are there some fixes -- and accepting we may be due for some level of -- some form of financial regulatory reform anyway. We have a patchwork of -- as we know, a patchwork of regulatory structures that are understandable historically but may not be optimal. Are there some elements of regulatory reform which might efficiently help mitigate even the rare crises that you say might be one in 80 years or a hundred years, they -- we humans crave mitigation of risk when the consequences are dire.

And we are pretty good at finding ways to do that.

Are there some elements, at least with hindsight, as we look back through the prism of the crisis, some elements of financial regulatory reform which might be efficient ways to steer the economy and the financial system clear of these types of grave dangers?

GREENSPAN: Most certainly.

Remember that when you're dealing with a market-based system, you have innovations occurring all the time. And not all innovations work. Indeed, you know, few people realize that Edison probably had more failures than successes.

And the issue of our system, which is essentially a creative destruction system, has many failures. And one of the purposes of a market system is to clean them out.

It is very evident to me for example that the amount of capital that the financial intermediaries were required to hold, in a regulatory sense, was much too low despite the fact that there's a very famous sentence or two, in a Spring 2006 Federal Deposit Insurance Corporation document, which said more than 99 percent of insured institutions met or exceeded the highest regulatory standards of the regulatory agencies.

One year later, that was trashed completely. So the question is, did we have too low capital? The answer is unquestionably yes. A great deal of the problems that can -- that are there and which are broken and have to be fixed. In other words, I'm arguing that we have to repair the system.

It is broken, but that doesn't mean we replace it. And that means significantly higher capital. It means that we do numbers of things, like for example trying to get an increasing proportion of derivatives standardized and put on centrally clearing systems or on exchanges.

The critical problem that we have, which we've got to resolve, is the too-big-to-fail issue. That is to me the major issue which is, if we do not confront it, we are going to be in terrible shape. Because remember, the purpose of a financial system is to take the scarce savings of a society, plus what it may -- the savings it may borrow from abroad, like our current account deficit, and invest them in a manner in which physical assets are produced that create the highest rate of growth and output per hour.

To the extent that you use those savings to prop up obsolescent companies or obsolescent industries or those which are too big to fail, which almost by definition are obsolescent, that savings is not also available for cutting-edge technologies which create the advances in productivity and, therefore -- (word inaudible) -- standards of living.

Now, there are innumerable other adjustments which will be made, should be made, and that's what the debate is going to be all about.

MODERATOR: On this side, back there, please.

QUESTIONER: Ben Upham (sp), Clarin (sp) Capital. It's often said that you're either learning or making money in the markets. And so we've learned a lot in the last year and a half. My question would be, what long-term structural changes do you think should be and will be learned from this crisis for the U.S. consumer? Savings is sort of the one that everyone goes to, but I would hope there'd be more lessons than just that.

GREENSPAN: Well, are you asking basically about the notion about a consumer -- consolidating all consumer financial affairs in one agency? I'm not quite sure what the nature of the question is.

QUESTIONER: So rather than from a government perspective, what ought the U.S. consumers sort of as a group, in aggregate, change the way they interact? For example, current account deficit would be one. Saving, investment --

GREENSPAN: You're talking about the --

QUESTIONER: (Off mike.)

GREENSPAN: I see. You're talking -- okay. Yeah.

Well, I think this is what markets are supposed to do. In other words, the fundamental purpose of markets is to infer the value preferences of the society as it's manifested in prices, and essentially invest or save. And this is one of the reasons why the financial system is a critical player.

There's a general belief that finance is just a casino in which people make money, lose money, do lots of things, but make no major contribution to our society. Financial intermediation -- and which really comes out of -- the old goldsmiths started fractional banking -- has turned out to be a remarkable human invention which has enhanced the standards of living of hundreds of millions of people over time.

And I think that we have to recognize that that system does work, but there are cases when it runs off the track. And one of the reasons it runs off the track is not essentially because the system itself is bad. It reflects what it wants to reflect, the -- what is out there to be reflected.

But there is an extraordinary cycle in human nature which goes from euphoria to fear in a remarkably consistent manner over the generations. The only way that that is going to change is if human nature changes, and there's no evidence that that's the case. So what we have to do is adjust to the fact that we will periodically be confronted with big euphorias and big bubbles.

Because, remember, a necessary and probably a sufficient condition for a bubble is a protracted period of prosperity, low inflation, and usually low long-term interest rates. When that happens, you begin to get major aberrations in the economy, and then eventually it burns itself out or something else happens, and you get the reverse, as we observed in the most extraordinary circumstances in the last several years.

So aside from the basic market forces, I don't think we've got a great deal of protection against ourselves, if I may put it that way.

MODERATOR: All right. On the side, in the back, please. Right here. (Pause.) I was pointing to the woman right here.

QUESTIONER: Julia Coronado with BNP Paribas. Mr. Chairman, I know you're a big fan of the Federal Reserve's flow of funds accounts, and I'm wondering, how do you interpret the unprecedented and savage contraction in private credit creation that is still ongoing? Despite the fact that the stock markets improved and credit spreads have come in, private credit is still being destroyed at a -- to me, at an alarming pace. And how does that inform your view of both economic activity and inflation?

GREENSPAN: Yeah, well, first, remember, where part of it is coming from is the dramatic decline in inventories.

In other words, the rate of inventory liquidation is utterly unprecedented. Since a significant proportion of those inventories come -- are financed by commercial and industrial loans, as well as consumer loans and other things, you would expect an extraordinary contraction in credit as the credit-financed part of the economy comes down as sharply as it would. But over and above that, we've had an extraordinary number of layers of financial intermediation, one on top of the other, where you go from mortgages, to mortgage-backed securities, to collateralized debt obligations, to collateralized debt obligations squared. And the system of mathematicians who've been employed by Wall Street have invented every crazy way in which you could pyramid on the system.

A goodly part of that pyramid has come down, and it has eliminated a lot of the multiple-layered types of things -- some of which, frankly, I think are good, and they will come back; others of which are of a type of failed innovation, and they won't come back, and shouldn't.

