Martin Wolf on Alphachatterbox: the transcript

PART 1

[Cardiff Garcia] Our listeners might not know that you spend a couple of months in the Americas each year, in New York mostly but also you travel around quite a bit. How is your sojourn treating you this summer?

[Martin Wolf] I've been slightly stunned and horrified by how hot it is in New York in September. But it's been very interesting and always gives me a different view of the world. I don't think it would be good to be here all the time, because I think being in America warps your view of the world very, very badly. But it's very nice to be here for a few weeks.

So you’d advise Americans to get out of here as often as possible to get some perspective.

Yes. I think of it as a reality distortion field, because of the weight and power of the United States and its distance from everywhere else.

First, Americans have to realize that that their country is in many respects, both good and bad, abnormal. And it's good to realize what other places are like.

And second, it's important for them to realize that actually what they do is not the only thing that matters in the world ­­ [to] have some sense of decisions being taken elsewhere, and how those decisions affect them.

That cosmopolitan perspective is evident in your book [The Shifts and the Shocks] as ​ ​ well. And I think the book is, if not unique, certainly unusual (for a crisis book) for its emphasis on Europe and emerging economies. I think it's probably about a third of the book, if not forty percent or something like that. When you set out to write it, did you intend to make sure that the euro zone got more attention?

Yes. In fact I think it must be almost half of it.

I had two objectives in this regard. First, to make clear that I view it as a global crisis, or a crisis of the global system, in which of course the US is an enormously important player. Probably, or certainly, the single most important player, but it's not the only player. I argue that the US was profoundly influenced by what happened elsewhere and that drove it.

And second, I also wanted to stress that the crisis didn't only happen in the United States; there were huge crises elsewhere with huge consequences. In China for example which we're now seeing it playing out.

So I felt that's what I could add to what I look at normally. And I think far too many of the books – this is just a guess, but perhaps ninety percent of the books written on the crisis ­­ have been written almost as if it only happened in the US. And as if what the US did was the only thing that mattered. I think that was wrong.

We're going to talk about some very dense themes from finance and economics. But before we do, I want to start with your introduction to the book, where you are personally revealing in a way that is rare for you, probably because your columns have space considerations.

So there's a lovely passage where you talk about your own personal values, how they were informed by your family. And you mention your father Edmund Wolf, a Jewish refugee from Austria. You describe his values as anti­fanatical and pro­Enlightenment.

Can you just share a little of that with our listeners ­­ how your own values and your own background have informed how you’ve come to think about economics and finance?

Well, that's difficult to do briefly. But first, I've always tried in my columns ­­ I don't know whether this is right or wrong, but it's the way I think the job should be done ­­ not to make them about me. To make them about the analysis. Because if you're writing columns, over the years you don't want people to believe what you're saying just because it's you. Authority is, I think, worthless. You have to provide evidence and arguments.

But a book is a different thing. If you're persuading someone to read a book of three hundred and fifty pages of text or so, you want to interest them in it ­­ and to some extent interest them in the author.

Most of it is rather dense analysis, as you said. But I wanted to make clear why I got into economics in the first place, why I think it's important, why it's always interested me. And what the political values are that drive me.

And as you noted there are two or three absolutely central elements.

First, I am directly a child of the Depression and the Second World War and the disasters that went with that. And I see those disasters as very much rooted in economic catastrophe, the Great Depression and all the rest of it.

Avoiding that sort of catastrophe is I think a prime function of economics, and that's why I was interested in it. I also inherited, partly because of those disasters and from my father's own values ­­ he was a writer, a journalist and a playwright ­­ a basic belief that there are civilized values. Those values are about the importance of individuals, of freedom and of democracy. But in a very un­fanatical way. So he perfectly well understood the role of the welfare state, and he was very much at that time a social democrat.

But he was also very fiercely anti­Communist because he saw that as the fanaticism of our time, just as Nazism was the fanaticism of his youth and young adulthood. So those values have always driven me to try to pursue the median, the middle way. And to justify and defend it ­­ both more broadly but above all in economics ­­ which I see is sort of a necessary condition for social, economic, and political stability.

You talk about how the threats to a widespread belief in a globalized economy, to those liberal democratic values ­­ those threats have changed in shape. They used to be collectivism, Communism. Now it's income inequality, sluggish growth. Was that the impetus for writing the book itself?

Yes. It is clearly true ­­ as one gets older, one learns ­­ that for thirty years I didn't have this perspective: I had not really taken on board how cumulatively, from the 1980s onwards, the transformation of our economies ­­ which in some respects, I think particularly globalization, were good ones ­­ was also unleashing forces which were increasingly, obviously dangerous to the sort of democratic, peaceful, consensual societies I believe in.

And here the main dangers were indeed rising inequality and the emergence quite clearly of something that looks more and more like plutocracy. Particularly here in the United States but also to some extent in Europe. The rise of economic insecurity, and with that, increasingly intolerant attitudes in the population, particularly the re­emergence of a sort of populist right, and the enormous economic instability triggered by financial liberalization done in a very bad way, in the context of a mismanaged global economy.

And these things together brought our economy very close to collapse. I had never imagined ­­ it was a lack of imagination ­­ that we we would get so close to the 1930s. But that time, and I think for the succeeding six months, we really were there. All the evidence showed that.

And so I really devoted all my writing then to trying to persuade people to take very decisive action. I don’t say that [my writing] was particularly important, but the action was taken.

But then I was very disappointed by the aftermath. We are still very much in this post­crisis world. And that was the experience that persuaded me ­­ those values, those fears and that experience ­­ to write this book.

The scope of The Shifts and the Shocks, for people who haven't read it yet, is immense. ​ ​ It's nothing short of your proposal for a comprehensive new intellectual framework for how to reconstruct the global monetary system. For how to structurally change the nature of economies in the developed world, but also in the emerging world. Did you set out to be so ambitious when you first started writing the book? Did you know that it would be this big a project?

No. What is now in the first half, which is the account of the crisis and why it happened, was really where I started. In a way that was for me to explain to myself why I missed so much. There are one or two economists who got little bits of it. I don't think anyone got it all, though some people who I respect got quite close to it.

I felt that I understood some of it, but there was a very important thing I hadn't understood. And the thing that I felt that I'd failed most to understand is how the macroeconomic forces – the big forces of savings, investment, trade, the balance of payments ­­ interact with money and finance. That's something that I think became missing in economics, so I had to study that. So that's what I planned to start with, to have an explanation of why this happened.

But then as I read more and thought more, and talked to more people, I became more and more dissatisfied with the system we have. I became increasingly convinced that it's only a matter of time before a new and possibly bigger crisis emerged.

And so I thought it was very important to start discussing serious reforms at all levels. I actually feel that the book is only part way through this program. But at least I felt that I had to put down for people some sense that they should not be satisfied with where we are. And they should recognise that we operate an inordinately fragile system, which is basically more or less designed to fail.

The ghost of Hyman Minsky is very present in this book. His reputation has been reinvigorated in recent years after having been ignored for quite some time. You've said that Minsky was doomed to be merely right but not rigorous, in that that was why he was ignored: he didn't have a macroeconomic model, and he wasn't the best or most lucid writer in the world. But clearly he influenced this book quite a bit.

Yes. I think part of the problem economics has ­­ and I can't say that I have it: I don't have the genius for it ­­ is that economists want precise, rigorous models which are easily mathemati­cizable.

