THE FINANCIAL CRISIS, THE US ECONOMY, AND
INTERNATIONAL SECURITY IN THE NEW ADMINISTRATION

New School University
New York City
November 14, 2008

11:30 – 1:00  Session II: Policies for the US

Moderator (Jeff Madrick):
            The second panel is about solutions; the first panel I think was terrific. This panel has a challenge to keep up the quality, but I think it’s going to meet it.
            I’m not going to take very much time introducing people. I am going to reserve the right to – I’m just getting the exact titles of the people I’m going to introduce and reserve the right to make comments afterwards.
            Allen Sinai is our first speaker. His company Decision Economics, Inc. I have to look this up because I’ve known him in so many roles over the years. Allen, why don’t you get right to it. Thank you.

Allen Sinai:
            Thanks very much. I think before we get to US policies, we need to talk a little bit about what’s going on, what’s wrong, because for me – I fancy myself as a doctor – my patients don’t die; when I make a mistake they just lose a lot of money. You kind of have to know what’s going on before you can make a policy diagnosis, has been my attitude and belief on policy, because there are different tools and different methods economists and policy makers have to deal with situations that exist. We should know, and I think everybody knows now, the US economy is in a full-fledged recession. Probably to be the longest and deepest since the 1981-82 and ’73-75 recessions, with a chance of something worse.
            This downturn began with the collapse in housing several years ago – we had a lot of lead time for this one – after an incredible boom and a bursting of the housing asset price bubble, which continues now.  The economic downturn is centered around a big cyclical and probably secular decline in the levels and growth of consumer spending. It’s a big deal, because consumer spending in real terms is 71 percent of the real economy now. This is a big lever for what else goes on in the US economy and the global economy, because so much of what is exported to us is exported to the American consumer as the end buyer and also to American business.
            With consequential decline in sales profits and cash flow for American businesses, major cutbacks are in train as we speak for production inventories and jobs and in capital spending. We are in the heart of that at this point, and we are in the heart of this downturn. The worst of it, which will probably stay that way with very ugly data and statistics in all dimensions in the US for another three to five, maybe six months. There will be rising unemployment—6.5 percent now, next week maybe 6.8, 6.9, will be up to 8, we think, in 2009, maybe a little more. That’s 10-12 if we didn’t have the demographics of the labor force in play that we have now, and that suggests there will be less consumption as a consequence, less sales, less earnings and business spending, and worsening financial conditions for households and corporations.  This in turn will be more credit risk for financial institutions which are chockfull of credit risks and imploding at this point, squeezing down because the financial services market is a lot less than it was.
            A global recession also exists. In part, it’s from reductions in exports of lots of countries to the United States and to each other, and with lags that will take down the growth of US exports, which will prolong our downturn.
            Along with a US financial crisis. That crisis is: massive declines in asset prices; large contractions in the balance sheets and numbers of US and global financial intermediaries; and an implosion of credit. We have a serious and potentially severe economic downturn indicated. Could be worse than what I’m about to tell you and how I’m about to describe it. We have a credit crunch going on within the financial system and outside the financial system overlaying this downturn, intensifying it, and the recession itself feeds into the credit risk, the contraction of credit intensifies the credit crunch. This is not an easy loop to break.
            The downturn of the US, the recession, we are characterizing as long and deep. About a year ago – we were forecasting recession at the time – our characterization of it was long and shallow. Always long. I’ll get to that. The deep—people ask about deep – deep is ’81-’82 variety, ’73-’75 deep. If you use real GDP as a measure, peak to trough, it’s about 2.5 to 3 percent on our forecast. We date the beginning of it—a somewhat technical matter—somewhere as early the turn of this year, which I think is where the NBER will end up, and no later than June, because real GDP fell in the third quarter. The only indicator that has stopped, that would stop them from dating it around the turn of this year is the fact that we have two quarters of positive real GDP. The monthly indicators that are used are all, and have been, well below the peaks of the four or five major indicators the NBER uses. We have dated this thing from the beginning at the turn of the year. If you take, as far as length, ’73-75, ’81-’82, and just the calendar dates, you have 16 months each as the minimum length. If you were to split the difference between the beginning of the year – I don’t know exactly what they’re going to do, and they don’t either; but it’s clear they won’t date it later than June, or earlier than December, January – if you split that difference, March, and add 16 months to it, just by calendar time kind of comparison, you get to late next year before you can recover.
            That’s not enough, because you can’t date an illness that any of us have by our age or how long the average illness lasts. You have to get into the patient with all the new imaging techniques and find out what’s going on, and date the nature of the illness, diagnose it, and see how long it lasts and what’s going on. Our thought is what’s going on is going to last quite a long time. If I had to pick a number, and this is totally speculative, I’d say 20-24 months, because you have to do this in this world, and then I would tell you, don’t believe it, but believe the notion of long. But I don’t even believe that until I tell you why it looks like it’s long.
            Where the patient is right now, the consumer – that’s the heart of the downturn. The housing and residential construction is still declining, but that’s kind of a sidebar right now. That’s only 3+ percent of real GDP. Real consumption is 71 percent of real GDP. It used to 67 percent or so. It’s gotten a little high. It’s going to regress to the mean, at least to the mean. What is going on around the consumer is both a secular and a cyclical adjustment. Actually, consumer-spending growth was far below its historical trend long before the 3 percent decline in the third quarter. It was running about 1.5 percent annualized. Historical growth and consumer spending is about 3.5 percent adjusted for inflation over 45 years. It’s an incredible number. It says something about our culture and what we do as consumers. But the long-run and short-run fundamentals around the consumer are just terrible. We look at six – I’m not going to go through them; it would take too long – and all six have been negative for quite some time. A couple of them – the household financial position, still a lot of job losses and a higher unemployment rate to go – suggest that what we are seeing in terms of the cyclical downturn in consumption, which was -3 in the third quarter, can continue to be that negative for two or three quarters, and in the long run, much lower than trend growth can go on and on and on.
            I would add to it the psychological perception element, which I do believe is part and parcel of all business cycles – not the numbers, not the models. I think American consumers understand that the world has changed. They can’t go on the way they have in the past. The technical aspects of that are you can’t get money out of your houses anymore; it’s just the reverse. You can’t easily get money from banks. Guess what? We’re going to have to actually save to finance what we want to do in the long run. We’re going to really have to spend less, borrow less, accumulate less debt, get our balance sheets in better shape. It’s going to be tough to do, because a lot of people aren’t going to have jobs, and every fundamental around the consumer is compromised. So it’s a secular thing, and I don’t know how long it’s going to last; but it’s not going to be the ’81-’82, ’73-’75 downturn in the consumer which was six or seven quarters. It’s going to be at least that, two years, maybe three, maybe four years; and we will actually have a much higher personal savings rate because of that.
            This is central, a central notion. Out of the weakness of consumption goes less growth in sales and earnings, and businesses then will cut back. Here’s one of the reasons why this thing is going to be long: It’s the second reason. The first reason is the length of time that we’re going to have a depressed consumer in all ways, psychologically, in terms of the income, and in terms of the spending. It is that the business capital spending downturn that tends to follow has only just begun, and it typically lasts about a year. Our thought is this quarter we’ll see capital spending roll over and decline quite a lot as businesses cut back. If it usually lasts a year in an ordinary recession, and this is a tougher one, it’s going to last easily a year, and that’s going to, on top of the consumer, keep real GDP depressed and declining.