QUESTIONER: And how does that -- (audio break) -- does this process -- (audio break)?

GREENSPAN: Yeah, it -- it's not influencing economic activity, for one important reason; that the sharp increase in the market value of equity worldwide has enabled credit spreads to come down very dramatically. And it's not the outstanding credit, or even the credit availability per see, the abstract, that finances economic activity. It's interest rates.

And if you get, for example, CCC corporate junk bonds -- about as bad as they get and still be capable of being sold -- those have been one of the most dramatic capital gains in recent months, as the spreads have all come down. So that in the sense that the financing system is gradually returning to normal, it's not quite there because, for example, banks are still going to experience losses -- or I'll put it the other way around. They've experienced losses, but they haven't acknowledged them yet.

And they're still there and they're still creating a problem.

And even though the OIS-LIBOR spread is back to normal, we are still looking at fears, on the part of loan officers, that they don't have enough capital to trust lending out to other people, for fear it won't come back. But that's gradually dissipating. And I'm not sure that's the problem that really confronts us.

MODERATOR: Right here in the fourth row.

Thank you.

QUESTIONER: Thank you. (Inaudible.)

Mr. Chairman, how specifically should we address the issue of "too big to fail"?

GREENSPAN: What? I'm sorry.

QUESTIONER: How specifically should we address the issue of financial institutions that are too big to fail?

GREENSPAN: If they're too big to fail, they're too big. (Laughter.)

I -- this one has got me. And the reason it's got me is that we no longer have the capability of having credible government response which says, henceforth no institution will be supported because it is too big to fail.

In other words, we could believe that. And I used to go up and testify, up until Fannie and Freddie essentially went into conservatorship, that the law said that full faith in credit does not -- is not backing Fannie and Freddie. And I could say with a straight face, with my fingers crossed, that that's what the law says. I presume the law will be enforced.

The Wall Street practitioners didn't believe it. And they gave essentially a 20-basis-points subsidy, to Fannie and Freddie, because they believed that it was not risky debt. They turned out to be right, and the government turned out to be wrong. It's going to be very difficult to reproduce the credibility again. Because when push came to shove, they didn't stand up to the pledge.

I think -- I mean, I hate to think of just arbitrarily breaking down organizations into various different sizes. At a minimum, you've got to take care of the competitive advantage they have, because of the implicit subsidy, which makes them competitively capable of beating out their smaller competitors, who don't get the subsidy.

And if you don't neutralize that, you're going to get a moribund group of obsolescent institutions, which will be a big drain on the savings of this society.

So I don't have a simple solution, but that something has to be done. There is no doubt in my mind -- and I don't think merely raising the fees or capital on large institutions or taxing them is enough. I think that'll -- they'll absorb that; they'll work with it; and they will still be inefficient; and they'll still be using the savings.

So I mean, radical things, as you -- you know, break them up, you know. In 1911, we broke up Standard Oil. So what happened? The individual parts became more valuable than the whole. Maybe that's what we need.

MODERATOR: Right here in the third -- fourth row.

QUESTIONER: Good morning. Brian O'Neill. Mr. Chairman, I'd like to build on the question earlier on regulatory framework, as well as on this "too big to fail" question. If 8,000 or so commercial banks in the United States at -- I guess, at most, they'd claim maybe 25 percent of credit intermediation -- a lot of the credit intermediation is done away from the regulated commercial bank system. And look at the concerns now about commercial real estate finance and the shutdown of the securitization markets related to that sector. What does "too big to fail" mean when nonbank credit markets are (3-X ?) the regulated system?

GREENSPAN: Well, I think "too big to fail" is a bad policy anywhere, because it is wholly contrary to the very structure of what make markets work. If you want to have a different type of system, you can go to a basically central planning type of system -- which it doesn't have "too big to fail." Everything is just controlled by government and nothing fails, which is one of the problems.

Failure is an integral part, a necessary part of a market system. When you talk about creative destruction, remember, what you're talking about is that you use the depreciation reserves or depreciation charges, plus of obsolescent declining facilities, plus the new savings of society, to invest in the cutting-edge technologies whose output per hour is higher than the average.

And so that if you knock out a low company or reduce its size and raise the other, the average goes up.

If you start focusing on those who should be shrinking, it undermines growing standards of living and could even turn them down.

So if you want the benefits of a market economy -- and they are huge, even granted they periodically go into the types of problems we see -- you've got to allow failure to occur. Unless you do that, the system will not work, and people who talk about, you know, open markets and everything else like that, that's meaningless if there's not failure in the system.

MODERATOR: Okay. Way back on the lefthand side, please. Yes. Yes.

QUESTIONER: Thank you. Nina Rosenwald, American Securities. A few days ago in The Wall Street Journal, there's an article by Lawrence Kadish predicting that if we don't -- if we're not more careful about the service on the debt that's growing, the national deficit, we could possibly destroy the economy. Do you have any thoughts on that?

GREENSPAN: Well, I think that's an arithmetical question. It's very obvious that the amount of debt service -- or, more specifically, let's just talk in terms of interest, as the aggregate size of the outstanding debt times the average interest on the debt. And clearly, as the debt increases in size -- doubles, triples -- interest payments go up proportionately. And you will soon find that, under the type of forecast we're making, they become the very largest part of outlays.

And there are simple mathematical calculations which can demonstrate to you that there are occasions in which certain relationships become progressively explosive. In other words, the large increase in interest payments increases the deficit and increases the debt, which in turn increases the interest payments, which increases the deficit and the debt, and that does not converge.

And I don't say we're there at this particular stage, but we're approaching it. And I must say that throughout my lifetime, I've always been aware of the fact that we never allowed federal debt in this country, going all the way back to Alexander Hamilton, to come anywhere close to our capacity to fund it. And that cushion that we always kept out there was one of the reasons why the dollar was such an important currency in the world and why we eventually became -- we displaced sterling in the latter part of the 19th century and have held to that position every since.

