Stephen C. Freidheim Symposium on Global Economics: The Legacy of the Global Financial Crisis

The first session of the Stephen C. Freidheim Symposium on Global Economics examines the impact of the financial crisis on Europe including Portugal, Greece, Ireland, Italy, and Spain, both the financial and political implications, and whether the Eurozone’s vulnerability to crisis has been resolved.

This symposium is presented by the Maurice R. Greenberg Center for Geoeconomic Studies and is made possible through the generous support of Council Board member Stephen C. Freidheim.

MALLABY: Great. Well, thank you, Richard. Thank you, Steve. And welcome to all of you.

Welcome to the first session of the Stephen C. Freidheim Symposium on International Economics. We have three people to discuss the first session, which is going to be “The Risks of a New Crisis in the Eurozone,” and we’re going to discuss the extent to which things have improved in terms of structural stability and where the gaps might still be. We’ve got three people, all of whom have been intimately involved in this debate I think pretty much through the, you know, nine years since Greece first revealed its problems.

We have, at the far end there, Isabelle Mateo y Lagos—sorry, Mateos y Lago. I’m sorry—who is now at Black Rock but has had a variety of policy roles dealing with Europe in the past.

In the middle, Ashoka Mody from Princeton, also at the IMF, was involved in policy on Europe, and has written a fantastic history of the European crisis that I recommend to you. And to my right, Jeromin Zettelmeyer, who is now a senior fellow at Peterson but has previously served with the IMF, the European Bank for Reconstruction and Development, and in the German government.

So I’m Sebastian Mallaby, and we’re going to have this discussion a bit on the stage and then open it up to members to join in.

So I want to start with the things where there does seem to have been progress in reducing vulnerability, so maybe I’ll start with Jeromin and ask—one institution that exists now and didn’t before is the European Stability Mechanism created in 2012, basically a kind of IMF for Europe, a crisis bailout fund.

Is it big enough? Are the rules around it written in such a way that it is danger-reducing?

ZETTELMEYER: So the answer is that no, it’s not big enough, so it could not, say, rescue a country like Italy for more than a year in terms of covering debt rollover, but it is backed up by the ECB through the OMT. And so I think the combination of these things makes it big enough.

It also, however, means that in order to really get the big, unlimited liquidity, you do have to at this point jump through the hoops of an ESM program, and there are many who would argue that that is not fast enough, not automatic enough, and that, you know, it puts the ECB into the position of having to, in some sense, delegate a decision on solvency to another institution. So I’m actually OK with that, but there is a very active debate on that.

Now one way to address that debate, which I think might be feasible in the current political setup, is to extend the ESM in a way that it would provide liquidity to prequalified countries without actually having to go through a program negotiation. And that is in principle something that probably both France and Germany would support.

And the really interesting thing is, is that prequalification then going to be good enough to also unlock the backstop, which is the ECB. That question, in my view, has not been really answered.

MALLABY: So some of these debates are familiar from prequalification for IMF programs but, I mean, it—boiling it down, good to have it not quite a finished product.

I want to move through these issues. I’m going to go to Ashoka with a different one. Another thing which exists now in Europe and didn’t before, I would say, is the sort of whatever-it-takes mentality at the central bank. And the question is here is that a norm that could be unraveled or is it something which you see lasting beyond the transition when Mario Draghi steps down next year and you have a different ECB leader. Do we—can we count on the central bank to do whatever it takes next time?

MODY: The short answer is no. The long answer is, just going back in a sense to what Jeromin was saying. The way the whatever-it-takes works is that the European Central Bank has promised that it would buy unlimited bonds of a country, and therefore, investors should not be worried that their investments are at risk.

But to reach that point, the country has to go through something called an ESM program. An ESM program, as Jeromin just talked about is the bailout fund. To get the bailout fund, you need to negotiate a program, and a program negotiation can take months. And so while the ECB can say it will do whatever it takes, the ECB will be waiting to do whatever it takes while this program is being negotiated.

And again, referring back to Italy, I don’t know which Italian government can deliver a program that is satisfactory to the ESM.

MALLABY: So just explain one thing. So you are saying that you have to negotiate a program before you get this liquidity from the central bank, but last time around, they just did it. There was no formal negotiation.

MODY: Last time around they promised that they would buy unlimited bonds, and investors were satisfied with that promise. But even last time, if the promise had been invoked—in other words, if investors had said, thank you, we’d like our money back, then the ECB would have had to slow down, stop the proceedings, get Spain and Italy to come into a program, then once that program was ready, the ECB would say, yes, we are ready to bail out investors. But even there, there are lots of limitations. The phrase “whatever it takes” is a very cute phrase, and it’s a lovely phrase, and it’s—in the heat of the moment that is what investors were looking for. And so it was a magical phrase. But this magic is a very sort of—a dicey magic because if it works, it works like a beauty; and if it doesn’t, it falls apart.

MALLABY: Well, let’s just—so I want to maybe get Isabelle to comment on this, but I have a very clear memory of coming to this stage and doing one of our World Economic Update meetings and saying to people, whatever it takes, isn’t this just a bluff? Why do the markets believe it? And the answer from the market participants on the stage was essentially that, well, Merkel has said that she is going to back it, and it was the sense of political commitment behind the central bank which really made Draghi’s promise credible.

And to me that illustrates how fragile that victory was, that it was sort of an impression around political will—

ZETTELMEYER: Specific individuals, too.

MALLABY: Yeah, exactly. So therefore, next time one couldn’t count on it. But Isabelle, do you want to comment on that?

MATEOS Y LAGO: Yes, I agree completely on that. It was the characters involved, it was Mario Draghi. We cannot be certain that his successor will be equally committed to a kind of whatever-it-takes mentality. We cannot be certain that he will have the political backing—he or she will have the political backing.

But I think more importantly, perhaps, there’s this focus on the sovereign going bust. What we’ve learned from looking at the Greece case is that death comes from the banks. And the same thing could happen in Italy, because once the spread on sovereign that goes high enough the banks lose their ability to roll over very quickly, they run out of money. And we saw it in Greece. The ECB had to pull the plug. And that’s nothing to do with the ESM, and I think that’s the channel that is still not sufficiently focused on. And I think the system as it stands right now is absolutely not prepared to deal with it.

MALLABY: So we’ll come back to the banks, but I think what we’re seeing is that both on the creation of the ESM that Jeromin addressed, and on this whatever-it-takes pledge, it’s not an entirely finished structure.

But Isabelle, one other thing for you: another thing that’s there and wasn’t there before is the central bank’s supervisory authority, and the idea here is to take some of the decisions around when a bank is insolvent away from national authorities that tend to exercise excessive forbearance and move it to the center, which is supposed to be tougher. How well do you think this is going to work?

MATEOS Y LAGO: Well, so that’s been working, I think, remarkably well—or in many ways the centralization of supervision, and if anything what we’re seeing now is that it’s in the areas where we haven’t centralized, like money laundering, that we’re still seeing problems, perhaps linked with forbearance. So that has worked well.

Unfortunately, what has happened since the last crisis is we’ve had a fragmentation of the European banking system. We have a more fragmented banking system today than 10 years ago despite the SSM. And without a banking union, you don’t have any private sector risk sharing, and so the SSM and all that is always going to be the cherry on top. What you need fundamentally is risk sharing by the private sector.

There is no capital markets union to speak of, and we’ve gone backwards in terms of banking union, apart from this centralization of supervision, which is a big step forward, but we’ve done one step forward and three big steps backwards.

MODY: Just to amplify—

MALLABY: Yeah, sure.

MODY: —on what Isabelle said, the banks in the eurozone essentially lend within the country. That’s what she means by the word fragmentation. In other words, a German bank is not going to lend to Italian borrowers. And that is because the system as it exists—in the United States a bank will lend to a borrower anywhere in the country. That’s because of two things: one, there is something called the FDIC—the Federal Deposit Insurance Corporation—that insures deposits anywhere. So a bank working in one part of the country does not have to worry about a process of default or runs anywhere in the country.

That system is where the breaking point in Europe comes. Creating a federal deposit insurance corporation in the eurozone is as hard as creating a eurozone fiscal budget, which is essentially what the Europeans have been trying to do since the inception.

You referred to my book. The first discussion of a eurozone budget arose in 1969, and I’m always—as you—amused when people bring it up as though it’s a new idea. It’s not a new idea because the Europeans are unwilling to do it.

MALLABY: So one thing that we’re seeing here is that we began with things where the glass is arguably at least half full, so on the centralized bank supervision, on the creation of the ESM bailout mechanism, at least it has been created. So that’s progress.

But now we’re getting to something like deposit insurance, which was discussed for a long time, but hasn’t actually been created. And there are other things like that which have been on the policy agenda.

And gentlemen, I want to come to you on this one. Fiscal transfers across the eurozone, which are necessary to stabilize an economic area which has a single monetary policy, by definition—and this is something I’m sure—a point he makes very well in his book—by definition, of course, one monetary policy is going to be too tight for some parts of that economic area. So that area will be in recession unless it gets fiscal transfers to offset, or unless there is enough labor mobility to offset it. But labor mobility is still I think only half the rate of the U.S. if you look at mobility across states.

So Jeromin, talk a bit about this question of fiscal transfers within the eurozone member states, which I know you’ve worked on a lot, and it’s been like stubbing your toe on a brick.

ZETTELMEYER: (Laughs.) That’s right.

OK, so it’s—first of all, it’s really important to remember—and Ashoka really brings this out very nicely in his book—that this whole idea of the euro is based on a grand bargain by which Germany would, you know, give us its currency—this is from the German perspective—hence, you know, essentially as a gift to Europe, this wonderful D-Mark with its stability properties would be shared by everyone.

And, you know, it was viewed as in a sense democratizing the D-Mark, and also the D-Mark was dictating monetary conditions in Europe before the creation of the ECB. Now we Germans are going to let everyone to come on our board, in a sense. That was how it looked like from the German perspective.

But, you know, only if that was the condition and it remains the condition, and even, you know, liberals or, you know, murky, center-left people like myself agree with that condition—on condition that we are not going to engage in systematic redistribution in the euro area. So the Germans do not want the Euro to become—and this is a consensus that goes from the Greens all over to the AfD—so the black hole through which Germany ends up paying for the rest of Europe.

So then the question is, you know—Ashoka, in his book, says, well, but that’s kind of the condition for the euro, for any currency to work. You need those fiscal transfers. And there’s a big debate around it.

So here we disagree a little bit. So for the euro to work, you would need, definitely, autonomous fiscal policy that can be used in a countercyclical way. That’s not the same thing as fiscal transfers because you are basically paying for yourself using future resources of your own taxpayers to expand the—

MALLABY: So you mean if Italy is—if Italy is in recession because of ECB policy, Italy should be able to run its own deficit and do its own stimulus.

ZETTELMEYER: Right. Right.

MALLABY: But don’t expect the Germans to pay.

ZETTELMEYER: Right. Right.

Now, the problem is that the original design of the euro, because of what—I forget what Ashoka calls it, the stability culture or the stability cult, one of the two things—(laughter)—in the euro area, you know, they wanted to prevent also big buildup of debt at the national level because then they thought that the ECB would come under pressure to bail out countries with large debts, right? So, to preserve the stability of the currency, we the Germans also put in these very strict fiscal rules, and those prevented precisely the policy degree of freedom that would have been necessary to combat it. So that we need to work on in any case. And there Ashoka and I agree we need to effective liberalize what countries can do with their fiscal policies and then maybe replace some of the role of fiscal rules with more market discipline. So this is sort of one thing. That’s a work in progress, but I think there is a broad consensus, certainly outside Germany and with some reasonable Germans jumping on that bandwagon, that this needs to be done.

Then the second question is, do you need actual fiscal transfers, you know, cross-border? And so here the point that, you know, a group of French and German economists that I was part of that—you know, we wrote a paper to try and sort of get Macron and Merkel to see more eye to eye—was to remind them of the fact that these fiscal transfers, even if you think they’re necessary, they don’t need to be permanent, right? So you can have a risk-sharing arrangement where if you hit a snag, you know, you’re going to be the recipient of fiscal transfers. If the other side hits a snag, the other side’s going to be. And you can calibrate a mechanism that takes into account how much countries—you know, what risk they impose on the system, right? So if you impose a risk—bigger risk on the system, your insurance premia are bigger, in a sense. And if you do this in a good way, you can have insurance without permanent transfers. Why? You have to believe me on this, because if you don’t believe me on this the entire insurance industry would not be commercially viable. (Laughter.) So it must be possible, right?

And so this is sort of the technocratic economist solution to Ashoka’s fiscal transfer problem. The problem with that is you need a certain amount of trust for this to work because you need trust in a new institutional setup that in principle can lead to countries paying into some fund for a long time and then maybe never drawing; or maybe, you know, the premia were calculated in the wrong way. So if that’s the case, you do end up with these permanent transfers. And so here the big point that Ashoka and I again agree on, I think, is that by the time we get through all these very aggravating and divisive crises, maybe we don’t have enough trust in the system to make an institutional reform, which on paper would be the answer, and would work, and it would respect the grand bargain, right? It would respect the basic rules. But we kind of need to take a leap of faith, and maybe we don’t have enough faith left in each other to do that.

MALLABY: So there’s a lot in that. I want to dwell on this for a second because I think, as you say, Jeromin, it is as the center of the whole bargain.

You know, Ashoka, one issue as I listen to Jeromin is that it’s all very well to say, you know, let’s let the Italians run their own budget deficit if they need a stimulus, but if they are allowed to do that, and at the same time they can issue debt with some sort of implicit assumption in the markets that the ECB or the ESM or the system in general is standing behind it, as we saw in that period of the first eight or nine years of the eurozone, the Italians are going to borrow very cheaply. So they won’t have market discipline on how much they borrow. And Jeromin wants to reduce the political discipline because, as he says, these stability rules are preventing the countercyclical fiscal stimulus. So doesn’t that just create a system where Italy ends up borrowing much too much?

MODY: It’s an impossible situation. There is—you know, Jeromin has given a technically nice idea. There are so many—so many problems even at a technical level.

So just the state of Nevada during the crisis received something of the order of twenty percent of its GDP in fiscal transfers. These are transfers. There’s no paying back.

MALLABY: There’s no insurance fund.

MODY: There’s no insurance fund. That is the social contract on which the American monetary union works.

The Greeks got a loan, which they have to pay back. Now, you know, we celebrate the fact that the Greeks did get a loan. But as a consequence, they have got an economy that is twenty-five percent below its pre-crisis norm. Nevada has a—has gone from an unemployment rate of about fourteen or fifteen percent to four percent. So the adjustment process works in a monetary union where there is a political contract.

The fundamental problem always in the eurozone is that there is no political contract. And therefore, every technical solution of insurance funds, of fiscal stimulus, runs repeatedly into this problem of what he generously calls trust, but what in effect is a deep—a deep distrust.

So consider the insurance fund idea. The notion is that on this occasion Italy will receive money and on a future occasion Italy will transfer back the money to Germany. The Germans may say hypothetically that is a sensible statement, but when is it likely to happen that the Italians will be—will be required to refund the Germans? Whereas in the United States, the state of Connecticut transfers money every year for the last twenty years, something of the order of five percent of its GDP, to states like West Virginia and such like. It’s part of what the DNA over here is. It’s not—it’s not there in the—in the eurozone.

MALLABY: Do you want to, quick?

ZETTELMEYER: Well, I mean, first of all, it’s not true that, you know, there is—there is, of course, a notional fund in the U.S. too. It’s called federal taxation and Social Security, right?

So it’s also the case that we have to distinguish a little bit two reasons for transfers. One is to support chronically poor and underdeveloped regions. We have this in Europe already, right? And so it may not be large enough, but that’s not what I’m talking about. What I’m talking about is what happens if a region which could well be a rich region—say Massachusetts in the 1980s—gets hit by a big, you know, adjustment problem, and in that case it will draw money through the federal insurance mechanisms, and then it will implicitly repay it back by continuing to pay all the time. So I don’t think this is unfeasible in the eurozone.

And you’re right, we don’t have an explicit political contract, but we have an implicit one—as you yourself emphasize in your book—which is the entire euro is essentially a political project. And the question is, how big do we need to push integration in other areas to make it work? And indeed, you know, part of the reason why we are having it is because we want to push integration in other areas. The problem is to do this at a moment when the crisis has left a very bitter aftertaste.

MALLABY: So, Isabelle, go ahead, yeah.

MATEOS Y LAGO: No, I was just going to rebound on that. I think talking about transfers in a way isn’t helpful because politically it makes it much harder to sell to public opinion, whereas I think what Jeromin and others, IMF as well, have been talking about is much more of an insurance mechanism. I think if we start talking in those terms, it’s politically much more palatable. And it’s true it would be a different system than what you have in the U.S. or in Germany or in Switzerland, where you have a political contract but guess what, nobody ever talks about it. I mean, if you put those numbers out in the press, I’m sure there would actually—(laughs)—be quite a lot of debate, but you don’t. So in Europe it’s going to have to be a different solution.

