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MGT585 – TUESDAY, JANUARY 10, 2012, CLASS #1
Introductory Remarks
In past years, it has become evident that halfway through the course we were
not successful in conveying what our backgrounds are. Sometimes you may think we
know a lot of stuff we don’t. And sometimes we might know some stuff that you don’t
think we do. So Steve and I are going to take just a few minutes each to talk about
ourselves and then go around the room.
My career has alternated between the government and Wall Street. I started out
in the government very fortuitously out of graduate school and I started out doing
research on oil and commodities in the wake of the 1974 OPEC embargo. So I was a
research assistant and I was asked to write a project on foreign investment in the U.S.
and in order to do that I went around Wall Street interviewing all kinds of people
because I didn’t know anything about the subject. And it turned out that this report got
a lot of attention because it was in the mid-seventies when the OPEC embargo had just
taken place, was a massive amount of money going to the middle east and Americans
were very worried that the money was coming back here to buy up the U.S. Because of
this report, I was invited to join the staff of Henry Kissinger, who was the Secretary of
State at the time – something beyond my wildest dreams. And I ended up staying in the
government for five or six years, working for him and then that was the republican
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administration, and then a democratic administration, the Carter administration came,
and I stayed in place for Cyrus Vance who was the democratic Secretary of State. I got
very immersed in all kinds of global economic and financial issues. It was just a really
wonderful opportunity to see things really from the top and because I was doing sort of
the economic and financial stuff, I was interacting with Wall Street people all the time.
I then decided to go to Wall Street and I went to Lehman Bros. – this was in 1979
– and Lehman Bros. was just starting a business in advising foreign government son their
finances, mostly developing countries. So I spent several years working as an advisor to
governments like Turkey and Peru and Indonesia and at the end of the time, I became
very knowledgeable about sovereign debt. I was then transferred then to Tokyo in
1984, where I was asked to oversee all of Lehman’s Asian investment banking, and I
spent a couple of years in Tokyo and then in Hong Kong; got very immersed in Asian
finance, and particularly in restructuring companies, particularly shipping companies.
And then from there I went to the Blackstone Group, and because of my Asian
experience, I was trying to do M&A stuff with Asian companies. I was then “drafted”
back into the government in the Clinton administration as Undersecretary of Commerce
for International Trade. And I was deeply involved in trade negotiations, but a lot of
those negotiations dealt with financial services, so I was never very far away from Wall
Street.
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Then I came to Yale, first as the Dean of the school for ten years and then as a
Professor for a subsequent six. And I met Steve very early on in my career. And we
have been friends ever since and when I used to bring students to Asia, we would
always stop and Steve would be the highlight of the trip when we would give briefings,
and I twisted his arm one day and he started to think about Yale and that’s how he got
here.
Steve Roach:
A couple of things. Number one: I think I’ve had a lot more career stability than
Jeff. I counted 18 different jobs from Henry Kissinger to Yale. Just kidding. But I’ve
actually had very few jobs. I got a Ph.D. in economics in the early seventies and
immediately went to work at the Federal Reserve Board in Washington as a bright-eyed,
very innocent economist. And I walked into a nightmare of an economy. We had just…
this was the early seventies, had just come out of wage and price controls and there was
a gentleman running the Federal Reserve by the name of Arthur Burns. Anyone ever
hear of Arthur Burns? It’s interesting – when he was in his heyday, he was like the Alan
Greenspan, the Paul Volcker, he was a household… everybody knew Arthur Burns. But
they did a survey, a focus group of who do you think Arthur Burns is, and they
recognized the name but they really didn’t know what he did. Several people said he
was the head of a… there was a detective agency named Burns Detective Agency, they
thought he was the head of that; several others thought he was the husband of a
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comedienne named Gracie Allen – that was George Burns – and several thought he was
the head of the CIA. But I worked for him; he was a horrible central banker – he should
have been any one of those… he was the world’s leading expert in the business cycle,
but he didn’t understand how to set monetary policy in an environment that was
increasingly inflationary. So the Fed in the early and mid-seventies made horrible
mistakes on monetary policy and we ended up with double digit inflation and I was
there during that process. And that really left a lasting impression on me as a young
economist and it was an impression that I carried with me all the way through to this
very day. Because it shows you that smart, well-intended people in charge of the policy
levers in a country like this can make enormous human errors and human errors that
will have lasting impacts on economies and markets. And we’re going to talk about a lot
of that today, because in terms of understanding the tension between Wall Street and
Washington, which this course is all about, this human piece is critically important.
I worked at the Fed through the seventies. I loved the job; it was a fantastic place
to work, largest collection of Ph.D. economists in any institution in the world. And we
had fun. You know, the economy was in a shambles, but we had fun! Your life became
the Fed, both during the day and at night. And it’s politically incorrect for me to tell you
what we did at night, but we really did have a lot of fun at the Fed. I ended up heading
up one of the research sections at the Fed, ultimately in charge of making a forecast of
the US economy and I and a colleague of mine, who’s actually still there at the Fed all
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these decades later, we built the first in-house forecasting model, not an econometric
model, but a judgmental model called the Black Box Forecasting Tool that was used back
then and is still used today by the staff of the Fed to provide policy advice for the
Federal Open Market Committee.
Late seventies inflation was 13%, I bailed and went to Wall Street and started my
Wall Street career, spent 3 years at a place called Morgan Guaranty Trust Company
which is now known as JP Morgan. It was a horrible job. I actually was once again naïve
in understanding the environment I was going into; I thought I was going into an exciting
dynamic national institution and this was sort of the final throes of the old House of
Morgan as a wholesale bank and the function of an economist was just not exciting.
In 1982 Morgan Stanley made a decision to really go full blown as a global
financial services firm and they wanted to build an economics department. And I went
there as the #2 guy in 1982 and it was just building an economics department there. It
was … I remember, I will never forget my first day there – they gave me a desk but no
chair, and a plug – back then we had computer terminals – and first thing I did was I
stole a chair from some other place, and a computer terminal. And I went to work and
just stayed there for days and rebuilt the forecasting program that I had set up at the
Fed and I just got to work forecasting and made a couple months later, put out my first
forecast in the US – this is 1982, the economy was in what was then the worst recession
post-WWII, and I made this bold forecast of a vigorous economic recovery, and it was
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right! It was purely luck because I honestly had no idea what I was talking about, and
that made a mark for me. And I stayed in the job sort of as the Chief US Economist, not
the Chief Economist, for about 8 years. And then the Chief Economist, who was an old
friend of mine from the Fed, retired suddenly, not by choice. And I was then asked to
take over and run the economics group as Morgan Stanley’s chief economist. It was the
best job I could ever imagine. I thought I’d died and gone to heaven. And I did that for
about 17 years and right around early 2007 I got a call from my good friend, a guy I’d
worked with for 25 years, John Mack who ran Morgan Stanley at the time, and said you
want to go to Asia and run our businesses as the Chairman of Morgan Stanley Asia? And
I immediately thought of the fact that there was really no way I could do that and
maintain my position as a Chief Economist, so I told John, no, I don’t want to do it. I
want to stay in the job that I was born for. And he said well, why don’t you think about
it? None of you probably know John Mack, but when he says think about it, it was said
with this slightly different inflection, intonation in his voice. And still, I thought about it
long and hard, talked to my wife about it, and I decided to give it a roll. And I went out
there in early 2007, moved to Hong Kong, family stayed here because I figured out
pretty quickly I’d be on the road about 95% of the time flying all over Asia, half my time
in China, and it made no sense to disrupt my family and bring them out to Asia. And so I
did it, stopped being the Chief Economist, and became at that point the first Wall Street
economist who transitioned into a senior banking role and I loved it. It was just, it was
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fantastic. And as Jeff said, he would bring these kids like you through every year and
there was one year he says to me, “what are you going to do when you get a little tired
of this or when you miss your family and want to go home?” I said, well it’s … good
question, I’m thinking about it myself.” And here I am.
And there’s more to it than that, but the main precipitating event in bringing me
to Yale really is and was a great friendship with Jeff over a long period of time. We hit it
off probably when we first met 30 years ago and maintained a constant dialogue on
macro policy and market issues ever since. The icing on the cake came when Yale set up
this new global institute which I am formally affiliated with – the Jackson Institute for
Global Affairs – and we have a few of you in this class right now who are students in that
Institute. But Yale is pretty darn different than Wall Street. I’m still employed at
Morgan Stanley, but I’d say right now it’s 65-35 Yale-Morgan Stanley.
