Andy Gluck's Blog

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It was an anti-Semitic slur that introduced me to Martin Wolf.

An economist I interviewed one year ago, when I first reported on the depths of global economic crisis, blamed “Jewish finance” for Wall Street’s woes, in particular the subprime mortgage crisis. As a Jew, I was shocked and, after taking a few seconds to get my bearings, I asked the economist, whose name is not worthy of mention, to explain the remark. He said Jews have a transaction-oriented “flight mentality” that had gripped Wall Street. I pressed him to explain further.

“Who’s the most important financial journalist in the world? The economist said. “Who? By far, Martin Wolf of the Financial Times.” “He’s made this point.”

The interview quickly ended, with my heart pounding from rage. As a child of Holocaust survivors, I felt morally obliged to follow up. So I Googled Martin Wolf and quickly learned that he was indeed a big deal. The Associate Editor and Chief Economics Commentator at the Financial Times, Wolf was awarded the CBE (Commander of the British Empire) in 2000 “for services to financial journalism.”

Undaunted by his celebrity, I emailed Wolf. “Please send me any columns in which you used the term (Jewish finance) to help me understand how you may have used the term—if indeed you did so,” I wrote to Wolf. “I do not want to malign this man as a bigot if there is some legitimate underpinning to what he said, which is hard to fathom. And I do not want to let him use your good name to justify his comments without checking in with you.”

Wolf responded in an hour. “Of course, I have never used such a vile term,” he wrote in an email to me. “To ascribe it to me is an anti-Semitic slander. If you, or anybody else, does attribute this unspeakable phrase to me, I will be forced to consider legal action.”

Thus began my conversation with Martin Wolf. What I found out in the weeks and months to come was that, like most anti-Semitic slanders, there was a strand of truth to what the economist had said: Wolf is indeed the world’s most influential financial journalist.

Wolf is an associate member of the governing body of Nuffield College, Oxford, honorary fellow of Corpus Christi College, Oxford University, an honorary fellow of the Oxford Institute for Economic Policy (Oxonia), a special professor at the University of Nottingham and a member of the Board of Governors of the Ben Gurion University of the Negev, in Israel.

His column in FT, the U.K. counterpart of the Wall Street Journal, is available online and almost always brilliant, and his latest book, Fixing Global Finance, clearly and concisely dissects the world economic crisis. I’ve learned a tremendous amount from Wolf and interviewing him is a highlight of my 25 years in financial journalism.

Gluck: The global meltdown that we’re seeing—was the U.S. the main cause?

Wolf: This was caused by deep systemic failings in the world system. Two underlying things have gone on in the last 30 years: we have been promoting the liberalization the world financial system. We started back in the early 80’s, pretty well everywhere, with a financial system with a very small balance sheet, largely liquidated by inflation, and so we were in some sense credit-starved. We had a very low ratio of credit to GDP. Over the last three decades, there’s been an extraordinary expansion in credit. This immense expansion of the credit system and of outstanding credit has clearly led to an extraordinary amount of bad lending, as one would expect to occur when credit seems so easy to create. In the U.S., for example—which is the most important case, but the U.K. is even worse—the balance sheet to the financial system has grown roughly six times as fast as GDP over the last 30 years and stands today at about 120% of GDP—a size that, as far as I can see, has never occurred before in the history of the U.S. So this is an enormous credit bubble and in the process, a very large amount of bad debt has been created all over the place. The second thing that has happened over these 30 years is we tried to transfer capital—or some of this credit—to emerging economies. Every time that happened, we ended up with a huge financial crisis and ultimately, after the last and biggest of these waves of crises in ‘97-’98 in Asia, most emerging economies—and the only real exception was those of Central and Eastern Europe—started to run very large current account surpluses. The capital they were receiving from the developed world came back out as foreign currency reserves, which were deposited in developed countries—particularly the U.S.—creating very low real interest rates in the U.S. and very large accumulations of liquidity in our banking system, further promoting on a very large scale the credit boom. When you look at the flow of income and expenditure, you discover that the principal counterpart of the excess savings of these countries were huge financial deficits, namely excesses of expenditure over income in the household sectors, particularly in the U.S. I see it partly as a function of the failure of the financial system to transfer resources efficiently to developing countries, which then had this blowback effect, and partly the result of these enormous financial deficits in the household sector, which were very much stimulated by and associated with gigantic and extraordinary housing bubbles in OECD (Organization of Economic Cooperation and Development) countries. It’s no doubt exacerbated by the fact that a large part of the credit that was supplied in the last few years was to households that could never pay it back. And it was obviously made worse by the fact that the instruments used to finance the credit bubble were these very complicated securities that are distributed across the whole financial system of the world and nobody knows where they are, which has created vast uncertainty, and they’re almost impossible to value. So there are clearly very important failures of regulation within the financial system which have also made the crisis worse than it would otherwise be. But I hold a view, at least at the moment, that we would have had a very severe correction in the economy even if that had not been the case because the credit bubble was going to burst at some stage.