And on this one I have to say I’m a bit less pessimistic than on some of the other issues. There is a—I have a sense that there is increasing recognition that a solution of that sort is needed, including in Germany. There’s a lot of confusion about what form it’s going to take. Obviously, if you talk of, you know, German taxpayers shipping off money to Italy or to the periphery, nobody’s going to be in favor of that. But, again, it’s an insurance mechanism that people have described, or at least some of the proposals are talking about, and I think that’s politically—that would be much more acceptable.

MALLABY: But talk to me about the politics here because, I mean, it was said, you know, if we go back, you know, nine months, people were saying, look, you know, we’ve got the French election, the German election; we’ve got to get through that. Once we’re through that, 2018 is the golden window of opportunity to get some of this type of reform done because in 2019 we’re going to face eurozone—European Union elections, we’re going to have musical chairs at the ECB and in—and in Brussels. So 2018, now, is the time to do it. Macron made his big speech at the Sorbonne. He laid out an agenda which includes some of this stuff. Didn’t it just dissolve on impact with German politics?

MATEOS Y LAGO: I think maybe it did for a bit, but not fully. I mean, Meseberg had a lot of—had a lot of positive developments. Frankly, it’s the other countries that killed it, perhaps because there was a little bit too much arrogance from France and Germany—I’m French, so I can talk of French arrogance—(laughter)—in sort of assuming the others would happily rubberstamp the plan. But I think, look, to hear a German finance minister talk of a European unemployment insurance, something that makes me very hopeful. So, actually, I wouldn’t be surprised if we did get somewhere on this—on the fiscal capacity at the eurozone level.

I think one very big issue around this—and again, it has to do with Italy, and there’s a—politics is a big one—but the other one is, you know, we’re not starting with every country having an ideal debt-to-GDP ratio and an ideal fiscal situation. We’re starting off with one large country, which is Italy, and a couple of small ones that have a debt-to-GDP level today that, you know, could get on an unsustainable path at the slightest shock. And that means they have very little room for maneuver to run an accommodating fiscal policy at any time. And I think that’s making the whole debate much harder to resolve because you—even if politically you would like to say, oh, every country needs to have the flexibility to run countercyclical fiscal policy, when you look at Italy, guess what? You can’t, right?

MALLABY: Right.

MATEOS Y LAGO: I mean, unless somehow you multiply the growth potential by three or something, but—(laughter)—exactly.

MALLABY: This gets to the issue of trust, right?

MATEOS Y LAGO: Well, it’s beyond the issue of trust because even if you, well, trusted them—I don’t know—I think it means the design of the fiscal rules to make economic sense is a—is a very difficult question when you start from—

MALLABY: My point is that the lack of trust is not simply a subjective thing that you could fix, it’s actually based on observation of the real condition in Italy.

ZETTELMEYER: Yes.

MODY: Yes, but she—I would just make it—I think I heard Isabelle say that even if there was trust, even if we believed in countercyclical fiscal policy, Italy with a debt-to-GDP ratio of 130 percent of GDP, it’s hard to justify a significant stimulus. In other words, if I—if I go back and put my hat on as an IMF economist—

MALLABY: Yes. (Laughter.)

MODY: —and say, you know what, Italy needs a fiscal stimulus—there are no constraints, and we trust that they will do it right—it’s not easy to do it. It’s even technically a very difficult decision. I agree with it, and if I was responsible for Italy I would recommend it, but it’s hard to do a significant stimulus for Italy at this point.

MALLABY: So we have discussed things where the glass was half-full. Now we’ve discussed the issue of fiscal transfers. The creation of centralized bank deposit insurance has come up a bit. Another thing is the notion of creating a eurozone-wide safe asset, you know, partly to help finance the central fiscal authority that could do transfers, partly to give banks in Europe a safe asset to hold so that you start to break that doom loop between the banks and the sovereign. Isabelle, you’ve talked a bit about this already. What about a European—a eurozone-wide safe asset? Are you optimistic that that could be created?

MATEOS Y LAGO: So no, but that may be—that may be for the better. So let me—let me elaborate on that.

The sensible thing to do would be to have a genuine safe asset with joint and several liabilities of all the members. Let’s imagine an ESM—a supercharged ESM that could—that could have unlimited capacity to issue paper on the market. That would be a genuine European safe asset, backed by the balance sheets of all the—of all the sovereigns.

Now, politically, this is an impossibility at this point. Maybe in twenty years, but today the creditor countries, so to speak, are adamantly against that. And so what’s been proposed instead is this very half-baked solution of a securitized product. I’m sorry, Jeromin, I think you were associated with this idea, so I shouldn’t be too dismissive of it. (Laughter.)

ZETTELMEYER: No, no, I’m not a co-author. I just defended it.

MATEOS Y LAGO: OK. (Laughter.)

So a securitization vehicle that would somehow be considered as safe. I’ve written about this, I think, from a private sector perspective. This is a complete nonstarter. And I think the Europeans have frankly wasted a couple of years going around in circles coming to that conclusion. Now, this idea seems to have been buried by the Council, so hopefully we can move on and focus on other issues.

MALLABY: Just the cliché view of finance is that the private sector people love securitization structures and complex blah blah blah, and the regulators don’t like it. Here you’re saying the opposite.

MATEOS Y LAGO: It’s the opposite. That’s right. It was the regulators trying to push for a securitized product, claiming that it would be declared safe and therefore all the banks should be very happy to hold it. I think one thing we’ve learned very clearly from the crisis 10 years ago was that securitizations are more complex than they seem, and you don’t want to assume safety or declare safety.

MALLABY: I see.

And, Jeromin, since you defend it—

ZETTELMEYER: It is totally wrong. (Laughter.) Also, in a sense, she’s an interested party because the private sector—

MALLABY: Now you’re going ad hominem.

ZETTELMEYER: That’s right. (Laughter.) No, I mean, you will hear this from private sector people frequently because they are holding out for, you know, the big prize, which would be a publicly guaranteed safe asset, meaning guaranteed by the Germans in some form, and that will never happen. I mean, it’s not even going to happen in twenty years. It will never, ever happen, OK?

So what might happen—and here we could start agreeing or discussing—is there is a real question—I mean, you don’t need either/or, right? You don’t need to choose between, you know, joining several guarantees on the one hand and securitization on the other. There’s a sensible thing in the middle, which is you create a European fiscal federalism type thing, and that issues its own debt—not guaranteed by the member states, but guaranteed by its own revenue stream, right? So if we had a euro area budget that would issue euro area debt, we would create that. OK? So this is the one thing that all three of us will probably agree on.

So the question, then, is, are we going to wait for that thing? That’s the twenty-year horizon, right? Or are we going to create something in the meantime that might be sensible? And here, you know, basically Isabelle and I agree on the technical—disagree on the technical merits of this thing, but it should—I’ll just say one thing. It is completely misleading to shoot this down by reference to say mortgage-backed securities in the Great Recession. Because here we are talking about a completely transparent assets in which there’s a regulation forcing specific portfolio weights. And the only thing that’s in the cover pool here is sovereign debt, right? So this whole issue of we don’t know what’s in it, we don’t know the quality of the underlying collateral—all this is gone. And this thing is very, very easy to analyze. And the truth is that, you know, if you make the junior tranches big enough, this can absorb virtually every crisis that you can imagine.

MALLABY: Well, I think everybody now has understood that, you know, we have a French member of the panel, we have a German member of the panel, and I guess Ashoka is kind of the ornery Italian. (Laughter.) Thank you for playing that role. And we see that, you know, comity and so forth breaks down sometimes.

But I think we should move on to a third bucket of issues. So we’ve discussed the stuff where there has been progress, stuff where we hope for progress in the future.

Then there are things, sort of new issues that have come up, right? New challenges that were not there 10 years ago, but which are there now. And the obvious one is sort of a crisis of political legitimacy, which I think has become much more obvious with the success of populist and anti-Europe parties across the eurozone.

And so I guess one question—and maybe Ashoka could comment on this first—if another crisis were to come, there would be a question of whether voters in the periphery, the debtor countries, would be willing to endure another round of austerity in the way that they did last time without the whole system falling apart. So have we kind of used up that ability to impose austerity, and if it happened again in the next decade, that would be the end of it?

MODY: Yeah, certainly I cannot imagine—since you have designated me ornery Italian—a kind of austerity that Greece experienced being imposed on it.

ZETTELMEYER: I agree.

MODY: I think it would be politically explosive not just in Italy but it would be politically explosive anywhere. And the problem is that the Italian situation is in many ways worse, several times worse than in Greece. Italy is about ten times larger in terms of financial assets and government debt than Greece was. And the Italian growth rate—Isabelle referred to it very gently in passing—the Italian potential growth rate is something like half a percent or three-quarters of a percent. And so the notion that the Italians will be able to bear this is just completely unrealistic.

There are several political problems right now. One is related to the euro. So the euro—in the crucible of the crisis in 2012, what happened was that Europe began to politically fray. The rise of the Alternative for Deutschland Party in Germany and the rise of the Five Star in Italy are exactly contemporaneous events. And in the AFD rises because some Germans believe that Germany is doing too much for Europe, and the Five Star rises because the belief is that Germany is imposing on Europe. That then creates the Five Star and AfD. They then morph into other variations, especially in AfD’s case, into the migration crisis. So you have a multiple set of events, parallel events that are creating a disjunction in politics.

On top of that, if you then also create a policy framework—remember, it’s not just the austerity, Sebastian. It is the sense that somebody is dictating to you. That is sort of the most corrosive part of the process. And therefore, the system, politically, is very fragile at this moment.

ZETTELMEYER: Just very quickly. So I really want to stress the last point. So there’s a huge difference between Italy today and Greece, right? Greece had a like twelve percent primary deficit even before interest payments. Italy has a primary surplus, OK? So Italy, in order to sustain its debts, does not require a huge amount of austerity. In fact, they may not require virtually any fiscal adjustment on top of what they have already done. They just need to resist the temptation to spend a lot. Still, it is quite implausible that Italy would agree to an ESM program—not because of the harsh conditions that this imposes, but because of, you know, the symbolism of getting conditions dictated by Europe. Because this government was elected to not take orders from Europe, and that’s what makes the current situation so dangerous. So we have actually a safety mechanism that in my view could deal even with Italy, particularly since they do not require a lot of austerity. But it requires a cooperative government, and I’m not sure that that’s the case right now.

MALLABY: Right, right. I mean, so I think we’re sort of seeing in a way three issues around this political legitimacy question which are distinct which have come up. One issue is, you know, would the voters be willing to accept austerity without some kind of massive reaction. The second thing is, how much collaboration can there be between governments given the rise of these populist parties which, as you say, Ashok, are kind of wanting the opposite things, if you look at the Five Star and the AfD. And the third thing—and maybe Isabelle could comment on this—is whether the technocratic institutions, notably the ECB, could do what it did last time. You know, it’s one thing, you know, to say whatever it takes when the government in Italy is run by a technocrat like Mario Monti. It’s a different thing in the current mixture of people there. So do you think the technocrats are going to be—

MATEOS Y LAGO: Well, I think the technocrats are absolutely not going to go out on a limb if they don’t feel there’s political support for what they’re trying to do, be it in the core or in the periphery.

But I’d like to say, this issue of the political fraying is perhaps even more complex than you all have said. I’m surprised nobody mentioned the issue of migration, which is frankly causing a major challenge right now to Europe in terms of this trust and this sense that maybe our shared values are not as shared as we thought.

And if you look at opinion polls in Italy, this sentiment of being completely abandoned by the rest of Europe in dealing with the migrant crisis has been a major contributor to bringing both Five Star and Lega to power. When you look at sentiment towards the euro, the population is still overwhelmingly attached to staying in the—in the euro.

And I think, you know, if you look back to Greece in 2015, Syriza won the election on a platform of saying no to the European bullies, saying no to the—to the Germans. They won their referendum saying no to the program, and then what did they do? They realized, well, oops, you know, we actually do want to stay in the euro, so we have to—we have to swallow the medicine.

MALLABY: But the—but the question is whether that—whether that gap between sort of the technocratically-driven decision by the Greek government and the evident popular will expressed in the referendum, that was a gap that they just bulldozed through. But couldn’t that be done again and again? Is this—

MATEOS Y LAGO: Well, I think the simple fact that it’s an open question is a big problem because Italy is much larger than Greece, as Ashoka said, and I think, again, it always goes back to this question of what do you do with this phenomenally large debt burden that Italy has—and, by the way, twenty-five percent of which is held in the eurozone outside of Italy. And, you know, there’s always a lot of sense that, oh, wouldn’t it be so much easier if you restructure this debt, but then what does that do to the—to the debtholders.

MALLABY: So I want to come to questions from the members in just one minute. But one last thing I’d like to get out there is, you know, we’ve discussed on the one hand progress that Europe has made, but it’s not complete progress; on the other hand, issues which have been discussed but action has not yet been taken; and then a third category of, you know, sort of new challenges that have arisen that weren’t there before; then, finally, is the issue of what’s the flashpoint, what’s the kind of trigger mechanism that could lead to all of this coming to a head.

And, Jeromin, maybe I’ll put this one to you. You know, the obvious thing, it seems, is that Europe has been helped recently by a strong global economy. The ECB has been running very loose policy. The oil price for much of this time has been low, which is helpful to Europe. Now oil is going up, the ECB is tightening, the world economy has been great but may not be forever—people are penciling in a recession, potentially, for 2020 in the U.S. when the fiscal impetus goes away. So we’ve got, you know, this slowdown in the European economy you can already see, together with policy tightening and worse external conditions. How much does that worry you?

ZETTELMEYER: OK. So the really important thing to bear in mind is that for the stability of Europe, whether the global economy or the euro area economy slows in the aggregate or not is almost irrelevant. And the reason is that the ECB will offset that through its policies.

What can kill Europe is divergence of growth inside the euro area. And so here the most worrying data point is that Italy, you know, after a little bit of hope, again seems to be maybe in danger of decoupling to the downside. If this happens for a few more quarters and the ECB does not accommodate that—which it might, right? It might, because Italy is big so it will have an influence on the average. But if we see a situation where essentially the ECB just stays on track in terms of normalization of policies, Italy decouples to the downside, we could really get to the situation that Ashoka describes in his book, which is the one-size-fits-none problem in the euro area. And then what does Italy do in a setting where it has very high debt, not much room for stimulus, and huge distrust from the others to use it, so—the little room that they have? So that’s the situation I’m really worried about.

MALLABY: So this coupled with the fact you’ll have a new ECB leader and it makes it hard.

ZETTELMEYER: Yes.

MALLABY: OK, let’s go to members for questions.

MODY: Can I just elaborate very quickly on that?

MALLABY: Sorry. Quickly. Quickly on that.

MODY: Very quickly on that. So the numbers for Italy are the following, that the Italian real interest rate—that is, the interest rate discounted for inflation—is a little over two percent. The Italian growth rate right now is 1 ¼ percent. With world trade slowing so rapidly, by my—if I was doing a back-of-the envelope projection, I would—I would not be averse to saying that Italy will have recessionary conditions in the second half of 2018. If Italy has—

ZETTELMEYER: ’19.

MODY: ’18.

ZETTELMEYER: ’18?

MODY: Yes.

MALLABY: (Laughs.)

MODY: Italy—the Italian industry production is falling right now. It’s literally falling. It’s not—it’s not—

ZETTELMEYER: OK. Second half. OK, got it.

MODY: Yeah.

ZETTELMEYER: I thought he said second quarter. My mistake.

MODY: And so if Italy has a recession in the next six to nine months with an interest rate—a real interest rate that is 2 ½ percent, there’s virtually nothing that the European Central Bank can do at that point to reverse the dynamics because at that point the banks will begin to accrue nonperforming loans, the interest rates will go up further. Italy could very quickly go into a very vicious cycle of low growth and financial instability.

MALLABY: All right. Sorry, yes. This is on the record. I see a question back there to start with. Please stand, state your name and affiliation, and just one question please.

Q: Can you hear me? Fernando Napolitano (sp). I happen to be an original Italian. (Laughter.)

A couple of remarks just for the audience. We do have a technocratic minister of economy today, and this is holding the point of the deficit not to go above 1.6 percent. We’re going to know in twenty-four hours because that’s when the budget law will be presented.

The second thing which is very important, which of course not because I am Italian but provides some element of positive thinking, is that even the Five Star Movement is on its learning curve. So it’s one thing to have propaganda and saying all this about thirty-five to sixty billion—that’s the kind of cost of the reforms they were asking—and everything is to be in government. They are, of course, appealing to their base, but it is the issue of the numbers. And the reason why we are optimistic is because this is external pressure coming from the other nation(s) in the ECB. Italy will, indeed, have to go through reforms. Yes, industrial production has slowed down. Yes, the nonperforming loans are where—you know, they’re not where they should be. But I think that there is a general movement towards more reforms because the last two ministers that we had were technocrats. So there is a bit of knowhow that is building up in the general population, and people know that sacrifices are coming—are coming to an end.

MALLABY: OK. Yeah.