Anyway, enough of me, and enough of Jeff. We’ve talked too long, is there any
time left in the class? We want to literally restrict each of you to 30 seconds – name, a
singular identifying characteristic or something you want to get out of this course that
you really haven’t put down on paper when you applied for the course. We don’t want
speeches.
[Students introduce themselves and discuss issues they are most interested in (no
transcription]
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Jeffrey Garten:
It’s a really great group of backgrounds and I hope that you feel really challenged
because we’re going to cover a lot of stuff. And my one regret is we don’t have time to
cover it in the depth that would really justify it; it really should be a full year’s course
which maybe we’ll do someday.
What I’d like to do now is talk about the course both in terms of the ideas and
how they’re going to unfold, how we’re going to do it. And I think that it pays to start
with some of the most important goals of the course. And I think they mirror a lot of
the things that you’re saying that you would like to better understand. The institutions
and the people in them, the importance of both Wall Street and Washington in society,
the way that these two arenas interact and how markets and policy and politics, how
they link together.
We entitled this course “Wall Street and Washington: Markets, Policy and
Politics.” And we thought a lot about it – there’s another aspect of policy and politics
and at least in my view it goes this way – that any of us can sit down and say this is the
right policy, this is what would be rational to make something work. But the politics
could be much, much different. And everything about this course is really the
compromise between policy that would amount to efficiency and fairness, that smart
people can figure out. And the politics, which always governs because that is the
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interaction of the interests. So I think every time we come up with something, we talk
about some issue, it’s very helpful to ask yourself the question, “Why is it the way it is
and not another way which seemed to make a lot of sense.” I’m very loathe to criticize
people in high positions unless I was really sure they have bad motive. Most of the ones
that I’ve come across don’t. I welcome your views after we finish this course, but my
guess is most of the people you meet you’re going to say, “they are very smart, they
have enormous amount of experience, they’re extremely dedicated, they believe in
what they do, they work really hard, and yet you could really wonder why in the world
were they doing it the way they’re doing it?” And they’re all prisoners of a political
configuration and when I say political, that doesn’t necessarily mean the Congress or the
administration; every organization has its politics. So I think this distinction here is not a
minor one.
And maybe that’s this first point here; we hope that you can understand what
some of the constraints are. We’re going to be dealing with some very imperfect
situations and you may have a very strong view, but it would be my hope that you could
argue both sides. That you could see it from both sides. In one of these classes, I
brought students to visit Lloyd Blankfein – it was about 6 months after he had taken
over Goldman Sachs – and I said to him, it was a setting just like this, and I said, “What is
the biggest thing that you’ve learned in the first six months of running a company?” And
he said, “Well what I learned was the closer I got to someone, the less stupid they
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looked.” And I couldn’t figure out what he meant, so I asked him. He was a trader, so
he used the example of how traders, from his perspective are always making some
stupid decisions until you sit in their chair and you see the information that they have,
and you understand how their view of the world is constrained. And I hope that some
of this comes out.
In terms of the format, you know Caitlin [the TA] spent months on a background
book with all the institutions. And I really hope that you take that seriously because we
could spend two three weeks just going over the institutions and it would be very dry
with the underfitting of a Yale education, but you have to know the substance because
you’re going to be subject to people talking about the BIS or the FDIC and if you don’t
know what these institutions do, you don’t have some feel, and we’re going to visit a lot
of them, you’ll get so much less out of the course. It would be like somebody speaking a
foreign language. We’re going to have some lectures, hopefully a lot of discussion,
that’s all in the syllabus. There are some Tuesdays where we don’t have classes, so
please follow that syllabus carefully. The syllabus is governing the only change is that
Andrew Ross Sorkin is coming on one of the days when class is scheduled, but his name
is not on that syllabus. I talked about a little bit of student projects in our pre-class and
mentioned that we’re going to have a little coaching after the class. Very important.
Important for the class, but also important for you individually. This is a management
school and part of what you learn here is how to articulate, how to make an argument,
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and we’re holding these presentations to 15 minutes on very big topics. And this will be
a crucial ingredient in your professional success, to be able to say something big and
complicated simply and very quickly. Not to mention be able to field questions.
And there’s a term paper, as you know. We take those papers very seriously and
one reason we do is that in past years they haven’t been so good. So every year we
tighten up a little bit and we are harsher in our assessment and we are expecting a
preliminary outline of what you are going to write about by February 10, and when I say
preliminary outline it’s at least a page, but that page has to be crystal clear – what is the
argument that you’re making and what are you going to use to substantiate it. These
papers are not a book report; you’re taking a position on something. And the syllabus
has a bunch of topics, any of those is fine. If you want a different topic, you have to get
an okay from me or Steve. By all means, pick a different topic, but what we don’t want
you to do is to pick one and we don’t know, we haven’t approved it before this outline
because every once in a while a student will take a topic that it may be very interesting
and have absolutely nothing to do with the course. So we’re trying to avoid that.
We’re taking 2 maybe 3 trips to New York and a week-long trip to Washington.
They’re almost all set; I think they’re going to be really interesting. And the one thing I
want to mention so there are no surprises is that you’re going to have background on
everyone we’re going to see. But for every meeting we’re going to have 4 students who
are going to be assigned the responsibility of asking a question. And the meetings will
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start with those 4 asking the questions so that we have some momentum. And those
questions need to be really thoughtful. And they have to be what I would call stage-
setting questions. Questions that basically open up an issue and questions that are
really befitting of somebody who is at a very senior position and is not thinking
necessarily about what happened that morning but what the purpose of something is,
or what the significance of something is, or his or her judgment that’s really big.
Class participation, as you know from the syllabus, is a really major part of the
grade. And the attendance policy is rather strict in the sense that you have one free
pass. After that you have to get my approval. We’re going to make it simple. Rather
than bounce between Steve and me, on this one thing, just get my approval that you’re
not going to make the class. If you fail to do that, you don’t get graded.
Overview of Issues
So let’s talk a little bit about some of the fundamental issues that we’re going to
talk about.
We’re going to talk about the historical drivers of the interaction of Washington
and Wall Street and we’re going to do that today.
We’re going to talk about the causes of the financial crisis and the regulatory
reaction and make some judgments about both.
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We want to talk about the post-crisis environment. And again, this mirrors what
a lot of you are interested in. What actually are the challenges for the financial system?
What are the challenges for particular institutions, whether it’s the Federal Reserve or a
whole slew of regulators? How do you think about global issues, the future of the euro,
the role of China, the role of the dollar – we’re going to get into all of this.
Of course we’re going to talk about the tension between Wall Street and
Washington, but we want to bring in Main Street. Main Street is a concept, obviously,
that often falls between Wall Street and Washington and how you think about Main
Street vis a vis the financial system and the political system, is a really big topic. It’s
probably the biggest driving force in American politics.
There’s a whole slew of international issues aside from the euro and China that
deal with regulation. It’s very important now because if we were teaching this course
five years ago this would play a far less significant role than it’s going to play 5 years
from now and we’re right in the middle of what could be a very massive transformation
from national to international supervision. We want to talk about leadership across
sectors. Is it possible for people to move between Washington and Wall Street back and
forth and be leaders in both spheres or are these spheres so different? Do they require
the same leadership skills or is there something that is very special to each? And if you
don’t believe in the crossover, what are the implications? What does that say about
national leadership when we have two arenas that are so powerful? And of course
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embedded in this are a lot of values and a lot of ethical issues, and while we’ll try to
raise those, I will stipulate right now we will not do a good enough job because some of
these issues are so complex that in a way nobody has the answers. It would be a great
achievement to even be able to mark where there’s an ethical issue whether you know
what the right answer is, but the whole system is riddled with those kinds of questions.
And then there are some specific things which we will obviously get into.