We're getting to the point where we're getting ever closer to where the capacity to fund that debt is. I don't know where that level is. Nobody knows. But there is no question that the cushion is going down. And we will learn very quickly when we're getting close, which is when long-term rates begin to move, inflationary pressures begin to build, and that's very late in the game to turn it around.

MODERATOR: All right, right up here, please.

QUESTIONER: Luck Komisar. I'm a journalist. What would you do about credit default swaps? Do you think that they should be permitted only by parties that have skin in the game? And should we ban them being used as casino chips by third and fourth and tenth parties?

GREENSPAN: Well, let me just say that credit default swaps as a concept is a very valuable addition to a financial system, because what it does is -- at least what it was supposed to do was largely move the credit risk from those who initiated it, which were institutions which were highly leveraged, to those who had much greater capacity to absorb losses.

And indeed, in the very early years, the credit default swaps were a very valuable instrument. Because we went through the telecom catastrophe, when too many telecom operators were doing something which only one of them could do as a natural monopoly, and there were a huge number of defaults. And not a single financial institution ran into any problem, and largely because of credit default swaps.

Now, I suspect that it was that success which ultimately ballooned the whole system into a point where, in 2005, the New York Federal Reserve, as Bill would know very well, began to operate -- that's Bill McDonough, former president, the Federal Reserve Bank of New York, who is a great colleague and a wonderful guy to deal with. In any event, in 2005, they began to have very serious questions about how the -- the plumbing was working.

I used to argue that we had this 21st-century product in which the back-office operations were done with 19th-century technology -- the telephone, the pencil and the pad -- and it just was scary, because nobody knew what they had agreed to.

And I think what we have run into is a critical problem here in which the contracts read that those who essentially give out the protection have the right to get back the actual asset which is being protected when it defaults. And when you've got 10 times the number of credit default swaps per unit that we're working with, it cannot work. Right at the moment, it works in part largely because everyone is willing to voluntarily take cash, but that's not what the contract says.

And there's something structural which we have to work at. There are a lot of little issues about having skin in the game or -- there was an interesting, I thought a very interesting Financial Times editorial the other day, in which they talked about the question of merely being a hedger, official hedger, should allow you to play in the game, so to speak.

It's an issue which I think has got to be resolved. I hope that we don't forget that this is actually a potentially very useful instrument in the financial intermediary system, but it surely requires some really major restructuring.

MODERATOR: Mr. Chairman, I trust your ego has withstood the assault of a lack of a fulsome introduction by myself. (Soft laughter.) You seem to be able to function without it.

GREENSPAN: Do you want to remedy that, or -- (Laughter.)

MODERATOR: That would change our whole relationship. (Laughter.)

Okay. Thank you all very much. (Applause.)

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THIS IS A RUSH TRANSCRIPT.

MODERATOR: This meeting is part of a Peter McCullough series on international economics. The next meeting will be on November 4th, in which Richard Posner will be the speaker.

I guess one of the oldest cliches in American life is for the moderator to introduce a speaker and announce that he doesn't need an introduction, and then proceed to give him a long introduction. Well, this speaker doesn't need an introduction, and I'm not going to give him one. (Laughter.) So I introduce to you Mr. Alan Greenspan. (Applause.)

ALAN GREENSPAN: (Off mike.) (Laughter.)

(Audience remarks and laughter off-mike.)

GREENSPAN: Sing a song.

MODERATOR: You know, since -- since the chairman and I are of the almost identical age, I feel free to say this. Everybody wants to have a course on anger management. I've been proposing a course on aging management. And I think it's far more imposing a requirement.

He'll be here in just a moment. (Pause.)

GREENSPAN: There's a first for everything. Usually when Pete introduces me, and as he's done that for generations, I think, there's always a zinger at the end. I didn't catch one, and it threw me off, and I don't know what to do about it. I guess you're trying to be increasingly kindly to me as we both go on in years.

MODERATOR: It was neutral, I thought.

GREENSPAN: Oh. Okay. (Laughter.) The small -- little, small morsels I accept.

Let me start off with a general view of what's been going on over the past year and what it implies about the future, to the extent that we can infer it.

The Lehman default was one of the most extraordinary economic events in global financial history. It's remarkable in so many different characteristics that I don't think that until we look back upon it, over the years, we will recognize this as truly a once in either a century or a once in 80 year event.

The critical characteristic of this particular period is perhaps shown by the extent to which short-term credits, which are the strongest part of any financial intermediary system, collapsed.

Under all circumstances that you can think of, in modestly severe financial crises, long-term debt collapses. You cannot sell anything over five years or three years or two years. Or as New York City recognized, when it was heading towards bankruptcy, the maturity kept shrinking and shrinking and shrinking.

But we almost never find a situation in which short-term debt disappears. It did in 1907, when the coal money rate literally had no offerings for 24 hours. And it did in part in the '30s on occasion.

But none were as severe as the one we are going through, because when the Lehman crisis hit, within days, you began to see the whole collapsing of the system and especially for trade credit.

Trade credit is something we rarely think about, and one of the reasons it's one of the really bread-and-butter pieces of transactions and product that the banking system offers. It virtually disappeared or in certain cases, the price went to 600 basis points over LIBOR, effectively shutting down the market.

The result was a collapse in export trade of unprecedented proportions around the world. You could look country by country, and every single one of them had a flat export pattern for a very long period of time, and then they all went off the cliff, and essentially simultaneously.

The other aspect of this was in the other parts of the short end of the money market, which got also very sharply constricted. And here it's a mixed problem, because one of the consequences of the extraordinary fall in exports was a dramatic backing up of inventories in transit. I mean, we don't think very much about how long it takes to go from the Port of Los Angeles to Shanghai, but just think in terms of what happens if you slam the door on the import capability of a number of countries and you have all of this inventory in place. It backs all the way up.