Q: So this is to say that Italy has always been—in November 2011, everybody gave Italy ready for Chapter 11. We changed.

The thing that is not enough appreciated about Italian economy, only a little bit, is corporate affairs. The stock exchange is a little bit of GDP. The mass is small to medium enterprises, ninety percent. Production is the asset. Export is building. Yes, the current trade war won’t help. But just to give you a little bit of information from the ground.

MALLABY: OK. We got it. Thank you very much. I’ll just get Isabelle to comment a bit on this. I think it’s just—this sounds like a predication that Italy makes a transition a bit like you described in Greece, away from a populist election promise and to something more—

MATEOS Y LAGO: So I heard something slightly different here, which is we’re not going to get a flare-up in the next—well, later this week or in this budget cycle. I think I would agree with that. That’s also our base case. This government is new. Probably right now its top priority is to stay in power. So creating a big financial crisis is not the way to go.

I think the question is, how will they handle their downturn? And if Ashoka is right, that could come, you know, very soon. But even if it comes within the year, there’s a downturn, what do they do? Do they do fiscal stimulus? Do the interest rates go through the roof? Does the system—or do they climb down? And I think that’s very much an open question.

MALLABY: Another question. Yes, Ben here.

Q: Benn Steil, Council on Foreign Relations.

I wanted to go back to the question about the political contract. If you go back to the 1990s and the debate about the euro, there were broadly two schools of thought: one, that we needed banking/fiscal/political union to underpin the long-run stability of the euro; there was another school that said, well, that may or may not be a good idea, but all we actually need is a credible no-bailout rule. Now, since the financial crisis, of course, that first school has been in the ascendant. The second school has been at least quiet.

But I want to say something in defense of the second school. There are many countries around the world that are dollarized—that don’t have their own currency, that use the U.S. dollar. In our hemisphere, Ecuador, El Salvador, Panama, they went through the financial crisis with nobody talking about de-dollarization. You’ve never had an instance of de-dollarization. Of course, there is no fiscal/banking/political union, but there is a credible no-bailout rule. Nobody actually believes that the United States will come to their defense. Is there something still to be said for the no-bailout principle?

MALLABY: Jeromin?

ZETTELMEYER: So, yes. And, in fact, in this Franco-German report that I was a part of that we wrote in January, we make that argument, right? So we argue that the no-bailout rule has to become credible again because we need it not just to make the system work intellectually, but to solve a political problem, which is the problem in the north, right? The question is, making it—

MALLABY: Meaning that the north will otherwise want to leave.

ZETTELMEYER: Yes. Yes. The populists are directly fed by this notion that the whole no-bailout clause—which, after all, is written into the European Constitution—that this was a big lie, right? And, you know, I wouldn’t say—I think, you know, we had what we call in Germany a notlüge—you know, an excusable lie—because in the end, you know, we needed to bail out Greece. And so it was—it was validated. But it is clear that this cannot happen systematically, right?

It’s also clear, in my view, that no fiscal rule, no matter how much you reform it, is going to prevent a potential crisis in the—in the future. But the trick is that it’s so much harder to make this credible in the euro than it is for El Salvador, right? And so what we have in our report is effectively a strategy to make it credible, and that involves first and foremost shielding the banking system from the consequences of sovereign debt restructuring because the only way you can make it credible is to say in extremis, right, we don’t want this.

And we do not think—I do not think that Italy requires a restructuring now. I want to go on the record for that, OK? But to make it in principle credible, you need the possibility of a restructuring. And to make that happen, you need a ton of risk-sharing because only then is the restructuring not so painful that you would never want to go with it.

And so that was the long answer to getting to the point that even though I am a big believer in the no-bailout clause, I don’t think it can be implemented without taking some from the first philosophy. So I think your two philosophies are really not either/or. I think the right way of thinking about it, since I have my German hat on today, is the no-bailout clause. But I think a clever German who doesn’t want bailout has to acknowledge that we will need risk-sharing to make it credible, right, which is why we need the first part of your agenda too.

MALLABY: Another question. Yes, right here.

Q: Yes. Thank you. Joe Naggar with Golden Tree.

I guess two areas I was surprised you didn’t touch. One is just, you know, U.K. and Brexit, and sort of the risks posed there. (Laughter.) And then—maybe it’s not a risk.

And the other one is just sort of the upcoming parliamentary, you know, elections and the kind of ECB, you know, Draghi, you know, changing—changing Draghi.

MALLABY: So, OK, those two things, I guess the eurozone—the Draghi change, but also the European Union elections. I’ll say one quick thing on Brexit and we’ll pass to Isabelle, maybe, for the switch in leadership in the eurozone.

So, on Brexit, it seems to me that after last week, when the Salzburg summit went badly, you know, the odds of a bad outcome by March went up. I think the base case is still that, you know, Theresa May, for all her robotic clumsiness, manages to get a fudge which kicks the can down the road on the difficult issue of what kind of trade relationship exists between Britain and the European Union. That will be—there will be a kind of political declaration, blah, blah, blah, and that will be negotiated later. What they’ve got to fix before March is a deal on Ireland. You know, they failed to do that because there is a hardline group of members of Parliament from Northern Ireland on whom Theresa May relies for votes to keep her government together, and they are absolutely refusing any sort of reasonable fudge that would allow customs checks in the Irish Sea between Northern Ireland and mainland Britain, which is the obvious solution to this issue. But I think it’s clear that there will be some sort of fudge. Those people will have to be rolled.

Then the interesting thing is Theresa May comes to Parliament with this fudge and says here is the divorce deal from Europe; we’re going to negotiate the trade details later; vote for my divorce deal. Whether she gets that through or not is a tricky question because there are people within her own party who would prefer Remain as an active movement, to get a second referendum going. The base case is I think she squeaks through, but there must be a twenty percent chance that there’s some kind of breakdown, and then who knows what might happen. It could be another election. It could be another referendum. It could be that we crash out. I think it becomes very hard to predict after that.

But there was this other part of the question. Can you comment on the European—

MATEOS Y LAGO: On the ECB?

MALLABY: Yeah.

MATEOS Y LAGO: Sure. I mean, on Brexit, I agree a hundred percent with what you just said.

On the—on the ECB, I think in an ideal world what you would like to happen is for the European leaders to say here’s the kind of role we want the ECB to play in the future in running economic—its part of economic policy in the system, and we’re going to interview a bunch of candidates and see which one is closer to that philosophy. The odds of that happening are close to zero, and instead we’re going to have a discussion around passports and gender and this or that form of diversity, and who knows what will come of it. And I think that’s a real issue, that we will not know until the next crisis, probably, how the ECB will behave when the time comes. I think that’s unfortunate. I hope I’m wrong and that we’ll see more of a discussion of, you know, how active should the ECB be in helping the European—in helping the eurozone have more convergence and perform better as a monetary union, but I fear we won’t get that.

MODY: If I may just add on that, in my view I believe less in the personalities of it here. I believe that the ECB operates under very severe political constraints, and the ECB at this present moment in time has reached its political limits. The QE is being withdrawn, not because there is a reason to withdraw it; growth is slowing down, inflation is stubbornly stuck. A normal ECB would at this time—just like the Bank of Japan is bumping QE, even though the Japanese economy is doing better than the eurozone economy—the QE would last for a much longer period of time. But because the ECB is buying bonds of different countries, some of which are riskier than others, there is always the potential that there might be some defaults, which will cause losses. And so the ECB, in my view, has prematurely declared victory, and that is—that has nothing to do with Draghi. That is to do with the fact that it is a central bank of a diverse group of countries with very different political interests.

MALLABY: Jeff (sp).

Q: (Off mic)—for your insight. You have answered one question I came here with, which is where are the risks of a new crisis. And it’s clear it’s Italy—(laughs)—which I’ve heard from other European observers.

You mentioned at the very beginning but didn’t come back to the banks. I’d like to hear about the possibility and the form in which the stress that starts in the banking system would take. Thank you.

MALLABY: Ashoka, do you want to talk about that?

MODY: Yeah. I was going to defer to Isabelle, but I would say—

MALLABY: OK. (Laughter.) You’re welcome to do that if you’d like to.

MODY: Do you want to take it?

MATEOS Y LAGO: Yeah, I’ll take it. That’s fine. (Laughter.)

MALLABY: Maybe this is for BlackRock here.

MATEOS Y LAGO: So the banks—well, the banks in Europe are still not in great shape. You have about a hundred billion euros of NPLs in aggregate on their—on their balance sheets, so that’s not a great condition in which to enter the next—the next downturn.

As we’ve said before, we’ve got—we’ve got better supervision, but that’s only for the largest ones. The smaller ones are still in a bit of a—not a no-man’s land, but let’s say looser supervision.

And then, thirdly, as in—as is the case in the U.S., the policymakers, in reaction to the bailouts of the last crisis, have decided to tie their hands significantly in terms of their ability to solve a problem, such that, you know, if, say—I don’t want to name names, but the largest German bank—(laughter)—had run into trouble, you know, eight years ago, it’s pretty clear what would have happened. Today it’s not. And the only certainty is that—is what it’s not allowed to do. But in terms of exactly what can the system, the authorities, do, we don’t know, and that’s probably a recipe for taking longer than it should to resolve the problem.

So I would say that’s my worry. That’s a system that is a little wobbly to start with. It’s in better shape than five years ago, no doubt. The NPLs have gone down. I don’t want to be too alarmist. But it’s a system that’s fundamentally not as strong as the—as the U.S. one, that is—still needs to go through a lot of consolidation. This consolidation is, unfortunately, not happening on a cross-border basis, which would be the better way of doing it. It’s not happening because national regulators are penalizing the banks that want to do this on a cross-border basis. So, frankly, this is all, you know, not terribly encouraging. Again, I don’t think it’s—as long as growth holds up, it’s not a risk. But when growth slows down, I think it’s as likely that the problem will start from the banking side as from the sovereign side, perhaps even more likely.

MODY: So I’m glad I deferred to her. (Laughter.)

MALLABY: Me too. Yes, a question there.

Q: Ed Cox, New York State Republican Party.

I’ve heard the words for solutions, whether temporary or permanent, of austerity, stimulus, restructuring. The Italian gentleman mentioned another word: reform. We would say deregulation here in the United States. What role does reform or deregulation have? And how it is implemented in the process of finding a solution?

MALLABY: So that is something on the list of things that, you know, Europe has made some progress on, which I skipped over. But, Jeromin, do you want to comment on that, or?

ZETTELMEYER: Yeah. So I think that like you probably meant, I mean, the big success story in that respect is that France is doing reforms, which about two years ago would have been thought of as inconceivable, right?

Germany actually needs to do quite a few reforms. So my job when I was in the Ministry for Economic Affairs was to push for that, but there was a huge sense of complacency.

And the rest of Europe seems to also think that, you know, apart from liberalizing its services sector, which everyone agrees on, Europe is—Germany is, if anything, too competitive, so they better don’t do reforms. I think that’s stupid because we have a long-run issue that has nothing to do with Europe and the euro area; it has to do with China and sort of our position in the world economy.

But then there is the—and Spain has kind of, you know, been OK, generally.

I think Greece has done under a reform-phobic left-wing government more reforms in the last two or three years than they did under right-wing governments before that.

So there is actually quite a good—lot of good stuff going on.

Again, the outlier a little bit is Italy. So Italy did some reforms under both Mario Monti and Renzi. There are—you know, these reforms have been controversial. So Ashoka will probably explain to you why they have done more harm than good. The question really is, to what extent can the type of reform that you have in mind as a Republican address the real deep-rooted problems of a country like Italy, which have to do with institutions, the judiciary, corruption, and maybe not so much regulation.

I actually agree with you that on product market regulation Italy still needs to do a lot. So there is sort of an intersection between, I think, the relevant reform agenda, what you have in mind, that’s very important, but it’s probably not the number-one problem in Italy.

MALLABY: I’m glad you brought up China because it does seem that, you know, if you take high-tech, AI, you know, that’s where—if you think about Europe’s future, the past was underwritten by a set of extremely competitive manufacturing companies—German cars, machine tools, and so forth, quite a lot of French strength in sort of big infrastructure and so forth. If you think about the next generation and what high-tech means, it feels as though Europe is less well-positioned in artificial intelligence, which is basically a game of aggregating data, with two big players—the U.S. and China—battling it out and Europe really not on the map.

MODY: Yeah. If I may just add to both of what you said, remember, Europe is a declining continent. It’s a declining continent economically, and it’s declining at a speed that is extraordinary compared to the United States and especially compared to Asia.

So if you look at patent statistics, in 1995, the Koreans patented about half the amount the Germans did. Today they’re almost double. Behind that lies a huge R&D infrastructure. Behind that lies an impressive educational structure.

China today is—does more patenting than France does. Again, behind that lies research and education.

The East Asian economies are powering ahead not because of what Europeans call reforms, but because they invest in education, research, and innovation. That is where the future lies. Oddly enough, despite all its strengths, Europe has failed to invest for almost a generation in these. European education levels are falling behind the rest of the world, and European universities in particular are falling behind the rest of the world.

So Europe is—you know, labor market reform, which is sort of the sort of standard reform in Europe, which is, you know, making it easier to fire workers, yes, that will do something. But what Europe needs is a Marshall Plan-like investment in education and innovation. And there is—that is a domestic challenge. That is not a eurozone challenge. Each country needs to do that. But if they don’t, then the superstructure of a bad macroeconomic structure of the eurozone imposes huge costs on Europe as a consequence.

MALLABY: The foremost expert on the Marshall Plan is sitting right here in the front row, so—

MODY: Right, exactly.

MALLABY: Isabelle, do you want to say something quickly on the—on sort of Europe’s structural growth challenge? I mean, we’ve been talking about financial pressures and so forth, but—

MATEOS Y LAGO: Yeah. I mean, I don’t want to overdo the negativity about—around Europe’s decline and inevitable bust-up down the road. I mean, Europe, you know, has had higher real wage growth than the U.S. since the crisis. It has—it has higher life expectancy than this country. It has educational achievement that it’s true has been stalling or declining in some countries, but remains high. So I think the question is, how do you preserve these accomplishments going forward? We shouldn’t negate them completely.

I think the trouble with structural reforms is, again, they are—right now the competency for most of them is at the national level, and most structural reforms are unpopular. I think now we’re seeing a switch in those countries, like France, that have elected pro-European governments. There’s a switch to this slogan of the Europe that protects. That’s been, in fact, adopted as the slogan of the—of the Austrian presidency.

And I think as part of that there is this sense—and also thanks, frankly, to President Trump—this sense that, look, we need to rely more on ourselves going forward. We need to roll up our sleeves and start assessing, you know, what is it going to take for Europe to stand on its own two feet. And that’s true in terms of global, you know, financial infrastructure, you know, how to escape the secondary sanctions on Iran and the like. That’s true in terms of defense. That’s absolutely true in terms of technology. But we’re at the very beginning.

So I think the good news is Europe is really waking up. And I’ve seen this in—you know, whenever I’ve been in Brussels or anywhere on the continent in the last couple of months. But it’s the very beginning, so we’re going to have to see where that goes. I’m hoping this will be an issue in the upcoming European elections and that can give some momentum for the next Parliament and Commission to really give a big push to these issues and, frankly, adopt a common strategy. This seems to be going against the wind, but frankly, where Europe is strong is on competition policy, where it’s acting at the European level; it’s on monetary policy, where it’s acting at the European level; now on banking supervision. So I think there’s a strong case on some of these issues for moving the initiative to the European level. But we’ll see.

MALLABY: I’m going to ask you each to give a one-sentence answer to a final question and then we’re going to wrap it up. If you had it to do all over again, would you want to create the single currency? Jeromin.

ZETTELMEYER: Yes.

MALLABY: Yes. OK, that’s quick.

MODY: No, of course not. (Laughter.)

MALLABY: Isabelle.

MATEOS Y LAGO: Absolutely yes.

MALLABY: Absolutely yes. OK, two to one. (Laughter.) Only the Italians disagree.

All right. So we’re going to conclude this. There’s now a fifteen-minute coffee break, and that’s on the first floor, and then we’ll be back here at ten for the next session. Thank you. (Applause.)

(END)

The second session of the Stephen C. Freidheim Symposium on Global Economics looks at how emerging markets (China, Brazil, India, Russia, etc.) have fared over the past decade, the extent to which reserve accumulation and flexible exchange rates have enabled them to manage shocks, and the question of current financial stability.

This symposium is presented by the Maurice R. Greenberg Center for Geoeconomic Studies and is made possible through the generous support of Council Board member Stephen C. Freidheim.

TETT: Well, good morning, everyone, and welcome to the second session, “Building Off BRICS: The Future of Emerging Markets.” My name is Gillian Tett. I’m the U.S. managing editor of the Financial Times.

And I should say congratulations to all of you who survived the U.N. traffic this morning—(laughter)—which gets worse and worse every year.