            And it also an effect – two areas I just mentioned add to 84 percent of total real GDP. So think of China, and South Korea, and Japan exporting into a country where 84 percent of total demand is on the decline, and perhaps sharply so. Those exports already have to go down. Those countries trade with one another, and yes, they’re exposed less to the US, except for China, than ever before, [but] they’re still exposed, and they’re going down. We have 27 countries now that we have dropped into the recession, including the United States. That’s 80 percent of global output as we measure it. It is early. Not all the data say that. It’s partly process.  It’s what we see, what we expect to happen in the US. I think before we’re done it will be more like 40 countries. So we have a nasty global recession – it’s a reality now – on our hands, and that in turn will hurt our exports and our business going forward.
            Part of this is inflation, which will come down, then impact on the financial system of this, and an ongoing financial crisis talked about in the first session before.
            The policy reactions toward what I describe we have seen on the monetary side and beginning on the fiscal side. For the US it’s absolutely necessary for monetary policy to provide liquidity into the system. It has done that in an ingenious way, a little bit too late for our taste. I think our Federal Reserve is late to the party, but they always are, so what’s new. Of course interest rates, lower interest rates. Once the illness is in train, lower interest rates can’t touch it. We could go to zero, and it wouldn’t do anything until the rest of the system heals, we start to pick up, and then those low interest rates would help.
            The liquidity that’s being pumped into the system, massive amounts of liquidity in the US and other places, now more toward recapitalizing banks, that’s the same thing. In the private sector financial institutions, balance sheets are contracting as we speak thanks to mark-to-market accounting, in part the short sellers and the asset deflation and debt deflation that’s going on that’s a 1930s phenomenon. There’s no way to stop them from swallowing the funds that come in, putting them into treasuries, shoring up their capital ratios unless we reduce, which we ought to do, those capital ratios during this time of extremis. There’s no way to stop them from swallowing it and holding it, not lending to each other, and not putting it out to you and I and others and businesses.
            We have two places where we are pushing on a spring for monetary policy: one is into the financial system itself. They’re not going to do anything with these funds. […?] might come down, but they’re still not going to put it out. And some day, when they’re able to do that, something that could make this worse than deep – severe – that would be off the chart in terms of its depth since World War II.  It’s on our radar screen as a possible scenario—would be the second place where we would be pushing on the spring: Nobody will want to borrow. Such a depressed demand side of the US economy, a 1930s phenomenon, so overwhelmed with bad income and high unemployment and bad balance sheets, they simply won’t borrow, and that would be not the 1930s, but that would be the modern-day counterpart to the Great Depression.  I hate to talk about that.
            Let’s turn to fiscal policy. Here we have the second arm. We have interest rate reductions all over the world. It’s absolutely essential, absolutely necessary. My view is it will do almost no good in the near to intermediate term; but we have to do it anyway, because on the margin it does help some. The liquidity injections of governments and central banks around the world, and in the United States, the joining of our Federal Reserve to the private sector in its deal-making in the private sector is not what we want central banks to do long run. I can’t second-guess it, I wasn’t there, I don’t know what I would have done with Bear Stearns 24-hour […?] bankruptcy, or what I would have done about Lehman or AIG. One would hope we would have been more consistent than what we saw; but it’s easy to be critical and very tough when you’re on the spot in the chaos that goes on in that decision-making world.
            We have now a wave of fiscal stimulus as the other arm of policy worldwide and US. More and more countries are doing it and will do it, which of course is necessary also. That includes increased government spending, which is a Keynesian kind of stimulus in economies that are weakening and falling, and then other means of using the government in the private sector to shore it up. In the United States, we see the government involved in the private sector taking stakes on behalf of the shareholders or the stakeholders – that is, us – in terms of the funds that they’re going to have to borrow for deficit financing. That is very new. I’d rather see more incentive to the private sector to participate in putting money up rather than the government; because down the road our credit rating will probably be lowered by those credit-rating agencies which, if we reform our regulations right, will no longer be hired hands of Wall Street. Wall Street’s here in New York, I shouldn’t say that here in New York; but that’s really what the credit-rating agencies did, and obfuscated the processes that were going on.
            The effect of fiscal stimulus, government-spending stimulus in most studies helps; but it’s transitory unless you keep doing it, and then you run into a problem of how do you finance the deficits that come with that. Normally it’s with higher taxes, and we may go down that road. I think the jury’s out on that. For the United States at this time, fiscal stimulus is kind of looking like it should be a bigger number all the time. I think I started at $150, went to $200, I may end up at $300 or $350, because $280 is about 2 percent of nominal GDP, and that’s probably a pretty good size; but the composition of it matters. If the problem is the consumer – we want our consumer not to spend as much, borrow as much; but I don’t think we want the consumer to go down 3 percent a quarter and take the whole US and world economy down with it. So I tend to favor and suggest tax cuts, permanent tax cuts, as a part of the stimulus, along with heavy-duty Keynesian government spending stimulus. I apply the law of equal ignorance; I just split it in half. So if I pick a number like $300 or $250, right? Two extremes, divide by two, that’ll work most of the time. You don’t need formulas to do it, and I tend to think more for middle- and lower-income families permanent income tax cuts from the rates we have now. In addition to maintaining them I have argued for financing, if we want to finance it by letting rates go back up to what they were before the Bush administration came in. I may change my mind on that, because maybe I won’t recommend or think about, from a macro stimulus point of view our models won’t say that we ought to do that; but right now that’s where we at because we do want to finance this.
            Of course on the government spending side – you’ll hear this again and again in Washington – this way there’ll be a lot of infrastructure spending, intelligently crafted for the short and long run. The discussion of that has been at a much more intelligent level in terms of how we use that money. We can use it cleverly and carefully. Aid to states and localities, you have to cushion the downturn on what I described to you as going to be awful for Americans with extensive unemployment benefits. They may be helped for health care losses that will occur.
            Part of the stimulus really ought to go to where it would be curative. I said this all started in housing and a bubble bursting in the housing.  I’m going to close here, I won’t take more than 45 more seconds. Nothing we have done so far really gets into stopping housing prices from falling. Those of us who bought too much, borrowed to much, we deserve to lose money. The problem is a big macro thing. Whether it’s the Paulsen plan, the original one, which was going to work to help the balance sheets of banks, didn’t do anything for the demand and supply of housing. Didn’t do anything. Even now the little bit that we’re doing to take down the foreclosures and bankruptcies—that would limit the supply of vacant housing. I don’t think that’s enough. I’m not kidding when I say this: I’m a free-market person and never in ordinary circumstances – sounding a little bit like ex-President Bush here – would recommend something like this; but I’ve suggested such things as a 1930s-like entity, where the government goes into the housing business. Because fundamentally it’s straightforward economically. It’s demand and supply. The supply of all the vacant housing and the inventories of housing have to be squeezed down, and the demand side, which under the scenario I just described of the recession and the state of the consumer will keep going down, the cat will never catch its tail.  Those prices keep going down, and guess what: everything structured in residential real estate keeps going down, the […?] deflation continues. If that deflation continues, stock market continues to do poorly, and we could end up with a severe episode; not the 1930s, but the worst situation that we’ve had since the 1930s. That would be about a 12 percent unemployment rate.