Gluck: You have such a constructive way of looking at this problem, calling the issue of the derivatives and the regulatory failures "complications." But you think that the real problem and solution may lie with China, which has accumulated these large foreign currency reserves. You argue that China must become a better borrower and distribute credit in China. Right?

Wolf: Yes. It’s very important, that we do two things now: restructure the global stock of credit and debt and, in particular, restructure the debt of households and restructure the financial system so it’s solvent. That’s a task predominantly for the developed countries—particularly, obviously the U.S. But beyond that, we have to get back to a different pattern of income and expenditure in the world, such that it doesn’t rely so heavily on this massive borrowing by the household sectors of a relatively small number of developed countries, which are now maxed out. They just can’t really be expected to borrow anymore. It’s obvious that U.S. and U.K. households are going to save more. This is a very big deal because U.S. consumer demand alone is about 20% of world demand. It’s equal to double China and India together. It’s simple arithmetic. If we’re going to sustain high levels of economic activity across the globe, then somebody else must offset this decline. If U.S. consumers are going to save more and spend less, somebody else has got to spend more and the question then is “Who?”. In the short run, it’s pretty clear that who is going to spend more is going to be the governments of developed countries. That is not a long-term sustainable solution, however. The longer term solution is for those people who are saving too much to spend some more, and the obvious example of that is China, where consumption is actually only 30% of GDP as against more than 70% of the U.S. and where total spending in the economy is only 90% of GDP and the difference being the current account surplus. A big structural shift has to take the form of higher spending around the world. Other countries which have to think about this are also developed countries like Germany and Japan, which might find it even more difficult. The oil surpluses are, of course, temporarily at least disappearing. The question, of course, for the Chinese is how can they go about this? In the short run, it’s very, very hard because the structure of the economy is not easy for them to change.

Gluck: They need a more sophisticated financial system.

Wolf: They need several things. In the long run, first of all, they have to raise disposable incomes as a share of GDP. At the moment, household disposable income is only about 40% of GDP. You can’t have a mass consumption society when disposable income is so small. The rest is corporate and government income and they have to transfer more income to households. That is actually a very big and complicated problem. Second, as you mentioned, the Chinese need a financial system. They’ve moved a long way in that direction, but must be better at extending credit to households. Third, the government needs to think of ways to promote more labor-intensive growth. The recent growth of China has been very dependent on massive investment and much of that has been very capital intensive and hasn’t been generating much jobs. That’s one of the reasons why income growth has been so low for households despite the very rapid growth of the economy. So these are big structural shifts. It is very widely felt in China and outside that the really big problem is an extraordinarily high savings rate in the household sector. This is actually very much exaggerated. They save about 1/3 of their disposable income. But because disposable income of households is less than half the GDP, it only actually generates little more than 1/3 of total savings in China. Most savings in China are generated by corporations and the government—not by households—and so I think we tend to overemphasize the household point. The changes needed are long-run structural changes, which will take years to carry. So, in the short run, they have to do basically what the Americans do—spend more. The government is in a very good position to spend more. It is trying to do so. Too much of this is going into investment, which will make excess capacity worse, but China has actually giant spending needs—government spending needs. It has huge environmental problems on which huge spending is justified. They need public health and education. They can also easily transfer income in their system and reach quite an efficient system directly from government to household through checks. The Chinese government is exceptional among developing countries in its relatively high level of bureaucratic sophistication, so I think it can do these things. In the short immediate term, that will allow the whole world to adjust. It will add a genuine boost to demand in the rest of the world. The same applies to many European countries and I’ve already mentioned Japan.