And one of the people who’s going to be at the U.N. today and speaking is President Mauricio Macri from Argentina, who I just had breakfast with. And in many ways he epitomizes what we’re here to discuss this morning because a couple of years ago Argentina was coming back into the fold, investors very excited about its prospects, so much so that it achieved the remarkable feat of selling a hundred-year bond. But, of course, in the last three months that excitement has largely unraveled. There’s been a new crisis. Argentina’s had to go back to the IMF. It’s still unclear what’s going to happen next. And in many ways this is a story that’s perhaps more extreme in Argentina, but epitomizes what we’re seeing in the emerging markets, because once again we’ve seen in the last few months turmoil erupt, and once again people are asking are the emerging markets actually reforming themselves onto a sustainable path or are we going back to the future towards a new range of—new wave of crises.

And we have a fabulous group of people to talk with us about this. Carmen Reinhart, Professor Reinhart, known to most of you, who is of Harvard Kennedy School and of course co-author of that famous book This Time Is Different, or maybe not so different. Next to her we have Brad Setser, who is from the Council on Foreign Relations, a fellow for international economics. And on my immediate right, your left, is Ruchir Sharma, who is head of emerging markets and chief global strategist at Morgan Stanley, and also an author and a great expert on India.

So, is it back to the future? Is it really this time different? Carmen, tell us, how do you assess the current stability of the emerging markets? Are you surprised by the latest outbreak of market turmoil around Argentina and Turkey?

REINHART: No. Actually, about a year ago I did write a piece called The Curious Case of the Missing Defaults, which is about a historical look at what happens typically when commodity prices decline, when capital flows withdraw. And just those two things alone usually give you a big pop in new defaults. The shoe that had not yet dropped at that time really was the impact of rising U.S. or international interest rates. So, you know, those three external factors played a big role in the boom in emerging markets—you know, low rates, high commodity prices, large inflows, above-average growth. That era has been gradually ratcheting down. Not all at once, but that’s where we are. So it would have been more surprising if they were doing great still at this stage.

TETT: Right. And before I turn to Brad, how much—how many defaults do you expect? I mean, wonderful title, The Curious Case of the Missing Defaults, but it also begs the question of, you know, when do those missing defaults actually appear?

(Pause.) (Laughter.)

Oh, I was actually directing it at you. But feel free to—

REINHART: You were doing it at me?

TETT: Yes. Feel free to hand it to Brad instead if you prefer.

REINHART: Oh, OK. So, all right, let’s take that in steps. OK.

So in the—among the low-income countries, we actually, I am almost certain, have had more credit events, more restructurings, than what we hear about in the press, because a lot of the low-income countries borrowed from China. This is very opaque lending. The terms are opaque. The amounts are opaque. And there have been several recorded restructurings already. So that stuff, those kinds of credit events, don’t get picked up so much in—because they are low-income countries, you know, former HIPCs and so on. So we’ve had already, I think, more defaults.

Now, the big ones, the big emerging markets, well, I have to say, of course, Argentina, Turkey have been in the headlines. But those are not the only sources of concern. Those cases are ones in which external debt is a big issue. But then you have other cases, like Brazil, where it’s internal debts that are a big issue. And time will tell whether these big ones will also, you know, have a new wave of credit events. Certainly, in the case of Argentina, it’s a narrow line that they’re walking.

TETT: Right. Brad, are you concerned about contagion? I mean, do you think we are back to 1997 or some of the other bouts of contagion we’ve seen in the past?

SETSER: I mean, my best guess is no, for the following reason. I think there are very clear, very obvious vulnerabilities in Argentina and Turkey. Why haven’t there been as many defaults? I think the simplest answer is that most big emerging market governments held more reserves than they had foreign currency debt, which created a level of balance-sheet resilience that they didn’t have in the past. Two countries that don’t really meet that now: Argentina, obviously; and then Turkey, which while the government has relatively limited foreign currency debts, the banks have a ton of foreign currency debts, so the aggregate balance sheet isn’t as strong. So that—the fact that Turkey and Argentina stand out so strongly on indicators of vulnerability compared to the other big emerging economies suggests there’s a little bit of a—of a firewall.

The other important factor—and I think this is a source of some greater uncertainty—is that in the past, at least in my interpretation of what drove the depth of the ’97 crisis—the first leg was driven by balance-sheet weaknesses, too many—too much external debt, too few reserves. And then the second leg was, you know, triggered in part by a commodity shock, a commodity price fall that in, you know, ’98 followed from the collapse in Asian demand. Right now oil prices are pretty high, which on one level makes it worse for Argentina and Turkey, but on another level makes it hard to see how you would get a second leg of transmission to the oil-exporting economies. And then when I sort of think about what could drive the next round of stress, what could make this more systemic, the obvious shock would be something out of China.

TETT: Right. Well, those are two great questions we’re going to come back to, both the question of China internal but also China’s role in lending to other countries, which of course has made the whole question of debt restructuring very interesting. But before we come back to that question, I’d like to ask you, Ruchir, two questions.

One is over the weekend I was with some of the current administration, along with Sebastian and others, and I asked them to what degree they felt the gyrations in the dollar and the rising U.S. interest rates were putting pressure on the emerging markets. You know, is this a problem made partly inside America? They said, of course, no, no, no, no, it’s not our fault, it’s all their fault, they have to hurry up and restructure themselves. Do you agree? Do you think this is a problem partly of America’s making?

SHARMA: Well, it’s easy to blame everything on America’s making in terms of what happens in the world today. But I think that what is it—(laughter)—you know, what is it really? Sort of if you look back at history, right, in terms of the facts, I think, like, it’s—to put some historical perspective on this, one, that the world is on a dollar standard, in that ever since we sort of got off the gold standard we’ve been on a dollar standard. What does that really mean? Two things, that—and this pattern has reoccurred all the time. Whenever you have a stronger dollar, you typically have contracting global liquidity, and that always leads to problems in some place of the world or the other. That is the history of the post-Bretton Woods world, is that concern.

The second thing, which I think is really underappreciated, is just how powerful the dollar is today. Which is that, you know, there’s been so much talk about American declinism and all these other things, et cetera, but in terms of the financial side American exceptionalism has never been this stark. And there are so many metrics the way that you can look at this. Look at the role of the dollar in the global system. Whether it’s a share of FX reserves, a share in international transactions, a share of global debt, the dollar’s role, if you take it all combined, has never been this powerful as it is today. That is one of those things which I think is extremely underappreciated. So what that does is that now even small moves in the dollar have a very large impact on the global economy, on global financial markets.

Now, what’s really interesting to me is that how we’ve sort of come full circle; that if you rewind back to last decade, the talk was exactly the opposite. The favorite term of the last decade was decoupling, BRICS, in terms of what this was going to be. All this stuff was being spoken about.

At the beginning of this decade, I—you know, like, I wrote a book basically arguing as to why this BRIC hype was completely overdone in terms of it was not going to—now we seem to have come to the other extreme. Oh, these emerging markets—

TETT: Well, it’s time for you to write a book saying back to the BRIC hype.

SHARMA: (Laughs.) But in terms of the fact that—now we are back to the old sort of—sort of lines, which is that emerging markets and, you know, that they are destined to sort of always fail and stuff like that. And the reality and the truth, as we know, always lies, you know, somewhere in the middle. Emerging markets, many of them—there are about two hundred countries in the world or so which are tracked. Out of these, only I think thirty-eight or thirty-nine are classified as developed markets. The balance are classified as emerging, and many of them for centuries have been emerging forever. Like—(laughter)—you know, like Brazil, Mexico, you know, in terms of if you look at their per capita income relative to the United States for the last hundred years, they’ve gone nowhere. When commodity prices go up, they all look good. When commodity prices go down, they all look bad in terms of how it is.

So I think we’re at that juncture now where we are back to a lot of pessimism about emerging markets. We are back to the late 1990s, which was about the last time we saw such American exceptionalism in the financial markets like we saw today—like we are seeing today. So on every single metric today American exceptionalism in the financial markets and the role of the dollar has never been stronger. And I think that’s what’s leading to all these stresses which are showing up in different parts of the world.

TETT: Well, that’s fascinating. I’m going to come back in a bit and talk about India, but I can see Carmen’s keen to come in.

REINHART: So I think one way to simply think about the sheer magnitude of the importance of the dollar issue is, you know, we think of Argentina’s great default in 2001. Argentina’s external debt in 2001, on the eve of default, was less than fifty percent of GDP, when the peso was one-on-one on the dollar. When the peso went also three-on-one on the dollar, external debt blew up to about 140 percent. So valuation effects are huge.

But I do want to take an issue with something Brad said. I completely agree, Brad, that there’s more differentiation and better management on the whole on the part of emerging markets. But I honestly think that we shouldn’t rule out contagion a la late 1990s, for the following reason. I think the markets are pricing in vulnerabilities in the currency, vulnerabilities in the case of Turkey in banking, but I don’t think they’re pricing a sovereign default in a big EM. And this is sort of like what happened with Russia. If you remember Russia before default, yeah, you know, you had—you had capital outflows from Russia, but once it defaulted it hit Brazil, it hit Mexico, and it hit Hong Kong, simply because those were liquid markets. So you get a lot of cross-market hedging and a lot of stuff even if they have pretty good fundamentals, say, in the case of Mexico.

TETT: So where would you think—if there was going to be a big emerging-market default which isn’t priced in yet, where would you see the prime candidate as being?

REINHART: The prime candidates, look, I love to quote Stan Fischer as saying, you know, when he was governor of the Bank of Israel, having a liquid market, a liquid debt market, is a mixed blessing because when you try to have portfolio adjustments that are quick and abrupt you don’t go to Bolivia because, you know, you don’t have much Bolivian debt. The price—you know, the—

TETT: So the—

REINHART: —the cost of that transaction would be enormous. You’d go to the more liquid markets, so places like Mexico, Brazil, Hong Kong, South Africa, which have deeper capital markets, which have deeper—currency markets are often hit hard in these episodes.

TETT: Brad, I could see you trying to jump in there.

SETSER: Yes. Two—

TETT: Do you want to defend yourself and tell us why there won’t be contagion?

SETSER: Well, I don’t like disagreeing too much with Carmen. (Laughter.)

TETT: Please go ahead. It creates more dynamic. (Laughter.)

SETSER: I do think, you know, one of the interesting dynamics of the past, let’s say, year and a half has been that we’ve discovered that U.S. policy shifts still matter for most of the world, and that when the U.S. chooses a looser fiscal policy, which implies a tighter monetary policy, it shouldn’t be terribly surprising that those emerging economies with strong financial links but weak trade links to the U.S. get into trouble. And so, in that sense, the fact that Turkey and Argentina led the charge shouldn’t at all be surprising.

I think, you know, in terms of events, I don’t think a sequence of countries getting into so much trouble that they either default or go to the IMF is my base case. But I can imagine sets of circumstances which could lead to that result.

The first thing, which probably isn’t priced in but is conceptually possible, isn’t a big sovereign default, but it’s a big Turkish bank entering into some kind of restructuring that is messier than expected. I think the baseline expectation is the Turkish government will come in and, if necessary, find enough dollar liquidity to avoid large losses for any cross-border dollar creditors. Right now Turkey doesn’t have the resources to do that on its own. It can manage the fiscal costs of a bailout, but it doesn’t have enough foreign currency reserves. And the politics of Turkey getting those reserves are complicated.

The second chain of events that I can imagine causing real systemic stress, setting China aside, start in Argentina. So Argentina loaded up on foreign currency debt. Macri’s government basically doubled the amount of bonds issued that Argentina had outstanding in three years. In the face of the currency shock, Argentina’s debt-to-GDP, the IMF says it’s going to go to seventy (percent) in their stress scenario, but their stress scenario is less stress than what we observe in the markets today. So if you kind of adjust for that, debt-to-GDP is eighty (percent). And Argentina’s solvency hinges on having access to a friendly lender, the IMF, that will provide cheap financing in periods of stress. If the IMF doesn’t want to play that role, I think Argentina would inevitably be on a path that would lead to default. And if Argentina defaults, I think then there becomes a question about Brazil’s resilience, noting what Carmen said, the high level of domestic debt, but also noting that Brazil still has more foreign currency than the government, Petrobras, and the big state banks have foreign currency debt. So the dynamics of transition would differ, but you could imagine that sequence. And if that sequence happens, then I think it’s something that would feel like a major systemic emerging market crisis.

TETT: Well, let’s turn, then, for a moment to the IMF. I mean, obviously, the IMF and Argentina are still in negotiations. There appears to be a lot of good will as far as Argentina is concerned towards—from the IMF towards Argentina, helped by the fact that, of course, President Trump seems very fond of President Macri. Do you think, though, that the IMF is willing or able to keep acting as sort of global nurse, as it were? Because, of course, the IMF itself is facing a big battle in the next year to try and replenish its resources, and there’s questions about whether the IMF has the ability or willingness to keep playing this role. Who would like to jump in on that?

SHARMA: Well, I think that, you know, I’ll answer that, but I just want to sort of, if you don’t mind, just finish one point here in terms of like this whole contagion bit and then, like, the IMF’s role here.

So my own sort of belief is this, that the Turkey and Argentina—you know, like, every crisis plays itself out somewhat similarly, but somewhat differently. And I think that, for me, like, the way that I see the world today is that the Argentina/Turkey episode is done; which is that what had to happen there I think has happened.

Issue is, like, can there be another leg to this? And I think it’s all down to one country, which is China. I think that if something happens in China, that is when you get the next leg down as far as this crisis is concerned. Apart from that, I think that the emerging markets will be able to sort of muddle their way through this entire thing. And the issue it that why China? Why is it that I’m worried about China more than any other country at this point in terms of if something happens?

Well,, as you well know, that most of the increase in global debt which has taken place over the last decade has been concentrated in one country, which is China. In fact, if you look at the increase in global debt across the world, I think more than half of it is just China in terms of what’s happened. And then the other increase in debt which has taken place has been of much smaller scale in countries like Turkey and possibly like a couple of other countries mentioned there. So I don’t see sort of the other countries being that vulnerable.

But in China’s case, there are two issues that they are dealing with currently, which is the fact that every time they have been—in the past, I mean, China has faced an issue, they have been able to ease policy quite aggressively. They’ve cut interest rates, pumped more money into the system, and off you go again. But that’s led to rising leverage over time.

The issue here is this today, which is that they’ve also followed a de facto currency peg with the U.S. dollar. And this is, for me, the most interesting part. For the first time that I can recall, Chinese interest rates and U.S. interest rates have converged. And as the U.S. keeps increasing interest rates, the incentive for capital flows keeps increasing even though they’ve been quite successful in maintaining capital controls as far as their economy is concerned.

But can China afford to increase interest rates when its economy is slowing down quite sharply just now? I think that it comes down to that. And I think they’ve drawn a line in the sand, which is seven-to-one on the exchange rate, which is what everyone’s watching now. If something were to happen to that exchange rate, I think that’s when you get the next leg and this becomes a contagion. In the absence of that, I don’t think there is enough vulnerability out there. Because remember one thing that—in terms of the whole point, that emerging markets for the past decade have been through a workout process.

And there’s one really easy way of looking at it. Since 2008, the U.S. stock market has more than doubled in value. In dollar terms today, emerging markets since 2008 are still below their 2007/2008 peak.

TETT: Wow.

SHARMA: So, you know, this has been a staggering period of underperformance.

And for me, I hate to say this, but as a market person I have to sort of distinguish here a bit, which is that it is typical at the end of a cycle for everybody to pile on on the pessimism, you know? As I said, in 2007/2008, everybody was optimistic on emerging markets. The same people today bashing emerging markets, you’d have to sort of calm them down in 2007/2008, BRICS and the irrelevance of America and how America was doomed to decline. And Lula’s favorite comment in 2009 still stays in my head, when he basically said this crisis was not black or brown, it is white in terms of it, in terms of, you know, what he said. And Gillian and I were talking about Brazil being in the crosshairs of the crisis.

So I think that this is typical behavior where we sort of pile on at the end, everything is negative, everything was positive in 2007/2008. It’s entirely possible that we get an entire leg down, but I would say the defining line for this is going to be China.

And this brings me back to the IMF point. Again, I was going back to like 2007. Do you know what the favorite articles used to be in 2007? On how the IMF is going out of business. Why? Because they said the IMF had virtually zero programs running anywhere in the world because no country in the world needed an IMF program in 2007. (Laughter.) No, you know, not one. You know why? Because of the two hundred countries in the world that we track, I think only about two of them for the first time in history recorded a negative GDP growth. I mean, the number was that low. And the two countries I think were Fiji, Afghanistan—basically, who cares, right? (Laughter.) So in terms of that’s what—that’s what happened.

TETT: Well, I think the people in Fiji care, yes. (Laughter.)

SETSER: Anyway—

SHARMA: So that’s what happened. And here we are today where we are back to the full circle. So that’s where I come out at, which is that now it’s—you know, like, contagion, yes, possible, but let’s focus why and where rather than just talk about it here.

TETT: Well, let’s talk about China, because—Carmen.

REINHART: But, but, but—whoa, whoa, whoa. (Laughter.) So you’re telling me that Argentina/Turkey issue, that’s done? That’s discounted?