Moderator:
            Theresa Ghilarducci is next. She runs the Schwartz Center for Economic Policy Analysis and is an economics professor here at The New School.

Teresa Gilarducci:
            Thanks. I’ll take twenty seconds to welcome you all here. We’re very grateful to the Economists for Peace and Security that we can co-sponsor this event, and we hope it’s a beginning of many more events.
            If comments can have titles, my title would be, “Three Cheers for Automatic Stabilizers: Where Goes Detroit Goes the Rest of the Nation,” because I’m going to spend the few minutes I have here to actually talk about the big part of the stimulus package that’s being ignored, and give you four recommendations for the stimulus package that thinks beyond tax cuts for the income taxes, and thinks beyond federal spending in terms of roads and bridges and other kinds of infrastructure.
            The financial crisis reveals the importance of income streams that are not related to labor or financial markets to be sure. Not only is it important to get money into pockets of families in recessions that aren’t related to finance markets and labor markets; but it’s also a way to get us out of the recession. We redouble our appreciations for government deficits, and this gives us a chance to rethink those sneaky aspects of our federal architecture, our fiscal policy architecture, that actually deliver stimulus and meet the criteria that we want from all of our fiscal stimulus programs, which are that they’re timely, they’re targeted, and they’re temporary.
            The parts of the fiscal policy architecture I’m talking about are the things we might have learned in our textbooks called automatic stabilizers. These are programs and systems that, as soon as a recession hits, inject money into the economy. The most obvious one comes from the progressive income tax structure. Since in recessions people are losing income, and they fall down the ladder into lower and lower tax breaks, we get an instant tax cut that does not require an act of Congress. Usually we stop there in our thinking, and right now, during this unusual time, we really have to go beyond that usual thinking.
            The other automatic stabilizer that has gotten a lot of attention, but it’s much too limited given this time, is of course unemployment benefits. Unemployment benefits are triggered by a recession; they are paid out the week a claim is made, so it’s timely; if you extend it or increase it becomes targeted to those families that need the money the most; and, from a macroeconomic point of view, it actually is targeted to the areas of the country that need it the most. So they’re nifty.
            But we’re ignoring all sorts of other automatic stabilizers that need help now. The first one is Social Security. Social Security works just like unemployment benefits. Many people retire or accelerate their retirement plans in a recession and collect either disability, even though that’s not the requirements for disability. It’s not an official unemployment insurance system. It works in all OECD countries as a de facto unemployment insurance system, or they collect Social Security early benefits if they can.
            Another important part of our automatic stabilizer infrastructure comes through fiscal policy. It’s indirect, so bear with me. It comes through the collective bargaining agreements or labor agreements, and it comes from the architecture of our employee benefits and rage structure. Here’s the example: defined benefit plans, traditional pension plans work as automatic stabilizers. Because people can retire early from a shrinking employer or shrinking industry, they can often retire much earlier than Social Security retirement age, which only starts at 62. You have autoworkers and steel workers retiring at 55, coal miners. We have a whole history of industrial policy that has been implemented through the defined benefits system. So we have all these communities with these early retirees collecting their traditional benefits, and those benefits are pre-funded, they’re a guaranteed payout; so they’re not related to the ups and downs in the financial market. So we actually have a nation that is in much better shape because we have traditional pensions, and because we have Social Security, early retirement benefits, and because we have disability payments. You didn’t appreciate that, did you? They’re very underappreciated; but they’re very large.
            The other reason why they are to be appreciated is that if you have 30 years of a shift away from these traditional benefits to a defined contribution or 401-K-type world, you no longer take the risk of retirement or layoffs; we’re going to give that on to the worker.  We’ve actually had a 30-year shift in those benefits, thanks to the structure of our federal tax system, which has just given more and more indulgence to the 401-K system, endorsed a policy of saying employers and government.  We had the unintended consequences of actually turning an automatic stabilizer into a destabilizer. We see it in the newspapers right now, where young people are having a hard time getting jobs because the older people are fearful, panicked – I mean fearful doesn’t describe it – panicked about the strength of their own 401-K plans [and] are hanging onto their jobs. So just when you want the elderly to not go back to work from retirement or to withdraw from the labor market, you have them clinging on to the labor market. That’s actually precisely the reverse of the behavior that you want from an automatic stabilizer.
            Over the last 10 recessions we’ve seen – yeah, 10 recessions – we’ve actually seen the elderly withdraw from the labor market, especially men. The women haven’t participated as much. But in this last recession – not this one, but the last one that we measured – we’re actually seeing a big increase in labor force participation of the elderly, and that comes from very much the change in the lack of secure pensions.
            Let me tell you about Detroit. If it weren’t for the automatic stabilizers that we have in Detroit, it would be much worse off. Believe me, Detroit and many other parts of the country are much worse off than any federal statistics, any national statistics that Mr. Sinai and others have invoked. The unemployment rate is at 6.5 here; in many other parts of the country including Detroit, it’s three times that amount. It would be worse if it wasn’t for 1) Social Security. The work force is 2.8 million in the metro area. Seventy thousand former workers are getting Social Security benefits. Twenty-five percent of the work force is actually getting money from former attachment to the labor force—and they got a 5.4 increase in their “wages.” Social Security went up last month 5.4 percent. It went up. Every other source of income went down, so Social Security is a huge injector into that metropolitan region.
            Negotiated pensions, defined benefit pensions are a very important source of income for that region. Thirty percent of the workers twenty years ago in Detroit were in unions. They got defined benefit plans, not 401Ks. Those negotiated benefits are paying their dues now. The incomes in that area are going up.
            Also very important, and this leads to my solutions, is that the health insurance industry in Michigan and all over this country has been built up mainly – and this differs region by region – by the health insurance benefits contracted at work. We have some areas of the country with much richer health insurance plans than others; namely, Detroit. So the place where ex-auto workers and their families are getting jobs, which is the health insurance – and there’s all sorts of programs to turn tool and dye makers into nurses – has grown up because there was an auto industry and rich benefit plans. That contour gives you a flavor for why I’m going to propose what I’m going to propose.
            Instead of just focusing on cutting income tax rates, we should look at the other way that the tax structure actually chooses winners and losers among industries and actually pumps money into the economy; and that’s the hidden aspect of our tax system, the tax expenditure side. Professor Stiglitz alluded to the housing industry being promoted by the tax deduction. He mentioned that the tax deduction might be a very poor way to expand home ownership and to provide subsidies for home ownership in this country, because you’re actually delivering the highest subsidy to the people who need it the least. I have done the same thing for the 401-K industry. It now comes through through a deduction, not a credit. I’m attacked today in The Wall Street Journal op-ed piece, the last couple of weeks by Rush Limbaugh – so if I get on Bill O’Reilley, I’ll win the triple-crown – for precisely that suggestion: that we turn the deduction into a credit. Professor Stiglitz, let this be a warning to you, what might happen to you also.
            I also agree with Professor Galbraith that we should immediately suspend the FICA tax for employers and employees, but with an important proviso.  We don’t suspend it, but we have the government pay it, so that the income is still going into the Social Security system, but we give relief from employers to hire people, and lower the cost of hiring. That’s a jobs program if I ever heard one.  We also increase the net take-home pay of lower-income workers the most – a stimulus program if I ever heard one. So focus away from that income tax and talk about the payroll tax.
            The third proposal I have is to raise Social Security benefits – you could do it through SSI, but a way that you could really help employers hobble through this period of time, and do it in two weeks— and to lower the Medicare age from 65 to 55. You will have all sorts of older people who are clinging onto their jobs be able to retire; you’ve lowered the health insurance costs of many many employers all over the country, especially in the manufacturing regions where they actually pay health insurance, just like that, and you’ve done it through a government program.
            The last proposal I have actually buys my ticket into a conference on peace and security: that we focus on health care as a stimulus package, not just roads and bridges or the green economy; that investing in the health care industry is a place to grow jobs. But we can’t have national health insurance or universal health insurance without dealing with costs. That’s actually clear to anybody who looks at health insurance plans, that we can’t just give health insurance to everybody and watch these costs go up. We have to do something about the infrastructure of health care delivery.
            We’ve already done that with the Veterans Administration. It’s becoming the best delivery system for health care, especially for elderly people, in this country. It has automated its medical records, and it has created a distribution of doctors and nurse practitioners that provides the best health care for the least cost. Most of us in fee-for-service have to go to specialists to get our good advice. The best way to deliver health care is to do it through internists or general family practitioners, and that’s what the Veterans Administration has developed.
            So here’s my proposal: Expand the Veterans Administration with the Iraqi budget, build spanking new wonderful clinics everywhere in this country, and then allow private sector groups to buy into the Veterans Administration. I am a trustee of the largest health care plan on the planet - if it gets implemented. This is the health care plan for retirees and GM, Ford, and Chrysler. Our members have retired mainly in the metro area. We have one of the best, newest Veterans facilities in the country in Detroit. If our [VIVA?], our health care trust, could just buy into the Veterans Administration, the negotiations that are happening now in Washington over the fate of the big Detroit auto firms could actually moved along very substantially; because a big part of the cash flow problems of GM, and Ford, and Chrysler are the obligations to that health care. Let the government help reduce that obligation in a creative way – we could do it in a couple of weeks – and let us buy into that system.
            There, in closing, are my modest proposals. To summarize: one is to rethink the way that we can do fiscal stimulus, and do it through the payroll tax and do it through re-jiggering the tax expenditure, so that they’re much more progressive. That will immediately raise consumer demand. My second message is to rethink what infrastructure spending is and rethink national health insurance as an infrastructure and jobs creating program. Thank you.

Moderator:
            Pretty provocative. Next on our list: Perry Mehrling, a professor of economics at Barnard, who specializes in monetary and financial issues, and wrote that book about Fischer Black.