And then, of course, we have the extent to which this and the backup of inventories in the sort of -- what I would call the regular economies; the effect was to create a huge buildup overall, worldwide, in days' supply of inventory, which collapsed industrial production. And industrial production went straight down virtually everywhere.

And if there ever was any doubt that we got ourselves into a truly global economic environment in the last decade or so, those doubts were put to rest with -- on September the 15th and immediately thereafter of 2008.

On top of this, we had a $17-trillion decline in the market value of listed stocks around the world. This happened in six weeks, and it disabled the financial intermediary system. Because remember what that system is all about. We have got, in corporations -- and, in fact, in any borrowing institution -- a capital buffer which exists that supports the debt. Debt ratings of any company or any institution are a function of how much capital buffer there exists at market values.

And when you bring down that buffer significantly, you erode the credit rating, all of the debt. Debt prices fall dramatically. And so the combination of the market collapse on equities plus the decline in the market value of all forms of debt removed a very large chunk of the collateral from the intermediary system, and it essentially immobilized it. And the effect was worldwide and unremitting.

In the United States, we saw very much all of those patterns and a very dramatic rise in the unemployment rate. Now, it's interesting in the fact that our unemployment rate has gone up far faster than most anybody else's. And the reason, essentially, is American business very evidently assumed that the crisis which was emerging after Lehman was going to be far more severe than it actually turned out to be.

And you can tell that by the fact that the total number of hours worked during this period went down more than did the GDP -- which, of course, the GDP fell quite significantly. And the result of that was that we had sort of a meaningless increase in output per hour. I mean, it didn't reflect efficiency; it merely reflected the fact that the business community squeezed the labor force by reducing average weekly hours and very substantial layoffs to a point where we are now at a level where the processes by which employment can start to pick up again are emerging, because we are really -- we don't have enough people to staff the level of economic activity we have, and essentially, where, I think, we are basically going.

The -- needless to say, the profits fell very sharply during the immediate aftermath of Lehman. But because of the major cost reductions that were going on, they overdid it. But the consequences, obviously, were that profit margin opened up, and profits are moving reasonably significantly.

The question is -- this particular period is very important, because how one evaluates it matters a great deal to what we do with respect to financial reform. If it's a once-in-a-century event, that is essentially what you would expect to happen -- mainly, this particular crisis -- once in a century.

And the reason is very interesting. Central bankers have always been aware of the fact that because risk-based management systems of necessity place enough capital to meet virtually every contingency to which they can think -- but I say virtually all, because were they to try to cover the so-called negative-risk tail, that would require capital being in place all the time, or being useful and productive only extremely rarely.

Now, financial intermediaries -- without getting into the nature of what causes all of this -- cannot function unless they have extraordinary leverage. And a problem that you have here is that when you get into this type of situation, you would expect that that once in a century, or once in 80 years, will happen. And when it happens, it's by definition incapable of being handled by the private sector alone.

And that -- I remember a seminar I was involved in 10 years ago in which we were discussing this hypothetical, and it sure looked hypothetical from any context. But what we recognized is that when that happens, the central banks have to step in and substitute sovereign credit for the private credit, which is precisely what has happened. And it may have stumbled around a bit with TARP and a variety of other means, but the TARP was very important and -- that is the Troubled Asset Relief Program, where the Treasury put capital into the banks. That helped very significantly to stabilize the system.

And then, what occurred was a remarkable phenomenon, which probably is the consequence of the fact that stock prices are never viewed as something which governments control. So we had this huge selling climax, basically in March of this year, and it reflected the extremes to which you could carry the notion of fear. In other words, human beings accept increasing fear only up to a point, history shows. And when you get to this level, at the level we reached in March, it starts to resist. And the markets began to stabilize. And going from an extreme negative to zero change was an -- actually a significant plus. And indeed, we have since recovered very significantly.

And the total amount of equity recovery since March is $15 (trillion), $17 trillion globally, and it's almost 5 trillion (dollars), incidentally, in the United States.

I've always argued -- and I think the evidence is increasingly the case -- that stock prices, to be sure, as everyone agrees, is a leading indicator of economic activity, but I think it is demonstrable that it also is a cause of economic activity, and replenishing the market value of capital reversed -- very significant part of the process of the disabling of the financial intermediary system. And the result of that, as we are acutely aware, has been economies going up in not only in the United States but worldwide.

And I think that if we could forecast the market continuing to rise -- and it's been fighting everybody's negative forecasts; I don't think it means anything, but the Dow went to 10,000 yesterday, because that just means that either Dow or Jones got up on the wrong side of the bed in the early stages and fixed the level of the index -- but it is relevant, only, if nothing more, is to put it on the front pages, as it did this morning, of the newspapers.

The argument is going to arise as to whether or not it's the stimulus or the capital gains which have repopulated the financial system and causing a remarkable collapse in risk spreads -- whether that's been the -- (inaudible) -- pushing or, I should say, the motivating factor of the nature of the recovery we're going through.

There's an awful lot to say on these issues, and I think they will probably be arising in the question period, and I think I better stop there, because the clock says I'm already over time. (Applause.)

MODERATOR: Mr. Chairman, some of us are having a little trouble adjusting to all the implications of the unprecedented numbers that we're hearing on the fiscal deficit side.

We casually talk about a trillion-and-a-half-dollar deficit, several times what it's been before. We casually talk about nearly another $10 trillion over the next 10 years, which would double the public debt. Some of us are concerned about the outlook for foreign debt as our current accounts remain high, though they are falling. This implies a huge amount of Treasury financings, it seems to me.

And I wonder whether we're being a little too easy and glib in assuming the market can absorb that level of financing at reasonable rates. And to what extent do you -- are you concerned about the implications of this huge increase in public and perhaps foreign debt?

GREENSPAN: Well, I think, Pete (sp), it's the most worrisome aspect of the economic agenda in the United States. It's not true throughout the rest of the world. And you've taught me over the years, having spent more time on this issue than anybody I know, very productively, it's something you just cannot push under the covers somewhere.