Gluck: In your book you point out that China has not done all that much in this direction, and from the Obama administration—just about a week into the Obama administration—there was criticism of China for not allowing its currency to float more freely.

Wolf: China is, in my view, a currency manipulator. But I don’t believe that is the heart of the crisis and therefore focusing on it is a mistake. It is quite possible that China’s trade surplus would remain extraordinarily large, even with a much appreciated exchange rate. The Chinese will argue that floating exchange rates are destabilizing for economies with very limited financial systems, very little insurance for companies. They can’t hedge and it would create massive instability in a country going through extraordinary stresses of development and I think that argument is actually great. You have to remember, for a floating exchange rate to exist, you need an open capital account with integration to the global financial system. China would face incredible risk because they’ve got such a primitive financial system still. For all these reasons—and I could go on, but that’s enough—focusing on the exchange rate as a mistake. The crucial thing to focus on, is the level of domestic spending in China. If domestic spending rises by enough—and it has to rise a lot relative to potential output—then the current account surplus will take care of itself. What we need from China is a plan to increase demand. Instead of having a GDP target—they’re targeting about 8% of growth of GDP, they should have a domestic real demand target. Since it’s a very heavily directed economy, they could make a domestic real demand target of 12% growth a year. Then we wouldn’t need to worry about the exchange rate. The point made by Mr. Geithner quoting President Obama is correct, but it’s not important and the crucial issue lies elsewhere.

Gluck: The stimulus plan that’s being finalized in Congress now, is that going to be enough to jolt the economy out of recession here in the U.S.?

Wolf: My reading of the numbers suggests very, very strongly that the answer to this question is no. But I never really thought it could. There’s still seems to be a lot of thinking in the U.S. that you can have a short-term stimulus that pump-primes the economy and then everything goes back to normal. I think this is nonsense. My view is that we are in a world in which, at least for the moment, private spending is collapsing. The government can and should fill the gap to sustain some level of demand in the economy. Otherwise, we risk a cumulative collapse in demand. As private sector demand collapses, this leads to higher unemployment and more bankruptcy, which leads to more cutbacks in spending, and so on, all the way down. That’s how you get a real depression. But this doesn’t mean that doing this for a year or two will bring everything back to normal. American household spending in particular—which was more than 70% of demand in the economy—is likely permanently to become a smaller share of GDP. In 2005–2006, U.S. household sector was outspending its income by about 5 or 6%. That has never happened in American history. This was partly on residential investment and partly on purchase of consumer durables. This was, of course, all debt-fueled and U.S. households were borrowing more than they had ever done before and its debt-to-disposable-income ratio doubled. This can never happen again. So we are not going back to normal, if by normal we mean 2005–2006. That’s just not available to us. The idea that the economy will suddenly surge back seems sort of a fantasy. Where will the new demand come from? As I said, the fiscal package is just palliative. In the long run, you need higher investment in the economy—particularly from the private sector. The other thing that has to happen, as I’ve frequently said, is exports have to rise. There has to be more demand from abroad. For a long time, the U.S. was spending more than its income and for quite a while it’s going to have to spend less than its income or foreigners will take up the slack. That of course, is going to take a lot time. The fiscal stimulus likely is going to have to last for quite awhile. It’s not just a one-off. It’s a holding operation until these bigger adjustments occur, but it is not about pump-priming so that America households can spend crazily again because they really are cashed out. Furthermore, what the Federal Reserve is doing is at least as important, if not more important. It is directly refinancing the banking system and that’s allowing it to adjust. Again, it’s a very important part of keeping things going and avoiding the kind of meltdown we had in the 1930’s. But both measures are going to take effect very slowly. To get back to reasonable equilibrium, we have to restructure the debt overhang and rebalance the world economy. If we don’t do that, we’re likely to be stuck with very big fiscal deficits for a very, very, very long time. Fiscal stimulus alone—and I’m very concerned the administration is not saying this—will not bring the United States back to economic health in a short period.

