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Senate Foreign Relations Committee Roundtable

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Location: Washington, DC


SENATE FOREIGN RELATIONS COMMITTEE ROUNDTABLE

SUBJECT: THE GLOBAL ECONOMIC CRISIS

PRESIDER: SENATOR JOHN KERRY (D-MA)

GUESTS: NIALL FERGUSON, PROFESSOR, HARVARD BUSINESS SCHOOL; DAVID GORDON, HEAD OF RESEARCH AND GLOBAL MACRO ANALYSIS, THE EURASIA GROUP; DESMOND LACHMAN, FELLOW, AMERICAN ENTERPRISE INSTITUTE; SEBASTIAN MALLABY, DIRECTOR, CENTER FOR GEOECONOMIC STUDIES, COUNCIL ON FOREIGN RELATIONS; DOUGLAS REDIKER, DIRECTOR, GLOBAL STRATEGIC FINANCE INITIATIVE, NEW AMERICA FOUNDATION

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SEN. KERRY: (Sounds gavel.) This roundtable of the Senate Foreign Relations Committee will come to order.

And it's my pleasure to welcome everybody here today. This is the second in our committee's roundtable experiment, if you will -- in this committee, anyway -- and I must say the feedback and sense of -- sorry, judgments on the first one were really very, very positive. We did one last week on Afghanistan and I thought it was one of the more in-depth and better ways of digging into that issue that we've been able to achieve. And I think a number of the senators who attended it also felt similarly. So we're doing this a second time.

We're going to have another -- but we're not giving up on hearings, I want to confirm to everybody. There are a series of hearings that are set up, and we will be proceeding forward. Today I talked to Secretary General Ban Ki-moon, who agreed to come here and join us for another roundtable on a number of topics of interest to the committee, obviously -- Iran, nuclear weapons, poverty and the food crisis in the world, Darfur, and of course U.N. organizational issues. So we'll look forward to having that discussion with the secretary general and to working with him on those issues.

Today we are going to talk about the foreign policy implications of the global economic crisis and look hard at the global economic crisis. A lot of folks have not connected the dots at this point, and there's a lot of dot connecting that we need to do in order to be able to make sound judgments about how we're going to get from here to somewhere with respect to a group of issues. A lot of issues will be severely impacted. Needless to say, the United States is not alone in wrestling with this global crisis. It is a crisis that has already brought down a government in Iceland, helped spark riots in the Baltics and Greece, and is likely to be a driving political force for some period of time. Perhaps one lesson we should take away from the experience of a number of countries already, looking back at some of our economic crises -- Japan, Sweden, others who have coped with these in the past -- is that it's a mistake to underestimate the severity of the economic challenge or the urgency of tackling it head on and not deferring tough decisions. And I believe nothing today will more immediately determine our ability to lead on a global basis than how we address the financial crisis that we face here at home right now.

Yesterday -- and let me just say one quick word about that and then I'll come back, sort of centrally focused on this -- Secretary Geithner laid out the broad framework of the administration's financial stability plan, and he and the administration deserve a lot of credit for acknowledging what a lot of people have avoided for too long, which is openly putting out there the severity of the banking crisis. I fear that it may even be more serious than currently presented, and I do believe that the economic recovery package winding its way to the president's desk is just not going to work unless we fully embrace the tough decisions and the specific details of how we're going to recapitalize our banking system and make our institutions work again. Our giving confidence to that set of choices rapidly is critical to a subset of foreign policy issues which will be addressed here at this roundtable today.

It is very clear from the reaction of the financial -- of the marketplace that folks are not going to wait around for long to see the details of the Treasury's solution, and I think Americans need to know exactly how the administration plans to remove bad assets while simultaneously protecting the taxpayer, and they need to know before the decline worsens. The market is waiting and more importantly, the world is waiting, and we need to put those answers in front of the American people.

The -- what Congress can do now is to face reality and to change that reality fundamentally by recapitalizing the banks, and in my judgment doing so in a way that is not geared to simply subsidized shareholders but to ultimately rescue the economy as fast as possible with minimal taxpayer bailout of those shareholders. I think recapitalization needs to occur immediately and be made available to all institutions big and small. And hopefully we'll do that, and I look forward to the Treasury plan filling out its details rapidly so we can do that.

Now, as we put our banking system in order, there are huge challenges facing us abroad, and this distinguished panel that is gathered here today is really well equipped to help us understand the full measure of those challenges. We are going to have to confront the potential for increased political instability, large-scale failures of other countries' financial systems; escalating financial protectionism or trade wars; economic nationalism that can help deepen the crisis, in fact; and competitors who may choose to exploit financial instability in ways that diminish our influence.

These problems are not confined to traditionally unstable corners of the globe. Europe is also in deep financial difficulty, and Turkey, Indonesia and Pakistan -- three of our most important partners in the Muslim world -- today face acute balance of payments crises. So we have to confront the fact that there's a great deal of anger out there among people who blame the model that we exported. Recently in the Davos meetings of the World Economic Forum, the prime minister of China was heard loudly and clearly criticizing America's model, and this will be part of the dynamic of the debate with respect to international relations.

Even as we restore confidence in our markets, we're going to need to find a strategy to project leadership, to share burdens, and spread stability as the crisis continues to reverberate worldwide. As we balance the domestic and global demands of the crisis, we need to be warned that in cutting corners for short term savings, we actually risk creating far greater costs down the road.

We're fortunate, as I said, to have this distinguished group here with us today, and I might just mention quickly that the -- and their testimony will quickly sort of lay this out -- but the range of issues that we will face, ranging from political leadership and regimes within countries that face challenges; the challenge of regimes that choose to stay in power by consolidating power and making financial choices that might be inimical to some of the reforms and initiatives of the last two decades.

The ways in which this will play out with extremism and the fragility of the number of nations already and the numbers of failed states is a challenge; the questions about state capitalism in places like Russia and China with histories of command economics predispose governments toward state ownership; protectionism, obviously, as the declining global trade flows raise concerns that countries may restrict imports or try to take steps to deal with their own export needs; effects on leadership attitudes towards the United States; supernational political and economic organizations will be affected by this -- the International Monetary Fund, the Financial Stability Forum, the Bank for International Settlements, the World Bank -- and as countries face declining revenues, those challenges will be present; the impact of the financial crisis on poverty and the linkage of poverty and demographics in countries to economic opportunity and to political opportunism; the effect of flow on aid resources. So you can see that the challenge is really very significant, and we need to understand it fully in framing our response here in this country.

Until last month, David Gordon was the director of policy planning at the State Department. He has previously served as vice chairman of the National Intelligence Council and director of the CIA's Office of Transnational Issues, and today he is head of Research and Global Macro Analysis at Eurasia Group.

Desmond Lachman is a fellow at the American Enterprise Institute. He studies major emerging market economies and is an expert on the role of multilateral lending institutions. He previously served as chief emerging market economic strategist at Solomon Smith Barney and in various positions at the IMF.

Doug Rediker is director of the Global Strategic Finance Initiative at The New America Foundation. He focuses on the nexus of finance, capital flows and foreign policy. He was previously a senior investment banker based in London.

Sebastian Mallaby directs the Center for Geoeconomic Studies at the Council on Foreign Relations and is a columnist for The Washington Post.

And Niall Ferguson is a professor at Harvard University in the Harvard Business School and one of our leading scholars on the role of economies and finance in the rise and fall of great powers.

So we have a considerable amount of firepower assembled here. Let me just remind my colleagues, the way we try to work this, folks, is really to have a discussion. We invite people to politely interrupt and/or pose a question and engage in a back and forth, and I particularly invite my colleagues, Senator Kaufman, Senator Shaheen -- I know others will be joining us as we sort of rotate through the day, which is normal -- but please don't hesitate. Just jump in. There's no "Mr. Chairman, may I?" Just ask the question, and if I need to calm somebody down, I'll try to. But what we really want to do is stay with a topic or a particular issue, try to understand it, challenge it, and have a good discussion.

There will be a record of this, and obviously we will also, as we did last time, print the record. I might comment -- the NSC was interested enough in the dialogue we had last time on Afghanistan that they requested a transcript, which we happily provide, and I think there was a lot of good thinking in there about Afghanistan policy.

Hopefully today we can have an equally informative framework laid out about the steps we need to take to protect America's interests and resolve a lot of global challenges.

So with that said, let me begin. I think we have an order pre- established. David Gordon, you're going to lead off; then Desmond Lachman; subsequently Doug Rediker, Sebastian Mallaby, and clean-up hitter is Niall Ferguson. Thanks.

MR. GORDON: Thank you very much, Mr. Chairman, senators. I want to commend you for holding this session on an extremely timely topic.

There are others among the panelists who can address the economic and financial dimensions of the crisis and their international implications much more directly. I want to jump right to some of the most pressing foreign policy concerns that I see being raised by the crisis, and I want to do so by focusing on two regions: Eastern Europe and Russia on the one hand, and East Asia on the other, because it's my view that these are the two regions where geopolitics and the financial crisis really intersect the most closely. So I'll begin with a few short opening statements on each of these and then make a couple of general points at the end.

Eastern Europe --

SEN. KERRY: If I can -- just also -- I know you're already aware of this, but I want to try to keep everybody's opening to sort of whet everybody's appetite. Don't try to cover everything, and we'll dig in as we get along. Great.

MR. GORDON: Eastern Europe, including Ukraine, Belarus, Poland, the Baltic countries -- so Eastern Europe broadly cast is right at the top of the list of emerging market countries that are vulnerable to a full blown financial crisis. These countries have been heavily dependent on external finance, relying on foreign banks who have sharply reduced their lending for a large percentage of the banking system.

For most of these countries, this is really the first full blown crisis since the crisis that accompanied the end of communism and the fall of the Berlin Wall and the end of the Soviet Union some 20 years ago. And for most of them, they have gone through the period since then with economic and financial ups and downs but nothing like what they're facing today.

One of the key questions is which of these countries will be effectively supported by the international community and the European Union. And on this, I think there's reason for positive views on Hungary, Poland, Bulgaria, but also reasons to believe that Ukraine, Belarus and a handful of others are largely going to be kept out of that.

SEN. KERRY: Why?