SHARMA: For now. Yeah, discounted. That’s the point, yeah.

REINHART: No, no, no, no, I don’t think so. I don’t think you can equate currency crisis or banking crisis with default. Default—a Turkish default does mean—there are banking exposures. Notably, Spain, Italy, they’ve made loans to Turkey, to Turkish companies. So it doesn’t even have to be a sovereign default. If it’s a large-scale corporate default, that has repercussions for European banks much the same way that the crisis in Thailand and Indonesia and Malaysia had repercussions for Japanese banks.

TETT: So what about—what about China itself? I mean, how concerned are you two about China? Because, obviously, you know, people are watching very closely indeed this currency movement and the question of whether the Chinese will stick to the peg or not. It’s one of those geeky things, really, in the weeds of the financial market, so most people are ignoring. But it’s incredibly important what’s happening right now. How concerned are you about what’s happening in China?

SETSER: Well, I think you probably have three people onstage who spend a lot of time paying attention to, like, Chinese exchange rates. So I’m going to challenge that China is focused on seven to the dollar. I think it’s probably ninety-one against the CFETS or the exchange rate index that includes more currencies than the dollar. But whatever it is, it is a binary decision at this point about whether or not China is willing to maintain an exchange rate at that level. It’s a binary choice—

TETT: And, of course, if it doesn’t, we’re back in the situation where the markets fall and we get quite a nasty punch.

SETSER: I think we would all agree that if China does—if the yuan goes down by twenty percent, that is a major shock to everyone, particularly to emerging economies.

REINHART: Absolutely.

TETT: Carmen?

SETSER: But then can I just on the—

TETT: Yeah.

SETSER: Yeah. China has to make a decision, one, about whether they are willing to follow the Fed up, the point Ruchir made. China can stimulate, even if it is raising interest rates or not, cutting using fiscal policy tools. I think the central government has plenty of fiscal capacity. And in that sense, I think it is a choice.

And then I think China still has more than enough reserves that if it chose to, it could maintain the peg for a long period of time. So in that sense, I think it is a real choice about how China wants to respond to the—to the trade escalation that is coming.

REINHART: Right. Let me echo what Brad said. I think an exchange rate shock coming from China would have major repercussions for emerging markets. We got a little bit of a preview in the summer of 2015—

TETT: Exactly.

REINHART: —with a fairly minuscule depreciation by any standard and everybody’s exchange rate adjusted by more and it created quite a wave of turbulence across emerging markets. I stumbled literally upon—you know, I was giving a talk in Peru this summer and started looking at five-year correlations, growth correlations of China and Latin America. Since 1995, those five-year growth correlations are .75, these are simple—and so a very significant Chinese slowdown has big EM repercussions, to echo what Brad said.

TETT: Right. I mean, one of the fascinating things about China right now is not only is it in many ways the linchpin of trying to work out where the emerging market’s going to be going in terms of contagion, but it itself has been a big creditor to many impoverished countries and that’s hugely complicating the role of the IMF and others at the moment. How do you see that developing? I mean, do you feel you have much transparency on what’s happening, about whether there have or have not been defaults on the Chinese set to date?

REINHART: So I have, over the last few years, been trying from secondary sources and from press putting together data on this lending from China. It is huge. It is huge in dollar terms. It’s not enormous, but relative to these countries’ GDPs, they’re the big lender because they’re specializing—

TETT: The IMF.

REINHART: The problem from the IMF vantage point is that they know neither amounts involved nor the terms. The opaqueness surrounding these transactions is huge. So what kinds of problems does that create for the IMF? Number one, if you think that Guinea-Bissau or Angola—Angola’s external debt, Angola’s the leading borrower from China, has external debt of—I’m just making this up—of fifty percent. It might not be fifty percent, it might be seventy percent, it’s that much additional lending. That’s a big issue.

The second big issue is China is not part of the Paris Club, so the terms of restructuring, any kind of—you know, like, the highly indebted, low income—the HIPC, the poorest-country initiative that initiated the debt forgiveness. All of that was coordinated under the umbrella of Paris Club. China’s transactions are known to itself and the recipient.

TETT: Right. Well, that’s fascinating.

I’m going to field in—sorry—the members for questions in just a moment. Before I do that, I’d like to ask one other question which is this. I don’t see any sign that the Federal Reserve or the current administration is willing to do anything other than put America’s interest first in terms of setting interest rate policy. Do you see any sign that the Fed or others are paying attention to the emerging markets, given the primacy—

SETSER: Well, I mean, Donald Trump, in a way, has been an advocate for the emerging market position. I mean, he doesn’t want the Fed to tighten monetary policy. (Laughter.)

TETT: I don’t think he quite looks at it himself and sits around to save Argentina. But anyway, yes.

SHARMA: No, I don’t think so. I mean, I think that the Fed’s going to continue to sort of—and that’s the big risk as far as emerging markets are concerned, that, you know, on this dollar standard the Fed continues to sort of increase interest rates.

The only thing which I can say here is that, as I said, that the pessimism is deep and the extrapolation is high, which that does happen and that happens. So the way that I’m looking at the world today, like all the emerging markets, is basically, like, two scenarios. One, that if something happens in China, we get under the big leg down. But the second one, and I think that this is also interesting for me, is that rather than talking about all the problems in emerging markets, starting to look at which of those economies, which have suffered unnecessary collateral damage in this entire washout which is taking place currently. And I can find enough pockets in the world where growth rates are doing relatively well. They don’t have any sort of external vulnerability. They’ve worked out a lot of the problems. Like the one, you know, region I’ve always liked a lot is Eastern Europe. You’ve got economies like Poland. So I was saying that, for example, the fact that I just mentioned to you that there are only, what, thirty-nine countries classified as developed countries in the world. And the next one to join their ranks will be Poland is my forecast, basically.

And then you’ve got other countries in Southeast Asia, other places, even in Latin America, which are not that exposed to some of this, where you can argue that there’s basically been—there’s basically a lot of collateral damage. And you should start looking at these places where the collateral damage has taken place because of how well the U.S. has done and the gap is so wide between the U.S. and the rest of the world.

So there are two positions. I’ll still be—I’m still concerned that there’s one other shoe to drop and that’s got to do with China. On the other hand, you start sort of thinking of places which have suffered collateral damage, are not exposed to China, and you think that basically these places suffered collateral damage, rather than piling on and saying everything is going down the tube her.

SETSER: Can I just jump in? I mean, I think, undoubtedly, the U.S. will adopt its classic position on it with respect to monetary policy, which is that it is directed at domestic U.S. conditions and that the Fed will only adjust its policy when it is clear there’s negative repercussions that are echoing back to the U.S. That’s the way it’s been for a long time.

I think the unknown is the Trump administration’s policy towards the IMF.

REINHART: Yeah.

SETSER: Trump doesn’t tend to make, best I can tell, policy decisions based on policy as much as on personality. He likes Macri, Macri gets a loan. He doesn’t like Erdogan, he really doesn’t like Erdogan, no way. Financial analysis of Argentina and Turkey has been a little bit secondary. If that continues, he may be more willing than might be expected to use the IMF as a bridge, which is what Argentina needs, given that Argentina’s debt sustainability, if you get stuck in old policy parameters, is fairly iffy. But conversely, Trump may be more inclined to use the IMF overtly as a tool of leverage to extract political concessions.

TETT: And do you think—going back to Carmen’s point about the Chinese lending and the way that that is, you know, challenging, complicating, sometimes even supplanting the role of the IMF—which I think is fascinating, I’d love to see your index of who is indebted to China and what’s happening there because I don’t think that’s publicly available, most of it. But do you think there’s any sense in the American administration now that they have to step up with the IMF, they have to show that they’re going to be nice to Argentina or anything else to try and counter the rising Chinese influence? I mean, this is a real, you know, big, geopolitical, great game.

SETSER: So we’re at the Council on Foreign Relations. I don’t think any one of my colleagues has yet detected the Chinese play for Argentina. I think if you want to do Chinese geopolitical expansionism, the more interesting case would be Turkey, given the geography. And then, obviously, the first case where the IMF’s relationship with China when the—when the IMF is going to be involved and the country hasn’t been terribly transparent and it doesn’t have the capacity to pay and it probably needs to restructure—well, it certainly needs to restructure its loans to China is going to Pakistan. And so I think that Pakistan is shaping up essentially as the test case for both the administration, the IMF and for China because China really hasn’t had to figure out how its debt will be handled and whether it will be just handled like everyone else’s or whether it’s going to be treated more specially. And I think that question will be resolved first in China. I’m sorry, Pakistan.

TETT: Yeah. Carmen, then others, the audience.

REINHART: One tiny note on the issue of the Federal Reserve. Look, the Federal Reserve, their mandate is a domestic mandate. It’s inflation, output gap, it’s a domestic concern. However, one thing that has been different is, number one, they’re providing much more forward guidance. So, you know, there are very few countries there that can be, you know, claim surprise to what the Fed has been doing. They’ve been doing things much more gradually and with much more forewarning.

So the issue of being caught off guard, you know, this is not the night—October 1979 spike in U.S. rates when Paul Volcker was, you know, trying to bring down inflation abruptly. Right? So in that regard, I think that has not reduced the influence of U.S. policy in emerging markets, but I think allowed for more preparation that this was coming.

TETT: Right. Well, that’s a good point.

Well, listen, I can see lots of hands waving already. A couple of quick pointers. Firstly, this is on the record. Secondly, please, if you ask a question, identify yourself. It’s not just courteous, it’s apparently compulsory here as well. And thirdly, keep your questions or comments short because I can already see a lot of hands.

Let’s start over here, I think the microphone behind you.

Q: Hi. Robyn Meredith, author of The Elephant and the Dragon.

Could we go from financial markets to the job market for a second?

And maybe, Carmen, given your past work on this you could comment.

I’d like to understand from you guys what you see the interplay is between emerging markets, particularly China, and the fact that, on the one hand, the U.S. has very low unemployment, but wage growth has been sort of low and slow. Could you talk about that phenomenon, how those may be interrelated and if we’re now seeing a sort of disturbance in the force of globalization? How is that likely to play out in U.S. wages?

REINHART: Well, for a while, part of the story on the slow wage growth was we had an unusually long and deep recession, characteristic of recessions following financial crises. That was—that was a big chunk of the story earlier on. The more surprising part has been of more recent vintage; that is, as we’ve marched towards full employment.

Look, there are all kinds of explanations. I’ll highlight a couple. One is we heard for a long time about lack of productivity growth. OK? We’ve also heard a lot about the role of globalization. Those have been, you know, two factors.

However, I think we—again, to pick on a very good point about extrapolating—I think at this conjuncture, it is dangerous or not dangerous, but it’s probably ill-advised to extrapolate, that because we have seen such abnormally sluggish wage growth in a period which had massive deflationary tendencies, not just for the U.S., but for the advanced economies as a whole—legacy of the crisis—I think it’s dangerous or risky to extrapolate that that is likely to continue.

My own expectations is that this is not a typical cycle, so don’t expect typical things, but that that below—that subpar performance may be—there may be a turning point around the corner there.

SHARMA: Yeah, I mean, I agree with that. Because, I mean, all the evidence in the developed world that we’re seeing so far across the developed world is that finally wages are beginning to increase, so that’s now happening across the developed world. Because the global unemployment, I mean, you know, this is one of those things, again, that we worry about something. That’s always, like, a rule for me, that what we worry about today will not be the worry five years from now.

So I think the one statistic to remember, that the global unemployment rate today in the developed world, if you look at it, is at close to the lowest levels in history, finally. So I think that finally now we’re seeing wage growth as a consequence of that.

TETT: The global unemployment rate.

SHARMA: Yeah, I mean, the global—

TETT: That’s fascinating. I haven’t—I mean, we all know about the U.S. unemployment, but we don’t often—

SHARMA: Yeah. Yeah, the global—yeah, so we keep track of this, of the global unemployment rate. It has to be for the developed market because emerging market unemployment rates are very hard to track. But the developed world global unemployment rate today is close to the lowest in history that we have going back 50 years.

TETT: Wow, fascinating.

Right, question over there and then we’ll go across there.

Q: Niso Abuaf, Pace University.

Is this working?

Perhaps this is the right time to connect this session with previous session.

TETT: We’re actually going to swap the microphone out. I think we—so if you could just—

Q: Niso Abuaf, Pace University.

TETT: Thank you.

Q: Perhaps this is the right time to connect this session with the previous session. In all likelihood, Turkey will have to restructure its foreign debt, which, as Professor Reinhart stated earlier, we can go down that path. That will mean significant—whether Turkey defaults or not, there would likely be a restructuring and that would be significant declines in the equity ratios of major European central—major European commercial banks, not only those in Italy and Spain, but probably also Germany. Could you just follow on that path a little bit maybe more? Thank you.

TETT: So are we facing new nasty banking surprises?

SETSER: I actually think that that question is much narrower. I think the real exposures are limited to a couple of European banks that have large Turkish subsidiaries who have, to some extent, funded those subsidiaries with cross-border loans.

The bulk of the stated exposure comes from, in the consolidated banking data, from the deposits in Turkey held by subsidiaries of European banks. And in a bad state of the world, those losses on that portion of the balance sheet—if you’re going to be, like, you know, Geithneresque, Paulsonesque, tough, whatever—the CEO of the BBBA or whatever bank can cut their losses by saying we’re going to not provide any additional cross-border credit. Write everything we’ve got down to zero, leave it to the Turkish government to manage all of the domestic deposits. It’s your bank, here are the keys.

My personal judgment is that the European banks, all the relevant European banks, are strong enough to make that decision and walk away from their subsidiaries. That still leaves the question of how Turkey would handle such a crisis. And that would be a real crisis.

One option would be to provide all of the recapitalization funds from the Turkish government’s balance sheet, in which case all the—most of the dollar credit would be protected. Another is to restructure a meaningful fraction of this. That would be Turkey’s choice when it comes to the equity capital.

There is a second question, which is that the Turkish banks writ large have about three-hundred-billion-plus in dollar liabilities and a lot of that is very short term, prone to runs, over half of it is domestic dollar deposits. And in order to provide dollar liquidity, independent of how you handle the equity, you could need additional liquidity support from someone.

So I think in the end of the day, I actually worry a little bit less about the direct exposure of the European banks and more about the absence of a real framework for managing the questions around the solvency and liquidity of the Turkish banking system writ large.

TETT: Right. Carmen wants to come in here and then we’ll go to a question there.

REINHART: So the orders of magnitude are not sort of late 1970s, early 1980s vintage with the exposure that U.S. banks at that time had to Latin America and other emerging markets. That’s not the scale.

However, I’d like to make a point of differentiation. It’s very different if a German bank has a problem at this conjuncture because of Turkish exposure than if an Italian bank has a Turkish problem at this conjuncture because the initial conditions in those two countries and those two banking systems are very different. You’re talking already about a case, in the case of Italy, which is already frail without incremental external shocks.

And so I think that that has to be factored into the equation, that this is not—it’s not going to have the same outcomes, whether it’s a Spanish bank or an Italian bank or a French bank. I think the most vulnerable spot is what it could possibly do to Italian banks.

TETT: And the usual moral is, if in doubt, worry about the Italians. (Laughter.)

Got a question, the gentleman with the red tie, and then the woman behind him.

Q: Eric Stein from Eaton Vance.

Ruchir, when you started, you talked about the problems of global liquidity in a strong-dollar environment. We’re in a strong-dollar environment now. And if you think back to February of 2016, we were also in a strong-dollar environment, a little different with commodity prices falling, but still EM, kind of risk off. Do you—and then we had the Shanghai Accord. You know, yes, there are issues with international cooperation today, but could you see a scenario—really for anyone on the panel—where the Trump administration, which certainly doesn’t want a stronger dollar, and EM countries, who also don’t want to see a stronger dollar, there could be more coordination to if not weaken the dollar, at least keep it from strengthening because it’s in multiple parties’ interests?

TETT: Well, we could have a new Boca Raton accord.

SHARMA: I mean, you know, that’s a very interesting thought. I mean, unfortunately, I just don’t know that as long as the Fed keeps increasing interest rates how you end up there. Because remember, like, a key principle of the Shanghai Accord was that the Fed sort of postponed. You know, like, basically went in a hole, you know, for a long period of time after that increase in December 2015.

I don’t see the scenario of that today. So the best hope for the dollar has to be that—I mean, the fact that, as some of our work shows, that it is today truly very expensive, so that, naturally, it sort of begins to peak. And also the fact that in Europe, you’ll find—you know, like, it’s sort of had this patchy economic recovery. We’re seeing some signs now that after the sort of weak economic data that in Europe economic activity is again beginning to pick up. So you’re hoping that, you know, that this lift comes from international.

But I don’t see the conditions for a Shanghai Accord just because of the fact that I don’t see the Fed focused on it because it—and the Fed maybe was different, you know, like, had much less confidence even in the U.S. economic recovery in February of 2016. Today I don’t see the Fed backing off, unless something dramatic happens to put them off that.

TETT: Right.