Gluck: You say in your book the reason the world economy is not in equilibrium is because of growing foreign currency reserves that less developed countries were trained to create. Please explain that?

Wolf: Well that’s part of the risk aversion of emerging economies and the associated savings surpluses of this decade. It’s why getting out of this difficult time is very much connected with the reform of the whole international money system—the future of the IMF and all the things, interestingly, that John Maynard Keynes and Harry Dexter White were concerned about in the negotiations at Bretton Woods in July 1944. They were learning very similar lessons. During the 80’s and 90’s, every time any significant emerging economy—and this happened again and again—started running a significant foreign account deficit and borrowing extensively from abroad, it would have a period of boom. But sooner or later there would be a financial crisis, a bubble that would burst. The foreign lenders would flee—particularly the banks. The currency would collapse because there was a very large amount of foreign currency debt in the system. This would lead to mass insolvency in the banking and corporate sectors, and a tremendous economic crash. The last of these crises affected Asia so badly in 1997–1998. And, if you look at the pattern of spending around the world after this, you will see that most emerging economies—with the exception of Central and Eastern Europe, which thought they were insulated by their close relationship to the European Union—moved to an export orientation with undervalued real exchange rates and very heavy foreign currency intervention designed to keep exchange rates down. Basically, the government intervened to effectively recycle foreign currency receipts as foreign currency reserves. Foreign currency reserves are a government capital outflow—purchases by governments of foreign assets—predominantly the liabilities of foreign governments and particularly the liabilities of the U.S. government. They take this trade surplus and park it back in the U.S. where it becomes lendable. Multiples can be created off this because this is base money and you can get an immense credit expansion on top of this recycled money coming back into the U.S. These emerging market countries were doing something quite sensible from their point of view. They were reducing their risk of a foreign currency crisis. If you look at what’s happening to them now, in this crisis, the countries with large foreign currency reserves are able keep spending, as China, India, or Russia have done. That has reduced the severity of the crisis for them. So, they all feel that their policy was vindicated. However, the problem is that for the demand and supply in the world to balance, with all the emerging economies essentially running current account surpluses or balanced, which they’d never done before, somebody else must run deficits. That is true as a matter of definition. That somebody was households and governments of developed countries, particularly the U.S. which absorbed about 70% of the trade surpluses of the world. If we want to get out of this, we have to create a system that allows emerging market countries to borrow. If you think back to the late 19th and early 20th centuries, when the U.S. played a very similar role in the world economy that China now plays, as the rising power, the best investment opportunities in the world are now in poor countries. They’re the ones that can expand their output. So the logical thing is to have capital flowing from rich to poor countries or poor countries with good growth, like China. But that’s not actually what’s happening. The absolute inverse is happening and in my view, that is a very large reason why we’re having this crisis.

Gluck: So we trained these less developed countries to do this because they suffered scores of financial crises in the last 30 years?

Wolf: The emerging world experienced between 1980 and 2003 about 80 major financial crises. As a result, they became massively risk-averse because, in many of these cases, these countries suffered depressions, not just recessions. GDP fell, in one year, by anything between 7% and 20% in quite a wide range of countries. Governments had to bail out the financial system at a cost of more than 50% of GDP in some cases, which were the equivalent of the cost $7 trillion here. So, clearly, they became completely shell shocked and decided they couldn’t allow themselves to be that vulnerable anymore. That is why my basic view is that the big lesson of this crisis is that the global financial system, as a whole, has malfunctioned for three decades and continues to malfunction in a very profound way. This crisis is, at least in part, a reflection of that and if we don’t fix those problems, we can’t have globally open financial markets.

Gluck: The emerging countries behaved rationally.

Wolf: Completely rationally, from a risk-averse point of view. It’s one of the best examples of the basic proposition that what is individually rational can create a collectively irrational outcome.

Gluck: With this persistent global imbalance in place, what’s the likelihood of the depression in the U.S.?