MR. GORDON: Because they tend to not have internal political consensuses around where they're going, and frankly in Europe, particularly in the EU, they're not necessarily seen as part of the relevant European space. And so this boundary over where is the European Union and the rest of the international community likely to intervene substantially and where are they not could very well interact with events in Russia -- friends in Russia I'm going to turn to in a moment -- to lead to two impacts. One is a loss of faith among certain countries in the project of integration with the West. And then the second is a hardening of the line in Europe between countries that are essentially looking Westward and those that will, I believe, in the future increasingly look Eastward to Russia.

Now, a lot of this really rides on the impact of the crisis on Russia. We've seen in the last six months Vladimir Putin to be increasingly and reflexively anti-American in his comments and his orientations. We saw a bit of that at Davos last week. We saw a lot of it earlier on in the fall and in the end of last summer. He blames Washington for a variety of global problems, including in particular infecting the world with the financial crisis.

But even as the financial crisis and the economic crisises (sic) had a very, very large impact on Russia -- Russia's lost roughly a third of its external reserves in efforts to defend the ruble -- we continue to see a consolidation in Russia of political elements closest to Putin, closest to the security forces, closest to those business elements that are themselves very heavily integrated into the Russian state.

We're also beginning to see, as the economic crisis hits, the beginning of both increasing authoritarianism in Russia, increasing state role in the economy -- although I don't think this is something that the Russians perceive as an ideological imperative --

MR. : (Off mike) -- you're just saying this has started since the financial crisis.

Wasn't this going on longer?

MR. GORDON: No. This is -- I think it's a deepening of a trend that had begun earlier, but I -- there was some hope that perhaps in response to the financial crisis and as conditions worsened there would be some loosening of the bars. We've actually seen I think the direction go the other way.

I draw an important distinction between the nature of the crisis that Russia is facing now and the crisis that it faced in 1998. In 1998 the Russian state was effectively bankrupt and the crisis led to a shift in influence away from the state towards the oligarchs and others in the private sector. Today we see just the opposite trend as oligarchs exposed internationally, exposed financially, become more dependent upon the Kremlin, more dependent upon the Russian state, more dependent on their own political linkages for support.

Now, what will be the impact of this crisis on Russia's broader foreign policy capabilities? I think we're looking at something that's essentially mixed. The good news I think from a U.S. perspective is that Russia's potential assent that people had been looking at in recent years as one of a -- of several credible counterweights to U.S. power is clearly on hold at least for the medium term. The crisis will also stall out the global reach and ambition of Russian companies. We saw several months ago the Russian fleet went to Latin America. I can say very definitively, we will not see that again in the foreseeable future.

On the other hand, the Kremlin's tenacious adherence to Russia's key foreign policy redlines -- on NATO expansion, on missile defense, on pipeline politics -- doesn't depend so much on Russia's economic power and financial power vis-a-vis the West, and it's unlikely that Russia will back down on those issues. Even more significantly, we're now seeing closer to home Russia trying to use its financial means to consolidate influence within the former Soviet Union where, as I mentioned, a number of countries are really reeling from pressure. We're beginning to see that in Ukraine. Last week we saw what I believe was a pretty direct example of Russian pressure on Kyrgyzstan having to do with the U.S. air base at Manas. We've seen already Russia issuing $2 billion in support for Belarus, a half a billion for Armenia, and they're trying to put together a larger fund to deal with -- I think it's the set of countries that are going to fall outside of the large support from the rest of the international community, but in particular the EU. So we are looking at also increasing Russian attention to and I think aggressiveness on gas, both vis-a-vis countries in the region and in an effort to try to ensure that Europe remains dependent upon Russia as its primary source of natural gas. So I do think that Russia and Eastern Europe is being very significantly affected by the crisis.

The second area -- and it's very, very different -- the dynamics are very different -- is East Asia. East Asia has been a success story for U.S. foreign policy over a long period of time. In recent years the United States deepened its relations both with our allies -- with Korea, Japan, with Australia -- while at the same time deepening ties with China. There was a very interesting report came out a couple of months ago from the Chicago Council on Foreign Relations that emphasized the soft power advantage that the United States is perceived to have by East Asians over China and others.

But there are reasons for concern. Stability in East Asia -- and there has been very strong stability -- has been built on a shared experience of rapid economic growth rather than shared values or an institutional framework within the region for managing relations. Furthermore, that economic growth was heavily based upon trade and external investment, both of which are now tanking very, very, very dramatically. And like Eastern Europe, East Asia is the other I think geographic area of the world that really is being disproportionately affected by the crisis. So East Asia is very exposed, and I'm struck by the continued relevance and strength in East Asia of nationalism as an organizing ideology -- if you compare it to Europe, certainly, but even to other parts of the world -- Latin America and Africa. Nationalism is alive and well.

So this is a very challenging mixture -- economic downturn, continued nationalism, lack of institutions to manage tensions should they arise, and the growth model that I believe is problematic.

Now, I think of particular importance in managing this for the United States will be how the United States and China recreate their financial and economic ties as we begin to come out of the crisis. The good news I think is that the crisis has reinforced the centrality of the United States to the global economy and to global economic health in the eyes of the Chinese leadership. But this has positive elements and some less positive ones. The good news is we're continuing to see a continued commitment by Chinese financial authorities for investment in U.S. paper -- in Treasury bills and other instruments. And I think despite the criticisms by Wen Jiabao that we heard at Davos, I think the Chinese have basically been very skeptical of efforts by people like French President Sarkozy to pose a much more radical and anti-American set of reforms for the international financial architecture. The Chinese don't want to go there.

But --

SEN. KERRY: Let me try to get you sort of to --

MR. GORDON: Okay. I'm just finishing up.

I think the downside of this is that China still sees a return to the status quo ante -- to China as superproducer and exporter and the United States as importer of first and last resort -- as their preferred outcome to the crisis. Now, I believe, and I think almost all economists agree, that that's a highly unlikely pathway forward. But there will have to be a very serious effort to reconcile the necessity of the U.S. economy to become less consumption-driven and the enormous difficulties that China faces in moving to a more consumption-driven economy over a short period of time.

Let me conclude by just a couple of points. The China discussion highlights the fact that the Obama administration will need to balance the focus on the domestic elements of the financial crisis with very crucial foreign policy issues. Now is a global leadership moment for the United States. While the crisis has shattered the myth of the economic decoupling of the rest of the world from the United States and has reinforced the continued primacy of the U.S. dollar as the global reserve currency, we shouldn't underestimate the erosion of the image of the United States as an economic leader around the world and the antipathy towards the United States as a source of the global crisis. The world is looking for American leadership in responding to the crisis, in challenging rising protectionism, in both trade and finance, in resuscitating the resources of the IMF to enable an effective response to key emerging markets like Turkey, Hungary, Pakistan, enhancing the role of the FSF and others as a global financial regulatory organization. But I think it's going to be very challenging for the new administration to balance that, and I think the role of the Foreign Relations Committee as a constructive player in your relationship with the administration will be very central to enabling them to move forward in a constructive way.

Thank you very, very much.

SEN. KERRY: Thanks, David. Appreciate it.

Desmond.

MR. LACHMAN: Thank you very much for inviting --

SEN. KERRY: Pull the mike down and closer a little bit. Just pull it -- yeah.

MR. LACHMAN: Is that any better?

Thank you very much for inviting me to this meeting, which couldn't be more timely. Much as you've said, that we're already seeing political fallout in quite a number of places -- Greece, Iceland. We've seen xenophobic -- (inaudible) -- action in Great Britain, problems in Russia with Ukraine that one could relate to the crisis. I think that you also mentioned the rise of protectionism and nationalistic economic policies. That is only going to deepen the crisis, and where I would agree that America really needs to provide much needed leadership.

What I want to talk about very briefly is the economic dimensions, and the basic point I want to make is that this crisis is very much global in its nature and it's not going to be short-lived. I think that there are very many reasons why one would expect this to deepen going forward, and the political fallout that we're seeing right now -- one really has to expect that that is going to get a lot worse in the year ahead.

Just in terms of the economics, I think that what encapsulates the seriousness of the crisis is the IMF has recently updated its world economic outlook, and what they're looking for now is output in the major industrialized economies contracting by 2 percent during 2009. This is something that we haven't seen in the past 60 years, and one has to be struck by the fact that this is synchronized across a lot of countries. What that means is it's very difficult for any country to export its way out of the problem, and what we're seeing is a lack of coordination of economic policy to address what is truly a global crisis.

SEN. KERRY: Coordination within the countries or globally?

MR. LACHMAN: Globally. That's -- I don't believe that you can have a solution to this crisis if you don't have coordination -- global coordination of monetary and fiscal policy, that you've also got to be -- having exchange rate policies got to come into play; otherwise you're going to have countries very much at cross purposes, and the danger is that we're getting beggar-thy-neighbor kind of policies pretty much in evidence. So going forward I would expect that as the crisis deepens this is going to get worse.

I would just say that I think that the IMF's forecast is perhaps sanguine and -- you know, they've been sanguine in the past. I think that their reasons to think that this crisis is deeper than the 2 percent loss of output -- it's not so much that I've got misgivings about the United States' fiscal stimulus package, which, you know, in my view is very much back-loaded and not particularly well designed -- and it's not because that's -- the United States isn't dealing with its financial crisis in a really meaningful way, but it's that I've got really very deep reservations about what's occurring in Japan and what's occurring in Europe.

Just if you look at Japan, what we're seeing is we're seeing exports dropping by 35 percent; we're seeing industrial production declining by 10 percent; we're seeing deflation coming back. We know that this country doesn't have monetary policy room for maneuver; we know that this country is totally compromised on the fiscal policy side, so we've got a serious problem with Japan.

When we look at Europe, I would venture that the situation is worse. You know, much of what has been said about Eastern Europe I would share. Eastern Europe is clearly the most vulnerable of the emerging market regions, but we've got a problem in Western Europe. We've got a serious problem that this is the first time that the euro as an idea is being tested by a severe global recession. So just to mention an example, what we're seeing is Spain -- unemployment in Spain, which was 8 percent last year, has already risen to 13 percent. Projections show that this will probably go to 18 (percent), 20 percent, and one really has to ask, you know, can a country like Spain withstand the rigors of the euro? Spain is not alone. We're looking at Portugal; we're looking at Italy; we're looking at Greece; we're looking at Ireland. All of these countries are really very much tested.