I frankly think that one of the most unfortunate events that occurred in the United States was the emergence of budget surpluses -- because, remember, it was the dot-com boom and the huge revenue surge that occurred as a consequence of that that basically eliminated all of the notions of fiscal restraint that had emerged during the early 1990s.

And, indeed, there was very significant movement -- the wonderful issue of trying to get a vote in the House and -- basically in the House in restraining the budget deficit back then. And we did build in a PAYGO system. We built in a lot of restraints that I think, had we been required to adhere to them subsequent to the surplus disappearance, we'd be in far better shape.

And what strikes me here as very unfortunate is the fact that people say, look, in the 1990s we were crying wolf on the deficit and all the dangers. Then it disappeared. Now, how do I know this one won't disappear? And the answer is, you don't, but you should very well presume that it won't.

And indeed if anything, the numbers that you're citing and the numbers we're looking at out there are probably underestimates of what the actual true most accurate estimate, of the long-term prospects, are.

You've been in government. I've been in government. And you know what happens in those various calculations. You always assume, when confronted with uncertainties about whether A will happen or B will happen, you always choose the most favorable one.

And reality doesn't like that, and it seems to cause problems. So I think this is a far more severe problem, mainly because of the issue of the markets essentially crying wolf once before.

MODERATOR: How do you see it manifesting itself in the marketplace, this?

GREENSPAN: Well, it's very interesting because we have just done -- confronted with this extraordinary set of circumstances, essentially in the money market, we've put together sets of equations which try to capture how one evaluates, what are the implications of, for example, the Federal Reserve doubling its balance sheet?

And the issue there is that you get some remarkable correlations on the rate of inflation with two factors. One factor is one every forecaster uses, which is the degree of slack in the system. And indeed there is no question that that has a very major economic impact.

And those who are arguing that inflation is dead, for an indefinitely long period of time, are arguing, we're not going to close that gap very quickly. But there is another.

There is another variable in that equation, which is what I call unit money supply, which is the dollar value of the money supply divided by the capacity of nonforeign business sector. And that has an even higher correlation but with a three-year lag.

And so you have a sort of slack effect variable with a three- quarter lag and another one with a three-year lag, so that if it's just looking at the economy as it worked historically, without any anticipatory elements in this equation, you don't get inflation emerging, because of all of the actions that have been occurring in both fiscal and monetary policy, for several years, but then it takes over.

And all history tells you -- as indeed so does this econometric equation -- that in the simplest terms, if the claims, aggregate claims, on the amount of goods rises relative to the physical amount of goods, inflation rises.

And it's got to. We define price as the value of the currency relative to the value of the good. So forgetting all of the econometrics every -- when you pump out huge amounts of debt issuance, which ultimately puts pressure on the central bank to essentially accommodate it in one form or the other, inflation takes hold. And what concerns me is, because it is unlikely to be a near-term phenomenon -- indeed, our forecast is that the rate of inflation is going to fall into next year, into the early first and second quarter of next year -- but then after, it begins to stabilize, and gradually rises.

The missing issue is, I do not have in that equation any what economists call anticipatory variables, because people begin to anticipate what's going on out there, and that will begin to affect the yield on long-term interest rates because a 30-year has a very substantial part of its value in, you know, five to 20 -- five to 30 years out.

So you begin to see it in areas of rising long-term interest rates and declining exchange rates. Now, I'm not overly concerned about the most recent decline in the dollar, for example, because remember, the dollar surged when the crisis began, as we still are conceived of as a safe haven. And we're now back to the levels of just prior to the crisis.

So it's not as though we've, you know, come all the way down, but it's very difficult not to look out over the future and make the case for a strong dollar with the size of fiscal problems which remain to this day unattended to.

MODERATOR: Now, some things seem to have happened in the last few years that at least I've never seen before, and what does that say to you? Does it suggest that maybe our models of more financial markets have got some flaws in them? What do you take out of these series of unprecedented events that have taken place?

GREENSPAN: Yeah. Pete, I think that's why it is critical to make the judgment as to whether this is truly a once-in-a-century event which is encompassed in the whole structure of risk management that has developed over the last 50 years, which has spawned innumerable Nobel prizes, has been embraced by the academic community, and explains a goodly part of what goes on in the world.

If this is truly, as I suspect it is, a once-in-a-century event, then we're essentially saying, yes, this is part of what we expect to happen, we expect it to happen extremely rarely; but events that happen extremely rarely do happen. And when you're living through them, it doesn't feel as though it's a one-in-a-hundred shot; it feels like it's one out of one.

And this means that a goodly part of our supervisory regulatory debate is not quite focused -- and truly it's very difficult to focus -- on whether this is a major breakdown in the financial system. Well, first of all let me say it is a breakdown. The question is that conventional historic theory always expects that there will be periodic breakdowns because no risk-management model covers all conceivable possibilities of capital.

But you can use that as a -- it's the standard lingo that everyone would use all the time, but it means something. And you've got to make -- before you decide to -- before you decide to make major changes in the system, you've got to answer the question, is this something which is rare but not out of the concept of conventional wisdom, so to speak?

Or are we actually looking at a change in the way the system fundamentally functions?

MODERATOR: Well, let me be sure I understand. What's your conclusion on that question?

GREENSPAN: Well, my conclusion basically is, I think it's not an aberration. It is an extremely rare event. But economics is an imprecise science, and we often look back on events which made no sense at the time and recognize that there were seminal changes which altered our way of thinking. I don't think that is true, but I can't rule out the possibility, knowing that all economics -- indeed, all of the social sciences, to a large extent -- basically are probabilistic and not as exact as we would like them.

MODERATOR: All right. Let me -- my final question relates to health care, health-care costs. We speak with great pride that we're going to have some new benefits that are deficit-neutral. And you have some of us who've been railing about the long-term problems, about which this does nothing. For example, as you know, Alan, Medicare's unfunded liabilities and promises are about $38 trillion. It strikes me that the specter of this long-term problem on health care is not being addressed. So how do you assess what's going on on health care?