Wolf: We are close to a conventional definition of recession now, two successive quarters of negative growth. There is no conventional definition of depression. Part of the answer to your question is what do you mean by depression? If we mean by a depression, something like The Great Depression…

Gluck: That’s what I mean.

Wolf: In which unemployment was 25% of the labor force. I must say, I find it incredible to believe that anything like this will happen. The reason I believe it won’t happen is that the ability to create money without limit. Nobody is actually fleeing from the dollar as a currency. Quite the contrary, they’re fleeing to it. So the Fed can create as much money as it wants and it can finance the government on any scale it wants in this situation. If you wanted to, in wartime—just to give you a parallel, I’m not suggesting that’s what we want—you could sustain a fiscal deficit equal to 30% of GDP and have it all financed by the Fed. I’m quite sure in the current situation you could get away with this. Because of this, a generalized collapse in demand of the scale that we saw in the 1930s, seems inconceivable. My worry, rather, is that we will have a decline in GDP, the government activity will reach a scale that stops it from becoming a true depression. And, therefore, it will be different from the 1930’s, but we’ll have a very, very weak recovery. And because the private sector is now so overleveraged and the financial system is so damaged and the loss of animal spirits in the private sector around the world is so great, there just isn’t going to be the inclination to go out and spend. Essentially, I fear we’re going to have something that looks in the U.S. a bit like—and this is my real worry—a bit like, or possibly worse than, Japan. Namely, we would have a very long period of weak growth.

Gluck: What’s referred to as the Lost Decade that Japan suffered in the ‘90?

Wolf: The nightmare scenario will be to have a global lost decade. A decade of weak growth, rising unemployment around the world and in the U.S. too, and this would lead to political instability, nationalism, protectionism, and then conceivably these political repercussions could become so severe as to start to undermine the whole network connecting the global economy. That would lead unquestionably to a second round of collapse as companies pull back their presence around the world; global supply chains start collapsing, and disruption that is difficult to foresee but which would certainly be very great. Provided we avoid those mistakes, the biggest nightmare I see at the moment is sort of what Nouriel Roubini calls an “L-shape recovery”. We go down and we stay flat for a decade or so while the private sector recoups its balance sheets, saves, and finally there’s a return of animal spirits. I don’t think that’s the most likely outcome. I still tend to think the most likely outcome is a long “U.” I have bets with friends that GDP in the United States in 2012 may not be higher than GDP was in 2007. So, I do think it’s possible this will be a long, hard slog because we have had extraordinary excesses and it’s going to take a long time to recover from them. But I remain optimistic. I can prove wrong, I cannot really believe in a Great Depression.

Gluck: You have written in your column in Financial Times that economic “shock and awe” are needed to keep the U.S. from slipping into malaise or possibly worse.

Wolf: Yes.

Gluck: Explain what you mean because a lot of Americans consider an $800 billion spending package to be shock and awe.

Wolf: Well, it’s $800 billion over two years, so it’s $400 billion year, roughly. I think many people in America seem not to understand how big their own economy is, so they get a bit confused by all this. I’m a bit worried about this.

Gluck: Put that in perspective then.