(Phone rings.) I hope that's not the Spanish ambassador. (Laughter.)

So --

SEN. KERRY: Hope it's not your stock broker. (Laughter.)

MR. LACHMAN: No. (Laughter.)

So I think that you've really got a problem in the euro area that is going to play out politically. I think that once you get unemployment rising to that level -- and I was disconcerted this morning, you know, reading about the Czechs complaining about what the French are doing -- that withdrawing foreign investment from the Czech -- you know, that this is I think really a sign of things to come.

Let me just mention briefly on the emerging markets that they are really in trouble because once you've got problems at the economic center in the industrialized countries -- (phone rings) -- I thought I'd turned this off -- excuse me. Once you've got problems in the center in the industrialized countries, at the periphery it's really very hard hit. And the way that this works is that firstly trade -- that if they don't have markets to export to, they're in trouble. You've got Central and Eastern Europe highly dependent on Germany's performance. As soon as the German economy slows down, that has an enormous impact on those countries. East Asia -- places like China -- we're looking at Chinese exports. They came out with their estimates either this morning or yesterday showing that Chinese exports had fallen by 17 percent. This is an economy that is basically an export- driven economy. If their exports are falling by 17 percent, you can be sure that the Chinese economy is going to have a great slowdown.

So the first way is through the trade area. The second was is through the banks, through the financial flows, that money -- if there are problems at the center, what occurs is that the banks at the center pull back; money doesn't flow to these countries. So we've got Eastern and Central Europe highly dependent on the banks in Western Europe. So we've got all of those currencies under severe pressure, and that one has to expect to continue going forward.

The third channel which would relate to the poorest of the countries is the commodity channel -- that if we get a deep slowdown in Germany -- if we get a deep slowdown in Europe, the United States and Japan, it's not a surprise that oil, which was selling at $145 a barrel something like six months ago, is now trading at below $40 a barrel. We've got metal prices down 50 percent; we've got food prices down 35 percent. So this really impacts very severely the poorest of the countries and poses a challenge.

I just reiterate that Eastern Europe is the most vulnerable of the countries. Russia is in serious problems -- it looks like it's got a full blown currency crisis developing, that they've got far too much borrowing abroad by the corporations. With these markets slowing down, you're going to get a problem in Russia.

And let me just finish by saying that China is going to be a huge problem; that I don't think that it's very easy for an economy that is very export-oriented, got all of those industries on its coastal fringe, to suddenly transform it to a domestic economy. We've got to be concerned that China is now reporting that 20 million workers who are returning from their holidays are not going to be finding jobs. China has to generate 20 million jobs a year. It has -- it needs GDP to be growing by something like 8 (percent) or 9 percent, and I think that the possibility of that, in my mind, is negligible.

Thank you.

SEN. KERRY: Thank you, Desmond. Very interesting. There's a lot I want to follow up on, but we'll come back as we get going.

Doug Rediker? Thank you.

MR. REDIKER: Thank you, Mr. Chairman and members of the committee, for the honor of addressing you today. And --

SEN. KERRY: Wait -- is your mike on?

MR. REDIKER: Sorry.

SEN. KERRY: Push the button there and the light should go on.

MR. REDIKER: Got it. Okay.

SEN. KERRY: Just leave your mikes on, folks. As long as you're not telling each other secrets it will be fine.

MR. REDIKER: Thank you, Mr. Chairman. It's a tribute to your leadership that this roundtable is being convened in recognition of the centrality of economic and financial issues to American foreign policy.

In thinking about the foreign policy implications of this crisis, I'd like to talk a little bit about deficits, but not current account deficits or trade deficits, but rather more strategic foreign policy deficits created by this crisis. And how the United States addresses these deficits will likely play a significant role in shaping the 21st century world order.

At its most basic, the current economic crisis has given rise to a deficit of capital.

The sudden withdrawal of credit and investment available to countries, companies, banks, and individuals around the world has resulted in a dramatic reduction in capital flows, especially in the developing world. This scarcity of capital is likely to worsen as current and proposed plans for stimulus packages and rescue programs in the U.S., Europe, China, and elsewhere soak up huge amounts of funding, thereby vastly reducing the amount of global capital available to these developing countries.

The inability to access capital through the global markets will likely restrict many governments in their ability to fund basic domestic programs. And when a government experiences an imminent funding crisis that poses a risk of civil unrest or that threatens its survival, anyone offering a means to provide financing warrants consideration.

An example of this scenario was NATO ally Iceland's response last October when its pleas for financial assistance went unanswered. In desperation Iceland commenced negotiations with Russia, and Iceland's prime minister explained his actions at the time by noting that his country had not received support from its friends, so it was forced to look for new friends.

Just this past week, the government of Libya came to the rescue of a major European bank for the second time. And Russia, in spite of falling share prices, a weakened currency and declining reserves, provided a $2 billion loan to Kyrgyzstan.

Now, the second deficit created by this crisis is a deficit of ideology. While the fall of the Soviet Union represented a clear triumph of democracy and capitalism over communism, the current crisis has again raised questions about what economic and political systems are in fact the most desirable and effective. Few if any are calling for a return to communism, but the current crisis has called into question several generally accepted principles of the late 20th century political and economic thought, including the benefits of Anglo-Saxon style capitalism, American style democracy and, more broadly, the ideological leadership of the United States.

Many countries in the developing world spent the last decade following the so-called Washington consensus. They embraced tough fiscal policies, opened their markets, removed capital controls and embraced the global financial order. Nevertheless, the current crisis has hit them very hard.

The financial crisis thus created an ideological deficit where even our closets allies in Europe, not to mention other countries with whom our relationship is more complex, like Russia, China and the Gulf states, are rethinking the balance between social values and market- based economies. There's renewed consideration of political and economic systems like state capitalism and authoritarian democracy. What were previously oxymorons are now ideological challenges to the status quo.

A third deficit raised by the crisis is one of creativity. As other nations rethink the ideological underpinnings of the international order, there remains an enormous yearning, as yet unfulfilled, for bold and creative solutions to the crisis on a global scale. And one of the unexpected consequences of the financial crisis has been the apparent establishment of the G-20 as the new forum in which many of the world's most pressing economic problems will be discussed and addressed.

For the first time, many of the world's fastest-growing emerging market economies, and not just the U.S. and Europe, have a seat at the head table, a table at which neither the U.S. nor anyone else has a veto. That means the G-20 is likely to be a more competitive platform for diplomacy, ideas and intellectual leadership.

And thus far, it has been Britain, France and the EU that has taken the intellectual lead in proposing and crafting the most creative solutions for reshaping the international financial system. In the U.S., while former Federal Reserve Chairman Paul Volcker received widespread international praise for a report that included several bold and innovative proposals, he went out of his way to emphasize that the G-30 report did not represent official U.S. policy.

Which leads to my fear of a fourth deficit, a deficit of attention by the United States to the global nature of this crisis and the strategic issues it compels us to address. It is understandable for the U.S., like other countries, to turn our focus inward and address the domestic impact of the current economic crisis before considering the more strategic global implications of our response. But it is imperative that we not send a signal to the world that we are now solely focused inward.

If we assume that we can try to right our own domestic ship and deal with international issue later, then we are almost certain to find that other, more creative, aggressive and opportunistic actors will step in and try to fill any vacuum created by a lack of attention on our part. By including foreign policy issues in our response to the economic crisis, we should at least consider how to address head- on these deficits of capital, ideology, creativity and attention. And I think this roundtable is a significant step in that direction. Thank you.

SEN. KERRY: Thank you. Very thoughtful, also. We'll wait a moment, and I'll come back to that.

Sebastian.

MR. MALLABY: Thank you, Mr. Chairman. I ask for a couple of pieces of paper to be circulated to support what I'm going to say, and I'm just going to make a few simple points about the intersection between foreign policy and the financial crisis.

Maybe this isn't -- I can give you this copy here. We can -- there's another one. I believe that somebody might -- do you have those -- no. Okay, sorry.

SEN. KERRY: We'll get that.

MR. MALLABY: I arrived with 25. I don't know where they've all gone.

Okay, so I guess just a few simple points about intersection. If you look at the International Monetary Fund's economic forecast which it says although it was produced just in January, the updated version may not be a bit too optimistic. Nonetheless, you can see a good snapshot of what a reasonable expectation is for growth around the world.

And if you look at these numbers with a foreign policy mind-set, a few things stand out. One is that rich countries are going to shrink in terms of their economies this year by a forecast 2 percent, whereas the developing economies are expected to grow by 3.3 percent. So the familiar patterns of relative power shifting out of the rich world and into the bricks in other emerging economies is not altered by the crisis. That's the first point.

On the other hand, the swing in the growth of the emerging economies and the bricks, in particular, is much bigger than the swing of the growth in the United States. And I'll get back to that a bit later. But the point here is that when the Russian and Chinese leadership go to Davos and say, you know, your growth model is messed up, you know, what they're not saying is that the United States is suffering a reduction in growth much less in percentage terms than the reduction either in China or Russia.

Which I think would lead one not to overreact to the rhetoric from the Russian and Chinese leadership but to take the narrative about a kind of challenge to the American model of capitalism with half a pinch of salt.

SEN. KERRY: Is there a quick snapshot of why that is the case?

MR. MALLABY: I think that there are problems in the U.S. growth models having to do with a reliance on free-wheeling finance that we're going to have trouble addressing. But on the other hand, there is a more fundamental problem in the Chinese growth model which is a reliance on exports, which was way in excess of anything they could possibly sustain, even without this crisis. They were growing around 10 percent a year, their exports were growing around 20 percent a year. You could not extrapolate that kind of export growth into the future and see it being sustained. Because as a share of global trade, there would have been more than 100 percent pretty soon. So there was a fundamental problem with the Chinese (predicate ?) for growth.

And in the same way, the Russians were based on growth which was very tied to energy. And you know, that was not sustainable. We had a bubble in energy prices.

So those got issues with their growth models, just like we do. We shouldn't be in a (transitive ?) mode of saying, you know, we have no problems.

That's not true at all. But nor should we, I think, succumb to the notion that somehow in the world of ideology and soft power that we've lost.