I think that one of the big values of this course is in the philosophical issues that
are raised. And some of you in talking about what you’re interested in, I think implicit in
that was you feel that something is happening, you’re not quite sure what it is, I’m
certainly not quite sure what it is, but I tried to find a few things and one of them really
is that the whole notion of capitalism is really under a big spotlight right now. I wouldn’t
have said this five years ago. And I wouldn’t have even said it in the middle of the crisis,
but the way that markets and governments are operating not just in the US but around
the world, the enormous dissatisfaction that the public everywhere has with these
issues of concentration of power or executive compensation or the way financial
institutions are bailed out, the socialization of risk, these are really big. Now it’s very
possible that a couple of years from now they’ll sort of die down. It’s also very possible
that we’re in the middle of a very, very big transformation in terms of the way the world
works. I don’t think anybody knows definitively, but it’s certainly an issue that underlies
this course. So is the role of finance in society. You know over the last several years,
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finance as a percentage of GDP has grown hugely in the US and the UK and I would say it
is in the process of growing in many emerging markets, maybe from a very low base.
It’s a big philosophical issue and we don’t raise it so much here, but it’s raised very
eloquently in England about whether or not there is an overextension of finance and
whether this affects societies and effects the values and it’s a big deal. How much is too
much?
How much stability can you have and not have a risk-taking culture? And if you
don’t have a risk-taking culture, how much growth can you have? How much innovation,
at the heart of all this? Can a government really be an investment bank? We’ve seen
attempts. In fact, and rather very surprising, that the preliminary evidence, the
American government didn’t do so bad in – at least in the automobile industry so far –
but is this the wave of the future? Is this something that we’re going to see much more
of? It certainly has come and gone over history, but as you think about the relationship
between public and private… And there are just a whole bunch of other issues I won’t
go into. I’ll just take the last one here, what does it mean public and private
cooperation? I’ve been at this school now for 15 years, and if I had to pick the biggest
cliché that embedded everything it’s public-private partnership. Well, what does it
actually mean? I know what it means if you’re talking about a particular deal, but what
does it mean in philosophical terms when you’re talking about Washington and Wall
Street? And by the way, what is Wall Street and what is Washington?
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I’ve put down a few things here [referring to charts], and I’ve left out a lot – like I
forgot pension funds – but when we’re talking about Wall Street we’re talking about a
financial system and there are a huge number of different entities, each of which is kind
of an industry unto itself. And when you try to figure out the connections between
them, you know it’s a mind-boggling thing. I had a little experience with this – I don’t
want to overstate it – but when I was at Lehman and when I went to Tokyo, we only had
three people in Tokyo. We had five in Asia. When I left we had 300. And my job, I was
in charge of it, was basically to pull the wires from New York to London and create a
global bank in Tokyo that mirrored the capabilities of New York and London. And in
doing so, I actually had to figure out, what is the relationship between the people who
sell treasuries and the people who speculated in commodities. And I have to tell you, I
started by getting people in different areas together and explain to me how they relate.
And then I realized they didn’t know. And so I tried to figure this out. Certainly Wall
Street is not a geographical concept anymore. There was a time when you could actually
draw a circle around what Wall Street was, but you can’t do that now because it’s
geographically so dispersed and we’re talking about Wall Street really in this course as a
global concept. The city of London, the financial center in Hong Kong, they’re very
closely tied.
And the government is just as big, and I put a few things here [see chart], but a
lot of these we’re going to visit. Certainly the Treasury, the Federal Reserves, the CFTC,
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the FDIC, the Congressional Committees, we’ll see all of those. But you’ve got here kind
of a Rube Goldberg mess because they’re overlapping mandates and yet there are
massive gaps. But that’s when we saw Washington; this is what we’re talking about, not
the administration. Or not two or three of the agencies.
So how do these two relate to one another? Just a few ways. But certainly, they
relate – financial regulation joins them. Congressional oversight joins them. So do
interest rates, currency values, what’s taxed, what’s subsidized, the trading of
government securities, trade negotiations that open up business for financial services,
government supported enterprises, law enforcement, industry associations – all these
things – lobbyists, campaign contributions, journalists, people who move back and forth,
this is the stuff that links Washington and Wall Street and makes it so you can’t really
draw a clear line between them. I’ve been experimenting with this little graphic that
you have Wall Street and Washington and a whole bunch of institutions that in some
ways …
The links between business and government are all over the place, of course. For
this course, we could have picked energy, we could have picked any regulated industry,
we could have picked telecommunications. I think partly we picked finance because we
know something about Wall Street; we could do it with another industry, but this is
actually, it’s bigger. It’s more generic. You couldn’t talk about any of those other
industries without talking about finance. So I don’t want to say it isn’t a little arbitrary,
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but I think it makes sense. If the question was, what actually constitutes the governing
institutions of the country? Or of the world? I would say finance and government. That
is the interaction has more to do with the way the world is than government in any
other industry. And this was another schematic I’ve been playing with [see chart], of
when Wall Street is up and when it’s down in different periods. And we’re going to talk
about this when we get to the history.
And finally, here we are – it’s 2012 – we’re talking about some very important
issues [see chart]. But it’s a little different than if we were talking about them 5 years
ago and it will be different 5 years from now.
So what are some of the environmental factors? Well we’re in the wake of a
massive financial crisis and we may be on the verge of another. We’re in the middle of a
wave of massive financial regulation. We have a huge number of global economic
problems that have emerged at the same time. We have a banking sector that is
changing structurally, the whole business model is up for grabs, and I think you’ll see
this when we go and meet a lot of people on Wall Street. As I mentioned before, we’re
seeing a huge wave of international regulation; there are a lot of big debates going on
with no answers about growth, about jobs, about competitiveness. Every one of these
issues is a Wall Street-Washington issue. Every one of these issues both reflects what
Wall Street does and what Washington does and is determined by the interaction of
government and finance.
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The role that Wall Street plays in influencing politics through money - huge issue.
Not saying it’s easy to get a handle on, but it is no accident that you have such a
powerful financial sector in a democracy where campaign contributions count for so
much. Fear of contagion – it’s palpable. There’s a fear that something is going to
happen and that it is going to be like a fire in a house of dry wood and yet very few, I
would say nobody really understands what causes contagion and how to stop it. This
one in the middle – who makes policy – who actually is driving… let’s take the euro.
Who is driving policy? Is it the governments? Or is it the markets? Who’s determining
the structure of the US economy? Is it government policy? Or is it government policy
reacting to what the bond market is saying? These are all issues that are very, very
acute and right in being debated even as this course unfolds.
You also have in this country what is going to be emerging as a really big debate
between people my age and older and people your age. Because all the entitlement
issues, that’s your transfer to me… and I’m not going to say thank you. And maybe you
don’t see a headline, generational issue, but underlying a huge number of the problems
and the challenges, and maybe even the opportunities, is the fact that we have massive
transfers going on, they’re going to get much, much bigger. There are 70 million people
just in the US – of 300 million, 70 million in my generation, post WWII, baby boomers,
and what we’re about to take in terms of social security and Medicare and all of these
things, is going to basically bankrupt the country unless something is done. So this is a
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political debate that is just going to be… it’s going to be waged on every single
conceivable level.
Steve Roach:
But the point is interest rates can be low for a lot of reasons. So don’t just jump
to the conclusion that because the yield on a ten year treasury is 2%, the US fiscal
authorities can keep doing what they’re doing. It can be low for a whole host of other
reasons that have nothing to do with our lack of fiscal discipline. Like weak economy
low inflation risk, some of the factors Jeff mentioned about other countries. What will …
I’ll talk about this a little bit is there’s … oftentimes markets will take a trend and
generalize it to reflect considerations that are really not shaping securities at that point
in time. And you hear this a lot and the debate over trillion budget deficits – if they
were so bad, interest rates would be double, triple what they are right now, so why
worry about deficits? Well, we’ll see.
Some History
Jeffrey Garten:
So now I’m going to give you the Cliff Notes version of history of Washington and
Wall Street and I think it goes without saying what I’m going to do in maybe 12 minutes
could be a yearlong course. I’m just going to talk about these six milestones and I have
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picked these six to illustrate some events that have shaped Washington and Wall Street
very fundamentally.