Wolf: The U.S. economy is roughly $14 trillion a year. That’s $14 thousand billion a year. $800 billion, therefore, is about 6% of GDP. Over 2 years, that’s 3% of GDP a year. In the context of a massive downshift in private spending, which is the main reason for the fiscal deficit today, a 3% a year stimulus is going to be an inadequate offset. It will not prevent the U.S. from not only being in recession, but staying in recession. The government is not filling the hole in demand enough. It is possible that the Fed’s actions will be enough to prevent it, but I’m not convinced of that because the Fed ultimately—while offsetting the collapse of the financial system—is not itself creating final demand which the government spending plans can do. So my feeling is to avoid secondary and tertiary round effects in terms of income levels and optimism, or collapse of optimism, it would be a good idea to have a larger stimulus in the short run. The $800 billion will be fine if it were all spent in a year. And I think it also has to be spent in such a way as to support consumption now. The transfers to people who will spend money and transfers to state and local governments that are so cash strapped seem to be that. But in the short run those seem to me the things you want to focus your money on. Now in the longer run, it’s clearly not. What really worries me is that the U.S. government might be driven into running these vast deficits for a very long time and that will be very dangerous because it could start undermining the creditworthiness of the U.S. government. Then, my assumption that there’s going to be no depression would turn out to be wrong. What worries me, and it worries me a lot, is because the stimulus package relative to GDP is only 3% a year or so, because the other countries in the world are not doing enough, the world economy will shrink much more this year than most people believe. It’s very likely that the whole world economy will shrink this year, which is the first time that’s happened since the 30’s, and this will lead to more pessimism next year. So more companies will cut back on their investment; more households will want to save more across the whole world. and that will lead to a downward spiral of disappointment and we will be in the “L” if we’re lucky. I would have liked to have seen a big enough spending package now to keep the economy from falling further down this year and next. In my own back of the envelope calculations, I’ve talked about this to some economists I respect—not the most ideological ones—my guess is that the stimulus package probably needed to be twice as big. If financed by the Federal Reserve, it wouldn’t have led to any effect on interest rates and basically can be financed for at 0% interest rates. That would have been more sensible. What worries me a bit about the Obama Administration is that they’re not being radical enough. I understand the very difficult politics of all this in America. But I actually think they are taking too much the view that the private sector should be left to heal itself. The people who believe that’s what we should do don’t realize how damaged the private sector is and how long that healing would take and how incredibly painful the recession would be.

Gluck: The whole emphasis that has been paid to getting the toxic assets off the bank balance sheets—what do you think of that?

Wolf: I’m worried about it very much. It seems to rest on the view that what went wrong here was that the banks went overboard on a very specific sub-class of bad assets. My view is they went overboard with credit in all directions. We’re going to find, as this recession unfolds, bad debt emerging everywhere. You can’t simply find a class of toxic assets, take them off the balance sheet and everything’s fine. What do I mean by bad assets emerging everywhere? Beyond the subprime mortgages, of course, there’s lots of other mortgage debt that is bad. There’s going to be lots of other household debt—consumer credit debt, auto loans and so forth, that goes bad. We are going to get a lot of emerging market country’ defaults in the next few years. We’re going to have a wave of corporate defaults—particularly on leverage buyouts, but not only on these—and they will be worldwide. In other words, we are going to have find bad debt everywhere. Just getting the so-called toxic assets off the balance sheets won’t fix the problem. That links to my second concern, which is the really big one. The financial system is fundamentally undercapitalized. It doesn’t have enough capital to function with the likely level of losses and remain solvent. The concern I have, therefore, is that the bailout plans will not provide the financial system with the capital it needs to be healthy. Allowing what the Japanese used to call “zombie banks.” And the third concern, which is directly related, is that the only way they can deal with the toxic asset problem in a way that solves the capitalization problem is to overpay very, very, very badly, and I don’t think it’s the government’s job to buy assets vastly above market prices, awarding most massively those financial institutions that were worst managed. They are precisely the ones that need to be closed down and restructured. People I trust from many different sources—some in the Administration, some outside—think that the U.S. financial system and the world’s financial system needs trillions of dollars of more capital. It won’t come from the private sector. It can only come by restructuring the liabilities of the institutions by transforming significantly large amount of debt into equity, which is a standard approach in bankruptcy. Or it could come by government injection of capital, in which case, government would temporarily own much of the financial system. Those are the only two ways of doing this, and I don’t think they can be avoided in all probability. If it’s not dealt with now, we’ll just have a bigger problem a year or two from now or even perhaps six months from now. This focus on the toxic assets—because it’s the politically convenient thing to do—is not going to solve the problem and is going to lose a lot of the momentum and credibility for the Obama Administration.

Gluck: What are the three things in coming months that you would look for if things are going to work out well?

Wolf: Passage of a bigger and effective stimulus package, number one. We’re going to get a stimulus package, and I hope it works. But I would like to see some sign of it working soon, and I must say I would have liked to have seen it bigger. The second thing I would like to see are clear signs that the American Administration has a package for the financial system which is sufficiently radical and comprehensive to make it absolutely plain to anybody that the financial system is viable and functioning under almost any conceivable circumstances. The third thing that I would like to see to be optimistic is a productive and effective meeting of the group of 20 developing countries in London in April in which they begin to emerge with a credible plan for demand expansion across the world and reform of the global financial system in support of it. Those will be the three things I would like to see if I’m going to be encouraged and optimistic about the future. The pessimistic things are essentially the inverse of this. Namely, that it becomes obvious that the stimulus package is far too small and it’s not working.