A third thing which sort of reinforces that last point is that if you look within the rich economies, the IMF forecast for U.S. growth, which is bad, negative 1.6 percent, is nonetheless the second best of all the eight richest economies. Bar Canada, the U.S. is forecast to do the best. So again, the familiar pattern that existed before the crisis of the real shift of power being towards growth, not towards Europe, not towards Japan, not towards any rich competitor, has not been altered by this crisis.

If you look across the table, you can generalize about the types of economies that are worst hit. Those with a very big exposure to the financial sector, the share of GDP, that means especially Britain where the city of London is a huge share of British output. So I think, among the richest economies, Britain is the worst of all. Those that were geared to very high energy prices and then secondly spent the energy windfall rather than saving it are now very vulnerable.

SEN. KERRY: Why again is Britain the worst of all?

MR. MALLABY: Because not only did it have, you know, the second biggest or equal the most important financial center in the world, London and New York being the top two, but around that in the British economy, there was an awful lot less to fall back on than in the U.S. economy where you've got lots of centers of growth, whether it's pharmaceuticals in New Jersey or technology in Massachusetts or the West Coast or what have you. I mean, it's just a much deeper economy in the U.S., much less reliant on one sector than in finance. And no other country had a financial center comparable to London.

So Britain was betting too heavily on finance for its growth and not paying the price, just as Russia was betting very heavily on energy for its growth and now is paying the price. And the countries that are really vulnerable are those like Iran which not only were geared toward energy but also were spending the energy revenues, not saving them, and presumed a pretty high energy price -- you can debate the precise number -- pretty high oil price for their budget to break even.

So my friends who think about, for example, the nonproliferation debate see not a lot of hope of persuading the Iranians to change their mind in their determination to build a nuclear weapon or at least to have a great capacity towards that. But the one thing that has changed in the last six months is that the economic basis for Iranian cockiness has gone away.

And the third category of the economy that is vulnerable right now is, as I indicated with China, that we're especially dependent upon export-led growth. Not only China but Japan and Germany have been hit very hard. If your growth strategy was essentially to essentially to sell to foreigners and then foreign demand dried out, you are now very badly hit.

Russia, I think, is an example of an economy, by the way, which was exposed not only to the energy prices but also in fact to finance because their private sector had borrowed a lot from Western lenders. And so when you look in the IMF table, the IMF is commendably open and honest. It published this table which I hope I've circulated now, which shows you what the growth forecast was from the IMF for different countries in November and what the growth forecast now is in January. So over the course of two months, they've revised downward the growth forecast for lots of economies and especially for Russia, revised down by a stunning 4.2 percentage points in the space of two months.

Now, just put that into perspective. Two years ago in 2007, I believe the U.S. grew around 2 percent or so. Let me see, 2 percent in 2007. The U.S. is now forecast to grow at negative 1.6 (percent). So the entire swing -- we feel that we're in a terrible mess here -- the entire swing in the outlook to U.S. growth between 2007 and this year is smaller than the swing in Russia in two months. So if you think that political eruptions are liable to follow from the dashing of expectations, the Russians are in for the high jump.

And you know, if you think back to the way that in the fall of 2007 few people predicted that the Suharto regime in Indonesia, which had been, you know, trucking along calmly since the mid 1960s, there had been (intake ?) for three decades, nobody predicted that in the fall of 1997 (sic), Suharto would be out within nine months. So the regime did fall. Economic crises have a way of triggering political eruptions, Indonesia being one example.

And I think that you could argue that the rise of Putin in Russia following the Russian crisis in 1998 is another type of example of the way that political direction changes in the face of these economic shocks. So whether you now get the fall of Putinism or -- (inaudible) -- as David Gordon was suggesting almost as a strengthening of this model of highly stated authoritarianism in Russia I'm not sure.

But my point is that, you know, Russia is a good example of a country whose growth outlook has fallen so quickly and so catastrophically that we would be naive to expect an absence of some political consequence.

Now, let me just make finally three sort of big-picture points about all this stuff. You know, one is that what we've learned in the Wall Street crisis is that Wall Street had risk models that were supposed to analyze what risks were and completely failed.

In the foreign policy community and in the Pentagon, we have another word for risk management. It's called contingency planning. And I would suggest that just as the risk models in Wall Street failed catastrophically, so, too, contingency planning in the foreign policy and in the defense establishments need a hard, second look.

When we are in a world where economies are bouncing along just a little bit like this, then we all see something happening, which is way out of the expected trajectory, it's rather small. But when the world is swinging around crazily like this, you're way off the expected trajectory, and you're quite likely to have a contingency which you would (describe ?) is extraordinarily low probability. But the --

SEN. KERRY: Give us a sense of some of the potential contingencies that aren't being evaluated. And should they?

MR. MALLABY: Well, I think that, you know, sort of significant regime change, some significant political shock with a change of political direction in any economy that is badly hit. And I would leave it for the regional experts and my colleagues from the Council on Foreign Relations to sit and (adopt ?) a bit. But you know, things that stick, you know, Iran. You know, at times there have been popular protests, actually pro-American protests, as you know better than me, Senator, in the streets of Iran. At times, the regime has been fragile. I think that goes away when the economy is going better with high oil prices. It may not come back. Russia would be another example, as David Gordon suggested, a switch towards authoritarianism.

But I think that, you know, I just throw the thought out there that as a general subject, contingency planning has become more important than it was in a more stable and more predictable world.

We were asked, all of us, I think, to say something briefly about the developing world. What I would say about Sub-Saharan Africa is two things, or maybe three. One is that the growth shock in fact in Sub-Saharan Africa is not as bad as all that, a fall of roughly from 7 percent growth recently to around 3.5 percent. So relative to the swing in Russia or places like that, this is a smallish swing in growth.

But when you are on the poverty line, any swing is pretty horrible. And so therefore, on humanitarian grounds, there would still be a case for the United States and other aid donors not to cut back on foreign assistance at a time when it's sorely needed and capital flows to Sub-Saharan Africa are likely to dry out.

I also think that on Keynesian grounds, as it were, that if you think about how you design a good stimulus for the world economy, we all know that stimulus works best if you give it people who are going to spend it, not to people who just put it in their pockets and save it. That means you give it, on the whole, to poorer people. Africa is poor. In terms of global stimulus, you give the stimulus in the form of foreign assistance to Africa, they will spend it.

And we are in a global crisis, as my colleagues have pointed out. And therefore, I think there is a sort of quasi-Keynesian argument as well as a humanitarian one for sustaining foreign assistance.

Finally, I'm going to end on this point which has been raised a little bit before, though I really want to drive it home, and that is our relationship with China. I would say that, you know, one of the biggest foreign policy challenges for the next couple of years is the decision, what kind of energy do we invest in trying to persuade the Chinese to change their growth model? It isn't possible right now to get out of this crisis by simply having the U.S. stimulate the whole world economy.

I've printed out a little chart here. I don't know if this is being circulated. I'll pass a couple out. This is from the website of my center at the Council on Foreign Relations. And it just shows you who is providing the stimulus in the global economy. It makes a very simple point. There are surplus countries in the world that have lesser savings and could stimulate a lot, and there are deficit countries, like the United States, that don't have very much savings and actually can't stimulate all that much.

But the weird thing is that the deficit countries, like the United States, have provided a much bigger stimulus in fact more than twice as big as a show of GDP as a share of GDP than the surplus countries which have (lower ?) savings and can afford it. So we're in a strange situation where everybody else is free riding on the stimulus for -- (inaudible) -- economy which in (their surplus ?) has low savings and less room to stimulate.

SEN. KERRY: That's basically because household debt has gone up to an unprecedented level relative to income. I mean, we've been borrowing in order to do the consumption.

MR. MALLABY: Correct, that's right. And so as a nation, we have room in the short term, and we are correct to stimulate, to substitute some government spending for private spending. But as a nation, we have less room to do this certainly than the Chinese. The Chinese went into this crisis with a budget surplus. They had a surplus. So they've got room to go way into deficit. They've announced something, they headline number is a lot bigger than the real number when you boil it all down. But they have room to do an awful lot more than they have done thus far.

And furthermore, I think most economists would agree that global imbalances, the fact that China was running this ginormous -- (inaudible) -- surplus and, therefore, by definition exporting enormous amounts of capital into the world, which were creating what Chairman Bernanke called a savings glut and causing too much money to shape too few assets, the value is gone and driving down the yield, causing effectively, I think, the subprime bubble. If I had to name one cause for the bubble, I would say it was excess savings flooding the world from these surplussed economies.

If we don't deal with that, we are going to come out of this cycle and go straight into another bubble a few years down the road. So I think it's a difficult diplomatic problem in the sense that we've run this experiment before.

SEN. KERRY: What's the incentive? I mean, how do you leverage China into changing their sort of almost cultural and historical bedrock value?

MR. MALLABY: Yes, that's precisely the right question because, as you know, Secretary Paulson tried to change their minds, and he failed. Why would we expect us to succeed this time? I would offer you one basic reason which is that China now is in a position a little bit like OPEC in the early 1980s. And what I mean by that is that OPEC discovered, after two oil shocks, that if you treat your customers really badly by jamming prices about twice on them in the space of a decade, what happens is, first of all, the global economy goes into a complete recession and demand for oil falls. And second of all, people substitute away from oil and get really mad at you. And then OPEC is facing oil prices that hit $20 a barrel. And they realize, the Saudis do, that it's not in their own interest to overplay their hand.

The Chinese, I think, overplayed their hand with their export model. They relied too much on exports. They had a surplus which is just unprecedented pretty much in world history. And the result was that they flooded the world with capital which caused the bubble which caused a recession which has now affecting them to the point where their growth is forecast basically to half from 13 percent two years ago to 6.5 percent now. And it may well end up being lower than that.

So they are paying the price for their own OPEC-style error. I think we need to go to them and make this point and then throw into it, look, we're willing to do a political grand bargain. We know there are things that you want us to do. We're happy to talk about that. But it is important for your interest and our interest that you get really serious. You thought as of two years ago that you had about 10 years to change your growth model. You thought you had time. This crisis has shown you don't have time. You need to do it now. Let's talk about how you get there.