Perry Mehrling:
            Thank you. I’m very pleased to be here. Thanks for inviting me. I’ve never been to this group at all. I’ve been pushing a certain proposal that you’re going to hear about, for financial reform more or less by myself, and I’ve been gathering allies for the last six weeks, and putting together some more here.  We’ll see at any rate – or find out what’s wrong with it, one or the other.
            Here’s where I start: It’s quite true what Jeff says, that I wrote this book, this biography of Fischer Black. This was my way, as a monetary economist, of coming to terms with the modern world and understanding that we are living in this financialized economy, and that I needed to get a PhD in finance. But I already had a PhD, so I wrote a book on Fischer Black.
            This is Fischer Black in 1970 [referring to slide]. What does he say here? He’s imagining a world that can be. He says, “Thus a long-term corporate bond could actually be sold to three separate persons. One would supply the money for the bond; one would bear the interest rate risk; one would bear the risk of default. The last two would not have to put any capital for the bonds, although they might have to post some sort of collateral.”
            What are these things that he’s talking about? The second person, this interest rate risk person, that’s an interest rate swap, okay? The third thing: That’s a credit default swap. He’s imagining this world that has been constructed since 1970. This is a brave new world, in fact the world we live in.  I understand the crisis that we are experiencing right now as the first actual test of that world. This is the first time we’re going through a serious downturn in this kind of financial system, and we’re finding out where its weak spots are, where it breaks. The temptation is to look at those breaks and to say, “Throw the thing out!”  Then we redo 40 years, and that’s a recipe for a very long recession. The other way is to say, “Where exactly did it break, and is that something that we can fix?” This is a story about free markets and the free market failures. Where are the externalities? Where is the role for government? Where is the role for regulation in adding to this brave new world that we have and controlling this?
            I’ll tell you a little story about how I came to this proposal: Back in April of this year, I forget exactly what prompted me, but I wrote my first letter to the FT, about credit default swaps. I was saying, it seems to me that the problem here is that credit default swaps are old actually in history. The bankers’ acceptance is basically a kind of credit default swap; it’s a kind of insurance where a banks says, if this person doesn’t pay, I’ll pay. It’s that kind of instrument. It was key to the organization of the British banking system in the nineteenth century. The entire banking system was built on bankers’ acceptances, what we call commercial paper today.  I happen to know about that because I know about monetary history. What’s different about the modern system is that this credit default swap – first of all, it floats freely. It’s not attached to a particular instrument. And second, there’s no lender of last resort for it. There’s no support for it. What’s happening in the world right now is that these things are getting very dislocated from the actual underlying credit risks; and what’s even worse, those prices are the prices that we’re using to mark to market on actual balance sheets. This sort of free-floating instrument is driving down valuations away from their fundamentals.
            That was a little letter, and based on that letter I was invited to a meeting that Joe Stiglitz held in Manchester in June, and I turned it into a little paper. They liked the paper enough that they said, “Why don’t you turn it into a chapter for the book?”  I spent about a month in the summer, August, revising it for the book. When this thing started to happen in mid-September – and in fact it was exactly when AIG went down – the penny dropped for me.  I said, okay, I get it, I see what’s happening, and I now think I know what we can do to fix it.  I wrote another letter to the FT, which they published September 19. I immediately started working on expanding that into a proposal, which I published in the Economists’ Forum in the FT a couple of days later called “Badgett Plus RFC (Reconstruction Finance Corporation) Equals the Right Financial Fix.” So it was a combination of this 19th-century British idea applied to modern finance and the Depression-era RFC. I wanted the government to go into the business of writing credit insurance, and the premiums you would accept payments with preferred stock. That was the combination that I was proposing.
            I proposed that while TARP was happening and got involved in the legislation. In fact, a Section 102 allows TARP to write credit insurance. Nobody even knows that. No press has actually remarked on that; but it’s there. I don’t know whether it’s because of me, but there are a lot of memos that I sent, emails, and I’m going to show you one or two of them.
            The idea is that the government should be serving as credit insurer of last resort, the main idea being that AIG was serving this function, that the [monolines?] were serving this function, and they’re not anymore. They’re certainly not writing any new policies. The old policies that they owned, the government is on the hook for. But nobody’s writing new policies, and as a consequence, the securitized credit markets are just completely frozen. That’s now an argument. The reason the securitization credit markets are frozen is because there’s no insurance backstop.  I’m proposing that we create one, that the government should be in this business. The first idea was that it could use existing credit default swap markets; it could be selling credit default swaps and creating - and this goes back to the idea I had about the 19th century, that we need a lender of last resort to backstop this thing - and that’s one idea in that CDS market.
            More generally, the government should be in the business of selling insurance against disaster risks, against other risks. It’s mostly doing exactly the opposite; it’s feeding in sort of the next 10 percent of losses we’ll help you with. I’m saying, don’t pay for the next 10 percent; pay for the bottom 90, or the bottom 50, or something like that; so that you create a floor on this thing. This price rate insurance would then be a new policy instrument. Just as bank rate was a new policy instrument invented by the Bank of England in the 19th century, here’s a second dimension to policy, that you can move separately from the discount rate. This price of insurance would be the price of systemic risk, because you’re insuring the triple-A securitized credits, the very very best ones. Those are the ones that go down only when the system is in systemic crisis, which it is now. No private insurer can actually fulfill an insurance contract like that, as we have seen, but the government can and the government is fulfilling that function. It just didn’t get any premiums for it beforehand.
            The idea of pricing that systemic risk is to change the behavior of people in this market.  If you had priced the systemic risk right, if the AIG was charging 15 basis points to insure the triple-A super-senior CDO tranches held by UBS – it’s in their report, they were charging 15 basis points – UBS was doing an arbitrage on this that they were earning about 15 basis points on. They leveraged this to the hilt because they were allowed to treat this as tier one capital under Basel II. If you charged 30 basis points for that insurance, that arbitrage would go away. They would not have been doing that at all. It would not have been profitable. We know socially it wasn’t profitable, after the fact. I say make it unprofitable before the fact.
            You could use this counter-cyclically, by the way, too. You could change the price of insurance cyclically, independently of the discount rate. Other benefits: You could use it to penalize complexity and reward simplicity, because you can choose what instruments you’re going to write protection against and which ones you’re not. The ones you write protection against, you can choose simple ones. You can use it as an oversight of the ratings agency; because what counts is a triple-A securitized credit. It could be up to the government, not just up to the ratings agency.
            I’ve only got five minutes left. I want to make sure that I got that proposal out. This is just to fill in what the government’s been doing instead of this. What it’s been doing is the Central Bank balance sheet – I’m just going to talk; I’m not going to point to numbers there – but everything that’s happened in the world in the last six weeks or even year has happened on the balance sheet of the Fed. The TARP is in fact a sort of side issue. They spent hardly any money, and the big numbers have been on the balance sheet of the Fed. A year ago, the balance sheet of the Fed looked like this: $900 billion-worth of Treasury bills on one side; $900 billion-worth of currency on the other side, a few small items – bank reserves, things like that, a couple of billion dollars here or there. The big numbers were Treasury bills and currency. The currency is still there; the Treasury bills are gone. The Treasury bills have all been sold, and the proceeds have been lent out to banks. The first trillion dollars of support for this system came from stripping the Central Bank of all of its Treasury bills. The second trillion, which you’ll see on the last slide I’ll show you, which is yesterday’s numbers.
            You notice that? You see that change from just a week before, $250 billion? This is October 1. This is right as they voted down the first TARP. So it’s $1.38 trillion. It’s already, you can see, $527 billion more than it had been a year before. So the Central Bank balance had already expanded. It’s now $2.3 trillion, as a matter of fact, right now. And so that’s another $trillion worth of lending on the asset side to private banks against dodgy mortgage-backed security collateral. Credit risk is on the balance sheet of the Fed big-time; we’re just not pricing it. I don’t know what haircuts they’re using for this. I’m suggesting pricing it; that’s what I’m suggesting doing. It’s there. The Central Bank is taking credit risk; they’re just not getting paid for it. And the consequence is—well, you’ll see here—reserve balances with Federal Reserve banks: it was up to $166 billion as of October 1. This is the bottom line here. Normally that number is about $10 billion. Required reserves in our system is $50 billion. Today it’s $550 billion. Excess reserves of $550 billion in the economy right now. It’s all been happening on the balance sheet of the Fed because the Fed has the freedom to maneuver.
            If I had time I’d show you AIG is on here, you can see Bear Stearns on here, you can see this $600 billion swap line with European central banks to keep them from dumping our mortgage-backed securities and supporting the dollar. It’s all on this balance sheet.
            This is just a primer about CDOs. The main point I wanted to explain about CDOs with this one is that most of it was triple-A.  When you hear about toxic assets, you imagine that somehow it’s all garbage. In fact, most of the CDO tranches out there have not defaulted and will not default; but they are trading at 60 cents on the dollar, and they’re being marked on the books of the banks at 60 cents on the dollar.
            This is the memo I sent to the Democrats, actually, September 26, before the vote, to explain to them why this wasn’t in fact some terrible Wall Street scheme, that you could add it to Paulsen. Now, the Paulsen plan of course is not going to happen, the first line [on the slide]. So only pay attention to the second half.
            The Republicans liked my plan because it would involve selling credit insurance instead of borrowing with more Treasury bills. The Democrats liked it because you could pay for this credit insurance with preferred stock. So it got into the bill, but they never used it, and I don’t know that Paulsen ever understood it, I’m not sure the Democrats ever understood it, because it was sort of last-minute. But it’s in there, Section 102.
            Since then what’s happened? Basically this is the collapse of asset-backed commercial paper. You can see that red line. That’s the collapse of financial commercial paper; and that little up-tick there, that’s the opening of the commercial paper funding facility, which is the latest thing the Fed has done, put about $300 billion-worth of commercial paper on the balance sheet just in the last week. So there’s been a collapse of the wholesale money market. We’re moving the entire wholesale money market onto the balance sheet of the Fed, little by little, but eventually those “littles” add up, and you get trillions and trillions.
            Here’s a [flight to quality?], collapse of M3. It’s all moving into M1. This diagram is supposed to show you the incredible increase in the money base from what? From $841 billion, mostly currency, just a couple of months ago, to $1.235—in just a few months. That’s this business about these excess banks, which are mostly increasing. This is where all the action is, and there’s going to be more of it. These are these new facilities that they’re talking about: The Money Market Investment Funding Facility hasn’t even opened for business yet, and they’ve allocated $540 billion. The Commercial Paper funding Facility now has $300 billion, as I say. These were the rates yesterday that they were charging.
            Our policymakers have been leaning on two things. They’re saying, Let’s make it possible for them to hold these mortgage-backed securities. So we’re going to help them with their unsecured funding. We’re going to take credit risks, and our credit risk is going to be to the banks themselves. We’re going to give them unsecured funding, non-recourse loans, all this stuff. And we’re going to give them capital here.
            I’m suggesting doing it the other way around: Support the value of [MBS and AAA CDO tranche], even at a very low level, and then they can get their own funding. Then you can use secured funding, use those things for collateral, instead of using them at the discount window of the Fed.
            Here’s just what the balance sheet looks like. These numbers came out at 4:30 yesterday. So yes, it’s $2.2 trillion in Federal Reserve Bank credit. This number here – I want particularly to note here other Federal Reserve assets, because the international dimension of this meeting - $615 billion. This is the swap line with foreign central banks. This is how we’re making it possible for foreign bankers that are holding dollar-denominated mortgage-backed securities that they didn’t ever intend to hold – they were in SIVS somewhere, and the SIV collapsed, and then their assets had to go back on their balance sheet. They have to finance it in the wholesale money markets, wholesale money markets are frozen up. This is how they’re financing it. We’re lending them money to the ECB, the ECB is lending it on to their banks, and to Switzerland, and so forth.
            These are big numbers, and here is just the liability side of the Central Bank, and that’s the last slide, just to show you reserve balances with federal reserve banks--$592 billion as of 4:30 yesterday. And $550 billion of that is excess reserves. The other big number is here: $558 billion US Treasury supplemental financing account.
            I started by saying it used to be that the Central Bank issued currency at 0 rate of interest in order to hold the Treasury bills. The US Fed used to be about financing the government. The government is about financing the Fed, that the Fed is issuing liabilities to the Treasury and using those proceeds to lend to private banking. Thank you.