Gluck: When will that be obvious?

Wolf: It will probably be obvious in six months.

Gluck: A lot of people fear that the U.S. taking control of banks and nationalizing them is taking us down the wrong path. What do you think about this fear of compromising capitalism?

Wolf: It’s complete bologna. I wouldn’t call it nationalization at all. I would call it a bankruptcy process. The government doesn’t have to control a bank for very long. If they want, they can control it for three weeks or even a week. The key decision you have to make beforehand is “Are you prepared to accept large scale default by banks to their creditors?” That’s a huge question because it involves many big ramifications for other sectors—particularly the insurance industry worldwide. If you accept for the moment that the financial sector is undercapitalized.—that there isn’t enough equity in the system to absorb the losses while still remaining sufficiently healthy to be soundly managed for the interest of shareholders.—then there’s not a problem. If the banks are adequately capitalized, this is not a problem. But let’s assume for the moment they are not and certainly the equity markets are suggesting they don’t believe they are. Then there are two things you can do. You can take hold over all the institutions that are undercapitalized by some standards—everybody knows what capital adequacy ratios are required. You would then say to the bond holders, starting with the most junior credits on upwards, that a certain proportion of the debt is converted into equity. Let’s suppose—and this is just a number—let’s suppose you needed a debt equity ratio of 10:1. The initial capital ratio was 0—I’m being very extreme—then you would convert 10% of the liabilities into equities, starting with the most junior credit. And you would say to the bond holders, just as you do in a normal bankruptcy, “Congratulations, you now own the bank.” It’s a private bank. You haven’t nationalized it. No problem. All you’ve done is, of course, restructure the liabilities of the banking system. Most economists think you can do that.

Gluck: But the existing equity holders are…

Wolf: Would be wiped out.

Gluck: Yes.

Wolf: But that’s what happens in a bankruptcy. If we allow a normal private company to go bankrupt, it’s bankrupt. The shareholders lose their money. This is capitalism. Equity is risk capital and by risk capital, it means you can lose everything you’ve invested. Now, the assumption I’m working on here is that probably “X” shareholders wouldn’t lose everything, but in institutions that are significantly undercapitalized, they would be massively diluted. That’s the consequence of their failure as shareholders. You’ve got to bear some risk as equity holders. I think it’s true socialism to say the government has an obligation to save the value of equity. The second possible way of doing it, which is closer to nationalization, is to say “We’re not going to wipe out creditors because we think that will create too big a problem for confidence in the financial system. The government will inject the capital that is needed to bring it up to the ratio. We suppose the government will then have a majority shareholding in many cases—as for instance, happened in Britain, where the government has a majority shareholding in at least one, if not two, of the big banks. Of course, the government would then say “We’re going to create an arm’s-length institution to manage this shareholding and when the market’s recovered and the economy recovers, we’re going to send it all back to the market,” and that’s what they did in Sweden. If you want to be more radical, you could say—which I rather like, actually—the government could give its shareholding to all the American citizenry. Each American citizen will get a share in the new whatever it is—CitiBank, whatever it might be. So, there are perfectly possible ways you have to make this choice, The crucial point only is right at the moment, if a bank is undercapitalized, and cannot adequately write off the bad debt, it will inevitably be unable to reveal the truth on its balance sheet because the truth will be that it has negative net worth. This will be a zombie bank and it can’t start lending. This is inevitably the case in a bank which can’t come clean on its balance sheet. If you don’t want either of these options, a bank can go out and raise more capital. That’s fine. If you raise more capital in the private marketplace, there’s no problem. We’re not going to do anything about that and then you’re free in private.”But basically, the government has to find some way of making sure that the banking system is fully capitalized such that people around the world will all say there’s no problem with leaving our money with this bank and the bank itself can say, “We can start taking normal risk decisions, because we’re a solvent institution.” That’s the key. There are a number of ways of doing this. Some of are more like nationalization and some are not. But I can’t think of any way of doing it– if it’s genuinely undercapitalized— in which the existing common shareholders are not massively diluted because.