The first is the debate between Alexander Hamilton and Thomas Jefferson and
not everybody here has studied American History, but Alexander Hamilton was the first
Treasurer of the US and Thomas Jefferson at the time was the Secretary of State. He
later became President. I don’t think it’s too strong to say that the differences between
these two men at the end of the 18 th century has pervaded American finance and
American politics to this very day. If all I did is talk about this one thing, I would give you
an insight about why this country is the way it is now. But the setting was that the US
had just fought the Revolutionary War. It declared independence from England and it
was a tabla rasa. There was no… they had to write a constitution, they could’ve written
anything they wanted. There was no government, there was nothing. All there was,
was that the war was over, the financial system such as it was had totally broken down,
there were 13 states, colonies, they had issued their own currency, their own bonds,
they were worthless, and now the US was an independent country and it had to come
together. And the debate between Hamilton and Jefferson was the debate about the
basic principles upon which the US were rested. Hamilton was called a Federalist. He
was someone who actually admired Britain; he wanted a strong state. He wanted a
central bank. He wanted a strong currency. And he wanted the federal government,
the new government, to buy up all the debt of the states and make it very clear to the
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world that the US was creditworthy because those states were, it would be like the
currency of Haiti, probably worse than that. And Hamilton also realized that the only
way to do this was to have some source of revenue – there was no such thing as an
income tax – so the revenue would have to be a tariff. And everything that he did
smacked of a country that would be eventually an industrial power, centrally controlled.
Jefferson, on the other hand, was a farmer, he lived in Virginia (Hamilton lived in
New York). Jefferson wanted a country that was very decentralized. He couldn’t
understand Hamilton. He said we just fought England – one reason we fought them was
because they imposed a tax on us. And here you are, you want to have a tariff right
away? You want to have a central bank just like the Bank of England? You’re trying to
play a trick on us because when the federal government buys up all the debt, suddenly
the federal government will have the country by the neck and everything you’re doing is
trying to make this centrally controlled. And they had this fierce debate which infected
the new Congress and actually it was done quite gentlemanly on one hand and viciously
through the yellow press, and they just couldn’t figure out how they were going to
reconcile this. And George Washington, who was the President, was at wit’s end,
because we needed a government.
And on June 20 in 1790 on Maiden Lane -- Maiden Lane is right on Wall Street --
Jefferson said let’s have dinner and settle this. Jefferson and Hamilton and two other
congressmen had a dinner. And it is reputedly the most famous dinner ever to take
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place in the US because at that dinner they reached a compromise. And Jefferson said,
you can’t have a central bank, but you can have a bank that operates in all the colonies.
You can have one bank; call it the First Bank of the United States. It isn’t a central bank,
it can’t print money, but it gets you somewhere, further than where you are. You can
have the federal government can buy up all the debt. You can have your tariff. But you
can’t have the capital of the US in New York because that’s too much power. You’ll have
the financial community and the political community in the same place and that’s too
dangerous, too much concentrated power. We won’t let you do that. And so they
reached a compromise and Hamilton was crestfallen because he wanted it in New York,
so they agreed that the capital would be formed, take 10 or 20 years to build it, and
there was the division right there between financial capital and political capital. And an
uneasy compromise between the centralization of power and decentralization. And
Jefferson felt that if the political capital was not in New York, that would at least give
some chance of balancing out what would become Wall Street. So that was a very big
thing.
By the 1830’s, the First Bank of the United States, had expired. It only had a 20
year mandate. So there was nothing even resembling a central bank except that in 1812
there was a war with England and the finances were in chaos so they had to create a
second bank of the United States.
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Andrew Jackson was the president and Nicholas Biddle was the President of the
Second Bank of the United States. And Andrew Jackson was like Jefferson – he was from
the rural US, he was a farmer. He also had borrowed some money and couldn’t pay it
back and forever hated anyone who was a lender. And he was absolutely determined
that that second Bank of the United States would not last and he did everything he did
to close it. And Biddle was a great banker and he went around the country saying we’re
going to have absolute chaos without any centralization. And Jackson won. He closed
the bank and the way he did it was there were a lot of federal deposits in the bank and
he took them out and put them in state banks. And sure enough, Biddle was right
because for the next 50-80 years, there was boom and bust. The U.S. had one financial
crisis after another. The markets would swing all the way; there would be rampant
speculation; there would be fraud; and there’d be a collapse. There was nothing at the
center. There was absolutely nothing at the center.
In 1895 we had a really big crisis. At the time England was the financer of the
world. And the British had invested a huge amount of money in Argentina. Argentina
economy collapsed; the British started pulling money from out of everywhere and they
pulled it out of the US. We were on the gold standard; so as the dollars were pulled out
of the US, the gold had to go with it. The US Treasury was about to collapse. We were
used to keeping $100,000,000 in gold; it went all the way down to $9 million. And the
President at the time, Grover Cleveland, didn’t know what to do. He called J.P. Morgan,
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asked him to come to Washington and he said, do you have any ideas? And it was very
unpopular because the country was in a very populist mood, the bankers were in ill
repute, especially because there had been these recurring crises, and JP Morgan said if
you issue bonds, I can get with the Rothschilds in Europe and we’ll buy them all. And I
guarantee you the gold will come back. And Cleveland said you can guarantee that the
gold can come back? And Morgan said yes. And they issued $100 million worth of
bonds. Morgan and Rothschild bought them all; even before they bought them, even
on the rumor that they were going to, the gold started to flow back to the US, and there
was a huge boom for several years. And Morgan singlehandedly bailed out the treasury.
Well this was a demonstration to the country of the raw power, the raw financial power,
and it did not sit well with the political interest that one guy could have so much power.
But there was nothing else, there was no central bank, there was nothing, this was the
financial system. And at the heart of it was JP Morgan.
There was another crisis in 1907. Reason: there was a lot of fraud, there was a
lot of speculation and banks started to fail. Now the president was Theodore Roosevelt;
Morgan was semi-retired, Roosevelt called him and said, come down here and Morgan
said I can help you, but this time it’s not going to be my money, I’m going to get the
banks together and save themselves. And at what is now the Morgan Library in New
York, he called all the bankers together and said you’re not leaving until you put
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together a rescue package. And they did, they stopped the dominoes falling, and once
again, the country went into a boom.
So this demonstration of such enormous power - not once, but twice – the first
time to save the gold standard, the second time to save the banking system, was too
much for the American public. You think maybe they’d be grateful, but that wasn’t it.
They were really resentful that a handful of people could have so much power, going all
the way back to Jefferson and the thing that he was worried about. And the congress
said, we’ve got to have a central bank. So it took six years, and by 1913, the Federal
Reserve was established.
As the 1920s came along, there was a major boom. Huge speculation, huge
fraud, lots of parallels between that and 2007-2008, and then of course there was the
stock market crash and the country went into a deep depression. So we get to the
1930s and you have a Fed, and the government, the Franklin Roosevelt administration
decides we have to have a proper regulatory system. So in the 30s you had the
establishment of the SEC, the FDIC, you had a whole series of laws to protect investors
and it really is in the thirties that you begin to see the leveling of the playing field. The
thirties really being a reaction, not just to the 20s, but to 150 years of basically Wild
West unregulated capitalism.
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And it brings me to the end here, to the forties, and there’s only one point I want
to make here. In the 1940’s, in the middle of the second world war, towards the end of
it, there was a debate called the Bretton woods in which the international monetary
system was devised. I’m not going to get into that, but in the middle of that debate
which was between the US and England, the only two powers left standing. But in the
US, there was a huge debate between the bankers and politicians, between Wall Street
and Washington, because Wall Street was afraid the main institution that Bretton
Woods created, the IMF, would be in Washington, and Washington was absolutely
obsessed with having the IMF in Washington. Why? Because they were again worried
about the concentration of political and financial power in New York, Washington vs.
Wall Street par excellence.
So it brought us full circle. What started as a debate about concentration, about
concentration of power, about the power of finance not being offset by the power of
government, came back to the starting point. It was always a source of concern. We
went hundreds of years before there was even a semblance of a balance, and even as
late as the 1940s that debate was taking place – not in a very sophisticated way, but in a
very instinctive way. That you had two sources of enormous power. By the 40s it was
really clear the US was going to be increasingly centralized since we were a major
industrialized world power, but the question of how the power would be handled and
divided between the financial capital and the political capital was the basis of the
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tension between Wall Street and Washington, that same tension that existed at that
dinner in 1790.
Now I’m going to turn this over to Steve to talk about the 40s and bring it up to
the present.
Stephen Roach:
Thanks Jeff. The allocation of scarce resources is the essence of the economic
problem from the days before Adam Smith to right now. And the intermediation of
capital, physical capital, financial capital, is really central to that same problem. And the
key premise of this course is this tension between the government and the financial
system that really plays into the heart of the economic problem. And this tension is one
that changes – it’s not static – and it’s changing right now. It’s changed constantly from
the period that Jeff described in the early days of this nation through virtually every
decade of the last century. And we’re in the midst of a profound change right now and
it’s audacious of us to try to draw conclusions as to exactly what that change means.