And they can be easily taught; you get lots of disciples who can produce more models with wrinkles just like that. But I've become increasingly persuaded ­­ perhaps I always felt like this, but even more so now ­­ that such models don't capture absolutely fundamental aspects of social reality.

And what you need is an insight into those.

Minsky had some really profound insights into the way people behave and into the way certain features of our economic system ­­ basically balance sheets and balance sheets relations ­­ drive the economy in the actual world. Which is a world, as all pupils of Keynes will understand, of radical uncertainty. Which is of course also the Frank Knight view, that the world isn't calculable; you can't reduce it to risk in any way.

Now once you take that on board it becomes obvious that it's really, really hard to produce rigorous models. Certainly generally­optimizing models become almost effectively impossible. And you have to think about economics in a very different way.

And this influenced me enormously. As I note in the book, the single idea and the one really pithy statement of Minsky that seems to me the most potent in understanding what happens, is the sentence “stability destabilizes”.

The very fact that everybody was persuaded there was a Great Moderation, the phrase used before the crisis, that we had cracked the problem of monetary policy, that our financial system was fantastically good at managing risk, at distributing risk efficiently to people who could bear it – there were all the ideas we had, and they should have warned us that something terrible was going to happen.

Because risk is endogenous to the system. The system creates the amount of risk it wants. That's the essence of our financial sector and the way in which people interact with it.

That to me is Minsky’s greatest and most powerful insight. And it means we should be terrified pretty well all the time. And particularly when everybody thinks everything's fine.

So one of the challenges of discussing a book like this one, that covers such wide territory, is knowing how to start talking about it. I've tried to come up with some kind of a systematic framework just for this discussion.

Here's where I want to start. You wrote a book that was published in 2007, but based on a series of lectures that you gave in 2006. The book was called Fixing Global Finance. It ​ ​ was a tour of global macroeconomic imbalances in capital flows and trade. And that came to play a very big role in the crisis.

Why don’t you start by taking us through exactly what role those macroeconomic imbalances played, and then we'll start talking about some of your ideas for fixing them. Because it’s a prism through which you seem to view a lot of the world and a lot of what happens in global macroeconomic cycles.

Yes. I don't think it's what always drives things but I think it has been very important in many episodes ­­

And underappreciated, right?

And underappreciated. And it's something I've been particularly interested in. When I look back on that book, I believe that its fundamental analytics were correct but didn't begin to go far enough. And that's why I wrote this book.

So the basic idea is that, stripped down, there were some very large shifts in the world economy in the late 1990s and early 2000s. At the end of which ­­ just to mention, the most important of which were the Asian financial crises and the rise of China, and the policies pursued by China ­­ the emerging world became essentially a huge capital exporter in aggregate, and pursued policies for a long time designed to reinforce those capital exports. Huge reserve accumulations, deliberate undervaluation in real terms of their currencies relative to what I think would have happened under floating rates. And they started to accumulate huge surpluses.

There were a number of other developed countries ­­ Germany and Japan in different ways ­­ pursuing quite similar policies, to some extent accidentally as a result of ageing, or as a result of collapses in the desire for investment in their corporate sector, which also generated huge excess savings.

And this is something that I develop more in my current book rather than in that earlier book: I have become more aware of the shifts in income distribution within our countries and the effects they have had. But the net effect of this was huge capital exports and a huge shift in the balance between savings and investment, shown in the real interest rate from the late 1990s onwards.

Now, the world economy has to balance. Demand and supply must balance, demand must equal supply. The question is at what level of activity.

My argument is that in the world system that we actually have ­­ this is slightly simplified ­­ the Federal Reserve acts as the global balancer. It effectively balances demand and supply, because when there is ever a huge net export of capital from the rest of the world, it almost automatically takes the form of excess demand for US liabilities ­­ or US assets if you like, or claims on the US to be most precise. Because it's the safest place. It's got the biggest capital markets, where everybody wants to put their money looking for decent, safe returns.

So what happens then is in those periods, and we're seeing it again right now, the dollar goes up and there's a squeeze on output in the United States. This tends to be contractionary. The current account deficit of the United States starts rising quite rapidly, and this is a contractionary shock for the United States.

And the Fed says to itself, “We’re not gonna hit our inflation targets, we’re going to have to pursue a more expansionary monetary policy”. Not because they think about it in these terms, they don't have to, they just see it. And by pursuing this more expansionary monetary policy, they do in fact create a huge demand boom in the United States.

This leads to the absorption of these excess savings, still at full employment in the United States. And as I said, the Fed ends up acting as the de facto balancer of the entire world economy.

Because the Fed is the one player in the system that is completely unconstrained in its ability to create money. And therefore it becomes de facto the world’s central bank.

But can we take a crack at explaining this in more basic terms, because we do have a lot of listeners that don't have a deep background in economic thinking?

Okay.

I loved that book, by the way. That book is partly responsible for my interest in becoming an economics journalist myself. And I came across it when I was a young­tyke journalist. But what I liked about it was the clarity with which you explain what happened in the aftermath of the crises of the 1990s.

So I’m going to take a quick crack at explaining what happened in very basic terms so that people who were like me in the middle of the 2000s can understand it.

You have these Asian financial crises. In the aftermath, you have three kinds of countries that have an interest in building up a stock of safe assets.

[1] You have the countries that want to keep their currencies down because they have an export­led model: if they have a weaker currency, it makes it cheaper to buy their products. China of course is foremost among them. The problem is that as they accumulate all these reserves ­­ the way that they keep their currency down is by selling it and buying US dollars ­­ and they have all these US dollars and they need to buy US assets with them, safe US assets. They end up buying treasuries.

Mostly. Also liabilities of the GSEs.

Or the GSEs, exactly, so things that are backed by the government, if not Treasuries themselves.

[2]Then you have the commodities exporters, who are selling [commodities] in US dollar terms, so they have all these US dollars. They also need to buy safe assets.

[3] And then there are the countries that experienced those financial crises at the end of the 1990s. And they're terrified of it happening again. So they want a stock of foreign currency denominated assets that they can use to defend against financial crises in the future.

So you have all these countries buying an immense amount of safe US assets. The problem is that it holds down the interest rates on those assets, because of course as you buy fixed income securities, the yields go down. The Federal Reserve has a problem now, because it wants to control the yield curve. It wants to control interest rates. But even as it's trying to raise rates, as would be appropriate for the US economy at the time, long rates stay low because so many countries are interested in buying those assets.

And so you have a problem of control for the Fed. I came across this concept first in your book before I’d ever heard of the “savings glut”, which is a similar concept that Ben Bernanke talked about. But that's where we are going into the crisis. So I'll stop there, and I hope I've done an adequate job of explaining this. Why did it matter so much in terms of breeding instability going into the crisis?

Okay, that's a simplified version but I can live with that because there's so much going on and more that I have to say.

My present book is more complex because it's of course richer. So I think one of the things that happened is that for the United States, one way of thinking about it is that all this desire to hold dollars was actually a contractionary shock for the real economy. And the Fed pursued by and large a pretty accommodative monetary policy.

So this environment that you describe ­­ quite an accommodative monetary policy, financial sector liberalisation, a huge demand for US safe assets ­­ was essentially a low interest environment. And in this environment, I think two interacting things happened in the US, and therefore the world financial sector.