SEN. : But isn't there also on China, I mean, the whole thing hasn't played out with China yet. I know still, this is the chart as of now. But they're beginning to find that that export model is also very dangerous in the fact that nobody's importing anymore. I mean, to say what's going to happen with China now I think would be a mistake to make policy because I don't think (it's ?) played out. If we go in the next year, like some of you have said -- (inaudible) -- stimulus, and the United States is buying nothing from China and Eastern Europe is buying nothing from China, the political implications for China are dire. So I think, you know, they just didn't build a bad model in terms of this and the points you make, which are excellent points, they also built a poor model in terms of it's like a Ponzi scheme. At some point, this had to end. When it ends and millions of Chinese lose their jobs as these plants are closing, I mean, they have an incredible domestic problem here that then they'd have to deal with, which is going to play out long before we should be making, I think, you know, kind of what our strategy is.

And I would predict that this number, this surplus, they're going to have to do something in China to make the $600 billion look like a real number or something even beyond that, or they're going to have dire political consequences.

MR. MALLABY: I would agree with you, yes.

SEN. KERRY: But Ted, doesn't that beg the question when you they're going to have to do something about it, their society is now, their economy is structured around manufacturing. And we have shifted. We are the consumer. And while you talked about, you know, their hope is that we can get back to the status quo -- (inaudible) -- I assume we're going to have to get back not quite from the status quote -- (inaudible) -- but to something in between. Am I wrong?

MR. : No. I think the devil will be in the details, but we're going to have to find a way to get to some place in the middle. The Chinese have a time line that's way too long. But I also think it's naive to believe that they can make a transition in any kind of politically stable way that is quick because they have enormous structural constraints.

SEN. KERRY: (I ?) have the makings of a deal. Let met do this because we want to come back. That may be the making, and we want to discuss the macro approach coming out of here. But I want to get Niall first and then we'll come back and play off everybody and kind of bring us back to the --

MR. FERGUSON: Well, thank you very much. Thank you, Mr. Chairman, and members of the committee for the honor of allowing me to address you. I have some thoughts on the relationship between China and America -- Chimerica as I call it.

I do think it's the key. I have a rather different view from Sebastian Mallaby about how far we can lecture them at this point. But I think my primary role here is to offer some historical perspective.

I'm not sure I believe these IMF projections terribly much, anymore than I believed the last lot. And I dare say the next lot will be just as different, Sebastian. But let's just assume they're roughly right. One thing they do show is that we're not yet in a Great Depression. So if the G-7, the economies are going to contract by something like 2 percent this year, that compares with a contraction of around 18 percent peak-to-trough, 1929 to '32.

If a depression is avoided, it's because of the extraordinary fiscal and monetary stimuli that are being administered at the moment as governments frantically try to repress a depression. And that's why I'm calling this the great repression.

But even with all these efforts, it is clear that some extraordinary pain is going to be inflicted on most economies in the world, and that will have due political consequences. And I want to talk about those.

But let's begin with the U.S. because not enough has been said about what the U.S. can do apart from what it should do. We don't know that the stimulus package or -- (inaudible) -- or anything else is actually going to work here. What we do know is that the U.S. has got sort of a (borrowing ?) requirement this year of around $2 trillion. Now, just keep that in perspective.

The deficit in 1942 was roughly the size that we are looking at this year. We are into World War fiscal policy but without the war. There hasn't been anything like this since World War II. And that's why finance and foreign policy meet. Because up until this point, the U.S. is relying on the rest of the world to finance about 50 percent of all its borrowing. And that money is gone. It is no longer available in anything like the quantity that we've come to rely on.

For Chimerica, that symbiotic relationship between China and America, is actually unraveling very fast indeed. Chinese reserve accumulations have slowed. If there are, as some people say, capital outflows now from China, the need for reserve accumulation is going to decline. And the possibility exists, as economists have been warning now for years, of a real dollar sell-off.

Now, if that's the scenario, I'd want to warn against three erroneous hypotheses about the implications of this crisis for the United States. One, that this crisis has destroyed the credibility or the legitimacy of the United States as an economic leader. Two, that this crisis is going to speed up the convergence of East and West, as Sebastian Mallaby seemed to suggest that it was. And three, that the dollar is about to lose its status as the world's leading reserve currency.

I think these three hypotheses are wrong, that they were doing the rounds at Davos last week. Why? One, with wonderful timing, President Obama's election has created an opportunity to restore the legitimacy of the United States around the world. It's tremendously good luck and it seems to be happening.

Two, if you look at what the crisis is doing to growth rates and assume this isn't all going to be over next year as the IMF seems to, it's actually going to slow down the rate at which Chinese GDP catches up with that of the United States. Goldman Sachs were talking about 2027. Forget that. If it ever happens, and I doubt it ever will, it's much more likely to be in the 2040s now.

Three, the dollar clearly isn't dying. Now, obviously, part of the reason for the rally we've seen in the dollar since last year. That's a 12 percent rally and the real trade-weighted exchange rate is technical. This is -- (inaudible) -- foreigners (flying ?), scrambling for dollars to pay off debts that they can no longer roll over. But I think part of this reflects the fact the United States really is a safe haven in the eyes of foreign investors and for good reason because the United States is one of the few countries that will not suffer major political dislocation as a result of this crisis.

Let me elaborate on that point. This is not just a crisis of the global economy. Mr. Chairman, this is a crisis of globalization. We don't need to look at IMF projections. We know that world trade has already collapsed by roughly one-quarter within, roughly, a quarter. The last quarter of 2008 saw spectacular declines in export numbers, ranging from as high as 47 percent for Taiwan to 35 percent for Japan. I could go on. I'm happy to circulate these numbers. They are terrifying, and they do bear comparisons, I think, with the 1930s.

The critical point is that this crisis of globalization hurt others more than the United States, significantly more. And I think it's precisely for this reason that the United States will retain its safe-haven status despite prodigious monetary and fiscal expansion that we're seeing right now.

Now, I think one possible interpretation of the latest IMF projections is that this crisis is going to affect some of America's allies very seriously and some of America's rivals much less seriously. The big losers if you look at the export numbers and look at the projections are Japan, South Korea, Taiwan. And it's also clear in here -- I want to repeat something that's already been said -- that this crisis causes a major problem for the European Union. I don't think the (EU ?) is going to break up, though some people say it may, because the costs of departure are really much too high. And even the Italians, I think, would be loathed to pay them.

But there are going to be huge strains that are already manifest in widening bond spreads and credit-default-swap spreads that suggest declining credibility of the fiscal policies of countries like Greece, Italy, Belgium and others. There will be mounting friction between the Germans, who don't like Keynesianism, and the rest. There will not be further progress in the direction of anything resembling an EU constitution. And crucially for the United States, Mr. Chairman, there will be absolutely no enthusiasm for any overseas military activity. In fact, defense budgets, I predict, will go to virtually zero as a consequence of this crisis in Europe.

Now, the economic weakness of some of our major allies around the world clearly presents an opportunity for two contenders for power, namely China and Russia. Now, as has already been pointed out, they have their problems, very grave problems, even if both remain positive, above 6 percent in China, even if the slowdown in Russia is not anything like as severe as it is in some of the economies I've already mentioned.

But -- and this is a critical point -- American policymakers need to remember that it is precisely when authoritarian regimes feel vulnerable that they are most likely to engage in risky foreign policies or explicitly to challenge U.S. predominance. Quote, Vladimir Putin at Davos, "Let us be frank, provoking military political instability and other regional conflict is also a convenient way of deflecting people's attention from mounting social and economic problems. Regrettably, further attempts of this kind cannot be ruled out." You have to admire his candor. (Laughter.)

So I think we should expect at the very least that China and Russia will seize the initiative at the G-20 meeting, step up their criticism of the United States and try to hijack international financial institutions with some kind of proposal that won't suit us at all. And we need to be careful because whatever we do we mustn't do anything that pushes China and Russia closer together. And we could be inadvertently doing this already.

Also, too, China is much more important to the United States. And we must avoid lecturing the Chinese about currency manipulation, especially as the Europeans and Japanese could just as easily lecture us about it at this point. The number one priority for U.S. foreign policy should be the preservation of Chimerica, the preservation of that mutually beneficial relationship between China and the United States.

I have two more points I want to make. In the (will of the world ?), I argue that you could predict where extreme violence, organized conflict could take place in the mid-20th century by looking at three things -- economic volatility, ethnic disintegration and empires in decline. I think that combination applies today.

The regions of the world where we're most likely to see not regime change but much more likely civil war are those places where we have seen a sudden upsurge in economic volatility, where there is already a legacy of ethnic conflict and where there is a waning hegemony. And the places I have in mind are, of course, the greater Middle East where I think most people would agree American power is not what it was and Eastern Europe, the Caucuses, the outlying reaches of the former Soviet Union.

The problem is, because civil war is almost certain to increase in these areas, that is what happens, the chances of the United States or its allies effectively acting in the event of such turbulence are almost zero now. And we've got to be (reminded ?) that one of the consequences of massive fiscal stimulus is pressure on discretionary expenditure. The TARP already will cost more than the total defense budget this year. And you can forget about aid.

The big question, Mr. Chairman, and other members of the committee is whether Russia, China or another power is going to take advantage of the instability in the conflict zones if we sit idly by.

I remain basically optimistic --

SEN. KERRY: Let me just interrupt you there to ask one question.

MR. FERGUSON: Yes.

SEN. KERRY: In terms of dollars spent and return on investment in foreign policy, does that predicate that, conceivably, in the effort to avoid the downside crises that you can't respond to, that there ought to be some component of expenditure and stimulus that is in fact geared towards that kind of conflict resolution or conflict avoidance? Or is that just pie in the sky, you're never going to get it, and you can't ever argue the connection sufficiently?

MR. FERGUSON: I suspect it's politically extremely hard to make the argument.

SEN. KERRY: But is it worth --

MR. FERGUSON: However, I think it would be very unwise for us now to start cutting Defense expenditure on the assumption that the global war on terror has somehow been cancelled due to the advent of the financial crisis. And I detect that assumption in many parts of the United States today. That's far from the case. On the contrary, we are likely to see an increase in terrorist activity as a result of the kind of instability that the financial crisis is causing.

(Poorish ?) democracies are wonderful targets for terrorists, and they become more vulnerable in a crisis. India, for example, is the prime target for Muslim extremists at this point, and I wouldn't be at all surprised if there were other attacks there. We are familiar with the (passing ?) of violence in Baghdad and Kabul, but there's no particular reason why it should be confined there.