SHARMA: Yeah, so I think the chances of an accord like that happening are low apart from Trump’s state tweets which will continue about a strong dollar on, you know, every other week maybe, or something.

TETT: Well, I should have said Mar-a-Lago Accord, actually, rather than Boca Raton.

SHARMA: Exactly.

TETT: I’m a bit jet-lagged.

Carmen, what do you want to—what are your views on that?

REINHART: I actually agree. Think back to the Plaza Accord. The Plaza Accord in the ’80s involved the Japanese agreeing to allow for a stronger yen and the Germans—which still had the DM—doing the same. The Chinese are not going—or the Japanese—that seems very improbable, if not bordering on the miraculous. And, well, Germany has the euro. So it doesn’t matter that the surplus is big if it’s not—so the conditions are, in my view, not there for that kind of agreement.

TETT: Interesting.

We have a question over there. The lady with—thank you.

Q: Lyric Hale with EconVue in Chicago.

Although the Chinese have now established themselves in global debt markets, they have failed at establishing the yuan as a global currency in comparison to the U.S. dollar. And in fact, I think only 1 percent of world trade is conducted in the yuan.

At the same time, crypto assets are on the rise in emerging markets whose central banks have failed them. For example, I read a survey that 18 percent of people in Turkey now own bitcoin. So my question is, is this a new phenomenon? Is this something we should look at, and then bringing in emerging markets as a factor? And bringing the full circle around to China, China itself is also a major player in crypto assets and in the manufacture of equipment that’s required to create and maintain them. So that’s my question. Thank you very much.

TETT: Who would like to jump into bitcoin?

Ruchir.

SHARMA: Sure. So, I mean, as you possibly know, that one of the big stories of this year has been the bust in cryptocurrencies, right? So basically, what a massive decline which has taken place. So I still feel as a share in terms of what they do, it still remains a very speculative asset, like asset—it’s far too small and stuff.

But other point which you raised, like, to me, is one of the problems of the global economy today, which is the extreme difference in the financial economies and the real economy, which is that the Chinese share of global economic output keeps rising. Today it’s about fifteen, sixteen percent. And yet, their share in the global financial economy is basically irrelevant, has declined. You know, all these people spoke about the internationalization of the yuan and what was going to happen. The 2015 episode where they slapped on more capital controls to prevent money from leaving was a massive step back in that direction in terms of it.

And, you know, like, I think there’s been so much talk today about Chinese expansion, overseas lending, et cetera. But one thing you have to take into account: I’m not sure what the ability of the Chinese to keep doing that is going to be. Their current account surplus has disappeared. So, in fact, you know, they’ll be running a current account deficit possibly soon. They were already doing it, like, in the odd quarter. And then their fixed reserves appear large, but they’ve stopped increasing in terms of it. And we are seeing some pattern, again, maybe of marginal decline. And as a share of their overall money stock, their fixed reserves aren’t that high, in fact. The number appears high, but if you look at the stock of money which is circulating like in China today, it’s not—it’s not that high.

So, yeah, I think that it’s one of those issues for which I don’t have an answer, but I don’t see bitcoin being the answer for it. But this dichotomy is a real problem for the global economy, but the dollar is so almighty, even though the U.S. share of global economic output is still about stable around twenty-five percent and everyone—China, et cetera, is rising.

But, you know, and the other thing which has failed people, I think—and this thing has been gold. Again, you know, we talk about what happens to these fads and trends. At the beginning of this decade, gold was such a popular asset in terms of how it was going to do, and here we are sitting at the end of the decade with the gold price having done nothing this decade. So, yeah, I think that this is one of those things where there’s no alternate to the dollar and it’s hard to see as to what will fill in that void.

TETT: Professor Reinhart and Brad.

REINHART: Let me make the following point. Chinese finance is very big in especially the low-income countries, but that covers a big share of the world. But their lending is in dollars. So saying Chinese importance is big in finance is not the same as saying the importance of the yuan is big or, you know, they are lending—this is dollar lending.

On the bitcoin, let me say I think one of the things that to me has been of interest is seeing it also emerge in cases where it’s a vehicle for capital flight. It emerged in Greece in 2015, in China at the time of capital outflows. It comes and goes. But I concur that at this time it’s still small potatoes.

TETT: Brad.

SETSER: Like, two years ago my research assistant convinced me that we had to do something on bitcoin and capital flight from China. And at the time, there was an almost perfect correlation between the price of bitcoin and measures of capital outflows from China. That correlation went away entirely. It turned out to be completely spurious, which I think probably informs my general sense of that importance of that question.

I think the key question, really key question is whether China’s reserves are adequate, and that hinges on a judgment about whether China’s reserves should be assessed relative to China’s domestic monetary base. And if you use that as the standard, China no longer is heavily reserved, which means it doesn’t have the capacity to use its reserves to maintain its currency in a way it has in the past.

Or if you think China’s reserves should be assessed relative to its external debt—in which case China is more than adequately reserved. It can pay off its entire external debt and still have, like, $1.5 trillion left. It is in no way in the same position of other weak emerging economies. Because it has controls, I don’t think the domestic monetary base is the right measure. But because of that, I also think it is far premature to think about China liberalizing its financial accounting. That is no longer in the world’s current interests.

SHARMA: Yeah, just one point I’ll make, that this entire thing that all because you have capital controls, you can avoid capital outflows, is not always true. As we know in emerging markets—and I come from India originally, I’ve seen this—that you can have all sorts of capital controls, but if people really want to get their money out of the country, they do. So, you know—

SETSER: Two things on this. One, China—yeah.

TETT: The U.S. Manhattan real estate market, yes.

SETSER: China’s control has proved more effective than most people thought.

SHARMA: Yes.

SETSER: Particularly in limiting FDI outflows. And then, second—and this kind of links everything together—if China wants to increase its reserve buffer, or have more money available to finance capital outflows, it could stop some of its external lending to Pakistan, so forth and so on, which is generating about a hundred billion a year drain on its balance of payments. So there are policy choices there, but they have global consequences.

REINHART: Let me say also, look, China’s debt problems are internal. This is domestic debt. And this is a country that—I mean, provincial debt, this is not headline, you know, and we don’t read about it in the papers all the time, but provincial debts have been restructured. They have lengthened maturities, trimmed interest rates. This is what a credit rating agency would call a default, OK? Not a sovereign default, a sub-sovereign, provincial default. And they’ve been dealing with that. They have tools, like any country that is so close that the debt is domestic that are, you know, different from the open economy-type crises that we’re seeing in Argentina or that we saw in Thailand or, you know, other more open economy external debt-related problems.

TETT: Right, right.

Well, I must say it’s been a fascinating discussion. I mean, I take away three key points from this very wide-ranging set of debates. One is that we are in some ways seeing a very familiar emerging markets cycle develop as the U.S. raises rates. However, luckily, it’s not yet at a scale that’s going to spark serious contagion yet. I mean, some debate here. Although there certainly are some very, very interesting potential routes for contagion if things do get worse.

And a third point, perhaps most intriguing, is that China really has changed the dynamic in many ways. What we’re seeing with China being both a potential source of contagion and emerging market risk and a lender to many developing countries is very, very intriguing. We’ve not seen that before. So watch this space. And thank you all very much indeed for your thoughts. (Applause.)

(END)

This is an uncorrected transcript.

Panelists examine the lessons learned and the continuing legacy of the global financial crisis.

PORAT: So I’d like to welcome everyone to today’s last session of the Council on Foreign Relations Stephen C. Freidheim Symposium on Global Economics.

We have a panel here today that clearly needs no introduction with Chairman Bernanke, Secretary Paulson and Secretary Geithner.

And I’m Ruth Porat, the chief financial officer of Alphabet and Google.

So the goal of our discussion here today is really to cover the arc of the crisis. What we want to do is talk about the choices made to address the biggest problems they confronted, to assess their choices, and then to look at the risks and the tools that are available today.

And this rock-star trio presided over a time when there were no good options. As we discussed back at the time, they were consistently choosing between least-worst options. And I firmly believe that the United States and the world economies would have been in a much worse place without their leadership and the decisions that they made.

But now here we are ten years later on the reunion tour. (Laughter.) And so they are asked—and you do get to consider—what if they had done something else, and what do they regret? We’re going to focus on that and also the lessons so that their successors can do as much as possible to both prevent the next crisis and get us through it as effectively as possible.

Presiders typically now go through bios. But instead, I suggest that once we’re done, in the improbable event that members still need to check the bios, please go to Google, click away. (Laughter.) And we’re then going to leave time for questions.

So I want to start with a rapid-fire question for the three of you, kind of an obvious one. What was the most terrifying moment of the crisis and why?

So why don’t we just go right down the row here.

PAULSON: Well, there were—there were plenty of terrifying moments for me, but I’ll focus today on, you know, when—the moment I learned that the House was voting down the TARP the first time because it is—and there was sort of a mix of devastation and terror. But to go to Congress and to say that the administration is powerless to prevent a financial meltdown and avoid an economic catastrophe unless you act, you know, you are—you know, that’s an untenable position to be in and it’s a difficult position to be in. And when they voted it down, you know, you’re exposing your vulnerability to the whole world.

So immediately we scrambled. And we were too busy to be—to be terrified, but I still remember that night waking up in the middle of the night and saying, wow, you know, if we don’t get what we need from Congress, how are we ever going to put this thing together? And that’s when I was looking at food lines and massive unemployment and so on.

PORAT: We’ll come back to that. Tim, your worst moment.

GEITHNER: Man. (Laughter.)

PORAT: A lot of choices there.

GEITHNER: A rich view, yeah. (Laughter.)

I think the hardest thing were in those weeks—those weeks I would say B.C., before capital—before TARP—when I think we were—we thought that things, like, at that point gone way beyond the strength of the tools we had to address at that point. You know, the Fed at that point was, like, way beyond the traditional frontiers of the use of the lender of last resort authority. It was not working. It was not enough. And that was scary.

And then, you know, when the—you know, President Obama was—you know, started getting ready to take office, at that point, you know, we were looking at an economy that was still, you know, falling off the cliff, shrinking annual rate of about, you know, eight percent of GDP in real terms. And there was this deep perception then, despite all the force of the actions that had been put in place in the fall, you know—despite, you know, backstopping trillions and trillions of dollars of liabilities in the financial system in the U.S. and globally, all the capital injections—you know, there was this deep conviction in early January that the system was insolvent and would need another, you know, trillion or more of capital. And trying to decide then what would work, what might be enough, what mix of things would solve it, that was hard too.

But there were other moments, I’m sure. (Laughter.)

PORAT: And, Ben, your biggest nightmare moment?

BERNANKE: AIG day. The day after Lehman’s failure, President Bush sent Hank and me down to explain to Congress about the $85 billion loan and we met with a select group of the heads of the—of both parties and the banking committees and so on, and we explained, you know, why we had to do this, why it was essential. You know, will it work? We think so. Will you get your money back? We certainly hope so. (Laughter.)

At the end of this discussion, though, Harry Reid, who was the majority leader at that time, looked at Hank and me and he said—he said, Mr. Chairman, Mr. Secretary, he said, I want to thank you for coming over here and explaining this to us. It’s been very helpful. He said, but I want you to understand one thing: nothing you’ve heard here tonight constitutes congressional approval for what you’re about to do. This is your call and your responsibility. So, like Hank, you know, it was pretty evident early on that the political support for this was not going to be particularly overwhelming, and it was a very lonely—a very lonely feeling.

PORAT: All right. Let’s dive into a couple of the events. Let’s start with you, Hank, with Fannie and Freddie, so I remember back in those days staring at a $5 trillion balance sheet and you were laser-focused on the risk to the economy from the fragility of the two housing entities. And you frequently said that you believe conservatorship of Fannie and Freddie not only averted a disaster, but did more to mitigate the reduction in housing prices and the number of foreclosures, and therefore helped people across the country, than any other event. And I think that’s not well understood. So can you help us better understand why you believe so firmly it helped homeowners?

PAULSON: Ruth, first of all, thank you. And, you know, as you said, you know, this was a—huge entities. And if they had imploded, you know, it would have been economic Armageddon, and it was really important to stabilize them before Lehman went down.

But to get to your question, the way I think about it is this. The bursting of the housing bubble was really the match that lit the fuse here that started the crisis and led to big, you know, reductions in prices of housing, which was devastating to many Americans. And that was a big cause of foreclosure. Now, before we nationalized Fannie and Freddie and put the credit of the United States government behind them, they were insuring about half of all mortgages, maybe a little bit less than that.

And—but after we did that, they were, for all practical purposes, the only source of mortgage funding during the crisis. So I can’t prove a counterfactual. But just imagine, without mortgage funding, how much farther down housing prices would have dropped and how many more foreclosures there might have been.

So again, I think this was important in two ways. It was essential to stabilize the financial system, but it also, I think, made a big impact in terms of dampening what was a very bad situation but could have been worse.

PORAT: All right, talking about much worse, let’s go to Lehman. Tim, so, you know, there was a lot of discussion around Lehman weekend about moral hazard. It felt like any corner you turned in New York, you heard moral-hazard concerns. And there was this notion that the government needed to draw a line somewhere so that others didn’t feel like, you know, heads I win, tails you’re there.

But after the carnage from Lehman, the debate began. Was failure of Lehman a choice the three of you made, or was it, as you’ve each explained, the result of the fact that you didn’t have legal authority? And I think the understanding around this was complicated by the fact that Lehman bankruptcy was September 15th, and just a short week later Goldman Sachs and Morgan Stanley became bank holding companies.

GEITHNER: AIG was the next day.

PORAT: AIG was—yes, AIG was right after that.

GEITHNER: I’m not pointing at Ben. I’m just saying. (Laughter.)

PORAT: We’re going to get to AIG, so don’t worry about that one.

GEITHNER: Everybody else—

PORAT: But I’m sticking with the bank-holding-company theme rather than going on to insurers, which we will get to. So what changed? Why not Lehman? Why Morgan Stanley and Goldman Sachs?

GEITHNER: You can go back to March, because it’s important to think back to that moment when Bear Stearns was at the edge of the cliff. And we were trying to figure out, could the system withstand the failure of Bear Stearns at that moment, or did we have the means to offset that damage by lending more freely to the investment-bank community?

And we made a judgment then, which I think was the right judgment, that failure would be terribly damaging and that we should try to figure out how to prevent it. But we also decided that, in the case of a weak failing investment bank like Bear Stearns, that our only option was to try to find a willing buyer large enough to effectively guarantee the obligation of that firm to prevent default. And in that context, we were able to find a willing buyer and find a—and we were able to, you know, induce and assist that by taking some of the risk off the balance sheet using the Fed’s ability to lend against collateral.

We had the same presumption going into that weekend. You know, that weekend Merrill Lynch and Lehman and AIG were all at the edge of the cliff. And we worked very hard to try to prevent the failure of all three of them.

In the Merrill case, we were successful in finding a willing buyer. In the Lehman case, we weren’t. Why was that? That was because Lehman was perceived to be much weaker and was much larger, more complicated than Bear. And the system was much more fragile. So the universe of willing buyers was very limited then. And in the end we had one potential buyer, and that buyer, Barclays, the British wouldn’t let them go ahead. They thought Barclays was effectively too weak to absorb the risks. So that left us with no option to lend in that context.

That was our basic judgment. We thought it would be bad. It was worse than we thought. But we were pretty sure it would be bad because the system was so fragile; bad enough worth trying to avert it, but not something in the end we had the ability to do.

You’re right that—I don’t know how—you said a week later or two weeks later. We figured out a way to buy a little more time with Goldman and Morgan Stanley. Goldman and Morgan Stanley that weekend were able to go raise a pretty substantial amount of private capital, something Lehman had tried all summer to do and failed to do. They were able to raise some strategic capital, a pretty substantial scale. And in that context we were comfortable making them bank-holding companies.

But the bank-holding companies as a nation didn’t buy them additional borrowing authority from the Fed. It created a little bit of pixie dust, halo effect, but that was fleeting. And it’s worth remembering the time that bought was very limited, and conditions around both of them eroded; again, a symptom of how bad the underlying—you know, the underlying storm was.

PORAT: All right, so on to the third nightmare, AIG. Moral hazard clearly on your mind with respect to AIG. You’ve said that you were reluctant to lend to AIG because you didn’t want every nonbank to think it had a backstop, so moving, you know, out of the pure banks.

Take us through your assessment of the risk if you did not act as you did. What do you think it—I appreciate we don’t have the counterfactual, but I remember so much at the time the concern was it going across the country and hitting individuals and small businesses. How did you look at—

BERNANKE: Yeah, well, were looking—we weren’t focusing on the investment banks. And AIG was a little bit at least under my radar, you know, in the summer, although we had staff watching it and paying attention to it. And when the first possibility came up, you know, they were—they were talking about acquisition, you know, various kinds of deals. When the possibility came up that we might lend to them, my first reaction was, oh, my God, this is really extending—you know, the Fed is supposed to lend to commercial banks. We had already extended this to investment banks, so this would be yet another step to insurance companies. And my initial reaction was this is something we shouldn’t do unless absolutely necessary. But then I fairly quickly, you know, over the same weekend that I was on the phone—and it was a tough weekend. I was, you know, talking to Tim and Hank about Lehman and trying to prepare for the FOMC meeting on Tuesday, and there was a lot going on, and then AIG.