There's one thing we have to back up to because it's in my present book, not in the previous one. Because it's very important. I think the very environment you describe ­­ very low interest rates particularly on the long end, and quite low interest rates at the short end ­­ also was the main reason why we got these huge increases in house prices. And that helped create the demand that the economies needed, particularly in the US.

So here we have an environment with low interest rates, rapidly rising asset prices, highly deregulated financial sector ­­ and the high demand by a lot of investors, here we're talking more about domestic investors, for safe assets, but slightly higher yielding safe assets than the ones that they traditionally bought (like government bonds, which are really very unattractive).

They wanted, as it were, higher­yielding AAA­rated assets. And the financial sector, in one of the most brilliant pieces of alchemy in the history of finance, created almost limitless quantities of this stuff by taking the mortgages, particularly in the US, that were backed by the rising price of housing ­­ people borrowed, a lot of people who really couldn't afford to, some people who could afford to ­­ packaging them into complex securities, getting them rated AAA on the basis of certain plausible assumptions.

And they produced them in quantities of many, many tens of thousands of these securities. Which were then bought by investors, traded in by banks, held by off­balance sheet entities of banks, held indirectly in a rather complicated way by money market mutual funds.

So the whole financial system was built around the enormous expansion of credit in the form of these sorts of securities. And as we know, when it became obvious that house prices were falling and therefore the underlying collateral was declining in value, people started getting seriously nervous about this. That began to become very obvious in 2007. And from then on we were moving glacially but remorselessly to what ended up being a more or less complete breakdown of the credit system in the panic of September and October of 2008.

Okay. Global macroeconomic imbalances setting the stage for the crisis ­­

Providing the fuel for this immense expansion of complex credit instruments and then their subsequent collapse in the revulsion period, the classic crisis period, of 2008. Which I think in most respects was probably the biggest financial crisis we have ever seen.

And I should emphasize that the book doesn't say that these were exclusively responsible for the crisis. They interacted with quite a few other forces including, as you just mentioned, the growing fragility of the financial sector, which I want to talk about in a minute.

But first, to stay on global imbalances, you do propose some solutions to this. They're not simple solutions but here they are.

You suggest [1] more equity financing or equity­linked contracts, [2] better insurance, and I think you refer to a much bigger IMF so that emerging economies don't feel the need to accumulate such big reserves, and then [3] a legitimate global reserve currency. Can you talk about each of those solutions and how they would help?

Well, the first is one of my broader points. (And by the way, I put these ideas together more than most, and perhaps anyone, but I think other people have had these ideas [individually].)

So I think the first thing that I've learned from this crisis in finance ­­ and international finance is just part of finance ­­ is we need more risk­sharing instruments. That means if something goes wrong, there's an automatic process for sharing risk between the people who receive the funds and the people who provided them.

Equity­type contracts have that great virtue. If something goes wrong, the people who put the money in lose some of it. And of course the people who acquired the funds when they did the investment will also lose something because their investment is less valuable. And the difference between that and a debt contract is you have exactly the same obligations in a debt contract until you go bankrupt. And then the bankruptcy is a pretty sudden event and tends to cause panic if lots of institutions go bankrupt at the same time.

So there's a general proposition that equity has this very nice property, as it were: the value automatically adjusts to the changing economic circumstances.

Specifically do you mean the way banks fund themselves or other financial institutions fund themselves, or more generally across the economy?

Here I'm trying to make a more general point. I actually think it's also relevant to the future of financial institutions. Our existing financial institutions are essentially creatures of debt intermediation, and that creates its own problems because they have so little equity funding of them.

But I was thinking in this context more of how capital flows across frontiers.

So if in the Asian financial crisis, going back to that shocking experience, nearly all the funding of these countries had taken the form of FDI, with very little bank debt, then the crisis would have been incomparably much smaller.

So the first lesson is that in my view, emerging countries and developing countries should have a very strong bias towards encouraging inflows of money from abroad in the form of equity or near­equity instruments rather than debt, particularly foreign­currency debt.

That's actually very important. And we are seeing this right now with a lot of foreign currency bonds, exactly the same problem. Because again, if there's a big shift in exchange rates, and that's very common, if you’ve got a lot of foreign currency debt then a perfectly solvent borrower one day can be wiped out the next.

I saw that in Indonesia, in the financial crisis. Because its currency collapsed and lost four­fifths of its value overnight, and so everybody who borrowed dollars was wiped out. It was a huge trauma.

There is one other interesting equity­type idea which I'm very keen on, which is GDP linked government bonds. So instead of just issuing bonds which have a fixed coupon, the value of the bond would depend on what happens to GDP. So if GDP goes down, the value of the bond will go down. And if GDP improved, the value of the bond would go up.

And I thought quite a lot of Westerners would be quite interested in taking on such assets because, on the whole, in the long run emerging countries should grow faster. And that would be a very good thing.

The second idea goes back to the very beginning of the International Monetary Fund at the Bretton Woods Conference in 1944, in which Keynes was, with Harry Dexter White, the big player. And his idea ­­ though at that stage he was absolutely determined that there shouldn't be freedom of capital movement at all; he was just talking about trade ­­ was that countries needed to have insurance. That if something went wrong ­­ there was a terms of trade shock or a sudden collapse in demand for their exports ­­ that they wouldn't have to impose massive austerity and go into depression.

So he would have been aghast by what's happened to Greece for example.

The idea was that we created the International Monetary Fund as a sort of insurance arrangement. But of course the International Monetary Fund has become, though it was increased significantly during the crisis, a very small fund. It has about a trillion dollars in usable assets. It changes with the value of the currencies that it holds. But it's about a trillion dollars. And now we have freedom of capital flows too, so we actually have liberalized.

And that means that for most large­ish countries, the IMF is basically useless. If you get into a serious crisis, it's not going to be able to help you at all.

Just to give you a contrast, and I'm not suggesting the Chinese would ever be willing to borrow this money, but they've held until quite recently about four trillion dollars of reserves, and they're not sure that's enough.

And so one trillion isn't enough. So I argue that if you want to encourage emerging economies to feel comfortable with taking the risks of capital flows, being exposed to the world system in this way, they need a bigger fund, more insurance.

Now, the final idea is far and away the most ambitious, and I think very unlikely to happen in my lifetime.

But the problem at the moment is that the one really usable reserve asset, or the one and a half ­­ there’s the dollar and the euro, really. If you don't hold the dollar in very large quantities or have the immense advantage in being able to print it, and suddenly there's a run on your country because people want their money out in a very big way, you're going to run out of cash to meet this very, very quickly. Your currency will collapse. If you've got a lot of foreign currency debt, you're going to have a bankruptcy crisis, and you’re going to go into a very deep recession.

Which is what I worry might now happen to a lot of emerging economies. So the idea is: let's create an international reserve asset, create it collectively. That was what the special drawing right, the SDR, was supposed to do.

And that is of course the most radical idea ­­ move to global money. Now my own view is that's clearly not something that’s in any imminent prospect.

But I do think it is worth stressing that in a completely open world economic system, where everybody is exposed to the world system and has the risks associated with that, the lack of a credible global money, other than that produced by one country, obviously creates an extreme bias in the system, and an extreme instability in the system.

There tends to be a run into dollars when anybody is nervous. That forces huge adjustment pressures on the US. And that's part of what led to the crisis. And I think it's happening again. And the only alternative the makes any sense, apart from going back to a world of exchange controls, is to have some form of world money.

So my guess will be that in the very long run ­­ if we're going to keep a global economy, and I'm not sure we will ­­ then we're going to have to end up with some sort of world money.