Moderator:
            Gary Dimsky. Gary started the University of California Center, an economist, has a diverse background in public policy issues. Thanks, Gary.

Gary Dimsky:
            Thanks for having me here. It’s a pleasure at this gathering. I’ve been a long-time member of Economists for Peace and Security, and I’m very very proud that these conversations started. It’s great to be at The New School, always.
            I wrote a paper that Jamie liked well enough to copy. It’s about why this crisis is different from the other Minsky-type crises that we’ve had. I’m not going to do that paper here, but just to say that it shows why some of the things that have happened that have pulled us toward this sub-prime mess were really not in full sway when Hy was thinking about and developing the mature version of his theory. He wasn’t thinking yet about some of the phenomena such as banks’ strategic changes, which beget this shift from financial exclusion to financial exploitation, which beget the mechanisms in secondary markets that led us to our current impasse.
            Instead, I’m going to follow actually Jamie’s advice. I think my instructions were, what do we do and how do we do it? In that spirit, I’ve got four points. There are many things to say, but four main themes.
            First, our banking and financial markets are broken and need fixing. Banking firms must perform their appropriate roles in our economy. Very simply, as was mentioned by others, credit creation, liquidity provision. If the banks and financial system function well, then the use they serve will be sustainable and have expanded wealth positions. If not, then it’s the financial system, not those units, that’s failed. That means, as Jamie put it in his book, that we’ve let the predators take prey, rather than have a system that is functional. Something that we’re going to see from Wall Street in coming months of debate is something that we really must be careful with; that is, we cannot afford to think of our financial sector as a source of national competitive advantage. We’ve been doing that, and that’s just the wrong way about.
            Secondly, the character of the borrower-lender relationship at the core of banking has been compromised and must be restored. There’s a mismatch between the units engaged in risk-taking and those engaged in risk-bearing.  Perry’s offered one kind of solution to that, which is to try to find an anchor for the risk-bearing side of it. I would say that I think we need to have a debate about that. The zone of businesses and households that have been encompassed by normal bank lending has shrunk as banks have moved towards standardized metrics that have sometimes been used for good, but often been used to fine-tune either financial exclusion or, more lately, financial exploitation. This has to stop. Banks must lend to borrowers and bear the risks of their lending, in my view. They must make loans they do not expect to fail. We can’t insure against that.
            We’re having a conversation like this about wildfires in California right now. Some of my policy friends, geologists and others, want to insure against wildfire risk with bearer bonds, and so on. But my point would be, if houses burn, you must put out the fire. That’s happening now in Santa Barbara. We have something like that going on right now in this sector. Banks, in my view, must be clearly distinguished from financial firms who are involved in risk exchange and in zero-sum speculative bets. There should be a firewall between these markets, the markets that trade risk in real time, in time, and markets that originate credit and capital and nurture it through time.
            At the hub of this is this question of what’s a bank holding company.  I want to go back to this very simple and serviceable definition: A bank holding company is an entity whose principal purpose for being is commercial banking. It may engage in activities closely related to banking, as was said in the 1956 Bank Holding Company Act, but not much more than that. You should not be able to become the bank holding company because it serves your convenience, and you must not be able to maintain your same strategies, as Morgan Stanley promised the other day, while maintaining that cover of privilege. It’s just wrong. It’s predatory, in Jamie’s words.
            The scope and purpose of government guarantees of banking must be reconsidered. The expansion of implicit government underwriting has to be reconsidered as well. I think 100-percent guarantees must be carefully nurtured.
            This brings us to the problem of regulation. The control of abuse of market relations by banks and the players in financial markets is of fundamental importance. There are two areas for control: One is the control of speculation. I think we have to be very careful about allowing our megabanks directly or indirectly to position themselves to make money from either side or both sides of zero-sum tradeoffs for borrowers. We have to make sure that our regulatory authorities have adequate scope of coverage, so that any intermediary that offloads risks must do so in such a way that those risks can be monitored transparently and in a timely manner. AIG is an example. We must insure that there’s principle agent responsibility in funds and sub-funds.  I think the idea of passive financial intermediaries so celebrated with SIVs has to be retired.
            The second dimension of regulation is to control the financial exploitation and exclusion. There must be meaningful regulatory inspections and expanded public reporting on the volumes and prices in all lines of financial business. This would include both formal and informal sectors. This regulatory power must include penalties for the denial of credit to areas, individuals, and businesses on the basis of race and gender, as well as penalties for selling overly risky credit contracts to them. That’s basically the Community Reinvestment Act. That’s a key part, and one must keep in mind that the African-American community was one of the key components in bringing Barack Obama to power, and it was the very first victim of the sub-prime crisis. The growth of sub-prime loans in the inner cities of our country was 900 percent between 1993 and 1999; while forms of regular mortages went down. That is a political fact that has to be kept in mind.
            Large banks, if they are too big to fail, must meet a higher community reinvestment standard, and we must, I think, remove the Federal Reserve from the business of bank regulatory oversight. It interprets safety and soundness at the least cost to taxpayers far too narrowly.
            Let me move on to housing and mortgages. I have a short paper here that calls for the creation of development banks along the lines of the NDS in Brazil. I think maybe it’s a good idea whose time may have come. With housing and mortgages, I think in the short term we’ve got to keep people in their houses. We have to recognize that the powerful finance system that we now have for mortgages is designed to flush foreclosures through. Allowing people to sell their homes for non-viable mortgages stabilizes nothing right now. We have to obviously balance a mix; there’s a mix of fairness and incentive incompatibility that has to be worked.  I think we have to start by taking an inventory of houses that are delinquent, divide them into owner-occupied and otherwise, and I think it’s not the right time to try to find the market value in markets like California or Detroit for that matter. Let’s find out the basics: What are they paying? Can they make it?  Then gear this calculation to some income level and offer relief on a sliding scale. Up to that point, the government can take an interest in your home with you and keep it until you sell it, at which point it cashes in, as you do. That’s something like the Homeowner’s Loan Corporation that Paul has suggested reviving. Beyond this point, I think if it’s completely non-viable, we need to take a look at Dean Baker’s rental proposal.
            Let us move on my other couple of points. In the medium term we could use some incentives for housing construction. In California, we’ve got about 500,000 people a year moving in, and we’re building about 225,000 units of housing every year. So we’re housing less than half of our increment. That’s a big source of the housing bubble. So in consulting with my colleagues in state government, they’ve indicated that restoring the federal rental housing credit would be very useful. The ’86 reforms really took the teeth out of it and resulted in a downward bump, especially in multi-family housing, which is where we really need some help right now.
            In the longer term, I have some ideas about land-use taxes that would perhaps remove or take funds from areas where there has been an inadequate attention to the need to create lower-income housing or mixed-use housing, and to use proceeds from such peoples’ homes to build affordable housing somewhere.
            My third big point is a stimulus to state and local governments. I had a change to reread Cary Brown’s wonderful analysis, 1957, about the Great Depression and fiscal policy. The point that he makes is that it didn’t really kick in for a long time, and the reason was that basically there was tax increases, especially at the state and local level, that almost offset the impact of the federal stimulus. That is going to happen right now in California and other states. We have about a $20 billion deficit. If you take into account – this is estimates that, again, colleagues have done for me – state, county, cities, and municipalities, some part of it’s self-inflicted, but not all of it; and we’re now being forced by the Republican Caucus in our state, which is fierce, pointing out that raising taxes is the wrong thing to do in a recession. Of course they’re right; and the advocates on the other side, like my friends at the California Budget Project who talk about things like maintaining unemployment insurance, and stabilizing Medical, and so on, as we call our Medicaid, they talk about the fact that this is no time to cut poor people’s expenditures either. They’re both exactly right, and that’s why we basically need some form of revenue sharing. Jamie’s been calling for it for a long time, and we have to hope that it happens.
            I would just close by mentioning that aggregate demand stimulus for a more inclusive and greener US has clearly got to be part of the program. What Marcellus Andrews called “the underlying inequalities” have got be recognized and dealt with.
            And just three quick ideas that others haven’t said: [End Tape II, Side A] –that would also increase jobs and basically facilitate many good things in terms of productivity and health and wealth. Secondly, let’s take on libraries and the digital divide. The library system has been reinventing itself for the 21st century. Let’s make that part of the national infrastructure fund. And finally, high-speed rail, the next US infrastructure. We’ve been studying our transportation infrastructure in California very closely. We are under extremely heavy loads. This would be a good time to build a railroad and to do it the right way for the next century.
            That’s all. Thank you very much. And let’s talk.