But as we got more information about it, I mean, it seemed to be a pretty clear call that we needed to do something on two dimensions. First was AIG, as I described it once, was a hedge fund on top of an insurance company. So it was like a mini investment bank that was insuring the credit of a lot of major financial institutions around the world. It had a very, very long position on RMBS, basically, both through securities lending and through its insurance of other firms. So its failure would have immediately created uncertainty about a lot of other firms, it would have created a lot of fire sales, it would have created just an enormous amount of stress, probably equivalent to another Lehman just from that dimension.

Then on top of that, it was, of course, the world’s largest insurance company. And so we had the possibility that this whole thing was going to leak into a whole new dimension. For example, if insurance companies fail, there’s complicated state-level arrangements whereby other insurance companies have to make good, and so that would actually raise concerns about existing policies, about other insurance companies. It was just—it was horrible to contemplate, frankly.

The reason we were able to act there—and I want to reiterate what Tim said, which is that it was a question of viability and feasibility. The reason that AIG was a feasible project for us was that even though there was no way—if the—if the hedge fund on top of the financial products division had been by itself, we would have been sunk. But it had, you know, all these insurance subsidiaries which were global and were profitable, and they could stand as collateral for a loan to address the liquidity problem. So we did have a means to do that.

And that’s, you know—even so, I have to say that people say we didn’t put tough terms on the recipients. Tim really nailed them pretty hard, you know, with eighty percent equity ownership and a whole bunch of other—eleven percent interest rate and all kinds of very tough conditions. And I was actually pretty concerned that they would, you know, just say, well, we’d just rather go with default because it was such a tough situation. But they did accept and we were able to—you know, it took a lot more effort, you know, many rounds to keep the company stable. It was the biggest headache we had, I think, during the crisis. But we did have the means to stabilize it because we had the collateral against which the Fed can make a—make a loan.

PORAT: And so the list of horribles continues. Let’s go to TARP where you started. So the TARP bank capital program put capital into over seven hundred banks. The money all came back with actually a nice profit for the U.S. government and did prevent the collapse of the system. Why was this so successful and so terribly unpopular at the same time? What were people missing?

PAULSON: OK, Ruth, I’m going to answer that, but I should have—when you mentioned Fannie or Freddie, I wanted to say something, because I remember when we were in the depth of dealing with that, calling John Mack, who was the CEO of Morgan Stanley, and asking for two of the very best advisers possible, and we weren’t able to pay a fee or indemnify, and we got Ruth and Bob Scully. And boy, did they make a difference.

So thank you for that.

PORAT: We got a dollar. (Laughter.)

PAULSON: What?

PORAT: I think we got a dollar.

PAULSON: You may have got a dollar. It was indemnification.

PORAT: Yeah, that was a problem.

PAULSON: I mean, no one else was going to step up without indemnification. And boy, did you all come through.

PORAT: Thank you.

PAULSON: You’re right. So, you know, TARP, you know, the money came back with a profit. But the important thing was we were able to get out and stabilize, recapitalize the financial system with lightning speed, put money into seven hundred banks and avoid a meltdown. But it’s clear why it was so unpopular, because we did not have more compensation restrictions, and putting capital into banks or into any private enterprise, taxpayer money, is a red line in the United States of America. Doing that is very unpopular. You know, we were perceived as, you know, helping the arsonists.

Now, why did we not place compensation restrictions? I think that’s really important. We were doing something that had never before been done. We wanted to induce many, many banks, even healthy banks, to take capital because the system was so fragile the crisis could spread very quickly from weaker banks—relatively weaker banks to relatively stronger banks, and we didn’t want that to happen. And we had no ability to force banks to take capital. On top of that, during a crisis no bank wants to raise their hand and say, hey, I volunteer to take capital, because they’ll be toast. That’s a sign of vulnerability. There’s a big stigma to that. And we knew we were going to put restrictions on CEO compensation. So if we’d gone a step further and said we want to control your overall compensation, that would smack of nationalism. The program wouldn’t have worked.

So what happened was we went out with lightning speed, we did something that was very nontraditional, and it worked. The Europeans went the traditional route. You know, they were—they treated their banks like we treated Fannie or Freddie or AIG, and they were going to nationalize them, so the only banks that took capital were those that were about to fail or failed. And, you know, their system was undercapitalized for a long time, and I think we reaped the benefits. But our programs are unpopular. What we did was objectionable to us and, you know, objectionable to the Americans, but it was the best of the alternatives we were looking at.

PORAT: You’ve each said that, made that point for each one of these very tough choices, which goes right to the point: a lot of worst choice, what’s the least-worst option. But to that point, that takes us right to I want to switch gears and now start getting a bit of self-assessment here. And the big topic, of course, is populism. And, you know, we’ve heard the thesis banks were bailed out, individuals weren’t; there’s a direct line from actions that were taken or not taken to the populist wave that we’re seeing here and actually, you know, around the world. So can you give us just your assessment here of all the actions taken to stabilize the system? Did they contribute to populism? How do we put this question about populism in context? You, Ben, yeah. The easy one I sent back your way. (Laughter.)

BERNANKE: Yeah, sure. So there’s no doubt that a financial crisis is going to worsen populism. We saw it in the ’30s. You know, there’s evidence for that. And on top of that we had a deep recession; many people suffered foreclosures. So please don’t, you know, think in any way that I’m denying that that was a factor.

That being said, I think that some of the recent commentary which says this all—all we’re seeing in the political world today traces back to the crisis, I think that’s way overstated. Take the United States in particular. You know, going back to the 1970s/early ’80s, people have been telling pollsters that, you know, by margins of three to one that the country’s, quote, “going in the wrong direction.” There’s been a lot of concern about inequality, a lack of social mobility. And I think that the underlying theme there has been mostly a reaction and resistance to globalization.

So if you—you know, what does Donald Trump talk about on the—he doesn’t talk about shutting down banks or—he talks about doing a number on Dodd-Frank so banks can be more—you know, can make more profits. What he talks about instead is immigration, trade. Those—I think the connection there is also tenuous, but I think where a lot of people are—particularly those who have cultural concerns are saying, you know, globalization has not paid off and we’ve not seen—particularly at the middle of the income distribution, we’ve not seen the benefits over the last three or four decades. I think that is the most important factor.

But, you know, again, I don’t want to deny that the crisis didn’t help. And certainly the fact that a lot of people either lost their homes or lost their jobs, obviously, that’s going to make people less satisfied. And, you know, again, the things that Hank was talking about, the fact that we chose to sort of try to keep the system alive rather than let it die and then resuscitate it, that put constraints on how we responded. And, no doubt, that also affected attitudes.

PORAT: And, obviously, all of this was happening in a very short runup to elections. So Hank passed the baton to you, Tim, on Fannie/Freddie. Sticking with this theme of populism, in retrospect, do you think more could have been done for homeowners? How do you think policies potentially should have been addressed differently, if at all?

GEITHNER: I mean, just to be honest about this, things we tried to do on the housing front to reduce the—reduce the scale of foreclosures were late and slow, and they were just not large enough to mitigate a lot of the damage. They were effective in slowing the rate of growth in foreclosures, in capping them.

And, you know, we did help millions of people stay in their homes and refinance at lower rates. And those actions were—they were helpful. They added to the power of what conservatorship did to keep the mortgage market functioning, and what the Fed did to keep mortgage markets—mortgage rates low. And that helped put a floor under house prices and was a critical factor in limiting even worse recession.

But the modification programs were—you know, they were late and slow; and lots of reasons for that. I would say one of the—probably the principal one was that we felt we had to work through the existing servicing infrastructure, which was—you know, which was terribly inadequate. And there were some pretty bad incentives in the complexity of the mortgage securitization market that it made it hard, too, to modify when it obviously was sensible.

And we—you know, the things we did that were very—that worked in the end were very—reached a lot of people. You know, just to be honest, they just came—they came late. Learning was slow. And that was damaging.

It’s not quite fair to say, although it is the popular perception, that the scale of the things we did for the financial system were larger, economically more meaningful than what we did for the average person. Just in terms of even simple math, of course, it’s not just that the financial programs earned a very substantial positive direct financial return to the taxpayer, and the people thought we would lose trillions of dollars on that and they earned a very substantial positive return.

But, you know, the scale of the tax cuts, direct transfers, benefits that went through the broader fiscal programs/housing programs, were much larger in dollars spent, ultimately, in that context. But, you know, that gets lost. That got very much lost under sand in the debate where, you know, to break a panic, to prevent the risk of another great depression, we had to keep the system functioning. You know, we just didn’t have the option.

You know, panics are different from other financial crises. You don’t have the option in a panic of deciding you’re going to save depositors and not banks and bankers, no plausible strategy that rests on that, you know, typical strategy in a crisis. And I’m not sure it is possible to reconcile the fundamental tension between what’s necessary to break a panic or save a country from a panic and what is politically attractive, feasible, in the moment.

And I think one reason why financial crises are so terrible is most countries try to get the politics right before they try to get the strategy right. And that usually leads people to be way late, behind the curve, too worried about moral hazard and fairness things, and they let the system burn. And that’s why you get massive unemployment in recessions, depressions, after most financial crises.

PORAT: Yeah, I’ve often quoted Hank, who, I remember, in the depths of the crisis, said you have to have the will and the means, and too often, by the time you have the will, you no longer have the means. And we just keep reliving that over and over again.

When you think about some of the hard lessons, each of you has said one of the toughest was communication. And that’s one of your biggest regrets, that it was just so hard to make clear to the American public how absolutely imperative this was and the limited choice set and how you were looking to really protect Americans across the country.

What would you advise whoever is in your seats when that next crisis comes to do differently, to be able to better communicate, land those messages?

Do you want to start, Hank?

PAULSON: That’s a hard one, because I was really tough on myself after leaving. I said I should have communicated better. And with hindsight, I look at it and I say, wait a minute, you know, we couldn’t break the back of this panic without going to the source, which was Wall Street. So we had the right policy choice, number one.

Number two, we all erred on the side of stability; you know, overtelling the public what they wanted to hear. But if we talked about how dire the situation was and our lack of authorities, you know, it would have been easier to have people understand why what we did wasn’t so—as unfair as it looked, right. But we didn’t want to spook the markets.

And then, lastly, at the end of the day, I look at it and say, wait a minute, you know, how do you sell these really objectionable, terrible things we did and sell them because they were better than the alternative and they were necessary? And so what the public sees is the hardship that resulted from the crisis. They don’t see the disaster that might have happened. So you’re never going to get credit for that.

So I look at it now and I say wait a minute, you know, anybody that’s heard me read a public speech knows that’s sort of a painful thing and I’m not a great orator. I happen to think I did pretty well one-on-one in negotiating with Congress and so on in that kind of communication. But Barack Obama is, you know, and I don’t think he sold it really well either. I think it’s—I think it’s—I think it’s that’s hard medicine to sell.

PORAT: Tim, do you want to add to that?

GEITHNER: Don’t have a crisis while you’re in office. (Laughter.)

PAULSON: Yeah.

PORAT: Fantastic advice.

PAULSON: Yeah.

PORAT: All right. So regrets analysis, what else, other than communication, if you could turn back the clock—and the benefit of this ten-year tour is advising that next generation whenever they may come. What else would you look at and say I wish I had either not done it or done something differently? Why don’t we go to the last one?

GEITHNER: I’ll do three big mistakes. The first is we let the financial system way outgrow its protections. It took decades, but, you know, on the eve of the crisis, the banks were, like, less than forty percent of the relevant part of the financial system, the rest was operated outside the protections we put in place in the Great Depression. That took a long time to happen, risk migrated outside the system, but that created a very fragile, fragile system, very dangerous system, a system much harder to stabilize than a typical bank-dominated system.

Second is we went into the crisis with very weak—very weak emergency tools for dealing with a panic. You know, Hank had to go to Congress twice to get authority that was existentially important. But, you know, typically you’re not going to find the political will to do that until the thing is way past the point of no return, so damaging that people can really feel it. At that point, it’s going to be hard to avoid the, you know, avoid the damage.

And I would say more generally, after the initial wave of policy, force, and fiscal stimulus and all the monetary policy drama from the Fed, the U.S. lost the will to sustain the fiscal support for a weak economy too early. And we made the classic mistake of putting the brakes on a little early than would have—would have been ideal. So those are three, but those capture a lot of—a lot of other things.

PORAT: Important, yeah.

And, Ben, your regrets?

BERNANKE: Well, you know, I feel like once we sort of understood the situation, we were pretty aggressive and we corrected mistakes pretty quickly and so on. You know, I wish that I had somehow had a better view of the situation well in advance of the crisis. Given how slowly our government works, et cetera, I’m not sure that would have meant you could have prevented it, but we probably could have at least explained it better and gotten ahead on some things a little bit. And so I think that that was something we, you know, we didn’t fully understand how these various factors—I mean, we knew that—I mean, people say you didn’t know there was a housing bubble? We knew there was a housing bubble, but we didn’t understand how it was going to translate into a broad-based panic that was going to bring down the even non-mortgage credit as we were to see. So I think it was not fully understanding the picture well enough, early enough, that that was difficult. And that really—

PORAT: Well, hold on there for one second.

BERNANKE: Yeah, yeah.

PORAT: If you were sitting there today, how much greater clarity and visibility do you think you have or—

BERNANKE: Of what happened ten years ago?

PORAT: No, sitting there today with the same level of visibility.

BERNANKE: No, that’s the problem. Well, I—

PORAT: So are the tools better, is the data better?

BERNANKE: Yeah. Oh, yeah, sure, it is better. It’s better. I mean, Nellie Liang, who was just nominated by the president to be on the board—when I was there, I made her the first director of a whole new division at the Fed called Division of Financial Stability which does enormous amounts of monitoring and analysis, things that just didn’t happen, you know, before that. So we’ve got a lot more visibility, a lot more effort, a lot more resources put into the systemic stuff.

But, I mean, another thing we learned was, though, that you can never be sure, right? So you need to also make sure the system is strong. And I’m sure we’ll talk about that.

But let me just say also on the communication—I didn’t say anything about that—I just, you know, I go back and forth on that myself. I mean, I tried to do some things on communication. I went on 60 Minutes a couple of times and I did my best there. And so sometimes I feel like I should have done more, and I’m sure that at the time I didn’t fully appreciate, you know, how much reaction there was going to be.

On the other hand, you look around the world, and can you point to a country where this problem was solved? It’s not obvious that, you know, that anybody has really figured out how to communicate this type of thing. And it’s unfortunately—it is, by the way, I think, a good reason to try to have the tools and the structure in place in advance and talk through in advance rather than have to do it, you know, on the fly.

GEITHNER: Can I just say one thing on this, Ruth?

PORAT: Yeah, please.

GEITHNER: You know, we all—we all say this. But you know, I think it’s good to go back and just remember, you know, we didn’t have good answers for what we were going to do next, what was going to be necessary, because, you know, we were feeling our way. And although it’s easy to say now that, you know, if we had had the time to go out and give a daily press conference so that people had a better feel for the choices we were making, that would have been reassuring, confidence-inspiring, would have broadened the political base for it. I don’t know. I mean, I’m not—I’m not sure. I don’t—I just remember what I really felt at that moment. And apart from being consumed by trying to figure out what next, what might work, what could we do, it’s just important to remember how much uncertainty surrounded really everything.

And that—that was—that lasted for six months. It wasn’t, like, a fleeting thing. Maybe nine months.

PAULSON: Yeah. And, Tim, to add to that, just to put an exclamation point on it, we did not have the authorities we needed. We knew we didn’t have them. We had actually consulted with Barney Frank and with others. We knew we couldn’t get them unless—and so we were doing things with duct tape and bailing wire. I mean, we were being—improvising with the authorities we had until the luck finally ran out. And so that’s—I think that’s part of the issue.

PORAT: For me, that was one of the most profound things, watching you constantly innovating, turning. If something didn’t work, you didn’t stop; you tried something else. And in the most—in that most recent New York Times editorial that the three of you wrote, you made the comment that Congress has taken away some of the tools that were so critical to you during the 2008 panic and it’s time to bring them back. So if you could actually execute on that, what are in particular the most important tools that were taken away that you think we all need to give back to those who are in your seats?

PAULSON: Well, so I want to also emphasize we have some tools and the system is in better shape. But as I look at it, I say one of the scariest moments for me was when the money market funds began to implode and when we heard from five or six of the big complexes that they were being hit with withdrawals. At the same time, I’m hearing from major triple-A industrial companies, could not sell their commercial paper, and—which they rely on for short-term funding. So I’m looking at it and saying, wow, you know, if they have to start cutting back and not paying their suppliers, this is going to move very quickly from Wall Street to Main Street because it’ll move very quickly to the smaller companies, who will be laying off workers. And so what did we do? We used the Exchange Stabilization Fund at Treasury to guarantee the money markets. Well, when Congress gave us, you know, the TARP, they also wrote in the law never again use the Exchange Stabilization Fund, OK? So those that come after us won’t have that again.