I think we need to be extremely careful not to simply allow our Defense expenditure and our aid expenditure to fade because it's discretionary and everything else is going to go up in the crisis. Where we spend the money that we do spend is, I think, an extremely important and hotly debated question.

I would far rather see -- if we are, as it were, having the fiscal policy of World War II without the war -- some of that money going into high technology solutions to security problems than into bridges, because I think the returns on expenditure on counterterrorism will, in fact, be significantly larger than the returns on building bridges.

I'm actually, at some level, optimistic. As I've already made clear, I think the United States is not teetering on the brink of losing its economic leadership or its political leadership of the world. I don't, as I've said, Mr. Chairman, buy the idea that this is the twilight of American power, and I think it is, indeed, possible this new president can follow the example of Franklin Roosevelt and Ronald Reagan and lead the United States out of a financial crisis into a position of greater power.

That's exactly what happened after the '30s. It's what happened after the 1970s. The United States has ridden out major crises and come out in a stronger position twice in the past hundred years. Power is always relative. And if this crisis, as I've tried to suggest, hurts others more than the United States then, logically, the crisis must, in fact, make the United States more powerful -- counterintuitive though that may seem when we're all focused on the domestic economic and social pain that the crisis is causing.

The question -- and this is my final point, is whether we can see that. And I think a body like this ought to be able to see it. The big danger is -- as in the 1930s, as in the last great crisis of globalization, and, I suppose, to some extent, as before 1914 -- we may exaggerate our own weakness, and we may exaggerate the strengths of our rivals. A great recession -- which is clearly what we're in, doesn't need to be the prelude to an American version of Kipling's great poem, "Recessional" -- and I'll resist the temptation to quote it here. Thank you.

SEN. KERRY: Well, thank you -- very, very stimulating, very important and helpful comments.

I happen to agree with you. I do think that you have to measure the relative impacts and relative power, and I think the United States remains not just still the world's, you know, strongest economy, despite our problems, but the strongest power. And I don't see that changing in the next few years, particularly if we make some smart decisions. That doesn't mean we're not going to live through a lot of turmoil and "sturm und drang" as these impacts are felt, and I'd like to, sort of, dig into those a little bit more.

One of the things that does bother me is, to the degree that these countries have bought into the, what you call, you know, "the Washington model;" and banks in Eastern Europe, for instance, have been bought by banks in France, and Switzerland, Italy, England, and now they are, sort of, tightening their vision to their own country and to their -- you know, they've got their set of toxic assets, and they're, sort of -- Therefore, in a place like Hungary there may be no lending -- or in some other countries, they're not alone, I don't want to just single them out -- because they don't own their banks.

I know that in Brazil, for instance, I think it's about 30 percent foreign-owned, 70 percent domestic, so they won't have that kind of dislocation, presumably -- and some are state-owned, some private. But there are other countries in Latin America, similarly, where they face this dilemma.

What do we do about that? Is that an IMF, World Bank -- is that, sort of, on order for the G-22, when they sit down in a month or two, to (save ?) this? "We've got to come up with a new structure here and, notwithstanding our difficulties, sustain them?" Or is there some mechanism already in place that will do that?

Go ahead. First, Desmond, and then we'll come back.

MR. LACHMAN: I think that it's very much the role of the IMF that when you do get these capitals stops there's nothing much left. That is basically for the IMF to try to coordinate some sort of official support to these countries, you know, because otherwise these countries already are in trouble.

It's as you say, that --

SEN. KERRY: Is IMF going to be troubled itself because of a lack of revenues from countries?

MR. LACHMAN: Right. The IMF, basically -- the resources that the IMF have got are negligible in relation to the problems that many of these emerging-market countries are facing. The problem is that through globalization, through these capital flows, the numbers have just become huge. You know, so as soon as the money leaves, countries already do have massive requirements. So, I think that the IMF, you know, that it is going to be playing a role --

SEN. KERRY: Is it adequate, or is there going to need to be a new structure?

MR. LACHMAN: Well, I think that the IMF is going to have to be dealing with the crisis in a very different way than they did when they dealt with the Asian crisis. It's got to be a lot less intrusive. It's got to be a lot quicker.

I think that the IMF is moving in that direction, that they've now got these facilities where countries can get the money without having to meet too many conditions. They can get the money very quick disbursing if they are in sound position -- you know, very much like the lines being offered by the Federal Reserve to places like Korea and Mexico. The IMF has got something of that sort. The IMF is going to have to go in a different direction.

But, I think that the amounts of money you're talking about are huge. You know, that the IMF has only got something like $250 billion to deal with problems that are massive. That's the last several months they've already pushed out something like $50 billion out the door, and I don't think that they really started. You know, my view is that this crisis is going to get a whole lot deeper and we're going to have very many more countries -- you know, countries of significance, like Turkey, you know, kind of coming and --

SEN. KERRY: I want to come back to that in a moment.

Let me just have Niall respond to the other question, and then we'll come back.

MR. FERGUSON: Yeah, the IMF is not only inadequately equipped with resources, I think it may actually be fatally flawed in design. After all, it was designed for an era of capital controls at Bretton Woods. In the absence of capital controls, it now is completely unequal to the task that it faces. It would be entirely -- it would exhaust all its resources, and more, if it tried to help just the East European countries that are currently in trouble. At best, it can give them about half of what they need.

And I think a question we need to address at this point is whether it is, in fact, a sufficient institution for the global financial system that has come into existence, since we dismantled capital controls and completely liberalized the financial system. And I have been arguing for some time that the World Trade Organization offers a better model for what might become a "World Finance Organization." In the sense that, unlike the IMF -- which only really has leverage when a country is in big trouble, we know that the WTO always has leverage, including over powerful countries.

And I think the argument that should be discussed at this point is whether the IMF mutates into something more like a WFO, or is replaced by something more like it. But, it's clearly not equal to the task that it's currently --

MR. MALLABY: There's a compromise on the table here, which is that -- I mean, I think that Niall is right, the attractive thing about the World Trade Organization is that there's a place where Brazil can win a case against a superpower, and so everyone feels that it's legitimate.

And you could have a situation where if the IMF sharpened its consultation process with countries -- for example, specifically China on its exchange rate, and determined that China was manipulating its currency, the WTO dispute settlement mechanism, the tribunal there, would view that IMF opinion as sufficient grounds to uphold the case against China for trade distortion. And so you'd be marrying the strength of the two institutions.

My own view about the IMF and the size is that, look, you've got a choice -- which I think you were hinting at in your question to Desmond, so obviously it's too small to deal with the vast capital flows. We have, sort of, two or three options for responding to that: One is -- which is the one of the last few years, each country for himself; amass huge amounts of reserves to ensure yourself against the danger of capital flight.

And then you have talk about the rise of state capitalism, because governments are just sitting on piles of money. That's not a sensible use of savings, that just locks up money in a vault. It's much better to have a credit union, where you collectivize the savings in the IMF so everyone doesn't have to save for themselves. And you limit the amount of the hot money that has to flow into economies when every country is accumulating reserves. They're going to (pile it ?) into T-bills, and it's going to cause another subprime bubble.

So, I'm strongly against leaving countries, "every man for himself, " to just accumulate reserves. I'm in favor of some kind of international mechanism. It seems to me we have the IMF -- for all its flaws, and I think it can be improved, it's the best thing on offer.

And to get to Niall's point about, you know, the advantages of the WTO, yes, I agree with that. But, there's an alliance there. They can work together.

MR. GORDON (?): The key for the IMF, though, is you have to find a way to change the governance of the IMF to make it attractive for a lot of the surplus countries to come in with contributions that will enable a multilateral mobilization of those surpluses. And so that's the other piece of this that will have to be put in place.

MR. MALLABY (?): Right.

MR. REDIKER (?): (Inaudible) -- (just a comment ?) I mean, the word that hasn't been mentioned here on all this is "enforcement" or "enforceability," because I think what you were alluding to with WTO, or WFO, or whatever, is it's got to have teeth, because currently, right now, you can have consultations, and consultations and discussions, and governance discussions, and all the rest, but currencies -- countries that have big currency imbalances are not going to change their behavior just on the basis of a bad story in the Press or a diplomatic overture which may cause some hurt feelings. There's got to be some sense of enforceability. And that's the difference between a WTO structure and any of the other type of structures that are out there today.

But, just to revert back to your first question, I think, about Hungary's banks, and that circumstance. I just want to point out that even if the IMF was well-capitalized and had all the resources, both financial and personnel, that it needs, it is not structured to go in and make individual loans to those people in Hungary, or other countries, who suddenly find that their banking system has been shut down because of the financial protectionism that you described, where most of their banks, if not -- I think it's 85 percent in Hungary are owned by foreign banks.

That is going to require some very big, more systemic thought. At the G-20, I think, is a good place to start. And also some, you know, public statements that the U.S. and others are against financial protectionism, in spite of a natural inclination to pursue it for domestic purposes.

MR. MALLABY: It's interesting that there have been two responses to the fact that the IMF has too little money to deal with the crisis -- the Japanese response and the U.S. response. The U.S. response is that the Federal Reserve bypassed the IMF and directly provided dollars to four important emerging economies -- Brazil, South Korea, Taiwan, and one other one. That was the U.S. response --

MR. : (Inaudible) -- (Provided name of fourth country.)

MR. MALLABY: Okay. The Japanese response was that they provided $150 billion, or something, to the IMF. They took a multilateral route for it. I think that's quite revealing.

Another option which we ought to mention at this point, which would in some ways be simpler, is the old 1980s model of agreements on exchange rates -- Louvre, Plaza. I mean, half these problems arise from the fact that we live in a world of globalization without the gold standard, with fiat money currencies and a strong temptation to manipulate those -- particularly, from the East Asian point of view, to promote exports.

So one simpler option -- and I think all of this is relevant for the G-20 because I'm sure these issues are going to be on the table whether the United States wants it or not -- I think another issue to contemplate is simply exchange rate agreements. Get the major powers to agree and avoid what seems to me to be the biggest risk at the moment, which is an explosion of volatility in foreign exchange markets.

MR. LACHMAN: I think that we've been down that route before, is that exchange agreements, in a world in which you've got free movement of capital, just doesn't make -- you know, that one really does have to have flexibility.

But, if I could just go back, you know, to the issue of the IMF and the G-20, you know, I don't think that we've got the luxury of talking about changing the world architecture. The crisis is right now. The crisis is going to intensify. I think I would agree with Sebastian, we've got to make do with what we've got, however flawed it might be.