There is an interim possibility. Which is to extend more widely the swap lines that the Fed provided during the crisis to a number of trusted central banks. You could imagine it's in theory willing to do that more generously, but of course that would be very controversial in Congress.

Okay, that's macroeconomic imbalances. I was struggling beforehand with whether to switch to financial stability or monetary policy. But as it happens, there's one thing in your book that you explore in considerable depth that links the two things together, but that also seems fundamental to a lot of the other problems that you write about.

And that's the way that money is created. We have this system where new money is created based on the decisions made by privately run banks. And you have monetary policymakers, central bankers, which are left to indirectly try to influence those decisions, but don't do so directly.

And what I mean by that is this. (This is a again a simplified example but it will have to do for now.) When a bank makes a commercial loan, the way new money is created is that the bank essentially now has an asset, which is that loan (the money it's owed). And it credits the borrower with deposits held at that bank: that's the new money.

So you don't have a central bank that's directly injecting money into the money supply; it controls the monetary base, and it can use the monetary base to try to influence the creation of new money in the money supply.

But actually the way it works right now is that banks, privately run banks, create the money and influence the money supply. This I think is the synthesis that you describe in your book as what creates a lot of the financial instability that you write about. But it also presents a very tricky situation for monetary policy. Do you want to start by telling us why this issue is so important?

Yes, I think you’ve described very accurately ­­ obviously, inevitably, in a simplified way ­­ how the monetary system works. I think it's become increasingly obvious that in a more complicated way still, the so­called shadow banking system creates money in much the same way.

Now. What is the problem with a monetary system of this kind? In which nearly all money, what people regard therefore as absolutely safe liquid assets ­­ what companies, individuals regard as safe liquid assets, which they hold for all conceivable rainy days, as well as for transaction purposes. This is created as a byproduct of the commercial decisions of certain classes of private financial institutions.

The awareness ­­ that this is the essence of our system ­­ has been there among economies since the nineteenth century. It’s not a new idea.

But interestingly, much of economics has proceeded as if it didn't matter.

And the assumption was that the government agency, the central bank, was able to control this reasonably well. And it wasn't likely to cause any huge systemic problems in a well run country.

Now in the last hundred years we've had at least two examples in our major economies where that turned out not to be the case. The first was of course the Great Depression, and the second was the crisis of 2008.

What is the danger? Well the danger is fairly simple ­­ simple to describe, complex to deal with.

Here we have all this money that is created by these financial institutions. That gives them the ability ­­ their debts are money ­­ if they see good opportunities (this is a point the great Swedish economist Knut Wicksell made back in the nineteenth century), they can expand credit without limit.

If the opportunities look good ­­ interest rates are low, the economy is booming, there are good assets against which to lend ­­ they can create credit without limit. And that's more or less what happened in the run­up to the crisis.

In the process of creating credit without limit, two things happened. One is that they take on increasingly risky assets, as the asset side of their balance sheet. And secondly their liabilities and assets expand very rapidly relative to their equity base, their capital base (the base of genuinely loss absorbing equity capital they have in their businesses).

So leverage rises in these institutions. So you get much more credit. You might get more bad credit. And you get much more leverage in these institutions.

Now at a certain point, if people begin to realize, “Actually those assets in these big banks, we don't really know what they are, but there they are and they're clearly going down in value”, and the paper they're holding, which is backed in some very complicated way against those assets, is declining in value ­­ and you can see that because they're declining like mad, and people don't really trust these banks, and you can see that in the equity capitalization of the banks ­­ people start saying to themselves, “Maybe the money I've lent to these institutions isn’t really safe”.

What was important in this case is there was, of course, the money that ordinary people placed in regular banks, which were backed by deposit insurance, and that was safe enough ­­ but that was very far from all the liabilities of these banks.

They funded an enormous amount of their books through something called the repo market. You know all about that. They had a large amount of corporate deposits. And in this world there was a panic­stricken revulsion from all those sorts of liabilities. There was a real run on the bank into Treasuries.

And that ended up by freezing ­­ because the banks are so central to it ­­ pretty well all the other short­term paper markets, like the commercial paper market, which is where a lot of the biggest corporations funded themselves, because they seem just too similar to all the other markets. And they were also ones in which the banks played a very large role.

So there was a comprehensive flight. And quite suddenly a huge number of financial institutions found they couldn't fund themselves anymore. They had to go to the Fed.

There was one other factor. The banks had been a little bit aware that they did hold large amounts of really quite risky assets in these very complicated structures. So before the crisis, they had wanted to insure themselves.

And institutions came forward to provide this insurance. The most famous in this case ­­ I'm just focusing on the US ­­ was AIG. And that looked an amply lucrative business to AIG, because they thought nothing could ever go wrong. But then, when the banks started asking if AIG could pay up, they realized that they couldn’t.

So the crisis then afflicted AIG. So what was happening was a comprehensive meltdown. And the one final thing is that a lot of this this occurred in off balance sheet structures, which were really affiliates of banks, but not within the banks' balance sheets. That made it very non­transparent.

The banks had told the regulators, “well these aren't really our responsibility”, but as soon as the crisis hit, for reputational reasons they couldn't just tell all the people who put their money in these vehicles, “we don't care about you”, so they pulled them all back into the balance sheet ­­ and then suddenly you did realize how leveraged they were.

So this I think is more or less what happens. And this is a very extreme example of the general proposition, which is this: People, companies, ordinary people hold money ­­ the stuff that has to be safe, whatever happens in an uncertain world ­­ in private, profit­making institutions that cannot meet those obligations in bad times.

Yeah.

And that creates always a permanent risk of a crisis, which we met over time by ever increasing the insurance provided these institutions ­­ central banks providing liquidity, deposit insurance, and now, straight­up bailouts ­­ which of course create so­called moral hazard. They encourage people to take more risk and make the financial sector, in good times, ever riskier.

I really like this way of looking at it too. That these banks and investment banks funded themselves by pledging, as collateral, assets and securities that their lenders believed to be safe as money, that for all intents and purposes to them was money ­­ yet it turned out ​ ​ that actually that was just a perceived safety, and the perception was wrong.

But because of the opacity that you just described, it also cast doubt on all the other collateral, some of which might have been perfectly good collateral, but nobody knew. And so you had a run and that was the crisis.

And in The Shifts and the Shocks, possibly the most radical idea that you present is the ​ ​ separation of credit and money. I want to emphasize to our listeners, by the way, that you do acknowledge the political difficulty of moving from the system we have now to something that separates money creation from credit provision.

But can you talk about how that would work? And then maybe take us through some of the difficulties of getting from where we are now to a world where money and credit are distinct.

Before that, I’ll just mention that the simplest set of alternatives to this system are ones which simply say, “Well, if this is the sort of financial sector we have, we can’t have it leveraged twenty­five to one, or thirty to one. Maybe three or four to one.”

Which is the way it was a hundred and fifty years ago or so.

So that there is just much more loss­bearing capacity in the system. And that would reduce very significantly the danger of panics.

Higher capital ratios.

Yes. That itself ­­ by the way, of course, there have been moves in this direction, but the sort of moves I've described here are associated with the work of Anat Admati and Marty Hellwig in their book, The Bankers’ New Clothes ­­ even this will be of course incredibly radical, and the ​ ​ banks would fight it to the death.

And have.

And have ­­ and they have won, of course, because they are such powerful interests.