I think one of the most powerful things that gets less attention that was done was the FDIC using a very broad, expansive interpretation, you know, the—of their authority to guarantee the liabilities of the bank holding companies and banks to issue new debt. That was very, very powerful and did a lot to help us break the back of this thing. Well, Dodd-Frank, Congress took that away. So those are—those are two.

I think that Ben and Tim have explained how the Fed used their emergency lending powers twice to avert disaster, first with Bear Stearns—which I think we dodged a huge bullet, because if they’d gone down before we had stabilized Fannie or Freddie, Lehman would have gone down, I think, almost immediately; it would have been a disaster—and used the emergency lending for AIG. Now that’s been taken away on an individual-company basis. You can do it on a systemic basis.

Now, we do have the orderly liquidation authorities to wind down a failing nonbank. We wish we had had that with Lehman. And, you know, I think that works during normal market conditions, and let’s hope it works during a panic. I’m not sure it will work the way Congress intends it to work during a panic because one of the things we learned is to break the back of a panic it takes fiscal authorities. It takes government money. And, of course, the intent of that is not to use government money. But maybe it could be used in a very creative way in the middle of a panic.

PORAT: This is a critical question. I’d love to hear Ben, or Tim—would you add to that list? What else would you think is needed to stabilize if we find ourselves in a panic?

BERNANKE: Well, from the Fed’s perspective, what the Fed does as lender of last resort is provide liquidity against collateral to firms that are illiquid but presumably still solvent. And there are two authorities: a discount window that goes to banks; there’s 13(3) which is used on an emergency basis for nonbanks. Both were damaged by the subsequent legislation. There are disclosure requirements now on the discount window, which make it more stigmatized and less useful, and restrictions put on 13(3).

So if you’re asking me what my ideal world would be, it would be a world similar to most other countries, like Europe in particular, where any financial institution that takes short-term runnable deposits—whether its commercial paper, or repos, or whatever it is—and uses that to finance credit should be subject both to, you know, sort of bank-like supervision and have access to Fed lending. I think that broad extension would make a lot of sense and would get rid of this artificial distinction between banks and nonbanks, which was actually one of the key elements in the crisis.

PORAT: OK, let’s talk a bit about leadership decision making in a crisis. Tim, let’s start with you. What do you believe are the most important principles that should be followed when in a crisis, both for those in government and also we have many corporate leaders here as well. What do you do in a crisis?

GEITHNER: Well, I think in a financial crisis you have to recognize, you know, there’s just huge uncertainty about the outcomes, and you know, you’re going to make one of two mistakes. Either you’re going to be late, and slow, and do too little, or you’re going to take the risk of doing too much—overdoing it. And in a crisis you have to have the—you know, you don’t really know what is the line, the margin between something that is going to get resolved with little trauma but without the risk of a panic and what tips over into panic, and you have to have the flexibility to, you know, escalate very quickly.

That’s one reason why it’s so important to have more discretion available to the Treasury and the Fed to take risks the markets can’t take in a panic because, without that authority, you won’t be able to act quickly enough to break a panic.

So I think the—you know, people talk about this lots of different ways. They talk about it as a risk-management framework for thinking about policy. You have to think about the—you know, the range of probabilities and what’s the cost and the damage that might be caused by something you think is remote, unlikely, but still could—is possible.

And in a crisis you have to give a lot of weight to that worst-case outcome and try to err on the side of doing as much as early as you can to reduce the probability of that outcome. That’s a simple framework.

But I think, you know, the most important thing is the people around you who trust each other enough to debate things and disagree, and to try to work through the options, and one of the great benefits that we had, apart from having, you know, two presidents from different parties over a dangerous transition willing to, you know, basically put country over party and short-term political interests, was that, you know, we had a lot of trust in each other, and enough trust that you could—we could disagree and we could—we could challenge each other and keep pushing it to figure out, OK, if not that, would this work. And if not that, then what might work?

PORAT: A really important line there: put country over party. And, Hank, I want to turn back to you.

Twice you got Congress to give Treasury unprecedented emergency powers: first Fannie/Freddie, then in TARP. And it’s probably the last time we’ve seen something—that coming together of both parties to do something that was so controversial and yet so critical. In the polarized world we have today, do you think you could get it done, or what would you advise whoever is in your seats to be able to have that kind of outcome as you did back then?

PAULSON: Well, there’s a lot in that, but as Tim said, we had—we were backed by really strong leaders, and when I came to Washington it was a poisonous atmosphere. I mean, 40 percent in approval rating would look pretty good. I mean, President Bush was in the high 20s then. But he encouraged me to work with Democrats and Republicans, and we had a year before the crisis hit. The three of us got to know each other, work with each other. I had a chance to develop a relationship of trust with the president, which is essential.

I had an opportunity to actually get things done with members of Congress—you know, work with Democrats and Republicans on trade deals, stimulus deals, et cetera. And so there was a lot going on, and the fact that there was divided government made a difference because the Democrats felt a really strong, you know, responsibility to govern. And a crisis brings out, you know—we saw, as I said—we saw the worst before the crisis, but you know, at the end it brought out the best.

So I’m not—there’s a lot of dysfunction in Washington right now. I’m not denying it. And this country’s terribly divided. So it’s—but I don’t want to ever say and bet against the United States of America and say that in a crisis we couldn’t come together and do what was necessary because the crisis brought people together quickly, and ultimately we saw the very best in our government. And I’m certainly never going to say that’s—no matter how bad things look in Washington, that we couldn’t do what was necessary.

PORAT: I’m going to open it up to members for questions, but I’m going to do a one-word answer from each of you because crises do have a horrible way of repeating themselves. What one risk are you most worried about out there that could be the catalyst for the next one? Ben, we’re going to start with you, and then we’ll be opening it up to the members here.

BERNANKE: Well, I’m worried about the deterioration—this is the foreign relations center—I’m worried about the deteriorations in international frameworks and institutions. That means next time—I mean, we didn’t talk at all about foreign cooperation, but we had enormous amounts of cooperation with other countries and it was very helpful.

PORAT: Tim?

GEITHNER: Yeah, I would say politics. If you want one word, politics.

PAULSON: I’d have to say the same.

PORAT: OK. On that note we’re going to open it up to members. I just need to remind everyone this is on the record. Please wait for the microphone and speak directly into it. Stand and state your name, your affiliation, and please limit yourself to just one question. And we have one right up in the front here and then we’ll go to the back.

Q: Thank you. Thank you. Mark Angelson, vice chairman, Joe Biden Foundation, speaking for myself, not for anybody else.

A question for Secretary Paulson, because you already answered in the last ninety seconds all the questions that I had, with the exception of one. How important were each of the fact that Tim had been the head of the New York Fed before he became secretary of the treasury? How important was the continuity of the chairmanship at the—at the Federal Reserve System? And how important was Warren Buffett’s investment in Goldman Sachs? (Laughter.)

PAULSON: Well, so they—first of all, all were essential. And, you know, that—to me, the way the three of us worked together, the way our skillsets complemented each other. You know, Tim—it wasn’t just that Tim had been president of the New York—was president of the New York Fed—that’s important—but he had started as a career employee and worked his way up to be undersecretary of treasury. That’s just phenomenal at a—at a young age. And had been through two financial crises at Treasury. So, I mean, he helped advise me all the way along in terms of where the levers were at Treasury. The fact that the continuity that went when he then became the treasury secretary for President Obama.

And then, of course, Ben just, you know—you know, what can I say in terms of the courage that he had and, you know, the fact that he had actually done his academic work on the Great Depression?

So none of the three of us—you know, as Tim said, we debated. We discussed all sorts of things, but we never debated whether we should take the risk of having a systemically important institution go down because we all knew that that was—that that was something that we—that just was something that—a risk that we weren’t going to take.

Now, in terms of the Warren Buffett investment in Goldman Sachs, I’m going to go back to the question that Tim got asked on Lehman and the bank holding company. Warren Buffett publicly stated that the reason he had the confidence to make that investment was we were up there seeking the TARP. I think the idea that the Fed could suddenly have declared Lehman a bank holding company, and put lipstick on Lehman and this institution that the whole world thought was insolvent was suddenly going to be safe, the key was that they had been trying to raise capital and they couldn’t raise capital. The fact that Goldman Sachs raised capital from Warren Buffett and all that entailed, a cornerstone investment, or Morgan Stanley had raised money from Mitsubishi, that’s what saved them. It wasn’t calling them a bank holding company. The bank—the Fed declared them a bank-holding company just as they were raising that capital. And so—

GEITHNER: Can I just clarify one thing, though, Hank, on this—I mean, again, not to cast aspersions on the strength of those two institutions at that point, but remember—

PAULSON: Yeah.

GEITHNER: —it was only when, on Columbus Day weekend, you used the TARP to put capital into most of the banking system, and the FDIC agreed to guarantee the ability of bank-holding companies to issue new debt, that you first saw a meaningful break in the panic. And even that eroded too over the following three months.

So it’s not—you weren’t implying this—it’s not quite right to look back at that period of time and say those capital injections by Warren Buffett and by the Japanese bank into Goldman and Morgan Stanley themselves or their bank-holding companies did more than buy a little bit of time. And that’s not to take anything away from those institutions and their management then.

PAULSON: Yeah, I agree with that. And with Morgan Stanley, you know, I still had to write a letter to the Japanese, you know, finance minister to keep Morgan Stanley from—to keep Mitsubishi from backing away from their capital commitment. So again, we were really on the brink. And we were at a point where, if either one of those institutions had gone down, I don’t think the system could have taken it. I think we would have had just a massive meltdown.

PORAT: We’ll take a question right up here in the front.

Q: Jeff Laurenti.

Actually I had a foreign-relations dimension. The G-20 had its big debut within a few weeks of the meltdown and panic. And it was seen in—I think it was March of 2009—as having successfully coordinated some global response.

What concretely was contributed by partners, both the traditional G-7 developed countries and the new emerging countries that were added in with the G-20, in terms of reflating the global economy? And what were they asking of the Obama administration to do that it wasn’t already doing?

GEITHNER: Well, the—I think the right way to think about the international cooperation was, you know, the Fed supplied dollars freely to the world central banks on a massive scale and lent directly to the European financial system on a very large scale. That was very important.

Ben helped coordinate a(n) interest-rate—global coordinated interest-rate cut by the major economies in October-ish of ’08, which was a very important signal. Hank and President Bush convened the first meeting of G-20 leaders to send a cooperative signal about commitment to prevent the collapse of the global financial system.

But then in March, early April, we helped orchestrate, you know, another power signal—powerful signal of coordinated fiscal or cooperative fiscal response, continued cooperation among central banks, and provided a huge dose of additional resources to the IMF and the World Bank so they could lend to the emerging economies that were, you know, very much caught up in the crisis. So it was the strength of that signal that added to the steps that we had taken as a country that helped start to turn sentiment.

BERNANKE: The G-7—let me just add to that. There was an incredibly important meeting of the G-7 in October of 2008 after Lehman, when we coordinated among ourselves in terms of the kinds of actions we were to take with respect to our own banking systems, and also made a joint commitment that we would avoid any further failures of systemic firms. So the G-7, I think, was dominant during that period.

The G-20—you know, it takes—it was a break-in period where people got to know each other. And so it took a while before the G-20 took the leadership role. But over the next few years it did.

PORAT: Right up here; this woman right in front.

Q: Thank you. Hi, Nili Gilbert from Matarin Capital.

As you took the extraordinary steps that you had to to stave off the worst of the financial crisis, there were many naysayers who worried about the potential for hyperinflation or a much weaker dollar as the Fed balance sheet expanded greatly, or for a fiscal crisis, as the deficit expanded and the potential for a loss of faith in U.S. credit quality; that if we had higher interest rates at that time, it would have been a disaster.

How much did you worry about the potential for those negative outcomes? And what do you think those naysayers got wrong?

BERNANKE: Well, we were quite confident that hyperinflation and all those things were not in the cards. We understood that the economics of a liquidity trap, where interest rates are close to zero, are quite different from sort of, you know, wartime situations when you get the hyperinflation. So we were not concerned about that. We weren’t concerned about the dollar. There were a lot of other concerns, I think, that were more minor that we tried to pay attention to.

We tried to go—I mean, we were often accused of being reckless. We tried to be as cautious as we could, consistent with achieving what we needed for the economy. But also, you know, in retrospect, we had a conference last week and the commentary on the monetary policy was it went too slowly and because they were being too cautious about, you know, things they didn’t understand. So we went—we went cautiously, but we were pretty confident that those risks of QE and so on were not really there.

And I would—the media people here, you know, I don’t think the media did a very good job. They give a lot of credence to people who were not really qualified to comment on these issues, but who were making these kinds of claims. And it hurt us, we got political pushback, we got a letter from Congress saying don’t do QE2 because it’s going to cause hyperinflation. So it was a problem for us, but we—obviously, the Fed is independent, we did what we thought was necessary.

GEITHNER: On the fiscal side, quickly, we thought it was essential to have a very substantial dose of fiscal stimulus given the collapse and private demand at that point. And, you know, with the financial engine broken down, monetary policy could not carry the sole burden of reducing the severity of the recession. We thought that was very important and, you know, ultimately got several rounds of substantial stimulus, not enough to offset the collapse and private demand, but it was very important to it.

We did make the judgment that that should be, although sustained for as long as possible, should be temporary and that we should work to get the deficit down to a sustainable level over a five-year period of time, which we ultimately did, although, as I said earlier, it happened a little too fast for comfort. We did that because we thought that the credibility of our capacity to provide a sustaining support for the economy depended on the world believing we would bring our deficit back down to a more moderate level within a reasonable timeframe.

So we were—we were not worried we were going to become Greece. We thought there was no alternative, but a substantial temporary increase in borrowing, but we didn’t think it was something you could justify doing indefinitely, and had to show some measure of political will to get ourselves back to a deficit that would stabilize the debt burden at a—at a—at a relatively acceptable level.

PORAT: The gentleman right up here in the middle.

Q: Angelo Lisboa, JPMorgan Chase.

Secretary Paulson mentioned the importance of healthy banks accepting and participating in TARP to avoid the stigma, right, and heightening the panic. Do you worry next time healthy banks will refuse government support and stay away from shotgun weddings?

PAULSON: The simple answer is yes, I do, because what happened, it was—it was fascinating and it was demoralizing to watch. Because we had structured these equity infusions, they were going to be preferreds rather than common, nonvoting, we agreed that everyone was going to take the capital, but it didn’t take long for the press and the public to start talking about these being nationalizations and then the stigma to set in. And there was a stigma.

And, you know, and you’re from JPMorgan Chase. I would say Bear Stearns—when you look at JPMorgan bought Bear Stearns and WAMU. And I think both of those acquisitions helped the country a great deal. JPMorgan made those acquisitions also because they thought they were in their best interest. But I don’t think that they or Jamie Dimon expected to see the kinds of repercussions he saw.

So, yeah, I think it will be harder during the next crisis to have policymakers do some of the things we did because they were so unpopular. It will be harder to have Congress vote for something like that again. It will be harder to get banks to take capital again. It will be harder to get banks to step up, the healthy banks, and make a risky acquisition in the middle of a crisis again. So all of that will be more difficult.

PORAT: On that note, the last question goes to the woman a couple of rows back behind our last questioner, right here. Yeah.

Q: Good morning. Kathryn Harrison from IBM.

I wanted to ask, one of the key innovations that came out of the financial crisis has often been called bitcoin and the rise of cryptocurrencies. Proponents of cryptocurrencies really focus on the benefits of decentralization and the ability to simply fork a network if a problem comes up. Given what all of you have lived through and described, decentralization would certainly not have been a strength. What advice would you have for those organizations who are in the process of building the new emerging economic models around governance and managing the crises that will inevitably come?

GEITHNER: That’s for Ben.

PAULSON: For Ben. (Laughter.)

BERNANKE: I think there’s a lot of silliness around cryptocurrencies, a lot of bubbles, a lot of people who don’t understand what they’re about. So I would put that aside and just say, though, that there are a lot of interesting technological developments having to do with decentralized trading and so on, which are potentially quite interesting.

And I actually—you know, thinking about the medium term, one of the big challenges to the financial system is going to be technological innovation because you’re going to see all different ways in which banks are going to get this intermediated in various ways. They won’t be able to do their normal functions because there will be technological substitutes or specialty firms that, you know, do some of these different things. And so the question of how the regulatory system and how the Fed and so on will adapt to that is actually quite interesting.

So the short answer, not a big fan of cryptocurrencies, but I think there’s some interesting technological developments. And we’re probably going to see some massive changes in the financial system over the next ten or twenty years.

PORAT: And on that note, a sacrosanct tradition, as many of you know, is that we finish on time. OK, Dr. Haass here—so we are on time.

I want to thank our three speakers here today, not just for the rich insights, but also for your leadership during some of the most painful times. So thank you so much. (Applause.)

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