SEN. KERRY: Let me come back to that.

Do all of you agree that this is not the time to -- I mean, we've heard these Bretton Woods II talk, and other talk, is this not the time to be considering, sort of, changing the architecture? Or do you have to change the architecture in order to change the rules of the road to respond?

MR. GORDON (?): I think you have to evolve the architecture. I don't think it's the time to start all over again. So, I think, for the IMF, it's back to the future. The IMF, six months ago we were worried about what role for the IMF in an economy that no one wants to get their resources.

Now the question is, how we can give them sufficient resources to do --

SEN. KERRY: Yeah, but that's all plugging holes, obviously --

MR. GORDON (?): Right.

SEN. KERRY: -- and the question here is, are there steps that we can take? For instance, I assume that it's agreed in the panel that one of the largest challenges is the Chinese model, and this whole issue of export-based economy -- basically, the United States, and we're borrowing to do it. Is that fair?

MR. GORDON (?): Mm-hmm. (In affirmation.)

SEN. KERRY: So, what's the biggest step that we could take, that would have the greatest impact on changing that in the least negative way?

MR. GORDON (?): I believe that that's going to have to be, first and foremost, a bilateral -- bilateral negotiation, and --

SEN. KERRY: And what's the, what's the -- what are elements of negotiation?

MR. GORDON (?): Well, I think that the --

SEN. KERRY: The minute we talk about currency manipulating everybody goes wild over there, so --

(Cross talk.)

SEN. KERRY: -- what are we talking about?

MR. FERGUSON: We should stop -- we should stop doing that. I find it extraordinary that Secretary Geithner did that almost the moment -- even before he was confirmed. I can't think of a more provocative thing to say to the crucial partner that United States currently has. And I still -- I'm marveling at its recklessness.

SEN. KERRY: Well, I think it was less --

MR. GORDON (?): If you take the whole thing in context, there was less there than met the eye, and the Chinese response, frankly, Niall, was they took it in and they did not see -- they did not make a reckless response to it.

I think both China and the U.S. have a essentially cautious approaches to each other, but we don't have a framework for getting from an economic model that we used to have, to one that we need to have. Part of it has to do with setting out a pathway for the Chinese, over a period of time, to shift toward a more consumption- based economy, combined with continued openness on --

SEN. KERRY: -- (inaudible) -- would that begin to happen automatically? I mean, you've had some 600 million people brought in to -- out of an agrarian society into a semi-industrial society, many of whom -- I mean, there's an increasing purchasing class, consumer class/middle class, even growing, in both India and China. Does that evolve on its own -- in a sense, as the --

MR. GORDON (?): It does, but probably not fast enough.

SEN. KERRY: Not fast enough.

MR. GORDON (?): That's the problem.

(Cross talk.)

MR. MALLABY: Yeah, I think (just even ?) Japan would tell you that you can get very rich and still have a huge savings -- (inaudible) --.

MR. FERGUSON: Another issue which is --

SEN. KERRY: -- (inaudible) -- sorry.

MR. FERGUSON: Just let me throw this in, Mr. Chairman. We must bear in mind that not everybody plays by the rules of what we used to call "the Washington consensus." It's not world of free capital movements, because the Chinese don't allow free capital movements. And one of the big questions is, what would happen if they did?

I actually think that if they did allow free capital movements there would not need to be this huge reserve accumulation, because the Chinese would very like -- much like to have apartments in Boston, San Francisco, and the rest, so that they could prepare their children more effectively to apply to Harvard and Stanford.

And there is a sense in which there is a potentially large outflow of capital from China to us, would the Chinese only allow it to happen. Now, I don't think they'd dare, but it would be worth suggesting to them that this might be simpler; that if they all played by -- if we all played by the same rules, in a free capital world, there would actually be adjustment. It's the fact that they don't that has caused the distortion.

MR. GORDON (?): I think that the leverage that the United States has, and the continuing influence that the United States has over China -- that we don't have over Russia, frankly, is the Chinese are scared to death about having an economic growth rate that is not sufficient to sustain social stability. And they see their economic partnership with the United States as the only pathway out of that.

SEN. KERRY: Well, I agree. The Chinese model is significantly tied to their domestic political strategy and always has been. I mean, it is linked to stability, stability, stability, and to the way in which they perceive that ability to deliver to their citizens. So, that's a hurdle. That's obviously a big hurdle.

But, come back for a minute to -- I mean, when we go sit down in -- (inaudible) -- what's the element of the negotiation for us if it's not the currency directly? What is it?

MR. MALLABY: Well, one thing is to look at the content of their stimulus. I mean, if they spend their stimulus -- which I assume, as Senator Cardin said, will get bigger over time, if they spend it on, sort of, hard infrastructure, (buy ?) stuff that's going to increase the power of their export platform, it's going to be bad, over time, for -- (inaudible) --. I mean, it's going to increase it.

If, on the other hand, they spend it on soft infrastructure -- meaning health services, their pension system, things that reduce the prudential reason for Chinese households to save, that's going to be great because that would encourage more consumption in China and, over time, gradually will encourage adjustment.

SEN. KERRY: Let me come back to a question, I think, you mentioned, Desmond, the potential of more pain. More countries feeling the downside of what is going to come.

Let's assume for a minute -- take us through, all of you, that it does get worse, what's the meltdown scenario here, and what is the accompanying threat with respect to al Qaeda, Lashkar-e-Taiba, you know, Jaish-e-Mohammed, all these elements that are out there that can just thrive off that kind of meltdown? Give us the picture.

MR. GORDON (?): Well, I agree with -- I agree with Niall that the main threat here is South-Central Asia. And I think that India is the focal point, and that India has the intersection of the external challenge from its neighbors, and a growing potential challenge from extreme elements in its own Muslim population -- a population that's been historically very moderate. But the Indian authorities are really worried about some signposts there.

But the other point that I think is really challenging here is if we are in this downtown scenario, and we can't make the commitment to dealing with Afghanistan and dealing with Pakistan, and it's going to take both financial resources and military resources, our risk here is going to increase. I think you put it well, we're in a race against time.

MR. LACHMAN: I thought that the factor that one really has to be worried about, in terms of political fallout, is the fact that the International Labour Organization, on a relatively sanguine forecast, is saying that we could be losing 30 million jobs globally in 2009, and that the number could be as high as 50 million.

If the crisis deepens, and we don't resolve it by 2010, those numbers are going to get a whole lot worse. So, I would have thought that -- you know, picking up what Niall Ferguson mentioned, you know, with volatility in countries' economic performance leading to political strains, I would have thought that this is very much in the cards.

Just as far as China, I would have thought that the leverage that we've got over China is that China has to have the greatest stake in keeping a globalized system alive. And all that they've got to do is look at what happened to Japan at an earlier stage, and how Japan got shut out of markets when it insisted on wanting to export.

What Sebastian said is absolutely correct, is that there's no way that a country that has reached China's size can increase its exports by 25 percent a year. You know, when you extrapolate that, something has to change and, you know, it looks like the moment has come.

SEN. KERRY: But, take us through. Paint the picture of cause and effect with a particular country and this continued downward spiral.

MR. FERGUSON: Perhaps I could throw in a thought here.

SEN. KERRY: Sure.

MR. FERGUSON: It's clear that we're not yet in a great depression, but the way you get into one is that you get into a tailspin of collapsing trade and then "beg of our neighbor" policies that are designed to mitigate that. As this tailspin worsens, unemployment rises.

Your original question was, how does this connect to terrorism and internal instability in countries? And I think it does in the following way: It's not so much the poor who become terrorists, it's the disappointed. And the problem with the surge in unemployment that Desmond Lachman is talking about is that it will affect people in the Subcontinent, and elsewhere -- and in the Middle East, in the Gulf States, who had high expectations, who did get some education, who did get jobs, and now lose them.

And those are the people who are most likely to be attracted by ideologies that say, "this is the fault of the Great Satan," "this is the fault of Washington's system." And that's what worries me most.

One of the interesting things that happened in the 1930s was that the disillusioned turned to primarily nationalist movements, and were quite quickly mobilized into states-based organizations. But that was the essence of fascism.

But, that may not happen this time around. Certain governments will try, however, to play that card. If you are an authoritarian regime suddenly confronted with a surge in unemployment, and a lot of frustration and disappointment among -- remember, young people, because these are relatively youthful societies --

SEN. KERRY: (Off mike.) -- (inaudible) --

MR. FERGUSON: -- you're going to have to mobilize them. And so the neighbor becomes the focal point.

And I do think whether we're talking about China, India, Pakistan, any of these major Asian countries, that looks like a likely scenario if the alternative is that people drift into terrorist organization and non-state agencies.

MR. LACHMAN: If I could just add something to your focus in this point --

SEN. KERRY: I want to give everybody a heads-up. We have about 10 minutes left, simply not because I want to cut you off, but because my schedule predicates that I have to be elsewhere, so.

MR. LACHMAN: The point I just want to make simply is it's not just a question that unemployment is rising and people finding difficulty in jobs, it's a question that people's net worth is being wiped out by this crisis; that it's very striking that across the globe equity prices are down by something like 50 percent, and it makes not difference which country you look at, this has really occurred.

I would have thought that that has to create a lot of anger, a lot of frustration. You know, people's life savings really being wiped out. And this is, in fact, what occurs, that if this crisis deepens we just get into the cycle that the asset prices fall more, the banks have more trouble. You know, we're really in a vicious cycle that really needs breaking, and I don't see how you break it unless you get coordinated policy action. And what I'm seeing is very little response from Europe.

SEN. KERRY: Very little response?

MR. LACHMAN: Response, right -- that they're very reluctant to reduce their interest rates. They're very reluctant to really clean up the banks. They're very reluctant to do anything -- the Germans, particularly on the fiscal policy side. You know, I'm just not sure how you break the cycle.

MR. MALLABY: I think, you know, to tie this back to policy, what we're all saying is that -- and this is why I find the IMF projections instructive, not because I take them as gospel, but simply because they give you a sense of how one particular forecasting unit has radically changed its outlook.

And this gets to, you know, what drives terrorism. It is, as Niall said, "the disappointed." It's when you expected to be getting richer and suddenly you're negative. It's that change in -- that shock to mentality.