But the more radical proposal still ­­ actually since then I’ve also come across an even more radical proposal, but which I think is too complicated to explain easily ­­ but anyway the more radical proposals take the form, very broadly, of a variant on what is called the Chicago plan.

And interestingly this plan was put forward first in the 1930s, by some very distinguished and mostly very free­market economists ­­

Henry Simons, Irving Fisher.

Yes, who came to the view, which is the view I hold now ­­ because it's not something I thought before ­­ that the credit system, this bank­based credit system, is the Achilles heel of the free market economy.

If you have a situation in which money ­­ which is a public good, has true public­good properties, so we absolutely rely on its safety to continue operating our economy (I won't go into the possibilities of money­less economies, as that's another set of issues) ­­ so if you have money created by these sorts of institutions, panics are inevitable. And the Great Depression was an extreme example.

What they suggested instead is that deposit money, or money that is available on demand, which you can withdraw at par (this is crucial: you put your dollar in, and you're confident that you get a dollar back, a nominal dollar but it’s a dollar) ­­ those promises have to be safe, and the only way you can make them safe is to insist that the banks hold money as assets as well as liabilities.

And the only money they can hold that is that safe are the liabilities of the central bank. And so that means essentially that as far as money is concerned, there is only one institution, the central bank. And the banks in this respect are just branch plants of the central bank.

You can perfectly well close the banks and just say that every individual can have an account at the Federal Reserve. And if every individual had their bank account at the Federal Reserves, or in this country the various regional Feds, and they provided basic checking and payment services, there would never be a run.

I think that's pretty clear. Everybody would know this money was perfectly safe.

And you could take your money and put it into other institutions, which would then invest it for you, but they would invest it in assets whose value, everybody would know, would go up and down, depending on market price. They might be equities, they might be bonds, whatever they might be.

And you would be told regularly of the value of this. And it will be made utterly clear to you that there was no promise to redeem at par. And if there was a generalized run on the particular assets in question, you might lose a very large chunk of your value. And that's just how it is.

So there will be the intermediation system that would have those characteristics, and there will be the money system.

And it would be functionally equivalent to an intermediation system that's one hundred percent equity capital.

Yes. Though it's equity on the side, as it were, of the investor. What it would mean is that if you put money into something every day, or every week depending on the nature of the assets, the value would go up and down. And that would depend on the other side of the particular balance sheet. There could still be debt instruments in this structure, or in one version there would still be debt instruments.

But the debt instruments will be held either directly by the individual or through intermediaries that were passing on changes in the value of those debt instruments to the public daily.

(Banks for example, right now have these all these debt instruments in their portfolios ­­ in fact most of their portfolios consist of debt instruments ­­ but they don't pass it through to the depositor. They tell the depositor that he or she still has the dollar. And that's the problem: if they lose enough of the value on their debts instruments, they can't meet that promise and that's why the panic arises.)

This then becomes a world which is far closer to being essentially one in which intermediaries don’t take risk. Risk is borne by the ultimate a provider of the funds.

That limits significantly the sorts of funding that can be provided, but it gets rid of what one could argue is essentially a fraudulent set of promises ­­ a set of promises to treat money as money when it isn't really money. When it isn't really safe in that way.

Now the problem with this [plan] is that ­­ and I'm increasingly aware of this, thinking about this more and more ­­ in this new financial non­monetary system, people (being very ingenious) will find ways of making near­money promises.

There’s always an innovator somewhere, right?

Take money market mutual funds, for example. My view is that when money market few mutual funds came along, they were making near­money promises. And they were holding risky assets, so they should be required to hold capital like a bank. and they should have been told, “you're a bank”. But of course it's often very difficult to impose these things.

The big risk is that in this world, where banking will be pretty boring, people will start wanting to hold other forms of claim which are a bit like money, if not completely like money. The shadow banking system will re­emerge, and the regulators will have to go around saying: “Sorry, you are making promises you can't keep. This isn't legal. This is not something you're allowed to do.”

And I think this is an immensely difficult regulatory process. The likelihood must be that over time this process will re­emerge. And that’s obviously the great danger.

The question then is whether a system which is clearly more logical, clearly safer, in which risk is really spread rather than supposedly borne by incredibly undercapitalized vast institutions (which notionally bear pretty well all the risk in the system) ­­ It's very weird that we have allowed this to happen, that these huge behemoths are supposed to bear all the risk of holding all sorts of risky assets on one side and have all these absolutely guaranteed promises on the other [liability] side.

We have allowed that to happen and it’s very, very unsafe. It's logical to separate it out, as I've said, but it's unquestionably very difficult to do. And it does involve really radical transformations of the financial system we have.

But if we leave it as it is now, I think we can be absolutely confident that we're going to have more huge crises.

I might even respond to that criticism by saying “don't let the perfect be the enemy of the good”. In the 1930s, when deposit insurance was introduced, it was in exchange for much stricter regulation of the banks.

And you know what? Eventually the rise of securitization did allow financial institutions to innovate their way into making into making money­like assets for their customers, or their investors, their lenders ­­ BUT it took seventy­something years. That's not half bad.

That is certainly something. I think if regulators are determined to be ahead of the financial institutions ­­ and they understand the incentives in the system to create pseudo­safe liabilities in order to attract people to hold those liabilities, and allow the institutions to expand and to make the money by taking risk in the good times, and dump it on the state in the bad times ­­ if they understand that properly, maybe we can do a better job than we did last time.

Certainly that's the sort of direction in which I would want to go.

END OF PART 1

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PART 2

So that's the direction in which we want to go. Let's talk about the world we live in right now for a minute. And this is this is a tangential but still related topic: macroprudential policy.

You don't argue against macroprudential policy in your book; you in fact write about some simple ideas for it. But you also write about the fundamental tension between macroprudential policy and monetary policy ­­ and how those things are at cross­purposes sometimes. You want to take us through that argument?

Yes. It's a complicated argument. (No doubt one of the problems with the book is that there are so many arguments.)

This is the way I think about it. Let's give a practical example. Think back to the early 2000s in the United States. There is a widely shared sense that Fed monetary policy from about 2001 to 2003 was too easy. And it's certainly a widely shared sense that they tolerated one consequence of that (though it wasn’t just a consequence of monetary policy; there were other things going on, as we’ve just discussed), which was soaring house prices and soaring lending against house prices.

My argument is that's basically how monetary policy worked at that time. Let's suppose that Mr Greenspan’s Fed had had a somewhat different view of what it should be doing, and had said, “Okay, this house price boom is terrible. We are going to do something about that by increasing substantially the deposit requirements in the loans” ­­ so reducing sharply the loan to value ratio, which is a very simple and obvious macroprudential measure.

Sure and by the way, this is my fault [for not having done so earlier] but I should define macroprudential policy a little bit. It's the idea that if you're going to have monetary policy trying to govern the economic cycle, and if you're going to have unimpeded or nearly unimpeded cross­border capital flows, then regulators should be taking care to make sure that the lending that goes on in the economy is prudent.

Yes, is safe, exactly. And above all with a view to saving the system as a whole.

So it's to look at the whole system ­­ in this case, they would be looking at the system and saying, “There's far too much lending against the collateral of housing going on, and real estate more broadly. It's cumulatively unsafe, so we will discourage the lending”. And the best way, the simplest way ­­ there are many various ways but the simplest way ­­ probably is to say that the loan to estimated value will be reduced.

