Martin Wolf and Robert Shiller: The Future of Investing

I attended breakfast yesterday morning at the Levin Institute and heard a discussion between Martin Wolf, Associate Editor and Chief Economics Commentator, Financial Times, and Robert Shiller, Arthur M. Okun Professor of Economics, Yale University. My notes follow:

WOLF:

You used to be one of the few Keynesians in economics. Suddenly in a crisis, we’re all Keynesians. Milton Friedman’s ideas have proved to be of no relevance. It looks to be a dismal situation for the dismal science. Do we need to restructure the economics profession also?

SHILLER:

I’ve been distressed about the state of economics for a while. Young people entering macroeconomics think that they have to approach a certain way. Students think that they can’t do what I’m doing, because it’s too off-the-beaten-path.

WOLF:

First thing when crisis is over is repeal a bunch of Nobel prizes.

What circuit breakers can we put in?

SHILLER:

New bill would create Financial Systems Oversight Council.

WOLF:

What do you think of idea of splitting commercial and investment banks—the bread and butter, vs. the casino?

SHILLER:

The 1990 Depression scare, following the S&L crisis, was the same issue: we were insuring savings & loans but not watching them sufficiently. Another part of the new bill is a resolution authority that will manage bankruptcies. This crisis felt like a total surprise—we didnt have contingency plans.

WOLF:

We see signs of genuine recovery, but it looks like force feeding. Even the Germans are running a deficit. All the major central banks are offering money for 0-1%, which has never before happened in peacetime. Are we in a Japan like situation: in 90s whenever Japan tried to tighten, economy tanked.

SHILLER:

My wife sees me on TV and tells me ‘Don’t smile when people are talking about depression."

Utley

What would have happened to US if WWII hadn’t ended the Depression?

SHILLER:

Best chapter in Keynes’ book is section on long – term expectations. He says, those expectations are part of our basic mindset, and they’re damaged in times like these.

Japan had two huge bubbles (stock market and real estate) and hasn’t gotten it together since.

After WWII, economics worried, will we go back to the Depression when war ended? My story on this is that, the experience of the war changed our mindset in fundamental ways. We were not in the Depression funk anymore. We had national electroconvulsive therapy.

WOLF:

We forget that 1945-75, Europe was a high-growth area: "les Trentes Glorieuses". This period also saw a lot of catch up investment in technology developed in 1920s, 30s, 40s.

Utley

How do we restructure financial sector? Too big to fail problem?

WOLF:

If you force banks to increase capital, they’ll lend less. Europe does not have a huge shadow system that needs replacing. If as most people believe, securitization doesnt restart in the US, then we need banking system to replace it, to sustain existing level of intermediation in the economy. This implies that you need huge amounts of capital in banks: enough to increase equity + enough to increase lending.

One solution: make banks ‘too good to fail’, by reducing the chances of a bankruptcy. Liquidity requirements relate to that. Another side: make the system failure-proof against failure of institutions. The financial system is a much denser network than it used to be. We need a financial system like the internet, in which nodes can stand on its own.

Major financial institutions are only nominally private institutions.

SHILLER:

Bank of England at least has had experience in dealing with financial crises.

The US regulatory authority has much less experience.

We’ve developed a shadow banking system.

Basel I and Basel II did not adequately see potential for bubbles.

We need a new currency called Regulatory Convertible Debt. It’s debt a bank can take, which only converts to equity if Regulatory Authority declares a systemic crisis. This is a very creative idea.

Q

What do you think of Stiglitz’s suggestion that certain derivatives should not be traded because they dont have underlying economic value?

SHILLER:

Derivatives have underlying economic importance. They’re really no different than insurance.

Q

What is optimal savings rate for households under normal fiscal conditions?

To what extent is it linked to rising median wages?

WOLF:

In UK, a lot of household savings are pension savings (much of it corporate).

The amount of savings corporates did on individuals’ behalf was driven by their assumptions about L/T growth of their assets. These assumptions were all insanely optimistic.

Most households have no idea how much is needed to save for retirement. They underestimate by 3 to 1 how much $ is needed.

Q

Comment on feasibility of minimum capital requirements, and phasing them in.

WOLF:

That’s what ‘s proposed in the pending legislation.

In this crisis, we discovered institutions we thought were not systemically significant, were (e.g., AIG) .

We have a well-developed (albeit not fully functioning) regulatory regime for banking. We dont have that for insurance.

Teten

How can we halt government’s natural tendency to grow?

WOLF:

From a European point of view, the problem is not your government. The problem is you’re not willing to pay for the relatively small government you have.

I disagree with a premise of your question. In W. Europe, the size of government has been relatively stable as a % of GDP for 25-30 years. The reason is that we hit the tax limit.

WOLF:

Rate of growth of financial assets will be low over next 25 years. Nearly all the growth in financial assets will be in emerging markets. They will be investors.

If you convert Chinese savings into dollars at current rates, in aggregate terms, the Chinese are now saving as much as the US. That money is now going into bad banks. That money will flow out of Asia.

London was once a national financial center which became international because savings were outside of London. NY will become an international entrepot. This shift in wealth towards the East is irreversible.

Utley

Future of capitalism? Which model will be pursued? What is role of state going forward?

SHILLER:

US has a longstanding commitment to free enterprise. This is not as big a blip as people think.

Capitalism is a rough and tumble world. We didn’t abandon capitalism after Great Depression.

WOLF:

There will be no replacement for the market economy. We’re not going back to the libertarian world, the 19th Century.

We’re going to see a more caged financial system, because governments became frightened out of their wits.

An absolute law: solvent governments always rescue financial systems when they look like they’ll collapse. This was not true in the 19th Century, because financial system is so intertwined with the state.

(Image via Wikipedia)