And so I think, you know, Niall's earlier point that, as a result of that it would be unwise to suppose that, you know, we can have the luxury of only focusing on the economic challenges. In fact, the foreign policy challenges have gotten worse. The likelihood of -- the need for contingency planning, the need for expecting the unexpected, the need, the possibility of bad things happening has gone up, not down.

SEN. KERRY: What should the president and our country put on the table in terms of the G-22 meeting?

MR. FERGUSON: I think the G-2 is more important -- in other words, the meeting between the United States and China, because I don't believe the G-20 can really achieve terribly much. It's far too unwieldly a body. I mean, it took two men, representing two powers, to come up with Bretton Woods. The idea that 20 different countries, with highly divergent interests, will come up with anything at all, other than grandstanding speeches, seems to me to be almost zero.

So, I think the most important thing to focus on that is what to say to the Chinese. I think, Mr. Chairman, that future historians will look back and say, "What a terrible opportunity was missed in late '07 to achieve a global bailout. When the Chinese dipped a toe in the water and contemplated investing in the U.S. financial sector, and then (took flight ?), didn't do enough. So the Morgan Stanley investment and Blackstone go pear-shaped and decide it's better to stick to Treasuries.

I still think there's a chance you could salvage this by saying, "China, the opportunity is there to do the one thing that would stabilize the global economy, which is to stabilize American asset prices in the financial system." It's impossible, actually, for the U.S. taxpayer, credibly, to recapitalize the U.S. financial system. It's actually plausible for China -- the Chinese to do it. It's they who have the $1.9 trillion in reserves.

And, of course, as I mentioned earlier, if you did relax capital controls --

SEN. KERRY: You say it's impossible. It's not impossible. You can do it. It's (just that ?) -- (inaudible) --

MR. FERGUSON: It's implausible.

SEN. KERRY: -- if you're going to play it at the back end, you're going to have some inflation -- (inaudible) --

MR. FERGUSON: It's implausible -- exactly because of the huge fiscal problems.

You earlier made the point that this began with a crisis of excessive leverage in the household sector and the financial sector, and we're trying to solve it with increased leverage in the public sector. And this is going to strain credulity on the part of international investors. The moment that shows up on the long end -- in the 10-year yields, and the yield curve is already steepening, the Fed is going to have to step in and start printing money.

I don't think this leads to a crisis of the dollar of the sort that people have been forecasting for so long, but it does lead to volatility. It'll be, "Is it safehaven --

MR. MALLABY: But, Niall, to the extent that the Chinese buy U.S. Treasuries, they are, sort of, financing our efforts to recapitalize the banks anyway, aren't they?

MR. FERGUSON: Right. Indirectly.

MR. MALLABY: I mean, I don't think it really matters if they do it directly or indirectly. And, in fact, directly must be -- may be worse because then you get political worries about Chinese controlling the U.S. financial sector, and so forth. It may be better if they just buy Treasuries.

MR. GORDON (?): And in the short-run there's no pathway back, credibly, to where they would say, we're going to do this without a degree of risk, because they would know that the U.S. polity would not enable itself. I don't think that's -- I think it's a tough one.

MR. REDIKER (?): -- (inaudible) -- may have a little bit of an outlier here on your question about Bretton Woods II and the G-20. I actually think it is time to use that forum for a bolder approach. And I think -- I mentioned in my written statement, Paul Volcker's G- 30 actually set forth, I think it was four core areas and 18 specific proposals. They were well thought through. They included a very international approach. They were signed on by all the other members, including Secretary Geithner and Larry Summers as members of the group, although they didn't take responsibility for the authorship or the specifics. I think that is a -- (inaudible) -- this administration would do very well to look at in going into the G-20.

I certainly agree with Niall's point that the key relationship is the us and China, but I think the G-20, whether we like it or not, is, in fact, the forum at which we are going to see some of these areas discussed. And if we go in and assume failure, or assume the best we're going to get is incremental steps towards the next G-20 meeting six months later, then I think the rest of the world is going to look at that as a disappointment and it's going to send a very bad signal.

SEN. KERRY: The biggest single step the U.S. could take to send the message abroad and try to restore confidence would be what?

MR. GORDON (?): Well, I think that the president should take a much more proactive step in getting out in front on protectionism. On the stimulus package, he ended up doing the right thing but only after prompted internationally. I think that a much stronger statement against financial and trade protectionism --

SEN. KERRY: That is creating jitters.

MR. GORDON (?): Yes. And combined with a commitment to expand the scale and scope of the International Monetary Fund. I think those are --

SEN. KERRY: Do you all agree that -- (inaudible) -- to be recapitalized?

MR. : Yes.

MR. : Yes.

MR. : Yes.

SEN. KERRY: And if everybody agrees they have to be, what's the simplest, quickest way to do it?

MR. FERGUSON: A Swedish-style temporary nationalization of insolvent institutions.

SEN. KERRY: Say again?

MR. FERGUSON: A Swedish-style temporary nationalization of insolvent institutions, wiping out the equity holders and giving the bond holders a 20 percent hair cut. That's what should be done. We're dithering, and it's going to cost money to dither.

MR. LACHMAN: Right. I'd agree with Niall Ferguson that what we're trying to do is we're just trying to pretend that these institutions are solvent. And it just seems remarkable that --

SEN. KERRY: How do you value -- can you, can you do it -- I mean, I hear the word "nationalizing" and everybody goes bananas, obviously for all the right reasons.

MR. FERGUSON: I prefer "restructuring." (Laughter.)

SEN. KERRY: Well, isn't it -- isn't it possible to do it, though, literally and honestly, without, in fact, you know, getting the government that directly involved? I mean, you could take warrants, or you could take common stock in a certain form, and stay out of the management of the bank, and not actually manage it but have the impact on the recapitalization, (could you not ?)?

MR. FERGUSON: I think the management of the banks has been the problem. (Laughs.)

SEN. KERRY: Well, in many cases, change the management. In many cases, change the management.

MR. MALLABY: But, I don't think that, conceptually there's -- you're exactly right that, you know, what you do is you create a government-run bad bank; you take the bad assets out of the existing banks; you --

SEN. KERRY: A lot of people are arguing that if you create a bad bank you're simply subsidizing the shareholders and avoiding --

(Cross talk.)

SEN. KERRY: -- and overpaying for the assets.

MR. REDIKER (?): That depends on the value -- that depends on the value issues of what you buy the assets for, and all the rest.

SEN. KERRY: Correct.

MR. REDIKER (?): -- (inaudible) -- why the warrants (are key ?). That's why you said warrants, and I think that's the answer to that objection, is that if you -- you know, in five year's time we'll be able to look back at the price at which the government acquired the bad assets out of the banks, and if it turns out that the price involved a subsidy to the bank shareholders. then you've got warrants in those banks and you pay the taxpayer back.

SEN. KERRY: But, you all are saying that's the single biggest step that you think would make a difference?

MR. MALLABY: Yes, but the problem is -- and I think the reason why we haven't got to it yet, is that, you know, (the possible ?) estimates of the amount of losses out there in the system are $2.2 trillion of losses. (So, without ?) troubled assets, it's more than $5 trillion.

The administration does not want to come back to the Congress and say, "Hello, we need a bad bank, we want to buy $5 trillion of assets.

How about appropriating $5 (trillion)?" That's why -- (inaudible) --.

SEN. KERRY: Question: You say we're not there, but if you continue down the road we're going, and they don't get rid of the assets, and they cannot lend, and the economy continues to get worse, don't you get there anyway with a lot more pain?

MR. GORDON (?): Yeah. This becomes politically viable after we have -- after we go through another round or two of pain. But, I think it may not -- I do not believe, frankly, that it is politically viable to do what we're going to have to do right now, and that's a very troublesome -- (inaudible) --

MR. REDIKER (?): But the history of every other circumstance even remotely analogous is they end up where we're all saying you're going to end up, it's just the political --

SEN. KERRY: More expensive, more pain --

MR. : Yeah.

MR. : Yeah.

MR. : Yeah.

SEN. KERRY: -- longer?

MR. : Yes.

MR. FERGUSON: Well, every passing month sees real estate prices fall by 18 or 19 --

SEN. KERRY: Well, the problem with it is if you delay it your $2.2 trillion/$5 trillion actually goes up --

MR. FERGUSON: Right.

MR. : Correct.

MR. : Right.

SEN. KERRY: -- because you create a lot more toxic assets, and you wind up with a bigger pot that you ultimately have to bailout (folks ?).

MR. FERGUSON: One thing that would make a lot of difference, I think, from the point of view of international perception, would be if the United States simultaneously, with this restructuring of the financial system, made credible commitments to deal with the off- balance-sheet liabilities of the federal government -- the unfunded liabilities of Medicare and Social Security which are the "Enron," as it were, of public finance.

Like so much in the history of the last 10 years, they're off- balance-sheet but they're waiting to become a problem. And I think this has been hinted at by the administration. I think it would be an extremely healthy measure if, in the midst of this pain -- which involves so much red ink, steps were taken that, over the long-term, major structural problems of public finance were addressed. I mean, if one is going to grasp a nettle, grasp all the nettles at once, it seems to me.

SEN. KERRY: You're saying the reform part?

MR. FERGUSON: That's right. I mean, if you reform Medicare and Social Security at the same time then there's a -- then there is a plausible case that the United States will ultimately achieve fiscal equilibrium. But that's not plausible at the moment, and I think that's one of the problems, is trying to address the problem of bank insolvency.

SEN. KERRY: Well, we've scratched the surface of a lot of very, very tricky and obviously monumental issues in a unique moment, a challenging moment, an historical moment, and one that we hope we can turn around and rectify it. But I think your comments today have been very helpful in helping us to, sort of, frame some of these questions.

And what we're going to do is try to sit down and scope some of them out and see how we pursue, as a committee, some proposals to the administration, and also some things we might be able to act on ourselves. We would welcome your ongoing thoughts and comments on this. We're going to leave the record open on this in case any of my colleagues have questions they want to submit in writing.

But, I'm very appreciative to you for taking time to be here today and help the committee to begin to frame this discussion from our perspective. Thank you.

MR. GORDON (?): MR.: Thank you very much for having me.

(Cross talk.)

SEN. KERRY: Thank you. Stand adjourned.

END.


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