Jeff Madrick:
            I shouldn’t have wondered at all whether we’d have a provocative panel. I want to leave all this time for questions, because a lot of ideas have been thrown out.
            I do want to make three quick comments: We focused a lot on financial issues. I think if and when we do get past this crisis, we’ve got to turn to what I think is the more fundamental crisis, and some people have addressed it. We’ve had a wage crisis in America for 30 or 35 years, and we don’t necessarily need a lot of federal spending to deal with it. We need enforcement of labor laws, we need enforcement of union organizing laws. The list goes on and on. I won’t list everything we can think of. Some of it has to do with the dollar policy; some of it has to do with some adjustment to fed policy. And I think some of it has to do with the attitude of the president, who should not be afraid to tell it like it is when CEOs make unconscionable amounts of money, and their workers make less money. Business is afraid to be singled out and scolded by presidents, and we haven’t done that for many many years. Peter Temin has been writing about that, the economic historian and economist from MIT. We should think about it.
            Number two: Ideology. Ideology is often a cover for self-interest, but ideology has carried us where we are, a free-market ideology that’s almost [?] in its extremism and widely adopted not only by a conservative group of economists and policy makers, but I think infected the media as well and become the center of the nation. There is push-back on it. Fannie Mae did this to us. We were talking about how Roosevelt really caused the Great Depression. There are serious papers about that these days. Watch out for push-back, because there is going to be push-back. And though Rahm Emmanuel said, “A good crisis should never be wasted,” and I think those words will live on, much like, “There’s nothing to fear but fear itself,” they are an echo of Milton Friedman’s, who said something similar in 1982, after the fact, and attributed his own success to the crisis of the 1970s.
            Finally, one word—Marcellus brought this up—one quick word about the nature of the corporation. We’re talking about financial firms allocating risk. There is a serious agency problem, as economists call it, in these financial firms. The people making the decisions weren’t taking risks. There was a joke always on Wall Street about IBGYBG—I’ll be gone, you’ll be gone. Let’s just do it. Stan O’Neill, after putting Merrill Lynch under, took away $190 million. Raines at Fannie Mae almost took away $90 million. It didn’t seem to me they were taking on much risk. They put their institutions and the nation at risk and made a heck of a lot of money themselves. So who were the smart guys? Maybe in the end they were. I think the nation has to address the issue of the corporation and the agency problem.
            I’m not going to take anymore time because I think there are probably a lot of questions out there. So let’s get underway. Sir.

Barclay Rosser:
            I’m Barclay Rosser from James Madison University. I’ll be on the first panel this afternoon. This is a financial question. It may be that Perry is the best to answer it, but if somebody else can answer it, that would be fine.
            There’s been a paper floating around. It’s been argued about in the blogosphere and a lot of other places coming out of the Minneapolis Fed by Chari, Kehoe, and Christiano. They’re sort of saying, this is all just hysteria.  If you actually look at interbank lending, and they’ve produced several series, you barely see it moving. We hear that interbank lending was frozen up, there are constantly stories; but if you actually look at the numbers, nothing happened. Our commercial paper has gone down; but all these other things we hear that are supposedly frozen—nothing happened. So it’s all just this hysteria. We have Paulsen and Bernanke, they’re scaring everybody, and they’re doing these things. Obviously, we have a recession going on, but it’s a recession caused by fear. We knew you’re only supposed to fear fear itself, and now were afraid. We’ve been pushed into this hysteria, and all sorts of people are getting bailed out who shouldn’t be bailed out. Does anybody up there have an answer? What is going on with these numbers? Was interbank lending frozen, or not? Why didn’t we see these data series that look like it’s barely doing anything?

Allen Sinai:
            They wouldn’t see it in the data. I think they are perhaps bound by the data. I don’t want to speak for them because they’re not here. But in the world of anecdotal evidence, which I think we have to pay more attention to as economists, though they’re not random samples, and in the observations around Bear Stearns and Lehman Brothers, certainly they weren’t lent to by the counter-parties; otherwise their capital would not have gone in the case of Bear Stearns from $24 down to $2 billion, and Lehman, $40 billion to $3 billion within the space of a week. So the facts of the world simply aren’t reflected in the data that those two individuals are looking at.
            Their comment, though, about fear and hysteria is, I think, right on. Every cycle, every crisis, every financial event of the kind that we have seen in history going back to the beginning of time has this kind of stuff part of it, and part of the overshoot, and part of the dynamics of the system. Again, we economists, finance people, and the models of Fisher [Klein…?] don’t really take that into account. And I would submit that we should take that into account, because it’s part of reality, and it’s part of the mystification of when you observe these cataclysmic things that go on, the puzzlement of why they go on. It’s not a puzzle to me. They’re part of the psychology, the fear, the greed, that is integrated into the actions that are taken. Our models are very sterile. They just don’t have those in them, except for some of those people who are plumbing those fringes in the profession ranging all the way to scanning the brain in terms of thinking about utility measures for consumers. These are actually fruitful areas to look at and will help us in the future understanding. I think they’re right on on that, but I think they just aren’t aware of the stuff that really went on.

Moderator:
            Did you want to respond?

