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

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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

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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

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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

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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

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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

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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

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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

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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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