We know we’re going through it.
And the story that I want to talk to you about in the next 15-20 minutes is what is
it that shapes the policy climate, the market climate, the economic climate, that bears
critically on this tension between Wall Street and Washington? What does policy
attempt to do? From a pure macro point of view, there’s a big debate right now
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between policies that are aimed at sustaining economic growth or fostering a stable
growth environment.
Could you argue that unstable systems are hard to sustain? That you could have
a big enough bust that sustainability itself gets drawn into question? Alright, that’s the
point I want to make here. In terms of the tension between Washington Wall Street I
will argue in a second that there are critical tipping points – Jeff alluded to them in the
early centuries and decades of this nation – but there are critical tipping points that
invariably are tied to crises that really change the playing field for policy and for the tug
of war between Washington and Wall Street. And out of those tipping points come a
real rethinking of the goals, the objectives, the mandate for public policy. In theory the
government, the Congress, prescribes the mandate for the fiscal authorities, the
regulatory authorities, and most importantly for the monetary authorities. We have a
system of checks and balances – that’s America. Power is not allowed to go unchecked
by any branch agency or group of public officials in this country. There’s no such thing
as pure absolute power. And so the mandates that are set by the broad-bodied politic
are absolutely critical in unmasking the way in which this tension between Washington
and Wall Street is played out, over a long period of time and especially over the last
several decades and in particular the last few years. And finally there’s this political
constraint, and by political constraint look no further than what’s happening as we
speak – New Hampshire encapsulating an acrimonious early start to the political season.
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And a political season in and of itself that has been extreme in many respects and some
of us have never really seen before. And where does that come from? What does that
mean? How does that play on the tension between Washington and Wall Street? Policy
– here I’ll go back a little bit further than Jeff – take it back to 1500, a little bit before
even both of us got our starts in this business. The rise and fall of great powers and
nations is something that’s been documented by actually a great Yale historian – Paul
Kennedy – for a long, long time. And I would argue that the policy debate, the tension
between finance and government, certainly Main Street, has played an important role in
shaping the ascendancy and descendancy of nations over the long sweep of history.
Policy in many respects is an outgrowth of the value proposition of nations, but it’s also
an outgrowth of the very human characteristics of policymakers and you will meet many
of these policymakers when we go to Wall Street, and when we go to Washington.
That’s why you’re doing these field trips. These field trips are not so that Jeff and I get a
night off talking to you. You’re going to meet people that were at the core of the
toughest decisions of our generation. Meet the Paul Volckers, the Bob Rubins, the Hank
Paulsons. And you’ll meet some of the key observers of their trends. And the healing
piece – look no further than the rise and fall of the FSU – Former Soviet Union, Japan,
look back here in the not that long ago, again, slightly predates us, the early 19th century,
China and India were half the global economy. And then they collapsed and now
30
they’re coming back. How much of this is an outgrowth of their own tug of war
between finance, government and their people.
Policy has played a critical role in shaping nations over the long, long sweep of
history. In this country, just to pick up where Jeff left off, I would argue that there are 4
critical milestones, tipping points, in the modern policy debate, in the modern tug of
war between Wall Street and Washington. The Depression as Jeff alluded to, the
immediate aftermath of WWII, the inflation – raging inflation – of the mid to late 1970’s,
and then the more recent crises. Each of these events changed the balance of power
between Washington and Wall Street. Each of these events gave rise to different
mandates, different major pieces of legislation that reflected the judgment of the body
politic as to how policy needed to shift and how the balance of power needed to shift
between Wall Street and Washington.
In the midst of the Great Depression, the Congress reached the decision that the
Depression– rightly or wrongly – was caused by the commingling of the investment
banking and commercial banking function. And so the Glass-Steagall Act was passed in
two installments – 1933 and 1934 – that separated commercial from investment
banking. No clear example of the tension, the tug of war, the interplay between
Washington and Wall Street was out of that piece of legislation that the company I
worked for for 30 years was born, in 1935, an outgrowth, the stepchild of the House of
Morgan. The focus, the mandate if you want to have it, coming out of the Glass-Steagall
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Act, was that the financial system should become more stable. The premise was the
unstable financial system pre-1933 is what precipitated the Great Depression.
Jeffrey Garten:
Could you explain why Congress thought what the theory was of combining
investment and commercial banking what they were alleging that made them want to
separate the two?
Stephen Roach:
Well probably the same thing that is being alleged today, when we fast forward
to 80 years later with the so-called Volcker rule that comes out of the Dodd-Frank Act
and that is that there is a tremendous conflict of interest between financial institutions
that are acting as repository of the people’s funds and then getting involved in
speculative or risky capital market activities. And a judgment was made back then as it
is being made right now that it’s fine for a financial institution to get involved in risk
taking activities, but it better not be at the taxpayer’s expense. And so, the separation
between investment and commercial banking was aimed not so much at protecting the
people’s deposits, as is the case today, but really in an effort to better safeguard the
financial system from the type of catastrophic collapse that was first evident with the
crash of 1929.
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We went through the Depression, some would argue, would have never ended
were it not for WWII, but it was not until the dust really settled in the immediate
aftermath of WWII where congress got back to the business of trying to sort out a better
financial system that would make it absolutely certain that never again could we go into
an environment that resembled the type of economic collapse that we lived through in
the 1930s when the unemployment rate peaked at 25%. And the devastation, personal,
social, you’ve seen pictures of the bread lines, was the first thing that the congress did
when the war ended – passed the Employment Act of 1946, requiring the fiscal and the
monetary authorities to set policy with an aim toward hitting full employment. Full
employment was not defined as an absolute number, but you’d better believe it was a
number that was a small fraction of the 25% that was hit in the depths of the Great
Depression. And so we had a single mandate that dictated the focus of a fiscal and
monetary policy and that was critical in shaping the way in which Wall Street priced
securities and operated. It was a very simple, and in many respects, a fairly easy to
understand world.
And then on my watch, as I said in my personal introduction, that single mandate
failed. Under the guise of just aiming for full employment, we lost track of what it took
to set policy in a way to maintain control over inflation and we had double digit inflation
and the government stepped in and said wait a second, this is the most corrosive thing
that’s happened to the United States since the 1930’s. We’re going to give you a new
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rule to operate under; a rule that would also force you not just to focus on full
employment, but also on price stability. And that also changed the rules under which
markets performed and Wall Street acted. And so beginning with the Humphrey
Hawkins Act in 1978 we had both Washington and Wall Street recognizing the
imperatives of policies that were being aimed toward both full employment and price
stability.
What’s an example of policy that creates full employment? The debate in the 50s
and 60s and 70s was that to use countercyclical fiscal policy as a means to augment or
compensate for a weak aggregate demand in times of economic slack. When the
economy would periodically go into a recession- cut taxes, reduce spending, manage the
economy with discretionary fiscal policies, use monetary policy in the same way, cut
interest rates and deal with economic cycles. Policymakers never believed that you
could repeal business cycles, but you’d better believe that you should use discretionary
policy to compensate for it.
Jeffrey Garten:
Could I make one point here? This is a debate… this debate between full employment
and price stability is very, very alive in the Fed right now. I only mention this because
we’re going to see a lot of Fed people. But I guess about a month ago I moderated a
session at the Council of Foreign Relations where the head of the Chicago Fed, Charlie
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Evans, made the following point (he’s written about it and he’s created a lot of fuss). He
says the Fed has a double mandate – price stability and full employment. He said if
inflation was rising let’s say very rapidly and let’s say it was up around 10%, he said we
would be running around with our hair on fire. He said it would be such a major thing,
we would do everything we possibly could do address it. He said we had the equivalent
with an unemployment rate of 9% and yet let’s not do anything. And so there you have,
and he has a whole bunch of recommendations saying there is no inflation to speak of,
the Fed is totally ignoring the full employment – even if you couldn’t get to full
employment, but now it’s absolutely tragic. And so leaving aside his recommendation, I
think what Steve is underlining here is these are two very fundamental goals and they
set up in times like this when maybe there’s high unemployment or other XX by
inflation, the most vicious kinds of debates as to what the Fed should do.