Perry Mehrling:
            I just want to say two quick points: One is that you definitely do see it in LIBOR spreads, big-time, and those spreads are still at historically unprecedented levels, even after this kind of liquidity infusion that I’m talking about here.
            The second point is that inter-bank lending is often misunderstood in the way journalists write about it. This was a very important way in which money market mutual funds were lenders in this market to the wholesale money market, by buying commercial paper from bank holding companies, by buying CDs, things like that, which they were then turning into institutional money market mutual funds. That M3 number I showed you that is collapsing, that the government no longer collects—that’s the shadow [in] government statistics—that’s the collapse of the institutional money market mutual funds right there. Every corporate treasurer is saying, “Forget this, I’m getting out of here and into something that’s insured by the FDIC and moving into M1” – you see that – or moving into T-bills.
            This hollowing out of the balance sheet of the Fed that I talk about, the opposite side of that is that’s generated another couple of trillion dollars worth of Treasury bills that people can hold. This is what we’re talking about. The liquidity trap is this demand for Treasury bills which are trading at, what, four basis points, or something like that. Yes, it’s all over the data, as a matter of fact. I don’t know what data they’re looking at, but I’ll have a look and I’ll get back to you.

[?]:
            My name is [?]. I’m a graduate student of Perry’s at Columbia, and want to ask him a question that I’ve asked him in private correspondence, but somewhat more pointedly, and it’s counter-factual. Yes, these three risks can trade separately, but they’re highly correlated, and if our problem was that the price of risk, and the price of liquidity and therefore the price of risk was kept too cheap for too long, when Greenspan finally got around to trying to raise this in ’04, he was faced with an inverted yield curve. He couldn’t transmit out his lack of appetite for risk out to the longer spreads because there was another source of liquidity out there: the rest of the world. China is buying—So that given that disconnect, if your facility was in place, had been in place, and we had had this tool at our disposal, would it have worked countercyclically, given that disconnect?

Perry Mehrling:
            That is counter-factual. You’re asking me if a facility that we’ve never seen before in the world had been in effect.  If we had been able to make UBS pay a reasonable premium for the systemic risk it was imposing on the rest of us, I think we would not have seen… A lot of liquidity that you’re seeing in these markets is because people are just harvesting these arbitrage profits that they never should have been able to make if they had priced the risk properly in the first place, I would suggest.

Gary Dimsky:
            If I could jump in for a moment, too. Just to say I want to share a Brookings moment. We were together at Brookings writing our dissertations during the savings and loan crisis. There we worked with Bob Leighton, and we were all very aware of something called recourse risk. That concept was very forgotten. The problem that will exist with a lot of efforts to fine-tune markets to insure that there’s insurance that’s adequate, and that we always know where the floor is, which is kind of the essence of Perry’s idea, will be insuring that the full scope of risks are understood at the beginning. And in some sense where Perry and I will have to sit down together, and others far more into the lending process than we, will be to understand whether or not we have created a system in which the short-term returns from selling off non-viable paper, even with recourse, make those loans viable within the frame of the financial industry as it exists right now. If that is true, then that frame has to be changed.

[?]:
            Sorry, if I could just follow very quickly—

Moderator:
            Allow us to go on, because I think we want to cover a little more territory. Thank you though.

Paul Davidson:
            Taxonomy is important if you’re going to make policy. As a former actuary for the United States Life Insurance Company, I used to have to set risk premiums at one point in time in my life, Perry. The problem is, what you’re talking about, and what everybody talks about when they say insurance, that’s not what you’re talking about. If you want to insure against a future outcome, you have to take a sample from the future, and then calculate your probabilities. Obviously, that’s impossible, so you take a sample from the past and assume that that’s the same as the future.
            Take unemployment insurance. Do you really believe that there’s some premium that you can set that the firm will never go broke? It’s unemployment guarantees that you want. Take FDIC. FDIC is very likely to go broke in the next six months or eight months, unless something happens. It’s federal deposit guarantees that you’re having, and that’s of course why we want, as Jamie and some others suggested, let’s guarantee unlimited deposits insurance, because you just don’t want it to occur. When you’re saying you want to set a risk premium for CDOs, that’s impossible. Fischer Black might have thought that was, but that’s part of an assumption that you can’t make.
            So what you need is government institutions that guarantee certain things which prevent the economy from collapsing. The Federal Reserve has finally learned that its function is to make sure there’s liquidity in the system and to prevent markets from collapsing. That, it seems to me, is the essence of the system. What we want to do is CDOs and all that other garbage that were created because they were illiquid loans that, by securitization, were made liquid; and you can’t do that unless you have a market maker in those things. We’re going to see, for example, auction rate securities are going to start collapsing. They’re now frozen, but a lot of them are municipal bonds. As Jamie’s pointed out, there’s a revenue problem now with these municipal and government bonds, and they’re the next ones to go. You’re going to insure against that, or are you going to guarantee that they don’t go? So I think that’s the policy question: guarantees versus insurance.  Or the prevention of something.

Moderator:
            Let’s have Perry respond.
Perry Mehrling:
            I’m quite happy to call it a guarantee and to charge for it.

Paul Davidson:
            What are you going to charge?

Perry Mehrling:
            Your question is not really about semantics, about what you call it, but in fact how you’re going to price it, and that’s fine. We should have that discussion.  I’ve thought about that. AIG was charging 15 basis points for this, and so in the first version of this proposal I said, well, why don’t we just charge 40? Because I had in mind the UBS arbitrage, and saying clearly that was a social cost; let’s eliminate that arbitrage. That’s a little data point right there that suggests the mis-pricing that was going on.
            As I’ve thought about it more, I’ve thought it might actually be better to treat it less like a CDS and more like an insurance policy in the sense that what you’re insuring is not last dollar; not 100 cents on the dollar, but say 80 cents on the dollar or 85 cents on the dollar. You know, you really are just insuring tail risk. In that case the premium can be lower.
            My basic point is just that the government is insuring this anyway in the sense—as we see now. When there’s systemic risk, the government steps in. It’s just not collecting any premiums beforehand.

[...Many talking at once…]

Moderator:
            Let me open this up to one other question, and then we’ll get to you. Allen, why are you so timid about your stimulus plan when Goldman Sachs is calling for $500 billion in stimulus, and [Sherril?] tells me [Kenco?] is calling for $750 billion? And Teresa, how are you going to pay for all those proposals that are pretty interesting, but where’s the money coming from?

Allen Sinai:
            You start slowly. A lot of stuff is going on. There’s a lot of liquidity being pumped in at very low interest rates, the world is joining the parade. We’re going to get global fiscal stimulus of size – economies are interrelated - and we do have big deficits coming that are unimaginable in terms of the numbers, plus we will have a sharply rising debt-to-GDP ratio. So I kind of want to start on the lower side, because I don’t want to see those debt-to-GDP ratios skyrocket, and then short-sellers and the global financial people attack the US government by selling the dollar; because that is ultimately what stops our ability to finance our own problems, is what could happen to the dollar.
            I’m prepared to go higher, depending how deep the downturn goes. Also there’s a difference as to how you do it. If you do it with government spending, I don’t find that you get, other than certain kinds of infrastructure, as long-lasting effects on the economy, but you do have higher deficits and higher debt.

Teresa Ghilarducci:
            Economic growth and the peace dividend.

Moderator:
            The post-World War II solution.

Jack Blum:
            My name’s Jack Blum. I’m a panelist this afternoon. I’m very curious why I haven’t heard education mentioned as one of the areas of stimulus. Twice in American history the land grant colleges and then again National Defense Education Act produced some of the greatest periods of productivity and investment in human capital. Right now we have a situation where college endowments have been bombed because their managers have been gambling, and a situation where students have no recourse and no access to loans. So shouldn’t this be way ahead of some of the other things we’re talking about? I’d much rather see the money go to that than to rescuing AIG or Goldman.

Allen Sinai:
            It’s in my little paper here. It says “Infrastructure Including Education,” so you didn’t read the second-to-the-last line on page 8 of that little paper. So I’m with you. I didn’t spell out how it would happen, but you can do that.

Perry Mehrling:
            Let’s just understand that the reason there’s no money for student loans is the freeze-up of the securitization operation.

Gary Dimsky:
            The other thing that should be said about education: when I turned in that second part about the fiscal situation in California, you should understand that the University of California has taken a 10 percent cut and is likely to have a deeper cut in terms of its state funding. K-12 education is already under-funded in California; it’s likely to take another hit. We’ve had sustained downturn in real education funding from the federal government even with all the other issues involved and no child left behind. So I think that’s got to be at the center, although I’m with Jamie in his book, The Creditor State, and in many of the discussions that he’s had before, and EPI, and so on; that is, that we have to be careful about how we talk about that. Human capacity is something that we should celebrate and fund, and give people more freedom to find their potential as human beings without being so fixed on whether we’re talking about work-force skills. The childcare idea, of course, also goes to the idea of freeing people for education.