GREENSPAN: Well, I've said publicly that I think that the criterion for the reform bill should not be revenue-neutral, but to recognize that before we started all of these discussions and negotiations, that by what I would consider somewhat optimistic assumptions, that Medicare was only half funded for, say, the year 2030. And in this particular reform bill, a lot of the offsets which create it being revenue-neutral are the types of easy cuts in the overall unified budget which one could look to to sort of resolve the broader issue that you're raising.

So the notion here that we are doing enough on the cost-side strikes me as not quite right. We have to do far more in recognizing that our major fiscal problem is not the stimulus; it's not even all the monies we've spent in TARP and elsewhere. It's basically a much bigger issue, which is, you know, the $38 trillion unfunded liability.

I find when you use that number, people just get numb. I mean, it doesn't tell them anything. But it is real; and it says that we either have to increase revenues or decrease spending by enough to take away that whole issue. It's very evident that if you try to do all of it on the tax-side, it would probably squeeze the economy to the point that the actual size of the tax base would decline, and you would -- probably would only get part of the revenues you thought, so that you can't get around the issue that part of the solution arithmetically is that some benefits have to be cut.

And it strikes me that what we're looking at is what every other country looks at: that if you have open-ended subsidized third-party pay-for-fee systems as the way we have, you've got to find some way to ration it. You cannot just allow it to keep going. If you -- if it weren't subsidized, then market forces would ration it.

Look, medical care used to be fully rationed by market forces. We just don't like to use the word today, but that's what we are confronted with. The aggregate amount of demand for medical services over the years -- and if you just even think what could happen.

Well, I mean, we're only in the early stages of transplant medicine, which are extremely expensive operations.

I mean, you could begin to see an extraordinary technological change, where I wouldn't say "Six Million Dollar Man" is about produced here, but medical technology's doing extraordinary wonders.

And as you've pointed out, we spend far more, many multiples more, on high-tech medicine using all forms of equipment, in which the evidence of improved life expectancy or low morbidity is not there, so that the system is broken. And I'm not certain that we've really confronted the fundamental issues that we're going to have to confront to bring our medical system in line with what we ultimately must have, which is a sound non-inflationary fiscal system that -- out, you know, 10, 20 years.

MODERATOR: I take it that you dared to mention the word "rationing" -- that you're not anticipating public office in any way. (Laughter, groans.)

GREENSPAN: Well, I was, and I was trying to head it off. (Laughter.)

MODERATOR: Yeah, I see. (Chuckles.)

Okay. This meeting, incidentally, is on the record. We'll turn to you now for questions. I think that's what the schedule allows. Yes, sir.

QUESTIONER: (Off mike) -- very much. Marshall Sonenshine, Sonenshine Partners. Mr. Greenspan, you've argued, I think persuasively, here and elsewhere of the rarity of the financial crisis and the fact that its solution would not efficiently be found in the hoarding of excess reserves over long periods of time in the private markets.

But a question about financial regulatory reform still would seem apt for the circumstances, and that of course was a subject that was well in hand and developed under the prior administration, well before the financial crisis, going back to the blueprint by the Treasury Department under Secretary Paulson.

Are there some fixes -- and accepting we may be due for some level of -- some form of financial regulatory reform anyway. We have a patchwork of -- as we know, a patchwork of regulatory structures that are understandable historically but may not be optimal. Are there some elements of regulatory reform which might efficiently help mitigate even the rare crises that you say might be one in 80 years or a hundred years, they -- we humans crave mitigation of risk when the consequences are dire.

And we are pretty good at finding ways to do that.

Are there some elements, at least with hindsight, as we look back through the prism of the crisis, some elements of financial regulatory reform which might be efficient ways to steer the economy and the financial system clear of these types of grave dangers?

GREENSPAN: Most certainly.

Remember that when you're dealing with a market-based system, you have innovations occurring all the time. And not all innovations work. Indeed, you know, few people realize that Edison probably had more failures than successes.

And the issue of our system, which is essentially a creative destruction system, has many failures. And one of the purposes of a market system is to clean them out.

It is very evident to me for example that the amount of capital that the financial intermediaries were required to hold, in a regulatory sense, was much too low despite the fact that there's a very famous sentence or two, in a Spring 2006 Federal Deposit Insurance Corporation document, which said more than 99 percent of insured institutions met or exceeded the highest regulatory standards of the regulatory agencies.

One year later, that was trashed completely. So the question is, did we have too low capital? The answer is unquestionably yes. A great deal of the problems that can -- that are there and which are broken and have to be fixed. In other words, I'm arguing that we have to repair the system.

It is broken, but that doesn't mean we replace it. And that means significantly higher capital. It means that we do numbers of things, like for example trying to get an increasing proportion of derivatives standardized and put on centrally clearing systems or on exchanges.

The critical problem that we have, which we've got to resolve, is the too-big-to-fail issue. That is to me the major issue which is, if we do not confront it, we are going to be in terrible shape. Because remember, the purpose of a financial system is to take the scarce savings of a society, plus what it may -- the savings it may borrow from abroad, like our current account deficit, and invest them in a manner in which physical assets are produced that create the highest rate of growth and output per hour.

To the extent that you use those savings to prop up obsolescent companies or obsolescent industries or those which are too big to fail, which almost by definition are obsolescent, that savings is not also available for cutting-edge technologies which create the advances in productivity and, therefore -- (word inaudible) -- standards of living.

Now, there are innumerable other adjustments which will be made, should be made, and that's what the debate is going to be all about.

MODERATOR: On this side, back there, please.

QUESTIONER: Ben Upham (sp), Clarin (sp) Capital. It's often said that you're either learning or making money in the markets. And so we've learned a lot in the last year and a half. My question would be, what long-term structural changes do you think should be and will be learned from this crisis for the U.S. consumer? Savings is sort of the one that everyone goes to, but I would hope there'd be more lessons than just that.