And the effect of that for the economy as a whole will be like an interest rate hike. It’s a tightening of monetary conditions, or of lending conditions.

So the Fed would then find that its monetary policy, which is the policy that it’s chosen in order to meet its inflation target, was less effective. Because the Fed would find that its own policies had prevented the lending that would normally make that policy effective.

So the Fed, I think, would probably have had to conclude that “well, what we have to do is lower interest rates”.

And in this situation ­­ I’m not saying that it’s completely unworkable ­­ the monetary policy arm of the same institution would have to act against the macroprudential arm. Because the macroprudential arm’s actions will be making the monetary policy arm’s actions less effective. And you could clearly imagine a war between the two.

Now there are ways around this. You could imagine the effect then of monetary policy largely on exchange rates. But for the world as a whole that doesn’t make sense ­­ and for the US, pursuing an exchange rate dominated policy would be really quite destabilizing.

So I think you have to recognize that macroprudential policy is also a monetary policy tool or bears on it.

So I make two points in this respect. One, you have to do them together. There's no doubt you have to do them together. And second, you have to recognize that you will in certain circumstances really be fighting one another and it's not clear how that's going to end up.

I guess one of the reasons that this topic is so important is that it relates to one of the big themes that economists and economic commentators have been talking about in the last few years: secular stagnation. It was I think re­popularised by Larry Summers, but of course it was an idea dating back to the 1930s. But it's basically the idea that you can either have financial stability, or you can have adequate economic growth, but you can't have both, for structural reasons.

I think you are fairly agnostic on the extent to which secular stagnation is a permanent phenomenon. But do you want to talk about your own views on how much it's affecting economic growth, especially in advanced economies now.

I think it is clear ­­ and I didn't have the nerve to use this term ­­ but it's been clear as a central theme of my writing as a columnist and also in this book, that we have suffered from chronically weak demand for a very long time long, since long before the crisis.

That's one of the reasons monetary policy had been really quite aggressive even before the crisis, except for a relatively brief period from late 2004 to 2006. And that's been made worse by the consequences of the crisis ­­ debt overhangs, damage to the financial sector, damage to confidence. All pretty clear.

The effect of this is that in the major developed countries, aggregate demand has tended to be really very weak. And in recent years the single most potent indicator of that is that we pursued what would be, by most historical standards, extremely expansionary monetary policies, with incredibly low intervention rates near zero and rapid expansions of balance sheets of the central banks, so­called quantitative easing, with remarkably little effect on demand. Demand has been weak or very weak.

That suggests there is a sort of chronic demand problem in our economies. And that's what secular stagnation is about. It's not about supply, though that's relevant too. It's about demand relative to supply. And it seems to me the clearest indication that we have a serious demand ​ problem relative to supply is how low equilibrium interest rates seem to be.

And of course this is reinforced and underpinned by how low long­term real rates seem to be, in the neighborhood of zero. And have been for years.

The monetary environment we've had since 2008, now getting on seven years, has no precedent as far as we can see. It is the most expansionary in design ever, with so little ​ ​ consequence. So I think that’s secular stagnation.

That's where we are. I think it's because of (we've discussed a few of them, not all) profound shifts in the world economy. I think the evidence seems to suggest it's going to be enduring. Indeed it seems to me quite possible, not certain, that what's happening in China today will reinforce it.

Let me again emphasize it's about the growth of demand relative to potential output. So it doesn't mean complete stagnation, just a collapse of demand relative to the growth of potential output.

And it does seem that we need incredibly aggressive policy to sustain a reasonable level of demand. Maybe we'll get another financial sector boom going ­­ that's the financial instability point ­­ but that could lead us to another big crisis.

Now, there are really radical things you can do about this. And the most radical one ­­ which actually brings us right back to our discussion of 100% reserve banking, or government creation of the money supply ­­ is of course an idea promulgated famously by Milton Friedman. Which is you take the whole business of creating money out of the hands of the private sector on an emergency basis.

He called it helicopter money ­­ you just distribute money from helicopters. Well that's not, obviously, what we would do. But we would basically just send money to people, and the central bank would fund that, and it will be a permanent increase in the monetary base.

The people would no doubt spend, and we would get rid of the demand problem.

But of course people are very terrified of the longer­term consequences of that in many different ways. No one has dared yet to say they're explicitly doing it, though I sort of suspect, when we look back thirty years from now, we'll have seen that the Japanese are doing that now. (Though they pretend they’re not.)

But it's not that there is nothing we can do in these circumstances. We can go to more negative rates. Zero isn’t the lower bound; we can go to negative rates, we can see that. We can change the inflation target, though I don't think that would help much, to lower real interest rates further.

But we're getting to the point where it is reasonable to worry that conventional, or even unconventional­conventional policies, aren't enough.

And if we have one more ­­ and this is a point I made very recently in a column ­­ it seems to me that one more serious negative shock for the world might well lead us into this sort of territory. Looking at the world economy right now, it’s not terribly difficult to imagine such shocks happening. And I presume that's why the Federal Reserve just now decided not to raise rates.

I should mention that you write about this in the new afterword to The Shift and the ​ Shocks, which you just finished. You have a kind of ascending level of potency for ​ monetary policy.

You start with inflation targeting, which you think is better than what we have now, but wouldn't be that useful.

And then you have nominal GDP targeting.

And then on top of that, you have nominal GDP targeting backed by helicopter financing.

By the way, full disclosure, this is also my preferred way for the central bank to move forward. But at the same time, I sort of understand the political objection here, which is it looks an awful lot like the monetary authorities injecting themselves into fiscal policymaking. How do you get around that?

Well, this is what I've always felt: In an ideal world, if we were in extreme crisis, certainly in the past I would rather this were done by cooperation between the two.

In that case, what would have happened is, to put it very simply, the fiscal authority decides to run a larger fiscal deficit (we just slash taxes, or if you're doing what Jeremy Corbyn calls People's QE, increases in investment), the central bank buys the bonds, that's agreed with them, and the bonds are cancelled.

It's essentially monetary financing of a fiscal deficit. It’s a fiscal decision, and it's made in extreme circumstances, and it continues until the problem goes away. That gets around the fiscal cooperation problem.

But if you think that the fiscal authorities are not prepared to contemplate such an idea, and cooperation will be very difficult, you could possibly imagine the argument ­­ this is the argument some friends of mine are putting forward, and I haven't yet written about it so I don’t know what I really think about it in terms of the politics ­­ is to basically say: “Look, you're doing this in order to raise inflation. That's a monetary policy objective, there's no doubt about it. And the central bank could be given this, since it's part of the government, as an additional instrument.”

The obvious way to do that would be simply to say that the central bank will be entitled to have, from the tax authority, the names of all taxpayers. (Ideally you’d want the names of all citizens, certainly all adult citizens. Countries which have large welfare states like ours [the UK], effectively they’re part of the revenue system, so it will be everybody. The US might be somewhat different, but you’d have to get around that from a technical point of view.)

And then you simply decide to send, I don’t know, three hundred dollars or four hundred dollars into every account. It would just appear and they will be entitled to go and spend it. And it will be a monetary policy instrument in more or less the same way that when the central bank goes out and buys trillions of dollars of US bonds from the market, the money ends up in the accounts of all the people who sold the bonds ­­ and they don't really ask how the Fed created it.

So you could argue that, if it was given that authority, this is basically in pursuit of a monetary policy objective, which is to get inflation up. And it will continue until the monetary policy objective is fulfilled.