Gluck: What’s are the chances of one of those creative solutions actually being adopted in your view? Will the leadership be there?

Wolf: We came very close to it with the TARP—it was incredibly mismanaged—and I actually think they are getting close to it again. The problem is that because the TARP was so incredibly mismanaged, a lot of the credibility of the U.S. government was shot. One thing they can do is put in preference capital, which is, of course, a form of debt, but it’s junior debt. You can have an automatic process of converting that into common equity, depending on the losses the bank bears. That’s nationalization-based stealth. It’s not something you actually have to publically announce, “I’m going to nationalize this institution.” How much you nationalize it depends on how bad its performance stands out to be. If it is the case, as many fear, that the banking system is fundamentally de0capitalized, then in the end they’re going to have to do one of these things. I would rather they did it sooner than later while the credibility of the government is still solid. These things have been done in many other countries which have hit financial crisis. This is not new. Even more amusingly, these things have often been done in other countries at the instructions of those now running policy in Washington. These people—I have to say people I know very well—who are running policy in Washington, are people who were in charge of the U.S. Treasury during the 1997–1998 Asian crisis and this is what they told those governments to do. So, nationalize, recapitalize. That’s what they did in Korea. If the American body politic is too ideological, unwilling to spend the money, then it will have a zombie banking system. Sooner or later, that will become intolerable and it will be done. The later it is, the worse the crisis will be. What’s surprised me in this whole debate in the U.S. is how ideological it has remained despite the evident breakdown. Historically, like most foreigners, I’ve always admired American pragmatism. I’m absolutely sure the U.S. will choose a means of resolving this problem choosing one of the means I’ve discussed—forced raising of private capital, debt for equity swaps or government injection of capital. I wish it were sooner rather than later.

Gluck: The last chapter of your book points toward a global financial system that’s in balance. It points a way to achieving a happy ending for the world economy. What’s the chance of that happening over the next five or 10 years?

Wolf: It couldn’t all be done in less than five years. We should now be thinking about how emerging countries can avoid a massive cut in spending because of their foreign currency problems. It’s really incredibly important for everyone to understand we are in a global economic system and we are all affected by what other countries do. That’s very difficult to understand It could take five years to make progress on this. But the whole of World War II was fought in five years.. So it really shouldn’t be impossible to re-jigger the global financial system in five years. It’s a question of priority. The orientation of the Democrats in power is entirely domestic, predominantly on social issues, with limited foreign policy objectives and little concern about the international economic system. It’s focused on what has been seen as essentially short-run economic and financial crisis. Like it or not, the new administration and Congress has inherited a massive financial and economic crisis which is not just domestic. The really crucial thing for Mr. Obama is to shift his mind and say “Whatever I thought this administration could do, fixing the biggest global economic crisis since 1930 is the priority for the next four years, and I’m going to do whatever it takes at home and abroad to do that.” I hope he will take this view. He can’t do any of the other things he wants if he doesn’t fix this problem, and that involves radical measures at home and abroad. If he does take that view, given how frightened everybody is in the rest of the world and how much the rest of the world wants American leadership, I think he could make progress in the next four years, such that it is obvious we are coming out of it.

Gluck: From reading your book, it seems clear you’ve got the ear of someone like Lawrence Summers, the top economist in the Obama Administration.

Wolf: Yes, I know Larry quite well. I would be very surprised if he doesn’t agree and I’m sure he’s influential. But advisors don’t ultimately make policy. The direction of an American administration depends on the political popularity and effectiveness of one person alone—the President. This is in this sense a monarchical constitution, elected monarchy. There’s only one principal and that’s the President, and it’s the President’s priorities that count. Mr. Obama has no background in economics whatsoever as far as I can see; no background in the international economy whatsoever. How quickly he can restructure his thinking about his role as President to focus on this as the dominant issue it obviously is, I don’t know. If he doesn’t do that, having smart advisors is not going to do it.

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