GREENSPAN: Well, are you asking basically about the notion about a consumer -- consolidating all consumer financial affairs in one agency? I'm not quite sure what the nature of the question is.

QUESTIONER: So rather than from a government perspective, what ought the U.S. consumers sort of as a group, in aggregate, change the way they interact? For example, current account deficit would be one. Saving, investment --

GREENSPAN: You're talking about the --

QUESTIONER: (Off mike.)

GREENSPAN: I see. You're talking -- okay. Yeah.

Well, I think this is what markets are supposed to do. In other words, the fundamental purpose of markets is to infer the value preferences of the society as it's manifested in prices, and essentially invest or save. And this is one of the reasons why the financial system is a critical player.

There's a general belief that finance is just a casino in which people make money, lose money, do lots of things, but make no major contribution to our society. Financial intermediation -- and which really comes out of -- the old goldsmiths started fractional banking -- has turned out to be a remarkable human invention which has enhanced the standards of living of hundreds of millions of people over time.

And I think that we have to recognize that that system does work, but there are cases when it runs off the track. And one of the reasons it runs off the track is not essentially because the system itself is bad. It reflects what it wants to reflect, the -- what is out there to be reflected.

But there is an extraordinary cycle in human nature which goes from euphoria to fear in a remarkably consistent manner over the generations. The only way that that is going to change is if human nature changes, and there's no evidence that that's the case. So what we have to do is adjust to the fact that we will periodically be confronted with big euphorias and big bubbles.

Because, remember, a necessary and probably a sufficient condition for a bubble is a protracted period of prosperity, low inflation, and usually low long-term interest rates. When that happens, you begin to get major aberrations in the economy, and then eventually it burns itself out or something else happens, and you get the reverse, as we observed in the most extraordinary circumstances in the last several years.

So aside from the basic market forces, I don't think we've got a great deal of protection against ourselves, if I may put it that way.

MODERATOR: All right. On the side, in the back, please. Right here. (Pause.) I was pointing to the woman right here.

QUESTIONER: Julia Coronado with BNP Paribas. Mr. Chairman, I know you're a big fan of the Federal Reserve's flow of funds accounts, and I'm wondering, how do you interpret the unprecedented and savage contraction in private credit creation that is still ongoing? Despite the fact that the stock markets improved and credit spreads have come in, private credit is still being destroyed at a -- to me, at an alarming pace. And how does that inform your view of both economic activity and inflation?

GREENSPAN: Yeah, well, first, remember, where part of it is coming from is the dramatic decline in inventories.

In other words, the rate of inventory liquidation is utterly unprecedented. Since a significant proportion of those inventories come -- are financed by commercial and industrial loans, as well as consumer loans and other things, you would expect an extraordinary contraction in credit as the credit-financed part of the economy comes down as sharply as it would. But over and above that, we've had an extraordinary number of layers of financial intermediation, one on top of the other, where you go from mortgages, to mortgage-backed securities, to collateralized debt obligations, to collateralized debt obligations squared. And the system of mathematicians who've been employed by Wall Street have invented every crazy way in which you could pyramid on the system.

A goodly part of that pyramid has come down, and it has eliminated a lot of the multiple-layered types of things -- some of which, frankly, I think are good, and they will come back; others of which are of a type of failed innovation, and they won't come back, and shouldn't.

QUESTIONER: And how does that -- (audio break) -- does this process -- (audio break)?

GREENSPAN: Yeah, it -- it's not influencing economic activity, for one important reason; that the sharp increase in the market value of equity worldwide has enabled credit spreads to come down very dramatically. And it's not the outstanding credit, or even the credit availability per see, the abstract, that finances economic activity. It's interest rates.

And if you get, for example, CCC corporate junk bonds -- about as bad as they get and still be capable of being sold -- those have been one of the most dramatic capital gains in recent months, as the spreads have all come down. So that in the sense that the financing system is gradually returning to normal, it's not quite there because, for example, banks are still going to experience losses -- or I'll put it the other way around. They've experienced losses, but they haven't acknowledged them yet.

And they're still there and they're still creating a problem.

And even though the OIS-LIBOR spread is back to normal, we are still looking at fears, on the part of loan officers, that they don't have enough capital to trust lending out to other people, for fear it won't come back. But that's gradually dissipating. And I'm not sure that's the problem that really confronts us.

MODERATOR: Right here in the fourth row.

Thank you.

QUESTIONER: Thank you. (Inaudible.)

Mr. Chairman, how specifically should we address the issue of "too big to fail"?

GREENSPAN: What? I'm sorry.

QUESTIONER: How specifically should we address the issue of financial institutions that are too big to fail?

GREENSPAN: If they're too big to fail, they're too big. (Laughter.)

I -- this one has got me. And the reason it's got me is that we no longer have the capability of having credible government response which says, henceforth no institution will be supported because it is too big to fail.

In other words, we could believe that. And I used to go up and testify, up until Fannie and Freddie essentially went into conservatorship, that the law said that full faith in credit does not -- is not backing Fannie and Freddie. And I could say with a straight face, with my fingers crossed, that that's what the law says. I presume the law will be enforced.

The Wall Street practitioners didn't believe it. And they gave essentially a 20-basis-points subsidy, to Fannie and Freddie, because they believed that it was not risky debt. They turned out to be right, and the government turned out to be wrong. It's going to be very difficult to reproduce the credibility again. Because when push came to shove, they didn't stand up to the pledge.

I think -- I mean, I hate to think of just arbitrarily breaking down organizations into various different sizes. At a minimum, you've got to take care of the competitive advantage they have, because of the implicit subsidy, which makes them competitively capable of beating out their smaller competitors, who don't get the subsidy.

And if you don't neutralize that, you're going to get a moribund group of obsolescent institutions, which will be a big drain on the savings of this society.

So I don't have a simple solution, but that something has to be done. There is no doubt in my mind -- and I don't think merely raising the fees or capital on large institutions or taxing them is enough. I think that'll -- they'll absorb that; they'll work with it; and they will still be inefficient; and they'll still be using the savings.