Stephen Roach:
With all due respect to Mr. Evans, it’s hard to argue – you could certainly argue
the other way – very much against him; the Fed is not doing enough with the policy rate
at zero and quantitative easing, that’s expanded the Fed’s balance sheet to 3 trillion
dollars. Maybe monetary policy is not the tool to deal with these problems, but we’ll
get to that as well.
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And then the crisis of ‘08 and ’09 underscore the fact that policies aimed at full
employment, price stability probably aren’t enough. That it’s time to rethink the core
premise in financial stability but in a different context and we’ll come to that in just a
couple of minutes. So the point here is that each and every one of these major events
and the implication it’s had for rethinking the mandate, the policy target, each of which
has been manifested in the form of major pieces of legislation and of course we’ll study
this one in greater detail in several weeks, this had profound impacts on the balance of
power and the tension between Washington and Wall Street.
The mandates that I’ve laid out for you here are mandates that reflect … that
really apply mainly to the broad settings of fiscal and monetary policy. And those bear
very critically on the core theme of this course – the tension between Wall Street and
Washington. Certainly there are other major policy statements that have occurred that
have a critical bearing – I think of Sarbanes Oxley coming out of the accounting scandals
and the corollary to that was a big settlement on the Wall Street research scandal
coming out of the dot.com bust which has had a profound impact on the way in which
Washington and Wall Street intersect in the dissemination of research by securities
analysts on Wall Street. But these I think are the major milestones in the way in which
this debate has evolved over time.
And then this is a little bit of an editorial on some of the major issues that have
shaped the most recent evolution of this tension between Wall Street and Washington.
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There was huge focus in the 1970s early 1980s in putting together all the apparatus of
policy toward fighting inflation. And you’ll meet America’s greatest inflation fighter
firsthand, Paul Volcker. When you’re an economist you don’t have too many personal
heroes, you know, it’s not a business that lends itself to heroic behavior. I will be the
first to tell you and I’ve said this to his face, Paul Volcker is my personal hero. And he
was very courageous in what he did to use the full force of monetary policy to tame
inflation. And you could argue, and I have and many have, that it was the victory against
inflation that set Wall Street on a course beginning in 1982 that created the greatest
bull market in modern history and created a lot of the froth in the industry and in the
economy that again came back to haunt us as we lurched full speed like Wyle E. Coyote
toward the cliff. We were very good, in retrospect, in fighting inflation. We were not
too good in managing the piece or sustaining a disinflationary environment. We really
got caught up in what I would say the hubris of victory – we called it The Great
Moderation. We had tamed inflation and so we lived in a new world of permanently
low inflation and very strong financial markets and financial services industry. Again,
this gets back to the point I tried to address when Mihir asked what about interest
rates? Why are they so low? It could have been low inflation, it could have been
globalization, it could have been technology? But a lot of things happened along the way
that raises questions about sustainability. In particular, as we move toward the crisis of
’08 and ’09, we had bubbles – initially in equities, in property, then credit. We had
37
massive global imbalances and we had a steady string of crises at home and abroad that
raised in retrospect significant warnings that maybe this was not going to have a happy
ending. And at the same time all this was occurring, we had the ideological capture –
and this is where the personal element of the policy debate, the tug of war between
Washington and Wall Street comes into play – we had the ideological capture of major
government and policy authorities who believed very much in a philosophy of self-
regulation at time of great complexity in markets and economies. And you will read
later in this course, I believe, correct me if I’m wrong, some selections from the report
of the financial crisis inquiry commission, which states right up front that this crisis of
’08 and ’09 did not have to happen but it was the ideological capture of our central bank
and the congress that played a key role in that regard.
Just a couple of quick comments on macro policy levers, because they’re very
important in unmasking the story that we’re going to unfold to you in this class. Central
banks are a key actor in this story and we’re at a fascinating and critical period,
unprecedented in many respects in the conduct of central banks in a modern society.
These are two lines that show you inflation adjusted interest rates for the United States
(blue) and for Japan (the red). Note the zero line. And note that in the case of the U.S.
we are well below zero and have been below zero for more than half of the last decade.
You can’t get more accommodative than what we’ve done. The Bank of Japan was the
first to move to a zero interest rate policy and now it’s swept the developed world. The
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European Central Bank is there, the Bank of England’s there, the Fed’s there, and what
do we do when central banks run out of basis points? The traditional role of a central
bank is to use the price of overnight money to anchor the yield curve. And by moving
that price of overnight money to zero, they’ve lost control over the allocation process at
the short end of the yield curve. So they’ve moved from prices to quantities in an effort
to come up with new and “creative” ways to control economies in a zero interest rate
setting. And this is the quantitative easing, the liquidity injections, and you will again
meet with officials, especially Hank Paulson, who played a key role as the architect in
those early days of America’s experiment of quantitative easing. Once the central bank
pretty much uses all of its firepower up, it then becomes incumbent, as the question
was asked earlier, on the fiscal authorities to fill the void and these are debt to GDP
ratios for general governments. And of course here you’ve got Japan and look, we all
sort of started here together, nicely grouped in the 55 to 70% zone in the 1990s. The
Japanese economy imploded; the Japanese debt to GDP ratio is 230% and rising. Ours
and elsewhere in the developed world are well below Japan, but they’ve moved up and
these are very optimistic forecasts. Who knows if these forecasts are going to be right?
What I do know is that right here 2010 the debt to GDP ratio for governments in the
entire, for all the advanced economies in the world exceeded 100% for the first time
since the end of WWII. And yet no appreciable impact on most of the economies.
Why? Because the cost of borrowing is artificially depressed by central banks. The
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interplay between monetary and fiscal authority is important to this question we raised
earlier – the balance between stability and sustainability. What would happen if market
interest rates were to move up from zero and you’ve got debt to GDP ratios in excess of
100%? Anyone want to venture a guess?
It might end up being a much tougher climate to absorb the financing costs.
Jeffrey Garten:
I’d like to go back because I think your question is very good and yours is the
beginning of an answer. But here you have the essence of the Washington Wall Street
nexus because if those interest rates go up and the government then faces the choice of
defaulting on the one hand or slashing social expenditures on the other. In the extreme,
you don’t have to default if you don’t do something else. But all these other things that
they do are central to the workings of society. And that right there is the big debate in
the U.S. where the very doctrinal debate is whether the answer is to cut spending or
whether in order to alleviate the pressure you cut some spending and you also raise
some taxes. So what looks here like a relatively technical issue is actually at the core of
all politics going forward. When I talked about generational tensions, it’s right there.
You ask about investment in education or investment in research and development, it’s
right there. So I think what Steve is illustrating here is there is no greater tension than
looking at this chart, realizing we’re out of ammunition and that the governments are at
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the total mercy of where interest rates are going to be and when I say the government,
by extension, society.
Stephen Roach:
I don’t think we’re nearing the apex of that. I mean I take your point but having
done this for a long time, one of the things I hear every year is it’s never been tougher
to manage the system; it’s never been more complex to understand markets. So it’s
sort of like Moore’s Law. The complexity factor is growing at an exponential rate driven
by I think really two main features – the integration of markets and economies called
glo bal ization and financial innovation which has created increasingly complex and in
many cases opaque financial instruments. So this gets back to one of the throwaway
lines I had in the earlier slide – in an increasingly complex inter-related system, wasn’t it
reckless of us to believe that we could move from regulatory discipline to an ideology
that was driven very much by self-regulation? That markets always knew best despite
the growing complexity? That’s one of the big debates that I think has yet to be
resolved in this, if you want to call it, use the word post-crisis, but you also put in the
footnote Jeff that we may not really be in a post-crisis environment. That’s a huge issue
that will continue to have a bearing on the way in which we sort out this tension
between Wall Street and Washington. So this complexity point that you raise is really
important.
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Jeffrey Garten:
I will add an anecdote – when did Greenspan step down?
Stephen Roach:
Not soon enough. I’d say like 2006. 2006.
Jeffrey Garten:
Let’s say 2006. So it was around 2005 there was a big debate about whether the
government should do something about derivatives? And Greenspan made the state-
ment that the government knew far less about the workings of the financial system than
the bankers. And then he went on to say, suppose I gathered all this information
because there were people like Bill Donaldson, former dean here, then Chairman of the
SEC, who wanted hedge funds that were using derivatives just to register with the SEC.