I think there are some problems with that from a political economy point of view. But it will be acting under its delegated authority from the political system to raise inflation. So I wouldn't be as worried about it as I was in the past. I wish we weren’t here, but it does seem to be where we are.

Sure. The connection between the stagnationist idea and inequality has been raised quite a bit by economists; in the US a couple of the most prominent economists that have brought this up are Amir Sufi and Atif Mian, who’ve said that essentially rising income inequality leads to people who are lower on the income scale to borrow more money.

And that if you have to generate demand through this kind of debt finance, especially when they borrow against their homes and things of that nature, you're just feeding fuel to the fire of the next financial crisis. So in terms of structural ideas, do you think this is a fundamental part of what needs to be fixed?

Well, what I do think ­­ lots of ideas, some of which are new to me ­­ but I do think that there are two other very, very big things going on. Perhaps three, but two of them fit together.

One is exactly what you said: the general shift in the distribution of income among households, away from people who spend most of their income to people who inevitably save most of their income.

And that has happened across much of the world. There are some exceptions. But it's generally happened. And in much of the world the fiscal system is not much of an offset. So the net effect I think has been to increase desired savings relative to investment, and lower equilibrium interest rates.

The second thing ­­ which I think is perhaps equally important and not discussed enough, but it’s in my book ­­ is one aspect of the shift in the distribution of income, the functional distribution of income as sometimes economists call it, between labor and capital.

Profit shares are very high in all our economies. Exceptionally high. Average returns on capital are correspondingly very high. That raises itself interesting questions. Average returns on capital are very high, but then you’ve got the puzzle, which is the other side of the story: investment is rather weak.

So the result is that the corporate sectors ­­ the non­financial corporate sectors ­­ of the West, or indeed of the advanced countries because it includes Japan, have had a strong tendency secularly (not every year) to earn more in profits than they invest. And therefore they're transferring a lot of this money to their shareholders, who are relatively rich, and that augments this excess­savings condition.

I do think that these two aspects of the income distribution ­­ the income among wages going to the top (wages and salaries going to the top) and between labor and capital more broadly ­­ linked with this very weak investment demand, which is being driven by demography, and itself driven by weak growth (so it's a vicious circle), is part of the reason why demand is structurally so weak and why we have ended up in this real­interest and nominal­interest rate trap close to zero.

I want to link what you just said about the dearth of investment to something you write, also in the afterword, about productivity growth. You make the point that people tend to view the recoveries in the US and the UK sometimes through essentially rose­tinted glasses ­­ that they see lower unemployment obviously than in the rest of Europe, and they might conclude that, well, some of the policies that were employed [in the UK and US] seem to have worked.

Your point is that actually if you look at the growth in living standards, that has still disappointed. And one of the reasons that we see the low unemployment is not because those economies are so strong, but because productivity growth has been so low ­­ that if productivity growth had been closer to its historical averages, unemployment would have been a lot higher.

And here's what I want to do. I want to quote something that you wrote [in the afterword]. Here's what you write about productivity growth and specifically weak demand. You say: “Weak demand caused weak supply, as a result of low investment, and weak growth caused weak demand, again principally as a result of the weakness of investment. This, then, was a vicious circle.”

This is I think something that Larry Summers called a “reverse Say's Law” ­­ Say’s Law being the idea that if there is supply side growth, then the demand will show up, magically or mysteriously or whatever.

This is the exact opposite. This is that weak demand leads to weaker potential growth, weaker supply.

How big a problem is this and what do we do about it?

I have a strong suspicion ­­ though it goes very much against the way economists think about the cycle; it brings me back to the way we used to think when I started economics in the 1960s ­­ that this is very, very important.

Economists like to think there is this supply potential which is sort of God­given, as it were ­­

The laws of the universe!

­­ that it’s just out there; that there’s a supply potential which is growing, and demand policy is just cyclical, and it’s about making sure (because it’s very wasteful otherwise) that demand goes close to supply.

But ­­ actually this is a point Paul Krugman makes, but it's a more general point ­­ if you actually look at the experience with large recessions, really large recessions (and this is particularly dramatic in this case, though it was also clear in the Asian crisis) estimates of potential supply converge on actual supply remarkably quickly.

If you look to the estimates of potential supply that were being produced by the IMF back in 2006 or 2007, or any such institution ­­ the OECD for example assumed until quite recently that potential supply would go on growing as it did before, as it had done (as I have shown in various articles) for decades and decades and decades. And that was a reasonable assumption.

But now, in most of our countries, actual supply is roughly a sixth below its pre­crisis trend, which is an enormous shortfall.

And lo and behold ­­ not surprisingly because as I've said, given that potential supply is always assumed to be close to actual supply ­­ we've now decided that potential supply is also pretty close to a sixth less than what we thought before.

But you have to ask yourself: what happened apart from the collapse in demand to explain this staggering collapse in potential output?

There are only two [possible] explanations for that.

[1] For some reason that had nothing whatsoever to do with the crisis, innovation, ideas, productivity growth just died. Well that seems incredibly implausible.

It seems that if it happened after 2008, surely it happened because of it.

[2] Or it collapsed because investment collapsed. And we know that investment collapsed in the aftermath of the crisis; it did everywhere.

So my argument is that potential output, the supply potential of the economy, does indeed tend to converge on actual output.

Because actually business doesn't waste much time developing the possibility of being able to produce much more than it ever thinks is going to be demanded. It just develops the capacity to produce what is demanded.

It’s also true, I think pretty clear, that innovation slows in a huge crisis. And again I think it's pretty obvious why: in very depressing circumstances, business fights for survival. It doesn't do these fundamentally innovative long­term things.

So I would argue ­­ and this is very much in keeping with the way many Keynesians thought in the 1950s and 1960s ­­ that actual supply and potential supply converge, and that actual supply is driven in the short to medium term by demand.

So if we pursue really bad demand policies, it’s not just about making a mess, losing a lot relative to the potential supply which is God­given; we actually make potential supply worse.

And that's incredibly important because it makes the argument for reacting very strongly to crises to get actual demand and actual supply, and so potential supply, up. It’s even more important because otherwise we lose an enormous amount forever.

And the evidence we have at the moment for the US and UK is that unemployment is low, which I think is wonderful (though the US has other labour market problems which are very important) ­­ but it looks as though the potential output in our economies is about a sixth below the pre­crisis trends.

The growth rates of potential output are also below trend, though that’s a separate and very important point, and these are enormous losses into perpetuity.

This is my last question before very quickly we take a couple of reader questions. There's so much more that I want to talk to you about, but I'm going to focus on Europe for a second because it'd be derelict not to ask at least one question about Europe, given that you write so much about it in the book.

One more quote. You write: “The eurozone must generate symmetrical adjustment, debt restructuring and further fundamental reform, including of its fiscal arrangements.” You mention banking union, a euro bond market, the restructuring of private debt.

Why is that good? Why is that better than just breaking up the eurozone?

Well, very good question. There are two answers to that.

The first is that they really, really don't want to break up the euro zone. And they're going to fight very, very hard against it.

And to some degree, I think sensible economists have to answer questions by policymakers which say, “Given that we have this overwhelming objective X, which you might or might not think is a sensible thing, what is the least bad way of doing it?”

And economists, it seems to me ­­ I remember this well in my days at the World Bank ­­ have to answer questions like that all the time. Because telling their political masters “Well if I were you, I wouldn’t try that” is usually not very helpful. They have their objectives, and you should try to help them (unless you think they are fundamentally evil). You have to try to help them deliver on those objectives as best they can.