So I mean, radical things, as you -- you know, break them up, you know. In 1911, we broke up Standard Oil. So what happened? The individual parts became more valuable than the whole. Maybe that's what we need.

MODERATOR: Right here in the third -- fourth row.

QUESTIONER: Good morning. Brian O'Neill. Mr. Chairman, I'd like to build on the question earlier on regulatory framework, as well as on this "too big to fail" question. If 8,000 or so commercial banks in the United States at -- I guess, at most, they'd claim maybe 25 percent of credit intermediation -- a lot of the credit intermediation is done away from the regulated commercial bank system. And look at the concerns now about commercial real estate finance and the shutdown of the securitization markets related to that sector. What does "too big to fail" mean when nonbank credit markets are (3-X ?) the regulated system?

GREENSPAN: Well, I think "too big to fail" is a bad policy anywhere, because it is wholly contrary to the very structure of what make markets work. If you want to have a different type of system, you can go to a basically central planning type of system -- which it doesn't have "too big to fail." Everything is just controlled by government and nothing fails, which is one of the problems.

Failure is an integral part, a necessary part of a market system. When you talk about creative destruction, remember, what you're talking about is that you use the depreciation reserves or depreciation charges, plus of obsolescent declining facilities, plus the new savings of society, to invest in the cutting-edge technologies whose output per hour is higher than the average.

And so that if you knock out a low company or reduce its size and raise the other, the average goes up.

If you start focusing on those who should be shrinking, it undermines growing standards of living and could even turn them down.

So if you want the benefits of a market economy -- and they are huge, even granted they periodically go into the types of problems we see -- you've got to allow failure to occur. Unless you do that, the system will not work, and people who talk about, you know, open markets and everything else like that, that's meaningless if there's not failure in the system.

MODERATOR: Okay. Way back on the lefthand side, please. Yes. Yes.

QUESTIONER: Thank you. Nina Rosenwald, American Securities. A few days ago in The Wall Street Journal, there's an article by Lawrence Kadish predicting that if we don't -- if we're not more careful about the service on the debt that's growing, the national deficit, we could possibly destroy the economy. Do you have any thoughts on that?

GREENSPAN: Well, I think that's an arithmetical question. It's very obvious that the amount of debt service -- or, more specifically, let's just talk in terms of interest, as the aggregate size of the outstanding debt times the average interest on the debt. And clearly, as the debt increases in size -- doubles, triples -- interest payments go up proportionately. And you will soon find that, under the type of forecast we're making, they become the very largest part of outlays.

And there are simple mathematical calculations which can demonstrate to you that there are occasions in which certain relationships become progressively explosive. In other words, the large increase in interest payments increases the deficit and increases the debt, which in turn increases the interest payments, which increases the deficit and the debt, and that does not converge.

And I don't say we're there at this particular stage, but we're approaching it. And I must say that throughout my lifetime, I've always been aware of the fact that we never allowed federal debt in this country, going all the way back to Alexander Hamilton, to come anywhere close to our capacity to fund it. And that cushion that we always kept out there was one of the reasons why the dollar was such an important currency in the world and why we eventually became -- we displaced sterling in the latter part of the 19th century and have held to that position every since.

We're getting to the point where we're getting ever closer to where the capacity to fund that debt is. I don't know where that level is. Nobody knows. But there is no question that the cushion is going down. And we will learn very quickly when we're getting close, which is when long-term rates begin to move, inflationary pressures begin to build, and that's very late in the game to turn it around.

MODERATOR: All right, right up here, please.

QUESTIONER: Luck Komisar. I'm a journalist. What would you do about credit default swaps? Do you think that they should be permitted only by parties that have skin in the game? And should we ban them being used as casino chips by third and fourth and tenth parties?

GREENSPAN: Well, let me just say that credit default swaps as a concept is a very valuable addition to a financial system, because what it does is -- at least what it was supposed to do was largely move the credit risk from those who initiated it, which were institutions which were highly leveraged, to those who had much greater capacity to absorb losses.

And indeed, in the very early years, the credit default swaps were a very valuable instrument. Because we went through the telecom catastrophe, when too many telecom operators were doing something which only one of them could do as a natural monopoly, and there were a huge number of defaults. And not a single financial institution ran into any problem, and largely because of credit default swaps.

Now, I suspect that it was that success which ultimately ballooned the whole system into a point where, in 2005, the New York Federal Reserve, as Bill would know very well, began to operate -- that's Bill McDonough, former president, the Federal Reserve Bank of New York, who is a great colleague and a wonderful guy to deal with. In any event, in 2005, they began to have very serious questions about how the -- the plumbing was working.

I used to argue that we had this 21st-century product in which the back-office operations were done with 19th-century technology -- the telephone, the pencil and the pad -- and it just was scary, because nobody knew what they had agreed to.

And I think what we have run into is a critical problem here in which the contracts read that those who essentially give out the protection have the right to get back the actual asset which is being protected when it defaults. And when you've got 10 times the number of credit default swaps per unit that we're working with, it cannot work. Right at the moment, it works in part largely because everyone is willing to voluntarily take cash, but that's not what the contract says.

And there's something structural which we have to work at. There are a lot of little issues about having skin in the game or -- there was an interesting, I thought a very interesting Financial Times editorial the other day, in which they talked about the question of merely being a hedger, official hedger, should allow you to play in the game, so to speak.

It's an issue which I think has got to be resolved. I hope that we don't forget that this is actually a potentially very useful instrument in the financial intermediary system, but it surely requires some really major restructuring.

MODERATOR: Mr. Chairman, I trust your ego has withstood the assault of a lack of a fulsome introduction by myself. (Soft laughter.) You seem to be able to function without it.

GREENSPAN: Do you want to remedy that, or -- (Laughter.)

MODERATOR: That would change our whole relationship. (Laughter.)

Okay. Thank you all very much. (Applause.)

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