And he wasn’t going to regulate them, but he was arguing he needs some more
information. And Greenspan made the statement, “I wouldn’t know what to do with
that information if we got it.” And you know it was under the pretense of humility. But
part of it was, I think, he genuinely had such opposition of any kind of regulation that he
felt that they wouldn’t even know what to do if they had more information. So if I
deconstruct that, it’s so complex, why are you bothering me with this, I wouldn’t
understand it…
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Stephen Roach:
But it was worse than that because he also truly believed…
Jeffrey Garten:
I’m getting him going…
Stephen Roach:
He truly believed, Jeff, that the markets were better at understanding and
hedging against risk than a regulatory or monetary authority can do. So he was
prepared to pretty much abdicate his oversight authority of which he – under the
Federal Reserve Act – is empowered to exercise and allow the markets to take that on
by themselves. And yet, as we saw in the days immediately after the failure of Lehman
Bros., the cascading cards of the collapsing counterparty risk that were very much tied
to the originate and distribute system of derivatives, were a huge piece in the unfolding
of that crisis. And so that is still an issue to be resolved.
Without prolonging this point too much, the horizontal blue line, call it 2% for the
inflation adjusted federal funds rate, is the average over a roughly 25 year period. And
so right now we’ve got the actual federal funds rate over 4 percentage points below its
long-term or neutral average. Is that the appropriate way to run a system? And what
are the consequences keeping monetary policy excessively accommodated as opposed
to putting it on a path to renormalize interest rates? Is it better to run an economy, and
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this is a good question – do we have a normal economy? Yes or no, and if we do, do you
want to have normal interest rates for a normal economy? Recognizing interest rates
were pushed down here in a time of emergency. If we’re in a recovery, presumably the
emergency’s over.
I think we are deluding ourselves into thinking that a ratio here or even a ratio
here is sustainable over the longer period of time. Economics is pretty good at
identifying forces and trends that ultimately are not sustainable. It’s horrible telling you
when you’ve hit the sustainability wall. We don’t know. But what we do know is that
this, the first time we’re crossing 100 since the end of WWII, is a warning sign. I’ll send
you and I don’t think it’s a sign, but there was a very good paper presented about 9
months ago by the former Deputy Managing Director of the IMF, John Lipsky, who
identified the real pitfalls that occur at this point in time and where long-term interest
rates probably should be in this context and what that means to the global economy.
Let me just move quickly to the end.
Economic mismanagement is not just confined to financial markets. And this is
where the point that Jeff spoke of earlier that’s so central. It’s very much a Main Street
story. So we talk a lot about the tension between Washington and Wall Street but make
no mistake as you possibly walk tonight by the New Haven Green and see Occupy New
Haven or Occupy Virtually any public square in any major city in the world today, that
there are significant tolls that are taken on Main Street as well. And that’s why this
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debate is so important. Because when policy mistakes are big enough, they take tough
tolls on real economies – this is an example of what happened in Japan, the blue line,
and then some 25 years later in our country. This shows the Japanese economy, the
share of the Japanese economy that went to business capital spending and during a
bubble period of the late 80s, the capital spending share went from below 15 up to 23%
of the GDP. And then the bubbles burst in the early nineties, and the capital spending
share collapsed and led to the first of Japan’s two lost decades and counting. In that
collapse, a generation of zombie corporations were created in Japan.
What’s a zombie? Forget about Japan? Walking dead, you got it. The walking
economic dead, some would estimate as much as 30% of all of Japan’s companies were
effectively out of business, but kept on life support by the government and that clogged
up the entire Japanese corporate structure for the better part of the 1990s. Not until
the zombies were put out of their misery did Japan have even the semblance of a
chance of economic recovery. Fast forward to America two sectors blown up in a period
of excess in the late 90s and early 2000s home building and consumers. And now some
have argued, and you would count me amongst them, that we have a new generation of
zombies, the American consumer. And if you don’t believe it, take a look at the
consumption numbers in the US – consumption is 71% of US GDP, the growth rate over
the last 15 quarters has been 0.4%. Doesn’t sound like much life from the biggest sector
45
of our economy. It’s a little bit grotesque to call American consumers zombies; my wife
takes personal exception to that, but I think you get the point.
What does this all build up to? I think this is one of the central points that I want
to leave you with this evening. And that is what I call the political economy of growth.
Governments, people, Main Street, Washington, Wall Street, we all want growth. And
yet we fail to make the distinction between sustainable growth and unsustainable
growth. We do not care about whether prosperity is true or false. All we care about is
growth. And that’s ultimately I think a fatal flaw in the policy architecture and in the
interplay between Washington and Wall Street. It’s growth for the sake of growth. And
the counterfactual to that, just to borrow your earlier point, is if we had a more
disciplined policy setting framework, we may not have had quite as much growth as we
had during say the mid-nineties to the early 2007 period in the United States, we might
have had to sacrifice a little bit of growth over that period to get a more sustainable
economy out of that. But we don’t have a political system that is willing to accept the
growth sacrifice. The political interplay between Main Street, Washington and Wall
Street is a rather fickle arrangement. And this is a theme that we’ll come back to time
and again over the course of the next three months.
And then look at what goes on in this country. You see here, this is the US House
of Representatives – I was interested to hear in many of your introductions, especially
those of you who are from countries outside the United States, you have a fascination
46
with our political system. On a night like this, that’s obviously understandable. So these
are just some records – incumbency re-election rates since the mid-1960s. And you’ll
note that for incumbents in the House of Representatives who stood for re-election
every two years, on average since 1964, 93% of them have been reelected. And actually
the number since 1980 is 95%. So what does that tell you about the valued proposition
driving politicians? That reelection is by far the single-most important objective of a
newly elected representative from the moment he or she enters office. And so the
window of opportunity to shift policy is very, very short. You could argue a year, you
could argue half a year, you could argue months. The system is in a perpetual campaign
mindset. This is an interesting point right here. The last mid-term election of 2010, the
lowest incumbency reelection ratio we’d seen since 1970. The birth of the Tea Party –
what does this mean for the dynamic between Washington and Wall Street? You’ve got
Ron Paul who’s supposed to… who knows, finish third or fourth tonight in New
Hampshire. And he’s the author of the bestselling book “End the Fed”. What’s that
mean for the dynamic between Washington and Wall Street? Where does that take us
in the continuum that you laid out in the pre-1940 period if we actually have a political
force that feels that strongly about a central bank that I would argue they don’t really
understand what it even does.
The political pressures for growth are extremely powerful in this country. You
hear it every day on the talk shows, in the CNBCs, on the editorial pages in the major
47
newspapers, the halls of congress. Everybody wants growth; growth is the antidote to
the jobs issue, the Occupy movement. But do we really have the answer of that debate
and what are the impacts of that on Washington and Wall Street. I don’t have the
answer to that, but I think what I want to leave you with is that this is a dynamic
interplay that is a continuum. It changes; it changes at tipping points that are driven by
crises that are matched by major regulatory initiatives. We’ve seen one with the Dodd
Frank bill in the last couple of years. We’re only just beginning to get a full sense of
what the power of this re-regulatory initiative is because so many of the rules are only
now just being formulated. What kind of a system will it leave us with as we look to the
Washington and Wall Street of the future in the context of a political system like this
that demands instant gratification? I’ll stop on that point.
Questions? Observations?
Jeffrey Garten:
I’ll make one observation about growth because I think central to your argument
is that growth is like a narcotic and our system lives on this narcotic and everybody is
complicit. Main Street wants growth; people are reelected because there’s growth;
Wall Street is only too happy to do its thing to foster growth. But the real political issue
it seems to me is that if you don’t have growth, then you have to have redistribution.
And it is only in the context of growth that some people, that everybody can gain. And
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that is the ultimate political dilemma that we face that is riddled throughout what
you’re saying. Is that if we don’t have growth and we don’t have a lot of it, the
generational issue that I was talking about is going to be really… it will be a battle that
will ultimately be fought in the streets. Because there is no... we don’t have a… let me
put it this way, we’ve never had to, over a long period of time, to redistribute… the
longest period was the Depression and even then when you actually take it apart, the
thirties, there were a couple of false dawns that gave people some hope. And it is a real
question whether the war hadn’t come along, whether our political system would have
fallen apart? So this is kind of a dance here in which all the parties have the same
interest and I think that when Wall Street gets ahead of the regulation, when Wall
Street runs wild, one reason the politicians are so lame is because they kind of like it
until something really… until the bottom falls out.