And the second reason, which is one I actually share, is that ­­ though I think the creation of the currency union was a pretty serious mistake, and I have felt that pretty consistently for a long, long time ­­ undoing it is a really difficult project, with immense risks. Economic risks, and risks to the whole survival of the European project more broadly, which I believe in.

I think if all the nations of Europe were on their own, deciding things on their own, then as we’re beginning to see with the refugee crisis it’s going to be an unspeakable mess.

We are neighbors. We depend on one another. We are all, physically, incredibly small countries. We’re all tightly packed together. And when we’ve been on our own, we’ve tended to make a terrible mess of things.

So I think the breakup of the euro zone will be a disaster for the political project. And therefore the right thing to do is make it work.

Unfortunately, though I think the European Central Bank's actions have helped immensely, and the willingness of people to bear pain has helped immensely, I think it remains a very, very fragile project.

The failure of symmetrical adjustment (which basically is why inflation is now so low and falling), the failure of debt restructuring means that the crisis­hit countries are going to emerge from this crisis with immense debt burdens; with still very high unemployment; with the loss of very many of their skilled labor force, their young people; and very, very weak economies, and in no position whatsoever to cope with future crises.

And they're going to come.

Okay, a couple of reader questions. I've condensed them into two. Because actually we fielded quite a few listener questions, but they all ended up being about one of two topics.

The first topic is about your home country, and the FT’s home country, the UK. And I'll just read one of the questions, but you can be assured that the rest were very similar.

This comes from an Alphaville reader called BBB+.

“Could you ask Martin whether and how much fiscal space the UK has to borrow more (in order, ideally, to spend on useful infrastructure, housing etc)? And what would be the effect of rate rises (whether incremental or sudden) on the UK's cost of borrowing?”

He goes on: “I am trying to understand the Chancellor and the Treasury's obsession with saving money ­ I don't really believe it is just ideological or ignorance of sound economics.”

What do you think?

Okay, let's be fair to them. It is true that the fiscal space ­­ like much space, you never know when you're going to run out of it until you do.

So for all I know, no one will be willing to lend anything to the British government, apart from the central bank (which has to), if they borrow another pound.

But it seems to me, therefore, we don't know BUT we have to make a judgment.

And I would make a couple of fundamental judgments as to why I'm pretty optimistic there's a fair amount of fiscal space. Or three.

First, if the government borrows, if it had made these decisions five years ago and prepared a credible, high­quality investment program with institutions that made that obvious, these would be a series of projects and programs which were one­off, so there's a defined limit to the amount of borrowing that is done. They have defined returns. You do it over ten years or so. I think most people would say that's actually going to raise our future growth rate.

And if you're moderately optimistic about multipliers ­­ that's less important now probably than it was a few years ago ­­ it's really quite plausible that this would pretty nearly pay for itself. So I think people could have been pretty relaxed about that sort of program, for that reason.

The second point I would make is that there are structural reasons in the world economy, which you've already discussed, why we are chronically short of high­quality borrowers who want to invest.

And while the UK government is not the US government, there aren’t many governments out there with a with a better credit rating and better long­term credibility in terms of meeting their fiscal objectives. And one of the ways you can show that is the capacity of the government to pursue an austerity program. We're not Greece!

And therefore I think if the British government had said,”We do intend to do such an investment program, it is credibly one­off, and we will do it while closing the current budget deficit” ­­ so it's clear the current budget deficit is under control; I just would have sold that with more tax rises and less spending cuts ­­ then I think it would have been quite easy to for them to convince markets.

And the third reason is ­­ and I repeat this endlessly ­­ is that that our current debt levels are by historical standards really quite low. Now it's true we have some contingent liabilities and that's quite important.

But it's important to remember that over the last three hundred years (and we have data on the UK for more than three hundred years) most of the time in fact, on average, the debt levels were much higher. Much higher than they are now. They're really very low.

One of the things people forget is we went into this crisis ­­ and this is why the criticism of Labour is really exaggerated ­­ with among the lowest debt to GDP ratios, gross and net, in the entire history of the UK as a financial entity, or since the late 17th century.

So for all those three reasons, I think this would have been pretty close to riskless. I argued back in 2010 that the decision was ill­timed, that Britain was not Greece. That the adjustment of the exchange rates would solve most of any difficulties people have with holding UK assets.

And I think all the evidence we have had since then ­­ which includes, I should have stressed, the fact that the British government did in fact overshoot its targets, thank God, but that shows that there was no real constraint ­­ that the UK government's fiscal position is not the main reason to determine current policy.

And I think the government's policies were, and are, a mistake.

The second topic won’t come as a surprise. This is the last question. Most of the questions that we took about this took the form of “well, what do you think about Janet Yellen’s decision not to raise rates?” ­­ or, when they were submitted before [that decision not to raise rates] “do you think she should?”

I will rephrase it using my own words. We talked a lot about some of the more radical ideas that monetary policy should adopt. But let's talk about what Janet Yellen should do now within the framework that she is very likely, for now, to work within.

So the idea being that tightening consists of raising rates and the most plausible ­­ very unlikely but the most plausible ­­ kind of loosening again would take the shape of more quantitative easing. And then there are things that they can do using the language of the Fed: forward guidance that kind of thing.

What do you think would be the most appropriate course of action for the Fed?

The way I see things at the moment is that the US economy, in and of itself, is quite finely balanced. The economy is not performing too badly. The labour market has certainly tightened. And if you were looking at it by itself, it's perfectly reasonable to say: we expect monetary policy to tighten slowly in response to the strengthening (though not particularly dynamic, indeed very disappointing) recovery of the US economy.

That’s the sort of starting point, which is more or less, as far as I can see, what they’ve been saying: the tightening will be slow, and it would not come to very high levels.

And obviously, I presume from a technical point of view, much of it would come through changing the interest rates paid on reserves ­­ given that they can't, without dramatic moves on reserve requirements (which I'm not opposed to), they can hardly make banks short of reserves these days given how much they hold.

So that would be the central value. But I would add to this a pretty important codicil. The US is part of the world economy, a very big part. The world economy’s long­term, medium­term and short­term operations are extraordinary uncertain.

We don't really understand what's going on. We don't fully understand why we've been living in this is really exceptional monetary environment for so long. There are very substantial risks out there, which are pretty obvious, in all major economies.

This being so while the expectation is that we will pursue a normal tightening course. Given that the US is a part of the world economy and will be affected by what happens in the world economy, it might well turn out to be the case that we are not able to do so soon.

And it is even possible, though we don't expect it at this moment, that we’ll be forced in the opposite direction of actually having to loosen. And it's this flexibility that is simply an unavoidable consequence of the nature of the environment we live in.

And the very final point I might make, which I think is very important, is: You want us to give you certainty. You want somebody to hold your hand and tell you what we're going to do. We can't do that, because we also don't know what's going to happen in the world. The uncertainty is what we are all living with, the unpredictability of this economic environment.

And ultimately the Fed cannot and must not promise to more knowledge and certainty about the future than it can possibly possess.

Martin Wolf, The Financial Times’s chief economics commentator. This taping ran a bit long, Martin. I apologize for trespassing into your time, but I gotta be honest: I’m not that sorry because this was a real treat. Thanks so much for doing the podcast.

It was a pleasure.