Moderator:
            We’ll take 20-second questions, all three at one time, and we’ll answer them, because we’re basically out of time.

[?]:
            I wanted to thank you for bringing up the issue of ideology and also the issue of unintentional consequences, and also economics and peace and security; but the conservatives didn’t want to destroy the country by their ideology, so we certainly have unintentional consequences; but the need for multilateral cooperation in the UN and the high-level task force Mr. Stiglitz is working with, don’t we need greater innovation for these things, and a new Bretton Woods, and trust-building education I think was brought up? But if we’re biased against those things and make it feel that it’s un-American, aren’t we closing ourselves off to many of the possible solutions in a global reality? Don’t we need to deal with these things much more constructively?

Moderator:
            Some of that will be addressed in the afternoon, Bretton Woods and other things. But let’s take your question and Lucy’s question quickly.

Lucy Webster:
            It’s a good idea to go back and forth. I just want to ask Teresa if there’s been any progress in getting your ideas to the Obama transition team, and what is the status, and what are the prospects? Thank you.

Luiz Carlos Bresser-Pereira:
            Bresser-Pereira from Brazil. Two short questions: First, in relation Theresa and the idea of building a social state here, James also in his presentation spoke very carefully about the need of revamping the Social Security system in the United States. My impression about liberal Americans is that you are very modest in your objectives. You should look to what happens in Europe and not discuss fiscal deficits, but what’s the tax burden in Europe? That’s the question. How do you finance […?]? You have to finance this not with cut cuts, but through tax increases. There’s no other way. This is a [?] problem.
            Second, Mr. Madrick made a comment about the need to rethink the American corporation, to rethink the agency problem, because the people that cause all these problems were not risking their money. That’s true, and I think we should discuss the difference between this group of people, they are golden technocrats. They are not classical capitalists at all. The difference between—That’s why the problem of creating strong controls on their pay, on their bonus and things like that, is extremely important and has nothing to do with—

Moderator:
            Interesting points. Let me just take one last question, and we’re ask out panel for—

[?]:
            Technical question: I’m Mac Roberts from Morgan Stanley. I think the financial stability was a terrific first idea, by the way, first-hand, for obvious reasons. Just a technical question for Professor Mehrling: If the pricing of the CDO securities is perhaps more efficient than one might think—55, 60 is actually an efficient market pricing—does that change your ideas about the guarantee?
            The second thing is that I sort of got my Lombard Street out over the summer and read it. Are we at any point here where our seignorage as a central bank is at risk? Two trillion, three trillion, four trillion? Where does the seignorage capability of the Fed leave?
            The last question is, from a [Clucky?]-Levy formula, does that give us any insight into how much fiscal stimulus is actually required?

Moderator:
            Let’s go quickly. Jamie wants to make some comments right after.

Teresa Ghilarduicci:
            I’ll just do mine real quick. I actually do believe that payroll taxes can be too high because there’s actually a risk of more economic activity shifting to the informal sector. One of the things that we can be very proud of in the United States is that there’s almost universal participation in the Social Security system, and it’s a very trusted government program. We actually want to really preserve employers to participate in the Social Security system and not loading on a lot of incentives to work off the books.
            I’m so glad I’ve been called modest. It’s the first time it’s happened in a long time. But I think Jamie and I were very careful to propose ways to finance the social welfare state through general revenues.

Gary Dimsky:
            If I could say just a word, just to amplify this. You saw such different regional proposals here. Both the Detroit area and many of the cities in California have a sub-prime crisis for quite different reasons; if you look at the data, look at the Kay Shiller data. The Sunbelt cities were going up by more than 20 percent a year in real terms. Detroit’s and Cleveland’s were less than 1 percent. So there we have a crisis of social reproduction, which is rooted in part in the collapse of incomes with the ability to use some of the mechanisms that exist from the battered but still existing welfare state in order to inject liquidity and income into people’s pockets.
            In California, we have a very different situation. There we have a sub-prime crisis because we, as mentioned, we weren’t building enough housing, and we weren’t able to basically maintain an asset base where real assets kept up with financial flows into that asset base. If we build housing in California, unless practices really change, it’s going to largely be built by undocumented workers who are not in that system. That is not a problem from the viewpoint of California, because that’s how our state works. We could imagine a flight of okies, the new okie flight from the Midwest, former tool and dye workers not becoming nurses, but instead coming out to do construction jobs; but that would be such a revision of the standard practices as they’ve emerged, it’s unthinkable. I think in some sense this is going to force us to think about that invisible dimension of economic crisis, the first one that really hit us in California, which was the collapse of our street-corner market for undocumented workers. That’s something that’s going to be in this mix as we think about stimulus, because we’ve got to deal with who is doing the manufacturing and industrial jobs in the United States these days? They are not all American citizens.

Moderator:
            Perry, did you want to answer quickly, and Allen will have a final comment.

Perry Mehrling:
            One minute on each one:
            What if the prices of the CDOs are actually efficient? As you know, these prices are actually mostly coming from prices of the EBX index swap, and we know some stuff about the organization of that market, so I think we know that they’re not efficient.
            But suppose they were. We could sell insurance at the current CDS swap price to say we’ll make sure that it doesn’t fall below 50, for example. That way there’s no way to arbitrage the government.
            But I would make a distinction between the old stuff and the new stuff. The key is getting the markets going again, and there you have a different operation.  Seignorage of central bank limitation - Allen has basically the same question. I view the Central Bank of the United States as essentially operating as the world’s central bank at the moment. That’s what a world central bank would be doing in the case.  It’s basically having expansionary global monetary policy on its own balance sheet. If the citizens knew that, I’m not sure they’d be that fond of that. But it is probably the right thing to be doing. No one else can do it.

Allen Sinai:
            When you take $29 billion of stuff that’s not worth $22 billion on the balance sheet of the Fed which is ultimately the financial condition of our country, I don’t think it’s the right thing to do.
            One question and comment really caught my eyes and ears, the gentleman who said something about this is not classical capitalism. I agree with that 150 percent, because I’m a capitalist at the bottom of everything. What we’ve had, and I think we should think about it, was unconstrained maximized shareholder value and aligning all stockholders and shareholders with that goal. That is simply maximizing the value of the stock. So these innovations, the twists and turns of business, the way that Wall Street took advantage of low interest rates, and the smart part, our best graduates from our best universities went there because they could make a lot of money on the shares of stocks, and most of them were paid out—is that really what the objective should be? That is absolutely a totally corrupt objective that we’ve all been following here for about 15 or 20 years, and we’ve seen it unravel, so I like that question.
            Classical capitalism, whatever the gentleman who asked that question means, we don’t lose here in the stuff we’re going to do with rules and regulations; we want to preserve “classical capitalism,” because that’s an essential part of energizing economic growth.

Moderator:
            Thanks to the panel very much, and Jamie’s going to have a few comments.

Jamie Galbraith:
            This is the final word on this really rather brilliant panel. I thought I would tell a short story that bears on the question of boldness in policy innovation of the kind that we need now, which also touches at the end on some of the questions that both Perry and Gary were talking about earlier on.
            On the evening of Pearl Harbor my father realized that there was about to be a critical shortage of rubber because the Japanese were moving to cut off the supplies from Malaya and the synthetic plants which had been invented would not be online for another 18 months. He drafted an order for an agency, the War Production Board, for which he did not actually work, and took it around to the commissioners at night, to their homes, and said, here is the rubber order. They signed it. The next morning, the sale of rubber tires in the United States was mad. He also drafted an order establishing a speed limit of 35 miles an hour and called up the governors of all the states to get them to enforce it, which they all agreed to, with the exception of Alaska and Coke Stevenson, the governor of Texas, who heard him out and said, Professor, I hear what you’re saying, but in Texas if you go 35 miles an hour, you don’t get there.
            A few days after that, a fire broke out in one or two great stockpiles of natural rubber that we happened to have in Providence, Rhode Island, under the management of the Reconstruction Finance Corporation. The great New Deal businessman who ran the RFC, Jesse Jones, needed to comment, and what did he do? He called in the press, and he said, Don’t worry about it boys. It’s insured.
            Thank you all. This has been an extraordinary morning. [End Panel II.]