Stephen Roach:
Well growth gets them re-elected.
Jeffrey Garten
It gets them re-elected.
Stephen Roach:
Again, I would just make this point here, Jeff. You could strike the word
prosperity and put growth in. And so…
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Jeffrey Garten
I’m just saying it’s a very poignant thing that you’re talking about for which
there’s… here’s where policy and politics come in because we could all think of policies
that temper growth, the growth sacrifice; but to say that politics are moving in another
direction, based on what Steve’s saying, I think is absolutely right, is to understate the
force that underlies the imperative for growth. If you’re on Wall Street, one could
understand why your head would be whipsawed because when there’s growth you’re
put on the pedestal and people just can’t get enough of so-called financial innovation.
Anything that moves the needle up. And then when the bottom falls out, you are the
villain.
Stephen Roach:
Well just to bear this out and I’ll get to your question in just one second, during
the 12 year period from 1995 to 2007, consumerism in the United States grew at close
to 4% for 12 years. It was the biggest consumption boom in modern history of the
United States. But real after-tax income growth in that period grew at a number
between 3 and 3.5%. So the difference between them of course is the savings rate
which went to a record low of 1%. How did we do it? We were convinced that in a
weak income environment we could consume beyond our means because there was a
new manna from heaven. We could extract purchasing power from the asset that was
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the biggest piece of our balance sheet, our homes. And yet what was missing in that
equation was that the asset was forming a bubble so we were extracting purchasing
power from an asset bubble and we were using a credit bubble to enable that extraction
process. That to me is a classic example of a false prosperity. So, the true prosperity
would have meant consumer spending, would have grown closer to 3.25%. Not a
disaster, but again to the earlier point, a more sustainable outcome. And so, if the
bubble had burst in housing, you would not have obliterated the consumer the way it
has today. So the difference between the true and the false prosperity is the growth
sacrifice; the growth sacrifice need not be that you push the economy into recession, it
just means that you grow a little bit more slowly with an aim toward sustainability. You
had a question.
What I wanted to leave you with in the slide is that looking back over the last 75
years plus, there are 4 pivotal moments that have changed the rules, the tension, the
balance between Washington and Wall Street, not just in the United States, but in the
world. The Great Depression, the post-WWII realization that full employment was a
critical objective, inflation, and now this crisis. You’re focusing right here and talking
about the Spains and the Greeces and the Irelands and the Italys of Europe, but you
could also be talking about the subprime crisis in the United States. And the risk-taking
that was embedded in all of those developments, whether they were sovereign
governments or individuals extracting equity and buying homes that they shouldn’t have
51
been. And so I’m putting words in your mouth, but what you’re alluding to is a debate
that now shifts away from some of the earlier gauges of economic success to one that
focuses on recapturing a more stable market and economic climate, recognizing the
perils of instability. Which gets back to this point that I started out my comments with
earlier – the tradeoff between stability and sustainability. And when we go to
Washington, one of the big features of the Dodd-Frank Act is the creation of a Financial
Stability Oversight Council that is housed in the Treasury Department. Charged with
assessing and measuring and developing metrics to assess systemic risk which is
believed to lie at the heart of the instability problems that turned a garden variety crisis
into what’s now fondly called The Great Crisis. And if we’re lucky, we will have the
opportunity and this is still a work in progress, so I may have to take these words back,
we will meet with a gentleman I’ve known for a long period of time, Dick Berner, who
was just announced as the first Director of the Treasury’s Office of Financial Research,
which will be the think tank behind the Financial Stability Oversight Council. And you’ll
hear from Dick firsthand what the Treasury and the U.S. government is going to attempt
to do to deal with these issues of systemic risk and instability so that the type of crisis
that we saw back here will never happen again.
How are you holding up? It’s been almost 3 hours!
Jeffrey Garten
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Okay, do you want to ask the last question?
STUDENT: I want to go back to the instability vs. sustainability question and I think back
to my undergrad macroeconomics class, first economics class in my undergrad career,
and my professor put up a graph of the business cycle on the board, and said do we
want growth, or do we want the elimination of boom and busts. And ultimately we
wanted an upper trend line, because if we’re on an upper trend the busts become
shallower and the peaks become higher. And so when we’re trying to decide what
would be false vs. true growth, I’m having trouble wrapping my head around how we
determine what is what because if we could talk about the forties and saying well to
finance the war, we need to borrow money that we … is the determination that false
growth leads to deeper busts in the future?
Stephen Roach:
That’s a great question and it’s a very, very important point in the current
debate. I can sort of see in my mind the blackboard that you were looking at in your
first economics class with a trend line and a bunch of curves on top of the trend line.
What that analysis would have shown is not necessarily that the next downturn would
be shallower, but despite the booms and busts there would be progress. And as long as
we focus on the whys and disciplined management of an economic system, the trend
through the peaks and troughs will have an upward slope and hence the next
53
generation will be better off than the current generation. And that’s the essence of the
debate right now. By focusing purely on trend, or as Jeff correctly put it, the drug of
growth, we did lose sight of the sustainability factor which can draw your professor’s
graph into serious question. And so you ask an even deeper question which is how do
you know when you go so far above the trend line that it’s time to say stop and be more
cautious? And there’s an art and there’s a science to that. And that’s what this Financial
Stability Oversight Council’s going to be charged with trying to design a series of metrics
that will provide early warning signs for economies, markets, industries, that go to
excess. It’s pretty astonishing to think that here we sit in 2012 with all the advances
that we’ve had in economics and science and markets, and we still don’t have metrics to
be able to tell us when the system has gone into excess.
To me, and this is my own editorial comment, and Jeff certainly may have a
different point of view, and he can express that, it’s ludicrous for me to think that we
did not know that we were in an unprecedented property bubble, an unprecedented
credit bubble from 2003 to 2007. With the benefit, not even with hindsight, it was a
debate that was raging at the time, and yet when the economy was growing – this is the
so-called siren song of the boom that I put up on the screen several minutes ago – this is
the drug that intoxicates us. Booms go on for a lot longer than you think. And while
that period occurs, there’s really not a lot of pressure to unwind or address the
excesses. I once had a rather contentious and very public debate with Alan Greenspan
54
on that very point in front of thousands of people in Korea. And he told me, and here
he was the so-called quintessential independent central bank, and he said, you know
when interest rates were low in this period that you are alluding to – 20003-2007– I
never got any letters from anyone telling me to raise interest rates. And I said, well Mr.
Chairman, I guess you don’t read your mail very well because during that period, and I
don’t mean to sort of pedal my own stuff here, but I published an open letter to Alan
Greenspan in Newsweek Magazine. Dear Mr. Chairman, interest rates are too low, they
need to go up by 250 basis points now. And he said, well, I never saw that. I said I’ll
send it to you. So there’s something called common sense. The same thing was true in
the late 1990s with the dot.com bubble. And Greenspan, to his credit, in late 1996,
raised the famous issue of whether or not markets are irrationality exuberant.
Unfortunately he never acted on that, but he did raise the question. And during the
property bubble and during the credit bubble, those questions were repeatedly being
raised, but they were ignored by those setting policy. And Wall Street and Washington
just kept racing to the cliff. You may have a different way of putting it.
Jeffrey Garten
No, I think there was a sense, more than a sense, policy, that we could sustain
the bubble. That once the bubble burst, all the Fed would have to do is pick up the
pieces. And so I don’t know if there’s a political science term here, but it was
asymmetric; why would you stop a bubble? How do you know it’s a bubble? And who
55
are you to basically say that the next person shouldn’t be able to take advantage of
something? If it does burst, it could flood the economy with credit and you could really
limit the damage. There was the political calculation and it would take somebody like
Paul Volcker to have the courage to take the opium away.
We’re going to cover these issues many times and many different angles, so I’m
going to suggest we end the class. But I do want to see the group that’s making the
presentation next week and the two groups that are making the presentation… and
also next week, and I’ll try to do this every week and try to signal what’s going to
happen next week. Next week the class is going to be devoted to the Financial Crisis –
the causes, and evaluation. We’ll stop short of the regulatory issues, that will be the
following week. And we’re going to watch a movie, “Inside Job” the value of which is it
will lead to a really interesting discussion.
< END >
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